ContraHour

Parabolic Move In Crude Oil Is Looking Extended

This is a bit of a stretch but a comparison of the current price of Crude oil futures and the Dow Industrials from 1987 would indicate that crude is getting a bit extended. 

The following shows a daily chart of crude oil futures hitting a DeMark Sequential 13 count.  After an already strong run higher, Crude has gone parabolic in the past two weeks.  This type of advance is not sustainable and often leads to a price collapse. 

The Dow Industrials in 1987 traced out a similar parabolic pattern on the final run to the highs and began rolling over shortly after hitting a DeMark 13. 

In addition, the following chart indicates that the weekly chart of crude futures have also hit a DeMark 13, although the price has run a bit further than I would like. 

All in all, it looks like crude could begin a multi-week process of rolling over after its astounding run.  If you bet against crude, remember to use a reasonable stop ore wait until price breaks down.  Parabolic moves can often run much further than you imagine. 

If you're bullish...

According to Mark Hulbert at Marketwatch.com, Trimtabs says we have been in a recession for six months and could be turning up out of it...

TrimTabs, the investment research firm in which Goldman Sachs Group Inc. in February became a minority shareholder, has both good and bad news about the U.S. economy.

Let's start with the bad news: Not only is the economy in a recession, according to TrimTabs, it has been in one for six months now. The only reason that this isn't more widely recognized is that it takes months, if not years, for the government to officially confirm that a recession has started.

Now the good economic news from TrimTabs: There is a distinct possibility that the economy has already emerged from the recession, or is about to.

TrimTabs bases this relatively cheerful assessment on an analysis of daily income tax withholdings from the U.S. Treasury. According to Madeline Schnapp, director of macroeconomic research at TrimTabs, withholdings during March were 4.1% higher than one year ago.

According to an econometric model that TrimTabs has devised based on the Treasury's withholding data, Schnapp is estimating that the U.S. economy added 48,000 jobs in March. That's not spectacular job growth, to be sure, but better than the diminution in total employment that TrimTabs believes occurred in previous months.

Schnapp hastened to add that we should not expect this job growth to show up in the employment numbers that will be released this Friday by the government's Bureau of Labor Statistics. That's because, she said, the bureau uses a "backward-looking methodology (that) usually misses economic turning points."

In fact, Schnapp is predicting that the bureau on Friday will report that the economy lost between 75,000 and 100,000 jobs in March. In effect, TrimTabs is warning investors not to be overly concerned about such numbers, should the bureau report them to be this bad.

The daily tax withholding data from the Treasury Department is not the only reason that Schnapp believes we should ignore the bureau's numbers.

Another is the TrimTabs Online Job Postings Index, which the firm describes as a "proprietary measure of online job availability." According to Schnapp, this index bottomed in early January and rose 1.2% in the past four weeks. She argued that "if the economy were collapsing, this indicator would be dropping like a rock, just like it did in 2000 and 2001."

Though the Hulbert Financial Digest does not track TrimTabs, it would appear to have navigated the market's gyrations in recent years quite well. When I last wrote about its jobs growth projections, in May 2005, the firm was aggressively bullish, recommending that clients be 200% long - fully margined, in other words. That was a good time to be bullish, as we may recall. See May 2005 column

The firm turned bearish Oct. 15, within shouting distance of the market's top. They remained bearish until March 23, when the firm turned neutral, and on March 31 it became moderately bullish, recommending an equity exposure level of 50%.

What would it take for the firm to recommend a higher exposure level?

Schnapp, in an interview, indicated that one factor that would likely lead her firm to become more bullish would be a marked increase in share buyback activity among U.S. corporations.

Even absent such a turn of events, however, Schnapp is willing to say that "once panicked investors realize that their fears of a deep and prolonged recession are not materializing, U.S. stock prices could shoot up very quickly."

If you're bearish...

If you're bearish, the current rally can simply be viewed as an unwind of the bets made by leveraged hedge funds.  The following explination comes from Contraryinvestor.com...

Before rushing to judgment about new bull markets and new cycle credit market and economic expansions based on what we may have "seen" in short term financial market movement, at least personally, we're going to need a little more corroboration.  Yes, call us conservative.  Yes, call us skeptical.  Extremely guilty as charged.  Why?  First have a peek at the following table.

                   

Asset Class/Investment Vehicle	Price Change From 9/18/07 to 3/14/08
Gold	38.1%
Crude Oil	35.5
Natural Gas	38.0
CRB Index	30.0
XLF - Financials	(30.2)
XLY - Consumer Disco	(19.9)
XBD - Brokers	(33.8)
FRE	(63.7)
FNM	(63.6)
US Dollar	(9.5)
Philly Housing Index	(24.2)

                                       

Now imagine for a second we could turn back the hands of time to the date of the first Fed rate cut in September of last year.  Imagine further that you had suddenly and miraculously been blessed with omniscient financial market foresight that was set to expire, if you will, on Friday the 14 of March in this year.  You are a hedge operator and need to structure a leveraged portfolio for this duration of time.  As you already know by now, the absolute dream levered portfolio would have been long oil, gold, commodities in general, and short financials, discretionary stocks, the brokers, the GSE's and the housing related stocks.  You would not have hit a home run with a portfolio like this, but rather would have been viewed on par with the second coming of the Messiah.  Long the top four asset classes you see above and short the bottom five could have been close to a career maker for many an investor up until a few Friday's ago.  Do you think what have been over time trends in these asset class prices escaped the notice of the levered speculating community?  Do you believe those chasing short term performance would not have signed over their first born children to have participated heavily in these trends?  Do you really think the ship was not meaningfully listing to one side by those who had collectively put this very trade on since the first Fed rate cut?

Before answering these questions, have a look at the next table.

