Today the S&P VIX is sub-17. This level of complacency usually signals that we are topping out or at least due for a correction. Rather than short individual equities, at these levels I find the idea of buying Feb VIX calls (struck in high teens/low 20s) to be a very interesting one. This is not even a bearish call and doesn't require bearish thinking. It should be a prop-bet or hedge and nothing more. It's always important when buying volatility to give yourself ample time. While Bernanke continues to monetize our debt with daily POMOs under QE2 and suggests on 60 minutes that QE3 is a possibility, this market could stay at these lofty levels for longer than a person could fundamentally believe possible (...it already has!) Several months should provide ample time despite the higher costs. Also it is worth noting that options buyers of VIX calls/puts realize that by definition volatility tends to spike higher/lower in short periods of time. Therefore, one must be nimble if considering this idea. The premium, unless very near its maturity date, will be less than the actual in-the-money amount. For example, if buying Feb 20's at 3.00, and the VIX goes to 27, the option is not likely to be worth 7 (as expected) but more likely 5.50 or 6. This is because VIX tends to snap up and come back down almost as quickly.
Other indications that market participants have become too complacent:
1. In the last three months alone, insiders have sold just under $10B worth of their own stock. (Tyler Durden at Zero Hedge.)
2. Valuations of NASDAQ darlings such as AAPL, NFLX, AMZN, OPEN, BIDU, etc are trading at shockling high forward multiples. This is very reminiscent of the low-rate manipulated market that led to the tech bubble in the early 2000s. The marginal buyer here is almost certainly playing a dangerous game of hot potato and is likely only piling in at this point as an inflation hedge and because of some hubristic belief that they will be the first out when Bernanke and Co can no longer successfully prop up the market. If this segment of the market turns sour, it will do so rapidly as there are far more 'renters' than 'buyers' in these names.
3. The Eurozone debt crisis is far from over. The media does an almost fascinating job of avoiding discussing this theme until something dramatic enough happens that it must be reported on. In the days between pronouncements from Merkel, or bond restructurings, the media is happy to behave as though the entire debacle has suddenly disappeared. I assure you, it has not. While I do not personally believe the European Sovereign Debt Crisis will play out in the coming weeks or even months, its very existence will continue to trouble markets for years into the future, which should at least make marginal buyers at these levels nervous about playing the role of the greatest fool...
4. Ditto for tensions on the Korean Peninsula. From headlines suggesting war is imminent to narry a mention the following day, it is almost amazing to witness a) how short-term oriented we've become as a society and as an investor class, and b) how effective the media is at setting the agenda. What is frightening is that the situation in Korea is not developing in a vacuum. With the US engaged in what many central bankers have dubbed a currency war, the price of food in China spiking higher as a result, the US monetizing debt and devaluing China's dollar holdings in the process, one must at least acknowledge that a proxy war between China backed NK, and US backed SK is not an impossibility. It may be mutually destructive and may be outside of the realm of current thinking, but WWI and WWII were economically motivated conflagrations that seemed to escalate rapidly after a tipping point incident that alone shouldn't have caused so much destruction, let alone worldwide participation. Follow the bonds...
5. Margin compression will occur sometime in the near future. If inflation should begin to pick up meaningfully (which it already has) then input costs will also trend higher. Not all of these costs can be materially passed through. Demand for certain goods is relatively inelastic, but clothes retailers, boat makers, household appliance makers, etc will not be able to pass on higher input costs to consumers who have seen their incomes, job security, and net worth all deteriorate. Without wage inflation, it is unlikely that we will see much successful pass-through pricing without a reduction in the top-line. Therefore margin assumptions must begin to be revised downwards.
6. On the topic of demand and inflation, one must consider that higher food and fuel prices will restrict the amount of disposable income that the American consumer has available for more fully priced goods and services. A reduction in the top line is therefore imminent for discretionary service providers and goods manufacturers. The Federal Reserve's goal of propping up the stock market to create a 'wealth effect' is providing an opportunity for insiders to sell and giving officials more time to work out potential solutions, but it certainly is not trickling-down to the majority of American workers, most of whom have very limited equity ownership, and who view a higher stock market not as a sign of a recovering economy but as endemic of a kleptocracy making off with what's left before the whole thing comes crashing down.
