Spring Trading


“We tremble to survey the growing labours of the lengthened way.” – Alexander
Pope

Once again, we had to look at the end of another grinding week – when all was said and done, were we up or down? At the beginning of the week, it seemed that hope was springing eternal as the Nasdaq put on its best day in over five years. But by the end of the week, it was all given back again. The Dow and S&P gave up another percent or so while the Nasdaq finished virtually unchanged, thanks to its larger leap out of the gate.

The rally was sparked by existing home sales and new home sales that came in above consensus, the latter barely so, and that brought in the bottom-callers faster than you can say short-squeeze. The uptick from January’s pace was accompanied by a significant decline in prices. This had some traders foaming at the mouth with excited talk of the market finally clearing.

When it finally does come, this will be the most over-anticipated rebound in homebuilding stocks in living memory. Traders are very aware that short interest in some of the companies is at staggering levels. There is going to be a series of frenzied leaps over any bone at all from the sector – all the way down to the bottom.

It was a familiar replay. Eagerness to be first in on the rally led to another false start out of the blocks. On Thursday and Friday, homebuilders Lennar (LEN) and KB Homes (KBH) both reported results that came in light of revenue estimates, and management observed that supply is still coming on to the market faster than it can be absorbed. Neither company sounded hopeful, except to pray for legislation to help fix the sector.

There are some other reasons not to get too excited yet. Inventories remain stubbornly high at 9.6 months, year-over-year sales are still down by nearly thirty percent, and the rapid decline in prices has wealth-effect implications. The strength in the sector was focused in the Northeast, where financial bonuses get paid out in February. Credit is problematic.

An opinion piece in Tuesday’s Wall Street Journal represented the liquidationists, essentially positing a giant foreclosure auction as the solution to the housing crisis. The Thursday edition countered with a page one article suggesting that this is the time for the government to intervene and not the time to emulate Herbert Hoover.

Rumblings in the press, though, suggest a bit of White House Hooverism, as it seems that purist elements within are unhappy with those mad socialists at the Fed for not letting the investment banks go up in smoke. Yes, what this country needs is a good dose of twenty-five percent unemployment to straighten it out. What was it that Potter said in It’s a Wonderful Life? “Now what does that get us but a lazy, discontented rabble instead of a thrifty working class?”

The rest of the week simply wore investors down. Oracle’s (ORCL) earnings were respectable, but revenues short of Street estimates and the company’s talk of customer caution were a disappointment. It was overdone, but the stock suffered from too many hopes of being impervious to economic conditions (or providing a sign that they were better). New orders for durable goods fell when they were supposed to rise, with a noticeable drop in capital goods. JC Penny (JCP) kicked out the retail sector legs on Friday when it cut earnings guidance and said same-store-sales were going to be down more than they thought.

The auction-rate security crisis continues. The simmer began to boil on Friday when William Galvin, the corporate regulator for Massachusetts, issued subpoenas to Merrill Lynch (MER), Bank of America (BAC) and UBS AG (UBS). It seems Galvin wants to know if there was more than a wink and a nod regarding the sale of said securities. Clearly he’s a communist. Who else would want to hold brokers to their word?

But Galvin isn’t the only one. More than one New York City law firm is starting to warm up the tort machine as disgruntled investors call in. The Street needs to get a little perspective here, and quickly. There’s a tendency to be mulish hiding behind arbitration agreements that hold the sheep – er, customers – responsible for any fleecing they get. If it happened to be a couple of Street denizens holding the shears and rope, that’s an act of God my friend. You know, God made the sheep and you wandered by, so we’re not responsible.

That kind of tenacity usually works with the retail customer who can’t or won’t pony up millions in legal fees. But this is the government, laddies. They make the rules. Run to the Fed window, load up on some treasuries and then start buying up some of those auction securities. It’ll be a whole lot better than paying billions in damages down the road, and in the end you’d probably lose very little, if anything, on the bonds.

Doesn’t anybody on the Street remember what happened after the tech crash? A few more weeks of headlines about canceled student loans, failing non-profits and laid-off municipal workers, and the senators and the regulators will come and get you and all of those contracts and arbitration agreements won’t be worth one lousy share of Enron.

Pull a hundred-dollar bill out of your wallet and look at Ben Franklin, the author of Poor Richard’s Almanac. Now repeat after me a priceless piece of advice from that famous tome: “An ounce of prevention is worth a pound of cure.” Keep repeating it, pick up the phone and for your own sake, start bidding before it’s too late.

It’s said that everybody on the Street these days is a technician. Not wanting to feel left out, we want to present one or two charts of our own.

I recently attended a luncheon where well-known newsletter writer, trader and pundit Dennis Gartman was speaking. The always-entertaining Dennis confessed to being a chartster, but allowed that as time went by his charts got simpler and simpler. Good point, so here’s a simple chart of the S&P 500 index from the last ten years.

S&P 500 Ten Year Chart

We don’t claim to be technical gurus, but doesn’t this look like a downside breakout?

Looking at this chart, it’s hard not to notice the big drop in the middle. That would be 2002-2003. Since that was the last time the market bottomed, we thought it might be useful to review that period.

S&P 500 Oct 01 - Nov 2003

There are some interesting comparisons to be drawn between that period and the current one. There were several failed double bottoms on the way to the first real bottom in mid-summer 2002. That marked the beginning of a triple bottom completed in the spring of 2003. During that time, the market put on two 20% rallies that failed.

GDP was above 2% during the spring and summer of 2002 and positive throughout the period. The Federal Reserve Bank cut rates below 2% by mid-2002 and to 1.25% by the end of the year. The ISM surveys were positive throughout 2002 (except for one dip in November) and actually bottomed in the spring of 2003, just before the market took off. Low interest rates, positive GDP, yet the market kept struggling throughout. What happened?

