Avalon Asset Management Company Lexington, Massachusetts Investment Management
Avalon Asset Management Company Red October
“The time is out of joint.” – William Shakespeare, Hamlet
Taking stock, the good news is that the markets were up ten percent last week, their best performance in over thirty years. The bad news is that it was still the worst October in over twenty years and one of the worst months ever for the equity markets. The good news is that a week ago, we were looking at the worst month ever and escaped. The bad news is that it won’t be for long.
There was nothing wrong with Tuesday’s near-thousand point turnaround in the Dow. Heaven knows that the markets were deeply oversold and overdue for that kind of action. Traders had been waiting for it for weeks, ever since the last furious bear-market reversal earlier in the month. You know, the one that didn’t last either.
No, big technical reversals often come around bear market bottoms. The flaws with this one were that to start, there were really no developments to back it up beyond charts and short-covering. The other is that much of the rally and most of the week was dedicated to the fine old Wall Street tradition of marking the close, in this case the close of the fiscal year for most funds. A tradition so completely improvable, and so completely reliable.
Next week, however, is going to be quite a different story. We are going to be hit with a blizzard of awful economic news and gloomy earnings outlooks, and this time there won’t be any help from trillions of dollars of institutional money worried about the look of their annual reports. As bad as October was for the markets, it was worse for the economy, with no closing flurry to dress up the score.
The time may come when the markets are too jaded to care about more bad news – they’re already indifferent to good news - but we’re not quite there yet. Consumers are scared, business is scared, and the markets are too. Yes, the markets will recover first, yes, they will do so while the recession is still on, and no, it won’t be next week.
The shockwaves from the Lehman (LEHMQ) earthquake are still reverberating around the globe, with insurance companies now on the hot seat. The fallout from that massive blunder is going to linger on awhile and probably keep turning up in new and unexpected places.
But best of all, we’re herding again. Having lemminged our way through real estate and its attendant securities, the global growth trade, emerging markets, energy, commodities and in the end T-bills, the new new thing is to cut back. Consumers are cutting back on spending, business is cutting back on investing and staffing, banks have cut back on lending. It seems that we just can’t get enough of one-way over-crowded plays that end up blowing up markets.
We can’t cut our way to prosperity. But everyone is afraid of what might happen, so we all cut anyway. And when we all cut at the same time, we end up virtually guaranteeing the worst of our own fears. It’s a virtuous circle.
At some point we will start to deaden ourselves to the downpour of terrible October data. We’ll get some data that won’t look so bad, and the markets will make a hopeful leap upward. It’ll be premature, but that won’t stop a move that could have some legs. Eventually the evidence that we got ahead of ourselves will become incontrovertible, and we’ll dump stocks again.
Yet the world won’t end, spring will return and we’ll finally look forward with an optimistic eye again. But it will take time. In the meantime, valuations are approaching multi-decade lows, so keep nibbling away. This is the time to be edging back in, not out.
The U.S. elections are on Tuesday, and while the result is likely to have a big impact on the markets on Wednesday, it will rapidly fade before the larger economic realities. Regardless of the crackpot theories that will circulate on the Street (where there is always a home for the absurd), market will rise and fall with real earnings and the economy, and they are going to remain challenged for some time regardless of the winner.
Indeed, the current situation is a poisoned enough chalice that either party could take some comfort in not winning. One certainly gets the impression that many Republican operatives will not be unduly put out if their man loses. If the Democrats take their presumed majority, the minefield ahead will offer wonderful opportunities to blame them for whatever goes wrong, and some things will certainly go wrong.
McCain himself is a run-off choice who really doesn’t excite the party faithful, many of whom are looking forward more to voting for Alaska governor Palin in four years than to voting Tuesday for the senator from Arizona. His biggest challenge going in is that more people are going to be voting against the Democrats and Obama, or for the Republican party, than voting for John McCain. A vote is a vote, so it’s a challenge for Obama too, but if McCain loses, his party isn’t going to miss him, whereas Obama would return.
It’s a truism in politics that the closer one gets to a losing result, the more extreme your opponent becomes. Thus, while Senator Obama takes the frontrunner road of framing his opponent in terms of his currently out-of-favor party, in recent weeks Senator McCain has shifted Obama from the left to the far left, and by Monday may be comparing him to Marx and Lenin.
