We continue to be concerned with the many obstacles to a strong recovery. Stocks have been rising to new highs for six months now and the bulls and bears continue to battle. We believe the economy has bottomed but remain skeptical that the stock rally can maintain its surge without bumps in the road. Although we have participated in the rally, we also hold plenty of cash and keep some stock market hedges in place.
We have taken a cautious approach to stocks but investors need to search for opportunities within the boundaries of their macro views of the economy. We expect the financial services industry to undergo many changes in the next few years. A year ago the financial system faced Armageddon and many financial companies have been saved with government help; while others have either gone bust or were taken over by stronger enterprises. We can expect the strong to get stronger while many others will need capital infusions, will be taken over by the FDIC, or will be forced to sell themselves. We think the opportunities in financial services will produce some of the best returns to those who have the knowledge and research to find the winners. Many funds have raised capital to buy distressed banks and build platforms to lead turnarounds for the financial institutions of the future. As such, we are buying the Paulson Recovery Fund. Although this is a high risk illiquid fund, we believe John Paulson has a unique knowledge of the financial industry. His firm is best known for identifying the imminent collapse of the housing market and the mortgage securities that came tumbling down. He also parlayed that insight into shorting many financial institution stocks. We believe his firm has extensive research on the banking universe and will now be able to pick the winners in the recovery phase. A select group of investors will also be shown opportunities to invest in or buy distressed banks and Paulson should have the access to what in our opinion will be some of the greatest investment opportunities of our life time.
For months we have discussed our concerns with the rising bankruptcy rates we expect in the corporate world. Many companies have filed Chapter 11 and many more will follow suit in the next couple of years. Leverage was a killer in the housing market, it will create record corporate bankruptcies, and it will severely damage the commercial real estate market. Companies borrowed to fuel the leverage buyout boom which helped to propel the stock market higher. Financial markets collapsed and bank financing dried up. These events coupled with a severe recession has put many companies into default while many more are heading in that direction. We try to invest where opportunities present themselves. We have plenty of knowledge and experience with bankruptcy investing and believe the next few years will produce significant returns for vulture funds who take over distressed companies by acquiring the debt of the target company. It is hard for individuals to participate in these opportunities on their own as large pools of capital are needed to be successful as well as extensive research capabilities. We have decided to pursue these opportunities through Oaktree Capital Management who is raising their fifth domestic fund focused on buying companies through the debt. Their track record is very good through many cycles and we believe the timing couldn't be better than now. A good investor should produce great returns when the timing is perfect.
Finally, we have been talking about the collapse of the real estate market for a year. Housing prices have plummeted around the country and commercial real estate is next in line. Housing has shown some positive signs in the last few months but we remain somewhat skeptical as much of the momentum is driven by government incentives to first time buyers. On the other hand, this may be the greatest opportunity in our lifetimes to take advantage of weak real estate markets. As such, we are focused on buying multi-family housing that produces positive cash flows. It may be a year or two too early to invest in commercial real estate so we are currently focused on housing. If our thesis on future inflation is inevitable, holding real estate should better protect our assets from a weaker dollar.
We remain concerned with the stock market and the many land mines left throughout the economy but it is important to take advantage of the opportunities created from the past year's financial calamity.
Tuesday, September 22, 2009
Monday, September 14, 2009
A Year After the Lehman Collapse
A year ago, the financial system was on the verge of imploding. The Lehman collapse set off a trying few weeks where many other financial companies such as AIG, Fannie Mae, Freddie Mac, Goldman Sachs, and Morgan Stanley were also on the verge of imploding. The Federal Reserve and the Treasury department flooded the financial system with liquidity and shored up the banking system with loans resulting in improved protection from failure. Today the banking system appears to be healing and the economy has stabilized but many risks still exist.
We have been writing about excessive leverage and our concerns with its likely drag on the economy. This morning Nouriel Roubini spoke on CNBC about his concerns with consumer leverage, corporate leverage, real estate leverage, and finally, the excessive amount of debt created by the U.S. government. His thoughts are very much in line with our concerns for the future. Economic activity can not be robust until debt levels decline precipitously and this can only happen with time.
