“Tomorrow, and tomorrow, and tomorrow, creeps in this petty pace from day to day” – William Shakespeare, Macbeth
Welcome to another week in Bottomville. The Doomsday choir swelled in numbers and volume, the equity markets fell to levels last seen in 1996 and the Dow officially logged a minus 25 percent drop to start the year. Those who thought they had seen it all in 2001-2002 are getting a new education in the meaning of decline.
How did we get here? Back in the days before time, I became hooked on economics in my first college course on the subject. I remember reading one of the few things that I had actually already learned in high school, namely that laissez-faire economic systems lead to greater swings in the economic pendulum. I would have thought that people like Greenspan had read Samuelson too, but maybe it wasn’t in their edition. I’m going to go out on a limb and predict that the laissez-faire warning will be reinserted in future texts.
For most of 2007 and 2008, MarketWeek was chiding the markets for ignoring the weakening trends in the economy and blithely dismissing negative developments. Even as late as the recent December-January rally, we were warning of too much optimism and blind faith in the magical six-month formula, the latter being a soothing pretext for hockey-stick revenue and earnings projections a couple of quarters out. With the second-half recover only six months away, one had to buy stocks before it was too late.
It isn’t too late anymore. Many of the Dow stocks are trading at single-digit multiples not seen since the seventies. The market’s innate sense of optimism has largely been exorcised, and the AAII investor sentiment index soared to a new record for bearishness of 70.3% (although leaving the record for fewest bulls still intact). Though some lament the clearly ringing bell of a capitulation day (what do they want, a thousand-point drop?) followed by a big reversal rally, it doesn’t always happen that way, and we think that we are largely at the capitulation point now.
Yes, we are in the deepest part of the trench. Before we are accused of calling the bottom, however, we admit to not knowing how wide the bottom part is, nor do we know if the very lowest point has been touched. Yet to those anxiously arguing over the meaning of the entrails, we would recall a familiar truism: they don’t ring a bell at the top of the market, nor the bottom. Though some find it smart to ridicule the government for not determining the beginning or end of a recession until well after the fact, the truth is the equity markets aren’t any different. It’s only months later that we are able to look back and point to the bottom of a cycle and say, “should have bought there.”
In fact, the climb off the bottom is usually accompanied by a largish group of doubters noisily proclaiming that the bottom has still not been reached. More punishment is necessary, the outlook for the economy is still uncertain, or possibly they have not finished covering their shorts. Bad news doesn’t dry up until well into the turn, so there is usually plenty of support for reasons to be hesitant. Yet if trading and investing were so easy and clear-cut, we wouldn’t be in the midst of the current gut-wrenching correction.
One catalyst for a rebound might be a suspension of mark-to-market accounting. We are for the suspension of that rule, one that we were never in favor of despite our CFA title as sworn defenders of truth in accounting. Lately the subject is much in the news, and as some have also doubted of late the wisdom of our position, a bit of explanation is in order.
The current mark-to-market situation is a direct product of the Enron scandal. At the height of its run, Enron’s management was famously scornful of Wall Street’s ability to understand its complex financial arrangements, and many cheered on the company’s maverick disdain. Then Enron flamed out in a spectacular crash, but along the way built many false moats around its many amorphous financial vehicles that in the end had little to none of the value assigned them by the company.
We were all properly outraged, and in response Sarbanes-Oxley accounting treatments were implemented and the pricing rules for investment were changed. No longer can the crooks make up their own prices, the thinking went, but they must observe market prices.
It was a good idea, but in the case of the financial sector, one that we have always been against. We are certainly for detecting fraud, and for that we think that change is overdue for the accounting and audit industry. The reason it doesn’t work in the financial sector, though, is that at times there simply is no fixed-income market to speak of. That may seem odd, given that the dollar volume of the debt markets completely dwarfs the size of the equity markets, but the debt markets are far more atomized.
In earlier times, banks simply classified most assets as held-to-maturity and valued them with a simple approach. When the fixed income market functions normally, those values should be close to market values. At times, though, the credit markets seize up and traders become afraid to buy nearly anything. It doesn’t happen often, but it obviously does, and when it does the current rules can strip banks of their capital by putting them at the mercy of those terrified traders.