There is a notable rise in the 'end the Fed' rhetoric lately and one need look no further than the growing Tea Party movement, the appointment of Ron Paul to head the Fed oversight committee, etc. The political turmoil in this country is not, in my opininon, rooted in foreign policy ideology, or family values issues, but instead mainly represents a class struggle. Somehow the Democratic Party has been colored as the political arm of 'nothern elitists' now seen by populists everywhere as being detrimental to the quality of life of the people in this country. Meanwhile, deficit-hawk Republicans get elected to 'rein in spending' who intern immediately move to deny unemployment insurance extensions to our nations involuntarily unemployed if they are not granted extensions to $600B tax cuts for the nation's wealthy. Really? Is the country too naive or disinterested to even consider how bizzare and hypocrtical that this is? If this Democratic administration had the guts people previously assumed that it did, why not push to end the tax cuts (and the Reaganomics obsession along with it) and redirect this money to at least a less inflationary way to directly create jobs via subsidies and invesment in new secular growth industries such as electric cars, the smart grid, wind and solar, nuclear power plants, rebuilding the nation's infrastructure, etc, etc, etc. Instead our nation's 'populists' decry this idea as 'fascist' or 'socialist' and instead prefer that we provide a shadow subsidy to our wealthy through unaffordable tax cuts and daily POMO operations. Are you kidding me? This will not end quietly. It may not be the coming of another civil war, but the political discourse surely is hotter than its ever been during a period when the equity market was bounding higher and higher.
7. The ability for the US Treasury to sell bonds at record low rates while monetizing our debt will not last forever. At some point foreign buyers will refuse to participate and the pricing will have to work higher unless you believe the Fed and the Primary Dealers can take down every issue from here to eternity. Any material rise in rates will certainly constrain real economic activity and our ability to return to reasonable employment levels and capacity utilization will be pushed out that much further.
8. There has been no real effort to reform HFT market manipulation. In fact, Getco, a leading HFT, was tasked as head market maker on the GM IPO. Wow. I knew it must have been substantial, but with this decision its now guaranteed that HFT lobbying efforts must be some of the most amazingly robust (and well-funded) of any such efforts on Capitol Hill. HFTs, along with the PDs, and the Fed, continue to make the stock market an unsuitable place for retail investors to invest. People are not as oblivious to ramp jobs, and stick saves, and bizarre low volume sell-offs/ramps as TPTB would like to believe. There is a reason that retail money has been steadily streaming out of the market, and that reason is that people don't like to play a game that they know is rigged against them. The flash crash was also a lesson on just how dramatically and rapidly markets can change when volume is dominated by algo traders and fast money institutions and not honest investors seeking to allocate capital to high EVA or ROIC generating businesses. Unless we see meaningful regulation and increased transparency regarding HFT, algo trading, dark pools, etc then those wise enough to have amassed investible wealth, will also be wise enough to avoid throwing it away in a casino.
I could go on and on, but to summarize, the incredible amount of both serious and pervasive issues confronting this market are, for at least the intermediate term, here to stay. It would behoove those with the wisdom to be intellectually honest to avoid being the marginal buyer in any stock which has risen 30%+ in a few short weeks. If you insist on staying on for the ride, at least take the opportunity to hedge yourself when volatility gets this cheap by purchasing longer-dated VIX calls at reasonable strike prices. Willing to discuss hedgining instruments off-line with anyone interested.
Disclosure & Disclaimer: This post should be taken as the opinion of the author only and is in no way a recommendation to buy or sell any security. The author may be long or short volatility at any given time without notice.
Monday, December 13, 2010
Tuesday, December 7, 2010
Market Update
Futures are looking higher this morning as Obama agreed to a 2-year extension to the Bush tax cuts and Ireland prepares to announce an austerity budget with $6B in spending cuts and $2B in tax increases. Amazing that the 'budget hawk' Republicans were able to push through this tax cut extension despite its $600B annual cost. Why not approve a $600B federal jobs program instead? I suppose its for the same reason that Republicans were blocking unemployment benefit extensions without compromise on these tax cuts. If one continues to believe wholeheartedly that trickle down economics is more stimulative than putting people directly back to work, then I encourage them to challenge my position in the comments section. I would be delighted to finally be convinced of the effectiveness of this ideology (if only to improve the flavor of the Kool Aid we are all being forced to drink...)