Another topic we have focused on is banks too big to fail are too big to exist. The Bank of International Settlement has concluded, as discussed in the WSJ, that "big banks' risks to the system increase more than proportionately with their size". We agree and have suggested that capital requirements should rise with the size of a bank. This method will allow banks to self judge wether they can garner sufficient returns on capital as their size grows. The BIS seems to have come to a similar conclusion as they suggest bigger banks pay higher taxes. If such tax is in the form of higher capital requirements then sytematic risk won't be avoided but managed more prudently.
We have been writing about excessive leverage and our concerns with its likely drag on the economy. This morning Nouriel Roubini spoke on CNBC about his concerns with consumer leverage, corporate leverage, real estate leverage, and finally, the excessive amount of debt created by the U.S. government. His thoughts are very much in line with our concerns for the future. Economic activity can not be robust until debt levels decline precipitously and this can only happen with time.
Another topic we have focused on is banks too big to fail are too big to exist. The Bank of International Settlement has concluded, as discussed in the WSJ, that "big banks' risks to the system increase more than proportionately with their size". We agree and have suggested that capital requirements should rise with the size of a bank. This method will allow banks to self judge wether they can garner sufficient returns on capital as their size grows. The BIS seems to have come to a similar conclusion as they suggest bigger banks pay higher taxes. If such tax is in the form of higher capital requirements then sytematic risk won't be avoided but managed more prudently.
Wednesday, September 9, 2009
Gold, Inflation, and the Markets
The market keeps rising but the fear of inflation is still embedded in investor's minds. The weakness of the dollar has oil, gold, and other commodities rising again. The federal Reserve and its brethren around the world are focused on curbing future inflation but the fight will be arduous if not impossible over time. Governments continue to spend on stimulus plans while also printing plenty of money to jump start the global economy. We find it hard to believe that in two years, inflation won't start to inch up or even climb higher.
The good news these days is the increase in merger activity. Companies can't seem to grow revenues in this environment so it is a good time to acquire revenues through acquisitions. Valuations are still low if one has a long term horizon and most CEO's make strategic acquisitions with an eye on short term synergies and long term strategic value. We expect Wall street to garner a bigger stream of revenues as well capitalized companies pursue growth through M&A.
Stock prices could benefit with merger activity as the supply of stock is reduced when the acquired company is no longer trading. Incrementally this is a positive for the markets but we still believe a weak economy, high leverage, rising unemployment, and a weakened consumer will make this economic recession last longer than most expect. If we are wrong, the government debt, the corporate debt, the consumer debt, and the real estate debt will create roadblocks to a sustained recovery. We will need to see many more bankruptcies and defaults in order to equitize the system and allow businesses to grow again.
The good news these days is the increase in merger activity. Companies can't seem to grow revenues in this environment so it is a good time to acquire revenues through acquisitions. Valuations are still low if one has a long term horizon and most CEO's make strategic acquisitions with an eye on short term synergies and long term strategic value. We expect Wall street to garner a bigger stream of revenues as well capitalized companies pursue growth through M&A.
Stock prices could benefit with merger activity as the supply of stock is reduced when the acquired company is no longer trading. Incrementally this is a positive for the markets but we still believe a weak economy, high leverage, rising unemployment, and a weakened consumer will make this economic recession last longer than most expect. If we are wrong, the government debt, the corporate debt, the consumer debt, and the real estate debt will create roadblocks to a sustained recovery. We will need to see many more bankruptcies and defaults in order to equitize the system and allow businesses to grow again.
Monday, August 31, 2009
What Will September Bring?
We were pleased to see Intel and Dell have positive outlooks for the rest of the year. At the beginning of 2009 our model portfolio had plenty of technology stocks. Companies and consumers defer such purchases first when economic conditions look bleak; however, if an enterprise wants to improve productivity and remain competitive, technology spending can't remain dormant for too long. As such, we don't find it too surprising that the technology sector has some positive teas leaves at this time in the economic cycle.
This doesn't change our stance of the last few months as we continue to proceed with caution. Investors are becoming a little more suspect of China's growth. China seems to be in better shape than the U.S. and most parts of the world but we have speculated that some of their commodity buying was a result of low prices and not current demand. Why not store cheap raw materials today and use them when manufacturing starts to surge again?