            

Asset Class/Investment Vehicle	Price Change From 3/14/08 to 3/20/08
Gold	(8.0)%
Crude Oil	(6.3)
Natural Gas	(8.2)
CRB Index	(7.0)
XLF - Financials	10.6
XLY - Consumer Disco	4.2
XBD - Brokers	3.7
FRE	53.8
FNM	53.4
US Dollar	1.5
Philly Housing Index	9.2

          

We're sure you are fully aware of what we are getting at here.  What occurred in the week after the Bear Stearns debacle was simply the dream levered hedge portfolio of the last six plus months being turned completely on its head.  And what it clearly suggests as one potentially very meaningful driver of performance during that week was levered speculating community leverage unwinding.  A leverage unwind that is not finished.  As we're sure you already know, if indeed you were a levered fund either choosing or being forced to unwind a portfolio perhaps due to the heavily increased margin/collateral capital calls from the prime broker community in the wake of Bear's sudden submergence, the influence of collective levered portfolio unwinding (raising liquidity) might have looked exactly as is detailed in the table above.  To delever you would have sold what you were long and bought what you were short.  So although the CNBC fan club may indeed have tried to celebrate the big bear market bottom for the financial markets, what we may have indeed experienced is simply more significant major macro credit cycle reconciliation - levered investment position unwinding (the hedge and levered speculating community).  Seems relatively logical, no?

And this is the very reason why we suggest meaningful reluctance in proclaiming an all healed and ready to head higher credit cycle that has all of a sudden been reborn due to the fact that a few financial stocks jumped off of their collective death beds.  Although the Fed members have apparently been reannoited as miracle workers, have they really addressed and/or ameliorated THE real problem of the moment which is financial sector balance sheets still loaded with problem credits?  Balance sheets now problem long and capital short.  Quite unfortunately, and we simply wish along with the Street that it weren't true, a one week change in stock prices does not change balance sheet asset values, especially those values tied to real world residential real estate prices and increasingly commercial real estate values.  So for now, despite the emotional and financial price roller coaster ride of recent weeks,  we reserve judgment on the true character of fundamental credit market, financial market and real economic change that has taken place.  We watch and learn.

"Bear"ied Below The Headlines?...We want to briefly take these comments just one step further in light of a number of financial sector acquisitions we have witnessed this year that would most clearly have had an influential outcome in a good number of credit default swap positions.  Further, why the credit default swap market may indeed be influencing financial market outcomes well beyond the singular world of derivatives.  We'll make this quick.  You may remember that just last month we devoted an entire discussion to credit default swaps, the leverage that had been built up inside of these contracts, and the potential for risk and unintended consequences therein.  We showed you US banking system derivatives exposure numbers through the third quarter of 2007, as well as what has been the growth in this segment of the broader derivatives world globally.  Please remember, as we described, this derivatives neck of the woods has moved well beyond simply acting as a form of insurance against long oriented bond or credit market positions held by investors to a world of growth in credit default contracts outstanding dedicated to nothing more than the trading of these vehicles themselves.  As we told you then using GM as an example, the credit default vehicles written against real world outstanding company bonds is probably near three times the volume of actual bonds outstanding.  Like many derivatives vehicles, these derivatives products have become an end in and of themselves as opposed to the purity of use of these vehicles to simply insure or hedge against adverse outcomes protecting larger financial asset positions actually held.  Simple translation?  The credit default swaps world has taken on a life of its own.         

Alright, fine, so how does the credit default swap market relate to equity market sector volatility of the moment?  It is absolutely clear that the "acquisition" of Bear avoided triggering Bear Stearns related credit default swaps and swaps against  CDO, SIV, etc. positions they may have held (assuming a potential Bear BK would have forced a mark to market event), which would indeed have happened had Bear formally entered bankruptcy and their bonds/debt became potentially very meaningfully impaired.  There is simply no question whatsoever in our minds that this was the key reason a theoretical acquisition of Bear HAD to happen.  Remember the details.  JPM took out Bear for a couple of hundred million at the headline $2 per share initial offer level, but concurrently announced it was going to need to charge off about $6 billion as a result of the so-called acquisition.  Even at the ultimate $10  level (which is basically shut up money offered to help prevent litigation, which might also have led to asset price discovery) JPM was "telling" us Bear was worth far less than zero by the charge-off number alone.  Of course the truth simply had to be that if Bear had filed bankruptcy and the credit default swaps written against their bonds/debt/asset positions had been triggered, the credit default swap liabilities in the market would have been well north of a $6 billion hit to whomever had written those Bear specific CDS contracts.  Well north.  And that simply could not have been allowed to happen.  By the way, just as an item of curiosity, JP Morgan has exposure to over 55% of the total banking system credit default swaps outstanding.  Are we connecting the dots clearly enough for you?

Sorry, back to the issue at hand.  So Bear avoids formally blowing up and the credit default swaps written against their liabilities/investment positions, etc. now become a moot point as JP Morgan (or for the true problem credits, should we say the Fed) is the new creditor and market based asset price discovery is avoided.  Hurrah for those folks who had written these default swap contracts.  They dodged a massive bullet that was heading one hundred miles per hour directly to a certain spot between their eyes.  But what about those "investors" who had purchased the CDS contracts/insurance against a potential Bear default?  Whether they did this against existing credit market investment positions for insurance reasons or were simply holding them as a trading position is immaterial.  Those CDS contracts purchased which probably had been very profitable, and zoomed straight up in value as Bear was in the process of disintegrating, became worthless with the stroke of a pen (and a $6 billion write down to come).

Now put yourself in the position of a meaningfully levered hedge fund who had purchased CDS contracts against Bear credit vehicles.  You had levered up against what was continually becoming very profitable CDS positions or credits as Bear was heading nose first into the tarmac.  Who knows, you might have even increased the position prior to the weekend based on info your fellow good buddy hedgies were feeding you about Bear's imminent demise.  When those long CDS contracts against Bear credits/positions went to zero virtually the Monday after the JPM acquisition announcement, all you were left with was massively deflated CDS asset values relative to the prior Friday and still in place leverage.  So what do you do when you get up in the morning on Monday after the Bear acquisition announcement (assuming you slept Sunday night, that is)?  You start delevering.  You start unwinding in place inflation themed trade positions to raise liquidity.  You sell what assets you can (gold, oil, commod's, etc.) and get less short those sectors you have heavily shorted (financials, brokers, consumer, etc.) to raise liquidity and decrease total leverage against a now immediately diminished asset base.  Who knows, maybe this was exacerbated if your already freaked out prime broker sponsor put in a call or two demanding more margin now that your assets had deflated post the Bear related CDS contracts nose diving.

