Bail-Out a Non-Starter

In a surprising move, the “bail-outs” have been rejected by the House.  The Republicans were at odds with their administration and spoiled the party:  2/3rds voted against.

Stock prices are probably one of the few things that aren’t highly levereaged these days.  When central banks around the world collude (http://www.financialpost.com/news/story.html?id=846876) to give the market $330 billion in new liquidity (and the USD still goes up!  so there was actually great demand for this new cash), stocks recover very quickly.  They did.

Through all of yesterday’s madness, I woke up today and remarkably had a profit for the week:  the European market had mostly recovered, and Dow emini was back at 10,655.  I made a number of day-trades in the gold and Dow emini markets:

Open Time	Type	Size	Item	Price	Close Time	Price	Profit
2008.09.29 20:09	buy	4.00	ym	10548	2008.09.29 20:09	10616	1 360.00
2008.09.29 18:04	buy	1.00	gc	898.4	2008.09.29 20:40	911.4	1 300.00
2008.09.29 21:23	buy	3.00	ym	10507	2008.09.30 11:10	10655	2 220.00
2008.09.29 17:33	buy	1.00	ym	10858	2008.09.30 11:10	10655	-1 015.00
2008.09.22 21:19	buy	1.00	ym	11093	2008.09.30 11:10	10655	-2 190.00

Intra-day moves of more than 5% on the Dow are very uncommon.  During the massive de-leveraging during the 1929 crash and followup recession, the Dow moved -5% or more on 23 occasions between 1929 and 1933.  It did this twice again in 1937, but then not once until Black Monday.

The last two instances would prove to be a bottom of the terrible 2002 bear.  Let’s examine that bottom in closer detail:

That might be what we see here – a whole pile of volatility as the financial industry sorts itself out through newly introduced central bank credit facilities around the world.  This does beg the question:  if the Fed was able to create $330 billion new dollars and sell them to central banks around the world on a whim in a single day, why bother with the legislated bail-out model?

Every $100 billion created is roughly a 0.7% increase in our monetary supply.  That metric has helped me determine when to get out of my gold and silver trades.

Top-Down Analysis

My bull call had me purchase a mini Dow contract at 11,093.  Though under water for most of the week, it’s sitting at 11,147 with a very modest profit of $270.  Further analysis

Quantitative Top-Down Analysis

The market has definitely partially priced in the buy-outs.  A quick look at the P/E ratios of some key sectors (from Yahoo Finance):

Basic Materials	17.69
Technology	20.34
Industrial Goods	22.38

Financials

We’re going to deliberately ignore the financials’ P/E right now – their current earnings are virtually meaningless looking forward.  What we do know is that they will be able to sell off 750B worth of assets at higher valuations than the open market. The investment bank which probably stands to gain in all of this is Goldman Sachs. This massive buy-out is being almost entirely organised by ex-Goldman chiefs, and you can bet that Goldman Sachs is now in a position to effectively conduct arbitrage between the current debt market and the new 750B buying spree. They’re particularly in a good position to benefit, having the lowest exposure and leverage to the CDOs out of all of the big banks.  The GS stock price over the next 3 months will double as the corruption index.

Basic Materials

This industry is worth over 5 trillion.  Roughly 4 trillion of that is oil & gas.  The remaining trillion — precious metals, industrial metals, chemicals and minerals should do pretty well.  Oil and gas will not.  The basic materials sector should be poised to get some gains

Technology

Technology is pretty ordinarily priced – if somewhat optimistic that they’ll be able to maintain earnings.  The business behind the technology sector is far too varied and specific to facilitate broad quantitative analysis.  Technology can be put in place to save money just as often as technology investments can be made into vapour-ware.  Technology does generally benefit from liquid borrowing conditions (it’s expensive to do research and bring technology to the market), and can be used to bridge problems in any context.  The buy-outs will benefit technology by proxy.

Industrial Goods

A continuing weak dollar should help the exporters out of this list.  After the government subsidies to the automotive sector, can it really get worse?