Last night the EU announced they had failed to reach an agreement to increase the size of their $1T rescue fund. Germany will not be adding to the bailout fund for its freewheeling neighbors (not yet anyway.) The fear is that more funds will be needed should larger nations such as Spain and Italy need assistance. (Does this amount to an admission on the part of EU leaders that the domino rally is already underway?) One would think this would put a dent in the futures, but not so.
China may see a rate hike soon, as inflation in October reached 4.4%, driven by a 10.1% jump in food costs.
With so many positive developments (I kid, of course!) why shouldn't we soon see Dow 36,000? And by the way, did anyone else catch Bernanke on 60 Minutes discussing the possibility of QE3? One would think that increasingly vitrolic commentary from both foreign and domestic leaders surrounding QE2, would make our proud Fed chairman at least somewhat apprehensive about discussing another round of asset purchases a month after the commencement of the current program, but you would be wrong.
Bring on the POMO.
Last night the EU announced they had failed to reach an agreement to increase the size of their $1T rescue fund. Germany will not be adding to the bailout fund for its freewheeling neighbors (not yet anyway.) The fear is that more funds will be needed should larger nations such as Spain and Italy need assistance. (Does this amount to an admission on the part of EU leaders that the domino rally is already underway?) One would think this would put a dent in the futures, but not so.
China may see a rate hike soon, as inflation in October reached 4.4%, driven by a 10.1% jump in food costs.
With so many positive developments (I kid, of course!) why shouldn't we soon see Dow 36,000? And by the way, did anyone else catch Bernanke on 60 Minutes discussing the possibility of QE3? One would think that increasingly vitrolic commentary from both foreign and domestic leaders surrounding QE2, would make our proud Fed chairman at least somewhat apprehensive about discussing another round of asset purchases a month after the commencement of the current program, but you would be wrong.
Bring on the POMO.
Tuesday, November 23, 2010
Korean Peninsula Conflict Heats Up
Futures are looking down big this morning as a flurry of negative news hits the tape.
Last night South Korea failed to inform North Korea that they were practicing a live fire drill. Believing they were under attack, North Korea responded by firing 100 rounds of artillery at Yeonpyeong Island in the Yellow Sea. South Korea responded with 80 rounds of artillery and scrambled fighter jets to stop the firing. Two South Korean marines were killed and 15 soldiers and civilians were wounded. Many think this was something of an accident, but others believe it stems from the sanctions placed on North Korea over the Chenoan incident and because NK was found to have a new uranium enrichment facility. Whether a demand for attention or a mistake (unlikely), the markets have been rattled and rightly so. This is a subject that I have cautioned on this blog numerous times that did not simply go away. The best we can do is hope for international assitance and a diplomatic solution.
Spain had a basically failed 3-6 month bond auction. The sovereign sold 3.2B Euro vs. the 4-5B Euro that had been planned. Spanish CDS is approx 20 bps higher and the 10-year is at all time high spreads. The EUR/USD pair is trading a full 0.0156 lower at 1.3469.
Last night South Korea failed to inform North Korea that they were practicing a live fire drill. Believing they were under attack, North Korea responded by firing 100 rounds of artillery at Yeonpyeong Island in the Yellow Sea. South Korea responded with 80 rounds of artillery and scrambled fighter jets to stop the firing. Two South Korean marines were killed and 15 soldiers and civilians were wounded. Many think this was something of an accident, but others believe it stems from the sanctions placed on North Korea over the Chenoan incident and because NK was found to have a new uranium enrichment facility. Whether a demand for attention or a mistake (unlikely), the markets have been rattled and rightly so. This is a subject that I have cautioned on this blog numerous times that did not simply go away. The best we can do is hope for international assitance and a diplomatic solution.
Spain had a basically failed 3-6 month bond auction. The sovereign sold 3.2B Euro vs. the 4-5B Euro that had been planned. Spanish CDS is approx 20 bps higher and the 10-year is at all time high spreads. The EUR/USD pair is trading a full 0.0156 lower at 1.3469.
