Where Are the Bodies Buried?

Whatever your views on yesterday’s Fed action might be, a disturbing question is emerging that few seem to be paying much attention to – How long does it take for the financial system to identify who owes what to whom?

CDOs of CDOs of CDOs of CDOs cannot stand unaccounted for indefinitely. Knowing where the bodies are buried is a vital component to putting an end to the uncertainty risk premium that has elevated the fear factor among many investors, which, in the process, has sucked the Fed into reverting to the Greenspan playbook of more liquidity. But will more liquidity alone do the trick?

The Bank Credit Analyst’s thesis, “The Debt Supercycle”, says liquidity will work its magic, provided inflation remains relatively tame. Massive amounts of money can be pumped into the system to help reflate assets and preemptively avoid a severe economic downturn. All well and good, but a reflating system that contains untold amounts of hidden toxic paper may end up producing unintended and unforeseen consequences. A true manifestation of the expression, “You don’t know what you don’t know”.

Therefore, as we approach the six-month anniversary of the great awakening, the moment when complacent investors woke up from their Goldilocks stupor and came to recognize that all was not kosher, the question of who owes what to whom still remains unresolved.

The longer it takes bankers to identify the toxic paper on and off the books, the more damage to the global economy they will incur as trust erodes both within and without the core of the financial system thereby exacerbating an already tenuous credit situation.

With bankers still unable (unwilling?) to identify where the bodies lie and horde their precious capital, the far less than transparent New Power Brokers (Petrodollars, Asian Central Banks and their Sovereign Wealth Funds, Hedge Funds, and Private Equity) have stepped into the breach to save the day. However, their rescue efforts come with a price – opacity. And opacity is precisely what is not needed at a time when so much remains unknown and trust hangs in the balance.

Investment Strategy Implications

Equities are undervalued and yesterday’s Fed action certainly helps improve everyone’s valuation model. Equities are undervalued in a scenario that overstates the downside risks to global growth and corporate profitability (see “Here Comes the Global Depression”). Equities are not undervalued, however, in a world of endless undisclosed toxic paper and new capital opacity.

It’s high time we all learned where the bodies are buried.

Liz Ann Sonders

Topics discussed in today's inaugural interview with Liz Ann Sonders, Chief Investment Strategist, Charles Schwab & Co. include economic sectors and investment styles, the fixed income market, and the credit crisis.

The length of the interview is 10 minutes 45 seconds.

Financial Contagion and the Negative Feedback Loop

Alternative media sources contain some of the best information for investors. Such is the case with the podcast service, “Bloomberg on the Economy” with Tom Keane. In a recent podcast, which is available via iTunes, Mr. Keane’s guest was economist Nouriel Roubini.

The program format allows for the deeper exploration of a topic, which in the very capable hands of Mr. Keane enables a listener to learn about a guest’s views that go beyond the sound bite.

In the interview, Mr. Roubini describes the chain reaction that is at the heart of much of fears of the financial contagion swirling about the investment markets. Coupled with the potential negative feedback loop to the real economy, the dangers of the credit crisis are better understood.

The case made by Mr. Roubini flows as follows.

Mr. Roubini describes the current financial system as a subprime financial system, lacking transparency and one in which a contagion could readily spread from the subprime mortgage market to other areas of the credit market.

The flow looks something like this:

From

• Subprime to
• Near Prime to
• Prime to
• Consumer Credit to
• Auto Loans to
• Credit Cards to
• Student Loans to
• Commercial Real Estate to
• Leveraged Loans to
• LBOs to
• Corporate Bonds

Note: The last item listed (corporate bonds) dovetails tightly with the credit default swaps (CDS) of corporate bonds and the concern expressed by PIMCO’s Bill Gross, as noted last week on this blog (“Here Comes the Global Depression”, Jan. 22, 2008). Additionally, Mr. Roubini notes that the CDS market is a $45 trillion financial Frankenstein, which did not exist a mere ten years ago.

Investment Strategy Implications

Current valuation levels support higher stock prices. This is true if one believes, as I do, that earnings for 2008 will not collapse by 20% plus. However, the situation is still very fluid and risks of contagion and the negative feedback loop exist and are very real.

