Avalon Asset Management Company
Avalon Asset Management Company
Grayed Expectations
What a difference a week can make. Last week hope floated; this week it limped, and rather glumly at that. Things might have been worse had it not been for quarter-end price-pushing to defend the averages (and more importantly, certain investment manager fees). Only last Friday, the market had seized upon February closings of sales contracts signed in December – driven by unusually warm, pre-subprime-crisis weather in the Northeast - as evidence that the Housing Crisis Is Over. True, it was the third time since last summer that this announcement had been made, but the Street does pride itself on calling turning points early. Especially during bull markets, when the chance of leaving any money on the table by not calling a turning point is a far more frightening prospect than worrying about how some easily forgotten predictions might turn out.
Had only last Friday been quarter-end. The pickup in existing home sales would have been rocket fuel for a market looking to mark up prices, and could very easily have led to a triple-digit increase in the Dow. Alas for those fees, we had one more week of treachery to traverse, and in the end the Dow finished with its first down quarterly performance in nearly two years. A dip in Ferrari sales in the Greenwich-Manhattan corridor could well ensue. Temporary, of course.
The week ending March 30th started off with the deflating news that February new home sales were not only not up, they were down, and with one of the biggest misses ever. This negation of Friday’s announcement that the housing crisis was over sent the markets spiraling downwards. By noontime, though, traders had concocted a reason to start pushing up towards quarter-end again: see, the miss was actually good news for housing. Surely it’s obvious: fewer new homes will mean less inventory and less inventory means a quicker correction. It’s a pity that any new homes were ordered at all, imagine the explosive rally we’d have had if new home sales had been zero. Unfortunately there were some home-buying saboteurs out there, although not enough to keep the supply of new homes from hitting its highest level in over fifteen years. But at least this lack of buying is a step in the right direction (you can see that clearly, can’t you?) and the market got back its losses.
No, while the confidence number certainly didn’t help matters, the real skittishness came from homebuilder Lennar Corporation’s (ticker: LEN) gloomy results and outlook. Lennar’s executives just came out and said look everybody, we don’t know where the bottom in housing is yet, so stop asking because we’re not going to guess anymore and that means no more guidance and oh, by the way, that sub-prime problem that was over last week? It isn’t. So much for the latest installment of This Time It’s Really Bottomed. Yet, the damage was contained, as traders still had two cards to play: quarter-end Friday, and Beloved-Bernanke Wednesday.
For some time now, traders have have been eagerly awaiting Fed Chairman Bernanke’s comments as oil for every troubled water, a high-grade lubrication for the trading machine. That’s a sure sign of bullish liquidity. After all, Fed chairmen are usually educated and practiced fellows who get appointed with the understanding that 80% of the job is looking calm and dignified while not scaring anybody (for the Treasury secretary, it’s more like 99%). When you hold high public office, saying what you think is out of the question. One does not wonder if we’re going to hell in a handbasket; one allows that certain difficulties, though not part of the baseline forecast, may yet possibly emerge. The FOMC statement is the record and off-the-record comments are not made. Especially not to Maria Bartiromo.
When Alan Greenspan was chairman, he deflected attempts to draw him out with practiced, dense circumlocutions. Complaints about not understanding what he was saying missed the point, because nothing was exactly what he was trying to say. Chairman Bernanke, apart from an opening act misstep or two, doesn’t say anything either, but his way of saying nothing is less opaque. He rephrases the latest FOMC statement in fairly simple terms, repeats the mantra that the Fed’s next decision will be data-driven (how revolutionary) and that’s about it. But since we’ve been in a bull market, traders have felt free to put the best gloss on those simpler words and to adopt him as their guy. That won’t end until we get a bigger correction of the kind that sobers everyone up again.
When Bernanke the Beloved spoke on Wednesday, though, he did not rephrase his remarks in the expected way. Not that he did anything out of the ordinary; he simply repeated that the Fed’s economic outlook is moderate and that they’re still worried about inflation. This sure looked like the same thing that the FOMC had said the week before, but traders had been looking for that wink and nod that says don’t worry boys, we’ve got our finger on the rate cut button. They didn’t get it. Instead, they were left without solace to ponder yet another weak durable goods number, and to further worry about the soft-landing scenario that the market - but not the Fed - has promised itself.
Thursday and Friday did bring some bits of better news. GDP for the fourth quarter of 2006 was upwardly revised, unemployment claims were slightly better, February personal income and spending were definitely better than expected, and the Chicago purchasing manager’s index turned in a remarkably lofty number. So why didn’t the market do better?
The number one culprit was oil, whose steady and steep ascent throughout the week just couldn’t be ignored. T. Boone Pickens went on television to tell us that $70 oil is right around the corner. Bad headlines and nasty rumors poured out of the Middle East. And the economic news was perplexing. The PCE inflation numbers came in hotter than expected. Durable goods stunk. Where did that Chicago PMI number come from? (Boeing is headquartered in Chicago and aircraft orders were up, that’s my best guess) All of the increase in personal income came from the services category, was that good or did it reflect higher physician costs and investment manager bonuses? The bond futures market continued to predict rate cuts predicated on a slumping economy, yet the latest data gave no accompanying relief in the form of lower inflationary prospects. Maddening. A week ago I fretted about stagflation, during the week the word seemed to be cropping up everywhere. Residential construction was down, office construction was up. While the economic interpreters argued back and forth over meanings, the indisputably real was that oil marched a lot higher, the Iranians had taken British soldiers as prisoners and Washington decided to slap tariffs on Chinese paper producers on Friday. Shades of Smoot-Hawley and 1929 again. There was just too much to worry about.
