I Still Can’t Get No Satisfaction

As a follow-up to my previous blog post (and in keeping with the theme of questions asked by my clients), I was recently queried the following:

“Why do you seem consistently filled with doom and gloom?”

I would have felt a little better if the question ended with “doom and gloom in the financial markets.”  I’ll assume that was the context of the question; if for no other reason than to soothe my ego!    Notwithstanding that, the short answer is that, against the backdrop of facts, I try my best to use reason instead of hope.

Let me take a few minutes to share our macro view, and it may help explain why our investment process has led us to where we are today.

In the big picture, the banking crisis of 2008 was never resolved.  The crisis was, as Kyle Bass put it, “smothered by the full faith and credit of rich Western Governments.”  What was already dangerously high public debt became even higher as bank debt was transferred to the public.  Compound that with the fact that debt accumulation was accelerating in reaction to the financial crisis and you are left with what we’re now seeing in Europe and potentially here in the US.

Anyone watching the European crisis has to be getting the sense that pain can only be delayed; not avoided.  Austerity cuts reduce public deficits, but they also crimp economic growth.  As we watch the race between increasing stimulus and debt, and that stimulus ultimately translating into meaningful economic growth, we are doubtful that growth will arrive quickly and materially enough before most of Europe’s debt reaches a tipping point.

On Monday, Spain was forced into a state bailout of its third largest bank, Bankia.  This represents a 180 degree reversal of Spanish policy and will cost between 7 and 10 billion Euros.  For those keeping track of post-crisis acronyms (TARP, LTRO, etc.) it will provide you the opportunity to add another to your list:  “COCO” — meaning contingent convertible bonds – the vehicle that will be used to inject capital into Bankia.

But Europe may not be the initial catalyst for Crisis Part II.  Hugh Hendry lays out a pretty cogent argument about why China may be the epicenter of the next pullback.  Briefly (and I’m happy to forward the full article to anyone who would like a copy), the argument goes like this:

  •  China’s massive currency manipulation punished its bank savers, so the citizens went on a home-buying spree figuring that homes were an appreciating asset.
  • The scale of China’s housing bubble dwarfs that of the pre-crisis US bubble
  • There are trillions of dollars of loans from underground creditors, who do not have rigorous (or any) underwriting standards.
  • China is aware of this, and to curtail the activity has been handing out death sentences to some of the underground lenders.  If this sounds too unbelievable (as I am occasionally prone to hyperbole), Google “Wu Ying.”
  • China’s government has spent so much money boondoggling unnecessary infrastructure under the assumption that exports will cover the costs; a global economic slowdown will crush their balance sheet.

Then Japan…

Japan has its own set of problems from awful corporate balance sheets to unbelievably dilutive corporate actions, to lousy demographics, to linkage to China’s growth.  We see no reprieve for the beleaguered Japanese stock market.

As for the US, reasons for optimism include the economic growth likely to be brought on by new oil and gas development projects.  You only have to look at North Dakota to get a sense of how powerful this can be.  The US is also experiencing record corporate profitability.  Earnings, driven by productivity gains, have been nothing short of stunning.  Yet, you can only increase productivity and maintain record margins for so long.  As the belt-tightening reaches its peak, earnings growth will no longer have that tailwind.  Further, top line growth will likely be hampered by a contracting global economy.  We also have a Presidential election coming up that will have significant tax and healthcare implications.  At best, we rate US stocks as a neutral.  But, its stocks are being treated like a strong buy on a relative basis when compared to bonds, cash, Europe, etc.

Finally, across the globe we are witnessing social unrest of varying degrees.  From the Arab Spring, to Greece’s anti-austerity riots, to the UK’s tuition protests, to Occupy Wall Street, the populous is becoming increasingly agitated.    Socialist and far right political ideology is gaining strength in Europe – France and Greece in particular.  The French just elected only their second socialist president since Mitterrand, and Greece’s neo-Nazi (Golden Dawn) party won 20 seats in Parliament by garnering 7% of the popular vote in last Sunday’s election.  Wealth disparity in the US is at record levels.  Unemployment in Spain exceeds 24%.  The list could go on and on, but you get the gist.

In an environment characterized by global fiscal distress, dangerous global monetary expansion, social unrest, and political upheaval, I find it difficult to hit the street with bullish optimism.