As we have been saying, the economic tsunami has passed and economic activity has improved. Most companies will say business is not getting worse any more but few see much revenue growth ahead. Stocks tend to reflect future earnings but sometimes other factors can affect reality. We believe the rally was justified to a degree as signs of an Apocalypse dissipated. Stocks were probably way oversold but because there was so much cash on the sidelines, investors jumped in to the market for fear of missing the next leg of the rally. Risk taking may be back but risk management is still more important. At some point there will be a stream of negative news which may reverse the upward trend of stocks. The consumer is still weak, debt levels everywhere are high, the auto stimulus is gone, and foreclosures continue to rise. Stocks can't go up in a straight line until leverage is much lower, credit is flowing to small businesses again, and the consumer is comfortable spending again.
This doesn't change our stance of the last few months as we continue to proceed with caution. Investors are becoming a little more suspect of China's growth. China seems to be in better shape than the U.S. and most parts of the world but we have speculated that some of their commodity buying was a result of low prices and not current demand. Why not store cheap raw materials today and use them when manufacturing starts to surge again?
As we have been saying, the economic tsunami has passed and economic activity has improved. Most companies will say business is not getting worse any more but few see much revenue growth ahead. Stocks tend to reflect future earnings but sometimes other factors can affect reality. We believe the rally was justified to a degree as signs of an Apocalypse dissipated. Stocks were probably way oversold but because there was so much cash on the sidelines, investors jumped in to the market for fear of missing the next leg of the rally. Risk taking may be back but risk management is still more important. At some point there will be a stream of negative news which may reverse the upward trend of stocks. The consumer is still weak, debt levels everywhere are high, the auto stimulus is gone, and foreclosures continue to rise. Stocks can't go up in a straight line until leverage is much lower, credit is flowing to small businesses again, and the consumer is comfortable spending again.
Monday, August 24, 2009
Of Course Housing and Auto Sales Are Up
The markets reacted well to strong existing home sales last week as they did when domestic auto sales jumped in July. It should be no surprise to anybody that those have been two extremely damaged areas in this recession. The Obama administration may have a trillion dollar Stimulus Plan but it is likely that only their assistance in buying homes and cars may be the only two line items that will directly grow sales and add to employment. It is working albeit at a big cost to Americans.
It is also unlikely that such programs will have lasting affects. Consumers always like a bargain and that is why they are gravitating to Walmart, TJ Max, McDonald's, and other discount retailers. So when the government handed out free money to buy cars and homes, consumers jumped for another bargain. Unfortunately, those programs won't last forever and this economy needs some other sources of demand to jump start growth.
99% of employment growth comes from small-businesses but 99% of news headlines comes from large corporations. The National federation of Independent Business announced the results of their July survey of small-businesses. The results are bleak. Small-business owners aren't convinced the recession is ending and their outlooks darkened in July. The recorded index declined for the second month in a row and the biggest reason for the drop was that small-business owners don't expect the economy to improve in the next six months.
This shouldn't be much of a surprise as financial institutions still haven't opened the lending spigots, sales remain weak, taxes may be rising, and the cost of health care is uncertain. The consumer is still weakened and their inclination to increase savings will keep the small-business owner concerned.
We continue to wonder why stocks keep rising but it seems pretty simple. Stocks were in free fall when the prospects of the Second Great Depression was looming. Investors ran for cover and focused on capital preservation with minimal risk. Now it appears that the recession has come to an end and the trillions of excess liquidity is looking for a place with higher risk and improved returns. Companies are reporting better earnings and investors seem to overlook the negative news and focus on the green shoots.
Stock prices must reflect the realities of corporate growth and the discounted cash flows of earnings. Bull markets climb walls of worry and we remain worried. We see improvement in the economy but we also see the plethora of risks ahead. The financial industry calamity we had can be attributed to poor risk management. Housing prices were expected to rise forever and leveraged financial instruments were viewed as gold. Consumers, businesses, and financial institutions yearned for more and more so they piled on debt. It was just a game of musical chairs until the music stopped.
