Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
Now What?
"Never underestimate the gullibility of large pools of money." - David Swensen, Yale endowment manager
"Never give a sucker an even break." - W.C. Fields
While pondering what title to use for this week’s column, we came up with the idea of “Red October.” Too bad we’d already used it one year ago exactly, for an October that was truly and deeply red. Friday’s broad-based sell-off pushed the latest version of the month into a loss, frustrating the hopeful spin put forth during the week that said that since October is usually a down month, a sideways move was in fact a positive indicator. Now it’s just a typical October loss, but maybe we will later find that that is positive also.
What went wrong on Friday was a challenge for the media, which prefers to use one-report factors in its descriptions, however wrong that may be. The economic data really didn’t produce much in the way of negative surprises, but reporters soldiered bravely on and tried to blame it on the drop in real spending reported on September.
The drop didn’t help, but it was mostly right on the consensus estimate. The week’s sell-off really came down to a mix of reasons that had been coming together for some time. Prices had been showing toppy behavior the week before, and the consistent failure of stock prices to keep gains from positive earnings surprises was weighing on sentiment.
Another disconcerting factor was that up days were featuring light volume, while selling days were showing conviction. Thursday’s big GDP-inspired rally was a good example. It didn’t help that the GDP number was roundly sneered at the following morning, with one Wall Street Journal writer going so far as to call it, “Grossly Distorted Product.” Ouch. You know that equities are running out of steam when commodities are supposed to be the best asset class, as a new global poll showed.
Pimco’s Mohammed El-Erian reiterated a view during the week that we share – zero rates by governments are pushing investors into risky asset classes, yet the economic outlook doesn’t appear that inviting. Our guess is that this will lead to more manic-depressive behavior by the markets (as if they needed any more) and more mini-bubbles in various assets. It isn’t easy being a policymaker at times like this.
Although third-quarter earnings have been doing a decent job of beating estimates, the story has begun to look jaded, especially given the mostly cautious nature of guidance and outlooks provided by companies. A fair amount of gains had already been built into prices and more was needed to keep the game moving.
If we were to point to any one culprit, we would say it was resurgent fears about the financial sector. It’s been underperforming the market for a couple of weeks, which is never a good sign (it doesn’t help that the other market leader, technology, has been doing the same).
When an industry analyst speculated that Citigroup (C) might have to write off some ten billion dollars deferred tax assets, it revived old fears of instability and hidden balance sheet disasters in the sector. A similar tax-asset observation about Fannie Mae (FNM) last summer by a Lehman analyst started a run on GSE stock that eventually led to receivership for them – and the immediate subsequent collapse of Lehman itself.
Corrections at this time of year are fairly common, as the impetus of quarterly earnings season wears off. Massive run-ups like the one we’ve experienced since the first half of March are of course quite rare, more characteristic of bear market rallies than secular bull markets. With the mutual fund fiscal year come to a close on Friday and cash levels running low, the stars have been lining up for a dash of risk aversion as we head into the final two months of the year.
By last week, the months-old refrain of “there is no abyss” that has underpinned buying on dips had largely morphed into “there is no growth.” It remains to be seen whether the latest song can keep its popularity, but one sobering truth is that despite all the references to liquidity that have popping up of late, almost no money has flowed into equities. Bonds have had something of a bubble, but equity managers simply don’t have much spare ammunition these days.
Besides being short of new funds, one of the biggest obstacles left for the equity markets to face is the widespread conviction that we wouldn’t get any correction of size – say, double digits – before the end of the year. The consensus prediction rarely comes true on the Street, and even when it does it often gets violently reversed afterwards.
The observation that the markets are overvalued by anything from fifteen to thirty percent has become more commonplace, so the current pullback certainly has room to run further. Markets spend very little time at fair value, though, so the only thing we might be able to look forward to with any confidence is an increase in volatility.
