Avalon Asset Management Company Lexington, Massachusetts Investment Management
Avalon Asset Management Company Comes a Horseman
“From the fury of the Norsemen, O Lord, deliver us." - medieval Christian prayer
In the spirit of Thanksgiving, we present our Rally Recipe: Take one brutally oversold market, a bunch of traders whose gooses are already cooked, dose liberally with overdone short-selling and then put it all into an options-expiration oven. Simmer slowly for a few hours, add a pinch of good news and flash-cook for thirty minutes. Voila!
The news that President-elect Obama was planning to anoint New York Federal Reserve bank governor Timothy Geithner as the next Treasury Secretary provided the whiff of good news that traders were starving for by the end of the week. It wasn’t quite on the scale of an appearance of Gandalf the Gray, but the selling was so overdone by Friday that the market really was ready to ignite on anything that looked like a respite from bad news.
Was there a lot of short-covering? Certainly. Did the options dealers leap at the chance to push some puts back out of the money? Of course. Did we desperately need a five hundred point snapback? Boy, did we ever. We’re very happy to take what we can get and leave it until Monday to start worrying again.
That rally did pull the Dow back to ‘only’ a five-percent loss, but the broader S&P was down over eight percent for the week after its worst two-day performance since Black Monday in 1987. It was joined there by the Nasdaq, which also fell over eight percent. October and November are shaping up to be the worst two-month period since, well, since you know when.
The news of Geithner’s (the ‘h’ is silent) selection was widely greeted by both sides of the spectrum. Geithner is not considered to be an ideologue, a genre that fell into disfavor about two thousand Dow points ago. He has much practical experience both within Treasury and at the N.Y. Fed, the central bank’s eyes and ears on the Street. While some may have preferred a more recession-hardened choice, most were surprisingly effusive in praise of his youth, energy and above all a needed change (not our words).
There is really only one question swirling around Mr. Geithner, and that is his role in the Lehman fiasco. It was originally bruited about that he had warned his elders against the consequences of a Lehman bankruptcy filing. Eventually there was pushback that it was his decision, followed by counter-pushback that it wasn’t. The question will almost certainly be posed at his confirmation hearing, but we wonder if Geithner will answer or take the more circumspect route of saying it was a joint decision: pointing the finger at either Paulson or the Fed would ignite a storm of controversy.
We suspect that it was ultimately Paulson’s call, probably the only soul on the planet who subscribes to the notion that it didn’t matter or that it was the right move. Chairman Bernanke is more of a pure economist and not a Street type, and we can readily imagine him deferring to Paulson and/or the administration on the topic.
Whether Mr. Geithner, or the rest of President-elect Obama’s team, can save us from the ravages of the downturn remains to be seen. It seems that the universal response is for everybody to cut back on everything, and the second problem is that that makes the first problem much worse. There are pension fund shortfalls, state and local budget shortfalls, and Hewlett Packard (HPQ) furloughing its workers for an extra week at the end of the year. The Pentagon canceled its Christmas party!
That last act was a mistake. Neither the economy nor the workforce is going to be helped by a Dickensian Christmas. We need the federal government to be spending money, because one of the most essential, important functions of a government and a central bank is to be around to put up money at times of crisis, when nobody else will.
The peanuts that the Pentagon might have saved out of the budget – really, would anyone have even noticed if they’d had a Christmas party? - means another lost job for a catering firm and its employees, and maybe a ruined Christmas for them. Times are hard enough. By all means keep it dignified, but for God’s sake, give people a punchbowl and a mug.
Speaking of hard times, has anybody else noticed that despite the fact that we have had the worst bear market and sharpest economic collapse in over seventy years, neither the Fed, nor the Treasury, nor the SEC has been able to think of a single mistake that one of them has made? Golly. It must be one of those wings-of-butterfly things we read about.
Listening to the ideological fury and rhetoric about the automakers last week, it occurred to us that we are at one of those seminal moments when we are all stuck in the past. If you listen closely enough, you’d think it was 1980, the year of President Ronald Reagan’s famous sarcastic remark about “I’m from the government, and I’m here to help you. ”
It resonated at the time, but that playbook is outdated. The role of government has changed significantly, but people still run around quoting it as if it were 1980. It isn’t. The Rolling Stones are no longer the biggest band on the planet, M.A.S.H is no longer the biggest show on television, and we have something called the Internet. We’re not wearing bad hair and fat ties anymore; pay phones have nearly disappeared. The times have changed.
Noted science historian Thomas Kuhn famously made the case that contrary to what one might imagine, science rarely advances by new and improved theories dealing knockout-blows to the existing ones. What happens in practice is that the guardians of established theories eventually get old and disappear. Their places are taken by younger scientists less wedded to older ways of thinking, and thusly progress marches on.
