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Avalon Asset Management Company The Case of the Hidden Bear
“There is but one step from the grotesque to the horrible.” – Sherlock Holmes, The Adventure of Wisteria Lodge (Sir Arthur Conan Doyle)
Sherlock Holmes famously observed that when one eliminates every other possible cause, the last one remaining must be the truth, however improbable. In a kind of parallel universe, we had last week’s market rally, featuring a market determined to ignore every possible cause for going down, and going up anyway, however improbable. Not even a terrorist attack in the city formerly known as Bombay (Mumbai) could derail the momentum train. The reason for the rally, you see, was because there’s a rally coming.
With that impeccable logic, stocks extended a three-day rally to four on the eve of Thanksgiving, despite the worst economic news of the week. Larger, more important fundamental factors outweighed the bad data. To begin with, the market had already rallied three days in a row, and everybody knows you don’t fight the tape. Second, the day before Thanksgiving is a traditional rally day - unless everybody is already counting on it to be a rally day, in which case it isn’t, but this time it wasn’t and so it was. Clear? Third, the markets had been oversold and traders felt that they deserved a rally.
Five days are better than four, so let’s take the Dow up another hundred. What’s to worry? Time to bid up everything, stocks, bonds (the 10-year rallied to 2.98%), oil (up $3.62 despite a much larger than anticipated inventory build). There is one tiny hitch, namely that they can’t all be right. Another unexpected obstacle came along late Wednesday afternoon, right about time that the feeling of entitlement to a twenty percent equities rally was becoming unstoppable: somebody had the bad taste to point out that the S&P had already rallied twenty percent from its trough of a few days before. Dang.
That realization kept things quiet for most of Friday, but in the end the self-affirming rush to the close (and the urge to mark up month-end prices) was too great to stop. The S&P, after hitting an 11-year low last Friday, finished its mighty bounce with an 11.5% gain on the week. We won’t mention that each day’s volume was lighter than the previous, because if you were to see how much those volume bars shrank in succession each day of the rally, it might make you nervous.
We’re at that stage of Bottomville. The first stage is marked by a relentless decline in prices as dismayed investors abandon their positions and seek the safety of cash. As the selling becomes exhausted, we move into the second stage of jaded retribution. The remaining investors and traders have become largely inured to more bad news, such that anything short of catastrophe is ignored in favor of a determined effort to play technical bounces and catch short-sellers by surprise. That’s the stage we’re in now.
At some point, a sustained rally is put together, whose very existence will begin to pull in fresh money and begin to convince some of the media that the worst is behind us. People will nod their heads wisely and talk about how the market rallies before the economy turns up. That’s the penultimate stage.
The last stage comes after the market has gotten ahead of itself one last time. The downturn starts to worsen or begins to retreat again, crushing hopes for an earlier recovery. Once again investors flee, and the previous rally is wiped out, to the accompaniment of great wailing and cynicism in the press. Jokes about the last one to leave should turn out the lights are revived.
Usually, though, the last downturn turns out to be as much an expectations failure as anything else, and the data is mixed. Investors will be tempted by valuations and start to move in again. The market will leave Bottomville under protest, as the media, short-sellers and others insist that it’s another undeserving sucker rally.
Maybe we’ll get to the exit stage by the spring, and maybe we won’t. There are plenty of reasons to worry about this recession getting a lot worse. In the meantime, though, we’re in stage two. It’s hard to say how things might develop, because valuations are still quite low, along with expectations. That makes it easier for us to get back to say, 950 or even 1000 on the S&P.
On the other hand, the flow of bad news is so substantial that even minimal expectations can be overrun. When bad tidings will trigger the decision to take profits and run is hard to say, but it’s going to remain a possibility every week until the end of the year. Treat every rally with suspicion.
Is the Obama factor a technical factor? We don’t know if it is, technically speaking, but it certainly is a trading factor. It’s become accepted wisdom for now that the markets will fall on a Paulson speech and rise on an Obama one, even if the latter doesn’t have that much to say. Of late, the market starts to fall as soon as the Treasury secretary begins to speak, and rise as soon as the President-elect appears on the podium.
President-elect Obama represents hope, and his choices for the economic team have been reassuring to the investment community. Secretary Paulson, on other hand, is nearly his own worst enemy. The markets just don’t know what to make of him anymore, other than to sell as he speaks. Neither do we.
