The Week Ahead: When the Liquidity Dries

by: Markos Kaminis
Bye bye miss American pie, singing that will be the day the market dies, that will be the day liquidity dries... You know, I almost altered topic when I heard about this foiled "terrorist plot" concerning JFK, but after further inspection, these idiots were nowhere near effecting their scheme and didn't have the capability to do so either. And don't worry, Chinese markets should not even catch wind of the news, considering the censored media box its communist rulers contain the population within. Actually, they'll probably hear about it, but America is just some fictional place to them anyway, where Mickey Mouse and Cinderella reside, and where evil men make military plans to aid the Japanese in the next invasion of China.

Nah, there are more important things to talk about than the potential return of the terror risk premium. There is a much more threatening danger ominously hovering over our great land, even more scary than a nuclear Iran. Liquidity, now as abundant as Chinese investors, may soon face drought conditions. I'm positively certain this argument will find criticism, sort of like how global warming does, and I'm absolutely sure people will forget I mentioned it when they can't find buyers for their Dow shares down the road.

I remember back in the good old bad days after the tech bust, when it began. You see, during the good times that preceded the loss of millions for many of my friends in the big city, companies didn't know what to do with all the capital they had flowing in. They spun off ideas that were generated in the mail room, and Ph.d's right out of junior college were finding investors for flywheels that could increase energy efficiency by 5% in 2025. You could do anything back then, and more importantly, you could sell anything.

But, after the meltdown, when people came to their senses and realized the "new economy" was just an excuse for ridiculous prices, companies started to take better care of capital. It was a reactionary response really, and that's what swings the pendulum of business cycles. In the years that followed, my colleagues in the analyst community went from using phantom metrics to old school valuation tools like price-to-book value. We started to notice balance sheets inflating. Microsoft (NASDAQ:MSFT) was one of the notables most easily identified, but not alone. Everybody was hoarding cash.

After a while, when it became clear the sky was not falling, activist investors started to ask what the heck their managers were doing with all this capital wasting away. And M&A activity resumed, while more recently, the private equity buyout binge began. At the same time, those wary of the Carl Icahn's of the world, started buying up their own shares, after all, it was a respectable thing to do. Nobody paid dividends anymore, but they started to again. And that brings us to today's excesses. We have come too far. The pendulum has swung full, and it's time to get out of the way of it's return.

I read this weekend that private equity buyout premiums are some 33% above last year's level. It's a fact that everybody is seeking the next takeout target. Every Monday, guys like me can't wait to see the wire to find out who else is going private or merging. Prices are inflating as a result. Not every company is going to go private my friends. You will not have to replace equities with art and antiques any time soon. Gold might not be a bad idea though, and oil and water even better. Eventually, this excess will be exposed as well.

Where's all the capital coming from, you are likely asking... but, you know the answer. Everywhere! Even China opened up foreign investment to it's citizens, though in some perverted communist manner, to try to stem the local splurge within its own market. Governments across the world are also taking part, moving some capital from dollars into securities. I point to China's interest in Blackstone as a prime example. Most of our money is flowing into emerging markets and now large cap shares, especially multinationals. So, what's to stop the spigots then?

Clearly, the most important risk factor to liquidity, and one discussed here often, is conflict with Iran. The mayhem that would result, likely involving Saudi and/or Kuwaiti facilities threaten global energy resources in an already tight operating environment. We are operating on a 20 day inventory of gasoline, so should supply become strained, get ready to line up at the station on every other day again. Another factor that could dry liquidity in the near term is a softening consumer. Higher fuel and food costs, as well as other costs of living increases including rising mortgage payments for many, should impact consumer spending. That impact should result in tighter margins that could lead retail, restaurant and other services sector businesses to reduce workforce, which in turn further impacts spending.

What happens if the consumer reduces savings, rather than spending, then 401k flows may lighten. I broached the topic last week. If retirement fund flows are cut so the family can enjoy a summer vacation this year, that too could strain the system. There are many things that can happen to dry liquidity, the least of which is rising share prices adjusting in premium for acquisition potential. The market adjusts. Nothing good lasts forever. Arbitrage opportunities are exploited and disappear. That's life in the big market. Now, let's take a look at the week ahead, which by the way, provides a good bit of insight into consumer sentiment and spending.

This week...

Monday kicks off a significantly lighter week's worth of data compared with last week's full slate. At 10:00 a.m. EDT, the Commerce Department will report April factory orders, and expectations are for an increase of 0.7% according to Bloomberg. This is a more complete reading than the durable goods orders report from a couple weeks ago, as it includes durable and nondurable goods. Previous data has been all over the place on this one, but last month's report for March showed an increase of 3.1%.

