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Sunday, October 26, 2008

The second mouse gets the cheese....

All week I have been inundated with various people (whether colleagues or market pundits) calling for market bottoms. I have not made up my mind yet on where the bottom will be, I think the US presidential election in November will be a real catalyst but expect any real political stimulus to come in 2009. Lawmakers will make a push to enact stimulus in a post-election “lame duck” session of Congress. This is likely to mean that a proposal takes shape, at least in draft form, by the week of November 10, and comes to the floor the week of November 17. Debate would probably last the full week, and could possibly run into early December. However, there is a possibility that stimulus could be delayed until late January or February. The legislative calendar is short, and it is entirely possible that lawmakers could fail to agree on a package. It is also possible that President Bush could veto a fiscal stimulus bill. It is also possible that if Democrats make significant gains on Election Day, they will aim to pass a first round of stimulus in November, and a second round focusing on Democratic priorities early next year. It should be noted that the stock market and economy rarely (read never) bottom at the same time, so at this juncture it might be prudent to start accumulating a little here and a little there. Remember while the early gets the worm it is the second mouse that gets the cheese. One strategy that is looking increasingly profitable is to sell out of the money short term puts, this acts similarly to a limit order with the key difference being the purchase risk and premiums received associated with the puts. With the VIX at such a high level you can find some substantial yields on such a strategy.

That being said let’s take see where we stand.

For several reasons, corporate liquidity is becoming a very valuable resource. First, the primary market is likely to remain slow, as investors are still recovering from recent losses. Moreover, expect banks to continue to act conservatively when underwriting new business, despite the windfall of new capital. Second, the bleak economic outlook is likely to cut into corporate cash flow - profit expectations are already falling fast. Third, the recent injection of bank capital and debt guarantees, along with other tools, are designed to help the credit markets defrost, but the toolkit offers little direct help to non-financials. In summary, corporations could get a hit on both the earnings and the liability side.
Slowing profit growth and the negative outlook for funding are causing firms to tap their existing credit lines. According to the Wall Street Journal 18 companies have drawn down on bank lines following the Lehman default. This is partly to replace funding across the malfunctioning credit markets. For many companies, credit lines are the best option, since the long-term primary market remains fairly inaccessible because of weak investor demand. The recent large defaults will have a long lasting impact on investor’s risk aversion. The terms of the facility commitments from agreements signed in the recent boom years are likely a cheaper source of credit compared to the current market rates on bond and loan funding.

One instructive example is Goodyear Tire’s announcement on September 25th, that they were drawing $600 mm from their revolving credit line. Goodyear explained the credit line was tapped because they had $360 mm frozen in a money market fund with redemption problems. Following the news, Goodyear’s CDS spread widened 300 basis points.

Dislocations continue to cross historical highs in virtually every segment of the credit market. The current disruption of funding markets and the subsequent poor market liquidity are the main drivers of this situation. Therefore, the improvement of short-term funding conditions is a necessary condition for normalization going forward.

Defaults. This recession will be deeper and longer than we expected just a month ago (let’s just hope is a long flat U as opposed to the dreaded L). While the money market will gradually improve as systemic fears begin to relax, stabilization will be slow. The slow normalization of the money market will cause bank lending terms to crunch tighter, perhaps sharply; GDP and profit growth will slow accordingly.
Spreads. While spreads on banks and other financial institutions have substantially tightened on the back of the recent policy measures, the macro uncertainty is still high. This should start to weigh on consumer, retail and cyclical names, expect them to underperform.

The sharp underperformance of EM equities relative to developed markets, and now of EM currencies to the majors are also what you would ‘expect’ to see in a broad global slowdown. And even the dramatic dollar move is consistent with this general theme as the market has been in the process of reversing a two-year view that the US is uniquely exposed to slowing – and in unique need of easier financial conditions – and moved to price a more uniform global slowdown. The shift in pressure to emerging market FX – most recently to EMEA currencies – is also in part a reflection of the fact that the global slowdown and credit crisis has broadened to a point where even the more resilient are likely to share more pressure that until recently the market expected them to escape. The acceleration in many of these moves is consistent not just with increased funding and financial market stress but with the data.