We may be in a similar game of musical chairs. The logic is that the recession is over and investors need higher returns. They step back into the stock market and feel much better as stocks have risen. Others missed the rally but need to get on the train so they take their over abundance of cash and enter the market which in turn pushes stock prices even higher. Housing sales and auto sales confirm an improving economy and more investors become comfortable taking the ride on the stock market express. Is this a ride to riches or are we at the top of the roller coaster?
We wish we knew the answer. We believe stock prices have risen too far, too fast. Business is improving but true growth is small. Until the consumer is back and small-business confidence improves, we will remain concerned. We still own stocks but writing covered calls and adding stop limit orders seems to be the best way to minimize risk. We may be giving up the upside if stocks continue on the current trajectory but investors need to focus on risk management.
It is also unlikely that such programs will have lasting affects. Consumers always like a bargain and that is why they are gravitating to Walmart, TJ Max, McDonald's, and other discount retailers. So when the government handed out free money to buy cars and homes, consumers jumped for another bargain. Unfortunately, those programs won't last forever and this economy needs some other sources of demand to jump start growth.
99% of employment growth comes from small-businesses but 99% of news headlines comes from large corporations. The National federation of Independent Business announced the results of their July survey of small-businesses. The results are bleak. Small-business owners aren't convinced the recession is ending and their outlooks darkened in July. The recorded index declined for the second month in a row and the biggest reason for the drop was that small-business owners don't expect the economy to improve in the next six months.
This shouldn't be much of a surprise as financial institutions still haven't opened the lending spigots, sales remain weak, taxes may be rising, and the cost of health care is uncertain. The consumer is still weakened and their inclination to increase savings will keep the small-business owner concerned.
We continue to wonder why stocks keep rising but it seems pretty simple. Stocks were in free fall when the prospects of the Second Great Depression was looming. Investors ran for cover and focused on capital preservation with minimal risk. Now it appears that the recession has come to an end and the trillions of excess liquidity is looking for a place with higher risk and improved returns. Companies are reporting better earnings and investors seem to overlook the negative news and focus on the green shoots.
Stock prices must reflect the realities of corporate growth and the discounted cash flows of earnings. Bull markets climb walls of worry and we remain worried. We see improvement in the economy but we also see the plethora of risks ahead. The financial industry calamity we had can be attributed to poor risk management. Housing prices were expected to rise forever and leveraged financial instruments were viewed as gold. Consumers, businesses, and financial institutions yearned for more and more so they piled on debt. It was just a game of musical chairs until the music stopped.
We may be in a similar game of musical chairs. The logic is that the recession is over and investors need higher returns. They step back into the stock market and feel much better as stocks have risen. Others missed the rally but need to get on the train so they take their over abundance of cash and enter the market which in turn pushes stock prices even higher. Housing sales and auto sales confirm an improving economy and more investors become comfortable taking the ride on the stock market express. Is this a ride to riches or are we at the top of the roller coaster?
We wish we knew the answer. We believe stock prices have risen too far, too fast. Business is improving but true growth is small. Until the consumer is back and small-business confidence improves, we will remain concerned. We still own stocks but writing covered calls and adding stop limit orders seems to be the best way to minimize risk. We may be giving up the upside if stocks continue on the current trajectory but investors need to focus on risk management.
Thursday, August 13, 2009
August 13 Is Bullish Day
It was twenty-seven years ago when we entered life on Wall Street. August 12th was the bottom of the market following the recession of the late seventies and early eighties where interest rates soared, inflation spiraled out of control, and unemployment pierced the 10% level. Stocks started to soar on high volume and the bull was off and running. Inflation was being tamed, interest rates were about to drop, and the economy was on its way to recovery. We can remember many professional traders loading up on call options as rising stocks generated more zeal every day. The bull was here to stay.
A score and seven years later investors ponder whether the current bull run is for real. The recession appears to be over but the economy is still weak. Retail sales numbers for July appear to be soft and the employment picture is not truly getting better. Of course, investors have driven prices higher with every earnings report that has shown improvement. As we have said in the past, earnings growth has been driven by cost cutting but sustainable growth will only be generated when corporate revenues improve.
