Earnings Season Is The Reason…

…not to sell your equity positions. At least not yet.

Based on the fact that a sufficient number of macro economic reports came in above consensus expectations during the first quarter, there is a high probability that 1Q10 earnings results will exceed earnings expectations in the coming weeks. And that appears to be more than enough of a reason for investors to sit tight with their equity holdings for just a touch longer.

Producing its second highest reading since being created one year ago, the Blue Marble Research proprietary Macro Economic Reports Indicator (MERI) registered a +8 for the first quarter of this year. The +8 number is second to the +12 reading for 2Q09, a quarter that resulted in well above consensus earnings reports for that quarter. Since most investors are of the bottom up stripe, waiting for the good earnings news should help restrain same investors from heading for the exits BEFORE the positive data is shared. The most immediate stock market relevance to the earnings reports is what happens to stock prices as the results are published. For those more bearishly inclined, the soon to be reported good news earnings season sets up a potential “buy on the rumor, sell on the news” scenario for stocks. However, on its own, such an occurrence is likely to NOT result in the long anticipated big correction (>10% in the US, >20% in higher beta markets).

Not Enough For The Big Enchilada

For something more substantial to occur to the downside in stocks, something more substantial needs to arrive on the scene to serve as the catalyst that brings into doubt both the sustainability of the bull market AND the economic handoff (from government spending to private sector growth) necessary for a sustainable economic recovery. There are many candidates capable of serving the role of stock market correction catalyst, with the leading prospect being rising long-term US interest rates. In this regard, the 10 year US Treasury rate is the prime suspect for the role.

As I noted in last week’s commentary, a rise in longer-term interest rates would produce a hit to valuation models that would be both direct and immediate. In its most simplistic form: rates up, P/E ratios down. Given the fact that so much of this bull market is anchored in the above average P/E ratio thesis (>15 times earnings, so justified due to low interest rates and low inflation), rising rates hold the potential of blowing a meaningful hole in that view – enough to take stocks prices down for the prescribed market correction amount (>10% in the US, >20% in higher beta markets).

What About Higher Growth Rates?

All fundamental valuation models identify two factors has having the largest impact on the present value of an asset – the discount rate (which includes interest rates) and the growth rate (of future cash flows/earnings). Accordingly, the offset to rising interest rates – rising growth rates – would most likely not occur as immediately as the bulls would argue due to concerns regarding the viability of sustained economic growth, as the aforementioned economic handoff will be brought into question courtesy the implications embedded in higher long-term interest rates. Regardless of what might be speculated re rising long-term rates, the very fact that rates are now on a upward glide path should be more than sufficient to raise the appropriate cautionary views toward equities.

Then there is the technical analysis hit to the market, as the upside move in rates would trigger a plethora of market technicians’ forecast of a major, multi-year head and shoulders bottom – with its measured upside move to 6%. As investors seek to make sense of the rising rate environment, market technicians will do their part in duly noting the message of the market – whatever it may be saying.

Our Old Friend The Shadow Banking System

Another equally important candidate for the catalyst role would be a global version of the Greek fiscal drama currently underway. As the lack of transparency in the sovereign and other debt markets (which I would include US states and other governmental municipalities throughout the world in that mix), just who is on the hook for what remains shrouded in the shadows (as in the shadow banking system). Such as point was noted quite articulately in yesterday’s FT commentary by Ken Rogoff.*

Investment Strategy Implications

To some investors, what I described above could easily be perceived as an attempt to squeeze out a few more basis points from the overvalued, long-in-the-tooth stock market stone. Such thinking may actually turn out to be correct. However, absent a catalyst it is hard to envision what could derail the bulls momentum.

Given the massive amounts of cash still sloshing around the world economy and financial markets, the strong economic health of most businesses, globalization damaged but not broken, and the global growth story still fairly intact, it appears logical that something more substantial will be needed to bring into doubt the bullish case. And that is what market corrections are all about – doubt that what was will resume.

For such doubt to arise, a catalyst is most likely needed to trigger the requisite angst that is the hallmark of a stock market correction. In this commentary, you have the two leading candidates for that role. There are others.

This is not a matter of if but when (and who).

*”Bubbles Lurk in Government Debt”, Financial Times, April 7, 2010.

In Defense of Financial Innovation

There is considerable talk (much of it rather regressive) about the future of the financial system. In one camp are the advocates of a return to basic banking. Think George Bailey and “It’s a Wonderful Life”. Paul Krugman, John Bogle, and Meredith Whitney appear to belong to this group. Then there are those who believe that the system should evolve from where it was, only with better oversight and far greater transparency. By all accounts, Secretary Geithner and Mohammed El-Erian belong to this group.

As unpopular as it currently may be, I’m on the side of the Treasury Secretary and PIMCO CEO for the following reasons:

I believe financial innovation must be allowed to grow and even flourish as the benefits of risk management and opportunistic investing through derivatives, structured finance, and other heretofore unknown instruments is vital to the complex world of globalization and global capital flows. Financial innovation allows for the more efficient use of capital in new and innovative ways thereby enabling greater growth potential across most markets and economies. Perhaps most importantly, as providers of global capital, financial innovation is important to the dominant players in the markets - major institutional investors (pension funds, sovereign wealth funds, endowments, hedge funds, etc) - and their ability to manage large sums of money in the vast and growing global markets and economy. They want it. Even need it.

The George Bailey model is simplification for its own sake. A Luddite-like natural recoil action to the pain and suffering caused by the failure of proper oversight and transparency. Moreover, the Bailey model would relegate the US financial institutions to a dumbed-down version of finance completely at odds with a globalized world and economic system (not to mention the unintended consequences of assets flowing to other, more forward-thinking markets). I believe Secretary Geithner sees and understands this and that is why, much to the consternation of many old school thinkers, he is intent on keeping the current financial infrastructure in place, just fix that which went out of control courtesy limited oversight and inadequate transparency.

With better oversight and greater transparency, the benefits of financial innovation to the global economic system far outweigh the damage wrought by the inept supervision of a complex world of finance and capital flows.