That being said let me venture a wild guess about the future. Deleveraging is going to be a long and painful process. The economy will not likely turn until either housing stops declining or banks start lending. Sadly I think both are likely to occur at the same time. As the banking system gets more aid bankers will start lending albeit and much higher rates. These higher rates will spur a lack of consumer spending which will bring prices down. This deflationary spiral will be countered by the new president and his various “stimulus packages.” It is my opinion that the government is terrible at market timing and as such will continue their inflationary inducing policies long after the deflationary threat has faded away. This couple with massive US debt spells a long-term weakening dollar versus export driven economies. We have already seen the Yen appreciate massively against the dollar and I expect to see the Brazilian Real, Reminbi, and the Rouble (so long as the Russian government doesn’t screw things up). I think we will see hardline retailers continued to be punished by reduced consumer spending but I think softline retailers like Wal-Mart, Target, and Costco could offer an interesting entry point should the equities fall further. I think the decline in oil will likely overshoot to the downside and should offer interesting opportunities to the savvy investor. I would particularly look towards MLPs and E&Ps offering high yields with clean balance sheets. Lately I have been thinking about how the economy moves in cycles. For example, the following I would classify as periods of consumer leveraging their balance sheets (1920s, 1960s & early 1970s, 1980s, and obviously the 2000s). Each of these periods were marked by massive run ups in equities followed by severe declines. What led to the next run up is of interest to me. The Great Depression was ended by World War II so I hope we can avoid that alternative. The 1970s was turned around by a massive drop in commodities and raising rates to the point of reducing inflation (this is possible although I would be shocked to see commodities fall to that point). The bear market of 1991-1993 was ended by the mass proliferation of the computer and the internet. So this brings us to now, I can’t help but wonder what innovation our policy will lead us out of this recession. As previously stated I think we will likely see some inflationary policies put in place by the new administration and this will revive the system but not stimulate significant growth without substantially deflating the dollar. Being an eternal optimist I am hopeful that someone will crack the energy mystery (maybe the University of Utah can rediscover how they cracked cold fusion). Either way I expect this to be three to four year period of slow to no growth. That being said I urge people to consider putting their money in companies with sterling balance sheets and enormously wide economic moats. I expect to post an example of such a situation over the next week or two. If you have any suggestions or ideas of your own please feel free to post them.

Also on another side note if you I strongly suggest people to look into various special situations. For example watch Volkswagen to see if it rallies in another short squeeze if it does, short it. VW was trading in the 80s during last week which is a PE of 33 times 2009 earnings which is five times the industry level (mind you the industry is likely to decline as consumers are less likely to purchase a car over the next year). Over the past year VW’s shares are up over 100%, this is due to the concentrated ownership and massive amounts of hedge funds who were short the stock and had to cover at the same time when there was an extremely limited float (especially with the bankruptcy of Lehman who was one of the largest lenders in the stock). On a fundamental basis VW is worth around $30 (it closed on Friday at 53 which is down from 90 the week before). I expect to continue to see this company to fall as hedge funds are no longer being squeezed (at least for now) and investors realize the terrible underlying fundamentals of the auto business. It is temporary mispricing situations like these that are going to offer the majority of profits over the next couple months. Keep an eye out for these, especially in the small cap and micro cap space as this is where they are more likely to exist.

Sunday, October 19, 2008

This will have to do....

I was going to write something over the weekend, but I had to work on both Saturday and Sunday so this will have to do.

Sunday, October 12, 2008

Mr. Toad's Wild Ride

It goes without saying that this past week is not one that will be soon forgotten. In light of the recent coordinated government interventions, I would expect money markets to start behaving more normally, and ever so slowly as risk aversions start to fade we will start to see an increased interest in corporate in bank debt which should assuage the equity market’s fears and allow them to become more calmed. This is not to say I am calling a bottom, I am just pointing out that the recent high volatility (highest recorded level on the VIX, although technically the VIX would have been higher during 1987 (somewhere around 150 vs. 70 or so now, it just wasn’t around then) can be expected to dissipate at as people become more risk tolerant.

