Party Like It's 1999
The stock market liked both the retail sales and the inflation numbers that were released over the last two days, with the Dow posting successive all-time highs. This week we look behind the headlines and a little deeper into those numbers to see if there is some justification for the exuberance, as well as offer some thoughts on valuation and the recent meeting of the Fed. And I know it will shock you that once again there is a change in the way the government collects its data. It should make for an interesting letter, so let's jump in.
It is getting lonelier to be in the bearish camp. I noted this morning on CNBC that Mark Haines introduced good friend David Kotok of Cumberland Advisors as a former perma-bear. Last summer, David invited me to his rather famous Shadow Fed fishing weekend in Maine, where economists, as well as money managers, some press, and the occasional official figures get together to fish, eat, drink, and talk economics. A very eclectic group by any standard. I took my 12-year-old son Trey and we had a blast. In fact, I was instructed by Trey as we left to be nice to David so we could get invited again.
One of the rituals is that one evening everyone sits around and predicts where various markets and rates will be the next summer, and modest sums are wagered in pools and side bets. Kotok at the time was thinking the Fed would raise rates after a pause. It will come as no surprise that I was one of the more bearish attendees. My thinking then, as now, was that by the middle of next summer we would either be coming off of or possibly in a mild recession, and that would mean lower rates and a lower stock market.
Today on CNBC, David says he thinks we could see 1550 to 1600 in the S&P 500, through a combination of earnings growth and P/E multiple expansion. He used the word Goldilocks in a positive way, which is certainly enough to get him drummed out of the club. I hope he's right. Betting against David is usually not smart. I think I took the under of whatever his market bet was last year on a side bet, so right now the markets are saying I may have contributed $10 to his coffers.
But if I were making those modest bets today, I would certainly take the under of 1500, for say, another $20, David? Double up to catch up. And we did get invited back, and hopefully not just because they want to take more of my money. Although we still have two more quarters to go to July, and I still think we will see a slowdown/recession next year. I may yet eke out a correct call or two.
Let's start with a quick look at the release from the Fed Open Market Committee meeting this last Tuesday. It is always a five-paragraph release, and four paragraphs were unchanged from last month. For the sake of brevity, here is the two-sentence paragraph which changed. Changes are underlined and bolded.
"Economic growth has slowed over the course of the year, partly reflecting a substantial cooling of the housing market. Although recent indicators have been mixed, the economy seems likely to expand at a moderate pace on balance over coming quarters."
The Fed now see the slowdown in housing as substantial, letting observers know they were paying attention. They noticed the recent up and down nature of various economic data.
But the interesting thing to me was the addition of the words "on balance over coming quarters." Oddly, I agree, and that is what I think a few Fed observers may have missed. I think that "on balance" we will see the economy grow in 2007, as the recession will not be overly long and the actual drop not all that much. The average of 2007 should be somewhat positive. But it seems like to me the Fed acknowledged there could be a few bumpy quarters.
Which brings us to the inflation numbers. We now have the beginning of a possibly good trend. Core inflation has fallen for two straight months, from a high of 2.9% in September to 2.6% in November. At this rate it night be back to the "comfort zone" of between 1 and 2% by mid-spring, allowing the Fed to consider cutting rates in May.
What could make them consider cutting rates earlier, at the March meeting? A visibly slowing economy is one thing, but the recent data does not suggest that the economy will be both visibly slowing and inflation back under 2%. Unless inflation falls much faster (at almost double the pace) than it has the past two months, they will not cut by the March 20-21 meeting, that is if you can believe the constant chorus of Fed governors worrying about inflation.
I should note that a number of very smart economists, including Paul Kasriel of Northern Trust, think they will be cutting at the March meeting. If they are going to do so, it is likely they will signal such a move in the release after the Fed meeting January 30-31. We only have one more set of inflation numbers between now and then, and given the propensity of the Fed governors to want to sound hawkish on inflation, it is hard to see a dovish release in January, short of a precipitous drop in inflation.
Retail Sales Conundrum
Retail sales for November were up by 1%, which was a much stronger than expected number. Given that the #1 retailer in America (Wal-Mart) had a self-admitted bad month, where did the strength come from? Inventories are building. Lowes and Home Depot warned of possible disappointments in November, yet the survey showed a seasonally adjusted increase in building material sales. With both the warnings and a slowing housing construction market, that seems like a major disconnect.
