Welcome to the FOMC Transparency Tour: 1st Stop is the Sausage Factory

Welcome to the FOMC Transparency Tour: 1^st Stop is the Sausage Factory

The week at least started well as the upper echelon of fund managers heard from their “well-placed sources” that Helicopter Ben had miscommunicated the FOMC position when he spoke about tapering and would set the record straight at his press conference, imbuing them with the fortitude to get long in front of Wednesday afternoon.   Well, they got half the story right as he did set the record straight.

Taken alone, the FOMC minutes were positive for the market as nothing indicated that policy was going to change course.  The indices acted accordingly, swaying between green and red.  Then we found out that those sources were no more well-placed than a convertible parked beneath a tree with hanging bird feeders.  First, the FOMC projections were released showing that the targeted 6.5% unemployment rate was now forecast to occur in 2014, not 2015, and that GDP growth was accelerating.  Then, just prior to the reporter from TMZ asking Bernanke about his personal plans, his prepared remarks were released. Therein, Helicopter Ben dropped not more cash, but the bomb:

“We also see inflation moving back toward our 2 percent objective over time. If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year; and if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear. In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 percent, with solid economic growth supporting further job gains—a substantial improvement from the 8.1 percent unemployment rate that prevailed when the Committee announced this program.”

So here we are: the transparency thing as he explained the Fed’s thought process.  The FOMC will begin to cut back this year and, depending upon the next jobs number, may do so before the third quarter ends.  The point that we reach 6.5% has been moved up but that is no longer the trigger; now it is 7% accompanied by an upward bias in the economy and inflation at 2%.  If only they kept that information to themselves we could have read the minutes and gone on our merry way as the market stabilized and perhaps moved higher.  In the old days, pre-openness, the market took the real hit when the rate increase actually occurred and usually upon the move deep into neutral policy territory.  I liked that more because the economy was then on better footing, earnings growth was apparent and valuation could withstand less accommodative policy.  But this is the worst of all worlds since we likely won’t see much growth in earnings this quarter, Europe is still uncertain and China is on the verge of a credit crisis that will make 2008 look like boom times.

I can’t imagine too many visitors to Jimmy Dean’s factory leave the tour and buy a few links in the souvenir shop, anxious to cook them up when they get back to the trailers.  Seems like traders feel the same way about the Fed post press conference, puking out their stocks and bonds, violating important levels of support.  However, once the vision fades and their stomachs settle, a curing period that will likely take us through earnings and up to the next FOMC meeting, they will recognize a great buying opportunity– at least for stocks.  Bonds, unfortunately, will stay in the grinder. For now, though, the carnage, bred through emotion, is likely done as atrophying now takes over.  Within that time frame there will be peaks and valleys as volatility, courtesy of Fed transparency, becomes the norm.  I’m up for nibbling for the long term but the market hasn’t corrected enough to find many real values.

iPad At The Ready; Is Icahn Greek & Germany’s 4 Day Work Week

Night after night, morning-to-morning, it’s the same routine.  The iPad sits at the ready, less than an arm’s length away on the nightstand, sharing space with an old school Blackberry, an alarm clock separating two generations of technology.  It’s the last thing I look at before I go to sleep and the first item I reach for when I wake.  I’m seeking out news, waiting for the solution.  That’s what I need to get off the sidelines, to put my cash to work. Sure equity valuations are cheap, that is if you believe the global economy is not worsening. Sure Treasuries are overvalued and in a bubble and asset allocation begs for a swap into equities but these factors have been in place for a year.  In the interim, China has markedly slowed and Europe is in an economic near death spiral. Ergo, I need something new: a plan that will work. I am fairly confident that I know what the answers are, I’m just hoping that some variations of it appear in a Reuters or Bloomberg headline:

ECB Lends $2 Trillion to Spain and Italy – Funds Targeted for Banks;

Greece Accepts Receivership: Icahn Reveals That He is Part Greek and Agrees to Head Creditors Committee

I would settle for one out of two, the ECB lending program being my first choice.  The last two days brought scant hope, with Spain’s Budget (a clear oxymoron) Minister asking for other “European Institutions” to “open up and help facilitate” a recapitalization of their banks.   (http://www.bloomberg.com/news/2012-06-05/spanish-minister-urges-eu-aid-for-banks-in-first-plea-for-funds.html).  I guess, a recognition by Spain that they have a problem is the first step toward a solution.  Record outflows of capital and the seizing up of the banking system has a way of offsetting the effects of too many carafes of sangria at three hour lunches more so than afternoon siestas.  However, there is little chance of Germany injecting capital directly into Spanish banks.  And then today, we had the ECB’s Mario Draghi tell us not to worry, capital is not fleeing, hoping to dispel us of the facts.  Nice try, Mario, but this will not help me sleep any better.

