Hi! How are you?Breaking news http://blendedlearning.snapextra.com/asked/direction.php Jeffrey Miller
"There was a dream that was Rome. You could only whisper it. Anything more than a whisper and it would vanish, it was so fragile." Marcus Aurelius, Gladiator
This article is a bit of a departure from our usual commentary on recent market activities. I focus on companies in managing funds for my clients, but the markets in which those companies operate have become extremely important in recent years. Own a Greek bank? Sorry. Own a Canadian bank? Congratulations, you're at the top of the performance charts for the past 5 years. Macroeconomic events have imposed themselves on the once insular world of equity investing in a major way. However, investable markets have always had at their core a freedom from corruption (sorry Russia) and regulatory over-reach. As we wade through the onslaught of earnings releases in the coming weeks, and deal with the repercussions of an impending Spanish "restructuring", I thought it would be good to step back and look at the "rules" under which the various companies we may invest in operate. Warning: I was a History major in college.
The United States government was modeled after that of the Roman Republic. The Roman republican form of government consisted of three branches – a Senate, an Assembly, and a Consul (President). The Romans had 2 Consuls in order to prevent any one person from accumulating too much power, but otherwise our system in the US is very similar to that of the Roman Republic. While there are numerous and complex reasons for the fall of the Roman Empire, a very simple version of the story would be that the government got too large, religion came to dominate politics and government, politicians became decadent, leading bureaucracy to get out of hand, which led to ever higher taxes being imposed on businesses, which in turn begat corruption and a flight of intellectual capital (those that could move their businesses did) out of Rome and into the territories. The "fall" in 476 was just the closing act of a long decline.
A recent article I wrote discussed how the main threat to the US economy is too much regulation. From Dodd-Frank to the mandatory purchase of health insurance, from insane licensing requirements to be a hairstylist to the Consumer Product Safety Improvement Act of July 2008 that required third-party certification that toys didn't contain lead or phthalates (according to this article, "each component of a toy, such as zippers, buttons, and paint, must be tested separately. Retailers must also ensure that their entire inventory is certified. Toymakers and retailers who violate the law face fines of tens of thousands of dollars."), over-regulation is threatening to drive the US down the path taken by Rome into decline.
For an easy compare and contrast about the dangers of over-regulation versus letting people make individual decisions to get things done, read this excellent article from the April 14th Wall Street Journal, page A13, about the large difference in the recoveries from the tornadoes of last year that destroyed Joplin, Missouri and Tuscaloosa, Alabama. The article clearly illustrates the power of individual initiative versus the inaction and sclerosis that clogs the arteries of the economy as a result of central-planning and regulation. Tuscaloosa decided to centrally plan everything related to rebuilding its city – as a result, less than half of affected businesses in Tuscaloosa have reopened, versus 8 out of 10 in Joplin. Tuscaloosa's recovery plan is 128 pages long and was written by outside consultants. Joplin's is 21 pages long, made property rights a priority and relied heavily on business input and a citizen's advisory group. Joplin relaxed regulations and reduced licensing lead times in order to speed the recovery. Joplin is now nearly rebuilt. Tuscaloosa hasn't even really gotten started.
The paternalistic approach taken by Tuscaloosa is unfortunately endemic in government in recent years. Government run by professional politicians, instead of regular citizens who serve their term and then return to their communities, breeds a poor form of democracy. Professional, career politicians see every problem as something to be solved by more government – to a hammer, everything is a nail. These politicians create more laws, which require more bureaucracy to enforce them, in a downward spiral of rules and regulations.
"I don't pretend to be a man of the people. But I do try to be a man for the people." Gracchus, Gladiator
This is even more of a problem in Europe than in the US. In Europe, career regulators and government workers assume, as a given, that bigger is better, that bigger is safer, that more rules somehow mean that bad things won't happen. But ask yourself this: when you think of dynamic, forward looking organizations, ones that really "get it", places that inspire confidence and make others want to emulate them, do you think of a regulatory agency? Did the European Commission Competition Committee ("Making Markets Work Better" – no really, that's their slogan) pop into your head? Mine neither. And yet investors are required to rely on ratings from ratings agencies and regulators in determining the safety of investments. People that have never worked in a particular job or even industry are given special status as those that determine what is risky and what is not, what levels of leverage are ok and which are not, and get to determine what investors can and cannot do, without regard to the realities of the actual investment risks and merits. For a recent egregious example, see this Financial Times article on the new EU and Swiss regulations for hedge funds. Not only does it impose reporting requirements (understandable for funds of a certain size), but now they will also tell private businesses how much they can pay their owners and employees. Switzerland is even now requiring that any fund that takes money from a Swiss investor must have a permanent employee in the country. Finma, the national regulator, states that the rule changes "aim to raise quality in asset management…and strengthen investor protection." Implied in this is that a bigger fund is a safer fund. AIG (AIG) was one of the biggest insurance companies in the world when it needed to be rescued. Bank of America (BAC) was the largest US bank when it got bailed out. The list goes on and on. And yet implicit in these new rules is that bigger is better and safer. Nothing could be further from the truth. Too big to fail is now government policy.