And it was not just Bear credit default swaps that plummeted.  As you know, with the Bear deal the Fed put in place the primary dealer credit facility, minutes before both Lehman and Goldman showed up at the window with hands held straight out.  Unquestionably CDS values related to Lehman, Merrill, Goldman, etc. evaporated for many a levered investor long those contracts.  And wouldn't ya know it, it was only one week later, after their earnings were reported, that S&P revised its "outlook" for both Lehman and Goldman to negative from stable.  And that, folks, is how it works.  Without question, the fallout from cascading CDS values for Bear and the other assorted brokers could easily have caused liquidation of meaningfully levered equity positions, both short and long, causing the very movement in sector prices we saw in the latter weeks of last month. 

Believe us, we're dragging you through this line of reasoning because we believe in the current environment it is nothing short of critical to understand and keep in mind these very important intra market relationships.  We need to understand how what we see in one sector of the financial market can have meaningful implications for asset price movement in many other parts of the very same broader financial market.  What we see in the headlines on TV is shallow, and what we "hear" on CNBC is almost meaningless.  It is the actions and unintended consequences underneath the headlines that are crucial to "see" and understand.  Can the CDS and other derivative markets influence equity market outcomes?  The derivatives tail is indeed wagging the greater financial market dog.  And it is understanding this that we believe is the key to both risk management and successful investment outcomes as the process of credit cycle deleveraging and reconciliation is sure to continue to play out ahead.  Be surprised at nothing.  Do not let short term financial asset price movements that appear illogical throw you off emotionally from remaining focused on the greater credit cycle reconciliation and deleveraging environment that now reigns the day.

Okay, now that we've dragged you through this, let's have a quick look back at another "acquisition" of a financial services company clearly on the ropes earlier this year - Countrywide.  On January 11 of this year, BofA announced the shotgun marriage of the two.  And what did we see after that?  Have a look at the table below.
         

Asset Price Movements Post the 1/11/08 BofA Acquisition of Countrywide
Asset/Investment Vehicle	Price Movement
Crude Oil	(7.0%) in 6 trading days
CRB Index	(2.2%) in 8 trading days
Gold	(4.4%) in 6 trading days
XLF - Financial Sector ETF	7.9% in 15 trading days
XBD - Broker/Dealer Index	9.7% in 15 trading days
XLY - Consumer Discretionary ETF	8.6% in 15 trading days

                

Notice anything special?  In the spirit of complete honesty, we intentionally picked a few subsequent price high and low points for each asset class really in order to get the point across that short term events in the CDS market can indeed influence broader financial market outcomes.  With the decline in gold and oil in the week after the Countrywide acquisition (which would likewise have shattered Countrywide CDS values), was it really the beginning of a straight downhill run for each asset class from there to the present?  Far from it as both turned right around and ran to all time new highs before the recent corrections.  How about the financials, brokers and discretionaries?  Was this three week nicely positive move the bottom of the bear market and economy with an all new bull market commencing thereafter?  You get the picture.  As you know, we wish we knew with absolute certainty where the equity market and the economy are headed, but no one does.  We just need to have a broad enough field of vision to hopefully ask the right questions.  And one question of the moment is the influence of interconnected leverage unwinding and derivatives markets on more conventional equity and bond market short term pricing outcomes.

If we are even close to being correct in terms of this interpretation of CDS and leverage unwinding fallout effects, we need to watch firms such as Wamu, Indymac, etc.  They might not be too big to fail as corporate entities in and of themselves, but are the CDS and other assorted derivative contracts written against or with folks like this too big to allow them to fail and trigger default swap contracts and/or counter party failures?  Talk about the derivatives market tail wagging the proverbial financial market dog.  This is where we are.

So as we move forward in the conventional US equity and debt markets, we need to remember that THE BIG INVESTMENT THEME we are going to be living with for some time to come will be deleveraging.  The wild west, devil may care credit cycle the US has grown to know, love and embrace over the last few decades is over.  We are now embarking upon and in the midst of important secular credit cycle change.  Change which will bring with it important consequences and opportunities very different than what we have come to know and expect over the past.  Will the short-term influence of now in place systemic deleveraging affect short term financial market pricing outcomes as we have already seen in recent months and as we tried to describe in this discussion?  You bet.  Please keep this in mind as you watch the blinking lights on the screen day-to-day.  We suggest that continually remembering the big and now primary investment theme of deleveraging will serve us very well in the months, quarters, and yes even years ahead.  What we are living through now is unlike any cycle of the past few decades where credit cycle reacceleration was key to forward outcomes.  Stand that on it’s head.  That’s in the past.  Deleveraging is the future.  The world is not about to come to an end, just the type of thinking and actions of the last few decades in response to the greater credit cycle that has peaked.

Bank Shots…We’ll leave you with one last thought about the near term before signing off.  Indeed it appears as though at times over the past month, we have been staring into the financial system abyss, so to speak.  Why has it felt this way?  Probably because in many senses we have been staring into the abyss.  Right to the point, at least in our minds, the near term critical issue for the financial markets is bank capital.  The commercial and investment banks absolutely must raise capital.  And that’s not going to be a fun experience.  Fed actions are only buying time.  Watch for this to come and soon.  Lehman's quarter end announcement simply reinforces this message/theme in our minds.  Why?  Because if the banks/investment banks don't act to raise capital and do it quickly, financial market and credit cycle troubles will accelerate meaningfully downward.  If indeed the capital raising process comes to pass, as we believe, the markets will stop trying to discount a crisis environment and can more realistically begin to asses by sector the implications of a very slow and drawn out economic recovery brought to you by the key investment theme of the moment which is deleveraging.

Technicals Point To Bounce For GOOG

Google has been one of the leaders on the downside during the past three months, having shed 42% from it's intra day high in November.  However, the sentiment and DeMark indicators show that the stock is due for a bounce. 

GOOG hit a DeMark Sequential 13 count on the daily chart along with tracing out a falling wedge pattern.  Falling wedges often indicate a price compression which lead to an upside reversal. 

The weekly DeMark Sequential chart is also confirming the daily.  The weekly chart shows the stock sitting on support from late last year while at the same time hitting a sequential 9 count. 

 

In addition, the weekly chart shows a spike in the put/call ratio (bottom panel of the chart) in the past several weeks.  Similar spikes in the past have lead to decent long side buying opportunities. 

All in all, it looks like GOOG is a prime bounce candidate if the markets can hold together here. 

DeMark Trifecta in Gold Says Sell

The gold futures have hit 13s on three time frames, something that rarely happens and presents a high probability of a reversal. 

The DeMark sequentials have hit a 9 on the dailies...

Source: Bloomberg

...a 9 and 13 on the weeklies...

