“For they are brokers, not of that dye which their investments show, but mere implorators of unholy suits.” – William Shakespeare, Hamlet
by M. Kevin Flynn, CFA
Well, there you are. Lying in bed, enjoying some terrific dreams and having a great night of sleep, when suddenly and unmistakably, the sound of the downstairs door opening wide is heard. What do you do? You might say it’s the bloody wind and try to ignore it.
Or should you decide to slip downstairs to see what’s happened? And if you opt for the latter, do you plan to do so in your current half-awake and undressed state, or will you rouse yourself fully and fetch a golf club out of the closet to go and confront what might be the neighbor’s cat? You could end up taking a divot out of your teen-age son. Or worst of all, you might actually find yourself wishing you had more than a golf club.
That’s about the situation we find ourselves in this week. After weeks of floating ever higher through stock market dreamland on the soft fluffy pillows of news that hinted at every dream coming true, the peace has been disturbed. Are these Greece and Goldman (GS) problems the ruffians in the parlor, or can we expect to roll over and go back to sleep? Then there’s the bomb in Time Square, not to mention the one burning in the Gulf of Mexico.
Goldman’s situation did go from bad to worse when it was announced that the Manhattan Attorney General’s office was launching a criminal probe of the firm. That doesn’t mean the firm is guilty of anything, but while civil cases carry the possibility of fines and enforcement actions, criminal matters carry the threat of being disqualified from entire business areas.
Besides the worries about Goldman itself, that raises some other unpleasant prospects for the financial industry. For starters, the government has the upper hand again in the battle for more market regulation. The Volcker rule now has a better chance of passage.
Another problem is the fate of the other major banks. In the wake of the tech wreck, most of the Street players found themselves signing some rather large checks and cease-and-desist orders. Given the size of the financial collapse and the public anger towards the Street now, it isn’t hard to infer that others may end up finding themselves in the line of fire.
Then there’s Greece, and indeed Europe. As we go to press, the EU has readied a $146 billion vat of oil to pour on the troubled waters. That might lead to a short-hunting reversal for a day or two, but whether or not the Greek problem is really fixed remains to be seen.
So far the Greek crisis has played out to form. The typical timeline in this sort of crisis is that an initial case of nerves is quickly allayed by assurances that Something Will Be Done. When nothing really happens, there is a fresh sense of crisis. A rescue package is found, and the market bounces around a bit while waiting to see if anything else blows up. If, after a couple of weeks, nothing else has gone very wrong – and that is usually the case – the market forgets about it and focuses on getting back to finding new momentum trades.
Thus, the Asian currency crisis of 1997 didn’t come to a head for a year. The Bear Stearns mortgage-backed hedge funds that blew up in July of 2007 started the firm on the path to its own demise in March of 2008. That didn’t stop the market from having a lusty rally in August of 2008, weeks before Lehman collapsed and the whole thing imploded.
The true size of the European debt problem has been estimated by many to be too big for the European Central Bank to handle, even with the help of the IMF. The latest Greek solution is by no means a certainty to work even for Greece, but if the country can squeak through the next week or so, it would not at all be unlike the equity markets to declare the problem fixed and move on to more pleasant prospects. The bigger bill comes later.
We’ve been overdue for a pullback, as last week’s big jump in volatility suggests. The markets in general are overvalued, but not extremely so. We’re at the point where a lopping off a few percent could actually help the rally, so long as the decline stayed orderly. But we’re also at a spot where another nasty scare could lead to something bigger.
We think it more likely that a larger decline comes a bit later, perhaps by the end of the July reporting season. That’s just the usual form – reactions tend to get exaggerated after a climb as steep as the recent one.
Predictions about what will happen over the next few weeks with the Goldman probe or the current Greek package is something of a mug’s game, though. We could still get to 1250 on the S&P 500 before things come apart in a more meaningful fashion. That doesn’t mean that we can’t see something big first, only that on balance it rates to come later rather than sooner. It’s coming, you can be sure of that. The real question is when the Street can’t avoid looking at it anymore.
The Economic Beat
The latest data points on the economy were mixed last week. Weekly sales data has been apparently indicating a normal post-Easter slowdown at the retail level. Housing and employment continue to show signs of weakness, but the signs are just ambiguous enough to allow the bull narrative to keep its grip. Only manufacturing is really posting good growth, although the levels are still subdued compared to prior years, while there are whispers of semiconductors having already peaked.
The Case-Shiller index reported another decline in February, at least at the unadjusted level (the seasonal adjustments have been recently disavowed). Most cities in the 20-city index fell. Nevertheless, we expect stable to rising price data for March and April, as the warming weather and expiring tax credits should have been favorable for the market.
