What's Priced In?

By my read, the landscape changed Friday. While the market was crushed, with important support violated and a test of the August lows certainly suggested now, I found it quite interesting that the Financials actually held in pretty well. Only Staples and Healthcare performed “less worse”. It was clear to me that the potential for a Fed ease imminently went up, but, so only because the chances of a near-term downturn in the economy did as well. So, while investors have been avoiding the carnage in Financials by rotating into other sectors lately, Friday was all about reassessment of that strategy. Earnings are at risk.

A client of mine who has also been bearish kept asking me if all of the bad news was already priced in as the market recovered somewhat over the past few weeks. While I certainly believe that the debate has become open and spirited regarding the economic outlook, I have maintained, without a lot of tangible evidence, that the “consensus” appeared to be that like so many pullbacks since the market rally began in late 2002, this was something to buy not sell. Last week, a couple of reports and a product announcement and the stock reactions gave me a little bit of the evidence I had been seeking: The Costco (COST) and Harley-Davidson (HOG) reports demonstrate that the consensus is underestimating what could be a significant downturn. Apple’s (AAPL) much heralded news conference confirmed that we are in a new environment. These are all very well-known companies, so the reactions certainly don’t represent the inefficiencies that one might expect in small-cap names.

COST had been humming along, buoyed by the widespread belief that the mortgage woes wouldn’t impact its upper middle-class client base. Their suddenly weak same-store sales growth this week, though, of just 2% (5% had been the expectation) and 1% decline in traffic was caused by a multitude of factors, but investors woke up to the fact that this one isn’t as safe a bet as they had previously believed. What was priced in? Certainly not any susceptibility to a high-end consumer slowdown.

The symbol HOG, which used to be HDI, conjures up a new vision. Not only does it represent the product for which the company is famous, but it also suggests the “slaughter” that investors have endured recently. Perhaps it was a marketing ploy that recently inspired Sun (JAVA) to make the switch, but the company got a nice run following the change 13 months ago. While HOG’s report this past week was atrocious, the response of the market (down almost 10%) suggests that even when the market sees a wounded duck, it treats it like a soaring eagle (beware soaring eagles if you should disappoint!). As you can see in the chart below, the stock has been selling off all year, estimate revisions have been negative and the PE was already so low that it seemed to suggest that the numbers had to come down. So, what was priced in? Clearly, not a really bad month of August.

AAPL put in what technicians term a “double top” this week. AAPL has been a stock priced for perfection and a company executing flawlessly, creating severe performance issues for large-cap managers underweight the name. The stock ran up into the “special announcement” mid-day Wednesday, but, unlike anytime that I can recall in the last few years, the news brought on selling as soon as the presentation began. By the time it was over, the stock had traded down but bounced nicely off of the 10dma. The next day, same price action, but it bounced off of the lower 50dma. On Friday, it busted through and closed below. Take a look at the chart below and you will see the scary part: The volume was even higher than in the panicky early days of August. I have been skeptical that this company that sells primarily to consumers would be able to continue to execute flawlessly, and the iPhone price cuts seemingly support my view. What was priced in? What is priced in now? The stock still trades at a lofty 5X sales and 30 PE, so I think that not too much bad is priced in at this point.

Those were three specific things that really jumped out at me this week, but here is an interesting tidbit. Mark Hulbert, in Barron’s, had a great article about newsletter writer sentiment. His last few paragraphs summarize his data quite well:

The bottom line? None of these nine top timers are bearish. The average equity allocation among all nine is 92%. This is higher than where this average stood a year ago, as well as where it was in early May.

This 92% average is good news for the stock market in its own right, of course. But it's particularly bullish relative to the average forecast of the 10 stock-market timing newsletters with the very worst risk-adjusted performances over the last decade. The average recommended equity exposure among these worst performers right now is 0%.

In other words, the worst market timers are quite bearish right now, while the best timers are quite bullish. Rarely are we presented with a contrast this stark.

There are no guarantees. But to bet on a new bear market right now, you have to bet against the timers with the best long-term records and with those whose records have been awful.