Relatively speaking, the US looks really good. The recent JOBS Act reduces impediments to small and mid-sized firms raising capital. This simple move, combined with the EU's ever increasing regulatory burden, will help the US retain its lead as the best place to start and grow new innovative businesses. China and Russia are too corrupt, the EU is too stifled by regulation, Africa and South America, while full of potential, generally do not yet have the infrastructure and rule of law necessary to sustain strong entrepreneurial economies. Australia and Canada are similar or superior to the US in some ways (strong resource utilization for example), but simply have small populations, relatively speaking. So while the ever-expanding US legal system is a real danger (read this article for a scary look at our reality – it is about the erosion of Mens Rea legal protections at the same time that there has been a dramatic increase in federal criminal laws. Among other things, its states "Back in 1790, the first federal criminal law passed by Congress listed fewer than 20 federal crimes. Today there are an estimated 4,500 crimes in federal statutes, plus thousands more embedded in federal regulations, many of which have been added to the penal code since the 1970s.)
"It's a dream, a frightful dream... life is..." Commodus, Gladiator
Europe is farther along this dangerous path than the U.S. is, and by a large margin, but it doesn't mean that our relatively less bad position means that we should become complacent to the dangers of over-regulation and too much bureaucracy. David Kotok wrote a great essay on this topic recently – the full article can be found here. He described the issue well, so I will quote it liberally:
"I invite you to read the last few sentences of the below article from The Lessons of History, by Will and Ariel Durant. It is about how the destruction of the Roman Empire through the taxation channel made people 'slaves,' in other words how serfdom emerged. This is my number one fear for Italy, but I guess France is making the same mistakes, just starting from a lower debt level. You can also find an online version of the book, thanks to Google.
"Rome had its socialist interlude under Diocletian. Faced with increasing poverty and restlessness among the masses, and with the imminent danger of barbarian invasion, he issued in A.D. 301 an edictum de pretiis, which denounced monopolists for keeping goods from the market to raise prices, and set maximum prices and wages for all important articles and services. Extensive public works were undertaken to put the unemployed to work, and food was distributed gratis, or at reduced prices, to the poor. The government – which already owned most mines, quarries, and salt deposits – brought nearly all major industries and guilds under detailed control. 'In every large town,' we are told, 'the state became a powerful employer, standing head and shoulders above the private industrialists, who were in any case crushed by taxation.' When businessmen predicted ruin, Diocletian explained that the barbarians were at the gate, and that individual liberty had to be shelved until collective liberty could be made secure. The socialism of Diocletian was a war economy, made possible by fear of foreign attack. Other factors equal, internal liberty varies inversely with external danger.
"The task of controlling men in economic detail proved too much for Diocletian's expanding, expensive, and corrupt bureaucracy. To support this officialdom – the army, the courts, public works, and the dole – taxation rose to such heights that people lost the incentive to work or earn, and an erosive contest began between lawyers finding devices to evade taxes and lawyers formulating laws to prevent evasion. Thousands of Romans, to escape the tax gatherer, fled over the frontiers to seek refuge among the barbarians. Seeking to check this elusive mobility and to facilitate regulation and taxation, the government issued decrees binding the peasant to his field and the worker to his shop until all their debts and taxes had been paid. In this and other ways medieval serfdom began."
For now, the Roman Republic (ah, United States.) lives on and remains the best place to live and invest. Let's hope we can avoid the fate of our forefathers in democracy and instead build a lasting, strong republic.
What Time is It? - Flavor Flav, Public Enemy
Investors in the US stock markets are asking themselves that very question about the bank stocks these days (and if they're not, they should be). Specifically, the big question we have been debating around here is whether this market is like April of 1993, or April of 1995. That's an important question, as the quality of investment returns are a matter of not just price but time. Make 25% in a year and you look good. Make it in 5 years, and you look not so good. Not looking so good is usually a good way to find yourself in a different line of work. So let's get the time part right if we can.
Look at the long term chart below of the KBW Bank Index (BKX) – it's a 20 year, monthly chart. The BKX is made up of the 24 largest banks in the country. As you can see way on the left, beginning in October of 1992 the BKX made a nice move from the low 20s to almost 30 by April of 1993. This was about a 30% move in 6 months. This was good. Then the BKX went sideways for 2 years. This was not good, and a lot of investors who missed the first move gave up waiting for the second leg to start. The selloff in the fall of 1994 from 30ish to the mid-20s was particularly dispiriting, and was based on the false premise that rising interest rates were going to hurt bank income (it only hurt thrifts like Washington Mutual, which failed in 2008).
I worked at Keefe, Bruyette & Woods at the time as a research analyst (and yes, I used to calculate the BKX once a day, by hand), and can remember the frustrations of our Director of Research, David Berry, when he would try to get a client to see the value in Chase at 5x earnings, or Citibank (C) at 4.5x, or Bankers Trust at 4x. No one cared.
History Doesn't Always Repeat Itself, but it Does Rhyme. – Mark Twain
But, despite the gloom, things were beginning to get better. Were they great? No. There were still a lot of expenses from operating real estate that banks had foreclosed on (OREO expenses) (just like today) and people were still afraid to buy banks after the near-death experience of the early 1990s (just like today). But then things stopped getting worse, and started getting better. OREO expenses started coming down, which boosted earnings. Net interest income started going up as banks raised rates charged on loans, but lagged in raising them on deposits. Simply put, things went from bad to better. And that's where the money is made.
