That Kind of September
“Try to remember the kind of September, When grass was green and grain so yellow.”
– The Fantasticks, lyrics by Tom Jones
by M. Kevin Flynn, CFAWall Street is a funny place. When fresh bad news on housing came out last week, analysts were quick to note that the data proceeded the Fed’s move to lower interest rates. Right. Well, no doubt the rate cut put a lift into the step of many who live on Manhattan Island. And it wouldn’t surprise me to learn that bankers and traders are lingering again over the photos of luxury real estate that are a staple of the back pages of the New York Times Sunday magazine.
But do they really think that people in Florida or Texas or Michigan looked up from their morning newspaper and said, “Honey, the Fed has cut rates. It’s okay to buy a house now?” Or even better, “It’s okay to sell our house and go bankrupt now?” Ironic, isn’t it, that New Yorkers like to think that everybody who lives on the other side of the bridges are s-o-o provincial. Yet the attitude emanating from Wall Street seems to be, “okay little people, the Fed cut rates, so you go out there and start buying and selling your little houses again.”
When the worst of the news came Wednesday that the supply of existing homes for sale had hit a new all-time record of ten months, the analysts intoned, “pre-cut.” Maybe they should have looked at the fine print that day that said mortgage applications were sharply down and that mortgage interest rates are moving up. Post-cut.
Then there was all the surprise that August income and spending hadn’t fallen off a cliff. The consumer is really hanging in there, they said. Why, because the typical consumer kept spending in spite of the losses on his or her subprime loan portfolio? Or was it because of the commercial paper crisis? “Honey, I’m afraid we can’t buy any clothes for school this year. I couldn’t roll over the seven-day paper today, so we’re out of money.” And what do you think has a bigger impact on auto sales, zero percent financing or monthly gains and losses at the Goldman Alpha fund? No doubt the latter has an impact on New York City area Ferrari sales, but listening to analysts last week made me remember how difficult it can be for the Street to imagine life beyond Manhattan and its suburbs.
Last month’s credit market crisis wasn’t just a danger in the canyons of Manhattan, of course, or the Fed wouldn’t have acted. But an economy the size of the American one has some inertia. Growth has been slowing for a year, but it’s still positive, it hasn’t left yet. A financial panic left unchecked might have changed that, but even if the Dow had dropped an extra five hundred points and the credit markets had locked the way they did in 1998, nobody should expect to see things like spending or income roll over in a month’s time. Nor, for that matter, will housing.
Our economy is still largely on the same path that it was at the beginning of August, slowing but growing. The credit market crisis, while not exactly a tailwind, wasn’t quite large enough to snuff out growth, not in a few weeks time anyway. The risks that we will experience an interim recession have grown (cf. Greenspan, Alan), but we’re not in one yet. On the other hand, the Fed rate cuts are not going to suddenly cure housing and re-ignite the economy. Lower interest rates need time to work their effects into final demand and consumption.
If the risks of recession have grown, though, you wouldn’t know it looking at the stock market. Look at the way the market jumped late Thursday afternoon on the rumor that Warren Buffett might buy a stake in Bear Stearns (BSC). You may legitimately wonder why such an investment in a beaten-down investment bank would light a fire under already-extended technology momentum stocks, but it did. As one observer put it, the market was reacting to the idea that more money is coming.
That part is true. More money is coming, though not from individual investors (although that’s supposed to be good, the idea being that the bull market isn’t over until the last pigeon has been plucked). Complacency and risk-taking seem to be rushing back into the marketplace. Traders are licking their chops over the onset of the Old Reliable, the fourth quarter that has been up nine years in a row and twenty-four of the last twenty-seven years (as measured by the Dow Jones).
This all strikes us as a disconnect from economic reality. The market is racing on ahead on the prospect of more rate cuts and more liquidity, as if the economy doesn’t matter and the subprime problem never happened. The solemn intonations of “a re-pricing of risk” are being erased from flash memory. Risk is being re-priced all right – it’s a hot commodity again. You have to respect tape momentum and the fever of the herd (see “1999, Stock Market Bubble” in your handbook) but a market that keeps racing to new highs on twelve months of declining profit growth strikes us as one that is pricing in the best of all the happy outcomes and none of the unhappy ones.
For us, the big question that remains is where is the money going to come from that will keep the consumer going. The equity markets keep cycling through outlooks that provide a reason to look the other way on declining profit growth – Goldilocks, buyout fever, global growth, don’t fight the Fed, pre-election year etc. The general idea is we should ignore domestic weakness because we really live in a global economy now and “they” are going to pull our wagon along until the rate cuts have had enough time to reflate the economy.
There are two problems with this idea. One is that the last time we came out of a recession, very low interest rates led to the huge run-up in home equity that restored consumer purchasing power. Obviously housing is in a different spot right now. Supply is at record levels, lending is tight, the mortgage business has undergone a severe contraction and yet price levels are estimated to still be twenty-five percent overvalued relative to income. Even if the Fed was willing to reflate housing, which seems dubious, it’d be hard pressed to do so within the next couple of years. Our illustrious Mr. Greenspan’s view is that the current housing situation is the worst one he’s ever seen and that the adjustment period will be prolonged.
