The Market: New Year’s Resolutions Are Made To Be Broken; More Positive On US Equities

The Market: New Year’s Resolutions Are Made To Be Broken

 

I sat back and marveled at the action in the global markets on Tuesday, wondering if these non-human entities had all of a sudden turned human making New Year’s resolutions to ignore underlying fundamentals and rally 2% a day. But guess what, markets don’t drunkenly warble Auld Lang Syne in symbolic banishment of times gone.  There is no Lord of the Calendar presiding over the indices, ripping the pages of 2011 from the binding, erasing the memory of an ailing global economy, resetting expectations to a level of attainability where economic indicators such as Eurozone PMI indicating a contracting economy are now a positive indicator.  In fact, the only symbolic symmetry I can find is in the economic hangover rattling the brains of money managers finance ministers and newly crowned technocrats the world over.

 

So as January rolls around we are still faced with the same positives and negatives, each release of data driving the markets, each tick of the currency market correlated to the price of commodities and equities.  But here’s THE but: I am more attracted to US equities than I was in 2011.  That is my resolution for the New Year BUT unlike those who resolve to lose significant weight in 2012, my complete transformation won’t happen in one day although it should endure past the next buffet – I mean, rally.

 

Yesterday’s Unicredit rights offering was not a positive sign for the markets.  The 27 investment banks underwriting the offering reportedly accounted for three-quarters of demand for the $9.8 billion offering, a high price to pay for a call option on future fees and one which toxifies (literary alert: new word) their balance sheets in the name of fees and, no doubt, in response to arm twisting by the ECB.  Shareholders were diluted to near zero and the deal was underwater from the first tick.   Can’t imagine there is much appetite for these types of deals going forward as it will swell “bad” assets at the banks involved, somewhat ironically I might add.

 

I still believe that we will see nationalization or partial nationalization of some banks.  The reason is simple: as with Unicredit, their problem loans and refinancing needs exceed their market caps.  Additionally, compliance with Basil standards has led to these banks pulling in credit lines, the most immediate response, which has stifled credit and slowed economic growth.  This, of course, is why the ECB has initiated their lending program.  I surmise that Draghi has had conversations with the banks taking advantage of this lending facility to participate in the new issue market.

 

Next week is critical as Italy and Spain come to market seeking capital from charitable buyers.  European debt is actually not a bad play if you can hold it longer term because it is extremely unlikely that either country will default.  However, I’m not playing and believe the price they have to pay to fund themselves will be extraordinarily high and for Italy this is only the beginning of their refunding.

 

All of this comes down to the fact that there is still no plan to “cure” the credit crisis in Europe, absent austerity measures that will likely not be enforced or enacted to the necessary magnitude and will only be effective in continuing to drive the EU economy into recession.  It is a lose-lose situation.  The loan facility has removed fears of a Lehman type moment but that is not nearly enough.  We still need to see the heavy artillery from the EU in the form of stimulus.  For example, Italy has had one of the slowest growing economies over the last 20 years of all OECD nations.  They can’t cut their way to growth.  I look at the banks continuing to park funds overnight with the ECB at record levels as insider trading: they know their market better than sell-side analysts or pundits and if they are willing to take such an imbalance in rates of return in exchange for the safety of the ECB, the problems are as bad as I imagine them to be.

 

But China will save us all!  No they won’t; they will look out for themselves and prey on the markets as they always have.  They see commodity prices declining so they will not enter the markets and be the support mechanism until they are down to their last copper penny.   China is on the bad end of two phenomenon:  its property bubble bursting and its primary end market’s  – the Eurozone – declining economy. Their trade surplus declined from $180 billion in 2010 to $160 billion 2011, numbers that any other nation would be happy with but not the Chinese.  This is positive for the US but may be a short lived victory as they dropped the value of the yuan this morning, a reversal of prior policy and a move that will undoubtedly flame already tense relations with the US.  This is a strong indication that the Chinese are very, and justifiably, concerned about their economy markedly slowing despite the recent PMI release.  This slowing will, of course, hit the global economy but especially Australia which is why I am short the Aussie dollar, albeit small for now.  Additionally, the property market in Australia is in horrendous shape and significantly hurting their banks and populous.  They have to lower rates, further pressuring the currency.