Here is how I believe the issue should be resolved in order to restore some semblance of sureness to the market. Actually, this is not really my original thought but rather that of an extremely successful hedge fund manager as we discussed the issues during a game of golf.  However, as a part-time talking head and part-time author, I am in conflict: the former imbues me with little respect for identifying ownership of ideas, claiming all as my own, while the latter avocation imbues me with abhorrence for plagiarism.  Since no one is paying for this advice, I will default to the former and provide what I believe would put the market back on firmer footing in response to Europe.  While the ECB is not allowed to buy new issue debt from sovereigns, it can loan money to them.  Spain will ultimately agree to a program and, in return, the ECB will provide a 30 year loan with a nominal coupon to the government, specifically targeted for the banks.  This will not crowd out any other creditors, thus limiting resistance.  As part of this rescue package, and in lieu of using Spiderman towels and English lessons (wouldn’t German be more appropriate?) to lure potential depositors, the banks will offer greater levels of deposit insurance, backstopped by the ECB.   There will be greater, collective EU oversight to large EU banks as a condition to German participation without obligation of further German funding.

Perhaps the above won’t happen so here’s another thought.  It was also reported by Bloomberg that the EU and ECB is at work on a Master Plan (http://www.bloomberg.com/news/2012-06-03/ecb-eu-drawing-up-crisis-master-plan-welt-am-sonntag-says.html) and may have something ready by the end of June.  Well, that would be nice but this would have to be authored and led by someone other than Merkel’s countrymen since Germany’s last Master Plan didn’t work out well for anyone and time has done little to  erase the memory.  The problem is that no other European economy has the economic wherewithal to plug the dyke.  I imagine that Germany does a daily calculation comparing the breakup of the currency and the potential impact on trade with the cost of being the sugar daddy for the rest of the EU, albeit without the typical prurient perks of being so benevolent.  The Germans undoubtedly realize that they would have the world’s strongest currency were the EU to fail, thus crippling their own economy by making the price of their goods uncompetitive.  Here’s a solution: cut off the EU like you would a drug addicted stepchild and allocate those funds to internal spending, thus inflating the D-Mark and maintaining competitiveness in global trade.  Instead of the annual Oktoberfest, have a  Freitagfest and a 4 day workweek, placing them on more even footing with the rest of socialist Europe. That won’t drive the DM to levels on par with the drachma but will get you moving in the right direction.

So as my search for the evidence of a solution forges on, I remain on the sidelines although even the hint of a legit solution (or of an improving US economy) will rally an oversold market.  Oversold rallies, however, such as today’s (June 6), are to be sold, not embraced. Commodities will remain under pressure and steel is still a great place to be short as analysts now begin to look for losses in the upcoming quarter.  Recall that last year, X reported a loss despite a combined 13% volume and price increases.   Their end markets, with a slowing global economy, won’t be so kind this time around.   They didn’t even bother to offer a mid-quarter update at their analyst day today.

One more thing – look for downward revisions to multinationals pick up speed as the dollar retains its strength.

Playing Poker with the EU: Why There Won’t Be A QE 3

Wistful visions of a Bernanke Put have kept many invested. It is everything they want it to be: the lifeline, the safety net, the impetus for economic growth.  However, I believe it is unlikely to happen.  The logic is simple: Europe is much more fiscally troubled than the US and is arguably the source of not only market turmoil but also for economic angst in the US.  Without a shock and awe resolution from the EU, any further easing from the US will be ineffective in reversing our declining economic fortunes so why waste the powder.  And with Europe in much more desperate shape, in recession , broadly, and possibly headed toward a depression in Spain (Greece there already) it is much more incumbent upon the EU to provide a shock and awe solution to their economic woes sooner rather than later.  Additionally, Bernanke has come under significant criticism for his prior QE’s so why not let Europe do the heavy lifting this time around?  The European solution, if credible, will obviate the need for further stimulus from the US.  China keeps threatening to stimulate their economy and should this happen,  this could also lessen the burden on the American economy.   If I were Bernanke, I would play this hand to conclusion.  Not even another deficient jobs number will change my view.  In fact, I believe that the payroll report will come in above consensus based upon what I hear from my source who has been almost clairvoyant in their forecasts based upon real-time information.  They see strength across all sectors.  It won’t be a blow out number but should be comfortably above consensus.  This will lead to a short covering rally and a good opportunity to lower exposure

Separately, a great review for The Big Win http://seekingalpha.com/article/625331-book-review-the-big-win :

Book Review: The Big Win

May 30, 2012

Just as whale watching is a popular adventure tour for nature lovers, reading about the whales of finance is a popular pastime for investors. InThe Big Win: Learning from the Legends to Become a More Successful Investor (Wiley, 2012) Stephen L. Weiss profiles one woman and seven men who have truly excelled.

