The Week That Was (Not As The Market And Media Will Have You Believe)
As the financial world is losing one of its best and brightest advisory brains through David Rosenberg's impending departure from Merrill, we believe in spreading his gospel as much as we can, as his vision and instincts have saved many people (at least those who have found the contrarian in them to listen and act on his advice) their life savings. David has the uncanny ability of calling it like it is and it is our duty as responsible citizens to disseminate his words.
The week that was according to Dave
1) Can you handle the truth?
The Fed and the Treasury are pulling out all the stops to bring mortgage rates down and it is not too hard at this point to see them falling to historic lows of 4.5% or perhaps even lower. Through the balance of the year, that rate relief should total $115 billion at an annual rate (even if we see the mortgage rate go down to 4.5% from around 5% right now, most of the decline from the 6.5% level that prevailed through most of last year is behind us). And starting April 1st, low- and middle-income households will start to see withholding taxes coming off their paychecks, which we estimate will total around $35 billion at an annual rate. So, we estimate the tailwinds from monetary and fiscal policy, as far as the consumer is concerned, are a hefty $150 billion at an annual rate. The savings rate is on a visible uptrend and, by year-end, when we estimate it will be closer to 7%, will likely have drained $175 billion out of spending. (Every one percentage point rise in the savings rate, it should be noted, as a static standalone development, is equivalent to 2.2 million jobs being lost in terms of GDP impact). On top of that, we have job losses totaling an estimated 2.2 million from now to the end of the year, and that comes at a cost of $110 billion to personal income (again, at an annual rate).
Based on our assumptions on asset values, we think the negative wealth effect could end up bosing a drag on spending to the tune of $400 billion at an annual rate through year-end. These headwinds amount to an estimated $685 billion. On net, the $535 billion drag on consumer spending is equivalent to a 5% contraction, though we anticipate that there will be more offsets in the form of further fiscal stimulus and expansion of the central bank’s balance sheet.
2) Are we seeing fiscal stimulus or … restraint?
The focus and headlines remain exclusively on what the Federal government is doing to boost the economy. But few write about what the state and local governments are doing to stay solvent – cutting back on spending at an unprecedented rate. Indeed, what seems to be forgotten is that after consumer spending, the lower level of government, with a 13% share of GDP, is the most important part of the economy – this is a sector that represents our teachers, law enforcement, fire prevention, and health and social assistance. The state and local government sector employs 20 million, or 15% of the total, compared with 13 million in manufacturing, 8 million in financial services, less than 7 million in construction and fewer than 3 million at the federal level. Fiscal gaps have now opened up in 42 states, and, when added to the shortfalls at the start of the year, they cumulate to a whopping $80bn; this offsets more than 60% of the fiscal tailwind. And, in 2010, the amount of fiscal tightening from the states/local governments is expected to total $85 billion, which bites into 30% of the stimulus we will see at the federal level.
3) Huge one-day rallies happen in bear markets
The S&P 500 surged 7.1% on Monday. Why, we haven’t had a day like that since … November 24th. And before that … November 21st! And before that … November 13th! And before that … who can forget October 28th (remember that 10.8% jump)? And before that … October 13th! And before that… September 30th. This is the 15th time in the past six decades that we have seen a 5%+ move in the S&P 500 and they all either occurred in a bear market (2007-09; 2001-02) or right after the stock market crash in Oct/87. In fact, two-thirds of those 5%+ rallies have occurred in this bear market!! And they have always, always happened on some major announcement or news item. But, to quote an oldie but goodie from Bob Farrell – the market inevitably makes the news, the news does not make the market. Look – we realize that there are many out there who are craving the opportunity to turn bullish. So are we. But we have seen this script too many times before. We just do not believe that a new bull market is going to be caused by Bernanke and Geithner, who have been at the helm through this vicious bear phase. The fundamentals, namely corporate earnings, are going to have to take over from hope to ensure that this rally has legs.