Thursday, November 18, 2010
Irish Bailout Talks Begin in Earnest, GM Prices, Fed Orders Stress Tests
Futures are looking significantly higher this morning as Ireland appears to be on the verge of a bailout by the EU and IMF. While Irish administration officials insist that no bailout is necessary, their central bank governor, Patrick Honohan, suggests that a bailout worth 'tens of billions' of euros is likely. Mr. Honohan also suggested he believes the rate on such a bailout loan would be 5%.
Why this is positive news I am unsure. Afterall, this goes to show that nothing European officials have been saying for weeks has had even a smidgeon of crediblity. I suppose this also means that Portugal, Spain, et al are soon to follow. The Euro is rallying on the news this morning to 1.3648 (or +0.0117).
GM priced its 'IPO' at the high end of the range at $33 on 478M common and $4.35B of preferred. With the shoe, the deal could come to $18.1B, the second largest IPO in US history. The Treasury sold $11.8B which reduces its stake to less than 37%. Ford shares are also rallying this morning on the announcement that it will sell a large portion of its stake in Japanese car maker, Mazda.
The Fed ordered new stress tests for the top U.S. banks yesterday, with a request that the top 19 banks also submit capital plans by early next year. The Fed also provided guidelines for banks that want to increase their dividends or buybacks which include meeting higher capital requirements and having shown they pass the current (and ongoing stress tests).
On the economic calendar today, we will have another Congressional Hearing on Robo-Signing and Other Mortgage Issues, this time with Citigroup, Wells Fargo, and GMAC in the hot seat. At 7 am we will get an update on the Leading Indicators, the Fed's Warsh, Kocherlakota, and Plosser will all give speeches this afternoon, along with Treasury's Wolin and Warren. Lastly, the Fed Balance Sheet and the Money Supply data will be released after the market close.
What is obviously interesting is that GM's first day of trading was a sure to be manufactured rally-up day. Reviewing the 'positive' news announcements, one sees little that is a concrete positive: Ireland 'might' be bailed out, GM priced well but the government still owns nearly 40% of the company, the banks are seeing more regular 'oversight' and stress tests prove it (right because the first round was very transparent...does anyone remember CAMEL ratings?? The European version was even more spectacular.) At best the stress tests will be taken as a token vote of confidence in the system with its obvious bias still intact. At worst, the stress tests might show the need for the four horsemen of the apocalypse to raise more capital. I can see it now, "BAC and C need to raise an additional $10B. But don't worry this dilution is no biggie. Especially not a big deal when you consider that they just raised the dividend 100 bps!!"
My non-binding advice would be to avoid buying this rally today. Hold some capital back as its unlikely we'll be able to get a borrow on GM until tomorrow or soon thereafter...
Why this is positive news I am unsure. Afterall, this goes to show that nothing European officials have been saying for weeks has had even a smidgeon of crediblity. I suppose this also means that Portugal, Spain, et al are soon to follow. The Euro is rallying on the news this morning to 1.3648 (or +0.0117).
GM priced its 'IPO' at the high end of the range at $33 on 478M common and $4.35B of preferred. With the shoe, the deal could come to $18.1B, the second largest IPO in US history. The Treasury sold $11.8B which reduces its stake to less than 37%. Ford shares are also rallying this morning on the announcement that it will sell a large portion of its stake in Japanese car maker, Mazda.
The Fed ordered new stress tests for the top U.S. banks yesterday, with a request that the top 19 banks also submit capital plans by early next year. The Fed also provided guidelines for banks that want to increase their dividends or buybacks which include meeting higher capital requirements and having shown they pass the current (and ongoing stress tests).
On the economic calendar today, we will have another Congressional Hearing on Robo-Signing and Other Mortgage Issues, this time with Citigroup, Wells Fargo, and GMAC in the hot seat. At 7 am we will get an update on the Leading Indicators, the Fed's Warsh, Kocherlakota, and Plosser will all give speeches this afternoon, along with Treasury's Wolin and Warren. Lastly, the Fed Balance Sheet and the Money Supply data will be released after the market close.
