Search This Blog

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.

No comments: