Twelfth Month

“One must have a mind of winter.” – Wallace Stevens, Snow Man

It’s going to start getting a little more difficult soon. The market has now put in two weeks of rally, amounting to five percent in all, since the 1343 low of Friday the 16th. Despite the recent tradition of the last day of November being a struggle, with an even longer tradition of some odd price action, Friday managed to finish narrowly in the green and keep indices up on the week. In some ways it was the most impressive day of the week.

But while Monday should be expected to see another leg up, due to its status of being the first trading day of the month, things might start to get tricky shortly afterwards. Politicians started taking their budget battle to the media during trading hours on Thursday, a sign that the main event should be coming to Broadway soon. The jobs report is next Friday, for better or worse, and after that we start to bump up against the calendar and the annual early-mid-December slump. Keep an eye on the ADP payrolls report on Wednesday.

One topic that has been very much in the news of late is special dividends. The pretext for these goodies is to allow shareholders to evade paying potentially higher taxes on dividends, as most assume that the current 15% taxation rate for dividends will rise. Personally I doubt that dividends will be treated as ordinary income, but it looks like a safe bet that the rate will go up, at least for taxable income. Many dividends will continue to flow into retirement and institutional accounts that will still pay no tax. However, tax avoidance seems to be the driving theme behind the payouts.

Long ago and far away, when I was first studying for my NASD Series 6 exam, one of the things that was emphasized as not kosher was the practice of “selling dividends.” In other words, one does not recommend purchase of a stock or mutual fund about to go ex-dividend (the cut-off date for being entitled to a dividend) so that the buyer might collect it, because the price of the security will usually drop by about the same amount as the dividend. All the buyer will have done is to incur a taxable event, in effect paying a tax to get back part of the purchase.

The case that stands out the most to me is Costco (COST), which has decided to pay a $7 special dividend. It isn’t a case of speeding up the deployment of corporate cash, because the company borrowed all of the money to pay the dividend. When the stock goes ex-dividend on December 10th, be assured it will fall by about $7. Why is the company in such a hurry to impose a taxable event on shareholders?

I can tell you one group that is particularly going to benefit – management. In general, senior managers do not have unfettered license to sell stock, so long as they are working for the company. It is generally done in installments, called 10b-5-1 plans that allow corporate insiders to sell stock in fixed allotments at regular intervals. Rather than bore many of you with a lengthy discussion of insider selling, I will simply say that top managers are usually expected to hold onto the bulk of their stock until they leave the company.

Charlie Munger, of Berkshire Hathaway and Warren Buffett right-hand man fame, likes to say that to understand management, you have to understand how they are going to get paid. In this case, CEO James Sinegal, who has about 2 million shares, is going to get a $14 million payout at a 15% tax rate – all without having to sell a single share. As CEO, his shares are locked in for the long-term anyway, but at 74, it isn’t clear how much longer he cares to stay on. If he were to retire a year later, for example, then $7 of the gains on the stock he owns will have been paid at a lower rate (15%) than whatever it goes up to. It’s the same for all of the senior managers who own lots of stock, Sinegal being the largest holder.

Forgive my not coming to the conclusion that these special dividends are selfless acts to benefit the widows and orphans (their funds wouldn’t pay tax on the dividends anyway, so long as it’s redistributed). The irony of it all is that the very same Charlie Munger sits on the Costco board of directors, and he has over 100,000 shares as of the last filing I could find. Charlie needs money like the desert needs sand. [I certainly wasn't the only one to notice, either, hardly surprising in light of the size of the dividend and its unusual funding. After I'd written the above, my attention was drawn late at night to an op-ed in the Wall Street Journal Friday morning that took an even snarkier tone.]

Another notion with a touch of the surreal is remembering to be grateful sometimes for regulatory agencies. In the summer of 2008, the economy was in a recession and oil was over $140 a barrel. The cover story was “peak oil” and the regulatory motto was that the free market handles everything on its own. Now four years later, economic output is higher than it was then and so is the stock market. U.S. oil prices, though, are trapped in a narrow trading range in the $80s. What about peak oil? Why hasn’t it rallied as much as the stock market, when until recently every increase in equities was accompanied by a bigger one in oil?

It isn’t all because of Canadian tar sands, though increased North American supply is playing a role. Brent oil, which is what the rest of the world prices off of, is at $110 by comparison. The Commodity Futures Trading Commission (CFTC) and UK regulatory watchdogs have recently been conducting intense investigations of potential price-rigging during those halcyon days of $140/barrel. Oddly enough, the latest bouts of risk-taking in equities have left energy futures sitting on the sidelines. That lack of speculation sure is hurting the economy, isn’t it?

