Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
Rounding the Turn
"Who is the bigger criminal, he who robs a bank or he who founds one?” - Bertolt Brecht (MacHeath), The Three Penny Opera
The spell of the market’s momentum became wobbly last week when unexpectedly tepid news surfaced in the housing and manufacturing sectors. Home sales were supposed to keep rising, but they basically fell (see below), and the big pop that was supposed to happen in durable goods went the other way. Earnings results were mixed and provided no big upside surprises.
Bulls snorted that it was only a month’s data, and that is quite true. One month does not a trend make (though it usually seems to work that way in the other direction). The problem is that the market is priced for the line that goes straight up, not the line that begins to flatten. There is disagreement, of course, over whether the line is flattening or not, and next week’s heavy schedule of economic releases will add fuel to that fire.
The fear that lurks is getting caught with too much baggage heading into October – or not enough for the fourth quarter. Money isn’t exactly pouring into equities these days, except the stuff that’s been borrowed by trading desks. The investing public is putting all of its money into bond funds, in a tidal wave that hasn’t been seen in decades.
The deluge into the latest California municipal bond offering shows how desperate the chase for yield has become. The real consequence of low interest rates in the aftermath of the tech wreck in 2001-2003 was not, as is popularly believed, a tidal wave of money borrowed from the banks and sent into real estate. Credit didn’t really get loose until late 2006. Rather, the effect was to suck existing investment money desperate for returns into the one area that seemed to be working, which was real estate.
But the yields on mortgage properties weren’t high enough to capture that investment Holy Grail of ten percent returns with no volatility (only Bernie Madoff could do that). If you wanted ten percent without going into junk bonds, you had to lever up. How much leverage? Well, our boys and girls on the Street discovered a very close correlation between bonuses and leverage, didn’t they? Ergo, there was no such thing as too much leverage.
Now money is pouring into fixed-income again, this time into corporate and municipal bonds, heedless of risk and creating some sort of bond bubble. Spreads, which are price differentials between non-government and government bonds, have nearly returned to normal levels and in some areas passed them. But the money flow hasn’t stopped, and the stock market rally has made many shy of equities. How to keep up those bond returns? We can almost hear Mickey Rooney say, “Hey gang, let’s borrow some money!”
That leaves two groups in potential trouble. The first is the bond issuers. Despite the premise that the bond market is pricing in zero inflation and low growth, if any, what would happen if the issuers get over-leveraged into an L-shaped recovery? That could cause some cash flow problems. For that matter, what would happen to the Chinese loan market if the local equity market turns south – or the commodities market? Those clever farmers haven’t been betting that stuffing it all into mattresses was the way to go.
The second group is of course the bond investors. Somehow credit bubbles always seem to end badly, a statement that may seem to be the most obvious of the year. But they do seem to recur over and over again in our modern, innovative financial system. It looks to us like the Fed is beginning to worry about it too, with its trial balloons that it may raise rates sooner than later next year. We don’t think an overheating economy is what’s on their minds. The equity markets have the front pages right now, as is usually the case, but the real story will probably be the credit markets – once again.
Watching the rating agencies try to hide behind “free-speech’ protection – you know, we just happened to be standing on the corner talking about this stuff, can’t help it if people took us seriously – is so much like the attitude of the other Wall Street peddlers. When it comes to selling, it’s all gravitas and pieties about how being the Global Brand and Blue Chip Franchise and the strength of our research analytics, sir.
But when the stuff they sell blows up, like auction-rate preferred securities or those solid gold, triple-A asset-backed CDO bits of paper that were sold with those global blue-chip names behind them, offering short-lived yield pick-ups that bankrupted villages and parish councils the world over (like offering premium cigarettes on the way to the firing squad), then it’s back to the same old sad story: we were merely intermediaries, only a conduit, just taking orders.
As Gretchen Morgenson has pointed out, financial penalties alone aren’t the answer: the bonuses are pocketed by the individual bankers while the fines are paid by the shareholders. It’s been a problem ever since the Street converted from partnerships to publicly held corporations: the risk has for the most part been handed off to the public. We don’t want to overlook the financial ruin of the employees holding Lehman or Bear Stearns stock, but the generals who sent them off to battle remain extremely wealthy and extremely free. We need some jail time.
However satisfying that might prove to be in the short run, however, prison views don’t suffice either, not when it comes to protecting the public. If we run up the penalties for egregious managerial failure on the Street, it could have the perverse effect of leaving us with only the biggest gamblers and crooks at the top. We need stronger controls as well, and if it means that the world has to get by without any innovation carrying a triple-A rating – an oxymoron to begin with – we can live with that.
In the meantime, the FDIC is considering tapping its credit line with the Treasury department to refill its depleted insurance fund, and the FHA has announced that its reserves will fall below its mandated two percent level. Taiwan export orders to the US fell in August sequentially and are down twelve percent on the year.
