The Unforgiven

“Deserving’s got nuthin’ to do with it.” – Clint Eastwood, “The Unforgiven

Two weeks can be an eternity for traders. Way back then, the investment banks warned of big write-offs and losses in the their credit operations, and traders rushed down the aisles and knocked each other aside to be the first to forgive them (cf. “Brother Love’s Traveling Salvation Show” from October 5th). This week the confessions kept coming, but the mood to forgive slipped out the back door and a couple of burly gents with truncheons took up its place. Sentiment rather shifted at that point. It took a couple of days for the enforcers to limber up, but after a couple of practice swings they found their rhythm on Friday and administered quite a beating to equity prices.

The week started off on a gentle enough note, with the market looking forward to the earnings treat it had promised itself. I was not alone in wondering if hedge funds would be squeezed into a repeat of last year’s catch-up rally. But when I saw Rick Santelli of CNBC fame visibly gasp at the housing starts number Wednesday morning, I knew it wasn’t going to happen. When a veteran like Santelli drops his jaw, you know things are different.

For all that, the market kept struggling to hang in there. The earnings from Dow stalwarts and global growth poster children United Technologies (UTX) and IBM (IBM) weren’t bad, but the guidance on domestic operations was less than sunny. It’s hard to explain why this should come as a surprise to anybody in the business world or even anyone who reads the papers. They were saying the same thing a year ago. The trucking companies have been saying it for weeks. strong>Fedex (FDX) told us the same thing last month. For that matter, last year. But a year ago, when you said the word “subprime” people were still wiping the drool from their mouths.

Of course, it’s been awhile now that we’ve discovered subprime toxicity and housing has been sulfurous all year, so why the sudden shift to hair shirts and switches? What seems to have changed is Wall Street’s belated realization that while equity prices can rally instantly over rate cuts, other things take a little more time. I really did hear and read people excusing weak economic reports over the last couple of weeks, especially in housing, by observing that the data was “pre-cut.” Now we’re post-cut, but it’s still the same bleeding.

It’s not just the housing-subprime plague again, but that there were so many cadavers popping up everywhere. Pretty apt for the month of October, isn’t it? Listening to the wailing of the housing banshees has been gruesome enough, but now you’ve got the credit ratings-for-sale agencies discovering “model adjustments:” i.e., all those triple-A bills of health they handed out to securities were a bit premature. Now it seems that that cold we thought you had sir, is in fact the bubonic plague. Awfully sorry about that of course, but our lawyers tell us that we had no way of knowing so off you go now. Please don’t come again.

When the global growth titans began adding a dirge of guidance caution to the mix it was all too much. The promise of high-tech earnings and low-tech rate cuts that had kept everybody in the game took fright and fled from the triple threat of dud Dow earnings (Honeywell (HON), Caterpillar (CAT) and 3M (MMM)), an evil Black Monday 20th anniversary (and if you think that didn’t matter, you don’t know traders), and a Friday afternoon. Any thoughts about going home long for the weekend evaporated by 2 P.M. and the last hour turned into one of those panicky exit stampedes that do so much to inspire faith in the system.

The ironic thing is that those Dow dud reports really weren’t bad. The numbers themselves were actually quite decent, but crowd perspective has changed dramatically. It’s as if everybody went to see “The Invasion of the Body Snatchers” at once, and now we’re worried that that neighbor who’s just come for a bit of sugar might really have come to suck out all of our bone marrow. Last October traders were absolutely tipsy when third-quarter earnings rolled out. When companies talked about sluggish domestic demand, they roared it off and demanded that the band play “We are the World” one more time.

Now a year later those same companies are talking in awed terms about the strength of their foreign operations, and the traders are howling like scalded cats at any and every domestic hiccup and acknowledgement that yes Virginia, the housing recession is going to affect business.

True, Caterpillar did lay it on a bit thick when they said it was the worst housing downturn since World War Two (making it the worst of three, and nobody from Caterpillar can remember the first one). But it’s utterly beyond me that after ten consecutive months of brutal declines in housing data, the markets should be surprised when Cat says their domestic operations are suffering. Excuse me for asking, but isn’t construction Cat’s main line of business? Yet here I am looking at a strategist’s quote in Saturday’s Wall Street Journal that Cat’s comments “put a spotlight on weakening domestic growth in the industrial sector, catching investors by surprise.” Which investors, the ones that just got off the return leg of the New York-to-Mars express?

Honeywell turned in good results and raised their guidance, but all the market wanted to talk about was how housing would affect sales at its Carrier air-conditioning division. I guess people were expecting that home air-conditioning sales would be getting a lift from the housing recession. 3M posted good results and raised guidance but lost nearly ten percent off its stock price. Partly it was the day and the closing panic, partly it was because 3M didn’t raise the high end of guidance, and mostly it was because they commented that there’s competition in optical film for LCD-TV’s and oh my God nobody’s going to buy HD televisions at Christmas so the consumer must be dying, the game is up, run!

This column has been saying all year that domestic growth is slowing. It wasn’t that hard to discern, because that’s what economic data, company management and profits have been saying. Yet on October 1st, the equity markets stood about 15-20% higher than a year earlier. That’s very above average performance for a year of declining profits. Now the market is starting to have doubts. Can Armageddon be far behind?