First, a caveat about what Weiss describes as “the ugly reality of whale watching,” by which he means “blindly following large, smart buyers into a stock or other investment.” (p. 25)

 

Unless an investor has insight into the whale’s rationale for making a particular investment, his time frame, and his risk appetite, the investor is at a considerable disadvantage. It is critically important, as Weiss writes, to “understand the process. … The true value of these case studies … is in understanding each investor’s methods, not standing in awe of their results.” (pp. 32-33)

 

Weiss’s eight legends—Renée Haugerud, James S. Chanos, Lee Ainslie, Chuck Royce, A. Alfred Taubman, James Beeland Rogers Jr., R. Donahue Peebles, and Martin J. Whitman— each carved out a niche and developed an investing style.

Haugerud, for instance, is a top-down investor. Her hedge fund, Galtere Ltd., has a five-stage investment process: taking the temperature of the global markets, developing a few themes, microanalyzing and selecting strategic investments, timing trades technically, and applying risk management. Her “big win” came in 1993. With gold trading as much as 40% above the world’s highest cost of production and the one-year bonds of Canada’s western provinces yielding 9 to 12%, she shorted gold for a rate of less than 1%, bought the bonds, and hedged her short gold position with undervalued small-cap stocks of mining producers in Australia that had high margins and low production costs. “‘All three legs worked,’ as Haugerud puts it, and all kept working for a good long while. It was a simple trade, and the returns were good enough to carry that year’s performance to her stated goal and beyond.” (p. 50)

Chanos is a short seller, Ainslie a stock picker, Royce a small cap investor. Taubman and Peebles are both real estate developers, Rogers is a commodities investor, and Whitman is best known as a distressed debt investor.

What do all these legends have in common? Weiss catalogs seven traits: no emotion, no ego, long-term investors, discipline, thorough research process, passion and work ethic, and drive. Or, reduced to six words:

 

“Drive. Passion. Process. Equanimity. Discipline. Humility. These are the commonalities between all those profiled in this book and the qualities that make for a great—and legendary—investor.” (p. 17)

 

The Big Win is an easy, thoroughly enjoyable read for those who want to learn from the whales.

Greece, Diamond Foods, Euro, Santorum, Friess and Me

Another day and Diamond Foods (DMND) is still with us. I took my profits on the trade, selling the stock when it was up 7% on the day versus a decline of 1% for the broader market.  Will possibly return.

I have been advocating for months that Greece be pushed into default.  Perversely, this would be the best outcome for the markets and the Euro after the knee jerk reaction lower.  Greece, in fact, is less important to the European economy than AIG was to the global economy, than Lehman or Bear was to the US economy.  Germany’s interest is clear in keeping Greece and other profligate sovereigns in the Euro which is that it is the 50 pound weight at the other end of the barbell.  Were Germany to be the even more dominant in the Euro, their goods would be less attractive, harming their export economy.  This would be good for other exporters such as the US, although our goods are already cheap in relative currency terms.

I have a small short position remaining in the Euro.  I cut the core position and had stopped trading around it as it moved to breach the 130 level because the market had become incredibly conditioned to a negative outcome, perhaps proof no more evident than the current level of the Euro versus other currencies despite the headlines.  My short on the Euro was never based upon a break-up of the currency; it was based upon the view that there would be massive stimulus, including rate cuts, to support a weakening EU economy.  Essentially, they would have to inflate to forestall a deep recession.  This has been the policy outcome and I expect it to continue.  I would be more comfortable sizing up the Euro short if Greece stays in the currency than if they are unceremoniously shown the door since, admittedly, perversely, I see a Greek exit as a strengthening event as the world will realize that the EU is one “sovereign” that is willing to do what it takes to address its budget deficits although this would be more of an accidental outcome than deliberate, having everything to do with Greek  insouciance and an unhealthy dependence on ouzo than the execution of a strategic plan.  Keep in mind the folly of the lack of any real plan by the EU: the EFSF relies on contributions from countries including Greece, Italy, Spain and Ireland.  The far-reaching agreement on a more uniform budget reform process is also of negligible value since lack of adherence by the signatories will result in sanctions and fines.  Of course they will have to borrow money from the IMF and the EFSF to pay these fines but that is beside the point.

Let’s just get on with it. Let Greece default, put it behind us and move on to Portugal, a country that the Germans apparently feel more kindly toward.

Despite all this, and despite Santorum mucking up Romney’s path to the nomination, I am still positive on US equities although fully anticipating a consolidation. I am not one of those in the camp hoping for consolidation because it is healthy for the markets.  I’d rather see an unhealthy market go up every day although that is, of course, unrealistic.