Today's market participants can not expect interest rate to decline or inflation to be tamed or unemployment to abate. Those were the 1982 bull market drivers so what will drive the 2009 market higher? We are not sure. Perhaps China and India will continue to grow quickly and pull the U.S. out of its economic slump. This country certainly needs help from the global economy. The U.S. usually leads global growth but if stock investors are discounting better times ahead, the U.S. will definitely need help from abroad to drive exports and spur revenue growth.
We are in a cash driven market. The fear created in the markets by the financial collapse left trillions of dollars on the sidelines. It is hard for investors to watch stocks rise while they sit with a plethora of cash. Each surge in stocks draws in more money from those who don't want to miss the next bull run. We may want to believe the economy is improving but it has only really stabilized. Growth is a long way away and when back-to-school sales are weak the markets will suddenly become concerned about Christmas sales.
Cash for clunkers has created a surge in demand for new cars. This program has certainly provided stimulus in the same way the subsidies for first-time home buyers has rekindled the housing market. Unfortunately, these subsidized sales may be stealing from future demand. If consumer incomes don't improve and the inclination to save is rising, this economy cannot depend on the consumer for future growth. With no consumer, it is either up to big business or the government to drive growth.
Businesses take their cues from the economic outlook. If final sales are driven by the consumer and unemployment continues to be weak, it will be hard for businesses to invest in the future. Perhaps technology companies will be the beneficiaries of the economic weakness as companies will need to improve productivity if revenue growth will be dismal.
That leads us to the government to create growth. The stimulus plan has many wasted programs but the auto and housing industries have generated some positive results. The banks have been bailed out by Federal help also and perhaps the commercial real estate industry will also get a helping hand. Most of the fixes are short term and have contributed to the stabilization of the economy and the end of the recession.
Where does this leave us? We may have borrowed some future sales to jump start the weakened economy. All of these programs have added trillions to the government debt burden. The government is no different than a consumer or a business when it comes to debt. If a consumer's earnings decline and his expenses stay steady or rise, he his likely to accumulate a debt burden. Should this trend continue or one lose his job or his expenses rise (i.e. gasoline and heating bills) that debt burden will result in a default on a mortgage or personal bankruptcy. The same process is true for companies. Too much debt is leading to a huge wave of corporate restructurings and bankruptcies.
As for the government, the debt burden being created may help in the short run and the bull market may continue for awhile. However, at some point in the future the fat lady will sing. The United States will need to pay back its debts. Unless the economy starts growing exceptionally fast, which is highly unlikely, the government will need to aggressively raise taxes, as they are contemplating for the rich. Higher taxes will likely crimp economic growth and make the debt burden even worse. The only other logical solution is to devalue the dollar while printing more money. (We are assuming the government won't default on its debts.) This is a situation that seems likely to happen and the ownership of gold or other hard assets in the future may be the only safe place to hide.
August 13th is a good day to contemplate where we are in the next bull market. We remain concerned that growth will be slow in 2010 and that stocks are being driven by technicals. The recession may be over but the lack of revenue growth from companies, a weakened consumer, and the debt burdens of this country will ultimately come to roost.
A score and seven years later investors ponder whether the current bull run is for real. The recession appears to be over but the economy is still weak. Retail sales numbers for July appear to be soft and the employment picture is not truly getting better. Of course, investors have driven prices higher with every earnings report that has shown improvement. As we have said in the past, earnings growth has been driven by cost cutting but sustainable growth will only be generated when corporate revenues improve.
Today's market participants can not expect interest rate to decline or inflation to be tamed or unemployment to abate. Those were the 1982 bull market drivers so what will drive the 2009 market higher? We are not sure. Perhaps China and India will continue to grow quickly and pull the U.S. out of its economic slump. This country certainly needs help from the global economy. The U.S. usually leads global growth but if stock investors are discounting better times ahead, the U.S. will definitely need help from abroad to drive exports and spur revenue growth.
We are in a cash driven market. The fear created in the markets by the financial collapse left trillions of dollars on the sidelines. It is hard for investors to watch stocks rise while they sit with a plethora of cash. Each surge in stocks draws in more money from those who don't want to miss the next bull run. We may want to believe the economy is improving but it has only really stabilized. Growth is a long way away and when back-to-school sales are weak the markets will suddenly become concerned about Christmas sales.