There have been seventy 5%+ sessions and twenty-nine 7%+ days back to 1920. The best 45 days in the market in recorded history actually occurred in the bear market of the early 1930s. Going back over the past 80 years, it is painfully obvious that spasms of this magnitude occur in the context of bear markets. This is NOT characteristic of a bull market. The last time we endured something like this was back when we bounced off the November lows – and 10 days into it, the market had surged 15% and every pundit and his mother were claiming that the wicked rally was dead. Caveat emptor.
4) New home sales higher but inventories bloated
New home sales surprised to the upside, rising 4.7% M/M in February to an annualized pace of 337K units. While upward revisions were made to both December and January sales, January and February levels remain the lowest on record. Activity in the South and West lifted the headline gain, while sales in the Northeast and Midwest fell.
Price concessions and lower mortgage rates were likely a factor over the month; indeed, median new home prices fell 2.9% M/M to stand at December 2003 levels and -18.1% versus year-ago levels (the worst YoY level on record). Relative to the existing stock of single-family homes, new homes remain nearly 20% higher, with a more striking disparity relative to distressed properties that are selling at an even steeper discount. In our view, an ongoing correction in new home prices will be necessary to stimulate demand over the next year.
Inventory levels remained problematic, with only a slight improvement in months supply, at 12.2 months in February versus a record high of 12.9 months in January. A figure closer to 6-7 months is consistent with a fundamentally balanced market, suggesting that ongoing cuts in homebuilding are in store. Since completion, new homes took a record 9.8 months to sell in February, reflecting both depressed demand and the need for ongoing price concessions.
5) Downward pressure on the housing market remains
We totally disagree with the views being espoused that the housing market is hitting bottom. To make that assessment in February of all months is a dangerous proposition. We shall wait to see what happens during the critical spring selling season. The key is that home prices continue to deflate, as they did in the new home sales report (median was -18% versus -11% in January), which indicates something very important: there remain more sellers than buyers. Indeed, at 12.2 months’ supply, the downward pressure on real estate valuation and bank capital is likely to prove resilient. We’ve said it once and we shall say again that it all comes down to housing, the quintessential leading indicator. In our opinion, there is simply no sustainable recovery in the economy, the stock market or the financial backdrop until we get some clarity on the outlook for residential real estate prices. And, in order to establish at least a tentative floor under home prices, we believe we would have to see the new unsold housing inventory recede to at least eight months’ supply. In fact, we went through the historical data on new housing inventory and found that when months’ supply is running below eight months, median prices are running +6.3% YoY on average. While inventories are currently above 12 months, median new home prices are running at an unprecedented -18% YoY pace (and a five-year low, in level terms).
6) Unprecedented plunge in corporate profits
The final report on GDP included the first estimate on 4Q corporate profits. Aftertax profits (ex IVA and CCA) plunged at an annual rate of 74% in 4Q, which was unprecedented, and by 36% on a YoY basis, which was also a record decline. The actual level of $930 billion was the lowest since the third quarter of 2004. However, relative to GDP (6.6%), profits are where they were in the summer of 1997. And, it wasn’t just financials this time, although sector profits did plunge at a record 97% annual rate (-67% YoY) and the level is back to where it was in 1994. Non-financial sector profits slid at a 36% annual rate in 4Q as well, and are down in five of the past six quarters.
7) Employment conditions are not stabilizing
There is also a view out there that employment conditions are on the precipice of stabilizing. That is hardly the case, in our view. Initial jobless claims edged up 8,000 in the week ending March 21 and the four-week moving average stayed near the 650,000 level – signaling that we can expect to see another substantial drop in nonfarm payrolls (ML call remains at -750,000 versus consensus of - 657,000 for the March report). Continuing claims for the March 14 week continued to surge, with 122,000 more displaced workers on unemployment insurance assistance, for a total of 5.56 million. Emergency unemployment compensation, which provides extended benefits for workers who have exhausted their normal 26 weeks of insurance, declined by 20,000 in the March 7 week, although 1.5 million remain on this assistance.
