Avalon Asset Management Company Lexington, Massachusetts Investment Management
Avalon Asset Management Company Lost Labor
"I do confess much of the hearing it but little of the marking of it.” - William Shakespeare, Love's Labours Lost
The official death knell for summer tolls this month. School has restarted, and in a couple of weeks the fall season officially begins. Unemployment in the United States is at its highest in a generation. It’s the last month of the third quarter, and we are getting closer to show-me time in the markets. So can the rally continue?
While there is considerable uneasiness in the markets about the distance that the rally has covered and the soundness of its underpinnings, it has been counterbalanced by the nagging fear of jumping ship too early and falling behind in the performance race, even if the ship may not be the safest.
Two paths look possible, yet both seem to lead to a correction. The first path takes the market slowly higher until the end of the year, climbing a “wall of worry” so to speak, so long as the economic data is sufficiently benign to keep the bullish narrative plausible and allow the quasi-momentum trade to keep going. Perhaps more critical is that the news is not scary enough to provoke the herd into a stampede of selling.
The alternative path has a correction happen this fall, but to provoke flight, people need to be convinced that the sell signal has arrived. It would be a mistake to assume that the market isn’t currently ready to sell, it very much is, a sort of contrary indicator that has helped keep the rally going.
Many investors have already built high cash levels, though, and have little need to sell further. They hope to stand to the side and ease back in after the damage has gone a certain distance (easy enough to do after a single-digit correction, but never as easy as it looked once the correction gets into double-digits).
Most assume some kind of discrete event is necessary, some sort of catalyst that will get the selling started, like a financial institution blow-up or the news that China simply doesn’t need any more commodities for the next six months. If we don’t get one, then it’s conceivable that we end up with a 2002-2003 type of situation where the reluctance to drop out of the rising current of hot air leads to a big fourth quarter, followed by a bout of strong disappointment in the first quarter.
If we do get the catalytic event soon, a typical fall-style correction could rapidly ensue and change the prevailing mood back to fear and loathing. That would set the stage for another rally based upon worst fears not coming true. However, that path doesn’t necessarily depend upon having the kind of cataclysmic Lehman-style event that everyone is now absolutely prepared for (and therefore less likely than ever).
No, a good-sized correction could come about from too simply much weight on the new edifice of good-times-is-here-again. It’s a curious situation. On the one hand, most investors, even the bulls boasting at the cameras, are ready to break camp and flee at the first appearance of a genuine crack in the structure. Such clear and obvious signals hardly ever happen: the markets actually rose during the week after Lehman’s bankruptcy last year.
In the absence of the signal-that-never-comes, investors perversely feel a kind of safety. Since they believe themselves to be aware of the dangers and ready to run, the market is able to drift higher, although the truth is that the only signal that the typical market would actually believe immediately is a flat-out crash.
However, events have to cooperate to a certain degree, and if the narrative gets too undermined, it can collapse anyway. Collapses usually come about from contradictions of overconfident markets. Sometimes they get overconfident in their upward trajectory – which isn’t the case now, despite the rise in prices – and get punctured suddenly, as happened in 1987 or 1998 or 1929.
More typically, though, the market is overconfident that it’s aware of the dangers, as in the last two bull markets, and will get contradicted not by one event, but by a series of items that wears it out. The break may develop slowly or quickly, depending on the rest of the circumstances. It’s nearly impossible to time, and there are always plenty of traders hoping to ride one more wave before the tide goes out.
In the current market, a sea still to be navigated is the end of the fund fiscal year, which comes October 31st for most fund entities. It coincides with confession-time for companies, the third-quarter earnings season. During such periods, tax-selling to match gains against losses can swamp sectors, and any kind of earnings disappointment can provoke fingers sitting on the triggers to protect gains (and bonuses, and incentive fees).
This cycle, it would appear that the most vulnerable candidate is the financial sector. Last earnings season, the seas were heavy with fear about potential losses in the sector. The quality of earnings wasn’t great, but lots of money was made in some areas and not as much was lost in others, so the banks were able to put on a rally. We wouldn’t say that the market is brimming with confidence now, but the less-bad fad has become a bit old and signs of backsliding could more readily trigger those fingers.
So here we sit. The market is clearly flustered by the employment situation and erratic Chinese market, with reports of growing loan losses at the federal home lending agencies not helping matters. The summer has ended, and for all the hoopla over the percentage increases in housing activity from completely dead to twitching dead, a normal seasonal turn downward could legitimately reignite fears about further damage to come out of the sector.