While many are talking about a swing to the left, though, we think that whoever wins the election, we will see not so much a swing to the left as away from the far right and back towards the middle. McCain is not a far right candidate, which is why Sarah Palin is on the ballot. Obviously Obama isn’t one either, but the electoral disasters of President Clinton’s first term are still fresh enough in the minds of Democratic leaders that we doubt that that they will want to stray too much from the perceived middle.
As for Senator Obama, he faces some of the same problems that dogged Senator John F. Kennedy nearly fifty years ago. He isn’t the candidate of the traditional party faithful; that role belonged to Hillary Clinton. Kennedy wasn’t the candidate of the Adlai Stevenson Democrats either. Obama obviously has to deal with being a minority candidate, which is never easy anywhere, and it may come as a surprise to you to know that Kennedy’s Catholicism nearly cost him the election (he was actually obligated to publicly state that he would not take orders from the Pope).
Kennedy won his election by the narrowest of margins (and many still say that he did lose but for former Chicago mayor Richard Daley’s creative voting program). Despite having a Democratic majority, that close win resulted in Kennedy constantly struggling with his own party, and we think that if Obama does win, it will likely be a narrow win that will carry the same baggage.
In the end, then, either a McCain Washington or an Obama one is likely to face a struggle. We can expect some health care reform in either case, and all investors can look forward to a sea change at the SEC (McCain has already called for Cox’s termination), starting with people that believe in the agency’s traditional role of regulation and enforcement. That would go a long way towards curbing unhealthy practices.
For ourselves, we would reinstate the uptick rule, bring credit default swaps into the tent (nearly all of Wall Street agrees on that one), and reform arbitration. We don’t really need sweeping rule changes, though, since the rules weren’t so much of a problem as the refusal to enforce them. What we really need are sweeping staff changes. So get out and vote.
It’s only fitting that the last week of the infamous October of 2008 should start off with housing news, the sector that started it all. While the news wasn’t great, it wasn’t so bad either, which gave the markets some permission for their Tuesday Turnaround.
Existing home sales for September were a bit higher than expected, which was helpful. The less good news were sharp revisions downward for prior months, and a second month in a row below the 500,000 rate. The latter hasn’t been seen since the ’90-’92 recession. Adjusted for population growth, it’s probably a postwar low. Building has come to a virtual standstill, which if nothing else is lowering the very high amount of supply still on the market. At the current comatose sales rate, it stands at a bit more than ten months.
Even so, it was a lift from August, giving some hope that the bleeding has stabilized. October is likely to show another downturn, but after the credit-crunch dry heaves have passed (sorry, but that was no hiccup), it seems a fair possibility that we are finally at the bottom. That said, however, we wouldn’t be surprised to see a prominent bankruptcy or two in the homebuilder sector. Mortgage-purchase applications remain at very low levels.
The Case-Shiller home price index found homes reaching new record year-over-year drops, with the 20-city index reaching (-16.6)% on a year-over-year basis. There are some other factors to consider: the rate of decline is flattening out, and it was August data. Yet there isn’t any indication that prices have stopped going down. Boston was up for the fifth month in a row, but with the many layoffs coming in financial services, the cushion that the area enjoyed from having comparatively little new housing built in recent years seems likely to end: local bureaus reported that prices fell in September.
The weekly chain-store sales reports that come out Tuesday mornings are barely showing a pulse, and looking at the Conference Board’s release of consumer confidence Tuesday of last week, one can see why. At a reading of 38 even (versus expectations for 52), the number fell to its lowest point ever, covering more than forty years of data. The stunning headlines that followed the Lehman bankruptcy into the subsequent credit freeze and market meltdown could have scared zombies back into their graves. The future outlook fell to a new low and the jobs outlook retreated sharply as well.
We are going to see a number of scary October economic readings come out (see below), but it still remains to be seen whether October, or perhaps October- November, turns out to be a pothole or a sinkhole. If credit begins to flow again, we can get out of this with maybe a tow job and a trip to the repair shop, but if everybody keeps hoarding cash and laying off staff, we are all going to sink up to our collective necks.
Durable goods for September recovered from a dismal August, but the headline total of plus 0.8% was distorted by a slug of airplane orders that tend to be feast or famine in any given month. Excluding transportation, new orders fell by (-1.1)%. More to the point, the category for business investment spending fell (-1.4)%. It was an improvement from August, but the October results will be scary. It’s hard to book orders when neither the buyer nor the seller can get financing.