With this analysis in mind, I will re-iterate my modestly bullish stance into October, and will keep my mini Dow position open.  If I traded SSFs, I’d be buying Goldman Sachs – this 137.99 level will be a bargain with all of the pure arbitrage profit they’ll be ringing up.

Update 09/29/08 11:34 AM: Looks like my timing was terrible for a Goldman Sachs buy.  Good thing I wasn’t trading SSFs.   I’ve picked up one more Dow contract at 10,858.

This Market Is Headed Higher

I’ve been quiet because I’ve been waiting to be right.  Let’s see how my predictions stack up:

Asset	Price at Prediction	Price Now	Difference
Gold	$806	$911	+13%
Silver	$12.75	$13.65	+7%
EUR/USD	$1.4119	$1.4849	+5%

I only recommended the gold and silver. I thought that the EUR/USD trade might not work as well because the bail-out does have some positive ramifications for the very large USD debt market. Apparently traders don’t think so. I think the EUR/USD is a little too strong now…

Anyway – it’s time to get out with our huge gains.  It might go up higher, but the money supply increase necessary to execute the bailout was fairly quckly valued – somewhere around a 5% increase is needed. On the longer term perspective (years to decades), this is actually a much more significant cost as the cost to borrow will double every 4-5 years it takes to pay – but we’re not looking this long term.

The Dow 30 is fairly averagely priced (trailing P/E of 14.77, forward of 12.73 – and analysts are fairly conservative one earnings estimates).  At the same time, the Japanese have started using their massive cash supply to start buying companies – having not suffered from overleveraging.  They avoided it this time around (this has already bit them – remember?).  The Chinese aren’t far off.  Now, Microsoft is beginning a $40 billion buy-back.  HP is buying back $8 billion.  Nike is buying back $5 billion.

This is combined with the banks new ability to deleverage by selling their OTC options to the government for what will inevitably prove to be very attractive rates (obviously it will seem to steep to the taxpayers, but not nearly enough to the bankers – something about crocodile tears comes to mind).

I don’t see a massive run-up and a new bull market.  A sector by sector analysis make a hard case for much of a run-up.  I’m looking for another 10% from this point.

Bankruptcy, The Dollar & The Chinese

Gold, Silver & Euro

Since I made the call, the EUR/USD has gone from 1.4119 to 1.4337, Gold from $806 to almost $900, and Silver from $12.75 to $11.655.  Not bad.  My trepidation for shorting, however, was misguided.  I had thought that the plunge protection team would have been more potent.  Evidently they either weren’t much use, or their firepower has been somewhat limited.

The New Bull Market

China has nearly 1.7 trillion in USD reserves as a combination of stocks, bonds and cash.  Incidently, the Dow Jones 30 total market cap now also stands at 1.7 trillion.  Why would China start buying up American companies?  They’ve already started, and they already have a tremendous holding in UK companies.  The Telegraph estimates that they own 9 billion euros worth of the top 30 British companies. It is in their best interests to keep Americans employed and buying their exports, as well as to allocate their already substantial investment into the American economy to service its own interests.

Is Morgan Stanley’s potential purchase by China’s Citic Group the beginning?  That’s wouldn’t be their first banking purchase, either.

This is something to consider when looking for something to buoy these markets.

Fannie Mae & Freddie Mac

This is probably the most blogged about topic in the financial blogosphere….  I won’t get into whether I think the intervention is right, will work or will make the housing and credit markets more stable.  What I will get into is another mid-to-long term shift in supply and demand.  Bill Cara calls it a tilt.  I’ll quote him liberally:

Yesterday, PIMCO’s Bill Gross was pleading for help from the Administration. However you paint this picture, color it yellow. Bill Gross represents Wall Street, so this is another case of Humungous Bank & Broker pleading for Intervention, a tilt in that so-called level playing field that would help HB&B.