Source: Bloomberg

...and a 13 on the Monthlies!

   

Source: Bloomberg

In addition, sentiment seems a bit frothy with the Commitment of traders report showing that the large commercial dealers going short (smart money) and the small speculators (dumb money) going long.

 

Source: Sentimetrader.com

Given the DeMark signals, it would be worthwhile to at least trim your gold positions if your long, and not get caught up in the frenzy if your not. 

Investors Still Underweight Energy

Marshall Adkins, expert energy analyst at Raymond James says that despite the tremendous outperformance of energy stocks in the past five years, the majority of investors are still underweight energy stocks.

Despite the impressive energy stock gains of recent years, today’s energy weighting is still lower than the 30-year average of 11.5%, by nearly 100 basis points, and this strongly suggests that investors are underweight energy relative to long-term historical averages. The reality, however, is that many investors have very short-term memories. Because ongoing sector rotation into energy stocks has doubled energy’s market cap weighting from 5.3% in 2002 to 10.6% currently, to many of these shorter-term investors energy stocks may well appear overweight relative to recent history. We clearly disagree with such a view. Given our thesis that long-term energy fundamentals are very bullish relative to the overall market, we are convinced that energy weightings will continue to move upward over the next five to 10 years.

Do earnings matter anymore?

From a fundamental perspective, a more appropriate measure of proper sector weightings should be sector earnings contributions. It used to be that earnings mattered and companies were valued on their ability to generate earnings and/or cash flows. Apparently, this does not seem to matter that much to today’s energy investors. As shown in the adjacent chart, the energy sector has accounted for 14.3% of the S&P 500’s earnings over the past decade (1998-2007) while capturing only 7.1% of the market weighting. In other words, energy stocks should have been valued twice as much as they have been in actuality if their market cap weighting were to match their earnings contribution. Alternatively, of course, perhaps the rest of the market should have been valued 50% lower, but that would not be nearly as pleasant.

The lowest point of the energy sector’s earnings contribution within the S&P came in 1998, a time when oil was averaging under $15/Bbl. When the price of oil went down, both in the early 1980s and in the late 1990s, investors readily discounted energy stocks, but as prices climbed, energy investors, once bitten, were much too shy to get on board. To also state the obvious: A reversion back to $15 oil, or even $40 oil, has long been highly unlikely, and it now seems utterly inconceivable given that OPEC is defending a price floor that we estimate is $60 at a minimum.

Even though energy stocks have performed extremely well over the past five years, the disparity between the energy sector’s market cap weighting and its earnings contribution has actually been widening. In 2002, for example, the weighting was 5.9% while the earnings contribution was 9.7%, a negative variance (or “underweight”) of 3.8%. With 2007 oil prices set to average at all-time highs, it is intuitive that energy’s earnings contribution has soared, and in fact it now stands at 21.7%. Also, while the market cap weighting has also increased, it is currently at only 10.6%, which means the market’s energy underweight has widened to 11.1% – nearly three times as wide as it was in 2002.

Why is there such a disparity between earnings contribution and market weighting?

The biggest reason we see behind this disconnect is that the market does not believe that $80+ oil is sustainable. As a secondary point, the market also does not seem to believe that natural gas prices, currently at relatively depressed levels, will eventually rebound. If oil prices plummet while gas continues to stagnate, then obviously future earnings come down and earnings growth turns negative. Under our commodity price assumptions, however, this scenario is extremely unlikely. For 2008, for example, we are projecting record $80.00/Bbl oil (up 18% year-over-year), followed by $85.00 oil (up 6%) in 2009. On the gas side, our $7.00/Mcf gas forecast for 2008 is flat y/y, but $8.50 for 2009 is up 22% y/y. We would note that current 12-month futures strips (~$87 oil and ~$7.50 gas) are considerably ahead of our forecasts. 

We would emphasize that energy sector earnings within the S&P are much more oil-levered (given that the mega-cap integrated energy companies are oil-focused) than the average E&P or oilservice stock we cover. To summarize, not only do we think that current energy earnings are sustainable, but earnings growth from energy companies should continue to outpace the rest of the market for the foreseeable future. The only fundamental difference we see with regard to 2008 and 2009 vs. the past few years is that energy earnings growth should be driven predominantly by oil rather than gas, at least for North American companies.

As a short term opposing view to this bullish outlook, is Ned Davis' study that shows Energy typically underperforms the market after a second Fed rate cut. 

However, this relationship hasn't worked out during this rate cutting cycle.  The Oil Services Index has actually outperformed the market in the 22 days since the last rate cut. 

Source: Stockcharts.com

I think this relative strength further bolsters the case that investors are still underweight the energy sector and are buying on any weakness. 

Contrahour does not own stocks mentioned in the post, although our clients do own other energy stocks. 

Market Slapping Me Out of My Bearish Stupor

I have been so bearish that I didn't want to post on the blog, pick stocks, or even get out of bed in the morning.  However, I've finally seen some signs that have shaken me out of my bearish stupor. 

The Henry Paulson news this morning, Bernake's indication last night that he's cutting rates again, and the equity investments in troubled banks over the past weeks, are the first indications that regulators and investors are getting ahead of the credit problems, not just trying to put out fires that have already sprung up. 

In addition, the technicals are turning up from very oversold levels.  The NYSE and NASDAQ bullish percent indicators have turned higher from levels that have typically marked bottoms in the market. 

And the "dumb money" is bearish, while the "smart money" is bullish according to Sentimentrader.com. 

All of it says to me that this is a market in which to buy the dips, not sell the rallies.   I'm not predicting a return to the old highs this year, but I'm guessing the market can chop higher for the next month.

If you're bearish (1989 Credit Crunch Redux)

I see this market like the market in 1989.  In October of 1989, the United Airlines junk bond deal for the employee led buyout of the company fell through.   This caused a similar crisis of confidence and an end of the “buyout” boom of the late 1980s.  The following chart shows what the market looked like in 1989.  Like, today, the market had experienced a sharp rally coming off of the 1987 lows. 

This is what the market looks like today…

This is what the 1989 market turned into – a giant ugly trading range that culminated in the decline going into the first Iraqi war.    To make money, you had to sell moves to the old highs and buy dips below the 200 day moving average.

I think one of the keys to determining whether we’re in a similar environment is the transportation average.  In 1989, the transports took a nasty fall after a strong run higher.  They never recovered and never even made a stab at the old highs.   That indicated underlying weakness in  the economy and the markets. 

