“Very great our loss and grievous, so our best and brightest leave us, and it ends the Age of Giants.” – Rudyard Kipling
At the close of trading on Monday, the first trading day of the new month, we marveled that the Russell 2000 index, the small-cap benchmark, had fallen six percent in six hours. That kind of move is usually associated with a time frame of at least six weeks, if not months – or a crash.
Yet on Tuesday, that same Russell rose by seven percent in only forty-five minutes, the last minutes of the trading day. If Monday was bizarre, Tuesday was positively the outer limits. That kind of craziness stems from an excess of leverage in the trading/hedge fund segment responsible for most of the action these days. The leverage gets boosted by the stock market’s “juice”: high-frequency trading (steroids for equity) and levered ETFs (equity cocaine).
We’ll say it again: this kind of wild volatility usually precedes a big bottom. It isn’t inevitable, but if the EU messes it up, we’ll get one. We’ll also repeat our assertion that Germany is unlikely to act until events grab the country by the hair and pushes its head over the cliff edge.
Even then the outcome is uncertain. Noted financial writer Michael Lewis has been bringing a lot of attention in the American investor community to the fact that the German people aren’t at all inclined to “reward” the sins of its lazy, backsliding neighbors and aren’t especially anxious either to be the backstop of Europe.
This is the kind of thinking that led to the Lehman debacle and subsequent financial meltdown, a fact many Germans in key positions recognize. But countries as well as individuals are capable of deluding themselves into believing they are the exceptions to the rule.
As we go to press, the news is that French President Nicolas Sarkozy and German Chancellor Angela Merkel have agreed (yet again) that a solution would be found. There are signs that the EU is edging towards the only solution that will work: write down the bad peripheral debt, recapitalize the banks and start over. However, for the moment there is (yet again) only another meeting with more talking scheduled. The tough decisions have yet to be taken, and the Catch-22 is that if the markets rise in optimism that a solution will be reached, then no solution will be reached. The more difficult the decision, the bigger the crisis that political institutions need for cover, and restructuring the periphery is very, very difficult.
Until that interesting day, markets will remain range-bound. The lower bound is thought to be in the 1020-1050 range on the S&P 500 index, presumably a point at which prices would be cheap enough to tempt value money back into the market. The upper bound is thought to be in the 1200-1250 range, presumably a point at which nobody feels safe anymore without evidence of decisive government action. Emotions could jump either boundary.
Then there is earnings season, set to begin with Alcoa’s (AA) earnings on Tuesday and getting underway in earnest the week after. Though not robust, the economic data has been a little better than expected of late, and many companies are saying that they see no signs of a slowdown. That’s the good part. There are also signs pointing in the other direction.
Whether or not earnings and/or guidance are spotty, robust or mixed, though, it still comes down to Europe. If the EU gets it right, global asset prices will rally, confidence will improve worldwide and earnings prospects will take a leap higher. If it gets it wrong, it means another financial crisis and look out below. It’s a tough spot to be in, isn’t it? As the old gypsy curse goes, “may you live in interesting times.”
The Economic Beat
The media said that the jobs report would provide some clarity, but one month’s data really isn’t all that much. Nevertheless, the September jobs report did provide some support for the idea that the U.S. economy is still in slow-growth mode and that the double-dip isn’t at hand. One could also call it substandard growth – most of the business press did just that (with no thought to the 2012 elections, we are sure) – but some is better than none.
The best part of the data was the revisions – plus 57,000 for August versus the original estimate of zero, and 127,000 for July against the prior estimate of 85,000. As Steve Liesman of CNBC observed, the revisions highlight the steepness of the drop brought about by the debt-ceiling battle (private payroll growth fell from 173,000 in July to 42,000 in August). We think that September will be revised higher as well, since the reported loss of 13,000 manufacturing jobs doesn’t jibe with either the regional surveys or the pickup in auto and aerospace production.
The increases are also coming against a headwind of continuing losses in government jobs. Yes, yes, we know, hallelujah and all that for you ideologues, but it’s still counter-cyclical and is slowing the recovery. What we really need is the self-discipline to cut during good times.