I look forward to the day when these blog posts are about how bright the future looks.  And I’m sure that day will come.  But right now, every developed country in the world has their pedal to the monetary metal yet has only managed to slow the bleeding.  If that is the best result that all out, globally-coordinated government action can deliver, it begs the question as to just how bad the underlying problem is.

i Findithardtobelieve

A few observations about everyone’s favorite parabolic stock, AAPL:

  • So far today, Apple has added $15 billion to its market cap
  • The Apple 530 calls, set to expire this Friday, jumped from $0.70 to $5.20 — a 742% return — this morning
  • That same call has now fallen by 60% in early afternoon trading
  • 90% of today’s intraday NASDAQ return is the result of Apple
  • The S&P 500’s 4Q earnings growth was 11.6%.  The S&P 499’s 4Q earnings growth (if you pull Apple out of the index) was 2.7%.
  • Thanks largely to Apple, the NASDAQ is outperforming the Dow Jones Industrial Average by about 7% year-to-date

Now, I would never be one to provide investment advice on a blog, as the regulators tend to frown upon such behavior.  Feel free to draw your own conclusions.

The juxtaposition of this phenomenon vis’ a vis’ Europe (specifically Greece) would be funny if it weren’t so sad.

Here’s a few stats about the state of Greece’s population, from Germany’s Der Spiegel:

  • Homelessness in Athens is up 20% year-over-year
  • People requiring free food (mostly soup and bread) is up 15% year-over-year
  • Suicide rates have doubled year-over-year (6 suicides per 100, 000)
  • Greece’s economy contracted 7% in 4Q
  • Their economy has now contracted 16% from its peak

If those bullet-points aren’t startling enough,   this slide show is certainly an attention-getter (copy and paste in your browser to view):

http://www.spiegel.de/international/europe/0, 1518, 814864, 00.html

It strikes me that the OWS crowd is in the right church, but in the wrong pew.  Income disparity is a tremendous problem.  But it isn’t the 99% versus the 1% here in the U.S.  It is a global phenomenon that is becoming increasingly desperate and violent.  If governments don’t come to grips with this soon  (and not by implementing further socialist programs), I suspect that social unrest will be the next tail risk affecting the markets.

After-the-close addendum:  The option I mentioned earlier that was up over 700% this morning closed the day at a 50% loss from yesterday’s close.  After reaching $5.20 during the day, it closed at $0.35.  Makes sense.

Another day, Another 4%, and Playing with the Robots

The day began with more bad news from Europe, with an unnamed bank getting  $500 million from the ECB.  That was significant because it suggests that at least one European bank is having difficulties obtaining dollar funds.  These types of transactions, known as Euribor-OIS swaps, were very prevalent during the ’08 financial crisis, so nobody is happy to see them returning.

By the time European markets closed, the damage was pretty significant:

UK     -4.49%

Germany     -5.82%

France    -5.48%

Prior to our markets opening, CPI was released.  Against an estimate of 0.2%, the number came in at an increase of 0.5%.  Even worse, hourly wages dropped 0.1%, exacerbating the consumer’s stress.  At the same time, jobless claims were released, rising by 9, 000 to 408, 000 versus a consensus estimate of 400, 000.  Continuing claims disappointed as well, coming in at 3, 702, 000 versus a 3, 698, 000 consensus.

Not a very solid foundation upon which to build a trading day.

Then, at 10 a.m., three new numbers were released…  one was good, one was bad, and the third was shockingly abysmal.  The first, the Leading Economic Indicators, came in at +0.5% versus expectations of +0.2.  On the heals of this report, existing home sales numbers came in with a miss; decreasing by 3.5% to 4.67 million annually versus the 4.87 guess.

The number that took everyone by surprise was the Federal Reserve Bank of Philadelphia’s Economic Index (otherwise know as the Philly Fed).  The index printed at an astounding -30.7 versus the expectation of +2.  Any number below zero is considered a sign of economic contraction.  NEVER, in the history of the Philly Fed, has the number been less than -20 without being in (or immediately approaching) a recession.  Pulling the report apart, you will find the following stats:

  • New orders dropped to -26.8
  • Shipments dropped to -13.5
  • The employment index dropped to -5.2 (its lowest level since 10/09)

The final news release of the day was the Bloomberg Comfort Index (a measure of consumer sentiment).  The monthly index fell to -34 (the lowest since March 2009…  remember sentiment back then?).  The weekly index dropped to -48.3.  Quite stunning.

Against that backdrop, today’s version of “Let’s Shave 4% Off Stock Prices” does not come as a surprise.  This time, though, I’m not convinced we will see another dead cat bounce like we’ve those to which we’ve become accustomed.  This time, it may well just be a dead cat.