The positive equity market assumptions made on this blog and in my reports are twofold:

• Earnings for 2008 will be better than the bear case expects thanks to the global growth story and stimulative actions (fiscal and monetary) taken by government bodies
• Financial contagion outlined by Mr. Roubini will not unfold to greatly significant degrees thereby mitigating the negative feedback loop between the real and financial economies

The risks to these points rests in their interrelated nature, one that is mutual reinforcing. Moreover, it must be noted that even if my two points do hold, the danger point has not completely passed for equities as the special aspects of 2008 (electoral campaigns in the US and the China Olympics) give way to 2009, a year without such positive factors at work.

At that point, a second wave of earnings declines could stretch a 10% decline in earnings for this year (a much more realistic expectation) into another 10% decline, or more, in 2009. This, however, is not the consensus view and, therefore, should be noted but not stressed at this time.

Bottom line: good valuation levels, a more resilient global economy, an oversold stock market, and high degrees of investor pessimism should be strong enough underpinnings for an equity market that is almost priced for a financial contagion disaster.

The Negative Feedback Loop

excerpts from this week’s report:

“In a week packed with reports, speeches, and events about the only thing that is nearly 100% to occur is the beginning of the end of Rudy Giuliani’s quest to become President of the United States. As America’s Mayor competes with Fred Thompson for the most boneheaded political strategy award, investors will focus on the plethora of data to be issued over the next five days.

For example, this week includes:

• Earnings reports (120 of the S&P 500)
• Economic reports (Dec. Durable Goods, 4Q advance GDP, Dec. Personal income and spending, Consumer sentiment, Jan. ISM Mfg., and Jan. Employment data)
• Speeches (Bush State of the Union)
• Events (FOMC rate decision, US Senate on stimulus package, IMF economic forecast, Florida primary)

The crosscurrents that will result from the above…”

Investment Strategy Implications

“With valuation levels forecasting a deep recession (see Expected Return Valuation Model on page 4 of report)*, any development that changes this newly entrenched thinking stands a reasonable chance of breaking the negative feedback loop. The great risk, of course, is should the vicious downward spiral…”

also in this week's report:

* Expected Return Valuation Model
* Moving Averages Scorecard
* Model Growth Portfolio
* Sectors and Styles Market Monitor
* Key US Economic Indicators

*To gain access to this week's report (and all reports), click on the subscription information link to your left.

Picture This: Société Générale's Head of Risk Management

When you lose €5 billion, there can be only one answer as to who's in charge of risk management.




Have a good weekend.

Technical Thursdays: When to Sell the Dead Cat Bounce

On the assumption that yesterday’s rally did not produce a selling climax and that more work needs to be done to complete the bull market correction we are in, the next investment strategy decision point will be when to sell/rebalance your existing portfolio. For this, a very useful tool is the same one used for the Lunch Money trades that occur from time to time – momentum and MACD.

The chart to your left* shows the current state of momentum and MACD (second and third lines below the price chart) for the S&P 500. Two points to consider:



1 - MACD is so depressed and, therefore, provides evidence that the market decline is not over as it is nowhere near a crossover point (blue above maroon line), which would signal a key reversal of the near term downward trend**. As a result, the current rally is most likely little more than an oversold market rally resulting in your standard dead cat bounce.

2 - If so, momentum becomes the primary guide to timing the portfolio adjustments one might wish to make. The rule of thumb is when momentum approximates the zero level the portfolio selling/adjustments should begin.

Investment Strategy Implications

For short-term timing purposes, momentum and MACD applied correctly are very useful indicators. The current condition of the equity market suggests that the dead cat bounce will exhaust itself when the oversold condition of the market reaches equilibrium, which is zero in momentum.

Note: There are other alternative outcomes, such as a resumption of the market decline before momentum reaches zero, which will be discussed in future blog postings should they occur.

*click image to enlarge. chart source BIgCharts.com
**Key reversals require both momentum and MACD to non confirm a new high or low in an index. For examples, please see prior Technical Thursday postings.

Priced For Recession - and Then Some

In this week's report, my proprietary Expected Return Valuation Model (ERVM) produced a result that a good friend of mine noticed matched quite tightly with the historical data of earnings declines in recessions.

The EVRM has the market trading at fair value on the assumption that, in a worse case scenario, earnings decline 22% this year. History shows that the last two recessions (2001 and 1990) produced earnings declines of 31% and 24%, respectively. Clearly, this is the thinking that pervades most investors. At least, as of today.





