The Case for Shorting Bonds

Bill Cara has claimed that The Trade of the Generation is to sell bonds and to buy gold.  I think he’s right.  Here’s why:

1. The inflation rate is currently being reported at 3.8%.  Most people think that the books are at least a bit cooked, and some well respected economists even think that we’ve averaged closer to 8% pa since the 80s.  The 20 year rate is currrently 3.487%.  Even going by inarguably understated government statistics, you’re losing money.
2. The target rate which governments lends money is 1%.  The real lending rates have been dramatically lower — near 0% for close to a year now.  Friday’s weighted average was 0.441%.  Wednesday’s was 0.33%.  This is actually an improvement over earlier in the month where we see the Fed lending at 0.253% on the 4th, 0.195% on the 5th, 0.18% on the 6th….  this is going to serve to increase inflation.

With effective rates at less than 1% and the current backdrop of financial crisis, do you think 3.487% pa reflects the inflation or default risk over 20 years?  I surely do not, and I think the current principle in domestic government bonds is a bubble caused by flight-to-quality and flight-to-liquidity from the bust of commercial bonds.

Top-Down Analysis

The shape of the US stock market is very different than it was even three months ago. The financials no longer dominate the landscape like they have for the past decade. Their weighting in the S&P 500 has fallen to 12.9% — down from 23% in 2006.  This is what I was referring to as I wrote on October 12:

Every 5-20 years, the market goes through a tectonic shift as the money invested in companies whose models are no longer as profitable shifts into companies who are.

As I also pointed out then, these cycles seem to be moving much faster as corporate, government and consumer leverage has done nothing but expand.

Here is how it breaks down today:

1. Technology – 15.1%
2. Healthcare – 14.9%
3. Energy – 14%
4. Consumer Staples – 14%
5. Financials – 12.9%
6. Industrials – 10.8%
7. Consumer Discretionary – 7.6%
8. Utilities – 4.2%
9. Telecom – 3.6%
10. Materials – 3.0%

It’s not very surprising to see consumer staples jump to 14% from just 10.5% in April – the market has most rewarded the safe play stocks.  Also interesting is the ascent of the healthcare sector.  I believe that this sector will only continue to grow in the long-term due to demographics.

Let’s take a look at the major players in each sector.

Technology

The dot-com bust marked the seismic change in Microsoft’s core valuation from a dynamic growth stock to a blue-chip value stock.  With a P/E around 10, it’s tough to see Microsoft as anything but a good deal, but even they are not immune to a global recession.  That said, they still have piles of cash, and they will likely benefit from the piles of new government spending which is about to commence around the world.  Most of the new hires will have PCs on their desk, and even the Mac desktops will be running Office.  That said, I still think that the forward earnings estimates are a little optimistic:  it’s expected that they will have earnings growth in 2009 and 2010.  This is not likely to happen in a deep global recession.  When there is blood in the water here — which I suspect there will be at some point — buy MSFT.  Most likely flat for the time being.

Cisco and Oracle are in a similar boat.  They too have been transformed into value blue-chips after a few decades of high flying growth stocks.  I feel that the consensus on Oracle forward earnings is overly optimistic.  They are not immune to global recession either, but they will also benefit from the NND (new new deal) government infrastructure spending.

Apple and Google are likely going through this shift in valuation sentiment right now.  I think they will continue to go through some pain, and I don’t think they make the current estimates for the next two years.

Nokia is a company on the other side of this pattern:  I think they’ve already gone through most of their pain, and the valuation is overly pessimistic at this point.

To summarise the technology outlook, I’m fairly neutral if not a bit bearish.

Healthcare

US Healthcare

During the last recession, the big players — Johnson & Johnson, Novartis, Pfizer and GlaxoSmithKline — were all able to do very well to manage steady earnings increases.  With the exception of GSK, they also maintained rising stock prices.  The massive, inefficient and extremely profitable health-care industry will only become more so with the introduction to even more government spending in health-care suggested by President-elect Obama, our aging population and burgeoning retiree class of fat boome

From 2000 through the end of 2002, the S&P 500 lost nearly 35%.  XLH lost only 10%.  I think things are setup for an even better result this time around.