What is obviously interesting is that GM's first day of trading was a sure to be manufactured rally-up day. Reviewing the 'positive' news announcements, one sees little that is a concrete positive: Ireland 'might' be bailed out, GM priced well but the government still owns nearly 40% of the company, the banks are seeing more regular 'oversight' and stress tests prove it (right because the first round was very transparent...does anyone remember CAMEL ratings?? The European version was even more spectacular.) At best the stress tests will be taken as a token vote of confidence in the system with its obvious bias still intact. At worst, the stress tests might show the need for the four horsemen of the apocalypse to raise more capital. I can see it now, "BAC and C need to raise an additional $10B. But don't worry this dilution is no biggie. Especially not a big deal when you consider that they just raised the dividend 100 bps!!"
My non-binding advice would be to avoid buying this rally today. Hold some capital back as its unlikely we'll be able to get a borrow on GM until tomorrow or soon thereafter...
Tuesday, November 16, 2010
Hang on to your Hats
The Dow is down 200+ pts this morning as a touch of reality is sweeping over the markets.
Ireland has now admitted that it is in talks to seek IMF/EU financial support for its government and banking system.
Finland has announced it does not approve of an Irish bailout.
Portugal admits that it may soon need assistance as it can't borrow on the public market except for at prohibitive rates.
Austra admits that it is witholding a 190M Euro tranche from Greek rescue fund as it continues to fail to meet its obligations under the EU support agreement.
So much for all the glowing things Trichet has been saying about the European economy...
The President of the EU, Herman Van Rompuy, said, "We all have to work together in order to survive with the euro zone, because if we don't survive with the euro zone we will not survive with the European Union. But I'm very confident we will overcome this." Mr. Rompuy also added, "We are in a survival crisis."
It's absolutely not too late to hedge oneself with the EUO which is still sub 20 at the time of this writing.
Yesterday, many economists, hedge fund managers, mutual fund managers, etc wrote a petition to the Fed demanding that it immediately call off its planned QE2.
China moved curb its burgeoning inflation with another rate hike this morning.
At 11:30 am PST today, Congress will begin its, "Problems in Mortgage Servicing From Modification to Foreclosure" hearing.
Also, President of the NY Fed, William Dudley said that the Fed did not obviously know how hard the dollar was going to get pounded on their monetization announcement.
All this and a POMO of $5B+ that has seemed to have had no appreciable effect on supporting the market...Giddy up...
Ireland has now admitted that it is in talks to seek IMF/EU financial support for its government and banking system.
Finland has announced it does not approve of an Irish bailout.
Portugal admits that it may soon need assistance as it can't borrow on the public market except for at prohibitive rates.
Austra admits that it is witholding a 190M Euro tranche from Greek rescue fund as it continues to fail to meet its obligations under the EU support agreement.
So much for all the glowing things Trichet has been saying about the European economy...
The President of the EU, Herman Van Rompuy, said, "We all have to work together in order to survive with the euro zone, because if we don't survive with the euro zone we will not survive with the European Union. But I'm very confident we will overcome this." Mr. Rompuy also added, "We are in a survival crisis."
It's absolutely not too late to hedge oneself with the EUO which is still sub 20 at the time of this writing.
Yesterday, many economists, hedge fund managers, mutual fund managers, etc wrote a petition to the Fed demanding that it immediately call off its planned QE2.
China moved curb its burgeoning inflation with another rate hike this morning.
At 11:30 am PST today, Congress will begin its, "Problems in Mortgage Servicing From Modification to Foreclosure" hearing.
Also, President of the NY Fed, William Dudley said that the Fed did not obviously know how hard the dollar was going to get pounded on their monetization announcement.
All this and a POMO of $5B+ that has seemed to have had no appreciable effect on supporting the market...Giddy up...
Monday, November 8, 2010
Today's POMO: $6.26B
Despite the Fed's $6.26B POMO today, the Dow remains down 60 pts. With little on the economic calendar, we could sell off for the rest of today and tomorrow, until the new POMO schedule for the coming weeks is released on Wednesday.