Retail sales come from the Census Bureau doing a sampling (polling) of various retailers. The retail numbers are notorious for being revised significantly. First, the initial monthly numbers are not yet adjusted for prices changes.
But even more interesting is a footnote in the retail sales release brought to my attention by Barry Ritholtz. It seems the Census Bureau changed the sampling group. They do this about every two and a half years, and did it for November. From the website:
"The Census Bureau periodically redesigns and reselects the samples for its business surveys to reflect the results of the latest Economic Census. The Advance Monthly Retail Trade Survey is being revised to reflect the 2002 Economic Census of Retail Trade and more recent data from the Business Register. This ensures that our sample is representative of the current retail industry. Revising the sample also allows the Census Bureau to redistribute the burden of reporting for small and medium sized companies." (http://www.census.gov/svsd/www/aug06faq.html)
So we have a different set of companies being surveyed. Nothing wrong with that, as when you read their explanation it makes perfect sense. But if you look at the potential sampling error further down in the explanations, the margin of error is much higher than 1%.
Ok, why am I being such a grinch just before Christmas? Because sales tax collections do not reflect a robust retail sales picture. Taxes are a fairly good indicator of sales and income. No one pays more taxes than they have to, and sales taxes are collected and reported regularly.
The Liscio Report calls up the offices of the various state sales tax collection agencies and surveys them as to how they are doing. Here are the opening few paragraphs from their report for November sales:
"Our index of state sales tax receipts took it on the chin in November, falling to 27% at or above expectation, down from 55% in October. Although the number of states reporting positive growth over the year rose to 80% from 72% in October, several of the states that did not make it to the zero line were in steeply negative territory.
"... the weakening consumption trend is now established, and the majority of our tax contacts expressed real concern about slowing in sales tax collections. It now appears clear that consumers are not spending the billions of dollars they have saved on gas in recent months, and comments on the effects of the dual slowdowns in housing and manufacturing centered on how much more is to come.
"No one offered any evidence that we're passing the bottom in housing, in fact year-over-year comparisons for building materials are drifting further below zero in many states. One contact had compiled a number of print pieces suggesting prices in his state were stabilizing. He laughed a bit about some instance of "sugar coating," and suggested that the reporter might have substituted "heading into the toilet," for "stabilizing" when discussing prices, especially since a recent 64% fall in monthly sales pushed the current supply up from 8 months to over 12. And weakness in manufacturing isn't going to reverse anytime soon.
"So, some states are meeting lowered projections, more are missing them, the possibility of further cuts remains, and our contacts in even the strongest states report yearly growth is now running 2-5% below where it was just a few quarters back."
Notice the states say sales taxes from building materials is down, yet the Census Bureau says they were up. But up can be a relative term. They were up on a seasonally adjusted basis. If you look at the actual sales numbers, they were down, reflecting the sales tax reports. However, looking at the Census Bureau data for year-over-year comparisons, we find both building materials and total retail sales are still quite good. The consumer is not dead yet.
If we are in fact going to see a recession or serious slowdown, it will come from weakness in the housing and manufacturing sectors, which will result in an increase in unemployment. We are only in the beginning stages of the housing slowdown, so we should not expect to see much of a negative influence yet.
Party Like It's 1999
And besides, the American consumer is committed to spending. I got this note from Phillipa Dunne. Federal Reserve Economist James Kennedy tracks Mortgage Equity Withdrawals (MEW). (He did a rather noteworthy paper with Alan Greenspan in 2005 on the topic, and has updated the data since then.) He released the third-quarter data this week. Pay attention here. Home equity withdrawals have added between one-half and one percent to the GDP over the past five years. If MEWs are down, would that not suggest a slowing GDP?
"Gross equity withdrawals were down 28%, and net (of fees, closing costs, etc.) were down 30%. This is the fourth consecutive down quarter, and the third in double digits. Gross extraction is down 47% from the third quarter of 2005; net, down 53%.
"The third quarter gross measure is equal to 5.4% of disposable personal income, down from 6.4% in the second quarter, and 11.6% in the 2005Q3 (the record high). The net measure was 4.0% of DPI in the third quarter, down from 5.7% in the second quarter, and 9.6% a year earlier. Had third quarter extraction matched the rate of a year earlier, it would have been $600 billion higher - the equivalent of three months of ex-auto retail sales, or 20 million jobs (based on average weekly earnings multiplied by 52). Despite these declines, MEW (relative to DPI) remains at roughly twice its 1991-2000 average."