On the other hand, the sacred ISM survey finally pointed up last month (see below), some kind of inventory reload is upon us, and many technology companies such as Intel (INTC) have been making hopeful noises. Third-quarter earnings estimates have been hacked to pieces, making for easy comparisons and easier beats (not that the Street, heaven forbid, would ever do something like lower estimates enough to be sure that they could be beaten). Sales comparisons get easier in October (though it won’t be official until November).
We saw one fellow come onto CNBC and berate the media for too much negativity about the economy. Really? The headline on page one of that day’s Wall Street Journal was, “Global Economy Gathers Steam.” The headline on page one of the Financial Times was, “Global Rebound Gathers Impetus.” The headline on page one of the second section of the Journal was, “Car Makers Upbeat as Sales Rebound.”
However, it seems that the front page of that day’s “Money and Investing” section in the Journal ran a story on the 185-point drop the previous day, and another had the temerity to wonder whether stocks might not outperform bonds the next ten years. Saboteurs!
Does that mean that the bond market isn’t patriotic either? Fourteen basis-point yields – if you can call fourteen points “yield,” rather than postage and handling costs - on three-month T-bills certainly doesn’t show any worry about runaway growth. Maybe bond traders noticed all the lost labor.
Markets are closed Monday in the United States in observance of Labor Day. The irony is that one in six Americans are getting the day off anyway.
Talk continued last week about the Fed needing more specific regulatory guidelines or tools to address situations like AIG and Lehman. To our minds, it’s part of a broader effort to deflect blame for the Lehman Brothers episode. The Fed has, and had, broad enough powers to intervene to keep Lehman from its disastrous end. It could have stepped in, but chose not to. Alan Greenspan, despite his libertarian weaknesses, would not have allowed such a blowup on his watch.
The Fed chairman that we did have, Ben Bernanke, has many virtues but does not have the one of being a financial markets veteran (although he certainly is more of one now than he was twelve months ago). He didn’t have the gravitas that Greenspan did, and still doesn’t. The combination of lingering criticism over the Bear Stearns rescue, a lack of guidance from a conflicted, lame-duck administration, and poor advice from the putative market expert, former Treasury Secretary Paulson, proved to be too daunting a hurdle for Bernanke to step out and invoke the Fed’s nearly unlimited emergency powers.
To atone for this failing, we are asked to believe that what the Fed really needs is more specific powers for such situations. The implied corollary is that Bernanke would have done the right thing, if only the right rules had been around, rather than get led down the wrong path by Treasury.
But that ain’t necessarily so, Joe. If a Lehman-like situation were to happen tomorrow, as improbable as that may be, Bernanke and the Fed and Treasury would intervene, tools or no tools. Decades from now, though, when laissez-faire sentiment reaches another peak, will a few extra lines in the rulebook make any difference? It will still come down to the actors in place, and if the will to intervene is missing, even divine powers won’t matter.
In the meantime, one of the Fed’s more immediate problems is going to be the increasing wave of populism that rising unemployment is sure to engender. There have already been lots of rumblings visible, and the growing calls for auditing the central bank and generally rummaging through its files for evidence of domestic and international skullduggery brings to mind the populist backlash of the nineteen-thirties.
Certainly the jobs news wasn’t good. As we predicted last week and on other occasions, last week’s claims number was again revised higher and the previous week’s improvement was cut in two. Claims remain stubbornly high at about 575,000 (post-revision), and continuing claims squeezed out another raise, despite the fact that they should have hit run-off status by now (our own state, Massachusetts, will begin to send out its first big batch of expiration notices next week).
The August jobs loss of 216,000 was slightly better than the consensus of 225,000, though not responsible for Friday’s market rise as many news outlets reported (the market floated up on very light volume in the afternoon, as it usually does on the eve of a long weekend). Yet revisions for the previous two months totaled fifty thousand, so the final total may prove to be on the wrong side of the consensus. The unemployment rate definitely was, rising to a twenty-six year high of 9.7%.
It was the smallest jobs loss in a year, but as more than one pundit pointed out, there just aren’t as many jobs to cut anymore. Perhaps most discouraging was the news that the odds of a person unemployed in July finding a job in August fell to one in five, the lowest such rate in fifty-one years (though not as discouraging as reading the anecdotes of the unemployed in the weekend edition of the Journal). Aggregate work hours, a good coincident indicator, fell, and although weekly earnings rose, it was due to the increase in the minimum wage.
