Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
One Year Later
"He didn't notice that the lights had changed.” - Lennon-McCartney, A Day in the Life
One year ago today, we received a call from another investment manager who confidently predicted that the Lehman situation would be sorted out by Monday morning. It was a can’t-fail situation. We hoped he was right, although uncertain about exactly what would happen.
Rampant, unchecked short selling and pressure from credit default swaps were decimating the value of investment bank capital. It was becoming nearly impossible for any company to access funding. By Friday, September 12th, margin calls and a squeeze in overnight funding markets left Lehman unable to open for business the following Monday. For reasons still controversial a year later, the government allowed the worst of all possible outcomes to transpire: the unmanaged bankruptcy of a global investment bank.
Counterparties around the world were left skewered by the filing when Lehman couldn’t complete its trades or legally return collateral. The consequences were devastating. A global wave of solvency fears and counterparty panic swept the world’s financial markets. The government was suddenly forced into massive intervention on a scale that made saving Lehman look like a few pennies of pocket change. It was the single largest policy blunder since the Great Depression.
One year later, as television specials and books about the event proliferate, the economy has not yet recovered. The global contraction in output was the greatest since the Depression and earned the sobriquet, “The Great Recession,” though it appears to have ended around the middle of this year. The stock market has recovered much of its losses, but is still down about 17 percent from a year ago. The economy has stopped shrinking, but output is still running about twenty percent below last year’s level.
It’s worth wondering what, if anything, we’ve learned from it all. The economist Paul Krugman, in a piece for the New York Times, wondered if his profession would be able to bridge the gap between Keynesian theory and the prevailing neo-classical theory. The latter had suggested in recent years that bubbles were either an illusion or impossible.
Mindful of the history of science, we think that many of the profession’s prominent neo-classicists will go the grave trying to prove that the crash was nothing more than an information glitch and that the system functions just fine. The house may have burned down, sir, but I assure you that the sprinkler system was perfectly sound. Yes, that sounds about right.
Median household income fell over the last ten years for the first time since World War II. On CNBC this week, I heard some of its very learned newsreaders wonder what was so bad about a boom-and-bust economy anyway? Quite right. When one is young and attractive, on television, and making a salary of six or seven figures while dating rich investment bankers, it’s hard to understand what all the fuss is about. There may be the odd bread shortage now and then, but doesn’t that just give the people an opportunity to try some tasty cake instead?
The stock market chugs along in its merry way, with Friday’s very mild pullback not symptomatic of anything but the cashing in of some chips at the teller’s cage on the way home for the weekend. It’s quite convenient in fact, because it gets a little awkward when the winning streak reaches too many days in a row. The odd day off now and then is so important if one wants to keep the show fresh.
The market has now priced in all of next year’s recovery and gone to work discounting 2011. The unlikelihood of all the best-case scenarios coming to pass means little, so long as today feels good and tomorrow will be better. That sounds familiar as well.
Here’s another familiarity: the bond market and currency markets are saying one thing, while equities are saying another. Very much like 1987, isn’t it? We think that the market will probably take out 1100 on the S&P 500 before vertigo sets in. There’s no cause for alarm, though, because traders are worried about the rally. So long as we’re worried, that means we’re not complacent. Thus, we are safe and the rally can continue. Got it?
Weekly reports outweighed the monthlies in a quiet week for economic releases. There was improvement across the board, although much, if not most, was calendar-related.
To begin, initial jobless claims fell. As usual, the prior week was revised higher and the previously announced drop shrank or disappeared. In this case it reversed completely, with the headline drop of 4,000 quietly revised to an increase of 2,000. You had to dig to find that out, though.
Thus, the claims did not drop by 26,000, as reported, but by some smaller amount. Even a drop of 20,000 is sizable and would be welcome, however. One mitigating factor may have been the impact of the Labor Day holiday, as many people leave early for the long weekend. If the improvement does stand up into next week, that will be good news, but only in a limited kind of way, because weekly claims are still running unusually and stubbornly high this long after the recessions onset.
Mortgage purchase applications shot up last week by 9.5%, raising the index to its highest levels since January (according to the Mortgage Bankers Association, which no longer publicly discloses the index values). We estimate that the index did indeed rise above 300 for the first time in a long while. The group attributed the increase to a drop in rates, but we would guess that the thirteen-basis-point drop was outweighed by the looming expiration of the homebuyers credit and some bargain-bin rummaging.
Foreclosure activity ran very strong in July and continued to do so in August, with a record number of properties entering foreclosure auction. The damage, as usual, is centered in the bubble-centric states of Florida, California, Nevada and Arizona, followed by the automotive-devastated states of Michigan and Illinois. However, a story this week local to our own state of Massachusetts is not atypical: another announcement that the remaining units of another high-end development would be put up for auction at about a fourth of the original asking price.
It’s true that clearing out surplus and damaged inventory is a necessary part of the healing process, but discounting that deep pulls down the general level of prices. It is bound to prolong the housing bottom, along with rising unemployment and the lenders who don’t want to lend.