Every time that tilt happens, the $USD sinks. Presently, the $USD has been on a powerfully bullish run, which has been tanking the commodity prices. The Administration has been touting the positive impact that is having on the US economy; yet the data does not confirm that. Traders have been selling off the Energy, Financial, and Tech sectors because they now clearly see that the US economic problem is a global problem. As other currencies have dropped, the $USD has lifted. But there is a limit to how far traders are prepared to push it higher, knowing that US banks, broker-dealers, insurance companies and hedge funds are likely to fail soon.

As Bill Gross mouthed his plea in the direction of Washington, he was signaling “Get set for tilt”. Yes, we are that much closer to a bottom in precious metals. As I see it, traders with a three-year time horizon can buy Gold with a 7-handle and Silver with a 12-handle and do well over that period.

Bill Cara’s Commentary for September 5

I think he’s absolutely right this time.  He’s definitely been a bit quick to pull the trigger on the precious metals, but there will be more dollars chasing less precious metals because of this bail-out.

As for my positions initiated just before noon on Friday, the Japanese open has treated them very well.  All of my positions are well up:  EUR/USD $575, Oil $137.50 and 30-year bond short $296.88.  This, I suspect, is only the beginning.  I don’t intend to ride this horse forever, but I think we’re talking about a few percent gain in oil and euros, and maybe a 5-10% drop in the yields.

Money from the capital markets is made from either identifying short-term mispricings as information expires, or finding economic surfaces which are tilted – so the money runs down.  This is the catalyst for the latter action.

What we have to calculate now is exactly how much this will cost, and then we can estimate the monetary impact and decide where to exit our positions.

Update 09/09/08 7:57 AM: I’ve exited out of my EUR/USD and 30-year bond futures trades with a modest profit, and entered new positions in gold & silver futures.  I’ll exit out of oil on New York open.

I’m Out – For Now

It’s been a brutal 3 weeks – and we’re not done yet.  However, with the unemployment rate jumping 0.3% while 86k jobs have been lost, I’m guessing that we’re on the brink of market intervention.

What does that mean?  I suspect we’re going to see a soft bounce in the US stock market, and a hard bounce in the Euro.

The Euro really hasn’t been the same since the G7 finance minister & central bank meeting at the end of Q1, so there definitely have been some changes in the policy of central bank reserves.  As a consequence, I’m not comfortable making large or prolonged trades here.  I think a lot of the proverbial fecal matter has yet to hit the fan.

With this all in mind, I’ve taken small positions long Euro (1.4235), Oil (105.90), and selling bonds (119.31250).  The plunge protection team is going to need to raise cash to boost stock prices, but it will boost inflation and kill cheapen bonds to do it.

The Working Group on Financial Markets has a lot of work to do over the weekend…

September Fundamental Review

My bearish stance is paying off:  I’ve been shorting NQ with 1-3 contracts all the way down from 1965.  The market is now so over-sold that it’s almost certainly due for a bit of a bounce.  That said, the fundamentals just aren’t improving — in fact, we’re overvalued to the point of asset bubble prices.  The S&P 500 had towering P/E of 25 to start the week.

The current market capitalisation weights of the S&P 500 are most weighted towards financials, techs and energy.  I suspect that energy earnings are going to get crushed.  Financials are not done deleveraging.

This market is headed lower.  Every bounce will be an opportunity to short.

Update Sep 04 4:14PM:  Every once in a while, if you take enough swings enough at the ball, you hit one out the park.  Nasdaq is -3.2% today.  There is good reason for this.  My NQ position is now worth $2,850 which is boosting my 4 week return to nearly 6%.

Advance America, Cash Advance Centers (AEA)

This is another recession play – Advance America, Cash Advance Centers is exactly what it sounds like.  It’s more highly leveraged than its peers, but not overly so – debt/equity is barely over 1.0.  Dividend yield is sitting at 10%.  I’ve entered in a small position (1%).

