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Sunday, September 28, 2008

Quick update

I don’t want to toot my own horn by my three calls last week would have paid off in spades: oil rallied 17%, Zion fell by 12% and was down in excess of 20% at one point, and WFC fell by 5% and was down 13% at one point (it should be noted that to profit from the downside on ZION and WFC you would have had to use short term puts which would have probably magnified your return due to the inherent leverage associated with options). That being said I am not faring well on my ZOLT short which has rallied 15%, that being said I still think a ttm P/E of 88.6 is a bit much for a materials company (I would mention its forward P/E is 18, which is based on, as previously mentioned, what I believe to be extremely lofty estimates). But enough about the past, let’s look towards the future.

I am sure you have all read that the bailout plan has tentatively passed. In its current form, it gives taxpayers an ownership stake and profit-making opportunities with participating companies; puts taxpayers first in line to recover assets if a participating company fails; (and) guarantees taxpayers are repaid in full -- if other protections have not actually produced a profit. The $700 billion would be available in phases. The first $250 billion will be "immediately available" to the Treasury Secretary, and $100 billion available "upon report to Congress," and $350 billion "available only upon Congressional action. While the industrial cycle looks to be slowing, in the US, the aforementioned bailout plan is likely to reduce the economic risk of a much sharper credit contraction. In addition, recently announced policy initiatives clearly go beyond the US: China and Russia have also taken steps to stabilize local markets. For example, last week, China announced a 27bp interest rate cut, as well as a reserve requirement reduction, reversing a couple of years of slow tightening measures. Globally policy makers are starting to act in concert to implement economically stimulating policies in order to avert a global economic meltdown. The real question is, will all these policies be enough to stimulate the global economy, or will it as I believe shift us from depression talk back to recession talk.

For the OECD as a whole, from a starting point of nearly 2% GDP growth in the first quarter of this year, GDP growth will flirt with the zero line in 2008Q4 and 2009Q1, but should manage to stay in positive territory. Of course, it is easy to see a technical recession in the OECD, particularly if US growth is softer than expected. But there are good reasons not to expect a deep OECD recession that could drag world growth materially lower. The world economy should continue to be cushioned by the strong demand from the commodity producing areas of the world (which have reaped the benefits of the tripling of oil prices since the beginning of 2007). If we fast-forward to the trough, what type of global recovery should we expect once the low point in the cycle has been reached? As I believe it would be prudent to expect the recovery phase in the global economy to be relatively subdued compared with the previous cycles. Indeed, the expected recovery is similar to the U-shaped upturn following the US Savings & Loans crisis in the early 1990s rather than the V-shaped upswing after the tech bubble in early 2000s. There are a number of reasons why we can expect the global recovery phase to be rather anemic, with the possibility of a longer than normal period of growth stagnation:

1. Although the bailout plan will do a lot to help stimulate the credit markets, bank lending will be tight for some time. The unprecedented policy interventions that have taken place over the past two weeks have led to a relaxation of stresses from the very extreme levels reached last week (when credit markets came to a complete halt), but conditions remain far from “normal”. As part of the deleveraging process, banks are clearly tightening credit (just look at LIBOR, on a side note a safe bet would be a further widening of the TED spread (yield difference between the interest rates on inter-bank loans and T-Bills) as I think private banks will continue to tighten which will raise LIBOR (plus LIBOR is currently understated) coupled with the fact that the FED will have trouble raising rights in light of the recent economic maladies, although it should be noted that this would be a short term bet because as we have witnessed before keeping rates too low for too long is a very bad thing). That remains the key message from the latest bank lending surveys from the Fed, the ECB and the Bank of England. Therefore, the lack of lending confidence is likely to curtail the strength of the upswing (particularly in consumption and investment).

2. Although it started out as mainly a US and UK problem the global housing correction has spread. Ireland, Spain and New Zealand are at the forefront of housing weakness. But other major economies have also seen some cooling. More recently there have been signs of housing weakness in parts of China and India. One of the key ideas to understand about housing is that it is a relatively illiquid asset (i.e. by and large people don’t buy houses to immediately flip them, the vast majority of homes are purchased to live in for longer periods of time) and as such housing corrections can have long-lasting macro consequences. For example, following the average OECD housing bust, the growth slowdown lasted four years on average (measured from the time GDP growth started to fall to the time when it bottomed), or close to two years after house prices peaked.

3. Fiscal easing has and will continue to help, but there may be constraints (for example rates are already extremely low and to lower rates further risks starting up the inflation machine). While a second fiscal stimulus package might well be implemented in the US next year, it is unlikely to provide as much bang for a buck as the first package. Nor is the Japanese fiscal stimulus package likely to give an immediate boost to the economy, given that it did not include large-scale tax cuts. The Stability and Growth Pact also makes easier fiscal policy less viable for many European governments, particularly as it might risk stoking current concerns about inflation. That being said, this constraint is less binding in EM countries, such as China, where there is substantial scope for both monetary and fiscal easing in response to a growth slowdown.

As far as portfolio positioning is concerned I still recommend loading up on EM economies that stand to benefit from high commodity prices and potential currency gains. The particularly attractive markets are those with high growth potential currently trading at low P/Es (i.e. Brazil and Russia). I think consumer stocks will continue to be punished as commodities remain high and lending remains tight, I would be shocked if these two factors coupled with a weak job market weren’t enough to incentivize the consumer to tighten up those purse strings. Interestingly, the XHB (the housing ETF) has outperformed the market by almost 20% over the last month. These companies may be unintended beneficiaries of any eventual financials/mortgage-backed-asset plan. The XHB has clearly has run ahead of the data, where only hints of optimism exists. With the recent reading of the NAHB index essentially flat, with housing permits heading lower, and with sales down, I would be shocked if the XHB went up anymore.

On the oil front, Goldman Sachs had an interesting conference call last week in which they reaffirmed their view of higher energy prices by year end. They included a snazzy chart which I have pasted below. My only warning is tread carefully because pure play E&P will swing wildly with prices of oil while refiners will swing in opposite directions (that is one reason why I like COP because it is both, plus it trades at some crazy cheap levels and has a 20% stake in Yukos).

Sorry for the short post. I just don’t think there is much to say; currently the market is in an awkward state of purgatory. Like I have emphasized before, the real action will start once Q3 earnings season begins, then we will know whether we are headed for a turnaround or a long drawn out recession.

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