Some hopeful discussion centered on the slowing drop in temporary workers (a loss of 6,500 in August, down from an average of 51,000 in the first half), but we feel obliged to recall the same observation: there just aren’t as many temporary workers to cut anymore. Although the inventory restock will bring back some temporary workers back, there is a strong risk that their return may be shortlived. The labor market is very weak.
However, the ISM manufacturing index finally made its long-awaited turn upward, though a good two to three months late in our estimation. Many were surprised that the markets sold off on the news, as it was widely reported that the reading of 52.9 had beaten the consensus of 50.5. However, 50.5 wasn’t really the baseline anymore, with most looking forward to a 53-level reading that had appeared in many prominent forecasts. Such sell-offs are a classic indication of buyer fatigue.
New orders grew smartly (it’s about time), and respondents were generally more upbeat than we’ve seen in a long time. Apart from employment, which was for the most part unchanged, and a blip in prices, the report was broadly positive. Still, the report only measures the change from the previous month, and after eighteen consecutive months of decline and a fifty percent rally in the stock market, perhaps traders were right not to pop open the bubbly.
The report was undermined a bit by the regional survey for the Chicago area released the day before and the non-manufacturing report released two days later. The Chicago PMI did weigh in with a neutral reading of 50, and a new orders reading of 52.5. Yet the tone of the respondents was largely skeptical, employment continued to contract steeply, and a neutral reading after ten months of decline isn’t all that stirring.
The non-manufacturing survey turned in another month of declines, with a reading of 48.4 versus the consensus of 48.8 (the four tenths really don’t matter). The non-manufacturing survey isn’t as cyclically sensitive as its manufacturing sibling and the decline wasn’t as steep as the month before, but it was still something of a disappointment. Employment readings continued to contract.
An interesting feature of all the surveys was the rise in prices. Much like the runup in auto prices, companies were very quick to take advantage of any stabilization to push through price increases. It’s probably just a rebound from heavy discounting, but a sustained effort by companies to raise prices to offset earnings damage from falling sales could prove to be disastrous. Let’s hope it wasn’t the case.
The July factory orders headline number (+1.4%) failed to meet consensus, but for a switch was better than it looked, as the previous month was revised up half of a percent, bringing the dollar total closer to the headline percentage estimate. However, that was all on the transportation side (Boeing’s (BA) big order), as new orders fell (-0.7)% excluding that segment. Shipments and inventories fell as well.
Looking through the numbers and taking the ISM manufacturing survey into account, the long-awaited inventory rebound, still missing in the July data, should begin to show up in August orders data. Even a very modest inventory rebound should result in at least a couple of months of uptick, possibly sending the market into a November frenzy.
We’ll need some good inventory news. Weekly retail sales numbers are still weak, August chain-store reports were down about three percent for the month, mortgage purchase applications fell from weak to weaker, and the Fed minutes showed plenty of concern. Pending home sales rose again in July, but may start to fall again if the government doesn’t renew the home-buying credit.
Construction spending fell again, and although some hopeful noises were made about the uptick in private residential spending, it remains down twenty-seven percent on a year-over-year basis. Going by the earnings reports that have come out of the homebuilders, the sector is still in survivor mode. Productivity and cost data for the second quarter echoed the earnings reports: cost-cutting and layoffs helped sustain profits, but you can’t cut past the bone.
Next week is a shortened week with the U.S. holiday and is light on data as well. The Beige Book, due on Wednesday, may be the most interesting report of the week for equity traders, unless the weekly claims report does something different. Data on international trade is due Thursday, but equity traders tend to forget it quickly. Import and export prices follow the next day, along with the first September consumer confidence reading from the University of Michigan.
A couple of reports that don’t usually get as much attention, wholesale trade on Friday and especially consumer credit on Tuesday, might get the market’s attention this time around. The mid-quarter update from Texas Instruments (TXN) on Wednesday should grab some limelight as well.
Avalon Asset Management Company is a Registered Investment Adviser
Avalon's MarketWeek is not intended as a market timing newsletter or service. No buy or sell recommendations are made for any of the individual stocks mentioned on the site, and neither Avalon Asset Management Company nor its officers, directors or employees make public stock recommendations. Please address comments to MarketWeek@AvalonAssetMgmt.com