Think of it this way, did FDR blow up the stock market after the 1929 to 32 crash? What he did was create the SEC, which served the system well until the free market ideologues got control of it over the past several decades and, with the aid of financial innovation, allowed the animal spirits to run roughshod over common sense and prudent asset management. Another example would be the Internet and the tech bubble blow up. Did technology innovation stop because of Enron and WorldCom and the multitudes of dotcom implosions? Of course not.

Financial innovation is a tool. And like any tool, it can be used for good or ill. You don't ban knives because someone gets stabbed. You don't ban guns because someone gets shot. And you don't ban cars because someone gets run over. Innovation is essential for forward progress. And, in the case of finance, an enabler of better asset and risk management.

Financial innovation is the baby. Don't throw him out with the bath water of poor oversight and limited transparency.

TARP Version 1 Revisited: Mark-to-Market Back in the Crosshairs

“Senior Wall Street executives said yesterday that they had been sounded out on plans for an “aggregator bank” that would purchase toxic assets from banks. Under one of the plans discussed, toxic assets would be valued by an independent third party. Where assets are purchased at prices below their book values, the government might then inject common equity into the banks to make up for capital wiped out by the sales.”
Financial Times, January 28, 2009

On the surface, mixed signals are emanating out of the US Treasury department. Last week, Treasury Secretary Geithner stated that he was comfortable with mark-to-market accounting. Today, we learn of the above quoted plan, which is a direct assault on mark-to-market – the real villain in turning a recession into potentially a depression. What gives?

To refresh your memory, mark-to-market accounting is rooted in the failed ideology of the efficient market hypothesis, which (in its “strong” form) says that when it comes to determining the fair value of an asset the market knows best. This dogma is so entrenched in the thinking of mainstream economists and many naïve investors that even Nobel Laureates such as Paul Krugman ascribe to this fantasy of the “wisdom of the market” (see "More on the bad bank"). Moreover, there is little doubt on these pages that the primary reason why TARP Version 1 went from “price discovery” (code for attacking mark-to-market) to bank capital infusions was due to the intimidation of then Treasury Paulsen by mainstream, non behavioral finance economists.

Investment Strategy Implications

Conspiracy theorist alert: Clever guy this Mr. Geithner. Publicly advocate for free market principles (mark-to-market) while working behind the scenes to exploit it (through the aggregator bank and price discovery (courtesy the "independent third party")).

The significance of keeping mark-to-market intact is the extraordinarily positive impact it will have on bank earnings as assets held at 20 cents on the dollar are written up ("say what?" you say) thereby producing large earnings gains. Moreover, by stabilizing the valuations of “toxic assets”, write ups will thereby alleviate banks’ capital requirements, which is the primary reason why bankers are reluctant to lend. Under the bizarro logic of mark-to-market, they need the cash to remain solvent – hence no lending.

Once mark-to-market is replaced by something like mark-to-maturity (suggested by Bernanke during early days of TARP Version 1), then, miraculously, liquidity will begin to flow through the banking system to the real economy. Sounds too simple? Allow me to refresh your memory on another non real economy factor that wrecked a large amount of unnecessary havoc on the global economy – commodity speculation and the price of oil.

Patience, The Lost Virtue

As the alternate universe of derivatives continues their great detoxification unwind, financial assets struggle to comprehend a world in transition to a new financial and economic order. In the process, fixed income markets remain frozen while equity markets lurch from one end of the prospective economic spectrum to the other in near 1.0 correlation.

Investment Strategy Implications

The derivatives tail continues to wag the cash market dog. For traditional investors (those who still believe in things like earnings, P/E ratios, and Discounted Cash Flow models), the only path through this chaotic, cold-turkey transition from an economically juiced, over leveraged, structurally imbalanced world to a less leveraged, more balanced one (e.g., global growth being less dependent on the US consumer) is patience. The alternative is to sell everything and hope that one is smart and quick enough to time their re-entry point.

Investors (in the true sense of the word) will follow the former while traders will choose the latter.

Lehman's Credit Default Swaps Settlement

If you are looking for a reason why stocks are plunging, here's one major reason.

Today, at 10:30 AM and then again at 2 PM (both eastern time) announcements re settlement of the massive Lehman Bros. credit default swaps will occur. According to one trading desk source of mine, the equity markets are far more concerned on this point than are the debt markets. Earlier this week, the settlement of Fannie and Freddie CDS' were announced.

While the settlement of the Fannie and Freddie loans was enormous, the CDS settlement prices were more than 90 cents on the dollar making the CDS losses far more manageable (less than 10 cents on the dollar). However, as the Financial Times noted last week, "In the Lehman case, numerous banks and investors have already made losses due to exposure to Lehman as a counterparty on numerous derivatives trades. The auctions next week are for credit derivatives which have Lehman as a reference entity. There are likely to be fewer contracts outstanding than for Fannie Mae and Freddie Mac because Lehman was not included in many of the benchmark credit derivatives. However, exposure remains unclear,..."

Expectations for Lehman CDS' settlements are in the 10 to 20 cents on the dollar range.

Investment Strategy Implications

The equity markets are pressured on multiple levels. One of them is the forced liquidations due to client redemptions, including mutual funds and hedge funds. In the case of hedge funds, it is unknowable at the moment but can be reasonably assumed that despite having an estimated 1/3 of their assets ($600B) in cash, many have exposure to credit default swaps and may incur huge losses as a result. Hence, forced equity liquidations.

By the end of day investors should have a far better idea just how extensive the counterparty damage is. Additionally, knowledge of the credit crisis process and the methods by which it will work its way toward resolution along with the interconnected dynamics of and impact to the real economy will advance. However, the psychological damage to confused equity investors may be far more long lasting.

Fear is feeding upon itself. And the greatest aspect of this fear is ignorance. Tragically, a leadership vacuum is evident with the failure to explain to the American public (and the world audience) what is happening and why. And in the process, panic in all its ugly forms is running rampant. Yet, time will almost certainly show that many equity values being posted today do not reflect their true intrinsic value. In other words, we are clearly at the point where, just as with many credit instruments, mark-to-market in many equities do not reflect their fundamental value.

