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Avalon Asset Management Company A Choice, not an Echo
“Now is the winter of our discontent made glorious spring by this sun of York.” – William Shakespeare, Richard III
This week’s quotation belongs more to the hopeful category than we’d like to admit. That we are in a winter of discontent seems undeniable, as is our need for a glorious spring. But the economic challenges here and around the globe will present some serious obstacles to the efforts of President-elect Obama to push our economy back into the sun.
For the moment, there is no disputing the amount of hope that has coalesced around the victorious senator from Illinois, as even many Republican luminaries seemed to bask in the post-election glow of such a seminal change in our history, taking pride in America’s ability to be the first in the Western world to elect a president of African descent. If the Republicans were going to lose, it seemed, they wanted it be to this guy.
Yet serious challenges remain, and he is not the president yet, as he pointedly reminded people at his first press conference on Thursday. That performance was reassuring in its crispness and command, but it also came on the second day of the Dow’s worst (point-wise) two-day performance in history. We are not going to simply stroll out of our current predicament, as a week of gloomy corporate outlooks and funereal economic news made painfully clear.
The markets were at their baffling best during the week, beginning with a two-day rally in the face of terrible economic news. Traders were anticipating an end to the election season, and is their wont bought the rumor and sold the news. Once the result had transpired, the markets were free to take profits after six days of a rally that had kept its head completely buried in the sand. Wednesday morning was particularly packed with reminders of how badly off the economy really is.
Even so, there were the inevitable attempts by the usual gang of idiots, if we may borrow a phrase, to pin the sell-off on the election results (despite any number of corporate CEO’s going on television and expressing apparently sincere delight with the news). The prize for the silliest rumor goes to the story that the markets sold off on a purported plan by Senator Obama to force all 401-k investors to buy nothing but treasury bonds.
Variations on the “secret 401-k plan” have been around for months. Indeed, the most popular result on Google (GOOG) is the revelation that Obama plans to nationalize 401-k plans as reparations for slavery. In the wake of the market crash that wiped out a decade of equity returns, and the subsequent lugubrious third quarter investment statements, a disgusted academic suggested in mid-October that employees might be better off if there were a kind of governmentsponsored GIC (Guaranteed Income Contract) available, potentially funded by buying treasury bonds.
Well, there you go. Three weeks later and boom, the market panics. It’s simple cause-and-effect, right? As we’ve said before, there’s always a home for the absurd on the Street.
After two days of brutal selling in anticipation of a lethal jobs report, the market then turned and rallied Friday: sell the rumor, buy the news. People must have wondered how such a lousy jobs report could end up with the Dow rallying two hundred and fifty points, but the consensus estimates had been blown out of the water by Wednesday’s ADP job loss estimate of (-157,000) jobs for October.
The whisper estimate for the BLS report shot up to a loss of 300,000 and the markets sold off heavily in anticipation. The actual result was worse than the published estimates, but better than the unpublished fears, so prices bounced back up again. You gotta love the Street.
One of the most pressing problems for both the outgoing and incoming administration is that for the most part, our lending institutions don’t want to lend money. They want to hang onto all of it for themselves. Terrified of default rates, counterparty risk and any vulnerable appearance to the wolves of Wall Street, banks are mostly interested in holding cash, shrinking the balance sheet and rebuilding capital ratios.
Of course if they all do this at once, it will make default rates go up, further damage balance sheets, lower capital ratios and tempt the wolves to come back. The credit-card companies are doing the same thing. It’s no wonder that the wolves are prowling, because as events have shown, our financial institutions love to be the sheep.
As the auto company woes mounted last week, a parade of executives showed up on the television looking properly grim and sober, nodding their collective heads wisely at the current-trend school of thought that says we have to retrain all of those autoworkers. In fact, more than one went on to say, the government should spend some serious scratch on retraining the American worker in general.
That might not be such a bad idea. Even so, when we look back at what the auto companies, the banks and Wall Street have gotten up to in the last ten years, we wonder if the government shouldn’t be putting management retraining at the top of the list, and get to the workers later. The hot new degree of the 21st century could be the RMBA (Remedial MBA); it would teach the danger of putting too much money into RMBS (Residential Mortgage-Backed Securities).