Perpetual 10% Annual Stock Returns

This article is about the assumption of 10% yearly stock returns, where it came from, where it is now, and some opinions on why it may not continue.

It is an amazing thing:  both GDP and inflation have between 1-3% annually, yet the market return since 1909 has averaged just over 9%.  Dow 30 stocks have performed at a clip of 10.53% since 1928.  If you assume that GDP growth is not inflation deflated (which it at least partially is), that is a 4-7% annual out-performance of stocks against economic growth.  The questions asked are  a) why, and b) will it continue.

This does suggest that the private sector and capitalism do work.  Existing business adapts to outperform country-wide economic growth, and returns these gains to the equity holders.

The model used in this forecast factors in historical returns, economic growth, dividend yields and the risk free rate.  The idea is, assuming economic growth continuing on a historical pace, the lower (risk free rate / dividend yield) is, the larger gains the market expects.  This particular assumption is also central to a few other major models, including the Fed Model (and variants).  The best model I’ve seen using these assumptions is from cxoadvisory.

A criticism leveled at this model is that the dividend yield has seemed to permanently shift to under 2% from the historical average of over 4%, and that this indicates that the risk premium has dramatically increased.

The most persistent challenger has been Rob Arnott, a Pasadena money manager and editor of the Financial Analysts Journal, who thinks future equity returns could be below 6%. (See "Dueling Market Forecasts" chart.) The big difference between his forecast and Ibbotson’s is that Arnott uses the current dividend yield (1.76%) as a starting point, while Ibbotson goes with the much higher long-term average yield (4.23%). Ibbotson believes the historical number provides a better picture of what investors think is ahead. He still relies on the assumption that markets are efficient, so current dividend yields must be low for a reason–his guess is that investors are expecting big growth in earnings (and dividends) in the future. Arnott, whose research has shown that low yields in the past were followed by slow earnings growth, thinks that’s balderdash. "One of my biggest beefs with the academic community is the notion that theory is fact," he complains. "When they find evidence that contradicts the theory, instead of saying, ‘Wonderful, let’s improve the theory,’ they throw it out because it conflicts with theory."

One immediate comment is that the dividend yield likely has fundamentally changed, but not because of earnings expectations;  Tax considerations and advances in investment banking have encouraged closed-end funds and companies to perform stock buy-backs instead of disbursing dividends.

What makes the earnings picture for the future look grim is the generational retirement of the baby boomers combined with what looks like another savings & loan crisis.

The question really turns into whether well managed companies need the kind of economic and credit expansion to succeed and grow their earnings.  Stock indexes, and stocks themselves by extension, are subject to economic darwinism.  Investment capital is taken away from companies who are not giving high returns on equity and assets, and these companies are replaced by organisations which do.

As a consequence, I do believe that stocks will continue to out-perform.  I believe that small-cap value stocks will do particularly well (as they historically have) in comparison as vehicle for achieving the most innovative ways of getting value and returns on investment.

Weekly Preview

Major upcoming economic events this week:

• ISM Manufacturing index from the St. Louis Fed – these numbers have been most recently stagant, registering below and around 50 – meaning little growth or recession in US manufacturing.  This could potentially go either way, but I doubt very much.  Contributing to the potential up-side is the low USD, which will make creating US export businsess more attractive.  Contributing to the possible  up-side is the low USD, which will increase manufacturing costs from raw materials (wages are experiencing deflation), and lower probable demand from decreased consumer spending power.
• Non-farm payroll net-change and unemployment rates – economists are forecasting nearly 75,000 job losses.  Could you argue against it?  Businesses everywhere seem to be cutting people, downsizing and going out of business.

That being said, the market has already been very week recently leading up to these events, so we go back to the principle that we know the overall direction (down) since the market hasn’t yet caught up with the fundamentals, and we will look for better prices to enter in our second and third short positions.   I’m keeping my current short position, which went from a $1,000 open p/l to $475 over the weekend.

Tags: USD, nfp, unemployment, manufacturing, ism, futures