To view the Lehman auction results, click here

To learn more about the credit default swaps settlement process, click here

Looking Beyond the Panic

Warren Buffett may have been way too premature when he declared in May of this year that the panic phase of the credit crisis was over. Recent developments suggest, however, that there are good reasons to conclude that Mr. Buffett's prediction is close at hand. Evidence for this thinking can be found in two items posted in today’s media.

The first is the Financial Times commentary by George Soros (“Recapitalise the banking system”*), which is a must read for all investors interested in understanding key aspects of the next steps in the credit crisis. The second is the simply awful results of the latest ISM manufacturing report.

With the near certain passage of the sweetened Senate bill, the Soros commentary may strike some as moot, for the Soros prescription will never go beyond the eyeballs of its readers. Such thinking, however, would miss the nuggets of insight embedded in his views. Of special note is how mark-to-market for illiquid assets will die its deserved death. For example, Soros’ recommendation “could require the Treasury to provide cheap financing for mortgage securities whose terms have been renegotiated based on the Treasury’s cost of borrowing. Mortgage service companies…could expect the owners of the securities to provide incentives for renegotiation as Fannie Mae and Freddie Mac are already doing.” In other words, valuation will be (and in fact is being) determined not on the capital requirements of impaired banks but on the US government. This is, in effect, the same valuation result that will occur under the Paulson plan (see section 132 of the House bill) and the announcement of the SEC and FASB made yesterday re fair value and FAS 157. Bye bye, fair value. Hello, common sense.

On the assumption of passage of the Senate bill by the adults in Congress, the pressure on the House will be enormous, made all the more difficult to resist considering the extension of the business tax breaks (in the Senate bill) and today’s dire ISM manufacturing report. The business oriented realists in the House will hopefully make the connection.

Investment Strategy Implications

The financial markets are not out of the woods. But with the full faith and credit (and the attention) of the US government now fully engaged, it does seem fair to conclude that Warren Buffett’s premature prediction will now come to pass. If so, then it’s time to look past the panic and examine the economic debris that the unnecessarily disorderly deleveraging process has wrought. In that regard, it can be assumed that overall operating earnings will decline moderately thanks to improving financial earnings (write ups!) offset by a substantial decline in the more cyclical sensitive sectors (consumer balance sheet repair via deleveraging). In the process, P/E ratios will likely continue their descent below their long-term average of 15x, but not into the deep recession zone of 8 to 12x. The near term effect should be a sense of relief for investors as the panic triggered by the credit crisis slowly recedes.

(Oh, did I mention the fact that the fourth quarter tends to be a very good one for stocks?)

*To read the Soros commentary (subscription required), click here

What’s In A Name?

A bailout by any other name would smell just a foul. Or would it?

The Bard may have captured the essence (pun intended) of the smell test, but then again he didn’t run for elected office. Nor did he live in a media saturated, image drenched world as we do. Therefore, when Bush left it up to the political tone deaf Treasury Secretary and Fed Chairman to be the messengers of the plan to rescue the US and world economy, he violated the primary rule of any political action – control the message. And controlling the message means framing the issue properly with a title that captures the essence of the desired action and one that will help win the hearts and minds of voters and their representatives. After all, who is in favor of a bailout of any sort? Least of all one for the “New York City fatcats (who) expect Joe Sixpack to buck up and pay for all of this nonsense*”?

To some, what you call something may appear to be trivial. However, behavioral scientists (and common sense) will tell you that many decisions made in life (including investing matters) are not done in a dispassionate, rational manner but by using mental shorthand tools (heuristics). And part and parcel of that process is how you frame the issue (framing). Therefore, if you let something get framed as a “bailout”, that’s what it will be perceived as.

So, as many members of the House rethink their profiles in cowardice by putting re-election before country, perhaps the administration and congressional leaders might consider a better process of explaining more clearly to the American public and their highly re-election conscious representatives what it is at stake.

The “Rescue America from a Depression” bill may not be the best smelling sausage to come out of Washington, but the stench of a deep recession will smell a heck of lot worse.

*Rep. Ted Poe (R), Texas

Cutting Off Your Nose to Spite Your Face

As of this moment (2:50 PM eastern) the House of Representatives has dealt a huge blow toward stabilizing the financial markets and avoiding a world economic crisis. The less than perfect Paulson bill would have accomplished that goal in numerous ways. One of them, which has been least understood and grossly underappreciated by most other than those who read this blog, is the method by which the Treasury and the Fed would have finessed the rules and stopped the gasoline that turned a house fire into an inferno – FAS 157.

The Paulson plan’s tourniquet that would have stopped the writedown bleeding is mark-to-maturity, the plan’s component that would have enabled Treasury and the Fed to finesse the insanity of FAS 157’s mark-to-market and ceased the graveyard spiral of lower values, more capital, forced sales, lower value, etc.

What Now?

There is still time for the House to come to its senses and immediately pass a bill that would be far better than the alternative of no bill. On the assumption that such an action did not occur, however, then financial assets and therefrom the world economy will suffer the consequences the likes of which are extreme in the best case.

Yet, there is an alternative, an action that could help alleviate the carnage, one that comes from the source of the carnage – FASB. A repeal or more likely a suspension of FAS 157 would go miles toward accomplishing what the Paulson plan would have achieved – stopping the graveyard spiral in asset values.

As for the odds of that happening, the answer is simply “who knows?” However, the consequences of no action by either the House or FASB are frankly unthinkable. Let’s pray for less principled outrage and more adult, common sense decision-making.

Unacceptable

As the world listens to Messrs. Paulson and Bernanke argue for support of their three-page $700 billion manifesto, I wish to focus your attention on a central aspect of the credit crisis – the scale and scope of the credit derivatives octopus.

To illustrate, consider this: If scientists can “identify all the approximately 20,000-25,000 genes in human DNA”, and “determine the sequences of the 3 billion chemical base pairs that make up human DNA,” then why can’t the financial scientists identify the extent of the credit derivatives market?