When I was a salesperson at Salomon Brothers many years ago, I received a call from Friess Associates, an account I covered (the Brandywine Fund), inviting me to a cocktail reception at the home of Foster Friess.  I had never met Foster – he had already ceded active portfolio management to his staff – but had been in his office a few times. Lining Foster’s office wall were pictures of him with Presidents and other important people.  I asked why I was being so honored.  Well, came the response, Foster wants your support for Rick Santorum, a candidate he is endorsing.  You can send a check if you can’t attend.  This was a less than subtle way of asking me to contribute to Santorum’s campaign. I said I would look at Santorum’s platform  and get back to them. This was not a response they appreciated.  After looking into his background, I decided very quickly that I couldn’t support Santorum and declined, offering instead to make a contribution to any children’s charity of their choosing.  As with my initial response, this did not go over well.  And times haven’t changed –  I still can’t support Santorum and Friess still does; in fact, he is Santorum’s main backer.  There is a reason these two hang together and both are scary. http://www.reuters.com/article/2012/02/10/us-usa-campaign-friess-idUSTRE8190AK20120210.  And, by the way, I’m a Republican.

Beware of Greeks Returning Gifts: Push Them Into Default

JP has been cutting my hair for about 15 years.  He says the initials stand for Jean-Paul but given his decidedly Asian roots, that would be akin to Woody Allen claiming his real name is Frederico Fellini.  But I understand that working in a salon versus a barber shop requires a higher end nom de plume.   JP’s hands shake, not a great affliction for someone who makes their living holding a sharp instrument to someone’s head; actually not great for the customer either.  But I like JP, and although most who see me would likely disagree, I think he does a decent job.  Until the Greek crisis grabbed the headlines, I never attributed his shaking to having held a pair of shears in his hand as a hazard of his employment.  All that has changed.

Me: Sorry, JP, but I have to call you my barber from now on, or hair cutter, if you prefer.  You choose.

JP: I am a hairstylist, not a simple barber.

Me: Wish I could agree but you’re on the downside of 50 and the standard for a hairstylist, according to Greek doctrine, is that you retire at 45.  Anyone who can’t afford to retire at that age is no longer a hairstylist but rather a barber.

Any doubt in anyone’s mind that if Greece stays in the EU, that we will be revisiting the debacle in 3 months, 6 months, 9 months and every day in between?  My solution to getting their foot off the neck of the global markets is to let them go, push them into default.  That is the only way to put this behind us and move forward.  Short term pain for long-term gain.  Clear the decks and onward and upward. Okay, enough clichés.  The overriding issue is that the profligate countries have to be weaned off the golden teet ofGermanyand, to a lesser extent,France.   Berlusconi has attempted to re-tradeItaly’s austerity plan by extending the implementation date for hiking the retirement age.  Irelandis seeking to re-trade their agreement.  At some point a deal has to be a deal and those living in violation of those agreements have to face the consequences of non-compliance.  By allowing Greeceto default, or pushing them into default (read: bankruptcy) others will get in line.  Of course, there has to be a shock and awe safety net forSpainandItalywere Greece to default but the ECB can and should provide that.  No sense being foolish about this – have to limit the contagion.  There will be enough unintended consequences as a result of this strategy but my sense is a Greek default won’t come as a surprise to anyone.  Of course, the CDS holders will get paid and those that wrote the insurance, or took the other side, will experience a result they weren’t counting on but there is a benefit here.  The CDS market will shrink; CDS writers will understand that countries can go belly up driving the cost of the derivative significantly higher.  And with the shrinking of the CDS market, high risk investments will decrease, involuntarily chasing high risk takers (read: French banks and former New Jersey Governors) out of the market.

Were this to happen it may temporarily prop up the Euro but make no mistake about it, the Euro is going lower.  Europeis trending into recession and the only way to combat contracting growth is by easing as Draghi did today.   TheU.S.economy is getting stronger while the rest of the world is weakening.  That translates into shortEuropeagainst long dollar.  Right now the Euro seems to win both ways; that can’t last forever.

Am I Still Bearish? Sort of Not

I have had very light equity exposure for an extended period of time with periods of being net short to being fairly long. Fortunately, with the indices having been range bound, the opportunity cost has been insignificant. As I mentioned in a prior note being bearish is exhausting, lonely and counter to my natural optimism (although I do admit to always maintaining a healthy dose of cynicism). Imagine taking your child to see 101 Dalmatians and loudly rooting for Cruella deVille to come out on top. Your kid shrinks away to another seat on the other side of the theater while others shun you. That’s how bears are treated.

I continually second guess my investment thesis, trying to see what the other side sees. I weigh the inputs underlying my stance, marking them to market. I try to remove the bias of my position as I seek additional data that is either supportive or unsupportive of my position. And of course, there is always the fear of acting from emotion that prompts a change in thinking, a feeling that you weren’t invited to the party, of being left out. And most of all, there is that greatest fear of all, of having reversed course at absolutely the wrong time. And in full disclosure, I have not always made the turn in a very timely fashion. I did well in 2008 but hardly made any money in 2009. Although I was still ahead of the game, it still didn’t feel good missing out on a ripping bull market move.

