Wall Street vs The Economy
10/15/06
PIMCO wrote in their latest quarterly report the following: "The combination of robust U.S. consumption, massive Chinese investment spending and positive feedback effects in Japan and emerging economies produced growth over the last year that exceeded PIMCO's expectations. Expansion prompted tightening by central banks to contain inflation that has been mild but accelerating. The Bank of Japan, the European Central Bank and perhaps still the Federal Reserve are embarked on an uncertain path of interest rate hikes that could, if pursued too aggressively, derail the global expansion. "
This statement reflects my own thoughts better than most other statements. The resiliency of the US consumer has been often questioned, especially in Europe. The decline in housing prices was to finally put an end to endless (mindless?) consumption or so the theory goes. Indeed, we already saw some cracks in the armor, but to this day we are all still awaiting the big swoon that many have predicted. If it does not come soon (like within the next quarter or so) the theory will become stale. Much depends on the price of energy. Gas prices declined by some 30% over the last 3 months and that puts a lot of money into consumers pockets. Still, every forecaster knows that there only so many one time events that can serve as an excuse before he needs to admit that the forecast itself (and not just the timing) was wrong. Nevertheless, the economy is slowing and consumers just might be on the verge of caving in about now. The fourth quarter is going to tell us. Look at the chart below, which came courtesy of the Institute of Supply Management and depicts several components. The PMI (Purchasing Managers Index) has been shown in this place many times over the past 5 years.
The message is clear. The economy is slowing and some sub-indices such as the employment index and the backlog of orders have already entered recessionary ground. A weekly gauge of future U.S. economic growth, the Leading Economic Indicators (LEI) slipped in the latest period in response to weaker housing activity and rising job claims, a report showed on Friday. Its annualized growth rate also edged down. The Economic Cycle Research Institute, an independent forecasting group, said its Weekly Leading Index fell to 135.6 in the week ended Oct. 6 from 136.4 in the prior week. "With WLI growth stuck in the doldrums, U.S. economic growth is likely to continue easing for the foreseeable future," said Lakshman Achuthan, a managing director at ECRI. The index level declined due to slower housing activity, higher jobless claims and lower commodity prices, marginally offset by higher stock prices, Achuthan said. The ECRI's index for new orders in the manufacturing sector also declined.
Meanwhile, we are in the midst of the yearly period characterized by performance anxiety for investment professionals. The last quarter has begun and many Hedge funds - investments for institutions like pension funds and endowments and the wealthy - have hit a rough patch. Recently, a well-regarded fund, Amaranth Advisors, made a wrong-way bet in the energy markets and lost more than $6 billion in a week. It will dispose of its remaining assets. Even the flagship hedge fund run by Goldman Sachs, whose trading prowess has few peers on Wall Street, fell 10 percent in August. A fund at Vega Asset Management, once among the 10 largest hedge funds in the world, fell more than 11.5 percent in September, leaving it down 17.5 percent for the year due to a bad bond/interest rate bet. Its assets, which once topped $12 billion, are now $2 billion to $3 billion, a person close to the fund said. The excess liquidity still sloshing around the globe has finally eliminated almost all mispriced assets worldwide. Declining returns have forced many hedge funds to increase their leverage and therefore their risk profile, which in many cases blew up in their face. Now, half a decade later, many have come full circle and find out that the U.S. stock market (of all investments) seems significantly undervalued. Coupled with the aforementioned performance anxiety this might make for an explosive fourth quarter coctail. Many funds had bet on a continuation of the "one-way-bet" in energy and raw materials but that misfired. Against their expectations oil declined by $25 from peak to trough and natural gas by over 65% in 12 months. Gold fell from $725 to $550 and Lumber fell from over $350 to $232 in less than 6 months. Now every hedge fund seems to be scrambling and it seems that they all want to make up their negative returns by investing in good old American stocks. The result is that every data item coming down the pike is treated as good news. Revised employment data are bullish because they signal a strong economy and a continued rise in corporate earnings. Bad news, like the weakness in retail sales, is bullish because it will keep the Federal Reserve from lifting interest rates. The old saying goes that the market can stay irrational longer than anybody can stay liquid. This is still true today. I am not saying that we have entered a phase of irrational exuberance (yet), but the stock market sure acts in recent days like investment managers are panicking into the market. How long this might last is unclear but economic indicators seem to play second fiddle at the moment. It can be fun while it lasts but don't get greedy. The market always dealt with hubris in a most unkind way.
Hermann Vohs
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