Banking analyst Meredith Whitney, who has done well this cycle apparently by analyzing data and then making conclusions (the reverse of what usually happens on the Street), warned last week that housing prices could fall another twenty-five percent. When reminded of the increase in applications, she replied that approval by the banks should not be taken for granted.
Whitney also repeated an observation that has begun to circulate more widely, namely that a return to long-term normalcy in housing means more contraction in the sector: the long-run rate of home ownership in this country is about sixty-five percent, and the current rate of about sixty-seven percent is still above that.
As the chart indicates, the deviation from historical average has some way to go before the correction is complete.
Nevertheless, housing sales data should continue to improve over the short run, partly driven by the expiring credit and partly by clearance sales. The improvement will probably come to an end by the fourth quarter, but not before providing an excuse for speculating in homebuilding stocks, oil futures, and anything else judged to provide extra beta to investors.
The monthly trade deficit for July showed its largest percentage increase in some years, but like most economic data these days, the larger percentages are due more to the lower numbers that make up the base of activity than to any robustness. The increases were led by price increases in the petroleum sector – crude oil on the import side, and refined products and petrochemicals on the export side.
There were also good-sized increases in sectors such as computer imports, which we put down to low inventory levels and the back-to-school season, and aircraft goods and parts, which are always lumpy. We predict that more improvement will begin to show up in the fall, as stores begin to stock up for the holidays, and caution that one, the inventory reload is already reflected in current prices, and two, the seasonal pickup is only that.
The increase in imports outpaced export growth, which will be a drag on GDP data. It’s only July, but oil prices held fairly steady in August and if we see another speculative surge in crude prices this month, that will subtract from the final calculation. The increased import number and lower GDP number have very little to do with economic reality, but it seems we’re stuck with the headline measure.
Import and export prices increased materially, another example we think of sellers seizing upon the opportunity to recover some money with price increases. Where oil prices might go is impossible to predict, but continued price increases elsewhere by overeager corporations risks inflicting more damage on demand.
Oil and gas inventories are still well above average, but we were supposed to get excited last week by a blip upward in domestic gasoline demand. We think it was largely a one-off centered on the end-of-the-summer Labor Day holiday here in the U.S., with people substituting inexpensive driving trips to nearby locales in the place of air travel. In addition, the start of classes means school buses and parents are back on the roads to shuttle students. We will be surprised if the increase lasts more than another week.
For the same reasons, we are unconvinced by the improvement in the weekly chain-store figures. The return of school, as well as cool and rainy weather in much of the country, is bound to necessitate a purely seasonal increase that may not at all be indicative of an improvement in general demand. The increase in consumer sentiment reported on Friday showed the usual climb on the back of rising stock prices, but overall is still well below its historical average.
However, the rise in auto sales last month from the cash-for-clunkers program is expected to generate a big headline increase in retail sales. If that comes to pass on Tuesday, you can expect lots of “biggest increase since” headlines. With unemployment continuing to rise and the 100,000 phantom jobs added by the Labor Department’s “births-and-deaths” model making only phantom purchases, however, we will watch the ex-auto number trend carefully.
Consumer credit fell dramatically in July, and whether one believes it’s all due to an increased savings rate, or partly to consumers rebelling against thirty percent interest rates (as we do), it isn’t going to lead to higher levels of spending. We suspect that the gouged are either paying off the mega-rate balances or suspending payments on them entirely, leading their card lenders to offer to settle the balance at a discount and start over. In either case, card balances, limits and spending are falling.
Wholesale inventories fell in July, which is largely in keeping with other data. The Great Inventory Restock of 2009 was supposed to have started in the third quarter, but it’s clear at this point that it didn’t start in July. However, the continued cuts into July, when combined with back-to-school ordering and holiday shipments (which begin to ship months in advance), could lead to the Great Inventory Fake-out of 2009. We should see a substantial bump in August and September that could then fade away.
Next week is a critical week, because it brings a large slate of economic data that should all be favorable to the recovery story and the bull narrative. Retail sales, housing starts, the homebuilder index, the New York and Philadelphia business surveys, even weekly claims, all are well positioned next week to make what may be only a dead-cat bounce seem like a glorious, three-masted recovery.
All of the activities referenced above have experienced relentless shrinkage that makes any improvement increasingly easy to come by, as well as inflated in percentage terms. Big things are expected from retail sales (plus two percent) and industrial production (coming off all-time lows), while the survey estimates have built in very modest, easy-to-beat increases. If the markets don’t react well to the increases, or less likely, they don’t materialize, it’s a clear signal to pull your trading money out of the market.
We will also see inflation data in the CPI and PPI indices for consumer and producer prices, respectively. Any negative surprises there will continue to hurt the dollar, currently buffeted by a momentum trade that threatens to undermine equities if it continues much longer. Business inventories for July are reported Tuesday, and it’s simply a question of how much they fell and how much the market will ignore it.
Friday is a quadruple-witching day, meaning that futures, index and equity options are all expiring. That should mean some extra volatility on Friday and possibly some selling pressure, as call option sellers seek to undo some of the damage by dumping stocks.
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