Bank assets may be earning a rate of return (inclusive of default rates) that would justify a certain valuation, but when something is in ill repute on the trading desks, or there is simply too much job risk associated with buying it, there really is no market price to speak of in the ordinary sense of the term. Forcing the banks to write down those assets to the prices of a phantom market strips them of their capital and in the end, harms the whole system.
However, not having experienced a housing crisis or credit crisis of the current magnitude before, nor having had debt markets as securitized as the current era, the regulators did not foresee what might happen if their righteous rule stepped into a fixed-income trading vacuum. Thus, the banks are forced to choose between losses that don’t reflect the reality of their cash flow and default experience, or trying to hide them in nooks (Level Two or Three) that provide fresh doubt to the markets and possibly their own auditors.
While it’s true that the older approach makes it easier to hide a bad investment, that should be a matter for the system’s audit and regulatory structure. We think it would be better for the health of the whole ecosystem if we return to the practice of identifying individual problems and weeding them out, as opposed to the current approach of spraying the whole region with DDT.
To those who thunder that the banks are simply not facing the reality of market pricing, we say that at the moment that concept is an illusion. Legg Mason (LM) threw in the towel in disgust last week on its SIV investments and sold them at twenty-five cents to the dollar. Those who might pay a better price in more reasonable times cannot do so now, while those predator funds who are in a position to buy, understand the predicament of the banks and naturally want to pay the cheapest price possible.
Debt markets are at an impasse, because the vultures want to pay twenty or twenty-five cents on the dollar for assets that would be mathematically valued by an auditor or economist at eighty or ninety cents on the dollar. We don’t blame the vultures, because they are not running a social services agency, and one can hardly blame the banks for not wanting to sell a buck for forty cents at a time when they are least able to do so. The result is a stalemate that provides a lot of material for righteous posturing while helping to keep the credit system in a kind of paralysis.
This is the worst decline in the markets in over seventy years. The housing bubble was severe, but not as inflated as the tech bubble. That bubble blew up too and nastily as well, but there were some crucial differences. The financial system was less involved, and since that time we have added the new mark-to-market rule and done away with the uptick rule. The fall is bigger and harder now.
Our contention is that had those rules been in place during the S&L implosion of the early nineties – and its concomitant recession and bear market – we would have a crisis similar to the one we are having now, and quite possibly worse. In the thirties, the government understood that lines in front of banks is a vicious contagion, so the FDIC was put into place to manage failing banks. The uptick rule was also put into place because regulators understood that unchecked short-selling could make otherwise functional institutions insolvent.
The continued absence of the uptick rule contributes to the insolvency danger, as might be seen in the current madness in GE, for example. It doesn’t make earnings fall, but it does facilitate price gaps and downdrafts in capitalization that leads to weakened balance sheets, anxiety and cutbacks that do have an impact on earnings.
A mark-it-all-to-market rule pushed into a fixed-income market that occasionally disappears creates lines in front of the banks again. It may not be black-and-white footage of people standing in the rain, but the lines are there nonetheless. If we want a way out, start by going back to the rules that worked and get rid of those lines.
The Economic Beat
The tone of last week was dominated more by the ongoing rumors and melodrama in the financial sector than by earnings or economic data, but it must be said that the latter didn’t particularly help.
The ISM surveys continue to show an economy in contraction, but the rate of decline, or second derivative if you like, is slowing. It’s to be expected, as the cuts in production that followed the credit crunch have been too violent to be sustainable. It’s also to be welcomed, as we are likely to see the rate of contraction continue to slow.
That may not seem like much to celebrate, but consider that if we can just start going sideways within a couple of months, the survey numbers could quickly rebound back to the neutral level, even though output levels were still much lower than a year ago. That would improve the tone of the headlines and the capital markets. Bottom-fishers would start to become more active, and the markets could begin their climb out of the wasteland.
That’s the theory, anyway. The facts are that the manufacturing index came in at 35.8, which had the virtues of beating consensus and not being as low as the previous month. Even so, any reading in the thirties is still miserable. The non-manufacturing index came in at 41.6, about on target, a deterioration from last month but one not as severe as the ones in the fourth quarter. We won’t torture you with the details of each component, but suffice to say that everything is still in contraction.
