Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
It's All Relative
"Call it hell, call it heaven, it's a probable twelve-to-seven." - Frank Loesser, "Guys and Dolls"
In a tribute to momentum and the calendar, prices hung on to edge higher last week in the face of mostly disappointing news. Although they should decline further, it could go exactly the other way. There are more skeptics than believers in this rally, but so long as mutual fund managers remain more worried about missing the last throes of the rally than getting caught by a downdraft, they will keep sitting on their hands. It’s a business decision that reflects the reality that fund managers live in a relative world.
Only six weeks remain to go in the trading year, really five when the holidays are taken into account. With little time left on the clock and a big rally having lifted all the boats, the tactical imperative for a fund manager is to maintain position relative to the competition. Whatever a manager’s thoughts about the market rally or economic recovery might be, it isn’t the time for taking a big position that goes against the crowd.
Should a correction develop, the fund manager’s peers will go down too. Most managers are fully invested. But should the market go higher, the manager can’t afford to be left behind. After a big up year, the focus in January will be on the performance rankings and the size of the plus number. Raising cash now could mean lagging behind if the rally continues, regardless of how sound or unsound the latter might be. Those who lag will also lag in gathering more assets, and that means revenue risk and job risk. Better to stand pat and let the market decide than to take chances.
With a big part of the market just waiting for the clock to run out, that leaves matters largely in the hands of tactical traders and hedge funds. Volume should stay light for the rest of the year, making it easier for tactical money to push the tape around. Knowing that the mutual funds are essentially bystanders at this point, the most popular strategy is to try to trap short sellers. The latter group is seen as being handicapped by its inability to spook any selling by fund managers through the rest of the year. That’s why you hear floor veterans remarking these days that it will take some sort of geopolitical event to turn the tables and knock the rally off its feet.
It’s a different situation for hedge fund managers. For one thing, they have been largely trading a longer-term outlook rather than the tape, and their view has been less optimistic. For another, hedge fund compensation is heavily tilted towards performance fees. Any pullback between now and the end of the year would be much more costly to hedge fund personnel than mutual fund managers.
The fact that the average hedge fund has only recently recovered enough via this year’s rally to offset last year’s losses, thereby putting them in a position to earn any incentive fee at all this year, puts them in a delicate position. They are keeping their fingers on the sell button as a practical matter. If they get wrong-footed by traders looking to trigger their stops, they still have the consolation of watching their longs go up. For the mutual fund manager, the key is not to let the market go up without you, and for the hedge fund manager it’s not to let the market go down with you.
All this could mean a bumpy market that nevertheless manages to grind higher until year-end. The last move up this year could have nothing to do with fundamentals or earnings, though you can be sure that some sort of cover story would be concocted. It’s not like it would be the first time that the stock market disconnected from the real world.
If the news flow did happen to turn bad enough, the tacticians would probably peel off and start to ride the trend in the other direction. Few expect such an outcome, however. The thinking is that while the news might not be terribly positive in the weeks to come, the percentage play is that it won’t get one-sided enough to start a rout before January.
Is this another example of the latest hot phrase in the economic world, “kicking the can down the road?” Of course it is. The next six weeks is about keeping the runner propped up long enough to cross the finish line; let next year worry about next year. Most strategists are betting on a correction to come either in January or perhaps April, when reality kicks in again and undermines valuations.
The consensus choice is for a springtime meltdown, an article of faith for much of the market for some time now. The idea is that fourth-quarter earnings comparisons, due to be reported in January, will be too easy to cause a problem. Given the natural tendency of the markets to outrun reality, prices would float higher before the edifice finally comes crashing down in spring, perhaps with quarterly earnings in April.
Taking the scenario to the typical bull conclusion, after a health-restoring correction of around ten percent or so, perhaps even fifteen if the markets got a little too carried away in the interim, then we could get back to investing alongside the government and surf the recovery wave. Ergo, the S&P should rise to 1400 or so by the end of next year, perhaps even 1500.
It’s a comfortable outlook and not too implausible on the surface, so what’s the problem? Why, for example, are the Germans getting their knickers in a twist, as the Financial Times reported on Saturday, over a potential asset bubble fueled by very low U.S. interest rates? That country’s complaints followed close on the heels of similar muttering by the Chinese on Tuesday.
It’s no secret that the Chinese like to talk their own book, and aren’t always very subtle about it. Being the largest foreign holder of dollar reserves and under constant pressure to let their own currency revalue upward, they’re not happy to see the U.S. dollar weaken. The Germans’ greatest strength is their high-value added export sector, and can’t be happy about the big rise in the value of the Euro against their competitor’s dollar.
However, it would be a mistake to dismiss the concerns of either country as mere posturing. They really do lay the blame for last year’s crash at the doorstep of an American financial system they see as being too reckless and too prone to extremes that disrupt the entire global economy. The fact is that view is almost universally shared around the globe. The Street tends to dismiss such claims as being self-serving and politically biased, and while there is a good deal of truth to that, the countries are nevertheless sincere in their views – and their annoyance.
On Tuesday, Fed Chairman Ben Bernanke talked about the difficulty of observing bubbles while stating at the same time that he did not see one. Bernanke is constrained in what he can say – it would have been folly on his part to publicly suggest a bubble was underway – but one can also understand the concerns of our trading partners. Their concern is that a rush back to business as usual is not only politically unpalatable to a public fed up with subsidizing outsized bonuses while eating the losses, but could strain a global system that doesn’t need any more stress.