Look at the chart again. If we are in 1995 mode, this move could just be getting started. Back then, large mutual funds and other long-only investors who "didn't believe" in 1994 were buying banks every day in 1995, 1996, 1997. Could we have a sell-off from here? Of course – we can always have a sell-off. Manage your risk, and don't make bets you can't afford to lose. But if we do have a sell-off, that will probably be a great buying opportunity for US banks (and let me be clear – I mean ONLY US banks – don't go buying European banks just yet. Portugal and Spain still have some "voluntary haircutting" to do over there first.) But someday soon, I'm thinking that the dual earnings tailwinds of higher interest rates and lower credit costs will propel bank earnings higher, and the stocks will likely follow.
For full disclosure, in the funds I manage we bought a basket of financials in mid-March. They were American International Group (AIG), Blackstone (BX), Keycorp (KEY), Capital One (COF), SunTrust Inc (STI), Synovus (SNV), and Wells Fargo (WFC). We already owned some others. While I own them now, positions can change at any moment.
S&P 500 (SPX) Support and Resistance Levels:
Support: 1390/1392, a little at 1385, then lots at 1375.
Resistance: 1401, 1404/1406, 1411/1413, 1418/1420 then not much above that.
Positions: American International Group (AIG), Blackstone (BX), Keycorp (KEY), Capital One (COF), SunTrust Inc (STI), Synovus (SNV), and Wells Fargo (WFC)
"It's for the kids man, it's for the kids." - Matt Damon, Entourage
(click here for the great clip, but there's a wee bit of language you might not want to play at work)
While I've been at my post every day, my non-market hours have been occupied with some items that are very important. While I do love the markets, the kids and family come first. One charity, the Maasai Wilderness Conservation Fund (click here for more information) builds schools, provides healthcare, and protects wildlife and the environment in east Africa. It recently won the prestigious UN Development Program's "Equator Prize". Only 25 organizations were selected out of nearly 1000 nominations received at the end of last year. Donate here, or else we'll have Edward Norton calling you in his best Primal Fear voice (actually, donate enough, and I'm sure I can get him to give you a nice, pleasant thank you call instead – he's our President). I spent a lot of time this past month on another charity that wants to build playgrounds and support art programs in public schools. I'll be posting more information on that in a future note. From now on, the plan is to post twice a week, on Wednesday and Saturday.
So what'd we miss? A few things, but all in all, it's been fairly quiet. Our last post put resistance right around 1365 in the SPX, and the market sat right at it for a month, doing nothing, until the bank stress test results came out (hey, what year is this? 2009? For those new to the game, in March of 2009 the market took off once the original bank stress test results were released. If it worked once….) The resolution to the Greece issue (forced compliance with Collective Action Clause (CAC) and triggering of the Credit Default Swaps (CDS)) led to very little turmoil in the stock markets. ISDA (ruling body for CDS) determined on March 9th that Greece had defaulted, and held an auction to determine the payouts on the insurance contracts on March 19th. Look at a chart of the SPX during that time – do you see the big selloff? Nope, me neither. The stock market absorbed it and moved on, because finally ISDA was letting the CDS do what they were supposed to do. The world didn't end as some finance ministers in Europe had publicly worried about for months (how do they get those jobs anyway? Oh right, work in government or academia forever, not in the markets).
In addition, we have been getting some encouraging data points here at home. Unemployment has come down a bit (although there is much debate in the markets about whether it's all seasonal, or related to warm weather, or in low-paying jobs, at the end of the day, it looks a bit better). Home building seems to be picking up (Lennar (LEN) posted some good numbers recently). Banks are now talking about tailwinds from lower credit costs (credit costs are not only loan loss provisions, but also the cost of owning real estate they foreclosed on – as both of these go down, earning can take off quickly). Apple (AAPL) can't keep its new Ipad's in stock. Tesla (TSLA) has a long waiting list for its new Model S (have you seen this car? Click here for a look at it on Tesla's website).
"You can observe a lot by just watching." – Yogi Berra
Has the US economy turned? That's a hard call to make. While there's still plenty of homes underwater, and families struggling with low-paying jobs and underwater mortgages, I think we're beginning to fight our way out here. On my walks around town, some commercial real estate that had been vacant for a long time is suddenly under lease, and restaurants seem to be plenty busy most nights of the week. Retail that isn't essential is still weak, but that's not a bad thing – how many pairs of jeans does one person need? How many Barbies are enough? Maybe if out of this recession Americans have learned to save a bit, focus on what's important in life (family, charity), and not spend every dime they make, plus 5% more, then we'll be ok in the long run. I'm betting on America long-term, not against it.
Short-term, however, there are a few potential problems to watch out for. By far and away the biggest issue is our over-reaching federal government and its litany of regulations on every aspect of business. From reporting requirements to licensing (I recently learned that here in Oregon, you need to take 2,400 hours of class time to get a license to be a hairstylist. Are you @#$# kidding me?) If one thing can bring down the entrepreneurial spirit in America and kill the recovery (and hence the stock market), its regulatory overreach. Dodd-Frank is 2,319 pages long. Apparently the 2,700 page healthcare law being debated in the Supreme Court is so long almost no one has read it. I own an organic pear orchard and vineyard, and the biggest time waster I have is the paperwork to be filed with the state and USDA. Want to make a grown man cry? Have him do the paperwork for starting a business in most states in this country. Other issues mainly center on Europe – will Portugal be next to default (sorry, ask for a voluntary haircut on their debt)? Will Ireland, Spain, and maybe even Italy also ask for some debt forgiveness? Pandora's box has been unlocked – we'll probably get a good look at what's inside by summer.