This is a national, if not global, emergency. In such an emergency, is it acceptable to say, “We don’t know what we don’t know?” Or, “It’s too hard to figure out.” Nonsense. If this emergency were a war, would it be acceptable to say, “We can’t build that tank or missile because we don’t know where the steel is”? Of course not. So, why is it acceptable to say we don’t know the extent of the credit derivatives octopus?

Perhaps certain US government officials do know but they are just not saying so. Perhaps those certain US government officials reside in the US Treasury and Federal Reserve Bank. If so, then their actions these past anxiety-riddled months are about as inept as could be possible as a more comprehensive plan of action should have been constructed (from such knowledge) rather than the firemen Hank and Ben put out the latest financial wildfire this weekend, right now routine we have been treated to.

Investment Strategy Implications

Along with the insane decisions to implement FAS 157 and eliminate the uptick rule, the outrageous neglect on the part of those charged with oversight of the entire financial services industry, and the fundamental rationale supporting each (efficient markets and laissez-faire), you can add the unacceptable argument that it’s just too hard to figure out the credit derivatives octopus.

In the process, the world’s markets and economies are now forced to experience a disorderly unwinding of the credit bubble – a disorderly unwinding that could have been mitigated had certain action steps, and the rationales supporting them, been avoided.

Sadly, today’s testimony will almost certainly contain a lot of shoulder shrugging “we don’t know what we don’t know, it’s too hard to figure out” statements. Unacceptable.

Minyanville: Understanding the Panic of 08

This week's Minyanville posting provides a concise review of how things got to where they are and how investors might go beyond their own fears and exploit the panic, including 2 buy recommendations in the infrastructure area.

"The Panic of '08 has nearly every investor convinced that the world is coming to an end. With the financial system shaken to its core, who can blame them? But is the world really coming to an end? Are the "evil doers" on Wall Street getting their just deserts while causing unbearable hurt for the rest of us? Is it time to repent, for the end is near?..."

To read my Minyanville articles including today's posting, click here

From Chaos to Sanity: The Imperative of Logic

Rules Matter.

If the NFL changes its rules of play, does that not have an effect on the game? So, why would a rule change by the FASB or the SEC or a law by Congress not have the same game changing effect?

When the FASB said that illiquid and opaque assets should be valued at their last sale (or whatever could be approximated as such), were they cognizant of the impact it would have on financial institutions with their capital requirements?

When the SEC eliminated the uptick rule and looked the other way on naked short selling, were they cognizant of the impact it would have in facilitating the bear raids from short sellers? And were they aware that such bear raids would virtually take off the table any capital raising options via an equity sale for financial stressed institutions?

When Congress let the financial innovation genie out of the bottle via various laws (mostly in the area of deregulation) and lax oversight, were they cognizant of the impact it would have on the financial engineers on Wall Street?

The answer to all of the above is apparently not.

Let me clear – the problems of excess amounts of leverage, animal spirits, and bad business decision-making are at the core of the credit crisis. There is no doubt that this is where the blame must lie. Be it no-doc, no-income mortgages, or homes purchased with the intent of flipping them in six months, or credit cards to teenagers in high school, or junk bonds with very generous covenants, the list is very, very long. However, the circumstances produced by such bad behavior are not the only culprits. For when coupled with virtually no oversight and the above noted rule, legislative, and regulatory changes, the bubbles that were blown are what the financial system is now struggling to unwind. Which brings us right to the single most important aspect of the crisis – will the unwinding of the excess amounts of leverage (the deleveraging process) be an orderly or disorderly one?

If left unchanged, the answer is what you see on your screens everyday. Firemen Hank and Ben rushing about to put out one financial wildfire after another.

But it need not be this way.

No doubt, there are many ways to achieve the same end result – a more orderly transition of the deleveraging process – but we’ve got to get beyond the reactive mode and become more proactive to begin to move from chaos to sanity. So, let me humbly offer a few immediate solutions to the credit crisis:

1 - Modify FAS 157

Change the rule from the insanely destructive and academically illogical mark-to-market to mark-to-moving average. By shifting the “fair value” reading from the last sale to the average of the past six months, you will get the closest thing to a reasonable compromise between the market fundamentalist ideologues (with their quaint notion that markets are always efficient) and the realists who know that in the short term investors can be anything but rational, especially when it involves illiquid, opaque assets.

2 – Require more transparency in illiquid assets

The FASB’s recent rule change for FAS 133 appears to be one such solid step in the right direction. More needs to be done.

3 – Begin the process of creating standards for derivatives

Financial innovation is not going away. And when conducting properly, financial innovation can be a very positive force for the real economy. However, when so much is constructed in the dark, in times of stress it becomes impossible to determine where the bodies are buried.

4 – Restore the uptick rule

Since the SEC has finally woken up and instituted sanity into the naked short selling arena, they now need to revisit their laissez-faire, market fundamentalist ideology and restore the uptick rule. By doing so, it will significantly reduce the incentive for the pre-Depression era bear raids that are wrecking such havoc.

5 – Move with a sense of urgency

I began this commentary with a reference to football, so let me return to that metaphor.

In a football game, there often comes a point where time is of the essence. And those teams that are prepared for such times act with clarity and a strong sense of urgency. They may not always succeed but the process is the correct one. The current crisis requires such a sense of urgency. If left unchecked, however, the bear forces at work will continue their bear raids (on equity and debt) until the threat to the system becomes more than it can withstand. Frankly, financial Armageddon is not too strong of a phrase.

Investment Strategy Implications

The impact on the economy has now become so significant that lives are being impacted, most dramatically within the companies that are being driven out of business or into the arms of the US Government and for why? Because rule changes have altered the game.

The laissez-faire, market fundamentalism Reagan doctrine is dead. Over. Finished. Kaput. In its place will be a return to the regulatory and oversight environment that preceded it. The danger is if the pendulum swings too far the other way and restrictions are imposed that severely limits the US’s ability to compete. Given the populist rant of the two presidential candidates, such a move to overregulation is not out of the question.

As I noted yesterday and Mr. El-Erian stated in his interview, transitions can be very messy. Let’s hope that some degree of clear thinking will produce the kind of results needed.