"So where," I asked Phillipa, "is all the strength in retail sales coming from?" The short answer is, because we are partying like it's 1999.
Bullish analysts would correctly point out that incomes are rising. Disposable income was up 6% in the third quarter, partly from rising incomes and partly from reduced tax payments. The third quarter was the first time in two years that income growth exceeded spending growth.
But income growth does not come close to explaining how we can see huge drops in Mortgage Equity Withdrawals, yet no apparent effect on sales. So where are we getting the cash? From savings. Phillipa writes:
"Our tax contacts in states prone to heavy exercise of stock options report a big upsurge this year. Individuals have been sellers of stocks forever, but the levels in the Q3 Flow of Funds report are at record highs. The first 3Qs of 2006 average $770B at an annualized rate; in 2000 it was $630B, and no other year comes even close. It's currently 11% of DPI; previous peak was 9% in 2000.
"(Net financial investments, basically savings less borrowing, has been positive since 1952 when the series started. In the 1950s it was about 5% of DPI rose to its peak of 11% in 1982, went negative in 1999 and now is -9.7% of DPI. This is another way of saying the savings rate is negative, but the levels are stunning to us.)
"In Q3 households sold $166B in treasuries, $139B in corporate bonds, and $757B in stocks, totaling about $1.1 trillion, and net purchases of financial assets was an unusually low $250B.
"Putting it all together, we have decent income growth, but households are still doing a lot of dissaving to keep up their spending. We keep looking to credit card debt to cover loss of mortgage equity, but perhaps people are also selling assets to finance spending. Eek."
Forget Goldilocks, Think Dreamgirls
But what does it matter if we sell assets to finance spending if the total value of the assets in our portfolio keeps rising? We are back to 1999. It really does look like Goldilocks this time. Oh, there are some rumblings here and there, but overall, Mr. and Mrs. Consumer Investor are quite happy to party on. Equity markets are going for new highs. Credit spreads are tighter than ever (except for sub-prime debt). Mergers, buyouts, and new debt issuance are at all-time highs. What's not to like? Michael Hewitt of Harch Capital Markets has the best line: "Goldilocks has been left in the dust. We are now gettin' down with Dreamgirls.
So should we be concerned? Why even think of comparing today to 1999 or 2000? Perhaps because of the half-dozen forward-looking indicators which typically (and up to now reliably) forecast recessions, like the inverted yield curve and slowing housing. I have written about them for the past few months. New readers can read those letters in the archives section at www.2000wave.com. Now comes Dr. John Hussman to give us yet another reason: valuations may not be as low as you think. (www.hussman.com)
I quote at length because this is so good:
"Charles H. Dow, who edited the Wall Street Journal a century ago, once observed 'It is impossible to tell in advance the length of any primary movement, but the further it goes, the greater the reaction when it comes, hence the more certainty of being able to trade successfully on that reaction... The best way of reading the market is from the standpoint of values. To know values is to comprehend the meaning of movements in the market.'
"Dow's successor at the Wall Street Journal was William P. Hamilton, who was also a brilliant observer of the market. Hamilton observed that bull markets generally occur in three phases. As Richard Russell summarizes: 'Phase one is the rebound from the depressed conditions of the previous bear market. Here stocks return to known values. In the second and longest phase, shares advance in recognition of improving business and a rising economy. During the third phase they spurt skyward on the hopes and expectations of a continuing rosy future... The low-priced 'cats and dogs' historically make great moves in this third phase...'
"As another follower of Dow, Robert Rhea, once wrote: 'the final stage is sometimes recognizable because people then buy stocks simply because they go up, and because other people are buying them.'
"With the S&P 500 currently trading at nearly 18 times fresh record earnings, on record profit margins, it seems clear that the current bull market is well into its third phase. To anyone who examines more than one or two decades of market history, even a multiple of 18 is very rich by historical measures, and can't be reconciled simply by reference to interest rates or inflation.