Week in Review and Week Ahead
Last week the S&P climbed over 3.6% as the Fed announced a $600B Treasury buying program that will focus on bonds between 2 and 10 years. The program will last 8 months and can be increased or decreased at any time. The Republicans took the majority in the House of Representatives and gained a few seats in the Senate, virtually promising two years of Congressional gridlock and the impossibility of further fiscal stimulus. I do however secretly believe that John Boehner is being more than a touch coy when he says that Republicans in Congress will 'listen to our constituents' and deliver what is expected/desired. This could mean that Boehner and Co. run on a platform of fiscal austerity but when push comes to shove may deliver the medicine that the Democrats should have with 'just giving the people what they want' as an excuse. We also got the October NonFarm Payroll number last Friday. Unemployment still officially stands at 9.6%, although the private sector added 159k jobs which was the largest since March 2007. This string of at least technically good news has pushed the three major indices to two year highs. The Dow is now up 9.7% YTD, the S&P up 9.9%, and the Nasdaq is up 13.7%.
This morning, futures are looking down a bit as the market looks to take a breather after last week's surge. A breather, if one occurs, will probably only last until 7:15 am PST, when the FRB NY launches its last scheduled POMO under the current schedule. The amount should be approx $6.5B (assuming the PD's are willing sellers...) at which time the Nasdaq led by AAPL and AMZN takes off and brings energy and commodity prices and equities up with them.
The EUR/USD is below 1.40 this morning as the dollar gains on several major world currencies. World Bank president Robert Zoellick actually suggested that the world's leading economies should adopt some form of modified gold standard. Zoellick, in an OpEd in the FT, called for a Bretton Woods II where countries agree to a system of floating exchange rates. Gold hit $1,398.35 this morning in response.
Also this morning, Zhu Guangyao, China's vice finance minister told reporters that the QE2 suggests that the US "does not recognize, as a country that issues one of the world's major reserve currencies, its obligation to stabilize capital markets...Nor does it take into consideration the impact of this excessive fluidity on the financial markets of emerging countries." Mr. Guangyao also mentioned that he expects China to have a very 'candid' conversation with the U.S. at the G20 meeting in Seoul this weekend regarding QE2. "This second round of quantitative easing is a shock to the stability of global financial markets." With every major world economy - Japan, China, Brazil, Germany, etc - decrying QE2 as essentially insane and combative to our trading partners, I can't imagine that headlines out of the G20 will suggest any sort of successful resolution to the growing calls for the US to change its policy approach or lose reserve currency status.
We have a rather light economic calendar scheduled for the week. We have wholesale inventories tomorrow, trade balance on Wednesday, and Michigan sentiment on Friday.
Also this week will be an announcement of a schedule for the next 4 weeks of POMO, which will be announced on Wednesday.
This morning, futures are looking down a bit as the market looks to take a breather after last week's surge. A breather, if one occurs, will probably only last until 7:15 am PST, when the FRB NY launches its last scheduled POMO under the current schedule. The amount should be approx $6.5B (assuming the PD's are willing sellers...) at which time the Nasdaq led by AAPL and AMZN takes off and brings energy and commodity prices and equities up with them.
The EUR/USD is below 1.40 this morning as the dollar gains on several major world currencies. World Bank president Robert Zoellick actually suggested that the world's leading economies should adopt some form of modified gold standard. Zoellick, in an OpEd in the FT, called for a Bretton Woods II where countries agree to a system of floating exchange rates. Gold hit $1,398.35 this morning in response.
Also this morning, Zhu Guangyao, China's vice finance minister told reporters that the QE2 suggests that the US "does not recognize, as a country that issues one of the world's major reserve currencies, its obligation to stabilize capital markets...Nor does it take into consideration the impact of this excessive fluidity on the financial markets of emerging countries." Mr. Guangyao also mentioned that he expects China to have a very 'candid' conversation with the U.S. at the G20 meeting in Seoul this weekend regarding QE2. "This second round of quantitative easing is a shock to the stability of global financial markets." With every major world economy - Japan, China, Brazil, Germany, etc - decrying QE2 as essentially insane and combative to our trading partners, I can't imagine that headlines out of the G20 will suggest any sort of successful resolution to the growing calls for the US to change its policy approach or lose reserve currency status.
We have a rather light economic calendar scheduled for the week. We have wholesale inventories tomorrow, trade balance on Wednesday, and Michigan sentiment on Friday.