The Real Risks of Deleveraging

The deleveraging process that is dramatically impacting the economy and markets has two very serious consequences to it. One deals directly with the insane process of mark-to-market of illiquid, opaque assets. The other pertains to the effects deleveraging will have on the real economy. Allow me to highlight the key points of each.

In terms of the financial economy, the process of deleveraging can be characterized as feedback loops gone wild. Virtuous circles (and their accompanying animal spirits) give way to vicious cycles, in which lower prices beget write-downs, which beget lower prices. And on it goes. In the process, bad assets become toxic, especially for financial institutions who, unlike other entities, have capital requirements that must be met.

There is nothing new in all this. Bubbles and panics have been around for centuries. And bad behavior is always punished eventually. The larger macro economic issue is the fact that the global economy is in transition (listen to El-Erian’s comments below). The dominant question in such a macro economic environment is whether the transition will be an orderly or disorderly one (ex. a declining US dollar). What is new, however, is the impact that the rule change made last November that has turned a difficult situation into the disaster the financial markets are facing today.

Thanks to the well-intentioned actions of FASB last November and the updating of the accounting rule FAS 157, illiquid assets must now be marked to the current market price (mark-to-market) in an attempt to reflect the true value of the asset. This is all well and good were it not for the fact that marks in highly illiquid, opaque markets can produce a highly questionable reading as to what constitutes "fair value".

Moreover, when such marked-to-market assets are owned by financial institutions operating with high degrees of leverage often reliant on short-term financing with mandated capital requirements, you have a recipe for disaster. But don’t take my word for it. Listen to Paul Volker many months ago or Steve Forbes on Fox Business News last night*.

Lastly, so much of the current investment climate has been co-opted by short-term momentum players, many of which are aggressive short sellers. Does anyone seriously believe that these players are interested in what the "fair value" of an asset is?

All this creates a toxic climate for toxic assets.

The second risk re deleveraging is how it will impact the real economy. One effect is already being felt – fewer loans are being made. Gone are the days when credit cards, auto loans, and no-doc, no-income mortgages literally flew out the doors of financial institutions. Gone, also, are the very generous covenants attached to junk bonds. In their place is an austere environment where liquidity is abundant but the risk appetite in frozen with fear. This is all bad but what makes this situation highly dangerous is the state of the US consumer.

The US consumer, the spending workhorse of the world economy has a personal balance sheet that is in serious disrepair. In the current economic environment, the need to reduce debt and increase their personal equity will only come about through a process of savings out of income. Say goodbye to your personal (home) ATM. Say hello to a higher savings out-of-income rate.

But savings out of income coupled with extremely low levels of borrowing means that the US economy is on for a period of depressed economic activity. The shop-til-I-drop, I-must-sustain-my-unsustainable-lifestyle US consumer is toast. A weakened economic climate coupled with the negative wealth effect (from real and financial assets) and a looming retirement calendar will do that.

All is not lost. There are pockets of strength that can help alleviate the financial crisis and perhaps help avoid a worsening contagion to the real economy. For example, there is a segment of the world economy that appears to be poised to emerge as the source of demand – the emerging middle class of emerging economies. Growth in their economies should remain positive and, given their generally solid balance sheets (not to mention fairly good policy processes), should make a positive contribution to global growth and stability. Not quite 100% decoupling but more than the pessimists believe.

By the way, speaking of solid balance sheets, most investment grade corporations have very solid balance sheets. The ability to weather a financially-inspired storm is quite favorable.

Then there are the large pools of capital around the world that sit waiting for the crisis to resolve itself. From sovereign wealth funds to money market accounts to central banks, liquidity is more than ample.

Lastly, Americans have a great capacity to adapt, to innovate, and come together in common cause**. All these factors should not be ignored as they represent a path out of the credit crisis quicksand.

There is one final point that I wish to make.

Rule changes matter. FAS 157 is a well-intentioned rule that is rooted in an antiquated principle known as the Efficient Market Hypothesis. For while investors in the long run are rational and risk averse, in the short run they are anything but. Modifying FAS 157 would one very easy way to reduce the vicious cycle of mark-to-market.

Investment Strategy Implications

The technical damage done to the equity market is sufficiently bad (but interestingly not terrible) that aggressively adding to positions should be done with great care. However, a prudent portfolio management policy of sector tilting coupled with a mindful regard that stocks have an upward bias (see prior blog posting on this point) is always appropriate, made even more so when panicky selling rules the day.

*FYI - Little ole me has written on this topic on several occasions on this blog and in reports. I encourage you to use the topics link for credit related issues to your left to explore the writings further.

**This point is contingent on a less divisive political climate. Therefore: Memo to McCain’s advisors – cool it with the Karl Rove tactics. You may win the election just like W did, but you will cause severe damage to the country in the process, just like W did.)

There They Go Again

commentary from this week's "Sector and Styles Strategy Report*:

Back on February 11th I wrote a report titled “What are the Sell Side Analysts Smoking?” The commentary and report focused on the excessively optimistic outlook earnings forecasts for 2008 by bottom-up analysts. Excessively optimistic in that top-down forecasts were substantially below the bottom-up numbers.

At the time, the bottom-up crew projected operating earnings for the S&P 500 for 2008 was an astounding +24% over 2007’s numbers ($102 versus $82.54). Whereas, the top-down forecasts had operating earnings for 2008 in mid $80s on down to the mid $70s.

Since then, particularly over the past two months, the bottom-up forecasts have gradually ground down to reality so much so that they have now reached the slightly negative territory of -2.4% (see Earnings Outlook on page 3 of the report*). One might therefore conclude that for 2009 the bottom-up boys and girls would factor in more of the data and analysis from the top down crowd but that is just not the case. For 2009, the numbers are equally, if not more, astounding.

According to the recent consensus forecasts, bottom-up earnings growth expectations for 2009 is a whopping +26%! Even after you exclude Financials you still end up with a +13.3% number. Excluding Financials and Energy gets you to 13.8%. And, lest you think that this dream state is restricted to the US, think again. The global numbers are a cool +18.7%, up from 2.8% currently projected for 2008.

Where does this thinking come from? How do you get such optimistic numbers when most top-down forecasts (from economists and investment strategists, often in the very same firms!) are much like this year – closer to 0%.

