Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
Fall Follies
"They tried to make me go to rehab, I said, 'No, no, no.'” - Amy Winehouse, Rehab
Early this summer, an idea making the rounds was that since the U.S. was the first Western country to go into recession, it would be the first out. Ergo, one should buy U.S. equities. As the appetite for risk returned to the markets – buttressed by a feeling that the governments have put an indefinite moratorium on anything really bad happening - the emerging markets took off and passed the U.S. to the upside, just as they had passed them on the downside.
Now the bull case making the rounds is that as the U.S. will be the last economy to emerge, there is still room to go in the rally and so one must buy U.S. stocks. Just follow the yellow brick road.
Stephen Roach, of Morgan Stanley (MS), complained last week in the Financial Times that due to “massive liquidity,” “financial markets are again ignoring tough fundamentals.” Gary Kaminsky of Neuberger Berman observed that the recovery is happening not on Main Street or in the real economy, but only on Wall Street. He opined that the markets would return to fundamentals eventually, but probably not until next year.
Along those lines, Barton Biggs (formerly of Morgan Stanley) announced that his firm had studied previous bear markets and had discovered that the average rebound bounce from a crash was about seventy-two percent. As the S&P 500 is “only” up some fifty-odd percent from its March bottom, it then follows that we have about ten or twenty percent left before being extended by historical standards.
Duly inspired, we did some historical research too. Something that caught our eye was the 1980-1982 recession and bear market. For one thing, the chart patterns from 1982-83 (top chart) and this year (bottom chart) look remarkably similar. It’s intriguing that the rally from the bottom of the bear market in August 1982 to its peak in the spring of 1983 was about seventy percent. Another intriguing facet was that looking at the last three recessions and their bear markets, all three of the initial rallies out of the bottom peaked in the springtime.
S&P 500 Index March 1982 - December 1983
S&P 500 Index March 2009 - October 2009
That may explain why so many investors are convinced that any correction won’t come until the spring of 2010. Some back this further by suggesting that the next slowdown in the economic data won’t start to become apparent until we’re into the second quarter of 2010. That would put history, fundamentals and charts on the side of staying long into the spring of 2010. What’s the problem?
In 1982, the catalyst that started the markets back was the Fed’s interest rate cut in August. Although unemployment continued to climb for some months, peaking at 10.8% before subsiding, the market rallied strongly into the springtime. Like the current rally, the 1982 rally came at the end of a “lost decade” for equities.
The seminal event for that rally was the belief that it was the beginning of the end for inflation. For this rally, it turned upon the major banks projecting in early March that they would make money in the first quarter. In other words, it was the beginning of the end of the fear that the banks might be nationalized.
It all looks so tantalizing for the theory that there’s another twenty percent left to go until the springtime. But there are some imperfections in this particular mirror. In both the 1982-1983 and 1990-1991 comebacks, the first big rally lasted about seven months. Our current rally just notched its seventh month last week. The 2002-2003 comeback lasted a year, but that particular crash didn’t involve the disappearance of money from the system. That’s another thing that the current recession has in common with 1990-1991 (the savings and loan crisis) and 1980- 1982 (high interest rates and restrictive monetary policy to choke money out of the system).
In the 1982-1983 rally, after the euphoria wore off, the market went sideways for the next eighteen months. It didn’t really revive itself until Fed Chairman Paul Volcker started making hopeful comments about the inflation battle (GDP had already been humming along). We suspect that the equivalent for the current period will come with the belief that the globe is finally growing again. The current move is only a dead cat bounce.
Next week the earnings season gets into high gear. The accepted wisdom at this time is that one, earnings will beat estimates; two, companies have to start showing revenue growth to keep the rally going. Regarding the former, we wonder how there can be any earnings surprises at all when the whole world is expecting that estimates will be surpassed. However, that kind of thing rarely bothers the Street.
As far as the necessity of showing revenue growth, we think that the slightest traces of improvement or even just flat-lining will be declared a victory for the markets. It’s going to be hard to brake the current trend. Some further twist to the narrative may be needed, but that won’t cost anything. Kaminsky also pointed out that mutual fund managers may not be interested in doing any selling until after the end of their fiscal year this month, in order to avoid passing on capital gains to shareholders (you would think there would be plenty of losses to offset them, but most of their losses seem to have been realized earlier in the year).
In sum, the follies look set to continue, unless some external event can come along to shake confidence. The markets are overvalued, but as more and more research indicates, the markets don’t do a very good job of correcting via selling pressure from arbitrageurs, the way efficient-market theory supposes. It seems that the arbitrageurs are more likely to get run over by the momentum players and simply give up. In other words, the trend is your friend – until the end.
One of the main reasons that the market could pull off its five-out-of-five last week was the lack of economic news. It really is so much easier to keep a rally going when one is freed from the gadflies of economic reality and can focus on more essential things such as charts and today’s hot play.
