Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
Stutter Step
"For my mind misgives some consequence still hanging in the stars” - William Shakespeare (Romeo), Romeo and Juliet
Just when you thought it was safe to go back in, the markets looked surprisingly hesitant about the right direction last week. Despite high-voltage results from the likes of Apple (AAPL), Amazon (AMZN) and Microsoft (MSFT), prices largely flopped around. Somewhat ominously, most of the previous week’s heroes ended up giving back their associated gains, symbolized by the Dow slipping back below 10,000. Has the relentless bull finally decided to take a breather?
Don’t jump to any conclusions yet. This market may be overvalued by a good ten to fifteen percent, but that is only about one standard deviation in Wall Street’s world. The price action is unquestionably toppy of late, but we’ve seen this kind of thing go on for months at a time before. Momentum markets simply hate to give up. We certainly haven’t seen any sudden shortage of bulls. The number of doubters may appear to be growing, but one has only to cue the wall-of-worry orchestra and the band will play on.
Certainly there are good reasons for doubts, and the market gets more vulnerable every week. The steady weakness in the dollar and the rising price of oil, which crested $80, never leads to good endings for equities, but big mo is big mo. The dollar is falling on momentum, and the equity and oil markets are rising on it.
“This is not a demand-driven rally,” said popular oil maven Phil Flynn, a sentiment echoed by the secretary-general of OPEC, who observed that with all the floating storage in the world, the price could have nothing to do with fundamentals. It rarely does, but the level of speculation has become manic in the last two years.
Was it oil then? To quote Chris Rock, “Not really.” Perhaps it was the lack of revenue gains: although companies are doing somewhat better than last quarter with revenue, the majority of profits continue to come from cost-cutting and accounting benefits that have started to leave traders jaded and cynical. There are even doubts creeping in about the sincerity and honesty of management and analysts when it comes to forecasting earnings results. Good grief! Are there no true believers anymore?
Quoth the Rock, “Not Really.” The quality of earnings has been less than sterling and the distressing fact remains that most companies continue to show declines versus year-ago quarters. The long and substantial run-up in equity prices heading into earnings season has raised the bar not only on success, but more importantly on what constitutes a real beat. It seems apparent that the consistent low-balling of estimates has led whisper numbers, or unofficial estimates, to build in a fudge factor that takes into account, well, fudging.
Key sectors have been behaving poorly. Semiconductor stocks have been trading sideways for weeks, hurt by suspicions about the durability of their recovery and guidance that has been relatively contained. Ditto for financials, where results from the Gang of Four (JP Morgan (JPM), Citibank (C), Bank of America (BAC), Wells Fargo (WFC)) have led to disappointment either immediate or delayed. The transport sector has weakened significantly of late, scaring technicians and even that rare breed known as investors, who worry about the poor stories coming out of the rails and shippers.
There are seasonal factors, too. Next week is the last week of the fiscal year for most mutual funds. Selling Apple now would mean more capital gain distributions to their shareholders in December; selling in November gives a chance to protect gains and raise some cash. Markets often tire and break down after quarterly earnings season.
Yet let us not make the all-too-frequent (and often fatal) error of draping too much rationality on the limbs of the market. There are many who believe that one can still bet on the market’s momentum through the end of the year, possibly into the spring before the arc of the rebound weakens and begins to return to earth. The scenario that we see the most these days is that the market will rally into the spring and then trade sideways after that. This is so widely held that one can be almost certain that it is the one thing that will not happen.
Earnings season continues next week, though most of the higher profile companies outside of retail have already reported. The market is primed to either break through 1100 on the S&P 500 or give it up and head back to the 1000 level, possibly even below. Two such opposite outcomes may seem hard to reconcile, but remember that it’s all about the momentum.
The week was dominated by earnings, but not without interest on the economic side. The bulk of the interest came from the housing sector, which had fresh data to report on homebuilder sentiment, housing starts, home prices and existing home sales.
The homebuilder index, a sentiment measure that has been in the cellar for a long time - though at least not in the deepest trench - fell two points. Had it risen two points, it would have added fifty points to the Dow, but it fell that amount instead, so it was ignored. In fact, the Wall Street Journal began sounding like a retail broker, speculating that maybe the builders were just worried about the expiration of the first-time tax credit. That explains a reading of 18 where 50 is neutral? How about, “business sucks?”
That more obvious explanation may have the defect of not sounding sufficiently bullish, but it does fit the facts. September housing starts were well short of consensus, and it turns out August was too. The latter was revised down to 587,000 from 598,000, and its bullish story of a 1.5% gain turned out to be a (-0.5)% loss (but they don’t give back the headlines, do they?).
September sales were reported to be 590,000. Given the revision trend, it’s likely that they were flat. Given that they are almost 30% below year-ago levels, and that permits came up well short of consensus and fell to 573,000 from 580,000, that would provide a real explanation for depressed homebuilder sentiment.
There is a silver lining: single-family starts rose again and seem to be stable at levels about ten percent lower than a year ago. That’s better than a decline, but the amount of hopeful verbiage written about this fact calls for a dose of realism. Single-family homebuilding is in such an anemic state that even a bankruptcy by a major builder would probably not take it down for more than a month or so. Conditions have indeed stabilized, but that can be said of dead people too. They don’t spring off the couch either.
It’s an oft-repeated observation that the new home business is running well below the natural level of new household formation. Exactly what that level may be in the current situation is difficult to know, yet surely pent-up demand will slowly build and at some point down the road, the business will accelerate. The problem is that although one can reasonably expect slow improvement in the sector, lift-off is likely to be far down the road. This isn’t a repeat of the 1990-1992 savings and loan implosion, but a far deeper credit contraction paired up with a much higher unemployment rate.