We still have a ways to go before earnings season finishes up, and the coming months could provide some contradictory data from home-buying pulling back and inventories bouncing around. The employment picture is worse than it looks, but that could be masked by continued seasonal adjustments (later to be overturned) to the data and the trick of kicking ever-larger numbers of workers out of the official count for purposes of calculating unemployment. Expiring benefits will push more people off the continuing claims count, even though hiring is rare.
Investors should tread with caution, as the tug-of-war between the market’s natural upward bias, a lack of investment alternatives and performance worries line up against volatile data and an economy that is likely to present a mixed picture for some time. It’s very difficult to say whether things will actually get really ugly, but the risk is higher than usual. We wouldn’t blame you for sitting out the next dance.
We earned mixed marks on our call on the advance estimate of the third quarter GDP. We thought it would get the market excited, and it very much did – at least the ones who didn’t stay away. We also thought it would decide the week’s direction, yet it would take a real spin job to claim that happened. The wave of disdain the following day for the results certainly helped take the shine off the result, but when equities are in form they blow right past that kind of thing.
An interesting sidelight on the GDP result – it was reported to be a consensus-topping 3.5% - was the late estimate change by Goldman Sachs (GS) on the eve of the report. Goldman lowered its estimate for the quarter to 2.7% on Wednesday afternoon, adding pressure to the day’s sell-off and causing some tongues to wag that Goldman had better be wrong if they knew what was good for them (a popular suspicion is that Goldman is a little too tightly wired into the government). The next morning all was forgotten when the three-and-a-half result hit the tape.
Funny thing is, we think Goldman was probably right. For all the headline cynicism dumped on the GDP number the next morning as being mostly propped up short-lived government fixes – a valid point – we saw no comments wondering what happened with the GDP deflator, which pitched in a very helpful 0.8% result while the gross domestic purchase deflator was nearly double at 1.5% (the price deflator is subtracted from the nominal figure, so the lower the deflator, the higher is reported real GDP).
A little over a year ago, we found ourselves criticizing for weeks the Bureau of Economic Analysis’s dubious and unsupported allegation that the second quarter price deflator in 2008 was only 1.1%, even though food and energy costs were soaring and the gross domestic purchase deflator was north of four percent (the BEA is the official purveyor of GDP data). We said that we simply didn’t believe it. Not heroic stuff by any stretch, but neither is it our usual practice to flat-out trash government data. We weren’t alone.
A year later, the BEA’s reported price deflator for that period has quietly risen to 2.0%, or nearly double what it once was, and that quarter’s real GDP has fallen to 1.5% from 1.9%. No explanation that we know of has been provided by the BEA. Now, if one takes current dollar GDP for the third quarter of this year (4.3%), and uses the government’s preferred inflation number, the annualized increase in the third quarter PCE price index (1.6%) instead of the BEA’s price deflator, then the result is real GDP of 2.7%. That was Goldman’s prediction. Perhaps they will have to wait another twelve months before they are shown to be right.
Another widely cited flaw in the GDP report was that the increase gained 0.9% from inventory changes. Inventories didn’t actually grow in the quarter, they simply decreased at a slower rate, and so this was counted as growth. This is not unlike a doctor beaming that although your fever has gone from 109 to 110 degrees, he is confident that the rate of increase is slowing. Nice if you don’t die in the meantime. There is a silver lining though, and that is that eventually inventories will have to be rebuilt and that additive to GDP is still lurking out there. How quickly and strongly remains to be seen.
While we are dissing government data, we may as well doubt the weekly initial claims data. Regular readers are aware of our frequent complaint that the regression model used by the Bureau of Labor Statistics for its monthly jobs report is designed to produce a good fit for your average economic moment. But we haven’t had anything like an average moment for over a year. Thus, the monthly births-and-deaths adjustment, which estimates net job changes from the appearance and disappearance of small companies, chugs along adding the same hundreds of thousand jobs even when the economy is tanking and businesses are plainly not hiring.