In a recent market soul-crusher, Mr. Paulson sputtered that the Treasury lacked authority to do anything about Lehman Brothers and tried to claim that the firm’s demise didn’t really deepen the credit crisis. Wow. The last time we saw denial on that scale was when Grady Little insisted he had no reason to pull Pedro Martinez in the championship series against the Yankees. Like Mr. Paulson, Mr. Little claimed afterwards that people who thought otherwise were “naïve,” even though every baseball player on both teams, every fan in the stadium and for that matter, the entire television audience watching the game knew that Martinez was done.
As in Mr. Little’s case, Mr. Paulson’s claim hasn’t found any takers amongst the cognoscenti. His counter that the AIG rescue was necessary because the company was globally “intertwined” certainly looks ironic compared to Lehman’s own global entanglements. On might even call it disingenuous, to use the secretary’s words. Mr. Paulson was trying to describe his plan to recapitalize the nation’s banks by tracking down leprechauns to their pots of gold, when aides leapt up and dragged him from the podium.
Okay, I made that last part up. But one of the larger mysteries on the Street is what game Paulson is playing. Is he channeling Mr. Little simply because he’s overworked? One theory floating around is that the TARP turnaround is due to a belated realization that there was no good outcome. Were the secretary to pay fair prices for the assets, the theory goes, the resultant panic at how little they were worth would probably wreck the banking sector. On the other hand, paying a price that would let the banks escape would mean sticking the taxpayers with big losses. After all, paying up would go against the former Goldman guy’s grain and he should be protecting us, shouldn’t he?
If this is true, then it suggests that the Fed (and especially the N.Y. Fed, home of Mr. Geithner) didn’t really know what the banks held, despite owning the Bear Stearns portfolio, picking through the Lehman portfolio in intricate detail, and having supervisory teams in place at every major bank. Or maybe they just forgot where they were. That can happen in the heat of the moment, you know. Just ask Mr. Little.
The other problem with that theory is that it supposes that the risk of a depression that would include unemployment reaching nine or ten percent and trillions of dollars of additional lost wealth and profits (the markets have already lost more than two trillion) is somehow preferable to overpaying by a couple of hundred billion now. Let’s hope not.
It could be that Paulson is simply covering for his boss, but it’s hard for us to accept the image of President Bush pulling all the strings from behind the scene. Maybe, but we’re not going to put our money on it. If we had to guess, we’ll take the simplistic route, because that usually turns out to be the case: the assets are too hard to figure out.
Paulson doesn’t feel like getting worked over by Congress again for the second tranche of money because he’s not sure himself of which assets to buy and at what price. One legacy of an anti-regulatory policy, it seems, is a lack of regulators who can go over the books. While there ought to be a big increase in the supply of financial types on the labor market soon, though, hiring them could prove ticklish.
While the remaining TARP money remains in stasis waiting for a fresh emergency, the credit markets are largely moribund as well. The Fed has helped things out by guaranteeing bonds, buying mortgages and pumping liquidity into the asset-backed securities market. In the meantime, the junk bond market – now over 50% of US corporations – is firmly shut, the municipal bond market is right behind it and stories of frozen-out individuals and businesses pile up in the financial press.
Credit is leverage, and the longer the current famine persists the more leveraged its effect will be on the economic downturn. Frightened financial officers read predictions of higher default rates, leading them to cut off lines of credit and in turn increase the eventual default rate. Add a General Motors (GM) default to the mix and them imagine the reaction in the credit markets. Think of how deeper and longer the recession would get.
This isn’t the time for that kind of adventure, yet our recent history shows no shortage of gamblers willing to roll the dice at the worst possible moment. Our suggestion is that until Congress comes up with a no-bankruptcy plan for the automakers, keep updating your list of good companies selling at great prices, but keep your cash where it is.
When we put together this week’s report, it was striking how bad the economy really is, especially when compared to the market rally. Housing news dominated, and upon looking at the (lousy) results, one can see why the feds are trying to get the mortgage market going again. Existing home sales fell (-3.1)% to below the five million annual rate, pricing continues to weaken and a whopping 45% of the sales were foreclosure-related. Inventory crept back up to 10.2 months from 10 months.
Yet in the logic of the day, that is relatively good because the number largely met consensus, and it beat the fear estimate. Besides, the “new new” thing is that bad economic data doesn’t matter anymore, because we’re inured to that kind of thing.
The Case-Shiller home price index showed a year-over-year drop of (-16.6)% through the end of September. That was worse than the (-11.9)% decline in median price from the existing sales data, and more significantly a reacceleration from the previous month. Given credit developments since then, the average decline could top the twenty percent level that many cities have already experienced. On the brighter side, it will be at least another ten or twenty years before we get to hear again that home prices never decline.