If the transports don’t recover, I think a similar 1989 – 1990 scenario is likely. 

The other problem is that we are not at a 40 week cycle low.  The 40 week cycle has worked fairly well since the 2004 bottom.  The cycle isn’t due to bottom until November.  Therefore, we’re probably in for another test of the lows at some point in the next several months. 

And all this leads investors to seek the safety of large caps.

More Unconventional Ways The Fed Can Add Liquidity

Nobody expects the Spanish Inquisition!

Our chief weapon is surprise. Surprise and fear. Fear and surprise. 
Our two weapons are fear and surprise.  And ruthless efficiency. 
Our three weapons are fear and surprise, and ruthless efficiency and an almost fanatical devotion to the Pope. 

Our four...no...amongst our weaponry....amongst our weaponry are such elements as fear....I'll come in again.

-- Terry Jones, Monty Python's Flying Circus

Last week, Ben Bernake told Senator Chris Dodd that he was willing to use "all available tools" to calm markets and restore market liquidity.  What Senator Dodd didn't mention was that Bernake also told him that simply lowering the Fed Funds Rate "is so old school and, well, so...Greenspan." 

Which got me wondering, what other tools the Fed Chairman has in his bag of tricks?  Here are my top five guesses as to how the Fed plans on increasing liquidity, countdown from five to one. 

5.  Forget the loans, just buy the collateral.  Last week Jeffrey Lacker, President of Federal Reserve Bank of Richmond, re-iterated that the Fed's discount window is wide open and it will take mortgage backed paper, auto loans, even boat loans as collateral.  Boat loans?  Why doesn't the Fed just go ahead and buy your boat?  Buying foreclosed McMansions would be way too obvious but buying boats would be discreet and more helpful.  Nothing would add liquidity faster to the economy than letting people get rid of the sink-hole-money-pit that is their boat.   Just imagine all the cash people will have when they don't have to pay for storage, docking, repairs, insurance and party supplies to fund their twice a year boating getaway.   It might be enough to pay for their mortgage.  And, good news hedge fund managers, the Fed will even take that beautiful $23.5 million Trinity yacht off your hands.  The Fed governors are still debating the moral hazard effects of bailing out hedge fund managers, one yacht at a time. 

4.  Break out the comfy chair.  Ben Bernake, a great student of the Spanish Inquisition, has used its chief weapons to perfection. 

Among the elements the Fed has used are surprise, fear and the soft cushions.  First, St. Louis Bank President William Poole scared the bejesus out of the market by telling everyone that he was waiting for a "calamity" before acting.  Which got the market wondering, what sort of calamity worse than the bankruptcy of nation's biggest mortgage bank, Countrywide, was the Fed waiting for? 

Then, Bernake's surprise 50 basis point discount rate cut shocked the market out of its fear induced depression. It came at just the right time to save the market from further meltdown. 

Next, Bernake broke out the soft cushions by "urging" Bank of America to make an investment in Countrywide Financial.  Punk Zeigel's provocative bank analyst Richard Bove speculated that the Fed probably had a behind-the-scenes-hand in brokering that deal to help further stabilize the market.  I'm sure that Countrywide CEO Leo Mozilo wasn't dying to give up 11% of Countrywide for $18 per share, especially if he really didn't think his company was headed toward bankruptcy. Mozilo might have needed some prodding from Bernake with the soft soft cushions to get him to accept the terms of the deal and keep the run on his bank from escalating into another full blown market panic.   

With that success under his belt, Bernake is now going to break out the comfy chair by engineer an investment in Bear Stearns (BSC), which is the market's other Achilles heel.  Haimchinkel Malintz Anaynikal is still rolling over in his grave, given how fast Bear Stearns squandered its image as the most conservative and stable investment bank on The Street so shortly after Alan Greenberg retired. 

Rumors have it that Bernake is "nudging" MGM Mirage (MGM) or Harrah's Entertainment (HET) to invest in Bear Stearns, which would have the dual benefit of increasing Bear's cash flow and lowering its risk profile. 

Other rumored Bear Stearns investors include the Blackstone Group (BX) or KKR, both of which have much more experience dealing with the crushing debt loads that bankrupted the Bear Stearns hedge funds.   Blackstone or KKR could return much needed "fiscal discipline" to the ailing investment bank by firing all the quant traders, cutting research analysts not on the Institutional Investor All Star list and, last but not least, saving more paper clips.  Plus, after leveraging up the firm's debt to equity ratio 20:1 and paying themselves a "special dividend" for being such smart, swell guys, they could "flip" Bear Stearns to a naive international commercial bank.    

3. Buy it Now on eBay.  If the Fed really wanted to put money in home owner's hands, it could use its eBay account ("HelicopterBen") to raise the bids on all kinds of stuff.     Underwear,  unused wedding dresses, keys to my old car, mac and cheese (hmm-hmm good).  That would put cash dollars right into the hands of consumers who have to sell all their belongings to meet the higher mortgage payment from their reset ARMs. 

2.  A new Bravo reality show.  Five Fed Governors go head-to-head trying to save the financial system, one foreclosure at a time.  These deeply flawed, yet lovable characters race against the clock (and each other), trying to flip a house before the foreclosure auction ends and another hedge fund blows up.  Ben is the brainy academic who tries to lead his team of talented but socially misfit governors, Don is the cranky and stubborn bank veteran, Kevin is the naive one who can't ever stand up to the others, Randy is the cocky one who knows his mad central banking skillz trump all the others, and Fred just tries to make it to the next round by not doing anything too daring or too stupid.  Find out whose left after this weeks episode of "Property Bailout".

 

1.  Carpet bomb the US with cash.  Screw the helicopters, bring out the big guns.  Instead of dropping wads of cash on Iraq, Bernake should direct our commander-in-chief to fire bomb cash dollars onto the worst areas of the housing recession - Florida, Arizona, Nevada and California.  Bernake, a great student of dropping things out of helicopters, has stated that, while unconventional, carpet bombing money is also an effective monetary policy tool.  The government already tested this technique in 2002 by sending every parent in the US a $400 "tax credit".  This averted a more serious recession and only had the minor side-effect of raising the CPI from 1.2% to 3.0%.  Bernake speculates the only side effect of carpet bombing bags of money is inadvertently killing some of the intended recipients. 