 

Now here is the good news as I see it and it resides squarely with the U.S. market and as a devout patriot, I couldn’t be happier.  The US treasury and stock markets are the global default markets of choice. Despite 2011 4Q negative pre-announcements hitting a high previously seen during two prior recessions in 2001 and 2008, the economic data is getting better.   Today’s jobless claims number continues to trend downward, which I believe is a function of a smaller sampling and companies having already cut through muscle so perhaps not an indication of a vastly improving employment picture but positive nonetheless.   Corporate earnings lag the improvement in the economy as companies ultimately respond by hiring more workers.  However, I do see earnings estimates continuing to decline, particularly multinationals from the combination of weaker export markets and a stronger USD.  Analysts are too optimistic in their S&P estimates for 2012.

 

So I remain relatively lightly position in equities, short the Euro against the dollar and short the AUD.  The U.S. equity markets will continue to react to the worsening situation in the EU and have a tough time rising near term.  However, asset allocation to equities, which I expected to see last year and perhaps we did to an extent, will ultimately drive equities higher so I don’t mind increasing my exposure opportunistically.

 

My preference is in defensive, domestically focused companies including healthcare, specifically managed care, nat gas, well-positioned retail, MLPs, utilities, US telecom and strong brands such as SBUX.  Some of my specific holdings are: CHK (CEO continues to pay down debt and restructure production toward liquids from nat gas as he said he would), WLP (inexpensive, buying back significant stock, defensive), NS (7.5% yld, insider buying), QCOM (market leader), GM (cheap but not in love with name), KO (yield, defensive but currency issues), EUO, short FXA.  Would not mind being short LNKD, GRPN, NFLX and ZNGA. This earnings season will be marked by currency adjustments and caution about Europe so I will mostly stay away from those companies playing in those areas.

 

Meanwhile, with some stability returning to the political scene in the US and Romney moving to the forefront, any sense of his emerging victorious in November will finally motivate US companies to spend the massive cash hoard on their balance sheet.  This is not an immediate event, however.

 

So there you have it. Nothing much has changed, the focus required to write 20”12” instead of 2011 really the only thing new.  I get the hang of that relatively quickly, usually after writing about 5 checks and filling out a few forms.  The markets however, have not changed their ways at all, renouncing their resolutions after a mere two days.

 

In sum, I am more positively disposed to the markets and have slightly increased exposure but want to get a better glimpse of the earnings season and the critical refunding periods for European debt before getting longer.

Where Are We Now

The market has had its run – and a big one at that.  Yesterday’s EU announcement was the big event bulls were waiting for and bears were dreading.  But where do we go from here?  That’s all that matters.  When the S&P has a near 4% increase in one day, on top of a double digit rise in the prior month, it’s time for a pause and some profit taking.  No one should be surprised by that.   In expectation of this give back I exited or significantly decreased my trading positions yesterday afternoon, but did not touch my core holdings.     Like the morning after hangover, the “why did I drink so much last night” question will plague many as they ask themselves why they dove into the market yesterday as it climbed higher.  Not only do they wake up with a pounding headache but they turn to the lump passed out next to them and think to themselves that he/she looked better in the bright lights of euphoria when their judgment was impaired by the toxicity of a spiking market.

My exposure is still higher than it was two weeks ago but still nowhere near fully invested although I never am completely in.  But even with that as a measure, I am what I would consider to be relatively light – roughly net long 35-40%.