Also this week will be an announcement of a schedule for the next 4 weeks of POMO, which will be announced on Wednesday.
Thursday, November 4, 2010
Bernanke in WaPo: 'Stock prices higher, people spend more'
Today, in an OpEd in the Washington Post, Bernanke finally came clean about the true intentions of QE2.
"This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."
This is explicit. Lower rates haven't increased home buying (tough to qualify/want a mortgage when you are jobless, banks aren't actually lending, home prices are obviously being falsely supported, etc) so that can't be the goal. Lower corporate bond rates are almost impossible at this point, so that can't be the main idea.
No, no, its obviously an attempt to boost the stock market at all costs at the expense of the dollar's reserve currency status, the respect of both our allies and our enemies, the purchasing power of the middle class, etc, etc, etc.
The S&P is up approx 15% since the beginning of September. Meanwhile, the commodity index is up 17%. This should make clear to any and all sentient human beings that this is a dollar devaluation that will hit most painfully for the already unemployed and the middle class. $8/gallon gasoline does not spur economic growth or the American consumer to again spend frivolously.
Meanwhile, leaders from countries around the world are becoming louder and louder in their demands that the US abandon its current policy on the dollar. (Brazil, China, South Korea, etc).
"This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."
This is explicit. Lower rates haven't increased home buying (tough to qualify/want a mortgage when you are jobless, banks aren't actually lending, home prices are obviously being falsely supported, etc) so that can't be the goal. Lower corporate bond rates are almost impossible at this point, so that can't be the main idea.
No, no, its obviously an attempt to boost the stock market at all costs at the expense of the dollar's reserve currency status, the respect of both our allies and our enemies, the purchasing power of the middle class, etc, etc, etc.
The S&P is up approx 15% since the beginning of September. Meanwhile, the commodity index is up 17%. This should make clear to any and all sentient human beings that this is a dollar devaluation that will hit most painfully for the already unemployed and the middle class. $8/gallon gasoline does not spur economic growth or the American consumer to again spend frivolously.
Meanwhile, leaders from countries around the world are becoming louder and louder in their demands that the US abandon its current policy on the dollar. (Brazil, China, South Korea, etc).
GS: QE2 to reach $2T, Fed Funds = 0 until 2015
In a note to clients this morning, Goldman (aka the Fed's private, unofficial mouthpiece): "In practice, QE2 is likely to continue well beyond June 2011—at least well into 2012—if our forecasts for unemployment and inflation are close to the mark. We believe that purchases could ultimately cumulate to around $2 trillion...Under our longer-term projections it is easy to come up with models that show no tightening until 2015 or later."
Given that it was Jan Hatzius that predicted a $500B QE2 announcement and so allowed the Fed to 'surprise to the upside' with $600B, I wouldn't be surprised if QE2 does reach not just $2T by 2012, but $2.1T, ya' know so they can 'surprise to the upside.'
This note to clients is surely at least a part of the reason why the Dow is up 140 this morning. Otherwise, it looked like we were set up to see a sell the news type of event. Be careful as today's POMO is about to begin.
Given that it was Jan Hatzius that predicted a $500B QE2 announcement and so allowed the Fed to 'surprise to the upside' with $600B, I wouldn't be surprised if QE2 does reach not just $2T by 2012, but $2.1T, ya' know so they can 'surprise to the upside.'
This note to clients is surely at least a part of the reason why the Dow is up 140 this morning. Otherwise, it looked like we were set up to see a sell the news type of event. Be careful as today's POMO is about to begin.
QE2 Announcement, Today's Outlook, POT update
Yesterday, the Fed finally announced its plans (at least for now) for QE2. The program will consist of $600B in longer-term Treasury securities to be purchased by the Fed over the next 8 months ($75B/month or $110B/month if you include currently planned POMO operations to replace MBS and Treasuries as they roll off of the Fed's balance sheet.) This means that with QE2 and QE Lite, the market will be propped up by the Fed to the tune of $27.5B per week. The Fed kept its options open to do more (or less) as the economic conditions change. They also kept the extended period language regarding the Fed Funds rate.