With the Case-Shiller price data lagging national sales volume data by a month, the housing picture should stay confusing enough to allow the market to think what it wants for another couple of months. The C-S price report for April, which we think will show the last leg of a temporary bump, won’t arrive until the last Tuesday in June. That should translate into two more months of hopeful headlines about a recovering housing market.
Pending home sales should show an increase for the next two reports, beginning with the March report due this Tuesday. Existing and new home sales probably only have one increase left in them, but the market probably will give the first month’s decline a free pass, due to the expiration of the tax credit.
Put it all together and that should allow the press to keep trying to convince us that the market has turned and perhaps give the homebuilders another lift into the end of the quarter. After all, confidence is an essential ingredient, isn’t it?
Indeed it is, but there still some headwinds out there too strong to fly around. The first is the very large amount of foreclosures and distressed sales still due to come onto the market through the rest of the year. That means price and supply pressure.
A second is the fact that prices have now fallen back to 2003 levels. While that allows the realtors to keep boasting about affordability – and it has indeed improved dramatically – it poses a price dilemma to the existing homeowner market. Faced with a choice of selling either at a loss or at a price down thirty percent from the peak, homeowners as a rule will not sell unless they have no choice. They will tend to wait out a return to better days, and that will keep a lid on demand. As for the first-time market, the credit is gone. Buyer supply has to have been run down dramatically by the year-plus program.
Biggest of all, maybe, is credit: while the banks are very eager to talk about improving loss ratios, they still have a lot of losses yet to come and are not at all eager to lend money, especially for housing. The news that the government is now taking on over 96% of mortgages comes as no surprise to us: every single bank 10-Q or 10-K that we read these days stresses the fact that any new residential loan business by the bank in question is strictly on an origination-only basis, with the load to be resold to the feds – or it isn’t made.
The feds themselves are slowing down their support, albeit mildly. The Federal Reserve Bank has left the mortgage market, at least for now. Fannie and Freddie have been tightening up requirements a notch or two. One could really say that both are only taking baby steps, so we shouldn’t expect dramatic changes.
But with employment and private credit still enfeebled, there is simply no reason at all to expect that the ratio of home ownership, which is still above the long-term average, will suddenly begin to ratchet back up again. Does anyone believe that the new census and temp workers are about to run out and buy a house? Or that anyone would loan them the money?
Take a look at mortgage-purchase applications. They have risen strongly two weeks in a row now, and we should find out next Wednesday that they did so again into the April 30 deadline. But that’s misleading, because the actual level of activity is still lower than it was last August and September, and is flat out weak by the standards of the history of the index. The government is going to run into more hard choices over the summer, as both doing nothing and doing more will be politically difficult to undertake.
Turning to employment, we listened in disbelief to a radio announcer talking radiantly about how the improving employment picture helped lift Thursday’s stock market to its gains. Initial claims did improve slightly from the previous week, but a figure of about 450,000 must be at the lowest levels of the improvement ladder. The four-week moving average rose slightly. Emergency claims have declined in recent weeks, but as we lap the peak of last year’s purge, a growing number of claimants are going to run out of benefits.
Despite the difficult picture in the claims market, the stock market is nevertheless dialing in a big gain in the April employment number, due to be released on Friday. The consensus calls for a gain of 200,000. It’ll take a lot of those census and temporary help workers to get there, not to mention the business births-and-deaths model. The latter is especially helpful for current reports, though the gains are completely revised away later. Given the low levels of small business confidence, we don’t know how anyone can take such results seriously.
The Fed’s Open Market Committee met last week and really had nothing new to say. The committee stated the obvious – the economy has improved a bit, but not enough for the committee to want to change its stance. After the prolonged rise in the stock market, the Fed may well have had ideas about taking a tougher line coming into the meeting, but Tuesday’s big losses amidst swirling sovereign debt fears took away their footing.
The members couldn’t have been inspired by the latest confidence reading from the Conference Board. While the reading of 57.9 was ahead of consensus expectations of 53.5, it’s still a dismally low reading that gets its boost almost entirely from the headlines about the stock market. Consumer sentiment as measured by the University of Michigan also rose in its final April reading, but the mild increase will fade away with the next correction
Still, manufacturing did put up a green light with the Chicago PMI survey registering 63.8 versus expectations of 60 and a neutral reading of 50. That should point to strength in the auto industry, which reports monthly sales on Tuesday. It also bodes well for the national manufacturing survey, the ISM, reporting on Monday. Our estimation is that we are in the sweet spot of the manufacturing rebound, but that it will also begin to ebb later in the quarter.