So where am I now? I am warming up to the market. Why? Well, I have often said I have seen this movie before and it ended badly but maybe there will be a different ending to this installment because everyone else had also seen the prequel to the 2011 financial crisis. My ending has banks struggling to raise capital, some, like Dexia or perhaps Greece, going belly up, credit continuing to tighten, economies contracting – the culmination of all these fears and others I haven’t listed causing a massive wave of selling. But guess what? Merkel and Sarkozy and the more responsible members of the G-20 and EU were also around in 2008 and they have no interest in revisiting that scenario. Granted they have waited too long and the cost of delay has ratcheted up the price of a cure. Germany and France have the most to lose by not putting forth a viable solution. While expectations for a total and complete solution are still high, they have been ratcheted down enough to be attainable, or near attainable with the promise to be completely resolved in the next 3 to 6 months. Shock and awe is not in the cards and everyone knows it. But will they give us enough to put a floor under the market and cause under invested funds to chase performance? I think so.

Swimming upstream, against the tide of bullishness that is the unwavering stance by the vast majority of pundits and market participants is difficult enough but imagine the flood gates being opened and the water gushing at you as you flutter kick your portfolio like a foam kickboard. The world is awash in liquidity. It all comes down to not fighting the Fed. But the much maligned U.S. Fed has recruited a legion of Central Bankers to fight the battle: the EU, IMF and China. This is a massive liquidity push by every printing press on the planet. So for now, I am entering into surrender negotiations and further increasing my exposure further.

I am by no means becoming fully invested for I still have that evil twin whispering in my ear. The global economy is in terrible shape but what do I know that others don’t? I don’t have an edge on China – it’s a property bubble that has already begun to leak – but the Chief Communist (as opposed to Chief Economist) knows that. I think that will end ugly but they can throw enough money at it in the interim to allow the S&P to rise to 1250, a random number, while their market declines. Europe is in recession but that thinking is convention and is nothing that $1.3 trillion can’t cure.

The most alpha will likely be generated through commodities and materials – the most economically sensitive investments – but I can’t go all that way in. There is too much risk in case I am wrong. I do like the fertilizer companies for the long term and although recovering, they have been beaten worse than a Middle Eastern dictator. I still prefer the more boring fundamentally, bottoms up investments epitomized by MDRX, KO, QCOM, WLP, NIHD. My risk is in bottom fishing on HPQ and, dare I admit it, RIMM. I cut back my Euro short against the dollar but will rebuild that position again at some point.

How long the cure lasts is what keeps a lid on my exposure. At some point austerity leads to slower growth and U.S. economic policy is non-existent as Washington remains rudderless. Everyone believes China will bail out every local government, corporate and individual spectators but I don’t. After all, they are communists and not prone to providing handouts to failing billionaires or local governments who have repeatedly disobeyed central government directives. There will be some pain to teach them a lesson.

I won’t be discouraged if there is a sell on the news mentality once the EU deal is announced. And I am rooting for another delay in the announcement because that means they are still arguing – eh, negotiating. And I expect leaks from the negotiations to cause some volatility. We should continue to move higher, perhaps rally 20% before going lower, likely hitting prior lows.

Whoops, there I go again.

European Sovereign Debt Crisis Survey – What Is/Was Discounted In The Markets

In my view, the most important issue facing the markets is the European sovereign debt crisis. This issue is the breeding ground for so many other factors facing the global economy being that the EU collectively represents perhaps the most significant trading partner for China and the U.S. With this in mind, last Friday, I sent out a survey containing 5 simple questions to a small portion of my contact list with the intent of gauging what sophisticated, institutional investors believe the market is telling us about resolution of the crisis. Admittedly, the sampling was small in terms of respondents but the dollars under management significant. I supplemented the written survey with  conversations soliciting responses to the same questions. Fortunately, not one of my friends added me to their Do Not Call List. Now, in full disclosure, I am not a graduate of Quinnipiac University nor a former employee of Harris Polling, but this did not stop me from understanding the clear message of the data. The overwhelming majority of the respondents believe that the market is discounting the most positive scenario and that if this were not delivered, albeit with a time frame for compliance of 3 to 6 months, that the indices would hit new lows. Giving credence to this view is the fact that the recent rally in the S&P began contemporaneously with the Sarkozy and Merkel speech wherein they stated that they have a meeting of the minds regarding what needs to be done to stem the crisis. November 3rd was the drop dead date they offered for presenting a unified plan although recent chatter and an increased sense of urgency has served to have brought the date for resolution closer by a week.