Speaking of bottoms, I just wanted to make a quick note on where and how I think we can bottom. In order for the markets to bottom, house prices will have to stop their decline. Now many people are predicting a price bottoming in the first quarter or second quarter of 2009 which is when many sub-prime resets will taper off. Although this is somewhat logical they are ignoring the wave of Option ARMSs and Alt-A which reset in 2010 and 2011. These will cause significant pain should their reset be anything like the one we went through with sub-prime resets.

Before we get into the meat of this week’s post I just want to take a minute to say, those who took my advice and went short on ZOLT, it is probably now time to close that trade, since recommending the short on Sept. 7th the stock has fallen from $17.21 (Friday Sept. 5th close) to $10.00 (Friday Oct. 10th close) which represents a nice 42% profit in the span of about a month.

The turmoil in global financial markets has recently put pressure on nearly all emerging markets (EM) assets. In part, the move has been driven by concerns for the global slowdown and its possible impact on EM. On the other hand, economies like Brazil and Malaysia appear better shielded growth-wise when looking at typical macroeconomic shocks. Over the last month, however, the forces of financial deleveraging, risk aversion and positioning liquidation have taken center stage in driving asset prices. This has raised concerns among investors about the vulnerability of different emerging markets to broader strains in the financial sector and global markets.

The good news for EM is that there is no strong evidence that they are caught overly levered in the middle of this deleveraging process. EM fundamentals have improved substantially over the last few years and are still supportive in terms of economic stability and growth, overall. In fact, the current turmoil is much different than previous episodes of distress for EM assets; it is not an EM crisis, it is financial volatility imported from a shock that originated in G10 economies. However, the recent underperformance in EM currencies with stronger fundamentals stands as a reminder that financial turbulence can affect local assets in many ways, and not necessarily in connection with the economic performance of the country. There are different notions of exposure to financial volatility. Local assets can come under pressure through various channels; a disruption in international capital flow, a reversal of capital flows accumulated in the past, a strain in the financing of short-term external liabilities or some genuine fragility of the local financial system. On average, emerging markets appear to be more resilient than major markets on most indicators (exhibiting more resilience to shorter-term capital flows disruptions, short-term financing dislocations and soundness of the banking system).

Given the recent government moves what does this all mean in the FX space? The US trade balance will likely improve further. While exports will probably slow on the back of slowing global demand, US imports may slow even more on the back of extremely tight financial conditions and expectations of a recession.

Despite the US trade balance improvement, funding inflows into the US are likely to slow as well, given the weak cyclical outlook. Moreover, the Dollar is clearly less undervalued at current levels and further appreciation would probably make life more difficult for the export sector and hence not help the weak US economy. Therefore, after a stabilization of asset markets, we are likely to see first a period of renewed moderate Dollar weakness, before the longer-term appreciation trend towards fair value kicks in.

Slowing global growth will continue to put downside pressure on currencies that display a strong link to cyclical forces, such as the AUD. However, some of these currencies have depreciated rapidly in recent weeks and this may limit the additional depreciation risks.

Moreover, lower oil prices and substantial policy stimulus mean that growth rebounds are possible in the not too distant future, led by strong structural stories, such as the BRICs and N-11. Rate differentials are also likely to play in favor of EM currencies, in particular following the rapid decline of policy rates in major markets.

So net-net, I think given the sharp pull back it might be time to purchase some EM equities or balanced ETFs. Sorry for the brief post, but I have been at work all weekend and still have another two hours plus of stuff to get done.

Sunday, October 5, 2008

Black murky waters...

In this past week the overall feeling in the market has shown a sudden and abrupt volte-face and it finally appears that the market and investing community has realized that regardless of the “bail-out” the economy is still going through tough times and is unlikely to reverse direction any time in the near future. Internally I am torn about this sudden widespread realization. On the one hand the value investor in me is in fine fettle, on the other hand the altruistic global citizen in me is nervous about our near to medium term prospects (hence the title of the post). That being said there is always a way to profit in any market so let’s try to find out how.