That’s not the kind of stuff that sounds like our problems are all in the rear-view mirror. Yet we attended a meeting of professional money types last week and were hard-pressed to find anyone who thought a correction would happen before the end of the year. Apparently it’s going to happen sometime next January/spring/year. It seems to us that the business has gone from worrying about an imminent correction to being certain that it will come, but not now. But it’s when everybody is leaning the same way on the rope that it breaks.
The economic week ended on something of a thud, though at least not a crash. The inventory and housing rebound stories got a case of hiccups, muting the bullish bellows of the momentum chasers.
The feeble result recorded the prior week for housing starts – the weakest August since records started being kept in 1959 – found echoes in the existing and new-home sales data released last week. August new-home sales weakened, recording a tiny uptick (that will probably disappear next month) due solely to a downward revision for July. The year-on-year change fell several percent from 2008 and turned in the lowest tally for that month since 1969.
The good news is that home inventories duly fell, because homebuilders have for the most part stopped building. One commented that there was little point building new when newly-finished homes are sitting around for sale at below cost.
Existing home sales eased unexpectedly, with the rate of first-time buyers and distressed sales remaining unchanged at 30 and 31% respectively. At least sales were a little above last year. The NAR tried to hint that the some of the drop was actually due to an increase in transactions clogging up the system and slowing down closes (!). It stressed the urgency of one, finding a realtor immediately to help close a sale before the first-time tax credit expires; and two, extending the first-time tax credit. Today is always the best time to buy a house in realtor land, isn’t it. Existing inventories also improved as predicted, but most accept the premise that it’s due to supply being pulled off the market.
Having enjoyed a briefing on the housing situation Friday from fund manager Whitney Tilson, the data seem to consistently point to a situation where the low end of housing is where the action is, which probably explains most of the recent price decline recorded in existing sales. Distress sales and bargain-hunting in the worst-hit states of California, Florida and Nevada have driven down supplies of homes in the below-$200,000 stratum to about normal levels.
It certainly can’t hurt that the lower stratum fits well into the first-time homebuyer range, where the $8,000 tax credit is available, and where all of the mortgages would be eligible for GSE repurchase. A warning from Tilson was the second-hand story that many of the sharks who were peddling subprimes two or three years ago are now swarming an understaffed FHA with more junk. You can’t keep a good scam down, it seems.
However, as one moves up the price scale, the market is more static. In jumbo-land (mortgages above the Fannie-Freddie limit), there are years and years of supply. Banks flat out don’t want to finance them without draconian terms, if at all. They have always been classic cyclical chumps, too scared to lend at the bottom and too eager to lend at the top, but for the near future it appears that banks want to be out of the lending business entirely. Fee business and earning the government yield-curve spread is what most big banks are interested in, in part because of the losses they will be spreading out over the years to come. It is a major policy challenge.
That dilemma was reflected in the Fed’s policy statement, which could have been written ahead of time by any number of market-watchers. Things are a little better, still rather weak, let’s hope for the best. The news that we were looking for was the status of the central bank’s buying plans for Treasuries and mortgage paper. There was no change on the former, but the latter will stretch out through the end of the first quarter of 2010 rather than end in October, as is planned with Treasuries. Surely the Fed wants to avoid a surge in mortgage interest rates during such weak demand conditions, but it’s no indicator of a robust recovery. They’re buying almost 80% of the GSE issues as it is.
Durable goods fell in August when they were supposed to rise, although it wasn’t as bad as it seemed, just as July’s results weren’t as good as they looked. Aircraft orders, which are large and irregular, ignited the launch-and-return over the two-month period. Orders are largely moving sideways, and the private investment category (capital goods excluding defense and aircraft) ebbed slightly in both July and August. Not a disaster, but a lot more of an “L” than a “V.”
In the weekly reports, retail sales fell back sharply from the week before, suggesting that the Labor Day back-to-school period may in fact have only been a bump. In what has become a regular weekly ritual, a fresh big decline was announced in jobless claims, and the previous week’s whopper morphed back into a minnow. Perhaps they are all fishermen at the Bureau. Although the four-week moving average is trickling downward, the levels of both initial and continuing claims remain disturbingly high. The level of mortgage purchase applications, however, remains disturbingly low. If this is a “V”, it’s well-disguised.
Next week has the ingredients to be pivotal. All segments of the economy are checking in, ranging from home prices (Case-Shiller index on Tuesday) through manufacturing (national ISM on Thursday) and employment (the September jobs report on Friday).
The initial estimate of third-quarter GDP comes on Wednesday, the Conference Board consumer sentiment report on Tuesday, and keeping the ISM company on Thursday will be a long sheet: September reports on pending home sales and personal income and spending, August data on construction spending, jobless claims, and more early looks at the jobs report. We are coming into one of the most volatile times of the year.
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