Avalon Asset Management Company Lexington, Massachusetts Investment Management
Avalon Asset Management Company Tangled in the Falling Vines
“I know I’m faking it, I’m not really making it.” – Paul Simon, Faking It
After a nightmarish thirty days of frozen credit, plunging prices and government missteps, the markets finally caught a break last week when the government began to put its rescue money to work. It was the best week in five years for stocks, the kind of rally that unhappily is nearly always found in the depths of bear markets.
It was one of the most riotous rides ever, beginning with the near thousand-point advance on Monday. That was followed by a fifteen percent peak-to-trough collapse from Tuesday to Thursday morning, followed in turn by another rally that managed to last until about the last hour of trading on Friday, when safety concerns again prevailed. Seasoned investors who’d jumped in when the VIX options volatility index surpassed the lofty forty level a few weeks ago were stunned to see it surpass eighty last week.
Throughout the week, the Street buzzed with stories of forced selling, margin-clerk dumping and hedge fund flight. The intense liquidation pressures in the last group had many throwing in the towel and announcing heavy cash weightings, a move roughly akin to buying hurricane insurance the week after Katrina’s visit. Trading flight led to oil dropping briefly below $70 a barrel, or half of its peak only four months earlier, with predictions that $50 might be on tap. We can expect the OPEC emergency meeting next week to announce a new program of production cuts to counter falling prices. That should be followed the week after by the new unofficial program of cheating on production cuts.
While the markets wildly welcomed the government’s capital-injection plan for the banking sector that came out of the new TARP plan (the “bailout” package), it’s important to keep in mind the governmental bungling that led to the necessity of the TARP package. We didn’t need to get as close to the brink as we did.
There’s another reason for investors to appreciate the bungling that made the situation worse than it had to be: because whenever we have these kinds of train wrecks in the market, every theory ever invented on the danger of trains is triumphantly trotted out by every fringe theorist in existence. Most such theories will use the wreckage as conclusive, inescapable proof that the trains are, for example, alien inventions by pod people designed to systematically eliminate us all, beginning with David Duchovnoy, who was actually killed on the train and replaced by another cunning pod.
This kind of rubbish leaps exponentially at market tops and bottoms. The markets find a tune for every story, no matter what happens. We railed in this column against the nothing-can-stop-us-now smugness that characterized the 2007 top, and now the perma-bears who have predicting the demise of the markets since 1958 have suddenly been thrust back into the limelight for their brief moment of crackpot glory.
Every decade since the nineteen-sixties has had a period when you could not pick up a newspaper without reading about the imminent and inevitable decline of the American empire. This view gets a warm welcome in Europe, for the same kind of reason that stories about problems with the New York Yankees are most avidly swallowed up by fans of the Boston Red Sox. It’s human nature, it’s the situation right now, and every decade for fifty years it has been one of the surest buy signs in the market.
Don’t misunderstand us – the problems were all there. The markets really were overvalued, decoupling really was a myth, the economy really has been slowing, the commodities and oil bubbles really were bubbles that had to be burst. We really did have an inventory excess in credit and housing that couldn’t avoid a correction.
But for every sober analyst who had been predicting the market downturn based on sound analysis of the fundamentals – and there weren’t many – there are probably a dozen now in the press preaching hellfire, damnation, and how to avoid it all by sending a check for $1500 for their newsletter. They are leveraging off the credit crisis that nobody, but nobody (ourselves included) predicted, and anybody who tells you that they did is lying.
Of course credit was bound to tighten: that’s been obvious to most for a year now, and we would say it’s been plain since the spring of 2007. But the total freeze of recent days was unforeseeable, because it didn’t come from within the financial system. It came from the spectacular series of missteps by Treasury, the Fed and the SEC that nearly succeeded in permanently destroying confidence in the entire Western financial system.
To be fair to those agencies, it may be that they were impeded in their actions by political pressure from political actors trying to force the system to recover with ideological medicine. In fact, I will go on the record right now as saying that my second-safest prediction of 2008 is that Hank Paulson’s eventual book will shift the blame to the White House (my safest being that both Paulson’s and Bernanke’s eventual accounts will shift the blame elsewhere).
But the feds did blow it. Not a day goes by without another story on the destruction wrought by the Lehman decision, from Hong Kong mini-bonds to heavy losses at Merrill Lynch (MER). On the brighter side, ideological remedies are now out the window and the guvvies are ready to do anything and everything to guarantee the stability of the system. The worst of it was not the work of the pod people or the total collapse of Western civilization, and our economy is going to suffer but not collapse. Warren Buffett took to the pages of the New York Times on Friday to offer his opinion that it’s a great time to be investing in the markets.
Although his op-ed piece was characterized as “Buffett calling the bottom,” Mr. B was smart enough to say that he didn’t know where stocks would be a month from now or even a year from now. We might have done better with such tactics last month when the rescue plan was announced and we thought that the bottom should be in on the market. In our defense, we qualified our remarks with the caveat, “unless the government messes it up,” and of course it did.
Yet the latest step in the rescue plan is a significant turn for the better. Paulson and Bernanke decided to pump up the leading national banks with capital and obligated all of them to take some, whether they wanted it or not (some didn’t). That avoided creating a new group of “wounded” banks for the short-sellers to target (i.e., those who accepted help, as opposed to those who didn’t). The feds finally caught on to the fact that punitive terms simply create more problems (have they been reading our column?), and structured the investments on reasonable terms that don’t crush existing investors. A good thing, because otherwise the government was going to end up owning all the banks.