The Chicago purchasing index that came out on Friday is the herald of those October results. The index plunged to a stunning 37.8, with new orders falling even further to 32.5, versus expectations for a mildly weak 48.0. Every category showed sudden, steep drops (including prices, a silver lining), as will most of the rest of the data for the month. The drive to pretty up the end of the fund fiscal year-end led to markets ignoring the Chicago result on Friday, but don’t expect that to continue. The desire to treat the month as a one-off V-shape is going to have to face some withering results.
Certainly the Fed doesn’t seem very sanguine, with the FOMC lopping another fifty basis points off the discount and fed funds target rates in a unanimous vote. The statement cast a gloomy eye on the growth outlook and talked of further downside risks to the economy.
An ironic spectacle that is accompanying the Fed’s efforts to restart the economy with some credit is the cawing by a motley assembly of journalists, monetarists and assorted crows du jour that the descent back to one percent interest rates is going get us all in trouble again. After all, the reasoning goes (I use the phrase generously), since it was those rates that got us to this mess in the first place, we’re just going to repeat the cycle again.
This view is such a wide miss of reality that we are reminded of the old saw that the further away one is from the facts, the more certain is one’s opinion of them. As Doctor Alexander Pope would say, “a little learning is a dangerous thing.”
One thing you can be certain of is that there is no chance of Drs. Bernanke & Co. suddenly smacking their heads and saying, “Of course! We have to raise rates to head off a depression. What were we thinking?” Another is that people forget the past very quickly. When rates were last creeping along at this level in 2003, the prevailing worry of the time was not monetarist inflation, but deflation. The economy was so weak, went the logic, that the Fed was “pushing on a string” and was nearly out of options.
The prime example of this fear was Japan, where interest rates had been at zero for seemingly eons, and yet so was growth. The Japan experience is more than an excellent demonstration that low interest rates do not automatically lead to asset inflation. It’s also a reminder that whether the Fed had quickly raised rates or not, low-cost money was still going to be readily available to large borrowers.
An unforeseen by-product from those low interest rates came about from the growth of the financial industry and the dearth of yields. More money is kept in bonds than equities, and in a world of low yields the only way to get better than a few percent on paper is through leverage.
Leverage is useful, as is securitization and financial engineering. However, mix the prospect of earning mythically-proportioned bonus payoffs with the inevitable tendency towards herding in investor behavior, and you get a lethal cocktail. It was rendered all the more dangerous by the fact that the relevant asset class, U.S. residential housing, had a stable long-term return history and a very attractive short-term one.
“Everybody” wanted in on those big returns, from the Ph.D.’s fresh out of math graduate school to the partners at the investment banks, from the legions of white collar workers making a nice living in their new careers as mortgage and real estate brokers, to the legions of householders who could ignore their meager income growth and take European vacations or buy new vehicles by selling off surplus value in their houses.
Everybody got in, from the people who were presented with an opportunity to have a nicer house and get in on the great investment opportunity of the decade, to the people who simply enjoyed knowing how much more wealth they had. Everybody from the people who found good jobs painting and renovating those houses, to those selling cars for the garages and garages for the cars.
Like the Titanic, the unsinkable housing play sank, and like the Titanic, a certain sense of invincibility contributed to bad judgment by those in charge. The housing ship didn’t hit any iceberg, though. That boat was overloaded with too much money in too short of a time, with the same inevitable results.
Low interest rates did create an incentive to take on additional leverage, but that was due more to the low returns available from unleveraged investments than to the volume of money available. The failure of Long-Term Capital should have taught both the markets and their supervisors a lesson about the perils of too much leverage in the fixed-income sphere, a decentralized world of desk-to-desk trading that works 99.99% of the time. It’s a percentage so seductive to the mathematical modeler and so deadly, because the residual 0.01% can be cataclysmic. Greenspan thought that the private sector would learn that self-evident lesson on its own, but he was wrong. To his credit, he admitted it.
The apex of credit euphoria was in the spring of 2007, a time that the Fed had raised rates to the comparatively high level of 5.25%. Despite those higher rates, it was a season of frenzied competition to originate loans that introduced “covenant-lite” lending and saw the return of PIK-bonds (Pay in Kind), an ill-born innovation that I thought had gone to the grave forever with the collapse of Drexel Burnham Lambert in 1990.
But if low interest rates weren’t responsible for the lending frenzy, what was? One need look no further than February of 2007. In that month, the financial services industry cashed the largest bonus checks in its history. Just as elephantine contracts led to corruption and illegal performance drugs in the athletic world, so the chase for epic bonus payments gave us reckless behavior in industry, including finance.