This trapped-in-the-past syndrome is pervasive. In the world wars of the last century, for example, generals often disastrously insisted on tactics from the previous war. The infamous Western front of World War I was turned into a slaughterhouse by generals employing tactics based upon horses, swords and muskets.
Progress comes from breaking out of rigid ways of thinking. Presidents Nixon and Reagan both stunned their own parties by breaking from accepted Cold War orthodoxy and attempting direct, top-level negotiations with China and the former Soviet Union. They were spectacularly successful.
Those of our Wall Street brethren who still insist on fighting the battle of 1980 aren’t doing the rest of us any favors. Rather than running around shouting “socialism!” and repeating slogans from two generations ago, they would do better to emulate Nixon and Reagan and address a rare opportunity to straighten out the mess with a new president, who isn’t captive to either of the two armies of an earlier day.
Of course we were over-regulated back then, but that was thirty years ago. As George Soros remarked in his testimony to Congress, we had too little regulation the last few years, and now it’s time for a little more. He was quick to add, however, and we agree, that there is also a danger of trying to do too much. So isn’t it time, then, for some common sense and sensibility? You know, check the date on the laptop, put away the old slogans and faded bumper stickers and get ready to negotiate the new decade?
Lately we have found ourselves in the most unlikely position of defending – a moment, please, before launching out of your chair in fury - the Big Three automakers and the United Auto Workers union. They’ve probably both been taken by surprise by the hostility towards them from the rest of the country: the prevailing attitude on the coasts seems to be a pox on both of their houses, while the southern states hope for windfalls for those foreign masters who dropped factories into their benefit-free states.
Like many boomers, we grew up with a cynical attitude towards both the Big Three and their unions who earned our distrust. However, much of last week’s rhetoric seems curiously stuck in the past. Listening to the vitriol, one might forgive a stranger for concluding that the automakers had been marching people out of their beds at dawn for the last twenty years and forcing them to buy gas-guzzlers at gunpoint.
It didn’t quite happen like that, of course. The sedan practically became extinct in this country because people wanted SUV’s and pickup trucks. Our elected government obligingly classified SUV’s as light trucks, exempt from gas mileage standards that we wouldn’t raise anyway, because our leaders said the market should decide. We chose big, and foreign automakers rushed to build SUV’s for the U.S. market.
In their home markets, these same foreign automakers have to cope with much higher gas prices than ours, because of gas taxes that we don’t want to pay. If they are accustomed to building smaller, more fuel-efficient cars, it is out of necessity rather than genius. Foreign countries would also never permit U.S. automakers to come in and build plants that pay less than prevailing union wages, as we do, or not participate in the mandatory state pension schemes.
As for the autoworker unions, they are a spent force, but you wouldn’t know it listening to some of the reflexive hatred that comes out of people’s mouths. You could substitute “spawn of Satan” for “unions” in a lot of commentary without altering a single shade of meaning.
The unions have already given everything back. Pensions and benefits have been off-loaded into trusts for older and retired workers; new workers won’t get them or their wages, and older higher-paid workers have largely taken buyout offers and disappeared. The automakers just don’t need any more concessions from the unions, yet whenever a puzzled executive tries to point that out, middle-aged ideologues burst into righteous, union-hating fury. It may be 2008, but they are still stuck in 1980.
The most serious credit crisis in seventy-five years has the two most credit-dependent industries, housing and autos, in a nearly paralyzed state. It’s a global problem. Detroit was already reeling from a weakening domestic economy and the sudden oil-induced decline in SUV sales when the credit crisis struck. Even if the industry already had a green line-up of fuel-efficient cars (and Ford (F) arguably does), it would still be on the ropes. The credit crisis is the federal government’s offspring, not Detroit’s.
We won’t dispute for a second that missteps over the years by both management and the unions had the automotive industry in a weakened condition domestically (it is making money overseas) when the crisis struck. Management needs to do a variety of things, of which the most immediate is to come back to Congress with a plan that can give the members some cover for helping them out.
Yet the automotive industry around the globe will suffer if General Motors (GM) files for bankruptcy. Suppliers would immediately have their credit cut off, and start to go out of business faster than the government could ever react. The bill for cleaning up the mess afterwards would be far bigger than most people can imagine, and many orders of magnitude larger than the money spent to pull the industry back from the brink.