That economy continues to muddle along, as seen in The Economic Beat below. Probably the most distinguishing feature of economic releases these days is that they are rarely as good or as bad as they appear to be. As more Sandy-related data arrives, it could put pressure on the stock market, a good example being next Friday’s jobs report. I wouldn’t think of predicting it either way, but for what it’s worth, consumer sentiment measures haven’t been at all pessimistic. Between the storm and seasonal adjustment factors, though, the number could be a sloppy mess.

The other side of Sandy’s damage, of course, is the rebuild, and we could see market-favorable data begin to emerge in the latter part of December. Throughout it all, we will toil in the shadow of the cliff. It appears as if the early make-nice stage is near its end, and one should expect at most another week of pretend civility before the gloves start to come off and the accusations of moral turpitude, theft, treason, spousal abuse and lying about your golf score start to fly.

The Economic Beat

Another week of mixed data presented evidence for everyone. Consumer confidence rose to a four and a half-year high of 73.7, but contrarians pointed out – correctly – that confidence peaks tend to presage downturns in the stock market. New orders for durable goods were better than expected, but personal income and spending data was disappointing. New home sales were less than expected, but pending home sales were better.

The manufacturing sector data was everywhere. The Dallas (oil-based) and Kansas City (agriculture) manufacturing indices reported negative numbers, but the Richmond Fed reported a strong increase. Durable goods orders were better than expected at no change, but excluding transportation were up 1.5%. More importantly, business investment orders were up 1.7%. It wasn’t a barn-burner, certainly, but it did trip up an element that had been loudly predicting a steeper down ramp into the end of the year from the fiscal cliff.

The Chicago PMI reported its first above-50 number in three months, but it had an odd piece of theatre attached to its dissemination on CNBC. Pugnacious reporter Rick Santelli gleefully said that it looked like a “10 out of 10″ piece of news to him, but in what looked to my eyes like a bit of stagecraft, had along a Chicago journalist to explain that it wasn’t so good, especially due to the drop in new orders. The Chicago PMI is released privately to subscribers a few minutes before its public dissemination, and Santelli’s reactions seemed less than spontaneous, to say the least. In any case, the drop in new orders wasn’t from respondents saying that new orders were going out the window – the percentage of respondents saying orders were smaller actually declined – but from a shift out of the “higher” category to “same.”

GDP for the third quarter was revised strongly upwards, from 2.0% to 2.7% (consensus was for 2.8%). That isn’t as good as it looked, given that it got a big boost from inventory and private spending was revised downwards. Look for the combination of Sandy and inventories to cut fourth-quarter GDP by a significant amount, but a Sandy recovery and post-cliff atmosphere could send GDP shooting right back up again in the first quarter of 2013. The latest Beige Book of surveys from the Fed concluded that “economic activity expanded at a measured pace in recent weeks.”

Homebuilder stocks had a little wind taken out of their sales when the September new home sales figure was revised sizably downward, from 389,000 annualized to 369,000. October was reported at 368,000. It would seem that the big lift-off that many had attributed to the Fed’s “QE-infinity” announcement in September didn’t materialize after all. Mortgage rates certainly fell in the wake of the Fed’s action, but the real problem is that banks are still in lock-down mode when it comes to residential lending. There were still plenty of write-offs to go around in 2012, though conditions seemed to improve in the latter half. Home prices are steadily recovering, but at a modest pace that is still quite uneven.

October personal income and spending numbers were soft. Personal income was unchanged, and spending declined. Commerce declined to provide a comprehensive estimate of the impact by Sandy, but its guess of about $18 billion in lost wages looks right to me. Since the aftermath lasted well into November, it probably won’t be until December data is released in January that we see the recovery effects in the data. For example, retailers were in general commenting that although November sales got off to a slow start, they were pretty happy with the pace in the latter half of the month. November auto sales, by contrast, are expected to be good.

Looking abroad, European unemployment continued to worsen and German retail sales unexpectedly fell, while business confidence unexpectedly rose (in France as well). The silver lining to a German recession is that it may begin to put the spurs to the EU confronting its debt problems in a more realistic way.

Next week is the first week of the month and the usual heavyweight with economic data. The ISM manufacturing survey is out on Monday, and the November jobs report comes on Friday. In between we’ll see auto sales Tuesday and on Wednesday, ADP payrolls followed by the ISM non-manufacturing report.

Other reports include October construction spending on Monday – probably depressed by Sandy – factory orders on Wednesday (mostly known from durable goods), and another week of claims data. They fell as expected last week, so analysts will be looking clues to normalcy in next Thursday’s report. The jobs report should get the full impact of Sandy.