We have to be fair, though, and point out that not all of the automaker problems are self-inflicted. To begin with, they had nothing to do with starting the credit panic that has crippled so many other businesses. One could even argue that the government owes them a bailout as compensation for its own blundering. The best way, after all, to get the banks lending again would be to go back to the weekend of September 12th and get a do-over on the decision to teach Wall Street a thing or two by allowing Lehman (LEHMQ) to file bankruptcy.
Unfortunately, that can’t be undone. Maybe another government do-over could be to guarantee Fannie (FNM) and Freddie (FRE) debt outright, and reverse the stupid political decision to place them into conservatorship. That bit of genius made the agency stock and preferred stock nearly worthless, shut the windows to more capital-raising by any financial institution and did some serious damage to bank balance sheets. So one might want to include Treasury in the retraining program too. And while we’re on the subject, better round up the rating agency people and enroll them also – in their case, make it mandatory.
Let’s see, who else might be eligible for management retraining? McCain’s campaign team, probably, not much of an argument there. Circuit City (CCY) management might seem an obvious choice, but we’re not sure if they were ever trained to begin with. How about all of the private-equity funds that now find themselves underwater in debt-laden deals made at the top of the market?
We may as well throw in Motorola (MOT), too, as they cleverly shed wireless phone share with a no-smart-phone development program. The insurance companies, right, them too. The SEC, you say? No, better to broom out the old entirely and bring in the new. Let’s see, then there’s the homebuilders, fair enough, they bought enough land for the 21st and the 22nd century, and have been writing it down ever since.
What about the hedge-fund managers that loaded up on energy in the second quarter? Or the real-estate moguls that binged on debt to buy during 2007? They’re getting leveraged returns, just not the ones they thought. They could sit in with the private-equity guys, who’ll be taking a class on investing in auto companies with the people from Cerberus.
Yes, there is ample opportunity for retraining. Some of it will be available to the traders who will buy into this quarter’s rally, thinking that the market has already priced in all the bad news and that the downturn will be much shorter than the common wisdom. We wager that you’ll hear the name of Goldilocks evoked again before the end of the year – and it’ll turn out to be just as wrong now as it was in the fourth quarter of 2007.
In the meantime, American voters went for change, rather than the echo. We’d like to wish the new administration all the luck in the world – because it’s going to need it.
In last week’s column we promised you a coming barrage of ugly economic news, and the week didn’t disappoint in that respect. We got it in spades.
The ISM (Institute for Supply Management) purchasing manager surveys produced stunningly bad results, the first in this cycle to register in the ISM’s official recession zone. The 1980-82 recession may yet be the worst of the last fifty years, but we are still only getting warmed up in the current one. The manufacturing survey produced the lowest overall reading (38.9) since 1982, and the lowest new orders reading (32.2) since 1980.
The non-manufacturing or services survey reported the sharpest decline in its eleven-year history with a reading of 44.4, as well as its lowest-ever employment reading. The same morning saw the big ADP jobs loss report, record-low weekly mortgage purchase applications, and another very bearish banking outlook from prominent industry analyst Meredith Whitney, carried on CNBC before the open. The markets had nowhere to go but the exits.
It’s tempting to draw a link between those reports and the factory orders number that came out in between on Tuesday, but there isn’t one. The surveys came from October, while the factory orders are from pre-meltdown September. The negative result for the latter of (-2.5)% was pulled by price drops in energy that led to a large minus in the non-durables category. Durable goods, by contrast, rose 0.9%, led by defense and transportation, but the landscape has shifted so dramatically since those orders were booked that the election-focused markets ignored the report.
Construction spending for the month of September was better than expected, with a loss of only (-0.3)% versus expectations of a loss of (-0.8)%. August and July were revised sharply lower, however, which is probably more significant. Given the credit problems that now plague every category of real estate and a probable pullback impending on the municipal side, we don’t look for any help from this area for the next few months. There is talk of an infrastructure stimulus program, but it’s months away at least and until then, just fodder for overly excitable traders.
Turning to the labor market, the news ranged from not very meaningful to outright rotten. Productivity and unit labor costs went the wrong way, but are more reflective of the sudden slowdowns in output and employment than any cost pressures.
Weekly unemployment claims, at 481,000, continue to creep towards the 500,000 level, while continuing claims hit a twenty-five year high at 3.8 million. The prolonged rise in continuing claims means that unemployed claimants are going to start falling off the back end as their eligibility runs out; President-elect Obama called for another extension.