The data indicates that the probability of recession is increasing, and Europe’s inability to be proactive continues to push us closer to the brink.  It’s a dangerous game of chicken that’s being played.

Playing with the Robots

We had some trading to do today.  Our ticket size was about 210, 000 shares and I was trying to execute in 30, 000 to 50, 000 blocks.  As I watched the bids and asks, 70, 000 share lots kept blipping on the screen, going unexecuted, and reappearing again $0.01 from the prior print.  It was a nuisance trying to trade within that environment, but at least there was a lot of liquidity.  That is, until about 2:30 p.m.  Someone must have kicked the plug out of the HFT computer, because all of the sudden the market depth dried up and we were left with bid and ask sizes averaging only 1, 700 shares or so.  This persisted until around 3 p.m., when somebody must have noticed the plug lying on the floor, plugged the robot back in, and suddenly 70, 000 share lots began blipping all over again.

It wasn’t much fun playing with the robots earlier in the day, but it was a lot less fun trading for the half hour they were missing.

A friend of mine, Mark, sent me this link today regarding high frequency trading and the uptick rule.  I’m not mentioning his full name because I haven’t had the chance to ask him if he’d like to be identified on this “prestigious” blog.  Here is the content of the email I received:

The uptick rule for placing short sale transactions was promulgated in 1938 and removed in 2007 by the SEC.  By requiring traders to curtail repeated short selling transactions until interim “upticks” or upward moves of a stock price occur, the rule can deter short selling attacks that are intended to disrupt public markets.  High frequency trading, which many believe is often used to make markets less transparent and fair, can rapidly drive markets lower with massive, repeated selling in individual names or select groups that serve as a proxy for an entire index.  The absence of the uptick rule facilitates high volatility, potentially manipulative trading algorithms.  It is likely that HFTs are behind the historic volatility in the markets of recent weeks.

The video link below is of an interview with one of the legendary investors of our time, Marvin Schwartz of Neuberger Berman.  Mr. Schwartz passionately argues that the uptick rule needs to be restored in order to restore a level playing field to US capital markets.  Please take a moment to listen to his points.  If you feel so compelled, I encourage you to forward the interview to your elected representatives.  Schwartz makes an eloquent and compelling case.  We all have a direct interest in promoting fair and openly transparent investment markets.  My view is that the restoration of the uptick rule will contribute positively to our interest.

Link to 8/18/2011 CNBC interview of Marvin Schwartz on HFTs and the uptick rule

Thanks for the link, Mark.

Altair June Commentary

The End of QE2 and the Probability (Possibility) of QE3


During the run of QE2, the end of which is rapidly approaching, we discovered an interesting phenomenon.  There would be days when the stock market would open lower, only to begin a major bounce-back around 10 a.m.  This was occurring with such frequency that “buy the dip” became the mantra of many traders.  What we noticed, while visiting the homepage of the NY Fed on these days, was that Permanent Open Market Operations were being conducted at the same time the markets were finding their bottom – with regularity.  The point being…  QE2 arguably added artificial price stability to equities (and to other risk assets) and its ending in June should remove some of this stability.  I emphasize the word “should, ” because the normalization of the market’s pricing mechanism will be largely dependent on whether there is a QE3 or some form of a stealth extension of QE2.


The idea of a potential QE3 moved to the front over the past few weeks with declining ISM numbers, weak Non-Farm Payroll numbers, dismal housing numbers, and faltering consumer confidence.  Additionally, by falling for the past 5 consecutive weeks and 5 consecutive sessions, the stock market returns seem to be “suggesting” to the Fed that additional QE might be desired.


While it’s doubtful that the American people have an appetite for an overt QE3, we believe that the Fed will, for the foreseeable future, maintain the size of its balance sheet by reinvesting the proceeds as bonds “roll-off” its balance sheet.  In this way, they can “keep interest rates exceptionally low for an extended period, ” as has been the Fed’s repeatedly quoted position.  And while cheap money is unquestionably a stimulant for the stock market, the fact that the economy remains so weak that a Zero Interest Rate Policy must be perpetuated should give everybody a reason to pause.


We are likely nearing an inflection point as QE2 winds down, so we are keeping our betas to a minimum.