If that isn’t enough to sway you, consider this: General Motors debt is the biggest credit in the high-yield sector, and automotive debt in general makes up a huge part of the corporate credit market. As of this writing, corporate spreads are at the highest levels the United States has ever seen, beyond the Great Depression, beyond anything in our history. If General Motors debt goes into bankruptcy, the entire corporate debt market will go into seizure. Only debt explicitly guaranteed by the U.S. government will trade. By saving ourselves the trouble of guaranteeing some fifty billions dollars of loans, or even a hundred, we taxpayers will end up having to guarantee trillions.
Do not heed any arguments that current auto bond prices already reflect a bankruptcy. People thought that about Lehman Brothers, and the result was total panic that toppled banks, insurance companies and the commercial paper market. The bond market is in a desperately fragile state: to quote Benjamin Franklin, an ounce of prevention is worth a pound of cure.
It is popular in these times to draw parallels to the Great Depression, and one of the depression-era problems most frequently cited is the beggar-thy-neighbor policy that countries pursued as they each tried to save themselves. The end result was the near-total destruction of trade. Yet people fail to see that setting the Midwest adrift amounts to the same thing. We are embarrassed to see New Yorkers old enough to have read the infamous New York Post headline, “Ford to City: Drop Dead” willing to turn around only twenty-eight years later and say the same thing to Detroit. Of all people, they should be the most ashamed.
We are risking a general depression, the prestige of our country and its manufacturing, and for what? To pay the last nine weeks of homage to a laissez-faire philosophy that has brought us to the brink of ruin? We have bled enough red ink already on the altar of that bankrupt religion. We suggest buying first-class passage to China with luxury accommodations for all its remaining adherents; with any luck their philosophy will catch on and keep that country from ever overtaking us.
As for the rest of us, we would do well to heed once more the words of Benjamin Franklin: “We must all hang together, or we will most assuredly all hang separately.”
We wish our readers a Happy Thanksgiving and a welcome respite from the markets.
It was another week without a glimmer of hope on the economic front. The two manufacturing surveys from the New York and Philadelphia Federal Reserve Banks came in deeply negative, with New York a tad better than consensus at (-25.4) and the Philadelphia a bit worse at (-39.3). New orders, shipments, employment, all tumbled. So did prices, with Philadelphia prices contracting for the first time this year, but that was no comfort to a market terrified of deflation. At least we were ready for it.
October industrial production turned in a surprise positive, but this was due to pushing more hurricane and strike-related (Boeing) red factors into September. The net result was a bigger drop for the earlier month and a rebound for the latter, but the Fed observed that after stripping out the noise, production fell about two-thirds of a percent in each month. Given the results of the regional surveys, the decline probably deepened in November.
On the housing side, the housing market index fell to an all-time low of nine. In case you didn’t know, below fifty is considered contraction. If housing market were a hospital patient, they’d be talking about pulling the plug. One wants to say that it’s always darkest before the dawn, but it may yet get darker first: new housing starts came in about as expected at 791,000, but the rate may need to drop below 500,000 before we reach a bottom. Permits fell twelve percent. Maybe it’s just as well, because mortgage-purchase applications also hit new lows. No credit, no house.
It’s hard to say how much uglier housing can get, but with Paulson taking his ball and going home, we have a pretty good chance of finding out. Several analysts pointed out that the suspension of the TARP program has already wiped out more bank capital, in the form of falling mortgage security prices, than the program had left to spend.
Inflation readings fell, but they fell so sharply that it just contributed to the general malaise. The PPI and CPI readings had the sharpest drops in 61 years, while the CPI core rate went negative for the first time ever (but don’t be alarmed, it only goes back to the seventies). Energy prices fell twelve percent at the wholesale level, highlighted by a twenty-five percent decline in gasoline prices, which have fallen an additional twenty-five percent so far this month.
Despite the headlines, we think that the declines will be a brief phenomenon, lasting more than one month but probably not more than two or three. Between the ongoing free-fall in oil prices and desperate price cuts by just about every vendor trying to move product, we expect pricing to deteriorate until energy and inventories stabilize. It shouldn’t take too long for either category to start to reverse, motor vehicles excluded of course.
A cold winter is expected in the northern states, and with heating oil and natural gas below year-ago prices, demand should pick up soon. Energy projects that might increase supply have been shelved or abandoned. An interesting question is gasoline: despite falling prices, miles driven by Americans continued to decline in September, according to the Department of Transportation.
With gasoline at its lowest price since the spring of 2005, there is already talk circulating of increasing gasoline taxes to prevent us from returning to our spendthrift ways. Given the loss of household wealth and the gain in unemployment, though, the new thriftiness may stick around for a while.
