Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
Sugar, Sugar
"Pour a little sugar on it honey, pour a little sugar on it baby." - The Archies, "Sugar, Sugar"
In the early part of the week, the Wall Street Journal fretted that a “greater fool” theory seems to be spreading through investment land. More and more managers are becoming skeptical about the market’s advance, but are even more afraid to miss out on it. Ed Yardeni, the well-known strategist, called them “fully invested bears.”
It isn’t news that fund managers have been chasing performance in recent months. We’ve talked about the weird symbiosis of late between fast money traders and fund managers – the managers buy the dips, then the traders step in with another push. The low volume that has characterized upward moves for some time has also been a staple of media coverage, leading many technicians to become increasingly nervous (and as if to counter, CNBC throws a wider slate of aggressively bullish types onto the screen).
Another problem is that fund managers are running low on cash. Rallies have more staying power when there is a steady supply of new money coming into the market, but it’s another well known fact that equities have seen very little new money. In recent weeks, it’s actually been the reverse. Traders can keep passing stocks back and forth or rotate through sectors, so low cash levels don’t necessarily doom a rally, but eventually there isn’t enough money left to catch a serious dip.
But short sellers have been pulling back as well. Although there is a lot of anxiety about the market’s advance and whether or not it’s justified, there is practically no fear at all that disaster might strike. Managers may be skeptical about the rally’s underpinnings, but they are absolutely complacent about the near-term outlook.
The fourth quarter of 2008 was so horrible that it’s hard to imagine who can come up with negative comparisons. Everybody’s revenues were down in the third quarter, but the Street is quite smug about the fact that merely being alive in the fourth quarter is going to look good by comparison with a year ago. The result is that although down days have more volume – one must keep one’s eyes on the exit - so long as the news stays mixed at worst, selling is unable to gain real momentum. As a result, prop desks chase the shorts with every rebound, and they’ve gotten tired of being targets.
The financial sector may be in for a long recovery period, it may be underperforming the rest of the market, but the conviction is that the government isn’t going to let anything really bad happen. The FHA may be in trouble, Fannie (FNM) and Freddie (FRE) are suffering staggering losses, there is plenty of concern about the deficit and how to navigate the stimulus issue, but the feeling is not yet. The near-universal consensus is that those are problems for next year, such that even the skeptics shrug and say it may not be healthy, but we’ll go higher into the end of the year.
So when the finance ministers of the G-20 countries get together and say that they don’t see economies good enough to withdraw stimulus, that’s a reason to rally. The Fed may be saying that they see zero rates for a long time, it may be sending out governors to talk about how long and slow the recovery is going to be, but the certainty that there is no disaster looming in the near term allows Wall Street strategists to blather about what a strong and sustained recovery it is.
It isn’t, and it’s highly unlikely to morph into one, but that doesn’t matter right now. What matters now is this quarter’s revenues and this year’s bonus, and the big money machine that has become so comfortable with running on the edge of a bubble. It will have few problems finding whatever cover stories are necessary to keep the game going.
Consumer confidence took a surprising dip last month. Although it’s fairly well known that the sentiment measures are not good predictors of spending, stock prices tend to react strongly to the report anyway. Perhaps traders react that way simply because they fear that’s what the rest of the herd will do, but they do, and so the fairly substantial price rally in the aftermath of the report was all the more surprising.
That’s another warning light, confirmation that the rally is being led by professional price movers. Care for a glass of 1999, anyone? Yet it’s understandable, because we have raised a generation of financial professionals who have come to believe that investing is essentially about piling into the hottest trade. It’s a time similar to the nineteen-thirties, when the formative experience of the roaring twenties kept luring traders back into a series of sharp rallies. The rallies eventually broke up on the lack of any foundation stronger than the hope that the tables would once again run in your favor. Caveat investor.
Looking elsewhere, it appears that we are undergoing a second erosion of salaries in the US, such that even if unemployed workers can get back into the work force, they are getting less, often for doing the same job. We got around that problem in the last recession by borrowing the difference, to an extent that would have been unimaginable ten years earlier. Now our workers are going to take another round of cuts with twice the debt and half the credit. That will matter to spending much more than the confidence measure, and explains it as well.
Two such workers will be the former Bear Stearns managers acquitted last week of criminal charges over the collapse of their mortgage-related hedge fund, a collapse that signaled that the end was nearing (and so of course the market rallied when it didn’t end in two days). The civil charges likely to follow will cost the managers even more money, but in this particular case, we think the government should find other things to do.
