Avalon Asset Management Company Lexington, Massachusetts Investment Management
Avalon Asset Management Company Subterranean Blues
“You don't need a weatherman to know which way the wind blows.” – Bob Dylan, Subterranean Homesick Blues
The market fell 300 points on Friday, and yet the prevailing reaction on the Street was a sense of relief that it wasn’t worse. The Dow and S&P were down over five percent for the week, the Nasdaq nearly ten percent, and yet traders and market-watchers were relieved that it wasn’t worse. That’s an ill wind, but did it blow any good anywhere?
It didn’t in emerging markets, where the destruction continues in full swing. Those markets were the number one pick of financial advisors last December because of (a) global growth; (b) decoupling; and (c) strong, Western-resistant economies. Ten months later, the US markets have fallen between forty and fifty percent, while the decoupled cream of the international markets, the so-called BRIC countries (Brazil, Russian, India and China) are down about fifty and fifty-seven percent at the low end (Brazil and India) and sixty-five and seventy percent at the high end (Russia and China). Add the surging dollar and the losses become even more severe to the U.S. investor.
Let’s not forget Mexico. Merrill Lynch (MER) highlighted in its conference call the week before last that credit-card delinquencies were spiraling fastest in Brazil, India and our neighbor to the south. Decoupling was de myth, it seems.
It’s no wonder, then, that liquidation and get-me-out-now panic are everywhere. Everything was thrown overboard in the first half of October – corporates, munis, commercial paper, stocks, commodities, you name it. With the exception of treasuries, if it could trade it went down and it went down a lot. Municipal bonds were finally able to put on a snapback rally last week, but they are still down on the year (and still a great buy, for that matter). But while that was happening, global markets were crushed as global growth became officially replaced by global recession and global panic.
As for the theory widespread in the first half that one should load up on commodities in time for the global slowdown, curiously enough, that did not work. Not unless you were bold enough to exit the asset class entirely in June, that is, as prices have now plunged from year-ago levels. Gasoline, oil and heating oil have all fallen to fifty-two week lows. Cocoa and coffee, which put on ridiculous spikes during the summer’s commodity-madness blowout, have similarly plunged, especially the former. Some of the more speculative trades, such as copper, platinum or wheat, have fallen more than 50% in just a few short months.
There’s more to come in commodities: the slower-moving financial players, such as pension funds and endowments, that were talking so learnedly about the importance of commodity investing in the first half are only now getting around to reviewing the disaster of the third quarter. Many will choose to throw it in now while they can still get out reasonably whole, thereby increasing downward pressure on prices. It’s an old problem: during market extremes, divergent asset prices converge.
The shockwave from the Lehman fiasco continues: one could hear National Public Radio this week recount the tale of a Norwegian church suffering desperate losses on the bank’s failure, while the weekend edition of the Wall Street Journal carried a story on Japanese banks whose existence has been imperiled by the sudden collapse. Ben Stein, economist, media personality, and Sunday columnist for the New York Times, continues to write in a tone of utter disbelief at the magnitude of the blunder (and throws in the Fannie-Freddie fiasco for good measure).
The flight towards the dollar ignited by Lehman’s bankruptcy turned into a rout on the Euro and emerging market currencies. That reverse tidal surge exposed a number of corporate treasurers around the world who’d been contentedly swimming naked in a sea of short-dollar plays. After all, the U.S. was headed down the tubes, the Fed would have to keep lowering rates and the dollar had been going down since, well, since a really long time. It was all so obvious and all so easy, a trade that worked beautifully until it didn’t.
Yet there are a few hopeful notes in our roomful of blues. Although the feds brought on the worst of the crisis with their willing suspension of rational thought, the destructive aftermath of the crisis has resulted in the political officers being banned from the room. Bernanke, Paulson and Co. have been duly chastened and are ready to consider any and every action to limit further damage (though SEC chairman Cox seems to be content to keep scratching his head). There will be no more experiments in dropping banks off the roof to see what happens.
It’s still not possible to even estimate the full extent of the damage done to our financial and credit markets by the reckless disregard for one of the world’s largest and oldest investment banks being marauded and sank in broad daylight (weakened, it is true, by its own crew). That said, help is on the way for the housing sector that is at the center of the crisis. It appears that most of the damage in the sector has already been sustained, and while there won’t be any quick bounce, the slope has flattened out.
Manufacturing is not in a state of excess inventory, neither here nor abroad. Most commodity prices have returned to nearly normal levels. There may well be some overshoot to the downside, but that will help consumption in this country. We are still in for some touch-and-go months, but the worst of the damage is over.