I believe a major part of the problem lies in the process by which bottom-up analysts go about making their forecasts. Specifically, when it comes to making earnings forecasts, many if not most bottom up analysts have a “silo” mentality, often acting as though there were no interconnections between their defined industries and companies and the broader macro climate. To be more specific on this point, I am not talking about your basic, tradition GDP starting point but rather the thematic and trend issues that are often hard to quantify such as the credit crisis and the risk of contagion therefrom.

Investment Strategy Implications

There is no news in stating that there are many risks facing investors as the last leg of 2008 unfolds and 2009 comes closer into view. Yet, what seems to be news to many bottom-up analysts is the interconnectedness and impacts from thematic and global macro trend issues.

Therefore, for the benefit of those who insist on using bottom-up forecasts exclusively, let me offer that the great risk for 2009 is the one I have written about time and again – credit related losses that move UP and OUT: UP the quality spectrum (within an asset group) and OUT to other asset groups, such as credit cards, student loans, auto loans, and corporate debt.

This danger is tied to the economic pain that results from deleveraging, with deleveraging not restricted to the banking industry but to the US consumer as he/she comes to terms with the consequences of a negative wealth effect and the need to repair their seriously overleveraged balance sheet. The result would be more savings, less spending, an extended period of subpar growth, and a transformation of the US and world economy away from its high dependency on US consumption.

Reliance on the traditional and the standard methodologies during times of economic transformation and change can and almost certainly will lead to faulty projections that can be very expensive.

*Published Aug. 25, 2008. Subscription required. For more information, click here

One Year and Counting

“Of all the newfangled financial creations that have caused problems this past year, arguably the most nerve-wracking are derivatives traded over-the-counter…”
Economist
August 8, 2008

And the beat goes on.

On several occasions over the past year, hopes rose that the credit crisis was about to abate only to be dashed by yet another set of surprisingly large bank write-downs. Surprising to some but not on these pages. The risks from the credit crisis are far broader than originally thought and only now becoming grudgingly clear. And there is truly no end in sight.

UP and OUT is my way of characterizing what Nouriel Roubini has accurately described as the full scope of the financial Frankensteins created over the past decade. UP in the form of write-downs moving up the quality spectrum within an asset group. And OUT to other financial instruments created by the wizards of Wall Street.

Exacerbating the situation is the (efficient market hypothesis inspired) accounting rule change instituted last November, FAS 157, in which assets impacted by diminished demand produce lower values requiring mark-to-market write-downs thereby requiring new capital to meet banking related capital requirements leading to further pressure across the entire banking system. A vicious circle.

The equity markets are beset with multiple layers of issues – some, such as inflation, likely to not be an issue for much longer. However, fears of a global economic slowdown are now more real than ever, particularly when we get to 2009 and corporate default rates begin to rise as noted in the following chart* from last week’s NYSSA Market Forecast event (courtesy high yield expert Marty Fridson):

Moreover, according to Marty, the peak isn’t projected until 2010 at an 11% rate. This is the origin/catalyst of the $250 billion (net) credit default swap pain noted by PIMCO’s Bill Gross back in January of this year. So, if you want to see how banking losses get into the $1 to 2 trillion range, this is one contributing component.

Investment Strategy Implications

Last week’s so-called “Olympian rally” in equities must be taken with a huge grain of salt. As noted in several areas of this report*, the contradictory nature of the recent market rally is hardly the stuff of sustainability. Highly fragmented market action with little to no sustained and coordinated leadership provides no real investment comfort beyond riding the bear rally from its undervalued levels.

Until there is more market structure, an overall market neutral approach is advisable to take. Scalping “lunch money” trades is also a good short-term course of action for a modest amount of money. However, given the looming danger of a no-end-in-sight credit crisis and a 2009 that may stress test more than the banking system, the deleveraging process on multiple levels (banking, US consumer) warrants an above average level of caution.

*see report. For subscription information, click on the newsletter link to your left.

Notes From NYSSA’s Market Forecast Event and the Forbes and Furman Interviews

The great value add in moderating events and conducting interviews is the ability to select the topics to discuss and questions to pose to some of the best minds in the investment, economic, and geopolitical worlds. So, here are a few takeaways from this Tuesday’s NYSSA Market Forecast luncheon and the two recent interviews conducted with the economic advisors to the US presidential candidates.

My panelists for the NYSSA event – Rich Bernstein, Marty Fridson, Don Rissmiller, and Phil Roth – covered a wide range of key investment strategy (fundamental and technical), economic, and credit market (specifically high yield) issues.

• The equity markets are solidly in the grips of the bear with narrowing leadership a major signal that a reversal is not quite in the cards. That said, the current rally phase bears monitoring for any signs of broadening strength, which has thus far not developed. In other words, a bear rally at best.

• The risks of a US economic double dip next year remain elevated. This is not the consensus view most investors generally have but one that is gaining traction, particularly when you consider the following two points.

• The credit crisis is far from over and was exemplified by one example – the coming dramatic rise in corporate defaults, specifically at the low end of the quality spectrum: high yield issues. Default rates, suppressed by recent generous covenants, will begin to rise in 2009 from current levels of just under 3% to 8% in the spring of 2009 and then to a likely peak of 11% in 2010. The ramifications to the banking sector in the form of credit default swaps could be substantial (remember Bill Gross' $250 billion in CDS write downs?).

• The US consumer will begin to save when he/she finally buys into the idea that prior postives periods of the wealth effect are gone for good. At that point, spending will decline and savings (from earnings) must rise as it becomes increasingly apparent that their retirement nest eggs – in the form of assets (real estate and financial) – cannot be counted on.

• Long-term US Treasury rates appear poised for a substantial decline largely due to the likelihood that inflation will not be a sustainable problem in the US, that the US economy will experience a period of longer economic weakness, and for the reasons noted above re the credit crisis. In this regard, it is worth noting that investment professional sentiment re the prospects of lower long term rates is almost non-existent. A contrarian signal for sure.

There were many other valuable thoughts and insights, which I will share with subscribers in next week’s “Sectors and Styles Strategy Report”*.

