Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
The Fall Ripens
"Was it a vision, or a waking dream?” - John Keats, Ode to a Nightingale
Market open, market up? That seems to have been the story of late. The theory of decoupling is making a comeback. The press is lending itself increasingly to sunny stories that seek to explain the relentless upward momentum in the markets – a momentum generated as much by a lack of selling as by buying fever.
While investors continue to pull money out of the stock market, traders keep bidding them higher and asset managers continue to sit tight, too worried about impending quarter-end statements to sell in any quantity and take the risk of falling further behind the performance curve
Much was made over a bullish Saturday article in the Wall Street Journal by noted market analyst James Grant, of the Interest Rate Observer fame. Grant, who had been largely bearish, turned bullish with the conclusion that this recovery would look like others. He largely attributed this exotic insight to the government stimulus program, the money that the Fed has put into circulation, and the pattern of past recoveries.
It is a mistake is to compare the current crisis to 1980-1982. That crisis was brought on deliberately by then-chairman Paul Volcker, who raised interest rates to nearly twenty percent to wring inflation out of the system. Manufacturing activity crashed. But Volcker was able to reverse the process by lowering rates in August of 1982, setting in motion a massive stock market rally and a decades-long decline in interest rates. No such exit option is available this time.
What’s more, the U.S. manufacturing sector was a much larger part of the economy thirty years ago (or twenty). The last decade in particular saw an acceleration of the exodus in goods production to foreign locales. There is a silver lining to this, insofar as there is hope that some of it might come back, but in general any recovery in manufacturing is going to largely take place elsewhere. That argues for a longer recovery process here.
As we sent our production abroad in the last ten or twelve years, we largely finessed the issue of declining incomes by borrowing to make up the difference and by selling tickets to the asset lotteries in technology and real estate. The credit window is closed now, and the American consumer is deleveraging. Perhaps one should then bet on the emerging markets, where we have relocated our production facilities? The problem is that their number one customer has left the building.
Set against this is the increase in the financial sector. Despite the recent contraction, the financial services sector is still much larger than it was twentyfive years ago, when IRA’s and their kin were created and pushed the average American into the stock market for the first time. We now have a large structure with large numbers of people whose inherent strategy for success is largely predicated on the buying of assets that rise in price. That makes a difference to market behavior.
A skeptic can reply, and rightly so, that the main difference this has made is the creation of unsustainable asset bubbles that result in mass wealth destruction. We think it would be blind to dispute the role of that growing sector. Yet for the current Street traders, who may be the greater cynics, the fact that a mini-bubble may be underway is not to be feared but a parlay leading to greater year-end bonuses.
Armed with the knowledge that on the one hand, the sharpest increases in bubbles come at the end, and on the other, rising stock market prices tend to have a restorative effect on confidence and the economy, momentum players have little reason to get out of the market.
One of our favorite metaphors for market situations like the current one is the stampede of the bulls (or cattle, if you want to be more broad-minded). When the herd is going at full steam, it ignores those first potholes and stumbles that signal problems ahead. Without some kind of major earth-shaker – like the failure of an investment bank – momentum keeps the herd moving in the same direction much longer than the onlooker would think (“can’t they see the danger?”).
Traders aren’t rewarded for guessing where the bulls will end up, but for guessing the next step. One keeps betting on the same direction until the herd is forced into another direction. Thus we ignore last week’s so-so earnings and reports of rising delinquency rates, because those involve consequences more than one step ahead. It’s popular to say that the market is a discounting mechanism, but that rarely means anything more than projecting today’s tape six months out – a practice that is often disastrously wrong.
One of the main reasons for Jim Grant’s optimism is that he is a monetarist, and the Fed has put a great deal more money forth into the system. That has indeed staved off worse declines. However, money supply growth as measured by M2 and M3 (no longer reported by the Fed but measured by various private-sector economists) is actually declining, M3 growth hit a new six-year low last month. The money isn’t going anywhere.
Fill a car up with gas, and it should go a few hundred miles, give or take. One can be forgiven for then thinking that whenever the tank is full, the car will go the usual distance. But when the transmission is broken, the car won’t go anywhere. Right now it looks to us like the transmission mechanisms in the market aren’t working. We got gas, but we’re not moving.
Can the government fix it? Maybe, but the stock market has already priced it in and is revving the engine. Any delays are going to mean disappointment. For now, we have the usual lull of the Jewish Holy Week that runs from Rosh Hashanah (sundown on Friday the 18th) until Yom Kippur on Monday the 28th. After that, the quarter ends and fund managers with an October year-end may want to start playing some defense. Looks ripe for a change to us.
The news largely came through as promised last week for the markets. The combination of the inventory rebound and easy-to-beat estimates led to a slate of rally-useful news. By week’s end, some bulls were noisily proclaiming that the recovery would include 5% GDP growth for the next several years and talking excitedly about massive profit growth.
Yet there are little cracks in the arc of the splendid recovery. Before we proceed to the doubts, though, we should give proper voice to the positive aspects. Production is having its long-awaited bounce, as evidenced in the activity reports from the New York, Philadelphia, and central Federal Reserve banks.
The New York Fed business survey for September rose from about 12 in August to nearly 19 in September, led by strength in new orders. The Philadelphia index rose from 4 to 14, with both indices easily surpassing estimates that could best be called, “extremely careful not to disappoint.” Industrial production rose for the second straight month in August with an increase of 0.8%, led by strength in autos and the cash-for-clunkers program. Perhaps even better was the revision to July, from an increase of 0.5% to one of 1.0%.