Random Thoughts on a Tough Two Weeks

• We run a concentrated small cap fund and had well above average cash balances going into the month of August.  By that account, we should have been conservatively positioned to weather this kind of storm.  Nevertheless, it was still a very difficult two weeks.  I feel like I've been beaten with a lead pipe.

• As of yesterday, we put a lot of cash to work adding to existing positions and buyibg several new stocks that hit our buy targets.  Like meagain stated on the comments of the last post, there are finally some bargains out there.  But it wasn't really until Monday and Thursday of this week that a lot of small cap stock valuations started to look ridiculously cheap.  That doesn't mean they won't go lower, but for long term holders, bargains are starting to appear.   

• If you assume we are still in a long term bull market, now is the time to buy.  Dick Bove said that at some point the Fed would step in and restore liquidity to the market and it clearly did that on Friday.  That could be a great buy signal.  Another buy signal is that the Russell 2000 hit the bottom end of its long term trend line last week and bounced.  In addition, the RSI on the Russell sank below 40, which has been a buy signal since 2003.  I'm going to guess we're close to a bottom but you never know what's out there.  The true character of this market will show itself in the quality of the next rally.  If it's accompanied by weak breadth like the one earlier in the week, then we'll roll over again.  However, if both large and small stocks advance, especially the financials, the markets should be fine. 

 

Chart courtesy Bloomberg

• The real problem for the equity market is that this epidemic could affect the overall economy.  If for some reason, you still beleive this panic is just a subprime debt issue, you should read John Rubino's article in this month's CFA Magazine.  He's written a whole book on the subject, and although he was way too early in his declaration of the end of the housing bubble, what he predicted is now currently occurring in vivid detail. 

The subprime pandemic has spread to the banking sector and hedge funds and it will soon start affecting the real economy.  It's pretty clear that Florida, California, Arizona and Nevada could fall into a housing-induced recession, if they're not already in one.  New York and Connecticut could fall into a hedge-fund/Wall Street induced recession. Those states would join a lot of the Upper Mid-West that still in the throws of a manufacturing-induced recession.  In a couple of months, we might find out that the only growth in the economy is in corn-growing states.  If the equity market rolls over again and breaks the uptrend lines, it will be because it's beginning to discount a recession.   

• The debt market is still in the middle an honest-to-God panic, but unless you actually trade debt securities, it's not apparent. Most equity traders and investors don't look at the bids on mortgage or debt securities.  That's because a lot of the paper doesn't trade very often.  For instance, the Bloomberg/Bear Sterns Asset Backed Aggregate Index only records a monthly average value.  You can see some of the panic starting in that index on July 31, but it's gotten a lot worse in the past 10 days.  This is a classic crisis of confidence because no one knew what this paper was really worth - it hardly ever traded before this week.

Chart courtesy Bloomberg

• The subprime debt market problems have clearly moved from homebuilders to high yield securities to banking.  You can get some sense of the panic from the high yield (junk) bond index from Bloomberg.  Since last month, the average high yield security has lost a quick 8%.  That would just about wipe out the dividend you were expecting to get from that paper. 

   

Chart courtesy Bloomberg

Of course, it's far from an outright disaster.  Since 2003, the high yield index has experienced several of these panics.  As bad as its gotten, it certainly could get a lot worse.  Investors fell in love with this high yield paper over the past three years and it will take a while to clear out the system if the panic gets worse.  Likewise, if the overall economy slows, then high quality bonds will be marked down as well. 

Chart courtesy Bloomberg

• The Fed woke up on Thursday and Friday.  It realized something was wrong (after Jim Cramer yelled at them) and began pretty massive open market operations.  The Fed desk made tons of repurchase agreements using mortgage backed securities as collateral to inject money into the banking system.  You can see from the chart below that this was a big operation and involved a lot of mortgage-backed paper (blue line). 

Chart courtesy www.bullandbearwise.com

Big operations that take place within a couple weeks time have sometimes marked bottoms in the equity indexes but its difficult to draw any hard conclusions.  I've marked the top 20 largest open market operations on the chart below. It's not definite that liquidity injections lead directly to higher prices.  The Fed has already been relatively active this year.  Six of the top 20 temporary open market operations have come in the past 9 months (that's almost half of the big operations if you exclude those after September 11th.)  Obviously, the Fed has been aware of the subprime problem and has been supporting the banking system with reserves. The crisis hit a new level this past week and the Fed stepped up operations even more.  I don't know if that means we're closer to the end or the beginning of this problem. 

Chart Courtesy www.stockcharts.com

• The problems with the huge inflows into hedge funds over the past couple of years is finally beginning to become apparent.  For instance, the "algorithm" hedge fund managers are making a mess of the small cap stock market.  I'm not going to disparage funds like Renaissance because they have outperformed me for years.  Renaissance Equity makes lots of small bets on lots of small stocks based on quantitative models.  This is a good strategy overall.  The problem comes when everyone on the Street starts employing similar strategies.  Renaissance has been so successful that every smart guy with a quant model has started a long/short fund.  Although Renaissance would disagree, it doesn't take a PhD to figure out how they are allocating their capital.  They are all using derivatives of earnings growth, earnings momentum and estimate revision strategies with maybe a smattering of valuation formulas thrown in for good measure.  This of course, leads everyone to short and buy the same set of stocks. 

When a disruption like we are experiencing in the debt market hits, a lot of managers have to cover shorts or sell stocks to cover losses in other markets.  This has lead to a lot of interesting moves in stocks.  As a contrarian manager, I'm often on the other side of the trade from these quant funds so I have a front row view of a lot the goofiness going on in the market.  Tons of stocks that have no business going up because they reported lousy quarters are ramping.  Likewise, stocks that should be ramping higher are tanking.  Here's a brief run down of some of the goofy moves I've seen over the past two weeks....

White Mountains (WTM) is a high-quality, mini-Berkshire Hathaway insurance company that most people have never heard of.  The company is generally conservative and doesn't split their stock (priced at $540) because they don't want the volatility associated with hitting or missing quarterly earnings expectations.  They manage the business on a multi-year timeframe and want the stock to behave in a similar manner.  Well, that hasn't really worked for them in the past week.  The company had a mediocre quarter which weighed on the stock over the past month but in the past week the stock had a 10% swing up and down on no news.  The historical beta on WTM is about 0.5.  In the past week, it's been about 4.  That's quite a statistical aberration for a stock that no one really knows about.  I'm going to guess there was a short and a long squeeze all in the same week. 