New home sales rounded out the bad news with a sharp (-5.3)% drop from September to October, bringing the bill to a (-40.1)% drop year-over-year. The run rate is now at its lowest levels since the 1990-92 recession. Mortgage purchase applications ticked up slightly from the week before, but remain at very low levels. In a note of black comedy, the homebuilders’ association jumped onto the stage with its own version of “Oh Lord, Won’t You Buy Me a Mercedes-Benz,” a $250-billion bailout proposal for themselves. It wasn’t warmly received.
We generally don’t bother much with GDP revisions from previous quarters, partly because they’re history, partly because GDP itself is usually misleading. So the first revision of last quarter’s measure from (-0.3)% to (-0.5)% isn’t that much of a big deal, but worth mentioning is something that disturbed prognosticators: consumer spending was revised lower, with an unwelcome offset from inventory data being revised higher. Not good for the trend.
That weakness was reflected in the October personal income and spending data, which showed a gain in income of 0.3% from the month before and a drop in spending of (-1.0)%. The income gain was largely a quirk of the hurricanes, though, while September income was revised downwards. The drop in spending was a bit larger than expected and had some economists talking of a drop in GDP of over four percent this quarter. At least the inflation data was tame: there isn’t any.
Much of the spending drop was in durable goods, which are larger-ticket items. Orders in October fell precipitously, a (-6.2)% drop that was more than twice as large as the consensus estimate. September was revised from a gain of 0.9% all the way down to a loss of (-0.2)%, clearly indicating a worsening trend that was darker than feared. Add the recessionary numbers in consumer sentiment to falling spending, GDP, home sales, employment and manufacturing, and why shouldn’t stocks be rallying?
Initial jobless claims “retreated” to 529,000, an improvement from last week’s dismal 542,000, but the four-week moving average hit a twenty-five year high. Continuing claims fell back below four million, but the ratcheting pattern of that category would imply that we will soon be back above it, even factoring in the drop-off effect as claims are exhausted.
The employment market was reflected in the two consumer surveys, beginning with the Conference Board’s confidence measure at 44.9, an improvement from last month’s all-time low. Its present situation index fell, as did the University of Michigan’s, and the board noted that consumers “remain extremely pessimistic.” Expectations rose, but the Michigan survey fell in the same category. The overall Michigan result fell to 55.3, a new low for the cycle.
Besides the drop in durable goods, more manufacturing weakness showed up in the Chicago PMI survey, which came in at the low end of its estimate range with a reading of 33.8. New orders fell sharply to only 27.2, the worst showing in twenty-eight years. The order backlog fell to its lowest level since April 1982, and the employment indicator fell sharply as well. The ISM national survey reports next week rate to be evil.
In other data, weekly chain-store sales fell sharply, although there remained some hope that consumers were waiting for Black Friday sales events. The Fed’s latest tool, an asset-backed lending guarantee facility, took mortgage rates down sharply and spurred a big increase in refinancing applications. That will mean an income boost for those who are safely ensconced in existing homes with good credit, but in our ever widening two-tier credit system, many will be left out.
Next week is relentless and should be a stern test of the market’s new optimism. We’ll get the ISM manufacturing report and construction spending on Monday, and both should be quite weak. Against that is the first-of-the-month trend that usually lifts prices, although Friday’s marking up of month-end prices may have exhausted most of the ammunition. Still, expectations have been set very low and it may prove nigh impossible to surprise the market to the downside.
The non-manufacturing side of the ISM will report on Wednesday, with factory orders set for Thursday. Along with motor vehicle sales on Tuesday, that should give a fairly complete picture of the production side of the economy. A look at retail demand will come on Thursday, with monthly same-store sales reports.
The labor side of the economy will show up first on Wednesday’s report on productivity and costs, followed by the almighty jobs report on Friday. The consensus estimate on the latter is for a loss of an additional 300,000 jobs and another big jump in the unemployment rate to 6.7%. Given the low bar and current mood, it will probably take a very wide miss to upset the market.
Central banks will get into the act with the Fed’s beige book on Wednesday and the ECB and Bank of England holding monthly policy meetings Thursday morning. Significant rate cuts are expected.
StockWatcher recommends that you wait for the auto rescue package to be worked out before buying any individual names. If the market continues to rise this week, don’t buy into any notions that the bottom is history. It isn’t.
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