Today, this changed, as Germany threw cold water on a shock and awe solution resulting in a 2% decline in the S&P. It would not be inappropriate to argue that the market went from an oversold to overbought and today’s action was normal consolidation but I disagree. Now, in fairness, I applaud the Germans for reining in expectations that became much too optimistic. I had, in fact, pointed out in prior notes that the news flow would create peaks and valleys in the averages along the road to November 3rd. Today was the first valley but I feel there will be more to come. I also mentioned late last week (Have We Seen The Future: The European Solution…  October 13th) that I had taken off some long exposure and right now I have no interest in revisiting my strategy. That was the right move and I further reduced my net long exposure early in today’s trading session.

I hope the Europeans continue to reset expectations but even if they do, it will only forestall the inevitable because I do not see shock and awe coming anytime soon. I remain cautious on the market overall and continue to see the Euro short as a compelling investment.

Have We Seen The Future: The European Solution/ China Slowing?

Being bearish is so exhausting.  I felt so lonely; every day reading analyst research reports increasing estimates, strategists targeting S&P 1300 – it was getting to me. And then the endless articles about the negative feedback loop, castigating those who dared voice a jaded view on the economy.  Much like those kindergarten girls who I coached in soccer many years ago, I thought every broad based comment was directed at me.  I needed a break.  I decided it wouldn’t be that difficult to change my outlook since I tend to be more optimistic than pessimistic. I find life much easier that way and with my golf game if I focused on the negative, if I only looked at the blemishes, I would be a really bad tennis player instead of a decent golfer (caution: literary license at work). I looked for an opening, a sign of what could go right.  Europe was the biggest near term issue and I decided to put myself in the Germans’ shoes. I took off my Tod’s, after all, they are a sign of profligate Italian spending, and figuratively put on a pair of Jackboots. I channeled Merkel and decided that the German motivation for holding the Euro together was stronger than the Greek’s desire to derail it.  After all, given that Germany is one of the strongest economies in the world with trade surpluses only recently surpassed by China, if they were to have their own currency it would decimate their export economy.  Germany needs weak partners in the Euro so that their machine tools and cars look cheap to the rest of the world. 

 

I took off all my short exposure, primarily index shorts, beginning of last week, which of course, took my long exposure higher. I added to this by increasing my holdings in some core holdings including KO, QCOM and WLP, and picked up a bargain in NIHD. I started to pare back exposure yesterday, first at a leisurely pace, only to see the news about the potential framework of the European bank recapitalization erase about a third of yesterday’s gains. The news wasn’t a surprise to me; I had written that I had expected bumps in the road to EU resolution from “leaks” and dissension to occur before we reached the moment of resolution. Slovakia didn’t scare me; their decision was an easy one – either return to using live cattle and goats as a currency or approve the ESFS.  For the Slovakian politicians, with 50% of their trade into the EU, it is only a question of how many new Mercedes and Volkswagens they could wring out of the Germans.  My reason for cutting back exposure was fairly simple which is that the market move higher was, in my view, entirely due to Sarkozy and Merkel guaranteeing a “deal” by November 3^rd.  For bulls, the European debt crisis had been the governor on the market, holding it back from much higher levels, believing that corporate earnings remain robust and that China is not slowing.  But has the market been too generous in taking Merkozy at their word when they have arguably done little to earn it.  And, by the by, the EU isn’t only about France and Germany.   

 

So what is the market assuming?  My best guess is that equity investors assume a shock and awe plan which would entail:  massive liquidity injections into the economy whether in the form of a TARP like plan or some other mechanism: continued buying of sovereign bonds; capital injections into banks and backstopping future equity holders accompanied by massive dilution to existing shareholders; and either Greece defaults in a controlled manner, with a one time alimony payment, or a write-down of its debt to believable levels.  SIGN ME UP.  Actually I did sign up as I noted above.  Instead what we got yesterday was the hint that the banks may be given a period of time to raise their Tier 1 capital ratio to 9%.  They are a number of ways to do this: sell equity which they have said they don’t need thus limiting the appeal of doing so at 50% of book (I choose not to believe those numbers); convert debt to equity; or cut credit lines which, of course, has the impact of improving the balance sheet. If this were to be the plan, we saw the future yesterday in terms of US equity market reaction and today, in the sell-off of the European markets.  It wasn’t good.  But even assuming the markets go for this plan either because optimists win the day or because the market retreats thus lowering the hurdle rate what is acceptable, and the banks succeed in raising capital, there will be marked uncertainty during the period of capital raising and the eventual effect will be a slowing of growth as credit availability declines.  And this, of course, assumes that investors are as gullible in believing that Tier 1 capital is 9% as they were in believing the stress tests were accurate.  Bottom line, to quote that noted philosopher Michelle Bachmann “the devil is in the details.” 