What happened was income, spending and profits. Real income plummeted in the second quarter of 2002 and stayed at low levels until the second quarter of 2003. Spending was stagnant. Unemployment rose steadily, peaking in the summer of 2003 (confirming its status as a lagging indicator). Corporate profits fell.

After the market got excited about looking through to the other side of the valley, it died the death of a thousand cuts. Week after week, employment was weak, spending was weak and guidance was weak. Does that sound familiar? It may be hard to believe now when the vogue is to blame the Fed for rates that were too low, but deflation was the dominant fear at that time. When the market decided that cheap money couldn’t matter anymore, it marked the bottom of the bear market.

The market hardly ever does anything new, but hardly ever repeats itself the same way either. We haven’t fallen as steeply this time because we weren’t as overbought, so the rebounds may not be as sharp or the bottoms as deep. We could get a springtime rally, but the combination of first quarter earnings and the reading of first-quarter account statements could mean a lot of money leaves the market next month instead.

Perhaps the best things to keep in mind are that one, the markets will keep trying to rally until they wear out; two, that we probably won’t reach bottom until optimism has been extinguished; three, that as difficult as the four quarters from Q3 2002 to Q2 2003 were for traders, it was a fabulous time for long-term investors to accumulate positions. Oh yes, one more thing. It was real estate that led us out.

The Economic Beat

Last week we said that the housing reports probably wouldn’t tell us anything new, but that the markets were likely to overreact and over-interpret the news anyway. We were right, but it was a pretty easy pitch to hit. Whatever you want to call the current economic situation, for the near term unemployment is ticking up while personal income is stagnant. That isn’t a stimulus for homebuying. While the decline in housing isn’t bottomless, and there will surely be attempts at bargain-hunting on the way down, it may be best to avoid homebuilders until prices have stopped falling.

Chain-store sales are still weak, and strength in mortgage applications is concentrated in refinancing. Fourth quarter GDP revisions showed the same result of +0.6% for the quarter, but with some underlying improvement in income and inflation factors. Unemployment claims dropped from the week before, but the moving average continued to climb. Don’t look for good news from the jobs report next Friday.

Consumer confidence took a huge drop, with forward expectations in the Conference Board survey hitting a 35-year low. Maybe confidence doesn’t have much predictive power, but try telling that to Lennar’s management (“we’re in a recession”) or the folks at JC Penney (“difficult environment for the rest of the year”). However, the Michigan survey released Friday showed expectations at a mere 16-year low. That gave a brief lift to stock prices (I wish I was joking when I wrote that, but it’s true).

Maybe the confidence surveys had some correlation with the personal income and spending report. That showed an increase in income of 0.5%, better than expected, but when you took out government transfer payments (Medicaid reimbursements were big) it was 0.3%. Spending moved up an anemic 0.1%, and that was when energy prices had taken a dip. Perhaps most telling was that the year-over-year increase in disposable personal income dropped to 1.3% while the PCE spending number went to 1.5%.

Before we get the jobs report next Friday, we’ll get the Chicago PMI on Monday, followed by the ISM national reports on Tuesday (manufacturing) and Thursday (services). Tuesday adds construction spending, and Wednesday factory orders (durable goods data suggest that they’ll be down). Looking at the list, it’s hard to imagine where any good news will be coming from.

A word on corporate profits: the BEA reported Thursday that they fell in the fourth quarter for the second quarter in a row. At the same time, the dominant consensus on the Street is for a sharp profit recovery in the fourth quarter. We can think of a lot to say about this, but two things stand out: the first is that the Street was making the same predictions for fourth-quarter profits a year ago. It didn’t pan out. Still, financials won’t have the same write-downs.

The second is that corporate profits hold the key to stock market sentiment and performance. Given the current trend and cautious environment, it seems likely that there will be a period of further deterioration. That could lead to a capitulation of optimism and the bear-market bottom. When we hear management guidance begin to sound more hopeful, your portfolio should already be loaded up and ready to go.

StockWatcher’s Corner

Given the current environment, it’s hard to recommend something as a trade, but we do hold to the belief that it’s a good time to start building positions. It might be testing to read the next quarterly statement or two, but a lot of valuation bargains are cropping up.

It seems to us that one of them is 3-Com (COMS). The routing and switching company has been in the news quite a bit lately for its busted takeover deal with Bain. It was trading above $3 when the deal was announced (at a price of $5.25), and has now fallen all the way to $2.20. Yet the company also announced in its results last week that quarterly revenues and EBITDA were up year-over-year, gross margins hit a record high and the Chinese business is growing.

The North American business did suffer. The takeover limbo was a distraction for management and a deterrent for customers, and domestic business spending hasn’t been robust of late. Those problems seem to be in the price. Against that is $1.16 of cash on the balance sheet, a book value of about $2.80 a share and a management refocused on its core business. There are a lot of these deal orphans wandering around, and the usual first reaction is an exaggerated sell-off.

There are risks, of course. China is the company’s biggest market, and that can cut both ways. The company’s would-be silent partner, Huawei, is also its biggest customer and it’s unclear how the deal collapse will affect relations. Still, the company is generating positive cash flow and is prepaying debt. Its Tipping Point subsidiary is a likely IPO candidate when market conditions improve. The H3C Chinese subsidiary is doing well and has plenty of time to address the Huawei situation.

There are no lay-ups in the markets these days, but buying companies with good balance sheets and positive cash flow after a broken deal and a flattened price can be a rewarding practice for the patient investor.

Corrections Dept: The PDF version of last week’s MarketWeek incorrectly stated that the CEO of Foot Locker (FL) had purchased over a million shares recently, when it should have said over a million dollars worth (well, we knew what we meant).

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