Chairman Ben, however, faces a different set of concerns. A certain amount of brave face is necessary, but the Fed has to be worried about the lack of lending and the well-known phenomenon of the liquidity trap. From its point of view, a bit of unjustified largesse for trading desks may have to be part of the price one has to pay to restore sufficient confidence to allow lending to go forward again. It isn’t a stretch to think either that the battle over Street compensation is one that the Fed would rather join another time – such as after Bernanke’s confirmation hearings.
But other countries don’t want to hear America say there ain’t no such thing as bubbles right now. Nor do they want to hear it said that even if there were, we couldn’t do anything about it anyway. One can understand why.
Will “Mutual Fund Monday” repeat itself? The pattern of late is for sharp Monday rallies, supposedly based on funds putting fresh (or recycled) money to work. As we go to press, futures are anticipating an up open. However, the calendar will be very busy during the abbreviated week, so we’re not making any predictions. The U.S. markets will be closed on Thursday in observance of the Thanksgiving holiday, and are also slated to close early on Friday (1 P.M.)
Historically, volume is very light on Wednesday afternoon and Friday’s market has an upward bias led by junior traders ready to believe anything. For ourselves, we wish our readers a long and restful holiday weekend, and a Happy Thanksgiving during these difficult times.
Housing data rattled market confidence last week with disappointments in the homebuilding sector. Permits and starts fell in October, rather than rising as expected. That result echoed the slippage in their sentiment index back to the 17 level (50 is neutral). Those results didn’t fit the recovery narrative that is supposed to justify current valuations.
Plenty of opinion swirled around these results – it rained too much, we don’t need more new homes anyway, it’s a smaller part of the market, it was the swine flu. It may be just an ebb tide after the expiring tax credit pulled buyers in off the sidelines. Or is it an indication that the pool of would-be buyers really isn’t that large? We’re still above the long-term average of home-owning as a percentage of the population. We will get more data next week, but it’s worth nothing that mortgage-purchase applications hit another multi-decade low last week, despite low interest rates.
October inflation data came in the form of the Producer’s Price Index (PPI) and Consumer’s Price Index (CPI). Both indices showed a 0.3% increase over the previous month, led largely by increases in energy prices. The year-over-year comparisons for both indices are negative at the headline level and subdued at the core level. Comparisons will be more difficult the rest of the quarter, but for now inflation seems to be something off in the future and many insist that the real danger is deflation.
A clear disappointment was the weak reading by the October Industrial Production index. Expected to rise by four-tenths of a percent, it rose by only one, and manufacturing showed a decline of one-tenth. Without utility output, production would have been down. The year-on-year decline rose. Capacity utilization crept up another two-tenths, but is still quite low at 70.7%. That doesn’t seem very robust in the light of the bounce in the auto sector.
November business activity surveys were both positive, however, with the New York Fed reporting a weaker-than-expected result and the Philadelphia branch a better-than-expected one. There wasn’t any good news in employment, but new orders did grow respectably, although at a slower rate in the New York report. Neither report correlates well with the national ISM report, but are certainly hopeful indicators of another positive reading.
Retail sales were another example of the phantom rise. Ex-auto sales were supposed to have risen by four-tenths of a percent, but only rose two-tenths. One could say that they didn’t rise at all, because once again the increases came about from sharp downward revisions to the previous month. Those revisions will help lower third-quarter GDP. It was a disappointing report, but had no impact on Mutual Fund Monday.
The leading indicators were something of a disappointment as well, rising 0.3% rather than 0.4%, and owing most of its improvement to a steepening yield-curve. Another positive was stock prices, which came as a surprise to us – we thought that they fell in October. The indicators were of the same tenor as weekly initial claims, which failed to crack the 500,00 barrier again. We still say that they are running too high this late in the recession.
Soon companies will take a breather in sacking the help, if for no other reason than to take stock and that it has to be getting harder to find people to lay off (though AOL is doing its part with another 2,500 pink slips announced). That will cause the claims number to finally fall back below 500,000 and perhaps touch off a rally in stock prices. Ill-founded, but a rally nonetheless.
Next week brings us the rest of the October housing picture, with Existing Home sales on Monday morning, new-home sales on Wednesday morning and the Case-Shiller price index (for September) out on Tuesday. The markets have factored in modest improvements for all three; the FHFA (GSE-related) price indices will also appear on Tuesday.
Sandwiched in between the housing sales data will be the first revision to third-quarter GDP on Tuesday. It’s expected to have fallen all the way back to 2.8% from 3.5%, and will be accompanied by data on third-quarter corporate profits. In the afternoon will come the FOMC minutes from last month’s meeting.
Wednesday will nonetheless be the day of the week: in addition to new home sales and the usual reports on mortgage-purchase applications and oil, we’ll get durable goods for October, personal income and spending, weekly jobless claims (a day early due to the holiday), natural gas (ditto) and the second reading on the University of Michigan’s consumer sentiment index. The last will follow by a day the more influential consumer confidence report from the Conference Board for November.
Despite the heavy calendar, volumes should still taper off beginning Wednesday afternoon and remain muted on Friday. That could lead to an increase in volatility. Throw in a heavy Treasury funding calendar, with two-year, five-year and seven-year paper on the calendar, and we could see some excitement.
Avalon Asset Management Company is a Registered Investment Adviser
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