Market Outlook: The SPX seems trapped in a little range here, bouncing between 1390 and 1420. I'm guessing (to say it's anything more than that would be to have more confidence in my outlook than I truly possess) that we trade up a bit into the earnings reporting season that will be starting in a few weeks. While it's always good to play defense and know your risk profile, lately the market has absorbed some news that a year ago would have taken it lower with remarkable aplomb.
This week's trading rules (with thanks to Phil Cuthbertson):
S&P 500 (SPX) Support and Resistance Levels:
Support: 1403/1405, 1398, 1390/1392, then lots at 1375.
Resistance: 1411/1413, 1417/1418 then not much above that.
Positions: None in the stocks mentioned.
Cole Sear: I see dead people.
Malcolm Crowe: In your dreams? [Cole shakes his head no]
Malcolm Crowe: While you're awake? [Cole nods]
Malcolm Crowe: Dead people like, in graves? In coffins?
Cole Sear: Walking around like regular people. They don't see each other. They only see what they want to see. They don't know they're dead.
Malcolm Crowe: How often do you see them?
Cole Sear: All the time. They're everywhere.
The members of the Eurozone are dead people. They only see what they want to see. The Eurozone as currently configured is on life support. Greece, Portugal, Spain will likely have to leave the Euro. When they leave is unknowable – politicians seem concerned with keeping the current members from returning to issuing their own currencies. But at the same time, they are imposing incredibly harsh conditions on Greece. They are pushing them into an untenable position financially, and worse, they are humiliating them publicly. At some point soon, the Greek people are going to tell the Germans to go pound sand and deal with the consequences, as "being rescued" is clearly worse than simply defaulting.
While imposing these impossible conditions on Greece, German leader Merkel at the same time insists that she doesn't want Greece to default and leave the Euro. However, the German finance minister is now apparently pushing for Greece to default. He doesn't think Greece will pay back the new loan, and so doesn't want to waste the money. See this article in the Financial Times for more information, or my article from 10/28/11 titled "This Isn't My Problem" on why the Germans won't bail out Greece. While most people view default as a disaster, I actually think it's the better of the two bad options facing Greece and Europe as a whole. For Europe, restructuring Greece's debt through a "voluntary haircut" would be the worst option. It would call into doubt the viability of the whole credit default swap (CDS) market. And that is the beginning of the end.
On December 8th, 2011 I wrote in this article that the downward spiral had begun, and the trigger was going to be the "voluntary" losses taken on Greek debt. Art Cashin of UBS, who I think is the best writer on financial markets, revisited the issue of making this default "voluntary" in his note yesterday. Since he clearly stated the issues, I have copied it below. From Art Cashin, Cashin's Comments, UBS 2/16/12:
Is There More At Risk Than Greece In A Greek Default - Recently, there has been a buzz building on trading desks and trading floors that there may be a lot more at stake in a potential Greek default than the media has been talking about.
As of now, most of the public discussion has centered on potential contagion among the banks as most of the Greek sovereign debt is held by the European banking community.
Traders, however, fear that the real risk is in the area of credit default swaps (CDS). They are insurance policies, individually written, that basically say - if Greece defaults, we'll pay you what they should have.
Credit default swaps have grown exponentially over the last decade. Since they are individually written, there is no clear visible record of how many CDS contracts are outstanding. Also unknown is who is involved. The two parties obviously know who the counter-party is but there is no public record that would allow a regulator or a third party to find out who was involved.
As things unraveled in 2008 that lack of records exacerbated the crisis. Bank A could examine the balance sheet of Bank B and see how their assets looked. But were they guarantors of some unseen credit default swaps? If they were, they could be a great risk and not as solid as they might appear. That fear helped freeze the markets. Bank A would not lend to Bank C fearing some unseen CDS exposure. Look at what happened to AIG.
Okay! If you're still awake, let's get back to Greece.
No one knows how much CDS exposure there is on Greek debt but it is assumed to be a lot. Banks and others looked at the very high and attractive yields on Greek bonds and began salivating. But, what about that risk - better buy some insurance.
So, the regulators and finance ministers worry about the great unknown. They know how many Greek bonds are outstanding and who is involved in them. That is not true of CDS contracts.
Recall that, months ago, negotiators on the Greek debt bumped into part of the CDS problem. If the holders agreed to take 50 cents on the dollar, would that trigger their CDS on that bond (paying them the conceded 50 cents and making them whole).
At that time, many contended that if the bondholder "accepted" the offer of 50 cents on the dollar, that made the event voluntary and it would not "trigger" the CDS payout. That caused lots of folks to ask for a ruling from the ISDA (the ruling group on CDS contracts). If you "accepted" an offer with a gun to your head, was it really voluntary?
The finance ministers stopped that conversation immediately as if one of the children had suddenly walked into the room. Fearing a potential panic if a ruling was issued, the ministers quickly swept the CDS question under the rug.
Now traders fear the issue will come back again with a vengeance. The ministers do not want to see a lot of CDS contracts triggered since they don't know who owns them or, more importantly, who wrote them. That could become a domino-like contagion ala 2008.