The passage of the TARP plan will increase our federal deficit substantially. The current fiscal year 2009 deficit (which is the current FY) is estimated to be at $565bn and this was before the passage of the TARP. If you take this plus the estimated cost of TARP plus additional maturing coupons our federal deficit could reach a staggering $1.5 trillion (with a T!). With all this additional debt you have to wonder how our dollar is strengthening versus other currencies. The key to this is it is all relative. The EU and UK were viewed as relatively strong and as such had strengthened substantially against the dollar over the past couple of years. Now that everyone realizes that they are not immune from the financial malaise, their currencies have been dropping precipitously. This in turn has been quite negative for export heavy companies. While I believe we will continue to strengthen against the EUR, GBP, NZD, AUD, and YEN, I believe we will start to weaken against EM currencies which are heavy on natural resource exportation. This is the perfect segway in to what is turning out to be my weekly update on the energy markets.

Over the past several weeks, the oil market has been whipsawed between two opposing forces: (1) strong near-term fundamentals driven by continued supply problems and extremely low inventories; and (2) rising financial and forward demand concerns which have been accompanied by significant financial de-leveraging. As the market continues to be pulled in both directions by these opposing forces, price volatility has surged. This surge in price volatility represents a significant departure from the past five years, as the one variable in the market that remained relatively stable was volatility, trading in roughly a 30-40% range. The market simply trended up or down and inventories in the United States and the rest of the OECD remained above or near the five-year average, providing a cushion to any supply or demand disruption. However, beginning this summer and accelerating this past week that trend has been clearly reversed – implied volatility reached 55% this past week as inventories continued to plummet due to hurricane-related disruptions. Volatility has not been this high, nor have stocks been this low on a seasonally adjusted basis since the Gulf War II in 2003 (see below):

US inventories dropped a massive 18 million barrels, bringing the total inventory draw since August 28, 2008 to 50 million barrels. US total hydrocarbon stocks are now at record low levels for this time of year, and US gasoline inventories are now at levels not seen since 1967 when demand was nearly half the level as it is today. Further, the situation for gasoline on the other side of the Atlantic is no better, with Europe also at low inventory levels with ARA stocks dropping to the lowest levels since 2003. Further, this week saw crude oil stock draws in Japan that took stock levels back to record lows for this time of year. What is critical is that this is the period in which stocks should be built globally to prepare for the winter months, not drawn. This puts the market into a very precarious situation as we near the winter heating season. Many observers point to the fact that demand is weak, so this observation is not as worrying as it would otherwise be. In fact, the US Department of Energy (DOE) reported exceptionally weak product demand last week. Although this demand weakness generated downward price pressure post the data release, it is again important to emphasize that you can’t consume what you don’t have. Ongoing refinery outages have left US refinery utilization at critically low levels leading to a loss so far of almost 70 million barrels of petroleum products. As a result of the outages, Colonial Pipeline – the primary artery for USGC petroleum product distribution in the southern and eastern United States – has been operating at reduced rates, generating local shortages and reports of long lines at the pump (hence the news of gasoline shortages in the south). It is important to highlight that despite this extreme tightness in gasoline supplies, traded NYMEX gasoline margins have weakened substantially in the past two weeks.

Over the past several weeks, concerns over the sustainability of Chinese oil demand have been brought into question. Driving these concerns have been real events. Two weeks ago Sinopec announced it would reduce fourth-quarter crude oil imports by 8-10 percent from previous targets as end-use inventories inside China remain high. And then last week, Unipec announced it would not import diesel for a third straight month again due to high domestic inventory levels. At the same time, expectations for 2009 Chinese growth have been revised down.

First, in terms of the base levels, these slower growth expectations do not have a large impact in terms of barrels. At most it would slow end-use oil demand growth by 70 thousand b/d and in terms of crude oil imports for the fourth quarter relative to previously announced targets, and would slow imports from 14% yoy growth to 9% yoy growth, which is still relatively strong growth from a historical perspective.

Second, the Chinese government still has two very significant policy levers at its disposal, both fiscal and monetary policy. On the fiscal side, unlike previous time periods of slower growth, the Chinese government has at its disposal 2-3% of GDP for fiscal stimulus. On the monetary side, we saw the central bank aggressively raise rates to counter inflationary pressures. Now that those inflationary pressures, particularly from agriculture, have abated, they are likely to be equally aggressive in lowering rates. The bottom line is that the government is likely to act with policy in response to the current concerns, which will likely avert a more serious slowdown. This aversion should help keep their demand high which helps add to the bullish oil argument.

In the near future I will make a specific company recommendation, so until then keep reading.