Even so, some were arguing that the dividend rate (five percent) for the government was an insufficient return for the taxpayers. The glaring flaw in that line is that the best deal for the taxpayers is for the system to survive and allow the investments to be repaid, not to pile on punitive rates that get paid out once or twice before the system collapses. But more than ever these days, one has a better chance of being in front of the cameras by ranting and raving than by being sensible.
Through three decades, I’ve marveled at how banks, time and time again, manage to lend money like a bunch of drunken sailors at the peak of bubbles – when they should be pulling back – and then make downturns worse by burrowing into holes and cowering in fear when credit is most needed. The current crisis still has some legs on it, and the inability to obtain letter-of-credit financing is hurting businesses ranging from retail stores trying to order Christmas inventory to cargo shippers unable to front the entire payment. We’re going to pay a price for that this quarter and next, at the least.
As the earnings season passes, though, the credit markets will slowly loosen. The markets will take to the notion that the month of October will produce horrible economic data, thereby taking most of the sting out of the eventual arrival of the results. We’ll write off this Christmas season, and start to look for grounds for hope again in the recovering bond markets. We’ll see a bit more turmoil and then a rally, and then probably more turmoil in the spring.
Yet we have to agree with Warren Buffett that it’s time for investors to start getting greedy. It may seem trite to observe that the night is darkest just before the dawn, but as the recent explosion of redemption activity shows, most of us are still afraid of the dark.
After two sparse days that included a day off for bank and government workers (but not bank and government executives), the economic data mill started up again on Wednesday with some loud, ugly clanking noises. Retail sales for September fell a much steeper than expected (-1.2), or (-0.6)% when excluding autos, about twice as bad as expected. Sales were weak across the board, although gasoline ticked up slightly (+0.1%) in response to falling prices. Weekly chain-store sales numbers in October continue to show further weakness.
An irony of the falling sales is the pile-up in inventories, as indicated in the report of a 0.3% August increase in business inventories. The irony is that the increase gets added to third-quarter GDP, even though it is anything but good news for the economy. That won’t stop GDP apologists from claiming that the economy is really doing a lot better than those naughty alarmists in the press tell you. It’s all a mirage, you know.
The consumer spending fear weakness was echoed in Friday’s consumer confidence reading for October of a reading back in the fifties, with a 57.5 number versus expectations for 65.0. That seems like a large miss, but if estimates had been retaken the day before the number would probably have been much closer. The market was able to largely shrug it off in the face of expiration-related buying.
The size of the September-October decline was a record, though, with the current-conditions reading hitting an all-time low (the data goes back to the nineteen-fifties) and given what people have been seeing on the front pages and in their 401(k) statements, one can hardly blame them. Perhaps spirits will get a lift from the elections, as a change of party often brings new hope, but whoever leads the new administration is going to find that getting this truck out of the ditch isn’t going to be quick and easy.
The deep panic in the financial markets also showed up in the manufacturing surveys from the New York and Philadelphia Federal Reserve banks. The Empire State (N.Y.) survey reported a huge drop to (-24.6), where (-10.0) was expected, with plunges in new orders to (-20.5) and unfilled orders to (-12.5). It was a record drop for the young survey.
The Philadelphia Fed, moreover, which had rallied back unexpectedly last month, jumped off the cliffs of Acapulco with a reading of (–37.5) that represented the sharpest drop in its forty-odd years of data. New orders fell to a stunning (-30.5) from September’s 5.6 gain, and every other category – unfilled orders, inventories, employment – was deeply in the red. At least prices were cratering too.
Those results were only partially reflected in the Industrial Production report, which showed a steep drop of (-2.8)%. Like most of the other output-related reads, it was a lot worse than expected (the biggest such drop since 1974), but there were some mitigating factors. Collapsing commodity prices and the hurricanes in the Gulf led to big drops in mining and energy-related output, along with a shutdown effect for many small businesses. The Boeing (BA) strike cut into output as well.
Next month’s number will probably be scary too, due to everybody putting orders on hold while the financial markets disintegrated, so it may not be until December that we get data that really shows the basic trend.
If there is a silver lining in the economic data, it’s the rapid weakening in prices as investors flee the energy and commodity sectors. That led to improvement on the inflation front, with the PPI total falling (-0.4)% and the CPI index unchanged. The monthly core number on the PPI crept back up to 0.4%, but much of that was a result of the end of pricing promotions in the automobile sector (given recent results, those promotions may be returning soon). Intermediate good prices fell.
Core prices on the CPI fell to a rate of 0.1%, the lowest since February. We expect continued weakening in inflation pressure (too bad they can’t include stock prices in the index), but two problems remain. One is residual price increases in the pipeline – food, for example, continues to rise and was still up sharply at 0.6%. Many producers and distributors in the sector instituted price increases after energy prices peaked, and will probably try to retain as much as possible for the time being. Year-over-year inflation fell to 4.9% in the CPI. That’s an improvement, but it’s still well ahead of income growth and changes in net worth especially, so spending will remain challenged.
The housing market is still hollowing out new lows for itself, and given the current state of (non-)lending, is likely to dig a little bit deeper before it hits bottom. The homebuilder index hit a record low of 14 in September, in tandem with the announcement the following day that housing starts and permits had posted another stomach-wrenching plunge.
The data missed estimates by a mile and hit a low not seen since January of 1991. On a per-capita basis, it has to be a post-war low. Existing home sales are due next Friday: all one can say is that expectations should be low. Weekly mortgage purchase applications are barely breathing, mortgage rates and fees have been rising again, and if you don’t already own a home, you probably can’t qualify for a loan.
Next week will be dominated by earnings news. Monday will see the release of the leading economic indicators, and Friday the latest data on existing home sales. In between, there are no other monthly reports. Fed chairman Ben Bernanke will speak to Congress on Monday.
StockWatcher will return next week.
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