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“He that sells what isn’t his ‘en”
July 21, 2008
“He that sells what isn’t his ‘en must pay his debts or go to prison” is an old stock market axiom that has stood the test of time. Loosely translated, it means that if you sell a stock “short” (betting that it is going down in price), you are responsible for ANY loss incurred if that stock rallies. And, last week that old market “saw” took on new meaning when the Securities Exchange Commission (SEC) changed the rules on “naked” short-selling (see last Wednesday’s WSJ story). Clearly, “naked” short-selling has been a “dirty” little secret on Wall Street for years, but that has now changed with the revelations from the SEC. Indeed, last week the SEC changed the rules and required that “naked” short-sales, in certain securities, be settled like the majority of stock transactions. To us, this was the “lit match” for the already gasoline-layered environment in the equity markets.
Manifestly, the selling-stampede was already “long of tooth” since most such stampedes rarely last more than 30 sessions. Recall that selling-stampedes tend to run 17 – 25 sessions with only 1 – 3 day countertrend pauses, and/or counter-trend attempts, before they exhaust themselves. In fact, the longest “buying stampede” chronicled in our notes was the 38-session upside-stampede into the October 1987 “crash,” while the longest selling-stampede occurred between May and July of 2002 and encompassed 44 sessions. Consequently, for the past few weeks we have been looking for some kind of “throwback” rally since 7-1-08 was session 30 from the DJIA’s May 19th high. As stated in our July 7th missive, “It’s not that we are turning aggressively bullish, but we think that unless the markets are in ‘crash mode,’ it is time to consider a corrective stock market rally.”
Additionally, our proprietary oversold indicator was more oversold than it has been in a very long time, so the stage was set. And when the SEC changed the rules on “naked” short-sales, that “spark” lit the “gasoline” and the rest, as they say, is history. The result was an explosive rally, especially in the Financials, that began last Tuesday, lifting the Financial Select Sector SPDR (XLF/20.67) an eye-popping 13% by Thursday’s close. According to one savvy seer, that was an 11 standard deviation event (for comparison purposes, a 4 standard deviation event is an event that is supposed to occur only once every 31,000 years). Given the SEC’s mandate, it was not surprising that the highest shorted stocks rallied the most (+15%), while the lowest shorted stocks rallied only 2%. It will be interesting, therefore, to see if last week’s “short covering” rally can sustain and broaden out this week. Whatever the outcome, we think the selling-stampede has ended. How far the rally will carry is unknowable, but we believe the equity markets have further “upside legs.”
Does that mean we think this marks the end of the stock market’s and economy’s consternations? Well, not really, for while “things” may not get a whole lot worse from here, we have a difficult time believing “things” will get materially better either. Indeed, our longer-term thoughts were best summed-up in an email exchange with one particularly bright Raymond James financial advisor who emailed us last week stating: “I started out in this industry near the end of one of the most devilish parts of the S&L crisis. I can remember my boss at a small IM&R branch saying ‘We can't make payroll this week and maybe next.’ I was 22 years old and just cutting my teeth in this business. What a wake up call! We got through it, but my question to you is what is worse. The $200 Billion loss in market cap of CitiGroup (C/$19.35) and $2+ trillion market cap losses in Financial Sector over the last year, or the $160 Billion taxpayer bill due to the S&L implosion of 747 thrifts in the late 1980's? Can you compare the magnitude of these events and is this worse?”
The response read:
“I started out my career 38 years ago as an analyst and this is the worst credit market environment I’ve seen. First, consumers are over-borrowed and their net worth is now in decline from lower residential real estate values and declining stock portfolios. Mortgage rate resets, and higher rates on credit card debts / personal loans, are squeezing the consumer even more. Therefore, consumers are getting increasingly squeezed; and retirees are even worse off. A recent Ernst & Young report (see nearby bullet points) states 77 million Americans will retire over the next several years and that three out of five of them will outlive their retirement benefits. Consequently, most working consumers, and the vast majority of retirees, are being severely squeezed by declining asset values, rising prices of energy, food, medical costs, insurance, etc. and have inadequate, or insufficient, retirement benefits.
I can’t compare today with the S&L crisis, but I think the risks today are potentially greater because the amount of debt being carried by the average consumer is so much greater. A report I read late last year (I can’t remember the source) said that in 1994, 50% of average consumers’ annual household cash flow came from borrowings (the rest from salaries, wages, bonuses, commissions). By 2006, however, the borrowings component was up to an astounding 86% of average cash flow. Americans have taken down a lot of second mortgage debt, credit card debt, and personal loan debt to buy cars, boats and other high priced items; and, they are now unable to deal with higher interest rates being charged on adjustable home mortgages and credit card balances. I’m fearful that this could be the worst squeeze on consumer seen in the last fifty years.”