Chart Courtesy www.stockcharts.com

Then there are volatile stocks that have become so crazy they're almost untradable.  Luminex (LMNX) is one of my favorite speculative stocks.  It develops the underlying analytic technology that allows more rapid drug discovery and disease diagnosis.  The company doesn't make money and trades at very high multiples causing it to be a favorite among short sellers.  The stock has a short ratio of 17 with over 10% of the stock's float sold short.  The company reported an uninspiring quarter but the stock has gone on a wild upside ride nonetheless...

Chart Courtesy www.stockcharts.com

And then there are bunches and bunches of low-quality  stocks that embarked on major short squeezes on absolutely no news.  Carbo Ceramics (CRR) makes proppants to help extract natural gas from aging wells.  It's had relatively mediocre results in the greatest energy bull market of all time.  Yet this week, it's looked like the next Schlumberger (SLB). 

Chart Courtesy www.stockcharts.com

I could go on and on but you get the point.   Low-quality stocks are acting great and great stocks are acting like dogs.  I think this is directly the result of too many hedge funds using similar algorithmic strategies, piling into the same stocks.

• The benefits of owning stocks that don't go anywhere becomes very apparent in a market like we had in the past two weeks.  My original Unlucky Seven Portfolio (great company's with stocks that haven't done anything in 7 years) is up a bit since I wrote the article vs. the S&P 500 which is down slightly more than 4%.  I'm not trying to highlight the performance (it was truly meant as a list of stocks to hold for 2-3 years) but I wrote the article for just such an occasion as we're experiencing right now.  The companies I picked were unlikely to keep pace with a run-away market.  But over time, quality companies bought at the right price will outperform the averages.  Like Warren Buffet said, "You don't know who's naked until the tide goes out."   

As an addendum for the Unlucky Seven, I wanted to pen a piece a last week about Citigroup's Charles Prince but didn't get to it because of the market.  I thought that Wall Street didn't like Prince because he wasn't Sandy Weil.  But in mid July, Prince said "as long as the music is playing, you've got to get up and dance" in regards to making large loans for risky LBO deals.  He added, "When the music stocks, in terms of liquidity, things will be complicated." I was wrong and Wall Street was right.  Prince is incompetent.  A good CEO understands the environment he's operating in and leads the company out of harms way.  Prince seems to be jumping off a cliff with all the other lemming bankers even though he knows what will happen.  I would normally suggest to sell the stock but I think it will only be a matter of time before Prince gets fired.   The stock will go up 10% that day.

Why Stocks That Have Nothing To Do With Mortgage Lending Are Falling

No analyst has been calling this correction better than Punk Ziegel's provocative financial analyst Dick Bove.  From calling an end to the run in investment banks to anticipating a correction for the overall market, Bove has been second to none. 

This weekend, he explains why stocks that have absolutely nothing with subprime or mortgage lending are falling.  The following is an excerpt from Bove's note out this morning: 

One need only look back at the experiences of 1987 to 1991, to determine what is likely to happen in the credit markets over the next few weeks. In that earlier period, it was widely believed that banking institutions were overstating the value of their assets. No one believed that the Latin American, LBO, and commercial real estate loans of the period could be sold at anywhere near the values listed on bank balance sheets.

Therefore, the market began to test the credibility of the banking industry’s liabilities. The biggest banks funded themselves daily in the credit markets. The lenders to these banks were going to determine whether these banks could pay down their debts or not. The way this was done was simple:

• First, assume that a given bank had to rollover a $50 million note.

• The lender would immediately raise the rate on the rollover.

• If the bank paid the higher rate, then the lender knew the bank was in trouble.

• If the bank said instead that it only wanted to roll over $25 million and it would pay down $25 million, the lender knew that the bank was money good.

• The only way the bank could pay down the note on the rollover was to have sold its best assets into the markets to raise funds (it could not sell its Latin American loans, for example).

• This meant that the financial markets across all spectrums had to absorb billions of dollars of high quality assets and this drove the prices of all financial assets lower.

• It also created a credit crunch because no bank was able to fund new commitments when it was trying to prove its own financial credibility.

This is now about to happen again. Bear Stearns (BSC/$108.35/Sell) has already raised questions as whether the company is valuing its mortgage holdings appropriately. It did this when it refused to sell mortgages at one of its “healthier” funds in order to meet investors’ requests for redemptions. Thus, the battle shifted from whether the assets are valued properly or not to whether the company can defend its liabilities.

To defend its liabilities, the company must pay down its debt. To do this it cannot sell mortgages; it must sell its highest quality assets into those markets that are most liquid. It will do this. It simply cannot show weakness in face of lenders’ demands for satisfaction.

The issues raised by Bear Stearns will be visited upon every major brokerage firm and every major bank. The market will test their ability to defend their balance sheets. This means these companies must pay down their debts. To do this, of course, means selling top quality assets.

While this is happening, all major lending activities to questionable markets will be curtailed. The deal market will stop functioning. Sub-prime borrowers will leave the market. Only the highest quality credits will be funded. The earnings of financial companies will fall. The economy will slow. The stock market will decline.

In time all of this passes as the Federal Reserve moves in to the markets with greater liquidity. However, one must experience the bad before it is time for the good.

It's very important for both traders and long term investors to understand this concept.  This is just part of the process in cleansing the credit system.  It is and could continue to be very painful.  But once confidence is restored in the financial system, it could mean a broad rally like after the 1998 resolution to the Long Term Capital debacle. 

So in the near term, remain defensive.  Sell if you can't stand another 10% - 20% correction from here.  But don't get too bearish after prices have fallen that amount.  At some point, the Fed will step in to restore liquidity and the bad lenders will have been wiped out.  And that will be the time to step in and buy.   

Adding AIG To The Unlucky Seven

Since CDW (CDWD), one of The Unlucky Seven stocks, recently was bought out, I have decided to replace it with one of my honorable mentions, AIG (AIG). 

AIG is a big hairy monster of a company, kind of like the Gossamer of the insurance industry.  I'd be a fool to say that I fully understand all of AIG's numerous divisions and subsidiaries.  That said, I think the stock is valued attractively enough to account for the risks inherent in analyzing such a large and diverse company.  For the most part, bigger is better when it comes to financial services companies since the larger companies are able to withstand major financial shocks.  And AIG is proof positive that bigger is better.  The company has endured numerous scandals, hurricanes, and other losses only to return to a strong growth path.   