In sum, the numbers are suggesting that the unemployment rate will jump in March to a 26-year high of 8.6%. The unemployment rate looks poised to break to or through 10% by year-end, and those who just see this as a lagging economic indicator do not take into account the extremely close relationship it has with banking sector strains, such as credit card delinquency rates.
8) Durable goods rise with downward revisions
Large downward revision to durable goods in prior months = lower 1Q GDP: Durable goods orders unexpectedly rose 3.4% M/M in February for the first gain in seven months. This was notably higher than consensus (-2.5% M/M) and Bank of America Securities-Merrill Lynch expectations (-3.2% M/M), with gains in tech, machinery and electrical equipment and defense aircraft orders – the latter up 33% M/M. This report is notoriously volatile and importantly included a large downward revision to orders in the prior month; together with a larger than expected decline in inventories, ML is now tracking a 7.2% Q/Q annualized decline in 1Q real GDP (versus -6.5% Q/Q previously), with capex down 29% Q/Q (versus -23% Q/Q previously). Inventories were trimmed by 0.9% M/M, with increased efforts by manufacturers to cut back metals, machinery and electrical equipment stocks. Still, overall sales continued to fall, leaving the inventory-to-sales (I/S) ratio at a 17-year high of 1.88 months. This suggests that meaningful cutbacks in orders, production and jobs will be necessary over the near term to work down inventories.
9) Seasonal factors skewing the February data
To be sure, there have been several data releases in February that have lined up on the strong side of expectations. Caveat emptor on any February data point that is seasonally adjusted at a time of the year when winter weather typically forces most of the country into hibernation. This was no ordinary February. At an average of 37 degrees (F), the month was two degrees warmer than a year ago and four degrees balmier than two years ago. As ML said, almost everyone likes to talk about how the latest data have all of a sudden signaled a turn in the economy, with retail sales, home sales, and this week’s durable goods report. Everyone was so excited about a 3.4% increase in February orders, and it seems as though the headline was taken completely at face value. But again, like so many indicators, the seasonal adjustment factor was extremely aggressive in providing a record boost (in this case) to the top-line figure. ML calculates that if a typical February adjustment factor had been used, orders would have shown a 5% collapse last month. We are still in the process of trying to figure out why this happened – it could be due to the mild weather compared to the last two years. The YoY trend in the non-seasonally smoothed orders data shows that the pace is still testing unprecedented negative terrain (-29%); ditto for shipments (-20%). The durable goods inventory/shipments ratio at 1.88 is close to an all-time high. That spells more production cutbacks and deflation pressure as we move into the second quarter.
So, we do advise caution here because we have seen a very aggressive set of seasonal factors that made the raw data look extremely strong in February. The seasonal adjustment for new home sales, for example, was the strongest since 1982. For orders, it was the strongest since the data were first released in 1992. The retail sales number in February in non-seasonally adjusted terms was the worst, a 3% decline actually, on record, and yet again a strong seasonal adjustment factor made it look flat … or flattering, we should say. Beware of reading too much into the data in February when a 40,000 raw non-seasonally adjusted housing starts number suddenly becomes a headline seasonally adjusted figure of 583,000 at an annual rate.
10) Second derivative on GDP growth is not improving
Many pundits believe that the second derivative on GDP growth is improving; this is not the case. Real GDP contracted at a 6.3% annual revised rate in 4Q08, and chances are high that there will be an even steeper decline for 1Q09 (-7.2%), in our view. But, the market does not trade off of the second derivative. If it did, then the S&P 500 would have peaked in the first quarter of 2006 as opposed to the third quarter of 2007; and would have bottomed in the fourth quarter of 2001 instead of the fourth quarter of 2002. However, we cannot stop people from believing what they want to believe, and there is incredibly strong belief now that this is a fundamentally based equity market rally. We are trying to keep an open mind, but are not convinced.