A glimmer of hope in the surveys, however, was that while manufacturing employment readings continue to disintegrate, the rate of decline slowed in the non-manufacturing sector. The decline is still deep, but less so than the month before. That was echoed in the weekly initial claims figure, which reported 639,000. It’s a gruesome number, but down from the week before, as were continuing claims. The four-week moving average for both continues to rise, however.
Although the press coverage of the jobs report was sensational, and perhaps fittingly so for a recession that has produced the largest percentage loss in postwar times, the actual number for February was less than the market feared. It is also probably more than the initial report, as the trend of substantial revisions of earlier reports continued. December’s total loss was revised 104,000 higher (probably beating the whisper estimate back then, but now it’s too late), while January was reported to have lost another 57,000 positions. Estimates, however, of how many people were really put out of work (without Labor Department adjustments) ranged as high as a million.
The unemployment rate, as you have probably all read, rose to 8.1%, the highest in 26 years. A peak of ten-plus percent is now beginning to be widely expected, and we ourselves have been expecting something in the range of 9.5-10.5%. The postwar peak is 10.8%, reached at the end of 1982. We may not reach it this time, though, because our current economy is less manufacturing-based. With the way the auto business is going, it’s becoming less and less manufacturing-based every month.
Motor vehicles sales are awful. The current run-rate is 6.4 million annual units, and one of the more cruel ironies is that this result actually beat consensus estimates. A year ago, speculation that sales might fall below ten million might have gotten you laughed out of the building. One is tempted to call it comically low, but it would be black humor. At least one silver lining in Toyota’s (TM) 40% plunge in year-on-year sales is that it has silenced the self-anointed expert idiot-logues of last fall who wanted to blame all of Detroit’s problems on the UAW and a lack of fuel-efficient cars.
In fact, the credit crunch in car loans is so dire that all of the major Japanese automakers have asked for Japanese government help in obtaining dollar funds for the U.S. market. Doubtless that inconvenient fact will be overlooked by the next expert that gets up on CNBC and tells us how we are wasting the taxpayer’s money on the auto industry.
The ever-shrinking universe of chain stores that still report monthly sales posted results for February that were better than expected, although still largely down year-on-year. The mix continues to shift towards the downscale, led by Wal-Mart’s (WMT) 5.1% increase. Weekly sales data are better than January, but they are still soft. Next week’s retail sales report on Thursday will be carefully scrutinized. Last month’s report was essentially dismissed by the market as too implausible, so the revisions could be interesting.
Personal income for January was pulled up by transfer and government payments; private sector wages continued to fall at about the same rate as the previous month. The PCE (inflation) numbers continued unchanged from the previous month, no inflation, no deflation. Personal saving increased upwards of five percent. That sounds good, but in the short term it’s part of the fear wave causing everyone to pull back, making things worse. Spending was up bit more than expected.
Actual production was down in January, so nobody was surprised to learn of the fall in factory orders for the month of (-1.9)%. That number was quite a bit better than consensus, but was pulled up by an increase in energy prices, so the celebration was deferred. Durable goods were reported to have fallen by less than last week’s advance report, but that good news (sort of) was offset by the severe weakness in capital goods investment.
Construction spending is falling at an increasing rate (-3.3% for January), as homebuilders have given up and corporations are freezing budgets. We probably won’t see any stimulus-led bump in that data until May or even June, when the April data will be reported. It may seem like a long wait. Pending home sales showed a larger-than-expected drop of (-7.7)% for January, a reflection of cautious buyers – mortgage purchase applications are running at very low levels – and tight credit conditions.
Aside from next week’s retail sales report, there isn’t much to grab the headlines. We would guess that government will again dominate the headlines. Chairman Bernanke will speak on Tuesday morning, and wholesale trade inventories come out the same day. The latter will be followed by business inventories on Thursday. Both amounts will be scrutinized for signs of further production cutbacks.
Friday will bring February’s data on trade figures, with the trade deficit and import-export prices for January on tap. The University of Michigan will report its first look at consumer confidence for March later that morning; given the trends in employment, we could well be headed for a new low. It’s always darkest before the dawn.