The advance estimate on first-quarter GDP came in at about consensus, perhaps a tad low at 3.2%, but it wasn’t the knockout number the market was hoping for. Perhaps we could get the Bureau of Economic Analysis (BEA) to help out by starting to give lowball guidance for subsequent quarters. Then we could have more rallies. It’s only patriotic.
A couple of numbers that stuck out to us were the price deflator, which for the second quarter in a row ran lower than every other government measure of inflation. Oddly enough, that helps the reported “real” rate of GDP – a coincidence, we are sure.
The other item that caught our eye was that real final sales slipped to 1.6% from 1.7% the previous quarter. The gains from the last two quarters have still been largely inventory-driven. Strong inventory gains are normal at the outset of a recovery cycle, but the weakness in final demand is not. Given the latter added to weak employment and credit, how much longer can the former last? But the Street mostly confines itself to making straight lines out of the last two dots, so that question won’t trouble our momentum warriors.
The BEA also reported that real personal income was unchanged in the first quarter. Not exactly encouraging. We’ll get the rest of the details (including March) on Monday in the monthly income and spending report. March construction spending also reports with a loss of (-0.3)% penciled in, but it will be overshadowed by the ISM report. The non-manufacturing version of the ISM comes out Wednesday.
Factory orders and pending home sales are due Tuesday morning. The former is supposed to report a loss of (-0.1)%, but that seems dubious to us. We look for a gain, which when added to expected good results in homes and autos could set a positive tone for the day – European debt permitting.
The surviving chain stores that still report monthly data will announce results Wednesday evening and Thursday morning. The rest of the week will see the usual clues to the monthly BLS jobs number, highlighted by the ADP payroll report on Wednesday.
In sum, next week will feature both ISM numbers, a glut of jobs and sales data, and another week of earnings reports, all set against a backdrop of Goldman and European financial drama. Things could get quite erratic, and indeed we will be surprised if there isn’t at least one 200-point move in the Dow. That’s without counting any intra-day top-to-bottom moves, either. Be careful not to get whipsawed.
Admit it, you’ve been thinking about dabbling in Goldman Sachs stock, haven’t you? You certainly aren’t alone. We’ve been around all kinds of such talk the last couple of weeks, ranging from the staunch “come on, this is Goldman” defense to the conspiratorial whisper of “you know, this thing could run all the way back to two hundred.”
Both schools of thought have a good point, but we’re not going to enroll, and we suggest that you don’t either. Yet how can we go against an eminence such as Warren Buffett?
Well for one thing, Mr. B is not about to trash a position he would have trouble selling. He was probably a lot happier with his preferred shares three weeks ago, before the SEC dropped its bomb. He may very well be wishing he was out of his holding right now, but prudence forbids uttering such thoughts aloud to the press.
Whatever he may think, though, our opinion is that although Goldman rates to emerge bloodied but unbowed, so what? Are you really getting compensated for the risk that investigations by the SEC, New York government attorneys and perhaps the countries of England and Germany won’t be able to turn up one single smoking gun? Can you really be sure that there is nary a single text message out there in the last three years that could get the company in trouble?
Wall Street can be a rough-and-tumble place, and as ethical as Goldman may think it is, the big investment banks live in a cloistered world. Much of the action on the Street takes place in a grey area, and what may have seemed on the right side of the line to a bunch of avaricious, intensely competitive traders swept up in the middle of bubblemania, might not appear that way years later to an unsympathetic sub-committee or Attorney General.
One criminal count could cost Goldman all of its government business. It cost Drexel Burnham its very existence. Bear Stearns and Lehman Brothers were both century-old banks with many billions of dollars in equity a year before they were snuffed out.
We say that the odds are that Goldman will survive. That, plus the always-tempting prospect of making the killer brag-trade of bottom-fishing a wounded giant is luring in a lot of flyers. But can you really be sure that this particular black swan won’t land on your doorstep? If you win, you might book a twenty or thirty percent gain, even fifty over a longer time frame. If you lose, you might lose it all, and nobody’s going to listen when you say that were blindsided.
If you really cannot bear passing up the chance to have a flutter, then we say at least hold off just a bit. The odds that you can get in at a lower price are very much in your favor right now. After all, we’ve yet to hear from the New York State Attorney General’s office, an entity not known for its kind and gentle approach to Wall Street.
As for us, we’ll take a pass. Given a choice, we’d take Las Vegas, where the odds seem about the same but at least they’ll give you free booze while you lose.