Consider the many signs that we are in a bottom. Good news is routinely ignored. Earnings results, good or bad, are generally an occasion for a clearance sale in the company stock. Panic selling has become routine, but the end of the mutual fund fiscal year is upon us: the last day to get a stock off the books is Tuesday. Retail investors have cashed out. Valuations are scraping the bottom as volatility has soared.
One of the world’s most famous weathermen, Alan Greenspan, put on a bravura performance last week when he had the intellectual honesty to admit that his Randian framework for viewing the world was fatally flawed. The libertarian vision of a world of offsetting rational self-interest achieving optimal results with no supervision necessary is as flawed as communism, for both depend on a collective purity of human endeavor that has never existed anywhere but in the utopian imagination.
Greenspan’s admission, so rare at the highest levels of government, may be grist for the delighted mill of many a rabid baker, but we admire its honesty and courage. Forget the partisan posturing and scandalized editorials, Greenspan’s preference for minimalist supervision was long thought of as, depending on one’s view, either his greatest weakness (e.g., here at Avalon) or asset (most trading circles). His candor is a necessary step towards more effective supervision, for what the financial system has lacked in recent years is not so much a lack of rules as a lack of belief that enforcement matters.
We don’t need to rewrite the rulebook, we just need to let the referees do their jobs. One can write pages and pages of rules, but if the government doesn’t want to enforce them, it won’t matter. One can have a central bank, but if it forgets that its essential reason for existence is to prevent systemic meltdowns, its charter is irrelevant.
The deregulatory pendulum swung too far: the worship of non-rule is as damaging as the worship of a rule for every step. Ignore the backsliding laments about the death of capitalism, for the coming sea change in the prevailing winds could give us back a system that is stronger than it’s been in decades. It can’t do much worse than one that blows up every six or seven years.
A week very light on economic data and top-heavy with earnings reports led off with the latest installment of the Leading Economic Indicators on Monday. There was a time when the report was a market-mover, but that was ages ago and the surprise positive of 0.3% for September (expectations were for something negative) was quickly dismissed by the market.
The increase was due chiefly to widening credit spreads, because a steepening yield curve is usually indicative of economic expansion. Every now and then, though, it’s because of a mass flight to safety. That would be last month. The coincident indicator fell (-0.5)%, and August was revised further downwards.
Looking over the weekly reports, chain-store sales continued to weaken. Mortgage purchase applications dropped to a new low that I couldn’t recall seeing before (a search of the Mortgage Banker’s Association website turned up no confirmation, though). Initial jobless claims climbed slightly from the week before, but remain at very high levels. Continuing claims paused for a week, but nobody is kidding themselves on the trend. The market looked relieved to see another sub-500,000 number.
Despite the fall-off in energy demand, supplies continue to build and prices continue to fall. Commentators like to play up the stimulus effect of lower energy and gasoline prices (now equal to or even below twelve months ago), but lower expenses aren’t quite the same as higher incomes. An aspect of the price drop that gets overlooked is the impact on our export sales: the Middle East and other oil-rich countries are suddenly going to need a lot less equipment from Caterpillar (CAT) or Halliburton (HAL).
Existing home sales rose 5.5% in September, the best increase in over five years. There was plenty to not like about the number – the steep price drops, the high percentage of foreclosure sales (nearly fifty percent), high inventories – and one can argue that the October lending-lock will turn the number down again. But it is the kind of result one gets at a market bottom. We just don’t know how wide the bottom will be.
Next week will get busy again, starting with new home sales on Monday. Given the tone of recent homebuilder reports, we can expect to see another punishing drop there. The Conference Board will report its version of consumer confidence (a component of the leading indicators that actually rose in that report, as it was taken pre-meltdown) on Tuesday, the same day the Fed begins its regular FOMC meeting.
Wednesday should be the day of the week, then, with the September durable goods data coming out before the open and the FOMC statement in the afternoon. The problem with the latter is that the Fed mightn’t yet be willing to take rates down again – a case can be made for not doing so – but the equity markets may sag further if they don’t. The futures market has priced in a 92% chance of a fifty-basis point cut, a number that probably better reflects the extremity of market sentiments than any sense of calculated judgment.
Thursday will bring the advance look at third-quarter GDP. Will the government take the risk of reporting another gimmicked number, like the second-quarter result? Will they own up to that particular charade or try another? Employment cost data is due as well, but the market is hardly worried about wage inflation right now.
Friday is another busy day: personal income and spending are due out before the open, followed by the Chicago PMI purchasing index at 9:45 AM and another consumer confidence number at 10:00. It’s also the last day of the fiscal year for the average mutual fund, a fact that has added further selling pressure to the market of late. This is one October that will be long remembered, and nearly all will be greatly relieved to see the end of it.
The markets have StockWatcher still cowering in his cave, but we plan to drag him out again next week.
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