Avalon Asset Management Company Lexington, Massachusetts Investment Management
Avalon Asset Management Company Tied to the Whipping Post
“But nothin’ seems to change, the bad times stay the same” – The Allman Brothers Band, Tied to the Whipping Post
When Greg Allman wrote that he felt as if he’d been “tied to the whipping post,” he was talking about romantic betrayal. That is perhaps closest to the feeling traders had last week, when the fiercest wave of equity selling in seventy-five years relentlessly ground traders’ spirits into the dust. Utter pain and betrayal.
“Good Lord, I feel like I’m dyin’“ is the tag line to the song’s refrain, and that was a sentiment echoing throughout the week with Wall Street traders, hedge fund and mutual fund managers hammered by redemption requests, credit-starved businesses, laid-off employees and despondent investors opening their quarterly 401-k statements. Stocks of every sector and very nearly every company, good or bad, were simply thrown overboard. The Wall Street Journal estimated that over $8 trillion of equity has disappeared from investor statements in the last twelve months.
The crowning irony was that much of the final damage was self-inflicted by retail investors. The markets would struggle to rally in the mornings and be overwhelmed in the last ninety minutes by waves of redemption-related selling from investors unwilling, or unable, to take any more pain. Mutual funds were swamped, and hedge funds were hit especially hard as every dollar of redemption often led to three or four dollars of selling by leveraged funds unable to get any more credit. We hate to say it because we don’t like to see the public lose money, but they were getting out at the bottom.
But wait, aren’t we heading for a recession? Doesn’t it make sense to get out now? We certainly are headed for recession – we’ve been making that point all year long – and in the opinion of most (including ours) we are already in one. But that event was already priced in when the Dow fell from 14,100 to 10,000 the last twelve months. The rest of the decline was the kind of panic selling that defines a market bottom, the counterpart to the frenzied buying that defines a market top. Markets overshoot.
The selling did seem to have reached an exhaustion point by Friday afternoon, a day when the market recorded the first intra-day thousand-point swing ever in the Dow Jones average. The index was actually up a few hundred points with just over thirty minutes left to go when the last wave of sell programs kicked in again, especially in the last five minutes (it had nothing to do with rumors of the Fed investing in banks, as some cub reporters tried to suggest. As soon as the sell program orders turned up, hopes that the buying reversal might run to the close evaporated and traders bolted for the exits again).
That last selling wave looked more than a little suspicious, but we must remember that we’ve been told for a couple of weeks now that the ban on short-selling was not only useless but was hindering the market’s ability go up. Just ask Morgan Stanley (MS) or General Motors (GM), two companies whose stock prices disappeared just as soon as the ban was lifted. Perhaps the short-seller buy-to-cover orders were mislaid.
Looking back at the week in its entirety, we began with the press and Congress falling on former Lehman Brothers CEO Dick Fuld, who in the space of thirty days went from being one of the smartest men on Wall Street to a pariah, thrown into the stocks by the financial press for being slow and dull-witted, and pilloried for his paychecks by a Congressional committee.
The Journal ran one of those exculpatory articles in which all blame for a systemic breakdown is imputed to a few bad actors, in this case Fuld and the margin clerks at JP Morgan Chase (JPM), who had demanded $5 billion each from Lehman and Merrill Lynch (MER; and they’re still after Merrill for the money).
If only it were that simple. Lehman was done in by a combination of factors, starting with its overexposure to real estate. But we’ll keep pounding the point home here: Lehman shouldn’t have failed. It was a cash-flow positive business, should never have gotten to the brink to begin with, and we believe that history will eventually judge the decision to let it go as the single greatest financial blunder by our government since the Great Depression. We are not alone in that opinion; it is a view that is gaining increasing traction around the Street.