The libertarian school held that corporate self-interest would naturally check risk-taking, but that school was born in a corporatist era that had never seen individual rewards on the scale of the superstar system. Individual self-interest, it seems, is the stronger, and the corporation or team can be reduced to a disposable platform for individual enrichment.
If it’s any consolation, the problem of individual enrichment is rapidly becoming a moot point, as evidenced by last week’s advance reading on third-quarter GDP. Consumer spending fell (-3.1)%, the biggest decline in 28 years, while GDP overall was estimated to have fallen (-0.3)%. Nearly every category declined, although a build-up in inventories that reflect weak sales demand may prop the number up a bit.
We have to point out that the implicit price deflator rose to an estimated 4.1% for the third quarter. The quarterly gross domestic purchase deflator has risen throughout the year, from 3.4% in the first quarter, to 4.4% in the second and 4.7% in the third. The pattern is likely to begin reversing in this quarter, and is consistent with the CPI data.
The BEA has yet to explain, however, how the GDP deflator fell from 2.6% in the first quarter to 1.3% in the second during a time of rising prices. It then reversed sharply to the current 4.1% figure. If the GDP deflator had risen consistent with other data, second-quarter GDP would have been flat to negative. We think that the economy is in its second consecutive quarter of contracting output, and just plain don’t believe the 1.3% figure.
Initial unemployment claims have been stable for several weeks now, along with continuing claims, though both continue to run at elevated levels. It may yet be some time before we hit the dreaded 500,000 weekly mark, but given the amount of job cuts announced last week, it seems only a matter of time. Next Friday will give us the jobs report; we probably don’t need to tell you that it won’t be pretty.
Personal income was estimated to have risen 0.2% for September, but we feel it only fair to point out that the previous two months’ results for income, spending and real disposable income were all revised downwards. Spending fell, as noted in the GDP report, but real disposable income was estimated into the plus column, thanks to decreasing energy costs. Gasoline demand remains weak, despite falling prices.
In other data, the employment cost index remained at subdued levels and the year-over-year rate fell to 2.9%. There’s no wage-price spiral on this horizon. The final U. Michigan reading for October consumer confidence was essentially unchanged at very low levels. And oh yes, the Federal Reserve bank cut the target rate to 1.0%, as mentioned above. In the opinion of many, including ourselves, it was more not to disappoint the market than anything else: the actual funds rate was already below the new target rate.
Folks, next week is going to be ugly, ugly, ugly. The October results for the ISM manufacturing and non-manufacturing surveys are due up Monday and Wednesday, and they are going to be terrible, perhaps record lows. Construction spending is also due on Monday, and it’s expected to have fallen at least (-0.8)%. October auto sales will round out the wreckage.
Factory orders are reported Tuesday, and aside from transportation are also expected to have fallen. Same-store sales results for October are due out Wednesday and Thursday, and you can guess what tone they’re going to have. A rotten jobs report is expected on Friday, with a loss of (–200,000) being the consensus, and pending home sales come later that morning.
A lot of earnings reports are due up next week, and with every company lowering its outlook last week, we can expect more of the same. Against a backdrop of dismal economic data, that’s going to take a toll on sentiment. While interest rate cuts are expected from the U.K., Australian and European central banks, it probably won’t be enough to stem the tide.
However, there is an election on Tuesday that could bring quite a different tide. Here’s hoping for everyone’s sake that the courts can stay out of it this time.
Oddly enough, this week’s StockWatcher is going to talk about two equities that are really bonds, or bond funds to be precise. Those two funds are Pimco Corporate Opportunity (PTY) and Pimco Corporate Income Fund (PCN).
Pimco, we think you know. They’re the country’s largest and probably best bond fund manager. The two funds in question are NYSE-listed closed-end funds that took a horrible beating last month, along with most everything else. Both funds have nearly 25% of their holdings in financial bonds, which were pariahs a month ago but are now virtually guaranteed by the U.S. government.
We think that investment-grade bonds are going to be one of the best places to be for the next twelve months. Many are sufficiently beaten down enough to offer mouth-watering yields. Pimco Corporate Income is yielding about 12.75%, and Corporate Opportunity about 14.2%.
But interest rates are going to stay low for some time. As liquidity slowly returns to the credit markets, bond prices are going to move up well in advance of equities. We think that you’ll get paid pretty well to sweat out the return to normalcy in bond pricing, and Pimco will do all the heavy lifting in issue selection. These funds look like a steal to us.
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