Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
Do You Buy It?
“Or art thou but a dagger of the mind, a false creation, proceeding from the heat-oppressed brain?”- William Shakespeare, Macbeth
Chatter at the end of last week centered on two things: Dubai, and Black Friday. The former offered the opportunity to see another chain reaction of default worries starting up, along with hits to bank balance sheets, particularly in the U.K. That led European markets down on Thursday, followed by a drop in the U.S. when its markets reopened on Friday.
European stocks, though, rebounded on Friday as the U.S. sold off. As we go to press, Asian markets are chugging along cheerfully and U.S. futures are comfortably bid. Was it all a desert mirage, or just another nifty buying opportunity timed to coincide with Black Friday?
The Dubai incident involves a quasi-bankruptcy by a prominent Arab city-state corporate entity that had put rather a lot of goodies on the credit card in recent years. In our country, we call it a default when a bond issuer declines to make an interest payment, but in this case we are avoiding such ugly words and instead calling it a “standstill” agreement. As in, “stand still and stop asking us for money.” Sounds to us like “stand-stuck” (or possibly, “sand-stuck,” and yes, we apologize, but couldn’t resist).
Such a default – or rather, indeterminate suspension of payment – provokes various memories amongst veterans old enough to remember such things as the Asian currency crisis in 1997. That started with a real estate boom-and-bust cycle, a Thai currency devaluation (incidentally, Vietnam devalued its currency last week) that spread throughout the region and eventually led to the Russian financial panic of 1998. The whole ungodly mess culminated in a financial panic in the West and the infamous meltdown of Long-Term Capital.
It would not surprise us in the least to hear this episode turned into another bullish narrative by the middle of the week. To begin with, the November-December turn usually produces an upturn in the market. It doesn’t matter whether or not it’s justified by anything – the market expects its treat and will get it, absent some sulfurous surprise egg being hatched.
Should the usual scenario play out, then you can expect to hear the resilience word being repeated by both the cockeyed and the pompous, and it could even evolve into some tale of how strong the market is. We can already hear the spin: it’s a testament to the solidity of the recovery; it’s not a threat to the system, just one company, and so on. The parade of managers telling us that this was all just a misunderstanding and a great opportunity to buy the dip has already started.
That could turn out to be the case, of course, though it’s too early to say without access to information that is unlikely to see the light of day. Yet it’s also worth noting that the Street completely ignored that Asian-Russian crisis throughout its development, until the tide went out on Long Term Capital and it was revealed that the emperor had no clothes. The correction was brutal.
Yet some market participants would say, “so what?” One could argue that even if you had absolute foreknowledge that we were in for a rerun of the ’97-’98 panics, it would be no reason to sell today. Wall Street will not want to give up its momentum trade until it’s absolutely forced to, and history suggests that such a turn of events could take many months to come to realization. There’s always a greater fool out there.
Retail shoppers may be smarter. They didn’t turn out in droves on Friday, nor did they stay away. Shopping centers reported reasonably brisk traffic that was a clear improvement over last year. Stores suggested that while consumers were willing to spend on the usual unusual bargains in electronics, they were otherwise cautious in their purchases and favored smaller transactions and lower budgets. Many chose to shop online instead, lured by cut-rate pricing and offers of free shipping.
It’s competitive out there, and consumers are being careful. That is, those but the few financial types lucky enough to be given a spot to hold out the baskets, and watch once-in-a-lifetime trading spreads fall into their collective hands (in a quaint Street tradition, such government-subsidized collection agents are known in the local parlance as “top producers”). For them, 2009 will be a year for renewed end-of-year indulgence – and possibly the last such year for quite some time.
But for now, comparisons with last year’s abyss are going to be easy. That’s as well known on the Street as the name of our President, but you should still expect the announcement of this event to be greeted with astonished delight. The trading playbook calls for a rally starting around Tuesday and continuing to next Monday or so. If form holds, we would then have a pullback of about a week’s duration before the “Santa Claus” rally kicks in.
Should the light volume trend continue, that will help traders guide the tape in the proper direction. Do you buy it? It’s a tough call. Even though it’s probably all a mirage in the desert, that won’t matter so long as enough of the crowd thinks it’s real. The irony may be that most of the crowd might not actually believe it, but believes nonetheless that the others do. So they think to go with the odds by pretending to see it too. It works until it doesn’t.
Many stories reported that Monday’s little big rally (little volume, big prices) were based upon the jump in existing home sales reported by the National Association of Realtors, which showed a 10.1% jump to a 6.1 million annual rate versus the average estimate of 5.7 million. Too bad the market was actually higher before the data were released. Prices did briefly rise on the news, but gave back the gains and settled lower. The main reason for the rally was the calendar – it was Monday, and the current trend calls for Monday rallies.
New-home sales also rose past expectations to a 430,000 annual rate versus expectations of about 410,000. Perhaps even better, September’s revision was actually in the other direction for a change, from 402,000 to 405,000. Silly talk about the industry’s fortunes turning up followed quickly, despite the drop in the homebuilder’s index the week before.