The Lehman wreckage sent a shockwave around the financial world. Lehman debt, commercial paper, stocks held in Lehman’s custody, all were lost. That started the seizure of the credit markets, the breaking of the buck for money-market funds, the subsequent meltdown of the short-term credit markets, the freezing of commercial paper, and at the heart of it all the counterparty paranoia that renders every institution suspect. The laboratory experiment by Bernanke and Paulson to see what would happen if they let one of the country’s largest investment banks file bankruptcy in the middle of an economic crisis didn’t teach the students a lesson. It blew up the building.
During Bernanke’s televised appearance last week, we noticed a familiar tic: when asked a question about something he would rather forget, the chairman has a tendency to look down at the table. For example, when Congress asked him about the Bartiromo incident (the brand-new chairman joked freely with a CNBC-TV newscaster and she promptly threw him under the bus), he looked studiously down. When speaking about Lehman last week, he looked down at the table again and spoke quickly about how it would have cost “billions.”
Yes, billions. Not as much as the $85 billion that they had to spend two days later to save AIG (now over $100 billion), not as much as the $700 billion they needed a day after that to save the banking industry, and not as much as the billions the government is now preparing to spend investing in banks. But, you know, billions. Ten at least, I should think.
Even worse, there might have been snide remarks about the free market and Wall Street big shots, and avoiding that has to be worth the trillion-plus dollars we’re going to spend instead. As the House of Representatives demonstrated the week before, a cutting comment in Washington easily trumps the economic welfare of our nation. What if former pitcher-turned-Pennsylvania senator Jim Bunning had scowled fiercely and said some rude things? For a couple of baseball fans like Ben and Hank, that prospect must have been too much to bear. Better to do nothing than to bear the proud man’s contumely.
Somewhere the ghost of J.P. Morgan is slapping his head in complete disgust, while Ben Franklin stands next to him and mutters that an ounce of prevention is worth a pound of cure. Even a ton of it.
Hank Paulson rose to the top of Goldman Sachs (GS), which is not an easy feat. We have to give him props. One thing we’re certain of, though, is that he didn’t get there by wowing the crowds with his rhetoric. He’s probably a great one-on-one negotiator with fellow financial experts, and I tip my hat to the stories of him getting down on bended knee to Speaker Nancy Pelosi (who didn’t need convincing so much as she needed cover). Full marks for that effort.
Nevertheless, his standup routine bombs. When I watched the latest iteration Friday evening after the market’s close, I was grateful. Grateful, that is, that the markets were closed, or else they would have fallen another three or four hundred points. Maybe by Monday they’ll have forgotten a lot of it.
Secretary Paulson was ebullient to say that the G-7 members were really united this time, and so they issued a communiqué that they were really, really serious, and were going to think really, really, hard (oh, and drink lots and lots of coffee too, I’m sure). Other than that, he couldn’t be more specific. I’d give that oh, three hundred points off the Dow.
The secretary also stated firmly that they intended to act quickly with the plan to invest in certain banks, and that they knew it was urgent, and time is of the essence and they’re working around the clock on it, but you know it’s important to get it right so he couldn’t say when they would be ready. Two hundred more points. Okay, so I underestimated: the speech would have cost five hundred points.
Think about it: when the House decided to put its votes up for auction first, the delay in implementing the relief plan helped solidify the freeze in the credit markets. The Fed has announced that it would buy commercial paper, but by week’s end had not yet done so. Paulson got the rescue authority, but completely deflated the markets when he said it would be weeks rather than days before Treasury would buy anything. And the result, according to the headline on Saturday’s Wall Street Journal, was “Worst Week Ever for Stocks.”
So my question at Friday’s press conference with Paulson would have been this: Sir, has it occurred to you that while you are all getting the lifeboats in perfect order, outfitting them with just the right supplies, and carefully picking the best crew members to man the boats, in the meantime the survivors in the water are vanishing? I think it may be time to stop fussing about which jackknife to bring and start getting the boats into the water, don’t you?
If the government does invest in banks, here’s a tip: Stop shooting the shareholders. It’s just making it worse. The scorched earth policy hasn’t worked, only made the entire world reluctant to be a shareholder - and yet there was Paulson straight-facedly moralizing Friday evening about how he had lectured the financials on the importance of raising capital. Fannie (FNM) and Lehman both raised capital within the last six months and then the government wiped it out. Have you checked your meds lately, Hank?