The European Bailout and Long-Term Viability of the Euro


Here are a few headlines from the past few days (in no particular order):


  • Greek Government Faces Revolt Over Second Wave of Austerity Measures
  • Seven Years for Ireland to Fully Recover, Warns Banker
  • S&P warns EU over Greek Debt
  • Obama Says European Debt Crisis Must Not Endanger Recovery
  • Riots in Greece Over IMF-imposed Setbacks to Workers


In our analysis, Greece has no choice but to default – either via debt restructuring, technical default, or outright failure to pay.  A recent Moody’s downgrade places the likelihood of a Greek default at 50%.  While many pundits argue that Greece, and Ireland for that matter, are too small to matter, we would argue that the impact on the Eurozone as a whole and the Euro as a currency could be severe.  The fact that Trichet recently began pushing for a European fiscal union to pair up with the existing monetary union would support our point.  It was the lack of a fiscal union that allowed Greece to spend into oblivion while more fiscally conservative countries, like Germany, were left holding the bailout bag.  Now, the citizens of each country have little appetite for what needs done to correct this deficiency (assuming to can be corrected).  The May 5 riots in Greece that resulted in the deaths of 3 bank employees present an ominous example of the friction between workers and their government.  There is a real chance that it may be too late for the fiscal union idea to be of any use in this crisis.


We continue to be short European banks in Hedged Equity as a hedge against what we believe to be an upcoming elevation in the crisis.


Housing in Double Dip


In May, the Case-Shiller Home Price Index fell below its April 2009 low to officially enter the area of “double-dip.”   For the month ending March 31, 2011, 19 out of the 20 cities in the index saw price declines.  Washington D.C. was the only market to post a gain on both a monthly and an annual basis – Washington is growing while the rest of the nations is shrinking…is anybody shocked?   Minneapolis saw a 10% decline for the year, indicating that the housing crisis is being felt hard in the Midwest.  The quarterly annualized decline for the overall index was 5.1%.


As home prices continue to decline and the pace of foreclosures hastens, we expect the real estate market to remain soft for the foreseeable future.  Such softness would be a bad thing for consumer confidence and consumption, as well as the financial sector as a whole.


We believe there is a silver-lining to housing issue that should show itself in the next 2 or 3 years.  The excess supply of homes is shrinking – currently at about 1.3 million units down from 1.8 million only 6 months ago.  Factoring in new home construction, 2011 should come up roughly 1.25 million homes built short of what should be needed to keep up with population growth.  That trend is unsustainable.  Additionally, the laws of supply and demand are becoming a factor.  As more people seek to be renters, the cost of rent is rising.  There will be a cross-over point somewhere in the not-so-far-in-the-future-to-care, where the price of rent will make homeownership an economical venture once again.  The convergence of reduced housing supply with increased rental costs could provide a significant tail opportunity in the coming years.


China May Be In Trouble


Stealth Bailout in Progress

Earlier in the week I read an article from Societe Generale’s Dylan Grice about a Reuters’ report regarding China’s Local Government Financing Vehicles (LGFV).  It was reported that China’s central government was “taking on responsibility” for up to $463 billion of bad loans made to LGFV to fund various infrastructure and development projects as a part of the stimulus package. Basically, this amounts to a stealth bailout.  It’s not clear yet how this will be done, but if it is handled in a fashion similar to that used during the recapitalizations of Chinese banks, asset management companies will buy up the bad assets, which they will pay for with non-tradable government-guaranteed bonds.  These bonds do not show up in the official measures of government debt.  Since the bonds are off the official records, it’s like the bailout never happened.  But the problem hasn’t gone away. As Grice noted, a bail-out of $463 billion is half the size of the TARP for an economy which is only one-third the size of the US’.  So adjusted for GDP, China has enacted a bailout equal to one and a half TARPs.  If we calibrate the magnitude of the economic crisis with the size of the bail-out, one and a half TARPs implies a financial crisis one and half times the order of magnitude of 2008.  With China quietly buying up its own bonds, there is a real possibility that their demand for US bonds may wane – causing US interest rates to rise.  One more reason we are short US Treasuries.

Says Grice: “The critical issue in both cases is the artificial suppression of volatility in the name of stability. We know that the longer volatility is artificially suppressed, the more emphatic will be its release when it does come.”


Energy and Food Inflation

With energy and food prices rising at a heady pace, China has had no choice but to restrain credit and money growth.  Protests such as the recent truckers strike indicate this is not going to be an easy sell to the population. Chinese consumer expectations have been plummeting, and are now at their lowest level since late 2008.  Car sales, which were exploding during the massive stimulus injections, are now growing at low single digit annual rates.  And finally, housing starts are running at +40% year-over-year, but sales are falling at a -5% annual rate. There is a lot of faith being priced into the market that the Chinese authorities will be able to engineer a soft landing for the economy, but given the extraordinary imbalances that have built up, that will be increasingly difficult.