As for the Forbes and Furman interviews, what was most striking to me was the clear difference in tone and temperament of each economic advisor. The Steve Forbes interview was much more assertive, more decisive in the economic action steps a McCain administration would take. Whereas, the Jason Furman interview sounded far less ideological with a far more pragmatic view from an Obama administration than one would be led to believe from the primaries. These contrasting points can be clearly heard not only in the tone and style of Forbes versus Furman but also in the substantive areas of tax policy and, strikingly, in Furman’s responses to my questions re what the US budget deficit would look like at the end of an Obama first term.

If you haven’t taken the time to compare and contrast the two interviews, perhaps you might want to consider doing just that. What you will notice is that my questions and interview style allows the guest to more room to fully develop his/her thoughts thereby revealing their more deeply held views.

Note: The Forbes and Furman interviews can be found at beyondthesoundbite.blogspot.com

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No End In Sight meets Mr. Alpha and Regression to the Mean

“U.S. bank stocks may be staging another suckers' rally.”
Reuters, July 31, 2008

From time immemorial the four most dangerous words in the investment language has been “This time is different”. Today, however, a new phrase seems destined to join the dreaded phrase group – “No end in sight”.


If an investor assumes that the IMF is correct, then the bank loss write-downs could reach $945 billion. If hedge fund investor extraordinaire John Paulson is correct, the number increases to $1.3 trillion. If Bridgewater Associates is correct, the number rises further to $1.6 trillion. And the top end of Nouriel Roubini’s disaster scenario range is a cool $2 trillion.

At under $500 billion in losses taken thus far, “no end in sight” is an apt phrase.

But, to quote the Joker, “Why so serious?”

Investment Strategy Implications

While the relief certain investors may feel due to Merrill’s actions may be premature, investment strategy considerations drive the current portfolio decision-making process. For, if an investor has been fortunate enough to have produced alpha thus far this year – for example, portfolio and investment strategy decisions made in the Model Growth Portfolio (MGP) have yielded over 300 basis points of alpha thus far this year – then the real risk may not be the next plunge in equities (that’s coming) but the danger in not exploiting the near-term momentum game courtesy hedge fund momentum players and thereby losing valuable alpha in any short-term bear market rally.

Therefore, the appropriate current investment strategy appears to be largely a market neutral one. With an undervalued market and no sustainable and exploitable trends or themes at work, being fully invested – yet with no particular tilt from a sector perspective* – seems most appropriate. It’s only from a style and size perspective that a modest tilt toward the Smids and growth (as opposed to value) remains advisable**.

So, when Warren Buffett declares that the financial crisis due to “financial weapons of mass destruction” is “far from over”, investors should heed the warning. For those who are paid to exploit near term market moves, however, an undervalued market dominated by hedge fund momentum players is too hard to ignore and an investor stands to lose a considerable amount of hard won alpha***.

No end in sight is real. However, regression to the mean in an undervalued market may take precedence for the time being.

*The MGP is strongly underweight Energy. This will change shortly pending their 2Q08 earnings reports, the potential of negative political influences therefrom, and technical analysis considerations.

**This, however, would change should the recent weak relative performance of the Smid growth styles continue.

***If wrong, then the absolute performance will suffer, no doubt, but the alpha remains largely unchanged.

Wildfires

It hardly instills deep confidence in our government officials when, after nearly a year, its prime modus operandi is to react to the latest financial crisis with yet another 11th hour solution. This is one of the longer term implications of the bailout plan for Fannie and Freddie.

For all the near term good that could be construed from the latest financial wildfire containment, it is hard to understand why after nearly a year Messrs. Paulson and Bernanke are still in a reactive mode. Given all the resources at their disposal and all the warnings that are plain for everyone to see, it is most disturbing to hear the hurried pitch for unlimited back stop funds for the two GSEs.

Investment Strategy Implications

The Nouriel Roubini scenario where the write-down contagion spreads both up (the quality spectrum, which in the case of mortgages involves Alt-A’s, near prime, and prime) and out (to other categories, such as credit cards, auto loans, and corporate debt) is the nightmare scenario that is threatened by the reactionary mode of government. The economic dangers that $1 trillion (on up) in banking losses would produce cannot be fully measured. But what can be assumed with a fair degree of certainty is that the deleveraging process that such a credit creation contraction would generate will exacerbate an already fragile global economic and financial situation, if not tip the global economy into a depression.

Getting ahead of the curve, being proactive with a well thought out plan would go a long way toward instilling far more overall confidence in financial institutions and, thereby, likely result in stable if not higher asset values (not to mention a better level of consumer confidence).

Putting out wildfires is necessary and helpful but hardly sensible forest management.

Smokey the Bear would not be proud.

Baby Steps

commentary from this week’s “Sectors and Styles Strategy Report”*:

Sunday evening’s US Treasury and Fed actions may seem bold to some. I beg to differ. Here are a few thoughts for your consideration:

A recent report from respected consultancy Bridgewater Associates upped the ante of banking losses to a whopping $1.6 trillion. In consideration of the fact that only ¼ of that number, $400 billion, has been write-off/down thus far was more than enough reason for investors to buy into the panicky feeling experienced these past weeks. For those who like I subscribe to Soros’ reflexivity thesis, the feedback loop to the real economy via a deleveraging contraction is the single most dangerous consequence of the credit crisis (even if the bank loss number is closer to IMF’s $945 billion figure).

As if that weren’t enough, the oil price crisis, with its worldwide inflationary consequences for all countries, is generating demand destruction in developed countries. Here, too, a feedback loop to developing countries presents yet another dangerous outcome to the world economy. Decoupling goes only so far.

These past few weeks, the twin negative forces are being manifested in fear among investors as the valuation inputs from declining earnings and high inflation are producing a dangerous cocktail of lower P/Es and declining earnings that may bring about a stock market decline befitting a super bear.