Cash for clunkers has created a surge in demand for new cars. This program has certainly provided stimulus in the same way the subsidies for first-time home buyers has rekindled the housing market. Unfortunately, these subsidized sales may be stealing from future demand. If consumer incomes don't improve and the inclination to save is rising, this economy cannot depend on the consumer for future growth. With no consumer, it is either up to big business or the government to drive growth.
Businesses take their cues from the economic outlook. If final sales are driven by the consumer and unemployment continues to be weak, it will be hard for businesses to invest in the future. Perhaps technology companies will be the beneficiaries of the economic weakness as companies will need to improve productivity if revenue growth will be dismal.
That leads us to the government to create growth. The stimulus plan has many wasted programs but the auto and housing industries have generated some positive results. The banks have been bailed out by Federal help also and perhaps the commercial real estate industry will also get a helping hand. Most of the fixes are short term and have contributed to the stabilization of the economy and the end of the recession.
Where does this leave us? We may have borrowed some future sales to jump start the weakened economy. All of these programs have added trillions to the government debt burden. The government is no different than a consumer or a business when it comes to debt. If a consumer's earnings decline and his expenses stay steady or rise, he his likely to accumulate a debt burden. Should this trend continue or one lose his job or his expenses rise (i.e. gasoline and heating bills) that debt burden will result in a default on a mortgage or personal bankruptcy. The same process is true for companies. Too much debt is leading to a huge wave of corporate restructurings and bankruptcies.
As for the government, the debt burden being created may help in the short run and the bull market may continue for awhile. However, at some point in the future the fat lady will sing. The United States will need to pay back its debts. Unless the economy starts growing exceptionally fast, which is highly unlikely, the government will need to aggressively raise taxes, as they are contemplating for the rich. Higher taxes will likely crimp economic growth and make the debt burden even worse. The only other logical solution is to devalue the dollar while printing more money. (We are assuming the government won't default on its debts.) This is a situation that seems likely to happen and the ownership of gold or other hard assets in the future may be the only safe place to hide.
August 13th is a good day to contemplate where we are in the next bull market. We remain concerned that growth will be slow in 2010 and that stocks are being driven by technicals. The recession may be over but the lack of revenue growth from companies, a weakened consumer, and the debt burdens of this country will ultimately come to roost.
Friday, August 7, 2009
Unemployment Drives the Market Higher
The unemployment rate actually dropped to 9.4% and only 247,000 jobs were lost in July. It seems like many people were fired last month but it is a big improvement for all of 2009. Stock futures have leaped and investors are euphoric. There is plenty of cash sitting on the sidelines and everybody has been keenly focused on this employment number. This could be the tipping point to send the markets running as more shorts cover positions, bears turn to bulls, and the fear of missing the next rally drives cash into the stock market.
The economy is still weak and economic growth is still not in sight. Company costs have been trimmed but top line growth is tepid. The consumer is saving and not spending; banks are still not aggressively lending; and leverage remains high at the consumer level, corporate level, and in all areas of government. The stock market may be separating itself from reality.
It is obvious that the patient has stabilized but he is not ready to run a marathon. Investors feel better about earnings as we all do but as we have said for awhile, stocks need to discount future earnings. Earnings and growth could improve in 2010 but current prices of stocks assume much faster growth than we think likely. If top line growth miraculously improves in the range of 3-5%, then earnings will skyrocket and stocks are trading in the right range. We just aren't that bullish.
The economy is still weak and economic growth is still not in sight. Company costs have been trimmed but top line growth is tepid. The consumer is saving and not spending; banks are still not aggressively lending; and leverage remains high at the consumer level, corporate level, and in all areas of government. The stock market may be separating itself from reality.
It is obvious that the patient has stabilized but he is not ready to run a marathon. Investors feel better about earnings as we all do but as we have said for awhile, stocks need to discount future earnings. Earnings and growth could improve in 2010 but current prices of stocks assume much faster growth than we think likely. If top line growth miraculously improves in the range of 3-5%, then earnings will skyrocket and stocks are trading in the right range. We just aren't that bullish.
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