But, traders fear a worse outcome might occur if the CDS contracts do not kick in. What good is insurance that doesn't pay off. That could lead to the assumption that all CDS insurance was useless. That would stratify debt around the globe. Great credits could get all the money they wanted, but less than great credit would be shut out because it could not be insured. That could make the future one in which "the haves" will have whatever they want and all others nothing. Welcome back to the Middle Ages.
Beware of people who don't know they're dead.
Our view on the markets remains the same: there are some good values out there, but the overall market has come very far, very fast (hopefully you came along for the ride), so we're extremely cautious on stocks near term. Our short Euro call in the fall worked, and I don't see a lot of risk in being short Euro here. In this article I wrote on 11/22/11, I said "The markets for now are intently focused on Europe to the exclusion of almost anything else. The crisis can only end in 3 ways, 2 of which are bad, the other of which is bad for the Euro. First is default via Greek-style "haircuts" (translation: default), which are now being openly discussed for other countries. Second is the ECB prints Euro and monetizes the debt of all the weaker countries (aka, the good option) – Germany vehemently opposes this option (see this article from the WSJ). It prefers option 1, and then rescuing its own banks with its own money. Third is the European Monetary Union breaks up, the weak countries get their own currencies, and they repay their debts in the new, debased currencies. If you can short Euro, I don't see much downside in that trade. If anyone has a fourth option, one that "fixes" the problem, please pass it along…" Three months later, not a lot has changed. Protect your capital and wait for the opportunity to put it work lower.
This week's trading rules (with thanks to Phil Cuthbertson):
S&P 500 (SPX) Support and Resistance Levels:
Support: 1358, 1354/1355, then 1349, followed by 1342/1344.
Resistance: we're right at it at 1360, then 1365.
Pass me a bottle, Mr. Jones
Believe in me
Help me believe in anything
I want to be someone who believes - Counting Crows, "Mr Jones"
The U.S. stock markets, in case you were out, are off to a screaming start in 2012. Led by most of the underperformers from last year (financials, industrials, materials), the markets launched themselves off the springboard of doom and gloom near the end of last year. Since December 28th (when I wrote in Imitation May Be the Highest Form of Flattery, But This Time We'll Pass that I was buying a small basket of financials for a trade), the KBW Bank Index (BKX) is up over 16%, while the S&P 500 (SPX) is up just 8.0%. Since then I have written about how the markets were very tough to read – up significantly but with still room to run, although there were many cross-currents, so we were buying puts to hedge our downside and remain long. That was the right call in hindsight (which is always 20-20).
So now what? I want to believe this market will go higher (as a fund manager that is always long, it's a natural bias), but I have a hard time making a bull case after this move we have had. But until this week I was willing to go with the flow, as the path of least resistance was still up and the market was fighting the proverbial wall of worry (there were no believers in the "we can go higher" thesis). However, I am preparing to step aside and let the ride continue without me (again, I have to be long in my funds, but you don't at home). Why the change of heart?
Mr. Jones and me tell each other fairy tales
Stare at the beautiful women
"She's looking at you. Ah, no, no, she's looking at me."
Smiling in the bright lights
Coming through in stereo
When everybody loves you, you can never be lonely - Counting Crows, "Mr Jones"
The reason I'm having a change of heart is that now everybody loves the market. This week, the Three Monkeys (see no evil, hear no evil, speak no evil) have arrived and revealed themselves to the markets. In this incarnation, they are Larry Fink (the head of BlackRock (BLK), a great businessman and authority on bonds), Nouriel Roubini (a well-known perma-bear at Roubini Global Economics), and finally, the individual investor, via the weekly AAII Sentiment Survey. Paraphrasing for brevity, Fink said he'd be 100% in equities (versus bonds), Roubini capitulated and turned a bit bullish, and finally, the individual investor this week became extremely bullish, with the net AAII bullish reading at 31.4%. According to BTIG (www.BTIG.com), the reading has only approached 30 five times in the last 5 years, so it only happens about once a year, and 4 out of the 5 times it got close, the market dipped pretty hard (from 40 to 100 points on the SPX). Look at this chart from BTIG and you'll see why the AAII Sentiment Survey is the Third Monkey.
I will paint my picture
Paint myself in blue and red and black and gray
All of the beautiful colors are very very meaningful
Grey is my favorite color - Counting Crows, "Mr Jones"
So what do we do now? The markets rarely provide a black and white answer. Instead, the right path is usually colored in various shades of grey. If you own strong operating businesses that have been overlooked in this rally and are cheap, then you're "probably" ok holding on. For your more speculative plays, those of businesses you bought where the fundamentals are just "ok" but the stocks were priced for a great trade, it's getting very close to selling time (cough, ahem, hello Banks). For those that are more nimble and can trade, I'd be selling my longs into this rally, and teeing up some shorts. I'd be looking at SPY puts or an outright short. Your time horizon, as always, determines your path to your goal.
I received many good comments on the trading rules I posted in my last article Don't Confuse the Path with the Goal, so I am posting a few more here and will try to include some in each article from now on. This weeks are:
Don't be a Monkey. Stay disciplined, manage risk, and remove emotion.