Although new home sales did rise (seasonally adjusted), doubtless helped by the tax credit, prices continued to fall. One little item that went unreported was that the median time for a new home to be on sale rose to 13.5 months. So far as we know, that’s a new record, and a very long time to be carrying an empty home on the books. One might think that as the year comes to an end, builders were more motivated to cut prices, but the increase, which was entirely in the South (every other region was down), came mostly in homes under construction. It may be that some new communities skewed the total.
Mortgage-purchase applications bounced back as well, but that shouldn’t be overstated. The increase was an impressive-sounding 9.6%, from an undisclosed downward revision to the week before (times must be tough over at the Mortgage Banker’s Association, they get more close-mouthed all the time). But that would only return the index to somewhere around the 230 level, which was officially called “very weak” when it was rung up back in February. That was in the deep, pre-tax-credit part of the recession.
So is residential real estate picking up? Not really. One in four homes are now delinquent or in foreclosure. The low levels of activity make for deceptively large percentage increases, usually downsized with the following month’s revision. But there is stabilization. The areas at the lower levels are being helped by bottom-fishers and the tax credit, while expensive homes in a few areas are getting some help from the stock market and asset reflation boom.
Yet many homes are already being counted twice as distressed auction sales get flipped. The official inventory levels are belied by the number of homes that would be on the market if there were any real demand. The Case-Shiller home price index showed another monthly gain in September, but despite the fact that twelve-month declines fell to single digits for the first time in 21 months, ten of the twenty cities showed monthly price declines. The FHFA, which uses Fannie and Freddie mortgage data, reported prices to be unchanged.
There is no mistaking the fact that homebuilding is in a historic trough as an industry and probably can’t get any worse (though individual companies may still have some serious problems). Even casual observers can tell you that we are below the replacement levels needed to keep up with the household formation rate.
But times are still tough. Financing is almost exclusively available from the government and builders. The USDA – yes, the United States Department of Agriculture – has a program for rural areas that has leapt to life with the drying up of credit in the private sector. It’s done over 133,000 mortgage guarantees this year, double last year’s rate and four times the level of 2006. Some builders in the South seem to be making special use of the program, which could explain the bump in new home sales in that region.
In the private sector, banks are still reluctant to lend into a falling market. It’s hard to see that changing in 2010 – especially given the workouts (at best) looming in commercial real estate and construction. There’s a reason that the Fed has started whispering about extending its purchases of mortgage-backed securities. Rates are one hundred basis points lower than this time a year ago, the presumably expiring tax credit inspired a late surge, yet new home sales in October were the second-lowest for that month since 1981, only five percent better than the all-time per capita low of October 2008.
The U.K. may actually recover its own housing industry first. London prices are paced by financial sector compensation, and 2009 has seen a big recovery in that respect. Activity in the capital city radiates outward throughout the country. But neither London nor our own shores should expect the kind of one-way market we’ve had since March to repeat itself next year. A sideways market next year would be a typical follow-on performance from a recovery rally, yet it would have a stagnating effect on housing.
Of late, realtors love to talk about the new affordability of housing, but that’s another mirage. The ratio of average home price to income has certainly fallen, which is what they’re talking about, and mortgage rates are very low. Unless you can get government help, though, the down payment requirements have gone up dramatically, from three to five percent to twenty. Income verification may sound fine, but it can be an obstacle to the newly promoted or hired – lenders want to see some longevity. We’ve a ways to go.
We don’t know if it’s catching the way the flu is, but our complaints about the credibility of certain government statistics are starting to be voiced at the national level. The revision to third-quarter GDP announced last Tuesday shaved off quite a bit from the original figure, taking it from 3.5% to 2.8%. Yet that figure came in for a lot of scorn, justifiably so in our opinion. Two items that stuck out were the implicit price deflator and final demand.
The BEA revised its already dubious estimate of 0.8% (annualized) for the price deflator down to 0.5%, apparently by counting the cash-for-clunker rebates as falling prices. We don’t think so (the lower the price deflator, the higher is the headline GDP figure). The price deflator for domestic purchases was 1.4%. The estimate of 3.5% for real final sales was widely disputed as well. In any case, the fall-off from cash-for-clunkers is going to make it hard to duplicate that estimate for the fourth quarter.
We’ve also remarked a recurring problem with weekly initial jobless claims. They were reported to have fallen below 500,000 for the first time since January, all the way to 466,000 from 501,000 the week before. One might have expected the market to rally on the milestone, yet Rick Santelli was quick to point out on CNBC that morning that many market observers have taken to wondering about the unadjusted figure, which actually rose last week by 65,000. The seasonal adjustment factors are having a bad year, which ought to be expected: typical smoothing doesn’t work well in atypical times.