Deutsche Bank kicks off its Media & Telecommunications conference on Monday, and Krispy Kreme (NYSE:KKD) will hold its shareholders meeting. United Rentals (NYSE:URI), which I followed as an analyst, will also hold its shareholders day Monday. Though earnings season is mostly over, notable reports for Monday include Bob Evans Farms (NASDAQ:BOBE), Credence Systems (CMOS), Financial Federal (NYSE:FIF), IDT Corp. (NYSE:IDT), Sigma Designs (NASDAQ:SIGM) and a handful of others.

Tuesday brings the usual retail reports from the ICSC-UBS and the Redbook to help us track consumer spending. The ISM Nonmanufacturing Survey should also help us to better understand the state of the economy, as it measures the vast service sector that dominates American business. The ISM is seen unchanged from April's measure of 56.0, according to Bloomberg's consensus.

The International Monetary Conference is meeting in Cape Town, and General Motors (NYSE:GM) is holding its shareholders meeting Tuesday. Reporting earnings, look for janitorial services firm ABM Industries (NYSE:ABM), Copart (NASDAQ:CPRT), FuelCell Energy (NASDAQ:FCEL), Guess (NYSE:GES), PLATO Learning (TUTR), School Specialty (OTCPK:SCHS) and others.

On Wednesday, the Mortgage Bankers Association will report weekly mortgage applications. The monthly Challenger Job Cut Report will add more color to the employment picture, as planned corporate layoffs are announced. The reported figure for April was 70,672. Last week's Labor Department report noted within the details that a lot of the job growth came from health care and restaurants and bars, and manufacturing lost personnel. Construction was mysteriously flat. There has been much debate about the accuracy of these figures, and Alan Abelson sheds some color in this week's Barron's.

The European Central Bank Governing Council will report its decision on interest rates for the Euro region. The ECB kept rates steady last month, but an increase is very possible this time around. The revision to first quarter productivity will be reported at 8:30, with expectations for a 1% increase. Unit labor costs are expected to have risen 1.5%. If this holds true and costs rose more than productivity, the Fed should be a bit bothered by the prospect of labor pressure on inflation. And right on cue, Federal Reserve Bank of Richmond President Jeffrey Lacker, Mr. Hawk to you and me, is addressing an audience on inflation.

The New York Society of Security Analysts is holding its annual meeting on metals and mining in New York. These meetings give me goose pimples, as I was scheduled to attend one on September 13, 2001 in the World Trade Center. It was horrible that morning when I had this sinking feeling like I needed to be somewhere, and then realized just where. My life may have been altered by just 48 hours, and many poor souls were.

This week's Petroleum Status Report has the potential to take gas prices back a drop, depending on how capacity utilization fairs, the direction of gasoline inventory and degree of change. We anticipated gasoline may have peaked recently, barring a severe hurricane hit in refinery territory. Wednesday's earnings reports include DSW (NYSE:DSW), Korn Ferry International (NYSE:KFY), Martek Biosciences (MATK), Shuffle Master (NASDAQ:SHFL) and others.

On Thursday, the Bank of England announces its decision on interest rates after having hiked a quarter point last month. Weekly initial jobless claims will be reported at 8:30 a.m., with a consensus view for 310,000. The estimates on weekly jobless claims seem to always be close to the prior week's figure, so they may be somewhat unreliable. Wholesale trade and inventory will be reported on Thursday as well, with the consensus looking for an April inventory increase of 0.3%, versus the same rise in March.

Consumer credit is seen increasing by $5.0 billion, according to Bloomberg. We suspect the consumer is nearly tapped out, and this figure might provide some insight. Credit rose $3.0 billion in February and $13.5 billion in March. May chain store sales should be reported on Thursday as well, providing further insight into the state of consumer spending. You would think we would get some real proof supporting our theory or disproving it perhaps this week, but it's still early to tell. We anticipate the next few months will tell if we are correct or not. However, this week's Barron's interview with Chief Investment Strategist Steven Leuthold supports our view for consumer softness and economic recession.

In an important ruling, the U.S. International Trade Commission is set to decide on the Qualcomm versus Broadcom patent battle. Reporting earnings on Thursday, look for Analogic (NASDAQ:ALOG), Bio-Reference Labs (NASDAQ:BRLI), Lakeland Industries (NASDAQ:LAKE), National Semiconductor (NYSE:NSM), Smithfield Foods (NYSE:SFD), Volt Information Sciences (VOL) and others.

Friday's international trade deficit is expected to have narrowed to $63.3 billion in April from $63.9 billion in March. China trade was a hot topic in this weekend's New Hampshire presidential debates. For a change of pace, I watched the democrats this time around, and I came away confident that there are some fine individuals on both sides of the table. Finally, the RBC Cash Index will provide even more insight into consumer sentiment. Reporting earnings on Friday, look for Kellwood Company (KWD), Vail Resorts (NYSE:MTN), and a couple others.