The other problem is that the market seems to basing its outlook for global growth on its own internal desires. “Europe is strong” is a credo of market cheerleaders, yet German consumer and business confidence is falling, Italian business confidence hit a 21-month low, Belgian business confidence is down and UK banks cut lending in the third quarter, though not by as much as they expect to cut it in the fourth quarter. The U.K. is at the very beginning of its own housing crisis. The Eurozone purchasing managers’ index has dropped to just above neutral. The stock market is taking some shaky paper here to the bank.
If we’re going to get a recovery, it’s not clear where the pickup in demand is going to come from. We’re still outsourcing manufacturing, financial services are in a contraction and we hardly have an inventory shortage. The uber-traders are talking up a rebound in technology gear, but they may be asking for more than that sector can deliver. Not that that has anything to do with the meteoric ascents in Amazon (AMZN), Google (GOOG), Apple (AAPL), Research in Motion (RIMM), Baidu (BIDU) and the like. That’s just momentum money pouring into a narrowing list of growth stocks. Risk is in again and don’t fight the Fed, remember?
Employment has been holding up, though decelerating in tempo with the economy. But real median income is not increasing. We’ll get another look next week at the situation when the jobs report comes out, which should get a boost from back-to-school employment. Despite Federal Reserve Governor Poole’s admonition on Friday that the markets shouldn’t be counting on more interest rate cuts, any further softness in employment would undoubtedly lead to the market baking in another cut. Frankly, the market could rally on any number – a drop leading to rate cut fever, a beat leading to a relief rally and anything in between a Goldilocks number.
Our outlook is that there’s going to be more bad news in October than the market is currently discounting. But this market keeps its dreams right by its pillow, and could well choose to ignore anything it doesn’t like.
The Economic Beat
The economic news last week was mostly negative. Housing continues to sag: the supply of existing homes for sale hit an all-time high of ten months, and the supply of new homes for sale hit a seven-year high. Once again, market commentators working from offices discerned signs of hope in the data (“it could have been worse”) while once again, the heads of building companies trying to sell the stuff said they saw no relief in sight. Choose your source.
The durable goods orders was a big disappointment and is likely to repeat itself in next week’s factory orders number. There is something of a bright side, though, in that the trend is not down but continues an irregular pattern of monthly ups and downs in ordering that is consistent with leaner inventory management and a slow growth economy. The Chicago PMI was positive.
Consumer confidence slipped more than expected to a two-year low, but the confidence number is mostly just a gauge of recent headlines without much predictive value. Construction spending showed an unexpected increase led by hotel, office and other commercial construction. It’s a little bit worrisome, because these larger projects with bigger lead times tend to keep going until well after the cycle has turned and then end up dumping a lot of supply onto markets that have already moved into a surplus position. It’s one of the few remaining sectors of the economy that still gets big cyclical swings.
Personal income data was released, and much of the growth again bifurcated into interest/dividend income on the one hand, and transfer payments on the other. The former suggests that wealthy households are moving more money into safer assets, while the latter suggests that the number of struggling households is increasing. Private payroll growth continues to weaken.
Personal spending was up but failed to move the market. We would like to think that this was because somebody looked underneath the data, but it was more likely due to it being the last day of the quarter. The spending number came in at plus 0.6 percent, which had some of the cheerleaders going because the consensus had called for 0.4 percent. But this was old news that we had already gotten in the retail sales number released earlier in the month; both numbers owed almost all of their increase to the same uptick in auto sales.
The data song remains the same: slowing growth. Although warnings of an uptick in inflation are multiplying, the Fed had to be happy to see that the latest PCE number (its preferred inflation measure) shows no trace of it. Next week we get the big enchilada employment report on Friday, before that we’ll see the two ISM surveys (probably close to last month) and new data on factory orders (should echo durable goods).
And oh yes, oil resumed its climb again, but the Wall St. Journal tells us that we can live with $100/bbl oil. Whoever wrote that story may want to revisit that thesis when the winter heating oil bill arrives.
Let’s say you’re not all that sanguine on the stock market outlook, but you’d like to hedge your bets a little. You think that the short-financial/long-tech trade is over, but you’re not ready to dip into cyclicals either.
You might want to have a look at asset management company Legg Mason (LM). Legg has a couple of things going for it – if the market does rise in the fourth quarter, the asset managers benefit directly, but the company also expanded its sales reach a couple of weeks ago with a new agreement that expands its distribution network.
The stock is selling at relatively cheap levels, too. At Friday’s close of $84.29, it’s selling at about 15 times estimates of current fiscal year (March ’08) year earnings of $5.39 (consensus), a discount to its group. It’s well off of its earlier 52-week high of $110.07 set back in February, and not much above its low of $76.80 set a couple of weeks ago before the Fed announced its surprise cut.
The stock sagged after its last earnings report, which beat estimates but also disclosed worrisome outflows in equity assets. It doesn’t help that long-time hero Bill Miller’s Value Trust fund is underperforming this year, despite its big holdings in hot internet-related stocks. But most of that news seems to be fully reflected in the current price, and the new distribution arrangements should help. Although domestic equities are not generally seeing inflows, Legg’s broad product portfolio (most of its assets are managed in separate companies working under their own names) would benefit from any improvement.
The balance sheet is in good shape, with debt to capital about 14% and a little over $11 a share in cash. One disadvantage is that the dividend is fairly small and the current yield is only 1.14%. Against that, its international operations benefit from the weakening dollar. If you’re looking for some upside participation, it’s worth a closer look.
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