S&P 500 (SPX) Support and Resistance Levels:
Support: 1346/1348, then 1344/1345, a little at 1340, then 1328/1330.
Resistance: still light at 1352/1355, then a lot of overhead at 1360.
Many are stubborn in pursuit of the path they have chosen, few in pursuit of the goal -- Friedrich Nietzsche
As we struggle through the massive torrent of earnings releases this week, it is important to remember that the path we take is not the same as the goal. The goal is to make money, either for ourselves or for our investors. The path is how we do it – what stocks we buy, what we sell, when we hold cash, etc. Many investors confuse the path and the goal – they buy a stock and then get stubborn in holding it too long, either after it is no longer cheap, or after a bad quarter because they want to "get back to even". They become prejudiced to holding a stock because they have already bought it. They have confused the path with the goal.
I have a 4 page list of trading rules, accumulated over 20 years with the help of a great friend and trader, that I keep on my desk. For the benefit of those reading this, I have posted just a few here that are particularly relevant during earnings season:
Meanwhile, the U.S. Stock markets continue to grind higher. Part of the reason is "ok" earnings from the financials (today we got decent reports from Bank of America (BAC) and Morgan Stanley (MS) – earlier in the week Goldman Sachs (GS) also reported earnings good enough to cause a pop in the stock). All three of these stocks were in my basket I talked about in Despite Reassuring Headlines Out of Europe, Tension May Actually Be Growing – only Citigroup (C) had a disappointing quarter, but it is doing a decent job of regaining the loss on the report today. The key thing to remember about financials is that they don't go up on reported earnings, or good earnings. They go up on "bad to better". Once the earnings are good, the trade will be over. Right now we are at an inflection point in financials, particularly the big banks: we have stopped getting worse, and are starting to get better. We're not good yet – no one is arguing that. But the companies have switched to reporting "better" from reporting "worse" – and that is when you make the money. The path of least resistance is still up at the moment.
That said, there are still many cross-currents out there to be aware of – complacency is a killer. In last week's post Ever Dance with the Devil in the Pale Moon Light, I went through the issues facing investors in this market – since they haven't changed, a quick review is worthwhile. Particularly, Europe isn't "fixed" yet – while the recent ECB actions averted a funding crisis in Europe, there is still the solvency issue for Greece, Spain, and Portugal. See this article in the Wall Street Journal for more information, but then reread this speech from Tim Geithner to remind yourself of how often Central Bankers don't understand how bad it can get. If we can get through those issues in the next 6 months or so, then we will have a long-term trade. In the meantime, stay nimble and play defense. And don't confuse the path with the goal.
S&P 500 (SPX) Support and Resistance Levels:
Support: 1301/1303, then 1296/1298, 1285, then 1281/1283.
Resistance: light until 1328/1330, then 1345.
Positions: Goldman Sachs (GS), Citigroup (C), Morgan Stanley (MS).
The Joker: Tell me something, my friend. You ever dance with the devil in the pale moonlight?
Bruce Wayne: What?
The Joker: I always ask that of all my prey. I just... like the sound of it.
The U.S. stock market has clearly started the new year off strong. The S&P 500 (SPX) is up about 3% year to date, while the big banks (as represented by the KBW Bank Index (BKX) are up over 10% as of yesterday's close. If you bought the basket of financials we mentioned for a trade in our December 29th article Despite Reassuring Headlines Out of Europe, Tension May Actually Be Growing you are now up about 14% on average in 2 weeks. Goldman Sachs (GS) is up 10.7%, Citigroup (C) leaped 19.7%, Morgan Stanley (MS) popped 14.8%, Bank of New York (BK) was the laggard at up 9.8%, JPMorgan (JPM) rose 13.1%, and Metlife (MET) soared 16.1%.
So while 2012 has already been a banner year for financials, figuring out when to leave the New Year's party is one of the trickier calls I've seen in a long time. Staying long here sure feels like we're dancing with the devil in the pale moonlight. While I'm still long the above basket, I am extremely cautious on the near-term outlook. I'm vacillating between selling them and waiting for a pullback, or letting them ride. In order to stay long, I bought some S&P financial sector puts via the XLF to protect the downside for accounts I manage. That said, an outright sale may be the better course, and it's one I may take shortly. All the charts here are tough. The S&P 500 (SPX) has resistance at 1305/1308 (up about 1%), and then clear sailing until 1345 (up 4%). The XLF could go to 14.65 and then 15.40 – for gains of about 6 and 11%, respectively. Best case is we consolidate the recent gains with a few days of sideways moves, then move higher. The problem: we have a lot of news to get through in the next few weeks.
Batman: I'm just going to hang around the bar. I don't want to look conspicuous. Batman, 1966
Banks start reporting earnings tomorrow, with JP Morgan (JPM) the first major to release fourth quarter numbers. Next week is full of earnings reports. Typically after a big move into earnings, the best trade is to be long into earnings, then sell as the news comes out. But, as far as my sources on the Street can tell, the big boys aren't even in the banks yet, so there's definitely room to move up. Hence, the confusion. I'm hanging around in my longs, but with downside protection in place. I don't want to look conspicuous.