There was a handful of monthly data, but not the sort that the Street pays much heed. Or at least, not unless they can show a positive surprise. Perhaps the best example of this is the ISM non-manufacturing report. The services sector that it represents may represent about seventy percent of the economy, but its survey isn’t considered to be as cyclically sensitive as its manufacturing cousin. Probably so, but one thing that’s certain is that traders tend to pass on the services report when it’s bad and jump on it when it’s good. We know that’s shocking, but it’s true.
For the record, the ISM report finally dragged itself back to neutral. One is supposed to call 50.9 growth (fifty is neutral), but it’s hard to do so when five industries reported growth versus thirteen reporting contraction. The best part was that new orders were at 54.2 and business activity rose to 55.1. Inventories and employment continued to contract, however, albeit at slower paces. Prices fell very sharply, which may not be a good sign, and exports shrank. Probably all the Street cared about was that the overall number was at 50.9 and the consensus was for 50.
The other monthly number was the international trade report. The trade deficit came in a bit lower than expected. Coupled with some encouraging noises from various government officials, that helped arrest the momentum trade in the dollar for a day. The improvement is mainly due to falling trade volumes: imports fell more than exports (largely because of lower oil imports) and exports fell in real terms. Apart from the dollar players, however, traders gave the report little heed.
About forty chains reported same-store sales comparisons for September. As you might expect, most companies had negative comparisons; also as you might expect, they were feted anyway for beating expectations. Nice work if you can get it. The mix trend is still intact, with discount stores faring the best and luxury stores the worst. October and November of 2008 saw staggering drops in sales, so comparisons should be easy for some time to come. However, a national retailing association projected that Christmas sales would still be down about a percent from last year’s dismal performance. I suppose that means that if this Christmas is simply flat by comparison, it’ll be another estimate-beating victory.
Wholesale trade for August had some interesting data. Inventories continue to draw down, but sales picked up, thanks largely to autos. On the other hand, the year-on-year drop in sales (-17.7%) exceeded the twelve-month decline in inventories. Restocking hasn’t quite happened yet. That suggests that third-quarter GDP might not be as robust as hoped for, but why worry? That’s just better for next quarter’s GDP.
A couple pieces of good news came from the weekly data. Mortgage purchase applications spiked up sharply, no doubt due to last-minute tax-credit hopefuls. Weekly jobless claims rose by 21,000 in the prior week, but then fell by about 30,000 last week. The numbers keep bouncing around between 500,000 and 550,000, but the thing to keep in mind is that even 400,000 would be very high this late in the game. A drop to the 500,000 level is long overdue and isn’t going to signify much more at this point than companies running out of workers to cut.
Before you celebrate, though, seasonal factors may have skewered the results. Unadjusted claims actually rose from the previous week, but summer employment this year came up about ten percent short of model expectations. Fewer summer workers means fewer claims to file in the fall, and the lack of seasonal workers able to file claims could be throwing off the model adjustments. Traders don’t have time to worry over such details, though, and drove the market higher joyfully because (drum roll) it beat expectations.
Consumer credit fell steeply again, this time by twelve billion dollars with about ten of that coming from the credit card sector. Average rates rose in the sector, no doubt spurring more cardholders to pay down their balances. We have been critical of the major card lenders for trying to gouge their customer base with usurious rates, though the companies try to defend such practices as necessary to manage risk. It looks as if they might shoot themselves in the foot on this one by driving their clients to eliminate balances that were a source of profits to the banks.
Next week will start slowly. There are no major releases scheduled for Monday or Tuesday, which should help the markets continue their upward bias, and Monday is a holiday for the bond markets in the U.S., as well as banks and government offices.
The action will get much more serious in the latter part of the week, beginning with the September retail sales report to be released on Wednesday morning and the FOMC minutes Wednesday afternoon. J.P. Morgan Chase (JPM) will report earnings Wednesday morning before the open.
Thursday is a big day. The Consumer’s Price Index comes out before the opening, but traders aren’t really very dialed in on the report of late. While there’s no shortage of opinion being expressed about what may or may not happen to prices down the road, outside of the currency markets they aren’t currently much of a trading catalyst.
Citigroup (C) and Goldman Sachs (GS) both report earnings before the open, and those two will have a big impact on what traders think. The reports will be followed by the New York and Philadelphia Fed regional surveys, at 8:30 AM and 10:00 AM respectively. To keep things interesting, both the oil and natural gas weekly reports will come out together at 10:30 AM, as the oil report is delayed a day by the Monday holiday. After the close, we’ll get earnings from IBM and Google (GOOG). Thursday is without a doubt the day of the week.
But Friday will be momentous as well. On the one hand, the market will be digesting the previous evening’s reports from IBM and Google, while before the open Bank of America (BAC) and General Electric (GE) will both report earnings. The government will weigh in with the Treasury’s International Capital report at 9 A.M., with the skinny on who has been buying our paper. Industrial Production for September follows shortly thereafter, with the University of Michigan weighing in last with its first October reading of consumer sentiment at 9:55.
The last two days could be very volatile. Our sense is that the markets are ready to declare the slightest upticks in revenue to be resounding victories – will the companies deliver?
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