There were other encouraging bits and pieces in the jobs report – average hourly earnings rose, the workweek rose, temp jobs remained grew another 20,000, not huge but steady. The aggregate payroll index, whose August drop of (-0.5)% presaged the drop in personal income, rose by 0.6%, suggesting we got it all back.
The unemployment rate remained unchanged at 9.1%, but this was partly due to an increase in the participation rate (more people entering the work force). That’s typical of recovery behavior, although the effect has certainly been muted in our credit-constrained economy. The phenomenon drove the “U-6” measure of total labor force underutilization higher, to a 2011 high of 16.5%.
Weekly claims rebounded a bit, but last week’s drop to below 400,000 withstood revisions and finished at 395,000. The current estimate of 401k should be revised up to about 405k, but that is still better than the 410k expected. The net of it all is that employment growth is sluggish, but better than feared.
So is the rest of the economy, as evidenced by ISM survey readings that were a little better than expected. The manufacturing survey produced a reading of 51.6 and the non-manufacturing version clocked 53.0. The market had feared a negative reading in manufacturing, so 51.6 is reassuring if not robust.
The ISM surveys are possibly the most misinterpreted data of all the economic releases, being qualitative measures that tell us mainly whether we are driving faster or slower than we were ten minutes ago, without telling us how fast we are actually going. For the last several months, they have essentially said that we are neither accelerating nor decelerating. The press and others often mistake this to mean that we aren’t moving, which is incorrect. We are.
Really, the data last week all told the same story: we are growing slowly, better than the estimates ripped by falling financial prices, slower than what we would all like. August construction spending rose 1.4%, factory orders fell slightly but capital goods increased, same-store sales were better than expected (though the sample is biased), the Monster employment index rose, car sales were better than expected but weekly chain-store sales have been light (an effect partly due to warm weather). We would also point out that the Philadelphia Fed coincident `and leading indices of activity have been steadily improving in recent months.
Next week is light for economic data until Friday. The U.S. equity markets are open Monday but the bond markets are not (why didn’t mother tell us to be bond traders?) and there is nothing of moment until the FOMC minutes Wednesday afternoon. Trade data is due on Thursday, along with import-export prices on Friday, which more importantly reports September retail sales. The consensus is for 0.8% with autos included and 0.4% without, but we think that the ex-auto category is going to be lighter than that.
There’s also a sentiment measure on Friday, along with some inventory data, but inventories have been telling a remarkably steady story this year and are largely being overlooked by markets. Other notable earnings reports on the calendar include PepsiCo (PEP) on Wednesday and JP Morgan (JPM) and Google (GOOG) on Thursday, before and after market hours respectively. The latter two results will matter more to markets than anything but the Europe situation.
The brilliant Steve Jobs – may he rest in peace – was a one-off in his ability to cross the perennial divide between engineer and user. Hard-core geeks, for example, not only didn’t mind that access to the early Internet required knowing a number of obscure command line abbreviations, they positively reveled in them. It wasn’t until the graphical interface layer known as the World Wide Web was introduced, though, that the Internet as we know it took off.
Similarly, the Apple (AAPL) PC and later the Macintosh were great innovations in making computing accessible to the non-geek, yet still cool for the geek. Yet the accounts we have read in the last few days completely miss the key business mistake that Jobs made in the first stage of his Apple career, but was clever to learn from and not repeat in the second stage.
We were on the front lines of what might best be called the user revolution in computers, whose use in the business place originally revolved around the mainframe. Those computers were like battleships, very large and expensive, suited to very big tasks and not so easy to maneuver. Access was limited to the priesthood and users were the bane of what was then called the data processing department. To be fair, the equipment of the time wasn’t really designed with the goal of bringing computing power to the masses.