While it should be a mistake to expect recovery numbers to display strength across the board, some of the weakness in the data still gives pause for thought about the arc of the current bounce. New orders weakened in the Philadelphia index, shipments fell in New York, both indices continued to give off weak employment readings and inventory destocking seemed to continue. The latter could be interpreted bullishly, perhaps, if one were to say that the inevitable rebuild would later add more strength to the recovery. It might also be interpreted as companies still not seeing sales data in sufficient strength to want to rebuild past minimum levels.
The rise in industrial production does suggest that the recession, as defined by a general contraction in output, has technically ended. However, that the original recession that began in 2008 has ended is not the same as having good times again. We were in a recession at this time last year, and output is still more than ten percent below those levels. Capacity utilization rose from the previous month, but still recorded another month in the previously uncharted waters of below seventy percent. The spike in electricity use benefited from a hot August in the northern part of the country and the restart of auto factories; both factors are set to reverse in September.
This leads to the issue of how good sales are running. Retail sales in August were reported to have risen 2.7%, led by gasoline and the cash-for-clunkers program, giving rise to predictable “biggest since” headlines (our local subway paper proclaimed that “The Shopper is Back,” leading us to muse over the old saw that the less you know about something, the more confident your opinion). Excluding autos and gas, sales were up 0.6% from a downwardly revised (-0.2)% in July. The year-on-year decline in retail trade eased to (-6.0)% from (-9.4)% the month before.
That’s a decent showing, and weekly sales reports showed a little life as well, though they probably benefited from the Labor Day holiday and back-to-school purchases. Anecdotally, auto sales are doing poorly again in September, unemployment is still rising and while there has surely been some pent-up demand showing its head of late, it’s hard to avoid the conclusion that another ratchet back down in retail sales is only a stock market correction away.
One area of weakness in retail sales was the housing sector. Housing related purchases – furniture, furnishings, home and garden – were all down. Housing starts rose 1.5% in August from the month before – a number better than it looked, as July was revised upward – but single family starts fell. It is also the lowest August total for housing starts on record, going back to 1959, when starts were at a 1.4 million pace, compared to 598,000 last month, and lower than any level reached in 1980-1982 or 1990-1992. It’s not surprising when set next to the size of the bubble we experienced. Surely the bottom is in for housing, but it seems to be rather wide.
Nevertheless, next week’s numbers for existing and new-home sales should show perhaps one more uptick, if only due to would-be homeowners trying to rush in to take advantage of the first-time credit. It may be extended. The numbers remain at such low levels (along with estimates) that monthly percentage increases are still outsized and generating headline-making “surprises,” despite the year-on-year weakness. Mortgage-purchase applications are still weak, however.
The best thing news to probably come out of next week will be the drop in new home inventory, what with homebuilders adding homes at the lowest recorded rates in fifty years and probably the lowest rates since the Depression. Even with absolute sales low, the inventory number should improve.
However, sales will probably start to fall again as we head into the fourth quarter. Keep in mind the size of the shadow inventory in existing home supply and the imminent reset problem in adjustable-rate mortgages; along with unemployment, that will keep downward pressure on prices. Wells Fargo (WFC) CEO John Stump said the bank expects increased credit losses and called for the government to raise the limit on conforming loans. That sounds like the upper end of the market isn’t doing very well, and it doesn’t sound like the approval rate for mortgages is going up anytime soon.
Weekly unemployment claims came in at 550,000 (reported at 545,000, but they will be revised at least 5,000 higher). That was good in one sense only: estimates had been gamed to the high side to ensure a beat (575,000). While those whose incomes are tied to higher stock prices crowed about the “big drop” (it will be about 7,000), two conundrums remain. One is continuing claims, which rose again to 6.2 million. With an estimated 1.3 million claims set to expire over the next few months, that number should be dropping; that it isn’t is a testament to the difficulty in finding employment.
The other puzzle is that these new claims numbers are very, very high this late in the game. The good news is that we simply can’t continue to shed people at this rate (can we?), but the weakness of this job market continues to surprise. Looking at the latest batch of earnings reports last week, we didn’t see anybody talking about better demand outside of semiconductors, which tend to be volatile. Optimists talk up the continuing weakness in inventory replenishment as an eventual source of strength, but that needs a pickup in demand that has yet to materialize.
Next week’s big kahuna is the FOMC statement on Wednesday. No rate increase is expected, so the focus will be on the state of current support programs that are nearing their expiration dates and on the committee’s statement. With the stock market having been on such a roll, the Fed may feel somewhat less pressure to project an air of hopefulness about the recovery, but one should always expect the base case to be guarded optimism (“the recession appears to be ending”, for example). It’s their job.
The committee probably won’t be worried about inflation. Although the PPI spiked on higher energy prices and some cash-for-clunker gouging, the core rates remained low for both the CPI (0.1%, 1.5% year-on-year) and the PPI (0.2%, 2.3% year-on-year). On the demand side, the output gap remains large, keeping downward pressure on prices, and the Fed may indeed be more worried about deflation.
The outside threat is that companies may continue to try and slip through price increases to make up for sagging sales, in the belief that the stock market will reward them more for better margins that punish them for lower sales. The combination of rising prices and falling demand is the worst nightmare of the monetary authorities, so don’t expect any quick pullbacks in conditions.
Durable goods, consumer sentiment and new-home sales are all due on Friday, making it the day of the week. All are expected to show an increase; perhaps the market will “borrow” on the impending Yom Kippur holiday on Monday and give itself a lift.
We apologize for the late appearance of this week’s MarketWeek, but illness set us back a day. Our recovery is indeed underway.
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