So where do we stand? We think we are the middle of the envisioned “W” shaped economic pattern. To wit, the economic “slide” began in 2007, which is the downward-sloping left side of the “W.” Said slide freakedout the politicos, as well as the Federal Reserve, causing them to take Herculean efforts in an attempt to stave off a recession. Those efforts have caused the economy to enter the upward-sloping middle part of the “W” whereby the stimulus gives participants the feeling that the worse has been averted and the economy will accelerate from here with an attendant rally in the equity markets. Unfortunately, we doubt that will be the way things will play. Our sense remains that with the over-stimulation comes higher than expected inflation, which will eventually lead the Fed to raise interest rates and cause the economy to slow again (the downward-sloping middle right side of the “W”), or the fabled economic doubled-dip. Nevertheless, aiding our near-term positive outlook was last week’s price breakdown in crude oil.
For months we have suggested crude was likely putting in a top. That “call” was driven by our sense the politicos were going to propose legislation to force the price of crude downward in front of the elections. While we think such proposals are wrong-footed, in the near term such rhetoric can be impactful; and last week oil broke below its rising trendline in the charts. If the slide continues, and it breaks below $120/bbl, “hot money” will think the top is “in” and act accordingly. This is the reason we have been shy of the energy complex for the past few months, as well as why we have recommended rebalancing ALL energy stocks in the portfolio. Rebalancing (read: sell partial positions) allows long-term capital gains to accrue in the portfolio, and causes cash positions to rise, giving investors the “ammunition” to take advantage of new investment opportunities as they present themselves. For the last few weeks we have suggested, “At such a potential short-term downside inflection point, what you need to buy are those companies/indices with the best relative strength characteristics and those with the worst relative strength characteristics. Since we already own those with the best characteristics, we have concentrated on those with the worst characteristics. Consequently, our vehicles of choice were financials and real estate.”
The call for this week: If the decline in crude oil continues to play, it should be bullish for stocks. Indeed, just as in horseshoes and hand-grenades, all you have to be is “close” when attempting to “catch” a bottom in the stock market to make a lot of money if you adopt a scale-in buying approach, which is what we have attempted to do over the past few weeks! As stated two weeks ago, “What a great time to be an investor” for if you are a well prepared investor, volatility breeds opportunity.
Ernst & Young Report (highlights):
- Three out of five middle class retirees can expect to outlive their financial assets if they attempt to maintain their current pre-retirement standard of living.
- Guaranteed income is projected to cover a decreasing share of retirement income, leaving households with increased responsibility for their retirement and at increasing risk of retirement vulnerability.
- Middle income Americans entering retirement will have to reduce their standard of living by an average of 24% to minimize the likelihood of outliving their financial assets.
- Those Americans seven years out from retirement are even less prepared and the study estimates that they will have to reduce their standard of living by an average of 37%.
- Those Americans with Social Security as their only guaranteed income have a 90% chance of outliving their financial assets during retirement.
- The very real possibility of living to age 90 or 100, combined with the volatility of inflation and investment returns, means that the risk of outliving one’s assets is quite high. Without additional guaranteed lifetime income streams, such as income provided by an annuity, middle-income Americans are at high risk of outliving their financial assets and living their final years in poverty.
“The system will hold together!”
July 14, 2008
. . . Maxwell Emory from the movie “Rollover”
“The system will hold together” is a line spoken by Maxwell Emory (played by Hume Cronyn) in the 1981 movie “Rollover.” The film centers on a plot whereby Mr. Emory, who is the chairman of First New York Bank, is secretly moving “the Arabs’” money out of U.S. dollars and into gold using a mysterious bank account numbered 21214. When the plot is discovered, gold prices soar, the stock market crashes and Maxwell Emory puts a bullet through his head. And, we couldn’t help reflecting on said movie late last week as rumors swirled that Fannie Mae (FNM/$10.25) and Freddie Mac (FRE/$7.75) were insolvent. The result was a continuation of the crash in the “Bobbsey Twins’” (aka: Government Sponsored Enterprise, or GSEs) share price with an attendant swoon in the major market averages. Eerily, we wrote about Fannie Mae years ago in a report titled, “Measure Twice and Cut Once” (written 4-28-2005) suggesting that, in our opinion, NOBODY can figure out FMN’s accounting and therefore its shares should be avoided. We concluded those comments by stating, “By our method of chart interpretation the financials have ‘put in’ a massive top and are now in ‘bear mode.’ Additionally, the poster children of the financials, namely the over-loved Citigroup (C/$44.52 [$16.19 as of 07/11/08]) and Fannie Mae (FNM/$54.21), have completely broken down in the charts and should, from a technical perspective, be sold and/or reduced on rallies.”