Yet there is a silver lining to all of this. The markets really are oversold. The VIX volatility index hit an all-time record last week, an excellent sign of a bottom. Help is on the way, at least by the end of the month. The bulk of redemption and margin-call selling should be over. Dow stocks were selling at single-digit multiples Friday, something that hasn’t happened since the nineteen-seventies, when inflation rates were double-digit for years. It really is time to start investing again - carefully, to be sure, but still time.
I was in the markets on Black Monday on 1987, and ever since I’ve been of the opinion that the markets actually caught a bit of a break that day. With the bang-and-crash decline, the correction was over in one session. The week after was tumultuous, and there was lots of volatility, but for all intents and purposes we were done. This time we stretched the crash out over the week, the equivalent of being in the dentist’s chair for five days rather than one. Even so, the same lesson runs through the crashes of ’87, ’98, ’02 and ’08: staying in cash after the crash is a costly mistake.
What do you know – we got the round of global interest-rate cuts last week. Nicely done. With eyes on the Dow-meter, many debated the efficacy of the cuts, and claimed that it wasn’t enough. That may be, and it may also be that rates will need to come down more, but it was a good start, and central banks can’t use up all of their ammunition in one go.
The Fed also put in some early appearances on Tuesday, in the form of Dr. Bernanke’s truly uninspiring performance and the FOMC minutes. The minutes, which are intensely scrutinized during rising markets, were largely ignored this time around. The committee talked about high inflation and its highly uncertain outlook to a market worried about the prospects for depression; they may as well have been preaching temperance to someone stranded in the desert.
One impressive turn was that after voting unanimously last month against easing the federal funds rate, the committee then voted unanimously for last week’s fifty basis-point cut. Compared to the Bundesbank, a.k.a. the European Central Bank, still preoccupied with the fight against 1920’s hyper-inflation, that’s moving at light-speed.
Turning to scheduled events, the first big releases of the week came Wednesday, beginning with same-store sales being reported by many of the chains (the weakening economy is steadily eliminating monthly reports). The disappointing tone of the reports quickly snuffed the jittery market’s nascent pre-opening rate-cut rally. The super discounters made out okay, and everybody else didn’t.
However, pending home sales turned in a surprisingly good result. They rose 7.4%, when they were expected to fall. Even the previous month was revised upwards. The National Realtor’s Association fretted about how many pending sales could close, given the current credit conditions, but at least one can say that lower rates and lower prices are starting to have an impact. No doubt foreclosure sales are a significant part of the mix, but that is part of the early stages of a recovering market.
It will probably be some time yet before we can start to call the housing market a rising one though, so long as mortgage applications continue at very low levels. At least the application rate flattened out last week, for whatever that’s worth. Existing home sales will come out on the 24th ; that will show the degree of difficulty in completing a purchase in this credit-constrained environment.
At 476,000, weekly jobless claims were about at the consensus estimate of 475,000. The market was relieved not to see them creep over the five hundred level, and it did mark a decline from the previous week. The level of continuing claims continues to climb, but the market has largely come to accept that we’re headed for at least seven percent unemployment. It just doesn’t want to get there too quickly.
Friday actually brought a bit of good news with the reports on foreign trade. The trade deficit narrowed about as expected, due to the drop in fuel imports, and import prices dropped by a larger-than-expected (-3.0)%. As energy prices keep falling and demand weakens, that trend will continue. The dark cloud in the silver lining, though, is that year-over-year prices are still 14.6% higher. That increase is definitely decelerating and should continue to do so, but we’re still left with much higher prices chipping away at incomes that have hardly moved and net wealth that has plummeted.
Next week starts off slowly in the form of scheduled releases and Monday is a holiday for U.S. banks and bond markets. Even so, weekend madness has become something of a custom lately in the halls of our financial sorcerers, so we’ll likely be digesting something interesting on Monday morning. Perhaps the G-7 will issue another communiqué. That ought to bring the bears to their knees.