We bring up the 1990-1992 era because many avuncular types, having apparently looked at the stock charts of those years, are genially issuing assurances that the current period is just like that one and that we should expect to emerge from the woods just around the next bend in the path.
They are wrong. The brunt of the ’90-’92 recession and concomitant credit crunch was felt in the commercial sector first and the condominium sector second. Home prices did experience a period of decline, but bubble-type characteristics were mostly in the sectors mentioned (outside of New York City, condos hardly existed until the latter part of the eighties, which saw a veritable boom in condominium conversion).
From the early part of 1990, when housing starts first declined, starts spent a total of exactly five months below the million level, with a much smaller population, before recovering. Single-family homes bottomed in January of 1991, eleven months after they had topped out in February of 1990. They rose almost uninterruptedly after that, with fairly strong gains along the way. Eighteen months after total starts first started to contract, they were back above the million level to stay in June of 1991.
Starts have now run below the million level for fifteen months in a row, far deeper than ’90-’92, and below 600,000 units for the last eleven months. It was a mighty bubble that we built, and the banks have much deeper wounds. Certainly they tightened lending in the recession of twenty years ago, as they will do during any recession, but credit was only really scarce in commercial real estate. Federal Reserve reports of the day indicate the main concern in single-family homes as one of buyers worrying about falling prices.
Some take another view of the current situation, insisting that the current low levels must surely be a bottom and therefore a very bullish time to buy. A very similar argument was being passed around in the fall of 2006, when the decline in starts was seen as a great way to clear inventory and thus anticipate the rebound. We are surely in a bottom, but it is a very wide one.
When the Fed stops buying mortgage-backed securities in the next quarter, as it has indicated, rates will rise, probably by at least fifty basis points. In historic terms, they will still be low, but the rise isn’t going to spur buying during a period of rising unemployment. There’s a reason homebuilder sentiment is low, and it isn’t just because the first-time tax credit is set to expire, as the Journal suggested.
That impending deadline did lead to a sharp pickup in existing home sales in September. Those first-time homebuyers accounted for forty-five percent of the activity, according to the National Association of Realtors (NAR). Foreclosure sales fell to a still very high rate of twenty-nine percent, and activity is still concentrated at the bottom end of the market. In that segment, supply is only a few months (excluding bank-owned real estate, which seems to be being released only gradually). But in the non-conforming segment of the market – in other words, mortgages that cannot immediately be resold to the government – there is a supply stretching out over one to five years.
The NAR reported that the median price fell 8.5% from a year ago, 11.7 percent for condos, and complained that the data was being distorted by foreclosures. By contrast, the FHFA (the feds) reported that prices for conforming mortgages fell in September to a (-3.6)% year-on-year decline. The Case-Shiller data are due next week. In any case, as chief economist Larry Yun commented, “without a firm foundation for middle-class wealth recovery, the post-recession economic growth will likely be one of the weakest in U.S. history.”
Naturally the realtors are agitating for an extension of the homebuyer tax credit, and some in Congress are talking about extending the credit into the spring and even broadening it to include all buyers. There has been little talk from either the Obama administration or the Federal Reserve on the subject, and we can understand why. As the subsidy goes on, the risk increases of greater and longer-lasting distortions to the system.
On top of that, the merest endorsement by the administration could turn the decline in the dollar, which so far has been sustained but orderly, into a not-so-orderly rout. One cannot predict all the effects of keeping the credit going, but two things are certain: from the realtor point of view, there is never going to be a good time to end it, and any extension is going to cost a lot more money at a difficult time.
Mortgage purchase applications took another steep step downward, reflecting the credit’s impending expiration. They’ve been a good predictor of the directional change in sales this year, so a decline in October home sales is looking more and more possible. That would increase pressure on an administration caught between the devil and the dollar.
On the sunnier side of the street was the Leading Indicators, which rose 1.0% from the prior month. As usual, the biggest strength was in the sharply positive slope of the yield curve, though in the current zero-rate situation it’s a flawed contribution. The coincident indicator was unchanged and the coincident-to-lagging ratio rose, which is usually a positive sign.
Weekly retail sales also posted gains, but caution is advisable, as weekly figures were boosted by colder weather and the Columbus Day holiday, while yearly comparisons look back at last year’s cataclysm. The October Beige Book (regional Fed survey) painted a mixed outlook from retailers. The rest of the report was a non-event, with nothing in the way of surprises.
The surprise of the week was the Producer’s Price Index (PPI), which dropped 0.6% with a monthly core change of (-0.1)%; last week’s regional Fed surveys had respondents complaining about input price pressure. The year-on-year decline fell to (-4.7)%. All of this was led by declines in energy and gasoline that have sharply reversed this month, so this month’s deflation worries may quickly be forgotten a month from now. A smaller surprise was a tick back upward in weekly jobless claims to 531,000. Unemployment is still ugly, and isn’t getting any prettier.
Monday will be the usual off day for reporting next week, which will get into gear with Tuesday’s reports on home prices (Case-Shiller) and the Conference Board’s consumer confidence report. The University of Michigan reports its final October reading on Friday, but the market pays significantly more attention to the Conference Board’s version. Last month’s unexpected decline weighed on stock prices; this month’s non-committal estimate is for an increase of nine-tenths of a percent centered around a very narrow range.
The middle of the week should be exciting. Durable goods and new-home sales are slated for Wednesday, the third quarter advance estimate on GDP is due Thursday. The latter may command the most attention of anything during the week. That doesn’t make much sense to us, but Wall Street isn’t about having linear relations with the real world.
Those reports will be followed on Friday by personal income and spending for September, tipped off by the GDP report from the day before, and reports on employment costs and Chicago-area business activity. It’s another busy week for earnings as well, although not quite as high profile as last week. The GDP report should decide the market’s direction.
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