There is plenty of blame to go around for the debacle of the last few years, but we need to focus on the more serious mistakes. We can understand the desire to throw a few rich denizens of the Street in jail, yet we’ve no doubt that plenty can be found without chasing people like the Bear Stearns duo, or for that matter even Ken Lewis, whose popularity in Washington D.C. is on a par with Osama Bin Laden.
The reason we say this is for the same reason the government doesn’t want you to shout, “Fire!” in a crowded theater. It’s important to keep the process orderly, because a panicked stampede can so lethal, such as the one in October of 2008.
For their part, the Bear managers knew that things were getting tough in 2007, but they weren’t sure what would happen and neither was Lewis. One thing everybody in this business knows is that saying things could get bad will immediately make them very, very bad. Back in 2006, Google’s (GOOG) onetime CFO George Reyes took nearly fifteen percent off its stock price in a matter of ten minutes when he casually remarked that as the company’s business got bigger, it couldn’t have the same growth rate. Reyes thought he was just stating the mathematically obvious. It was a very expensive lesson.
For the same reason, no Treasury Secretary will ever say that the administration supports a weaker dollar, nor will a Federal Reserve chairman say that the economy is going to hell in a handbasket. Regardless of what they might know or think that they know, it would be irresponsible and start a panic.
We, of course, have no such constraints, and so we will tell you that although the economy could be on a “strong and sustained” recovery, and the United States could win the next World Cup, we strongly suggest that you do not bet on either outcome. If you still have the urge to do so, then maybe it’s time to cut down on the sugar.
The week was nearly devoid of economic data, which benefited the market’s rise: during low-news weeks, whatever trend is in place tends to keep going.
In the weekly data, week-to-week and month-to-month sales comparisons are starting to flag, although it’s too early to call it a trend. Year-on-year comparisons are getting better, however, due to last October’s maelstrom. Retailer caution over current sales is being ignored in favor of more bullish narratives. Inventories are down! They’re going to stay down, too, but that may not slap everyone in the face hard enough for another quarter.
Mortgage purchase applications continued to decline sharply, this time to a nine-year low, according to the Mortgage Banker’s Association. The index value isn’t released to the public anymore, but we estimate it to be around the surreal level of 220. Therefore, one should expect it to rebound shortly, but also expect October/November home sales to crater: purchase applications have fallen in a straight line since peaking in the week of October 2nd. At least refinancing activity is picking up again, as the Fed helped push mortgage rates back below five percent.
Weekly initial claims were another good example of the market taking the candy and jumping into the stranger’s car. Claims were alleged to have fallen to 502,000 (probably 505,000) from 514,000 the week before. Yes, yes, says the trader, who obligingly puts on a fleeting solemn look in memory of the fallen, but the trend is definitely improving. Recovery is on the way. It isn’t, but maybe the reality is that the datum was just another pivot point for bidding prices higher.
The devil is in the adjustments, and in the standardized government models that do a poor job of accounting for non-standard times. It’s a dilemma that we’re largely stuck with, because an alternative policy of re-tooling models during unusual times would only ever work in theory. In practice, we’d end up with a lot of biased garbage. At least the current garbage is consistent.
Claims did not fall last week. According to the Labor Department’s data, they actually rose by nearly 47,000 from the prior week. Actual continuing claims did not fall by 139,000, but rose by 10,000. The difference is in the seasonal adjustments.
Seasonal adjustments are a good thing, and are helpful in removing calendar distortions that can obscure the underlying trend. In business, the tendency for companies to rid themselves of the unwanted or unbudgeted worker accelerates as the year comes to a close. The adjustments try to eliminate this calendar effect by comparing the actual data against some sort of mean seasonal measure.
But this method defies logic during a period like the one we’re in. Unemployment has risen by over fifty percent in the last twelve months, more if you use the aggregate U-6 number. Thirteen months after the bottom fell out and layoffs soared, we are still laying off people at a nearly identical rate to a year ago – last week’s raw number of 529,446 is less than two percent smaller than the year-ago number of 539,787.
That shouldn’t be happening. A better adjustment at this point would be to add workers to the total, counter to the usual seasonal trend, simply because the supply of workers to eliminate is getting smaller. Layoffs should not be picking up along with the season this year, they should be neutral to down to account for the effect of the emptying of the tub.