Investment Strategy Implications

Incrementalism is a product of a belief that what is in place will work. Yes, there may be pain but the tools at hand are the tools that will produce the good result in the end. In the case of the governmental powers that be, that belief is market fundamentalism. This is at the heart of the problem and difficulty in reaching sustainable financial and economic solutions. As long as the Treasury, the Fed, the Administration, and the Congress operate under the rules of market fundamentalism, the actions taken will be like baby steps (such as the Bear Stearns and now the Fannie and Freddie bailouts as well as the Term Facilities to commercial and investment banks) when more serious, more comprehensive, more activist solutions are required.

But let me not restate last Thursday’s blog posting and point to the general market consequences that declining earnings and high inflation will produce.

The following rather simple table provides the P/E levels investors might contemplate should earnings experience even a moderately bad decline from last year’s $82.54:






Does the market fully understand and anticipate such a scenario? I doubt it. More likely shorter-term factors are moving the markets as the dominance by momentum-playing hedge funds produce surges and plunges (mostly the latter of late). Nevertheless, the numbers noted in the above table must not be ignored as its outcome seems more likely the longer market fundamentalism ideology results in baby steps.

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Where’s John Maynard Keynes When You Need Him?

This morning’s testimony before Congress affords US Treasury Secretary Paulson and Fed Chairman Bernanke yet another opportunity to allay the fears of all parties interested in the health and wellbeing of the world’s economies and markets. Unfortunately, however, what is likely to be heard is more dogmatic drivel regarding the magic of the markets as the elixir that cures all ills.

Words such as “market discipline” will almost certainly be uttered by Messrs. Paulson and Bernanke today, as they cling to an ideology, “market fundamentalism” (laissez-faire or neo liberalism, if you prefer), whose time has passed. For with their adherence to “market discipline” comes the front line, the first wave of economic chaos in the form of a rolling destruction of major chunks of the financial services industry (not wholly undeserved) and the multi-dimensional feedback loop that the resulting deleveraging and radical shrinkage of the credit creation process will produce on the US (and ultimately world) economy.

Perhaps one might wonder if those on the other side of today's testimony table might provide some philosophical leadership in this highly charged political year. Guess again.

The Republicans find themselves locked in a defensive mode attempting to preserve their market fundamentalism ideology. (Supply side voodoo economics still rules this roost.) And where they are proactive is in areas that are tied to the ole timey magic of the “invisible hand” such as oil crisis = more land for drilling. No real solutions. No real comprehensive energy policy. More of the same animal spirits, magic-of-the-markets thinking.

As for the Democrats, their agenda is fairly obvious – look busy! As they appear to “fight” for the US consumer against the dark forces of cowboy capitalism and market fundamentalism their real end game is more power via a landslide victory this fall. Until then, why take more than band-aid economic action that will result in any form of a rebounding US economy when the more advantageous political objective is to pin the McCain tail on the Bush donkey?

Investment Strategy Implications

Cowboy capitalism expressed in the financial markets is market fundamentalism. They are rooted in the same philosophical thinking that has wrecked havoc on the world’s economies and markets via fat tail economic and financial crises that mega trends such as globalization, technological innovation, and financial innovation have only exacerbated.

What is needed, and getting more desperately so with each passing month, is new thinking and a new intellectual philosophy regarding government, the economy, and the markets. A good start would be a clear recognition that the philosophical underpinnings of the past two decades, the market ideology known as market fundamentalism and its economic counterpart, cowboy capitalism (replete with trickle down economics and ever resetting stock options for corporate executives), has produced radicalized results for the interconnected world economy and markets. What is needed is fresh thinking and a willingness to transform a broken system rooted in a defunct ideology. But that is not what you and I will hear today.

What you will hear is regulation and half measures. But neither is a real, sustainable solution. Therefore, the only remaining question is what will it take for transformative action that will produce less radical economic and financial results? The answer might lie in a global recession to rival the one some 70 years ago. Then we may see who emerges as this century’s John Maynard Keynes.

Not So Fine at $4.09

“She’s real fine my 409”
Beach Boys



When the price of gas in the US hit $4.09 a gallon, the song that many consumers began singing was decidedly out of tune from the one the Beach Boys sang many decades ago.

Back in the day, 409 had a different, simpler meaning. Summertime, hot rods, muscle cars, and cheap gas. Today’s tune is, unfortunately, more about demand destruction than it is about how to pick up chicks.

Demand destruction is underway on several levels with high energy prices the central part of the scene. Deleveraging is also playing a major role in demand destruction via credit contraction. Then there is threat of greater regulation and more activist governments.

I have noted this more activist role several times before. And, while the US Congress is in recess this week, recent developments show the increased regulatory threat continues and is broadening. Take for example, the recent surprise announcements re CFDs.

Contracts for difference (CFDs) is a swap instrument that many hedge funds (and no doubt other institutional investors) use to establish positions without disclosing the true nature of the ownership. Within the past few days, however, certain rules changes have been instituted by the Financial Services Authority (FSA) that took most professional investors by surprise. Below are a few links re this story.

Investment Strategy Implications

The world economy is experiencing the dark side of both globalization and financial innovation.

Developing economies, led by China with its policies of excess money creation and subsidies along with hot money flows, continue to provide the demand fodder for high commodities prices, most notably oil. Coupled with capital market flows by major institutional investors away from equities and into commodities (as an asset class, often satisfied via swaps like CFDs), the unsustainably high price of oil will produce one of two high probability outcomes – stagflation (the lite version, most likely) in developed countries or a global recession.

The contraction of financial innovation is also underway as write downs and bail outs force business model changes for financial firms while the consequences of deleveraging produce a substantial cutback in credit creation.

Gas at $4.09 or higher is unsustainable to the world economy. Developed countries can attest to that. So will developing countries, many of whom are heavily dependent on exports to developed countries’ consumers.

The Bank for International Settlements is correct when it declared that the world economy is near a tipping point. For the equity markets, the relevant primary investment question might seem to be “Have the equity markets come to fully appreciate the danger?” In other words, have prices discounted the risks?

I would propose, however, the more relevant question to ask is “Do investors correctly see the complete picture?” In this regard, the answer is more likely no.

409 was in a simpler time. $4.09 is much more complex.

Enjoy the weekend and a happy fourth.

CFD related links:
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