After two empty days, though, Wednesday is loaded. We’ll get the N.Y. Fed’s manufacturing survey, the September retail sales report, and the PPI index all at 8:30. Tuesday may yet be the day that the Morgan deal closes, and Intel (INTC) and CSX will report earnings after the close the same day. With Coca-Cola (KO), JP Morgan and Wells Fargo (WFC) all reporting earnings before Wednesday’s open, the market will have an awful lot to process between Tuesday’s close and the next opening bell.
Thursday morning will see a slew of stocks that have been in the spotlight lately reporting before the open, including financials Bank of New York (BK), CIT Group (CIT), Citigroup (C), Huntington Bancorp (HBAN), Merrill Lynch and PNC Bank (PNC), along with such names as Harley-Davidson (HOG), Hershey (HSY), Nokia (NOK), United Technologies (UTX) and a fistful of steel stocks.
They’ll compete for traders attention against the CPI, which will probably not get a lot of respect this time around from the deflation/depression-obsessed market, the Philadelphia Fed manufacturing survey, and the Fed’s Industrial Production report. The latter two will probably get quite a bit of attention from markets looking for evidence of how bad things may or may not get.
Friday is an options expiration day. Given that puts have been the favored item on the trading menu of late, we could see a fair amount of cover buying in stocks the last couple days of the week. Housing starts come out before the open, but the real number for housing this month will be existing home sales the following week. The University of Michigan will release its preliminary estimate for October consumer sentiment later that morning; we’re going to go out on a limb and guess that it declined.
On a side note, I bring you some tidbits from a 1973 issue of Newsweek found recently in an attic: the cover story, “The High Cost of Eating” caught my eye. It seems that administration economists were estimating that food prices had risen six percent in 1972, the highest increase since 1951.
That sounds familiar, doesn’t it? I won’t depress you with the details of food costs (like the fact that McDonald’s (MCD) had to raise the price of its hamburgers from twenty to twenty-three cents), but the stories of how people were cutting corners were similar to what one sees today. A difference is that people were driving around then looking for better deals (the issue came out before the Arab oil embargo), but gasoline is too expensive for that now. Onward and upward.
We suggest you put on your investing shoes and start sharpening the order pencils, because a lot of stocks are going for dirt-cheap prices. We’re going to throw out a bunch of names for you to look at, starting with Apple (AAPL). We were trying to pick up some Apple stock last week at the astoundingly low price of $88, but the market was moving too quickly for us.
Here’s the math on Apple: they have $23 a share in cash and no debt. At $88, you’re getting the rest of the company for about ten times earnings. Benjamin Graham would positively beam at that margin of safety.
Another is United Technologies (UTX), which we featured last week. It’s now trading at a decade-plus low multiple of 10.3 times earnings and less than seven times cash flow. The company is confident enough that it announced an increase in its dividend last week, giving it a yield of about three and a quarter percent. We’ll take that.
Honeywell (HON) is selling at 8.7 times earnings, just under six times cash flow and about two-thirds sales. Even with the recession coming, it’s undervalued by about fifty percent. Western Digital (WDC) is selling at 3.7 times earnings, two-and-a-half times cash flow and barely more than a third of sales per share. Another giveaway price.
Refiner Valero (VLO) goes for four times earnings and just over two times cash flow with a 3.3% yield. What are you waiting for? Yes, we know that crack spreads are at a low and that gasoline demand is down, but the last time we looked engines still ran on it. Wouldn’t you rather buy at the crack spread low than the high?
These valuations reflect panic, redemptions and margin calls. They have nothing to do with fundamentals. We can’t promise that if you buy them on Monday they’ll be up on Tuesday, but we are quite certain that they will be up very substantially the Tuesday a year from now.
Corrections Department: Last week we referred to the problems of Hypo Vereinsbank when we should have said Hypo Real Estate Bank.
Avalon Asset Management Company is a Registered Investment Adviser
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