 

The other issues of course are what a Greek default would do to the markets and the potential for a downgrade of French debt.  The best news for France is just like in WWII, they were on the sidelines while we fought the battle.  As the US came through virtually unscathed so will the French.  As to a Greek default, the result is more up in the air. Most equity investors I believe assume that any default would be accompanied by ring fencing the debt of Spain and Italy and this would be positive.  Who needs ouzo when we have grappa? Of course, any significant haircut only worsens the bank’s balance sheets but that is assumed to be taken into account as well. What about a big haircut: well, the banks responded to that potential today much like Hercules did when faced with the same scenario. 

 

But wait! Here comes Mario Draghi to the rescue.  That’s like putting Bernie Madoff in charge of compliance.  Draghi knows how to spend it so he knows austerity from the other side.  He will undoubtedly cut rates at either his first, or more likely, second meeting.  By that time, European numbers will show recession and commodities will have declined to a level low enough to provide cover for a 50 BP cut. 

 

Unless the Troika comes forth with a plan of shock and awe that removes all doubt about further contagion, I see the market fading.  Even if the shock and awe doesn’t dazzle, the surrounding issues are becoming too prevalent to ignore. In my view, as evidenced by the trade numbers form China, the European economies are slowing significantly.  US earnings season has a decidedly different tone out of the gate then those of the past 6 or so quarters. And Washington is still a mess. Actually the bright spot from Washington is that I expect a partial ray of sunshine as the Republicans and Democrats come to common ground on some mechanism to create jobs. I would expect infrastructure spending and military put to work in some fashion but keep in mind that there is a decent lag to the passing of the bill and the actual spend.  I also believe that if Romney is able to break to the front of the pack convincingly, it might actually help matters in D.C. and bring Obama more to the center while also giving business leaders hope if Romney can take a strong lead in the polls over Obama.  However, with no votes being cast in any primaries just yet, this is way too soon to call.

 Is China’s export economy slowing or are they trying to fend off a trade war and pressure to let their currency rise by showing such poor numbers?  Depends if you believe their numbers or not.  I do in this case but only because it supports my investment thesis on China slowing. I’ll take what they give me.  Jawboning down economic activity further pressures commodity prices allowing them to stockpile inventories. 

 JPM:  if JPM can’t put up decent numbers with the strength of their franchise, then what does that say about the rest of the financials?  The regional brokers are in for a world of hurt. JPM is picking up share in IB and still down 31%.

 Although I disagree with what appears to be the overriding premise of the OWS movement which is the distribution of earned wealth to those who haven’t earned it such as community organizers (sorry that slipped.  After all, community organizers are the farm team for the Presidency), I do admire their ability to mount a globally coordinated effort.  In fact, I would like to see them share their insights with the EU and Washington in terms of how to accomplish a purpose, any purpose at this point. 

 I think RIMM’s moment of silence for the passing of Steve Job’s lasted a bit too long.

European Sovereign Debt Solution

The way I see it is if the Troika (EU, ECB, IMF) provide a different “minister” to speak with the media each day for the purpose of leaking out potential solutions, the Dax will be at 7000 and the S&P will hit 2000 before they have to come up with a plan that the markets may not like and that may not be a workable solution.  In fact, the credit markets may heal themselves in tandem with the equity markets moving higher.    Brilliant!!!

The European Sucker Play; US Stock Bargains; Apple

The most important real near term news coming out of Europe will be the ECB rate decision tomorrow. Trichet is bidding adieu at the end of October and this is his last opportunity to reverse the prior rate hike. Does he head to Hotel du Cap admitting a mistake or stick to his guns and allow Mario Draghi to cut, although he has previously said it isn’t necessary. Perhaps the economic releases this morning may spur the correct decision, in conjunction with recent declines in commodity prices. Eurozone services PMI fell to 48.8 from 51.5 according to Markit survey, first month since August 2009 below 50. In other releases, Germany was sub 50 as well, France barely above 50, Italy and Spain continue below 50 at very low levels of 45 but they are already in recession. My guess is that France and Germany experience contractions in economic growth as well.

More importantly, does the troika come up with a major bail out prior to Trichet leaving and before Draghi takes over. Not sure how many EU members want an Italian telling them they have to pony up vast sums to save Italy. Fox guarding the chicken coop? Not quite but this will ratchet up the opposition or lengthen the time to cure if Trichet doesn’t act first.

The Financial Times had the story that wasn’t a story. The following 2 lines squeezed the shorts, lit a fire under those with light exposure and gave us all something to talk about.

“There is an increasingly shared view that we need a concerted, co-ordinated approach in Europe while many of the elements are done in the member states,” Olli Rehn, European commissioner for economic affairs, told the Financial Times. “There is a sense of urgency among ministers and we need to move on.”