Whether it’s coming or not, it’s probably further off than next week. We’ve been saying that too much money was lined up on the October-rally side of the trade, and those kinds of imbalances are usually punished in the market. With the herd thoroughly frightened, it could be easier to get a bit of rally going. At some point next week, the focus will begin to shift to the Fed’s October 31st meeting and a rate cut that, thanks to the market’s dismal week, now looks increasingly likely. Apple’s (AAPL) earnings will probably help out on Monday, but there’s risk from American Express (AXP) and Merrill Lynch (MER), who will likely both have bad news to report. The unknown is whether or not the market can get by them, or starts to despair instead about whether another rate cut will be enough.

Longer term, there are two more horrors to worry about. One is the Asian stock bubble, which has to burst sooner or later. We will feel its effects. The other is the growing danger of a banking-led recession. The latter is a subject near and dear to Bernanke, who has studied the Depression extensively.

I don’t know what it is about the banking business. I have some ideas about what underlies their apparently irrational behavior, but the point is that time after time they make the same very expensive mistakes. They all converge on the same lending fad and end up throwing out all the brakes in a race to outdo each other with reckless behavior. When it all blows up, as it invariably does, they fire everybody connected with management’s foolish behavior. That way they guarantee that nobody with experience is around the next time temptation lurks.

Having lost billions in reckless lending to their commercial customers, the banks will then decide that the problem is not their own incompetence but that lending is just too dangerous a business. This is what Bernanke fears, and why he has said that if necessary the Fed might have to bypass the banking system (joking that the Fed might have to throw money out of helicopters, hence the nickname). The banks will run back to the much safer fee business and try to gouge their retail client base as much as possible to make up for their losses. We can all expect letters soon announcing thousand-dollar penalties for overdrafts. This is a real boost to the economy.

Then there are the issues of fourth quarter earnings estimates, which look to still be too high, and such minor details like oil touching $90 a barrel. The latter trade is beset with speculation and hot money and could blow up at any time. But until it does, it’ll make for some scary headlines. The fourth-quarter market rally that everybody was betting on two weeks ago is on some pretty wobbly legs.

The Economic Beat

Last week’s data did nothing to disturb the picture of an economy laboring down the lane with the housing recession tied to one leg. On the one hand were regional manufacturing reports from the Chicago and Philadelphia Feds, the Chicago report on Monday being pleasantly healthy. The Philadelphia report, on the other hand, was less than robust and although only a blip under expectations, was something of a disappointment on a Friday that was looking for a pick-me-up after a rough morning of messy earnings. Unfortunately for the market, the Philadelphia report tends to be the better indicator of the national number. Fortunately for the market, it betters the climate for a rate cut.

At the other end of the stage was housing, wearing black and sounding like one of the toil-and-trouble hags from Macbeth. Not one of the cheerier crones, either. Housing starts fell over 10%, a startling drop to the lowest level in fourteen years. Permits plunged as well, indicating no relief is on the way. Not to be outdone, the housing index from the national homebuilders’ group dropped to the lowest level the series has ever produced since it began in 1985. The index rested at 18 in October; in March of 2006 it stood at 54. The group hazarded the outlook that things ought to start picking up in about oh, six months or so. It’s offered the same outlook every month this year. They have a good sense of humor.

Filling in the middle was industrial production, consumer prices and unemployment claims. Industrial production crept along at a very restrained 0.1% pace, 1.9% year-over-year. There was a bit of a bright spot in that business equipment production was up 0.6%. Consumer prices were pretty much on target core-wise. The total year-on-year change is starting to jump up a bit, which worried the bond market but was mostly overlooked by equity traders. Although unemployment claims produced a middling number, it felt heavy compared to the previous week and was something of a letdown. Leading economic indicators came out as well; they were up a bit, while last month was revised down a bit.

The Fed banks rounded out the cast by acting as the chorus with its monthly release of the “beige book,” its anecdotal survey of business conditions. It didn’t seem to me that the reports of some caution and tight credit conditions constituted news, but the stock market seemed to take it as an ominous change of key. Maybe they thought that the Fed’s big rate cut last month was just Ben and the boys having some fun. More likely, the market is still guilty of thinking that the rest of the economy responds to a rate cut as fast as the stock market.

Earnings will continue to hold court next week. Or should I say that the earnings trial continues next week? At least there’s no housing news until Wednesday, when we get existing home sales. Thursday will serve up durable goods and new home sales, and there’s another confidence number due on Friday. Durable goods may give us a break; they’ve been alternating up and down every month. I’d be surprised if any of the others show strength, but they may well serve as inspiration. Rate cut!

Stockwatcher’s Corner

Speaking of $90 oil, there could be a real opportunity looming soon in some of the refiner stocks such as Valero (VLO), Chevron (CVX) and Marathon Oil (MRO). All of them have issued profit warnings recently, citing higher crude oil prices as pressuring margins. Their stock prices have followed, but not as bad as the beating that oil services giant Schlumberger (SLB) took last week.

So what’s the interest? Right now market volatility and sentiment is such that the refiners could take some more beatings too when they report earnings. But these aren’t fallen growth stocks, they’re cash flow mega-cows that have been suffering as crack spreads, or the price difference between refined and unrefined oil, have collapsed.

That can’t last, though. Either the spread will start widening, or oil prices will retreat, or both, and refiner margins will widen again. We’re not about to have an oversupply of heating oil or gasoline, and best of all the demand for gasoline isn’t going to be affected by what’s going on in the housing industry. If these stocks get taken out to the woodshed over the course of earnings season, it could prove to be a very good entry point.