Energy

With oil prices finally falling from the sky after demand tails from the entrance of a global recession, what happens to the big players will have a large impact on the overall market.  According to Bloomberg, each $1 of oil increases Exxon Mobil’s EPS by $0.11.  Were this the extent of it, Exxon would be approximately 3x more profitable.  Exxon’s business is far more complex than this, and must buy oil in addition to drilling it to refine it into gasoline.  Consequently, the spread between gasoline and oil is also important.  Assuming analysts have already modelled this reasonably accurately, this calls for a 34% decrease in profits for 4Q, and then a further 15% decrease for 2009Q1.  This seems a little bit optimistic:   gasoline and crude prices have fallen about 64% since their peaks.  Some of this can be explained away in hedging and delta-neutral integrated deals, and Exxon — like other cash-rich organisations — will be able to play accounting gains with their earnings.  Let’s, however, look at the last time oil was at $45 in August of 2004;  Exxon mobile was trading at just $45 (it closed at $73.42 today), and the global economic prospects were much more promising.  Will monetary inflation push this up even further?  I doubt it.  As a consequence, I think Exxon is worth a lot closer to $45 than it is to $73.42.  I see similar prospects for the other major integrated energy stocks.

Consumer Staples

Today we witnessed the largest deflation in CPI since the 1940’s.  That said, ex-energy and ex-food, there was actually a 0.1% increase.  With this year’s deep recession and job losses, I doubt the volume of consumption will increase much.  The flight to safety and quality has also given the top companies in this sector a relative premium to its peers:  Proctor & Gamble is now trading at 16.64x earnings.  Non-durable consumer goods is trading at 16.7x earnings, and the non-cyclical consumer goods is trading at 15x as a whole.  I believe, as a consequence, that the safety premium has already been established, and that these companies will get cheaper relative to their earnings as they disappoint.  The only hope for their earnings is that the monetary inflation turns into broader inflation.  I’m non-committal on the fair value as a consequence.

Financials

At some point, these institutions will stablise, but not yet.  The glut of ARM resets won’t hit until 2009Q3, and there is still a lot of pain left in the housing market.  That said, $700B on the balance sheet and another $700B increase in almost free lending from the Fed will do a lot to ease that pain.  We don’t know enough about the balance sheets of these companies to know with any degree of certainty what will happen.  This one is a wildcard.

Industrials & Consumer Discretionary

Whatever happens to the automotive industry – whether they get their bailout or not – the shareholders are going to get screwed.  Out of the S&P 500, there aren’t many companies left standing.  The largest ones — Daimler (21B market cap, 4.45x earnings), Nike (21B market cap, 12x earnings) and PACCAR (8.62B market cap, 7.49x earnings) seem to have a pretty hard ceiling.

Conclusion

With the current market conditions, I see another 10-15% in downside, with a particular focus on energy stocks going down.

Sector	S&P 500 Weight	6-12 Month Outlook
Technology	15.1%	Neutral / Moderately Bearish
Healthcare	14.9%	Neutral / Moderately Bullish
Energy	14%	Bearish
Consumer Staples	14%	Neutral / Moderately Bearish
Financials	12.9%	????
Industrials	10.8%	Bearish
Consumer Discretionary	7.6%	Bearish

Global Plunge Protection Team

At the beginning of this week, I opined that we are near the end of the bottoming process, but that we had some pain to face this week before we could move.  That pain showed itself yesterday with a punishing -5.27% day for the S&P 500.  Today, the global capital masters have decided to rein the pessimism with some massive rate cuts.  The prime rate in the UK dropped a staggering 1.5% to 3%.

Although the lending market has improved somewhat (but nowhere near as much as it should have with the trillions which have been pumped into the system at or near zero interest), the push for more and less expensive cash is becoming a lot like pushing on a string.  The global apetite for debt has cratered.

The result of these rate cuts — if they work, and the outcome if they don’t will not be pretty — is inflation.  The entire model of money supply intervention to manipulate the markets in order to avoid economic recession is insane.  Expanding the monetary base to this end does nothing but delay and exacerbate the inevitable.  This is all just a symptom of the macroeconomic divide which has been sucking wealth and production out of the West for the past 30 years from running consumer, trade and government budget deficits – all at the same time.  Neither candidate spent time on any of them.

Spot silver spiked to over $10.74.  With effective returns in every global currency negative while the supply rapidly expands, do you think it’ll stop there?

Market Overly Optimistic

I do think that we’re nearing the end of this bottom – for now.  The end of quarter loss-selling should be over.  Christmas shopping is nearing.  We’re so oversold that the downside is largely exhausted – it’s easy to make the case that the people who were shaken out of stocks are probably mostly out.  The big margin calls have been made.  We’re ready to start moving up again.

But not this week.  Manufacturing is down (ISM 38.9 from 43.5 – and manufacturing prices have fallen 53.5 to 37, signalling a massive decline in demand).  What do you think that’s going to do monthly factory orders tomorrow?  ADP’s official guess on unemployment and NFP change on Wednesday will not be pretty, and neither will the real BLS numbers on Friday.

The only wildcard is the election.  Will unfounded optimism and new hope prevail?  It didn’t help when Bush  was elected mid-bear market.

Adrian Ash outlines how massive expansion of the monetary base will lead to stagflation.  Silver’s still under $10.  Buy it there while you can!