By no means, though, should this be taken as a sign that the game is up. An interesting development during the week was the prospect of first quarter earnings. A week ago, it was legitimate to wonder when it would ever dawn on the market that those earnings were going to be on the soft side. So what did traders do? As the week went on, everybody started to talk down earnings. Completely trash them, in fact. This is one of the oldest games on the street. When things start to look a little less rosy, it’s time to reset the bar. Set it low enough, and you can still get a nice series of upside “surprises,” rally to follow. It’s a hoary old maneuver, but it usually works.
Next week will bring a very rare occurence. The current market darlings of economic data are the FOMC report and the jobs report, respectively. Next Friday is the first Friday of the month, so the jobs report will be released. But by long tradition, the stock market does not trade on Good Friday, though it isn’t a government holiday. The biggest news of the week – scheduled, that is - will be released while the U.S. stock market is closed. The bond market, however, will open until 10:30 A.M. so they can get their licks in. Draw your own conclusions. In the same vein, many foreign markets will be closing around the weekend: some on Thursday (Holy Thursday in Catholic countries), some on Friday and many more on Easter Monday, a national holiday in most of the West. So Europe will trade on our jobs report on Friday while we are closed, and we will trade on it on Monday while Europe is closed. Should be interesting.
StockWatchers’ Corner
Last week, Gamestop (ticker: GME), the video gamestore behemoth, announced a sparkling quarter that easily bested estimates. Not only that, they went on to give glowing guidance for the following quarter, year and indeed the entire much-anticipated next cycle of video games. There was no arguing with this data and the stock shot up the rest of the week. The video game publishers rallied in sympathy, but that group may have been getting ahead of themselves.
A closer look at Gamestop’s numbers makes for some interesting reading. The top line is indeed being driven by next-generation sales, with the biggest growth coming in hardware numbers. Given the high and very-high ticket prices of the new consoles, this is hardly surprising. With the PS3 selling at $600, the Xbox at $400 and Wii systems checking in north of $300, one can see that same-store-sales comparisons measured in dollars are going to be easy for some time to come. But Gamestop is making practically nothing from these consoles. Gross margins on the new hardware segment were a puny 5.5%, making them net losers overall. The bulk of their profits are coming from sales of used equipment and games. A quick visit to my local EB Games (whoops, Gamestop) backed this up. The staff laughed when I asked about new consoles – they hadn’t gotten any in a month. But it was easy to see that they were doing a bang-up business in used products. I would estimate that more than half of the store display space was given over to used software titles.
This is great for Gamestop. The margins on used products are much better than on new ones. Every next-gen console sold means a last-gen console that Gamestop can (re)sell. They don’t have to make money on the new consoles because they can make it on the old ones – more, in fact, than they made the first time around. Video game consumers are making out too, because the arrival of the next-generation hardware has made the still very usable last-generation hardware much more affordable. It’s a virtuous circle.
But while Gamestop may benefit handsomely from selling the same copy of a game three or four times, its original publisher does not. They sold that copy one time only. If you take a couple hundred bucks into a Gamestop, you can walk out with a PS2 system and some games to go with it. Gamestop makes about a hundred dollars profit. The video game publishers and console makers make zilch.
There is no doubting the growing popularity of video games. Certainly the street doesn’t. Brokers and analysts have been drooling over the next-generation hardware cycle since last fall, keeping the video publishers at very lofty valuations in the face of every hardware shortage. But Gamestop’s recent success says more about its own improved positioning at this stage of the cycle than it does about any of the game publishers, who are also facing increasing competition from the console makers’ efforts to sell their own games. With continuing shortages of new boxes, one has to wonder about if and when those publishing profits are going to be coming in as predicted. At these valuations, there’s little room for error.
Circuit City (symbol: CC) announced last week that old managerial standby cure for sagging profits: mass layoffs. The stock price duly rallied in the wake of the announcement, but then fell back again. Was something amiss with this time-honored tactic?
The problem, it seems, is that Circuit City decided to fire 3400 of its “most highly-compensated” staff (excluding anybody in management of course) and replace them with less expensive workers. That explains the reflexive lift in the stock price. On closer examination, though, it seems that they are going to replace their highest paid salespeople – in other words, their best salespeople – with um, newbies. The analysts who follow the stock began scratching their heads – nobody could recall a business-school study about a retailer that grew its way to success by sacking the cream of its sales force. In fact, doesn’t Wall Street work exactly the other way around?
Well, time will tell. Perhaps what Circuit City is really trying to do is drive all of its sales out of the stores and onto its web site, so it can get an Amazon-like multiple. That would be a brilliant stroke indeed. Or it might be that management, having seen some of the piles of money being thrown at retailers lately by private equity, has gotten the idea that dressing up earnings for the next couple of quarters might be a clever way to attract a buyer. And then management might cash out. But that kind of thinking would be cynical.