That said, in my opinion these two GSEs will not be allowed to fail because the collateral damage would be global, as well as enormous, since their “paper” is held by institutions around the world. Also, allowing these GSEs to fail would accelerate the current credit crunch and send the housing complex even further into a death spiral. While some are suggesting a “conservatorship” approach under the Federal Housing Enterprises Act, we peg the probability of that as low due to capital cushion/statutory capital issues. Similarly, we think the odds of a capital infusion by the government to be low, as is the government’s implicit backing of the GSEs’ debt. I guess bringing the GSEs on to the federal balance sheet makes some sense because assertions that would increase the government’s debt by $5.3 trillion are an overstatement. Indeed, the $5.3 trillion figure refers to the GSEs’ holdings of mortgages/loan-guarantees, which are not the same thing as liabilities. Still, such a nationalization of the GSEs would require congressional approval and that would likely take a long time.
Our guess is the solution lies in either a private capital infusion, with certain guarantees like with Bear Stearns, or giving the GSEs the ability to draw on lines of credit from the Treasury Department and/or the Fed. In any event, I would be shocked if some action is not taken and taken quickly. Manifestly, it appears the only entities showing decent growth in the mortgage business have been Freddie and Fannie, so impinging these two behemoths in any way would worsen an already dicey environment, which was punctuated yet again by the FDIC’s seizure of IndyMac (IMB/$0.28) over the weekend.
Clearly the GSE gottcha’ of last week cast a pall over Wall Street, which was already struggling with new all-time highs in the price of crude oil. Plainly, at least so far, we have been wrong with our “call” that the politicians are going to do anything and everything in an attempt to force the price of oil lower before the elections. Last week’s price surge seemed to be driven by fears that Iran’s 2.5 million barrels per day of oil exports will be interrupted, exhausting any spare OPEC capacity. While the GSEs’ situation is worrisome, our sense is that the current market mauling is mainly about the vertiginous rise in crude’s price. Indeed, we have been adamant since the beginning of this year that the U.S. would NOT experience a recession in 2008
as defined by two negative quarters of GDP. However, we are becoming increasingly worried about 2009’s recession prospects unless crude “cracks” and cracks soon.
Indeed, the “perfect storm” seems to be having an increasing impact on the American consumer. Most recently, we have argued that what we may experience is a “W” shaped economic pattern, often referred to as a “double dip.” While it’s true that as of yet we haven’t had a severe economic slide (read: recession), said recession was prevented by the herculean efforts of the Federal Reserve and the politicians. Those efforts muted the economic slowdown, but, in my opinion, have potentially only pushed the recession further out in time. Consequently, I think we are in the middle part of the “W” pattern where participants believe the worse is behind us. Unfortunately, unless the environment changes, and changes quickly, I think we will enter the right side of the “W” pattern, resulting in a double-dip. And, maybe this is what the equity markets are sniffing out.
Speaking to the equity markets, today is session 38 in the “selling stampede,” and my oversold indicator remains more oversold than it has been in decades. In last week’s letter I related that Lowry’s point spread between its Selling Pressure Index (read: supply) and its Buying Power Index (read: demand) was at 265 points at the 1974 stock market “lows.” Currently, that spread is over 500 points, the largest in the 75 year history of the Lowry’s Organization, and therefore VERY oversold. Meanwhile, the Bespoke Investment group notes:
“Want another frustrating fact about this market? Recently, it seems that every time the market goes higher, it goes lower by a greater amount the next day. We quantified this by looking at every time this has happened in a 50-day period going back to 1940. You guessed it. We’ve just completed the most ‘up one day, down the next’ events in a 50-day period in nearly 70 years.”
In this whipsaw environment, trading has been difficult. However, our yield theme recommendations (read: dividends) are holding up pretty well. Some of the names that play to this theme and are favorably rated by our fundamental analysts remain Linn Energy (LINE/$23.37/Outperform), Alaska Communication (ALSK/$12.22/Outperform), Embarq (EQ/$43.50/Strong Buy), Inergy (NRGY/$24.98/Strong Buy), Legacy Reserves (LGCY/$24.70/Strong Buy), Magellan (MGG/$22.51/Strong Buy), and Teekay (TOO/$19.46/Strong Buy, to name but a few.
The call for this week: Friday felt like Bear Stearns II, since the news about the GSEs broke on Friday just like with Bear Stearns. Hopefully, this week will be a déjà vu dance of the week following the Bear Stearns’ news with the financials leading the way to the upside. Yet as Michael Steinhardt recently said, “There is rarely a moment such as this where as a contrarian, one sees so many reasons technically, [and] stock market-wise, to be bullish. I can’t imagine a circumstance where a market is more available, more ripe, for a rally than this one. Still, this time it’s different.”
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