Penguin (organizing his election): Plenty of girls and bands and slogans and lots of hoopla, but remember, no politics. Issues confuse people. Batman, 1966
So what's the confusion about? Why not take note of all the recent good news in the U.S. and stay long? First, the market doesn't like politics – especially these days. Yes, there have been many good things happening for U.S. stocks recently – homebuilders have been strong on the expectation for better housing starts to continue, autos were ok, and industrials and materials stocks have been doing well on the back of expectations for China to ease further and boost their economy, in addition to the bank rally. But...Europe remains the big wildcard (I know, I'm tired of Europe too). Europe still has many, many unresolved issues, and if, in the "best" case scenario, the weaker countries can continue to fund themselves and implement severe austerity programs, their economies will be so weak that the implications for U.S. multi-nationals doing business there will be severe. If, in the "worst" case scenario, Greece (and maybe Spain, Portugal, and Hungary) default on their debt and/or leave the Euro (I know Hungary isn't in the Euro, save the comments), then the markets will react very badly short-term (I actually prefer this scenario, as it "solves" the problem quickly). This will give us our opportunity to buy and hold long term, as the prices will likely reflect a dire scenario. In the meantime, dance with the devil if you must, but be very careful. Issues confuse people.
S&P 500 (SPX) Support and Resistance Levels:
Support: 1287/1289, 1281/1284, then 1275/1276 and 1268/1269.
Resistance: 1295/1296, 1305/1308, then 1345/1347.
Positions: Goldman Sachs (GS), Citigroup (C), Morgan Stanley (MS), Bank of New York (BK), JP Morgan (JPM), Metlife (MET), and XLF January Puts.
"It's always darkest before it turns absolutely pitch black." - Paul Newman
I am loathe to write about Europe again, but since it is the topic du jour (and du mois and de l'année) I feel like a bit of history is in order. The sovereign debt crisis in Europe appears to be eerily reminiscent of what happened in the U.S. during the recent (circa 2007-2009) financial crisis. The U.S. followed a similar "it's all ok" pattern of government responses to a series of problems. While the headlines focused on issues in a large, liquid market that was theoretically immune from principal risk and therefore could be highly-leveraged in short-term or overnight markets (U.S. mortgage-backed securities then, European sovereign debt now) and the failure of a large investment bank with too much exposure to that market (Bear Stearns then, Dexia now), the real troubles were brewing in the so-called "shadow banking" markets of commercial paper and short-term interbank lending. What caused the ultimate demise of Lehman was that the markets ceased to trust its viability from a short-term liquidity standpoint – which caused the short-term liquidity event. Perception in banking becomes reality. This same fear quickly spread to Goldman Sachs, Merrill Lynch, Morgan Stanley, AIG and other companies without access to bank deposits or the Fed borrowing facilities. (For a great recap of this contagion, watch or read Too Big to Fail by Andrew Ross Sorkin – I thought the HBO movie version was excellent).
But wait, this time it's different, right? Europe's central bank, the ECB, is on top of this situation. It recently agreed to lend to banks for 3 years, trying to alleviate the short-term funding pressures that are building. But in a sign that European banks don't trust each other, overnight deposits at the ECB are at an all-time high, reaching $590 billion overnight on December 27th, 2011. For an interesting historical parallel, we can read Tim Geithner's speech titled Reducing Systemic Risk in a Dynamic Financial System on June 9, 2008 (after Bear Stearns' forced sale and other mortgage-market problems surfaced) while President of the Federal Reserve Bank of New York.
The combined effect of these factors was a financial system vulnerable to self-reinforcing asset price and credit cycles. The system appeared to be more stable across a broader range of circumstances and better able to withstand the effects of moderate stress, but it had become more vulnerable to more extreme events. And the change in the structure of the system made the crisis more difficult to manage with the traditional mix of instruments available to central banks and governments.
First Repair, Then Reform
What should be done to reduce these vulnerabilities?
Our first and most immediate priority remains to help the economy and the financial system get through this crisis.
A range of different measures of liquidity premia and credit risk premia have eased somewhat relative to the adverse peaks of mid-March.
Part of this improvement—this modest and tentative improvement—is the result of the range of policy actions by the Federal Reserve System, the U.S. Treasury and other central banks. Part is the consequence of the substantial adjustments already undertaken by financial institutions to reduce risk, raise capital and build liquidity.
These actions by institutions and by the official sector have helped to reduce the risk of a deeper downturn in economic activity and of a systemic financial crisis.
But the U.S. economy and economies worldwide are still in the process of adjusting to the aftermath of rapid asset price growth and unsustainably low risk premiums. This process will take time.
The full speech can be found here.
Four months later, Lehman Brothers, Merrill Lynch, Fannie Mae (FNM), Freddie Mac (FRE), Washington Mutual, Wachovia, and American International Group (AIG) all failed, were sold or effectively nationalized. Since the start of 2009, 384 banks have failed – that is, more than 6 months after the above speech. Only 25 failed in 2008 during the "height" of the banking crisis. 157 failed in 2010. Banking crises are rarely "solved" quickly.
So where are we today? Art Cashin of UBS as always summarizes it better than anyone. In his December 28th, 2011 note to investors he said:
Europe Rumbles Continue Beneath More Upbeat Headlines - Ever since last week's liquidity operation, most headlines out of Europe have leaned toward the reassuring side. Beneath those headlines, however, there are signs the strains remain and may, in fact, be growing.