The mini-computer, a far more user-friendly device, changed that. It gave rise to the explosive growth of DEC (Digital Equipment Corporation) and transformed Hewlett-Packard (HPQ) from a scientific instruments company into a major computer player. Universities were quick to latch onto the mini, which allowed direct access to the computer (heresy in the mainframe world), in turn hooking a generation of geeks into spending hours on end conquering programming and (of course) game challenges.
However, minis were still under central control. They shut down for maintenance, went down unexpectedly, limited user time, and software evolution was unsatisfyingly slow for the geeks. When your terminal said you couldn’t come back until 6 AM the next day, it was only natural to wish the terminal itself was the computer. Into this breach stepped the two Steves, Wozniak and Jobs, who put a device on the table that wasn’t just a game. It was a computer!
They got the PC part right, but Jobs crucially misjudged the marketplace later on. When big corporations finally decided to buy PC’s by the boatload and put them on people’s desks, they weren’t motivated by notions of cool or superior interface. What they wanted was to give employees a spreadsheet program (usually Lotus 1-2-3), a word processor, and possibly a modem. Microsoft’s (MSFT) Windows operating system wasn’t tied to one box the way Apple was (and still is), nor were IBM’s DOS or OS2. Competition among box makers meant that Windows/IBM-based PC prices were well below the Apple products.
Yet Jobs and Apple wouldn’t compete on price. They had the best PC, so why should they? But for a corporate purchaser buying thousands of PC’s, the fact that Apple was cooler and had a better interface than Windows wasn’t worth paying another $500 a box. Apple lost the corporate marketplace and to this day remains a small, albeit premium, player in the PC world. Airbooks and iMacs, though strong in multimedia and boasting devoted followers, have less than ten percent of the market and have usually had less than five percent.
Yet while Jobs never really budged on Macintosh pricing, he didn’t make the same mistake with the other i-line products. First models of new products command premium prices, but then drop very quickly as competitors imitate them. Apple devices still set the pace for form and function, but the company has learned not to get undercut: the 3Gs iPhone that was the last word two years ago is now free with a two-year contract. It’s that combination of cutting-edge design and bracketing the top and bottom price points that has made Apple so formidable and successful a competitor in the recent decade.
The word is that the ailing Jobs made sure that the Apple pipeline is sufficiently robust for another five years. We would guess that the product line is good for at least another 18 months. It isn’t necessary (or possible) for Apple to find another Steve Jobs, yet his trademark negotiating and design skills weren’t superhuman and can be broken up into different positions. The real catch is that Jobs was so good at what he did that he was the unquestioned leader. If current CEO Tim Cook and the Apple board can keep the team focused and not get caught up in leadership battles, the Jobs-inspired magic could last a long time.
Conspicuously absent from the Apple board of directors is anyone from the venture capital field, and if the company wants to remain successful it will stay that way. VC is an endeavor for experienced long-shot bettors where the occasional jackpot pays for the many losers that outnumber the winners by as much as ten-to-one. As successful a strategy as it can be, it’s a completely unsuitable mindset for a mature company, technology-based or not.
We believe that this is one of the chief problems haunting Hewlett-Packard (HPQ): the chairman of the company is Ray Lane, managing partner of the early-stage venture capital firm Kleiner Perkins. Yeah, we know he ran Oracle (ORCL), but that was long ago. He’s been drinking the Kleiner Perkins Kool-Aid for over a decade now. HP (we have long positions, unfortunately) is a first-class engineering company with tremendous share, poised to eat Dell Computer’s (DELL) lunch in consumer PC’s, where the latter has badly executed.
HP’s consumer printer and PC businesses are admittedly mature, but so was the mainframe business thirty years ago and IBM has thrived anyway. HP doesn’t need a Meg Whitman to come in and sell the company jewels or go off looking for the kind of “disruptive” home run that VC-types are obsessed with; it needs a Lou Gerstner to come in and polish the jewels it has. Nor, we would add, does it need someone who runs a money-losing online retailer. Growing sales by selling below cost is easy, but it won’t work for HP. It may seem odd to say, but HP might be best served by moving its headquarters to the East Coast and getting as far away as possible from the sirens of Sand Hill Road.