What this suggests is twofold:

• The market has already reached a zone of a realistic worse case scenario valuation with an overshoot to the downside likely.
• Any changes to this view will have an immediate impact on present value levels.

Two positive factors to consider:

• Should decoupling show itself to be more resilient than the bears think, upside adjustments to the current worse case scenario thinking will take hold rather quickly.
• If the fear of more credit derivative shoes to drop diminishes, upside adjustments will also take hold rather quickly.

Investment Strategy Implications

I would argue that both positive factors will occur in some form before this quarter is over as the global growth story is more well entrenched than the bears give it credit and that the worst of the credit derivative write-offs are behind us. Moreover, an election year has a way of producing a sense of urgency that should inspire elected officials to act more swiftly.

Many have equated the current economic climate to that of 1990. If so, the short but violent 20% decline in equities that took place then has already been achieved now. All that's left is a capitulation of the bulls.

* click on image to enlarge and sing along!

Here Comes the Global Depression

excerpts from this week's report:

"Forget recession, try depression. At least that’s what the momentum driven panic in the equity markets is signaling.



Valuation levels are now so low that fair value readings are aligned with an earnings plunge in S&P 500 operating earnings for 2008 of nearly 22%!* To achieve such a collapse the world economy and not just the U.S. must slump into a massive recession this year. And for this to occur, policy actions taken by central banks and governments..."

"Adding fuel to this fire are the words of key market influencers like Bill Gross of PIMCO. His missive this month speaks of yet another credit derivative shoe dropping in the form of credit default swaps. According to the Bank for International Settlements (BIS), there are approximately $45 trillion of credit default swaps. Mr. Gross points out that..."

"As if this weren’t enough, an increasing number of market technicians have now signaled that the bear has arrived. Be it the crossover of the 50 day moving average..."

Investment Strategy Implications

"Investor fear is so thick you can cut it with a knife. Yes, the market should be lower due to the credit crisis (it’s reached that status) and an economic slowdown/recession in the U.S. However, to take prices down to 20% plus undervalued levels is more than..."

*see table on page 3 of this week's report

also in this week's report:

* Expected Return Valuation Model
* Moving Averages Scorecard
* Model Growth Portfolio
* Sectors and Styles Market Monitor
* Key US Economic Indicators

To gain access to this week's report (and all reports), click on the subscription info link to your left.

Quotable Quotes: Adversity

"Adversity begets opportunity."
Catalano proverb

Therefore, a few words on adversity.


“Things that were hard to bear are sweet to remember”
Seneca’’

“When everything seems to be going against you, remember that the airplane takes off against the wind, not with it.”
Henry Ford

“There is no education like adversity”
Benjamin Disreali

“Sweet are the uses of adversity.”
William Shakespeare

“I know God will not give me anything I can't handle. I just wish that He didn't trust me so much.”
Mother Teresa

“If I had a formula for bypassing trouble, I would not pass it round. Trouble creates a capacity to handle it. I don't embrace trouble; that's as bad as treating it as an enemy. But I do say meet it as a friend, for you'll see a lot of it and had better be on speaking terms with it.”
Oliver Wendell Holmes

“I ask not for a lighter burden, but for broader shoulders.”
Jewish Proverb

Hiding in the Healthcare and Consumer Staples Bushes

Last night's Market Forecast dinner here in Boca Raton produced the first full blown bear. So, when panelist Jeff deGraaf (formerly with Lehman Bros. now with Ed Hyman's firm, ISI Group) described his market view as being totally bearish, it was a breadth of fresh independent thinking.

Combining both fundamental and technical analysis (he holds both a CFA and CMT designation), Jeff's overall market conclusions differ from mine but that's okay, even good. I have a great deal of respect for Jeff and look forward to exploring his view this evening at my next Market Forecast dinner in Naples.

While Jeff and I may disagree on the macro picture, we are in complete alignment on two economic sectors - Healthcare and Consumer Staples. As the above chart shows, these traditionally defensively viewed sectors have far outperformed the broad market since the summer of 07.

Investment Strategy Implications

Be you bull or bear, Healthcare and Consumer Staples (including Global Consumer Staples - KXI) appear to be sectors well suited for the investment times. For bears like Jeff, they are solid defensive plays. For correction bulls like me they are appropriate for the corrective times I believe we are in.