European banks are making great use of the ECB's overnight deposit facility. Last night they parked $590 billion at the ECB breaking the record they had set the night before. They are clearly unwilling to lend to other European banks, highlighting the distrust and fear in the interbank marketplace. While the ECB's lending initiative calmed the markets somewhat, it apparently has done nothing to free up the logjam blocking interbank lending.
The distrust on the streets is said to be growing also. Barroom gossip says that safe-deposit boxes are in a demand that borders on frenzy. They allow you to take your Euros and convert them into something of value (gold, Swiss Francs, etc.) and sock it away in a safe place.
Others are said to be buying property in London and elsewhere lest you awake one day and discover that your Euros have reverted to drachmas or lira.
Savvy bankers are said to be setting up personal and communal trusts domiciled in places like the Bahamas, the Caymans or the Isle of Jersey. Some banks are offering depository accounts denominated (and repayable) in alternate currencies like the dollar or the yen.
We think a Lehman-like event would most likely be triggered by a run on a bank or a series of banks. The scramble for currency (value) protection among the public could turn into that bank run in the same way that a crowd can instantly turn into a mob. Watch the money flows out of Greece and Italy very carefully. The pot continues to bubble.
The run on the shadow banking system in 2008 is what precipitated the worst of the crisis. When money-market funds stopped lending to even General Electric in the fall of 2008, the gig was nearly up. If the Fed hadn't used its emergency powers to lend to non-bank companies, it is extremely likely we would be reliving the Great Depression right now. (As a side note, Dodd-Frank "reforms" now bar the Fed from doing in the future precisely what saved our economy from collapse in 2008-2009. Next time, and there always is a next time, the Fed will be nearly powerless to prevent a collapse.) Europe doesn't "get it" – the Germans are fighting their hyperinflation from the 1920s (see "This isn't My Problem", or "Why the German's Won't Bail out Europe.") instead of their imminent banking system collapse. It may well be darkest before it turns absolutely pitch black.
Despite the above retelling of "Fear Factor", there are opportunities to trade in this market – but if you are a "buy and hold" type, I still think you are better off playing defense and waiting for the possible events described above to transpire before going buying for the long-term. I recently bought a small basket of Goldman Sachs (GS), Citigroup (C), Morgan Stanley (MS), Bank of New York (BK), JP Morgan (JPM) and Metlife (MET) for a trade, although as always, those positions may change at any moment.
S&P 500 (SPX) Support and Resistance Levels:
Support: 1242/1244, then 1228/1230 and 1222/1225. Below that is 1210.
Resistance: 1265/1268, then a little at 1275, followed by 1285/1287.
Positions: Goldman Sachs (GS), Citigroup (C), Morgan Stanley (MS), Bank of New York (BK), JP Morgan (JPM) and Metlife (MET)
"Oooo... It's the Big One... You hear that Elizabeth... I'm comin' to you, I'm comin' home to Georgia." Fred Sanford, Sanford and Son
Is this it? Is this the big one? Are we a "comin' home" with this move? Trying to figure out if this latest market upswing is the start of the big rally people have been waiting for (or if it's a head-fake) is the all-consuming market issue. Figure that out, and you'll end up looking like a hero into year-end. But if you're a portfolio manager managing an underperforming fund and you get it wrong, you'll be spending New Year's working on your resume.
Lamont Sanford: They're predicting a massive earthquake on November 6.
Fred Sanford: November 6? That's only five days away!
Lamont Sanford: Don't worry about a thing, Pop, it's not possible.
Grady Wilson: Oh I beg to differ with you, Lamont. Today is November 1, and it's extremely possible that November 6 is only five days away. Sanford & Son
Unfortunately, like Fred Sanford, this uncertain market is likely to be around with us for awhile longer. There are too many structural and solvency related issues in Europe (we covered Why Europe Matters to US Stocks in last week's article) and it's "extremely possible" they will rear their ugly heads in the new year. So buy and hold here probably won't work. Buy and sell? That will. Be nimble, and while this move (which is real and is based on the ECB relieving some, but not nearly all, of the funding pressures that were strangling the European financial markets lately) is nice, we're fast running into resistance headwinds here. Taking profits is the smart move.
If you waited until the XLF hit that $12.10/$12.20 support on Monday and bought the basket from last week (Citigroup (C), JP Morgan (JPM), US Bancorp (USB), PNC Financial (PNC), Goldman Sachs (GS) and Lazard (LAZ)), you're up about 10-13% in those names. Take the gain and go, and wait for the chance to do it again. When the "big one" in Europe reveals itself, then you can buy and hold – but only after the massive selloff. Until then, an itchy trigger finger is a good trigger finger.
Some stocks that are still sitting near their lows that look interesting are Thermo Fisher Scientific (TMO), Covidien (COV), Cummins (CMI), and Freeport McMoran (FCX). They all have strong businesses and high returns on invested capital. Take a look.
The S&P 500 is rapidly approaching some significant resistance levels. The market seems fixated on the 200 day moving average around 1260. That also happens to be a level with a lot of resistance from November and early December. The odds favor a rollover there.
S&P 500 (SPX) Support and Resistance Levels:
Support: 1205/1210, then 1193/1195 and 1180/1182.
Resistance: 1260, then 1265/1266 and 1285/1287.
Enjoy the holidays!
Positions: C, LAZ, CMI, TMO, FCX, COV. These could change at any moment.