Price shocks do tend to shift behavior: the Arab oil embargo induced a cut in demand that lasted several years. In any case, the sheer violence of the price changes this year will prevent consumers from taking prices for granted for some time – but we wouldn’t be surprised if taxes are raised anyway. State tax revenue has been dropping precipitously, and conservation would be a convenient pretext.
Turning to employment, the picture continues to deteriorate sharply. New jobless claims spiked again, this time to 542,000, pulling the four-week average up over five hundred thousand, the highest such reading in years. Continuing claims finally pierced the four million mark, a twenty-six year high. Unfortunately, the population is larger than it used to be, so if we end up falling into an ‘80-’82-style recession, the rate is going to peak at much higher levels. That means more strain on the states: Ohio is already planning to appeal to the federal government for help paying unemployment benefits.
The Fed did raise its unemployment forecast for next year to about 7.5%, but many economists are already predicting something north of eight percent, with Goldman talking up nine percent (they were also predicting $200 oil, so take it with a grain of salt). In its minutes, which weren’t warmly greeted by the market, the Fed also lowered its economic forecast for this quarter, this year and next year. Next year is expected to run at break-even, thanks to a second-half recovery. Ever notice how things always get better in the second half? Things were supposed to get better in the second half this year, too.
In case you didn’t know it, the entire globe is feeling the pain. Japan lowered its outlook for the second month in a row and the sixth time this year; it is officially in recession, along with the Eurozone, Germany, the U.K. and a host of other countries. The European PMI fell to 36.2, a big drop from the prior month and a wide miss of estimates for a small decline. Reports of labor unrest in China are picking up, and Switzerland made a surprise cut in interest rates. The stock market in Russia is trading virtually by appointment, having shut over thirty times since the Lehman debacle.
In that vein, the index of leading indicators fell sharply in October with a decline of (-0.8)%. Weekly store sales were again negative year-over-year, with rising unemployment (and fear) trumping lower gas prices. Nobody raised their outlook.
There was a time when we used to go out for lunch on the day before the Thanksgiving holiday and not return. The market would virtually cease trading on Wednesday afternoon, return for a quiet Friday morning and then close back down for the weekend.
Oh, for the good old days. Although anything can happen in the markets, we’re not looking for a Thanksgiving rally this year. Monday will bring data on existing home sales, to be followed by the Case-Shiller home price index on Tuesday and new-home sales on Wednesday. That’s a lot of housing data to not be thankful for.
Tuesday will also bring another revision of third-quarter GDP, along with corporate profits (or lack thereof). The Conference Board will punish us with its November consumer confidence verdict later that morning (un-confidence might be more apt), to be followed by the University of Michigan’s final November read on sentiment the next day.
Wednesday is in poor taste, in our opinion. Along with the new-home sales and the sentiment reading, we’ll get durable goods, personal income and spending, initial jobless claims and mortgage-purchase applications, and of course both weekly energy reports, with the natural gas report coming out at 12:30 PM. Don’t they know it’s a long weekend coming up?
Thursday the U.S. markets are closed, for which we and the rest of the world will give thanks. Friday the markets close early at 1 PM, but we’ll still get the Chicago PMI that morning. Enough already.
StockWatcher doesn’t want to recommend much of anything until there is more clarity on the auto industry finance package, for we believe that a GM bankruptcy would lead swiftly and without much resistance to the 5,000 level on the Dow.
However, if Congress does pass legislation to stave off that event, as we expect, we think that one should be buying corporate bonds, which are at their highest spreads ever. It’s a simple case of buying low and selling high. We also suggest municipal bonds, which are at historic spreads as well. 2009 could be the best year in decades for bonds, assuming we can survive another nine weeks.
For an equity play now, you might want to consider a move such as selling January 60 or January 65 puts on IBM. For starters, options premiums are quite high: as the stock price veered towards $70 on Friday, the January 60 puts were fetching close to $4.50. That would be pretty nice income if IBM stays above the strike price.
If it doesn’t, we think that you could do much worse than buying the stock at a net price of about $55.50. At current levels, IBM is trailing at about 8.8 times earnings and less than six times cash flow, a historically cheap price for a company with a great software, services and consulting franchise.
If the stock was put to you with a $60 strike, you’d be paying about six and a half time earnings and four and a half times cash flows. Those valuations may be based upon trailing earnings, but they are still quite low. The company should finish the quarter with over eight dollars a share in cash. If earnings fell by twenty percent next year, you’d still be getting the business for about seven times forward earnings. The opportunity of a lifetime, as Jimmy Stewart once repeated.
A price of sixty-five dollars a share would represent a fifty percent retrace from its recent high of $130.93 set only four months ago. But they were long months, weren’t they?
Avalon Asset Management Company is a Registered Investment Adviser
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