I would imagine that the world knows who these 9 services are (they are mentioned by name in the article). I am not sure who the bottom 10 are, but it begs the question: How can I be confident in my position when the guys who seem to get it wrong all the time are of the same view? The broken clock is right twice a day, I know. I also know that even the blind squirrel finds a nut occasionally. But really, can these guys who ALWAYS seem to get it wrong be right now? The short answer is that I don’t know, and I don’t really care. The quant funds were “getting it right” until they weren’t. Looking at the 9 that Hulbert profiled, the only things that stood out were two guys who seem to like to buy dips (which has definitely worked over the past decade except in the bear market). Without more information, no one is really in a position to judge their positions. Even Bill Miller gets it wrong every now and then. So, while I admit a bit of concern being in sync with people who have not done a good job over the past ten years, I am comforted that what I think might happen is probably not priced in. My guess is that no one listens to these guys anyway, but they are aware of the bullish newsletter writers that Hulbert cites.

I want to conclude with three charts that depict ways that things could be worse than what is “priced in”. The major point is that the easy credit in so many different aspects of our economy over the past several years has pulled demand forward, yet it has still petered out. I think that what is priced in is that the Fed will ease enough to fix the problems. Careful analysis, though, shows that lower rates can’t help the consumer if lenders don’t pass them through. No rate will make an upside down mortgage suddenly work. Further, given that we are essentially at full employment, we can’t really count on an increase in overall personal income coming from growth in the payrolls. So, it doesn’t surprise me that gold, traditionally seen as an inflation hedge, soared this week. Inflation and government bail-outs are the only things that will work besides time (I vote for the latter).

Autos

Everyone knows that new car sales have been weak (though used car sales have been strong). Is it priced in that they could actually weaken further? Note that through July, inventories were GROWING (3rd panel) despite the decline in sales (August sales were down y-o-y again). So, car sales are down 5-10%, but historically, recessions have seen declines peak at 15-20%. Typically, one would expect inventory growth to go negative before a bottom is in. Is anyone looking for a decline of 20% from these already “depressed” levels?

Housing

Everyone knows that Housing has been weak, but could it actually get a lot worse? There are several things that stand out about the past 12 years since the Existing Home Sales began their 10-year run that came to a halt two years ago. First, it coincided with a major tax law change (improved capital gains treatment) that allowed older owners with significant equity to trade down. Second, that same tax law change helped boost a huge run-up in the cost of housing (not the only reason). Third, the stock-market crash really improved the perceived value of a home as a financial asset (prices held up very well, turnover reacted much better than typically during recessions). Fourth, rates have been low and remain low (how much lower would they have to be to stimulate more demand?). Fifth, speculation is at an all-time high. So, now we see that home sales, both new and existing, have been plunging and prices have been slightly negative. But, what is priced in? Most of what I read consists of attempts at calling for a bottom or at least stabilization, but could it get worse? Prices historically can fall more and/or can stay down for longer. This boom is in many ways unprecedented. Won’t the bursting of the bubble be as well? The recent expansion of existing home inventories in absolute terms is very troubling. The inability to sell one’s home should you desire to relocate or to move is one of the most frustrating experiences I have ever personally experienced. As more and more people face this burden, it is likely to take a toll on consumer confidence.

The last chart addresses overall consumer spending. I understand that there is a lot of debate about the value of the Personal Savings Rate, but it seems clear to me that in the long-run, Personal Income drives Personal Consumption. In recent years, though, consumption has been fueled by something else (the home equity extraction). We are already seeing a halt in the 20yr decline in the Personal Savings Rate (at zero), which “coincidentally” began just as the housing market peaked. Retail sales remain quite muted relative to the overall rate of consumer spending. Data shows that consumer credit expansion, though, has been at a much higher and increasing rate than overall retail, suggesting that either balances are running up or that perhaps more people are borrowing than before (revolving and non-revolving). In any case, what is priced in? In the last recession, despite the plunge in Personal Income, real consumer spending never went negative as is typical in a recession. If we were to go into a recession now with consumers unable to play the refi or HEL games, will that be the case this time?

So, I will remain “Armageddon Alan” as my friends and clients now think of me. I think that this time is very different from other times, with the primary distinctions being that we are bursting a very big bubble that touches more people “closer to home” than the equity crash did in 2001-02. The tightening of credit won’t be limited to just housing. The pundits keep telling us that there either isn’t a problem or that it is contained. We are sitting at full employment with rates that are already pretty low historically. Lowering the Fed Funds rates in almost certain to be ineffective but risky (inflationary possibly and dollar-crushing probably).