Those are real workers being laid off in the unadjusted data, and a difference of 100,000 in one week is something to think about. The labor market remains too weak this late into the recession. That the unemployment rate should continue to rise is normal behavior at this point in the cycle, but layoffs as a percentage of the work force are higher than a year ago. As bad as things were then, once the government became serious about saving the system, we would not have expected this result a year later. Hopefully layoffs will begin to significantly ease up in January, for we are certainly overdue on it.
The weakness is finding its echo in the consumer confidence numbers released last week. The Conference Board reported a mild increase to 49.5, up from 48.7 the month before. Beyond a small decrease in people expecting conditions to worsen, it was virtually unchanged, remaining well below its long-run average of 86. The University of Michigan’s sentiment index was also about the same, reporting a result of 67.4. It doesn’t bode all that well for Christmas spending.
Yet actual spending correlates better with income than confidence. Personal income rose 0.2% in October, according to the BEA (Bureau of Economic Statistics), and there were upward revisions to previous months. That’s hopeful. On the other hand, real income for the private sector fell. The difference is largely in government spending and dividends (most dividends are effective in calendar quarters and often paid the next month). So the government safety net is helping, and the extension of unemployment claims eligibility will further help. But the private sector is lagging, and will probably continue to do so until bonus payments hit next quarter.
Elsewhere, weekly retail sales put in another good week compared to the last two Octobers. Retailers cited increased seasonal spending; that should help with fourth quarter GDP estimates. Durable goods zigged down instead of zagging up in October, but that was largely a result of a big revision upward to September data. Taken together, the two months were a wash as far as dollar expectations. The category for business private investment fell again by (-2.9)%, the second time in three months, but our thought is that it’s gone into a zigzag pattern, and so should bounce back next month.
Treasury auctions went quite well last week and will probably continue to do so as the end of the year draws near. Institutions will stock up on safe money to protect the year’s results from the last few weeks, and there is also the motivation to gussy up end-of-year balance sheets. Certainly the Dubai fright isn’t going to do anything to upset that tendency. Next week will see the critical ten-year and thirty-year auctions.
It will also bring a big chunk of data, including the last jobs report to be released in 2009. The consensus calls for a slowdown in conditions, with job losses to fall to (-100,000) from (-190,000) in October, and the unemployment rate to stay the same. That looks optimistic to us on both counts, but the good old seasonal adjustments could come through. Although small business isn’t hiring, the model keeps creating new jobs from that sector. They get revised away eventually, but the immediate headline is what counts in the markets. As for the unemployment rate, the Bureau can always strip another chunk of bodies out of the labor force.
We’ll get lots of survey data on business activity next week. The Chicago Purchasing Managers Index (PMI) on Monday will give us the last guess at the national ISM (also once called PMI) manufacturing number due out on Tuesday. The non-manufacturing number follows on Thursday. With the month turning the page and the importance of the data, the odds favor some action next week.
There’s plenty more to chew on: November motor vehicle sales, October construction data and pending home sales also come on Tuesday. The Beige Book comes out on Wednesday afternoon, though the day may belong to the morning’s ADP and Challenger job data. November same-store sales will start coming out after the close on Wednesday into Thursday’s open, and there should be plenty of talk about Black Friday and Cyber Monday as well. The 30-year and 10-year Treasury auctions are reported the same day.
All of that will make for quite a bit to digest going into Friday’s star, the jobs report, which should overshadow the factory orders report later that morning. Maybe the jobs report won’t be the star after all if the adjustments seem implausible. Several Fed officials are scheduled to speak next week, including chairman Bernanke on Thursday, and President Obama has the jobs summit on tap. It will make for a very interesting week – and don’t be surprised if the debt markets steal the show.
We want you to know that we like RF Micro Devices (RFMD). As the name suggests, the company makes radio frequency parts, as well as specialized semiconductor components.
We like the company for several reasons. It has a decent balance sheet, with a debt-to-capital ratio of about 29% and approximately $1.35/share in cash at the end of the quarter, pretty respectable next to Friday’s closing price of $4.33. It has since used some of that cash to repurchase an additional $197 million of convertible debt, which should also reduce its share count.
Its last quarter produced positive surprises in earnings and revenues, and the company raised its guidance for free cash flow for the current fiscal year (March). It currently trades at less than eight times free cash flow.
Those are the numbers; we also like the product line. We see the cell phone market continuing to migrate towards smartphones, and RFMD management expects the company to be a major beneficiary of the move. Smartphones have a higher RF content, and management predicts that it will be shipping into all major smartphone platforms within eighteen months. The growth of mobile video should act as a tailwind for RFMD’s product line.
The company will present at the Credit Suisse Annual Technology conference on Tuesday. The presentation will be webcast, and we think you may find it worth a listen.
Avalon Asset Management Company is a Registered Investment Adviser
Avalon's MarketWeek is not intended as a market timing newsletter or service. No buy or sell recommendations are made for any of the individual stocks mentioned on the site, and neither Avalon Asset Management Company nor its officers, directors or employees make public stock recommendations. Please address comments to MarketWeek@AvalonAssetMgmt.com