AIG is the world's leading insurance and financial services organization with operations in more than 130 countries and jurisdictions.  The company has four major divisions:

1.  General insurance.  In the U.S., AIG is the largest underwriter of commercial and industrial insurance.  This segment offers everything from property insurance to kidnap-ransom insurance for expats. 

2.  Life insurance and retirement services.  Following its acquisition of American General, AIG is the second largest life insurer.   AIG also has one of the largest U.S. Retirement Services businesses through AIG SunAmerica and AIG VALIC.   

3.  Financial Services. The company engages in aircraft and equipment leasing, capital markets transactions, consumer finance and insurance premium financing.  AIG's growing global consumer finance business is led in the U.S. by American General Finance. 

4.  Asset Management. AIG provides asset management for individual and institutional markets with specialized investment management capabilities in equities, fixed income, alternative investments, and real estate. 

Like I said, AIG is a beast.  In the late 1990s, a mutual fund manager for a major US fund admitted to having a giant "map" of AIG's 100+ subsidiaries on his wall in an attempt to better understand the company.  What a waste of time.  I have done no such "in depth" analysis.  But what I have done is summarized my findings from reading through the 10-k, 10-q and several analyst reports.  Here are the important points I think you need to know: 

AIG's balance sheet makes the company a financial Juggernaut.  AIG's size is an advantage in terms surviving disasters, accessing cheap capital and generating operating leverage.  You can absorb a lot of losses from hurricanes, floods and earthquakes if you have AIG's balance sheet. Even AIG's asbestos losses, which have been a chain around the company's neck, are likely to begin declining over the next five years. 

And you can also overcome a lot of mistakes when you're that big.  AIG recently took about $180 million reserve on problems with its subprime lending division.  That's barley a blip on the company's $103 billion in equity or $14 billion in net income last quarter. 

Once this giant starts running, it picks up speed.  The operating leverage AIG can gain from its worldwide operations should allow it it maintain industry leading margins and returns on equity.  There are few, if any, insurance companies that come close to matching AIG's competitive position and absolute growth opportunities in Asia over the next several years.  AIG has the only wholly owned Chinese insurance subsidiary.  This is a huge competitive advantage that should allow AIG to gain a foothold in many of China's fast growing financial markets. 

AIG has relatively stronger growth prospects than its peers given that nearly 60% of total earnings are generated in fast-growing foreign markets.  AIG’s franchise is not easily replicated and its strong presence in leading and emerging international markets is a catalyst for future growth.  Also, AIG is expecting double-digit earnings growth in Japan as Edison Life and Star Life, AIG’s two operating companies in Japan, merge together and the Company works to rebuild the book of business and grow its insurance in force.

And this monster is getting leaner.  The company recently underwent a company-wide capital review, which indicated it had $15-$20 billion of excess capital. As a result, AIG's Board of Directors has expanded AIG's existing share repurchase program by authorizing the repurchase of up to $8 billion in common stock. As part of this authorization, AIG intends to repurchase $5 billion in common stock during 2007.  In addition, the company will increase its common stock dividend by approximately 20% annually.  In May 2006, AIG raised its quarterly cash dividend 10% from $0.15 per share to the current quarterly dividend of $0.16 per share.

AIG has retained its results-oriented management culture.  Even though hard-charging Hank Greenberg is no longer at the helm, the company has retained many of the competitive advantages that he instilled.  Most upper level managers at AIG are paid bonuses based on their three year performance numbers, not their quarterly or yearly results.  That provides some incentive for not doing something stupid in the short term just to "make the numbers."

The company has been scrubbed clean.  Between the New York Attorney General, the SEC and Insurance regulators, I believe no Fortune 500 company has been so closely monitored for the past two years.  Ever since the company became one of the biggest targets of the re-insurance scandal, I believe that management has taken steps to make sure the operations are as clean as possible.  Combined with the reporting requirements from Sarbox, AIG's top management should have a better handle on the business than ever before. 

Given these positives, I think the main risks in owning AIG are the same as with any other insurance company.  AIG has written a fair amount of policies in the energy sector so another Katrina-like hurricane would obviously cause losses.  The domestic life insurance business has been highly competitive for several years now and AIG hasn't written as many policies because pricing has been under pressure.  And a declining bond market will initially hurt the company's portfolio of investments, although the higher yields will benefit the company over the long term. 

Last quarter

The Company reported 30% growth in EPS during the first quarter of 2007.  Earnings per share were $1.68 vs $1.29 the year prior.  The company had a strong showing in foreign life insurance, financial services and asset management.  In addition, the General Insurance segment remained strong with premium growth in the energy, environmental and construction lines. 

The company had difficulty in the highly competitive US life insurance business.  However, foreign life insurance sales remain strong in Asia.  Overall, it was an impressive quarter especially in the foreign market segments.   

Valuation

I've looked at AIG's valuation on a historical basis and as a sum of the parts valuation.  Either way the stock still looks cheap. 

Since AIG is such a complex beast, I decided to value each division separately as compared to its respective peer group.  For each division, I calculated the valuation based on the peer groups price/last twelve months sales, price/last twelve months after tax operating income and price/2007 estimated after tax operating income.  I then averaged these three values to derive a price for each division.  Based on my sum of the parts valuation, I believe AIG is worth $83 today.  Having said that, I would add that I believe the company deserves a premium valuation for some of its divisions because of their high growth rates and high ROEs.  However, to remain conservative, I'll stick with the mid $80s as a target.

AIG is also cheap relative to its own history despite the fact that the fundamentals seem to be improving consistently over the past four quarters. The stock currently trades at 10.9x forward earnings, which is at the low end of its history and in line with its peers.  If the stock traded at its 20 year median forward P/E of 16x, the stock would move well into the $100s. 

The stock is also trading at the low end of its historical price to book value. The chart below shows that AIG is currently trading at 1.8x book which is at the very low end of its range. 

I believe AIG deserves a higher multiple because of its superior return on equity and relatively high growth rate. The company's ROE of 17.0% is actually much better than the company's multi-line insurance industry peers, despite the fact that AIG is overcapitalized. 

And along with a high multiple, I believe that earnings estimates can also continue to go higher.  The consensus estimates for this year hav