The monthly jobs report was indeed bleak, despite it’s beating the whisper number. The loss of 240,000 jobs was bad enough, but the massive September revision from (-159,000) to (-284,000) was worse. August was sharply revised downwards as well, while the unemployment rate shot up to 6.5%. Predictions for the peak rate have started moving from 7.5% to 8.5%. Losses are widespread, but at least soaring oil prices have created a lot of mining jobs. Education and health care continue to hire as well.
We’re used to everybody talking up their book on the Street, but even so we couldn’t help scratching our heads a bit on Thursday, and especially Friday, at the ability of some to persevere against all evidence to the contrary. In the wake of an especially dismal jobs report that came at the end of a week of lousy data all around, some wags were nevertheless strenuously warning the president-elect that if he tried anything but more tax cuts and no new regulation, we would surely enter a depression.
To take an example, celebrated trader and newsletter writer Dennis Gartman has been making such a case, and we’re a bit puzzled. We have a lot of respect for Mr. Gartman’s admonitions on the virtues of exiting losing trades quickly, and are familiar with his love of pointing out the graves of those who stubbornly averaged down to zero. But it looks to us as if we’ve all already lost quite a packet on the more-tax-cuts, don’t-regulate trade. With even Alan Greenspan willing to cut his losses and call it a day, maybe it’s time to stop averaging down on this one.
Retail sales appear to have had their worst month since 1980, though we will have to wait until this Friday for the official verdict on the overall total. Motor vehicle sales were stunningly awful, so bad as to prompt serious talk of General Motors (GM) heading into bankruptcy. Total sales were at the lowest annual rate since the 1980’s recession, while car sales ran at the lowest annual rate in forty years. Ford’s (F) sales were down 30% while GM’s sank over 45%. Both companies reported steep losses later in the week.
The combination of the lending freeze and headline-panicked consumers simply put sales on hold for the month. Retail stores joined the queue of dismal results, as all the major retailers reported declines save Wal-Mart (WMT). Higher-end stores suffered severe declines, as evidenced by Nordstrom’s (JWN) (-15.7)% drop in same-store sales, a Saks (SKS) fall of over 17% and a Neiman-Marcus crash of more than 28%.
Pending home sales applications fell in September by (-4.6)%, but there were several reasons for the market to pay them no heed. The first was that the results pre-date the worst of the credit meltdown, so the statistics seem ancient. A second is that poor results are now so routinely expected, especially in housing, that only catastrophic data have any shock value. Finally, although the market was breathing a sigh of relief that the jobs data had missed the whisper number, analysts were seriously concerned about that report’s implications for the damage to the economy. Nobody had time for pending home sales.
Next week has an especially light calendar, with a four-day week for many: bond markets will be closed on Tuesday, November 11th (along with banks and the government) in honor of Veteran’s Day. So will many of the European markets. There is no monthly data to speak of until Thursday, when we get international trade data for September. The drop in oil should help those results, although the rapidly rising dollar will not. Both factors will affect the report on monthly changes in import and export prices the next day.
Friday looks to be the day of the week. Retail sales data for October will be released before the open and will most likely drown out the import-export prices results. Business inventories for September will follow later, likely to be ignored by the markets, but economists will pay attention to the impact on third-quarter GDP. The preliminary consumer sentiment reading for November is due from the University of Michigan: traders will be looking for any grounds for hope for a change in trend from the bad retail sales figures earlier that morning.
Last week, Barron’s suggested that Pulte Homes (PHM) might be a ripe candidate for recovery, based upon Pulte’s stash of over $1.1 billion in cash.
Not only does Pulte have the cash – more than $4.50 a share’s worth - the company is still managing to be cash flow positive, despite its many write-downs. Management has set itself a goal of having $1.6 billion in cash by the end of the year.
For these reasons, we suggest that you may want to take a look at Pulte’s preferred stock, trading on the NYSE under the symbol PHA. At Friday’s close of $13.76, it’s yielding a very juicy 13.4%.
Pulte has debt, but only $25 million of it is due next year. The rest doesn’t start coming due until 2011, by which time we think that the homebuilders will have had time to stage a recovery. In fact, much of the debt isn’t due for at least another twenty-five years.
We continue to hold to our thesis that the credit markets will recover before the equity markets – in fact, it’s a precondition for any equity market revival. As the credit environment normalizes, these kinds of issues will trade back to yield levels more in keeping with long-term bond yields. That should mean an opportunity for some significant capital appreciation from current levels.
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