"On closer inspection, of course, valuations are even more hostile. Over the past three years, profit margins have widened to record levels, which has detached P/E ratios from other fundamental measures - such as price/revenue, price/dividend, and price/book ratios. The S&P 500 is currently about double its historical norms on those metrics. That isn't a forecast that stocks have to eliminate that valuation gap, but it certainly does suggest that stocks are priced to deliver unsatisfactory long-term returns from these prices.
"It bears repeating that if profit margins were at normal levels - even on the basis of profit margins that prevailed during the 1990's (indeed, anytime prior to the past 3 years) - the price/earnings ratio of the S&P 500 would currently be nearly 25. Unless investors want to speculate on the notion of a 'permanently high plateau' in profit margins, the stock market is strenuously overvalued at present. Neither current earnings nor 'forward' earnings should be considered - in themselves - as anything close to robust or reliable metrics of value here."
Hussman's reference to a "permanently high plateau" is from that famous quote:
"Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as (bears) have predicted. I expect to see the stock market a good deal higher within a few months." - Irving Fisher, Ph.D. in economics, Oct. 17, 1929, a few days before the big crash and the beginning of the Depression
Maybe I just don't get it. Scratch that. I clearly don't get it. I simply don't see the risk versus reward of the broad stock market at these levels, with all the warning signs we can see today. To argue for higher market levels, as almost every economist is (Barron's in their recent roundtable forecast had not even one bearish participant), is to believe that this time it's different. It almost never is.
I admit to the possibility. But I find it hard to risk capital in long-only stock investments, my own or clients', in what looks and feels like 1999. Party on, Garth!
The Billion Dollar Cowboy
I have an office in what many think is the best baseball stadium in the world, The Ballpark in Arlington, recently and infamously known as Ameriquest Field. I look out over right field, and often watch games from my balcony with friends. It is a dignified structure, which harkens back to the feel and spirit of baseball from earlier generations. They built four floors of commercial offices in the enclosed outfield, and I was lucky enough to get one 12 years ago. I enjoy sitting on my balcony at night, with the stadium empty, just basking in the glow. It enriches the soul. Every off-season for 12 years, I have wondered what it would be like if only the Texas Rangers could get some pitching. The stadium cost $90 million to build and was funded mostly by a local sales tax. The naming rights were sold a few years ago for $70 million. Did the city taxpayers get any of that? Dream on.
And now, a few hundreds yards away, there are six massive cranes working on what will be a 300-foot-tall new Texas Stadium for the Dallas Cowboys. The plans were unveiled to the public this week. To say it is Texas-sized is almost an understatement. And you could not have a more stark contrast to the stately Ballpark. This is a steel and glass monument like no other field in the world. It can seat up to 100,000 (though games will typically be 80,000). It will be the largest such venue in the world, and in theory will be open in 2009. (http://stadium.dallascowboys.com/)
The video screen hanging 110 feet above the field will be 60 yards (180 feet!) long and weigh 600 tons. The end zone seats get screens that are merely 48 feet wide. Monster screens will hang outside the field for those who just want to come and tailgate.
The two steel arches supporting the stadium are over one-quarter of a mile long and will be the largest single-span arches in the world, bigger than the St. Louis arches. The Statue of Liberty could fit under the retractable dome. Each end zone will have a glass door 120 feet high and 180 long, which can be opened in just 18 minutes.
And the cost? $1 billion, give or take. Ten times the cost of the Ballpark. The taxpayers are contributing $350 million, plus a ton of new roads. The mind boggles at the expense, both public and private.
I drive past the construction most days, on my way to the gym. The new stadium will be right across the street from a monster Wal-Mart. A sign of the times? I am not sure what it is a sign of. I have only been to a few Cowboys games in the past ten years, preferring to watch football on TV for the replays. But a 180-foot screen? I will actually probably attend a few games now, as the experience will be totally different.
The kids are starting to gather for Christmas, and the whole crew will be here by the middle of next week. The girls are demanding Dad take them salsa dancing tonight, so I am going to have to hit the send button soon, as I have to get there in time for lessons. I must confess to liking to dance, but somehow I do not have the feel for the salsa. Maybe that is why I cannot understand the markets - I have no innate rhythm.
I hope you are having a great holiday season. I certainly am. And Peter and Barbara Bernstein are coming to Dallas, and I get the privilege of having dinner with them next week. Right now, I intend to write next week and then take off for the New Year weekend and then come back with my 2007 forecast issue.
Your wishing he had his shopping done analyst,