In the case of weekly claims data, during typical times businesses increase their release of employees as they head into the final quarter of the year. Thus, although unadjusted claims are currently rising sharply, the effect is muted by the usual seasonal adjustments. But this isn’t a typical season, as we’ve been mired in the Great Recession for most of the last twenty months. For businesses to still be shedding so many jobs this late in the game is not at all typical. Claims rose last week to an adjusted 530,000, still higher than expected, but the weakness is deeper than the numbers say.
New home sales slumped at a 402,000 rate in September, coming up well short of the 440,0000 estimate that would have represented growth. August was hit with an additional big revision downward of 25,000 homes, leaving the new home business in a much more fragile state than the markets had priced in (and explaining why the previous week’s homebuilder sentiment report had been a dud).
New home sales don’t represent very much of the housing market, less than ten percent, but this was clearly an unwanted sign of weakness. The ten percent drop on an anemic prior year took us to the lowest level of new home sales for September since 1981, as near as we can make it. We are very much still in the bottom in housing.
The best that might be said about the result is that it helped spur the Senate passage of an extended, expanded homebuyer tax credit. Yet while we have been broadly supportive of stimulus efforts, another such extension does leave us uneasy, especially the expansion. We can’t throw money at such problems forever, and the establishment of an industry dependency on these subsidies has to be taken into account. The economy isn’t likely to be much stronger in April 2010 than it is now, nor is employment. At some point we have to let the markets clear.
The Case-Shiller home price index continued to show a lower rate of year-on-year decline, rising from August and improving its rate of annual decline to just over ten percent. The mix of homes being sold is changing, though, and may be exaggerating any rate of improvement. Still, there is no doubt that prices firmed during the summer selling season.
However, mortgage purchase applications continue to fall away from their tax-credit expiration peak, and have fallen to the lowest levels in months. Even the refinancing index has been falling, suggesting that the potential refi pool may be nearly dry. Given the drop in demand – which may not last long if the tax credit is renewed – and the impending reset problems looming in prime mortgages, it isn’t unreasonable to expect some wavering in prices over the coming months.
New orders for durable goods were reported to have risen by 1.0% in September, though the market had been looking for more (consensus was (1.5%). The proxy for private sector investment, a.k.a. non-defense new orders for capital goods excluding aircraft, rose two percent, which is good, though it followed two months of decline.
In that vein, the Chicago PMI rose to an unexpectedly strong 54.2. Its employment index fell, which may have been what traders were gloomy about, but we don’t think the report really got much heed from the equity markets. The national ISM number comes out Monday, and we’ll all be looking at it with great interest: the New York and Chicago reports were good, but the Philadelphia report softened, and the last one is widely thought to be the best precursor to the national number.
Consumer confidence turned in some disappointing results, ranging from the sharp decline reported by the Conference Board (47.7) to the confirmed September decline at the University of Michigan index. Unemployment is weighing on the consumer, as are falling real incomes, reported to be a twelve-month drop of (-2.8)% by the BEA. Real PCE expenditures fell (-0.6)%, a result that stems from the cash-for-clunkers expiration. The weakish nature of the report helped set the stage for the day’s market sell-off.
The ISM report will be joined that day by reports on pending home sales and construction spending for September. Pending sales should show one more bump from the rush to cash in on the scheduled-to-expire tax credit.
Motor vehicle sales and factory orders are due on Tuesday, with the latter featuring a mild adjustment to last week’s durable goods report. They’ll be followed by the ISM non-manufacturing index on Wednesday. The big kahuna, of course, will be the October jobs report that is scheduled for release on Friday morning. The last report showed a worse than expected result that spurred further buying on the grounds that it would keep the Fed on hold. A similar reaction might be difficult to pull off in the current context.
Other scheduled reports include consumer credit and wholesale trade reports on Friday morning, along with information on productivity and cost trends on Thursday. Same-store sales for the chains that still report monthly data also come that day. Comparisons with last year’s collapse should help produce some positive-looking data. It might have been the day of the week but for the jobs report on Friday, but the reaction to that one is consistently unpredictable.
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