“Capital positions of European banks must be reinforced to provide additional safety margins and thus reduce uncertainty,” Mr Rehn said. “This should be regarded as an integral part of the EU’s comprehensive strategy to restore confidence and overcome the crisis.…”

Rehn’s statement was nothing more than an attempt to put a temporary halt to the market crisis, an admirable goal, but hopefully there is ultimately more substance behind it. With the public division in the EU about solutions, I fear any resolution will be a long time in coming. Even the ESFS is flawed with Italy and Spain committing to guarantees of 79 billion Euros and 52 billion Euros, respectively. And, of course, Greece has agreed to be on the hook for 12 billion. I feel better now.

So the market basically did a hosanna that it has dawned on the EU finance ministers that they have developed a sense of urgency and will act together. Truth is we don’t know that they will act together but ultimately there has to be a plan. Unfortunately, from where I sit, the plan won’t be good for anyone, particularly the banks. We need a flush of the credit markets with tremendous pain being visited on the private sector because the political will for government to bail out all troubled banks and PIIGS does not exist. The result would be to wipe out the equity of a number of French banks as we are seeing with Dexia, which was originally bailed out in 2008 by France and Belgium. Now here they go again. Public shareholders have twice suffered significant losses. Dexia is also a good example of contagion as the municipalities in the US that do business with Dexia will likely see their borrowing costs increase as a result. And this is a minor case of contagion; it will get worse (Plus the 2008 similarities continue with good bank/bad bank solutions that don’t work.)

My bet is that Greece defaults in a “controlled” manner (not sure that exists) with limited alimony payments from the EU as a going away gift. At the same time, Italian and Spanish debt issues are ring fenced, the French banks recapitalized after taking significant write downs which almost wipes out equity holders with new shares or debt being backstopped by Germany and France as the main players. France loses their AAA, which is past its sell-by date anyway. We will also see massive liquidity injected into the European financial system causing a further decline in the Euro.

I’m waiting for this event to increase my exposure. With the slowing in China, Europe and the U.S., I’m highly confident that I can get a better entry point and keep more hair from falling out.

AAPL – still a cheap stock and the issues are well discounted in the stock price. I’m not going to beat up on Street research – well yes I am. The Street clearly has no idea what is going on with the company. If they can’t get major product launches correct, how are they doing the more difficult task of forecasting. It took me a few days to get a number I was looking for which is what percentage of ipads sold are wifi only. I’m going with the only answer that I got which is 65 – 70%. This is interesting because much was made of the fact that the new Amazon product is only wifi. Well, at a $300 difference for a product with a great brand name and very good functionality, if I didn’t own an ipad, I would seriously consider the Kindle Fire. I know that the ipad has 425,000 apps and the Fire doesn’t, but frankly, I ran out of patience after putting the first 150,000 apps on my screen. My issue with AAPL is margins. With strong competitors like Amazon and Google (android) at lower price points, is yesterday’s pricing of the iphone 4 and 4S a harbinger of lower margins and more competition? Apple has never been one to price to competitors’ levels but shouldn’t hat have to change? Tim Cook noted that 92% of the Fortune 500 are testing ipads. The opportunities in the enterprise space are interesting but keep in mind that most likely this is demand push by Apple, a common sales technique which I am glad to see them employ. I’m sure there is reverse inquiry as well. I would also guess that corporate procurement execs are more concerned with costs in a challenging economic environment and agnostic as to which quality brand they purchase. The dominant corporate usage is also likely wifi since it will be on premises as ipads are not a good substitute for laptops. Nonetheless this is a great revenue opportunity particularly if it scales into other Apple products.

Finally, on the US. We’re still without a plan and the economic numbers continue to look punk, today’s non-mfg ISM the latest example. Freight stocks are moving higher despite yesterday’s IATA airfreight numbers remaining below seasonal trends indicating a slow economy. Asia and the US showed particularly poor.

Even though the market is oversold and will have bear market rallies, I remain on the sidelines for the most part but do like a few stocks.

Wellpoint’s valuation seems compelling at less than 9X 2011 EPS. Company guidance is in a tight range either side of $7.00. They just added $5 billion to their buyback, an astonishing 21% of the company. Management said it will be completed over several years but they just bought back $1.5 billion since announcing a $1.6 billion program in February. That was about 5%. Plus I’m getting an okay yield of 1.6%.

I also like KO. Not huge growth but very dependable, the risk to earnings from currency being discounted by recent downgrades from the Street. At a 12 P/E and 3% yield it provides good, lower beta market exposure. If market explodes higher, neither WLP or KO will lead the pack but I will participate in the upside with limited downside.

QCOM remains a core holding. Tim Cook is an engineer and over saw procurement so he’s definitely on board with QCOM as the relationship, started in earnest this year, has taken root on his watch. They own CDMA and are embedded in android as well as ipad and iphone. QCOM ahs also been very friendly to shareholders, often returning capital.

HPQ is also inexpensive, even with a haircut (all the rage in financial circles these days) to earnings. My primary concern management, including the BOD. Still wish Meg didn’t speak about making the quarter. Would rather have had her reset bar lower.