For those without conviction, get out now, because the market will begin to dissect the EU solution in earnest and, more acutely, naysayers will circle around Italy, driving their rates higher and CDS spreads wider.  The volatility will continue unabated as news flow continues.  “Europe in Recession.”  “Super Committee Deadlocked; Parties Still Far Apart.”  “China Agrees to Buy EU Bonds.”  “China Declines to Participate in EU Bailout.” “European Leaders Disagreements Threaten Accord.”  “Italian and Spanish CDS Spreads Widen.” ” “France AAA Credit Downgraded.”  “Obama Has Not Been Seen in Washington for Weeks.” “Berlusconi Seen Partying with Lindsay Lohan and Porn Star Legislators Voice Their Jealousy in A No Confidence Vote.”   Expect to see them all. Yes, even the one about Berlusconi.

My primary issue with the plan announced yesterday is that there was no obvious ring fence around Spain and Italy.   There are tools that the ECB has at its disposal and will do all they can to make Italian and Spanish bonds look attractive but for those that take their cue from the credit markets, and I am usually one of those, the lack of any substantial rally in Italian and Spanish debt was a troubling sign.

So here is my conclusion:  the market is still fine.  I am not selling into the headlines but did lighten up into yesterday’s close. The markets continue to be in an overbought position.  But if the market just tracks reduced expectation for S&P earnings growth, it still has nice upside.   There is sufficient bearishness and cash to propel us higher into year end.   There will be profit taking and substantial volatility along the way as Merkel leads her colleagues through the hammering out of the details but as the biggest beneficiary of one currency, Germany still has much too much to lose if the agreement falls apart or doesn’t satisfy the markets.  My preference continues to be for defensive stocks so I capture some upside without being mortally wounded on the downside should the market collapse.

I got stopped out of some of my Euro short against the dollar but will add. Euro goes to par eventually.  I had sold most of NIHD before earnings but bought it back yesterday with an average cost near yesterday’s close.  Clearly that was a mistake but I’m sticking with it.  Less than 3X EBITDA is too cheap for this stock.   HPQ – still astonished about initial BOD approval to spin or sell PC business.  Apparently they did no prior analysis on that decision given comments from Whitman yesterday.  I’m still there but believe entire BOD should be fired.  Like KO, WLP., concerned about QCOM into EPS and high expectations.

Am I Bearish – Part II: Very Much Not – For Now

As I detailed in my post from 10/21, the resolution to the European sovereign debt crisis has played out according to what I had anticipated.  Merkel had sufficiently lowered expectations to allow for a plan the market would embrace.  U.S. corporate earnings are benefiting from the same mechanism: beating lowered expectations.  With bearishness so high, as expressed in cash not just sentiment, the market was spring coiled for a pretty strong move higher.   I had raised the prospect of a knee jerk sell on the news, always need an “out,” but that was not my high probability case and I did say I would have added on that momentary decline.  I dont’ expect same reaction in US markets as we had in Europe.  Asia type pop is more likely today.

But that is just for today, we will go up by 10-15% from here.  How do I get to my upside: market basically flat on the year despite S&P earnings up approximately 15% this year and forecast up 13% next year.   So we’re behind by that 15%, at least.

So where are we now?  Europe is in a recession and it will deepen.   In order for the banks to get to 9% Tier 1 ratios, they will begin by pulling in credit lines, removing that portion of  their liabilities.   This will lead to a further stifling of credit. Austerity measures will further crimp spending.

But most importantly we face the overhang of the details.  But at this point there is no reason not to believe that the EU will work out sufficient details to support the plan.  Maybe Washington can take a lesson on getting a plan to the finish line from the 17 EU currency countries. Nonetheless the trend of the market is higher. I am still sticking with high quality defensive stocks for the most part: WLP, KO.   After today, junk will still be junk and quality, still quality.  NFLX still overvalued, RIMM, despite all its problems, still cheaper than NFLX.  At least they are making money during an all out assault on their business model.  Hold sold most of NIHD before release given high expectations and big run but will buy tight here, down 14%.

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.

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.