That they are not shows how weak the labor market really is. Last week’s number prompted observers to say it was at least less bad, but it wasn’t. It was just as bad as a year ago, and given the circumstances, worse. According to the Labor Department, the October civilian labor force was 1.6 million smaller (not seasonally adjusted) than it was in October of 2008 (adjusted = 0.9 million). The truth is that initial claims are a higher percentage of the labor force than they were a year ago. It’s a good example of how the “normalizing” seasonal adjustments can end up adding distortions instead of removing them.
When the market is rising, one must paint the news as good, and so it was that we were told that the latest quarterly Jobs Outlook and Labor Turnover Summary (JOLTS), also from the Labor Department, was really great news. The hiring and separation rates (people leaving their jobs) were unchanged, but the number of job openings was up! It’s true, although most of the increase occurred in the low-paying hotel and restaurant sector. Yes, but you see, that’s a cyclically sensitive sector and so it validates the robust recovery. Who cares if actual hiring in the sector fell?
There was also a small pickup in manufacturing openings and hires, one that we think ought to be good for another month or three as the muted bounce in inventories works its way through the data. Such good news was wasted on the public, however, whose confidence levels took the sharp drop entering November, at least as measured by the University of Michigan’s consumer confidence survey. It fell back to a very low reading of 66, or about even with last April.
Confidence was supposed to rise this month, not plunge, but was apparently pulled down by the weak labor market. Perhaps consumers didn’t notice the exciting pickup in the JOLTS report, or failed to realize that the seasonal adjustments showed jobless claims were theoretically falling instead of the actual rise of nearly ten percent. Or it may be that the ingrates simply didn’t have enough long positions in tech stocks (and judging by the trading volume, there weren’t many). Yes, and the clocks turned back too, and that never cheers people up. A classic buying opportunity.
The trade report showed that the deficit widened in September, but had no other revelations. There was some spin about this and that, but do not believe anyone who tries to sell you on a trend. Oil and natural gas prices rose in September on speculation, while the resumption of the school season led to a temporary increase in gasoline demand that didn’t get any additional traction. Excluding oil, the trade figures have bounced around all year without any real trend, apart from the globally subsidized increase in automobile trade. That business definitely went up.
It’s a heavy calendar for the week of the 16th-20th, which is also an option expirations period. On Monday, we’ll lead off with the report on October retail sales, which are expected to bounce back by about a percent. Given the tendency for the headline number to be inflated by downward revisions to previous months, we wouldn’t be at all surprised to see the consensus surpassed. The New York Fed’s November business activity survey will come out at the same time.
Later on Monday we’ll get the business inventory report for September, but indications for September suggest that the restock didn’t quite get going yet. October data may be more useful. A better picture of any rebound should come from the October Industrial Production report on Tuesday morning, and the Philadelphia Fed business survey for November on Thursday. The former is expected to show an unrealistically modest improvement, while the latter has a pusillanimous prediction of no change. Dis game is rigged.
An interesting development should come from the Producer Price (Tuesday) and Consumer Price (Wednesday) indices for October. These are up against unusually steep drops from last year, a pattern that continued throughout the fourth quarter of 2008. The year-over-year comparisons should start to show some big numbers. Bad for the market? It should be, but then again it should be even worse for the dollar and that of course is good for stock prices. Until it isn’t.
We’ll get a new look at housing trends with the November homebuilder survey (“Housing Market Index”) on Tuesday afternoon and October housings starts on Wednesday morning. Starts have been largely flat the last three months and we don’t see why October should have been any different. Perhaps they will pick up again when the massive welfare payments – excuse us, we mean tax refunds – to the homebuilders get wired to the homebuilders this month. We’re still trying to figure out that one.
One of the last reports will be the October Leading Indicators report. The stock market rally actually faltered in October with its very late sell-off, but the yield curve steepened and weekly claims slowed slightly, so look for another modest increase.
Another parade of retailers will report earnings, led at one end by home improvement companies Lowe’s (L) and Home Depot (HD), a veritable flood on the other side with apparel companies, and in the middle companies like Target (TGT), TJ Maxx (TJX) and Sears Holding (SHLD).
Our prediction is that almost all will report lower earnings than a year ago, but beat estimates thanks to lower inventories and tighter cost controls. Although the companies will be cautious about the sales outlook, the Street will feign astonished delight at the beats, and CNBC will load up the cameras with more ebullient fund managers predicting thirteen or fourteen hundred on the S&P. It’s a wonderful world.
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