The market, not totally impressed with this as $500B-$1T was expected, only managed to close 4 pts higher on the S&P and 26 on the Dow. This morning however, the futures are pointing much higher despite an unexpected jump in initial claims. Initial claims came in at 457K vs. the 427K expected. Continuing claims at 4340 vs. 4328K expected. The EUR/USD is now at 1.4263 (+0.0139) a level which suggests coming pain for German exporters, etc. It will be interesting to see if EU members have any creative way of addressing their ever-rising currency while we devalue the dollar at hyperspeed. The Yen is 80.62 to the USD, also a level at which Naoto Kan will likely be forced to redouble his efforts at intervening into the currency market. The VIX is again sub-20 (and by the looks of things, go lower still this morning) and gold is flying at 1,378/ounce. Oil is greater than $85. So, exactly what the new normal looks like...rising unemployment and soaring inflation. This cannot end well...
Lastly, before the market gets underway, its worth noting that per a call I've been making on this site regarding POT, the Canadian government has blocked the Australian miner's takeover bid for POT this morning. POT closed yesterday at $145.50, but is already looking down to $139.90 pre-market.
The market, not totally impressed with this as $500B-$1T was expected, only managed to close 4 pts higher on the S&P and 26 on the Dow. This morning however, the futures are pointing much higher despite an unexpected jump in initial claims. Initial claims came in at 457K vs. the 427K expected. Continuing claims at 4340 vs. 4328K expected. The EUR/USD is now at 1.4263 (+0.0139) a level which suggests coming pain for German exporters, etc. It will be interesting to see if EU members have any creative way of addressing their ever-rising currency while we devalue the dollar at hyperspeed. The Yen is 80.62 to the USD, also a level at which Naoto Kan will likely be forced to redouble his efforts at intervening into the currency market. The VIX is again sub-20 (and by the looks of things, go lower still this morning) and gold is flying at 1,378/ounce. Oil is greater than $85. So, exactly what the new normal looks like...rising unemployment and soaring inflation. This cannot end well...
Lastly, before the market gets underway, its worth noting that per a call I've been making on this site regarding POT, the Canadian government has blocked the Australian miner's takeover bid for POT this morning. POT closed yesterday at $145.50, but is already looking down to $139.90 pre-market.
Wednesday, November 3, 2010
QE2 Announcement Expected Today: Look Out!
So, today is the day, and thank goodness gracious it has finally arrived. Afterall, I was getting awfully tired of commenting on QE2. At 11:15 PST today, Ben Bernanke will announce the amount of destruction he intends to levy against the US dollar. The consensus expectation has now moved into the $500B range with $100B in monthly installments over the next 5-6 months with the express optionality to increase the program should it prove necessary in future months. The extended period language surrounding interest rates is also expected to be repeated (surprise, surprise...).
What will be interesting is whether or not the market decides to sell this news. Many were (and some still are) hoping for a $1T QE2 (QE1 was $1.8T). So, $500 or less may be seen as a disappointment for those equity bulls who hoped for nothing more than the complete and utter debasement of the USD.
My advice to anyone who would listen was to be very cautious heading into today's announcement. Positioning with too much of a directional bias is unnecessary while the stakes are so high...
Also today, we saw the majority of the results of the midterm elections. The Republicans have not surprisingly taken control of the House and have gained seats in the Senate. With gridlock guaranteed, we can all forget about the idea of having another round of fiscal stimulus, which is still what I believe the country most desparately needs. Sure, QE2 may add to the bonus pool at Goldman Sachs, but fiscal stimulus might actually be able to create jobs, rebuild the nation's crumbling infrastructure, launch the US into the race (against China) for green tech, etc. But alas, we will have at least two years of a do-nothing Congress that will likely be focused more on finding a way to smear our president (Remember Newt's '94 Congress?) than it will be on creating jobs and economic relief for suffering Americans.
The market is down a touch this morning. Probably the result of profit taking ahead of an uncertain Fed announcement and also an acknowledgment of congressional gridlock.
What will be interesting is whether or not the market decides to sell this news. Many were (and some still are) hoping for a $1T QE2 (QE1 was $1.8T). So, $500 or less may be seen as a disappointment for those equity bulls who hoped for nothing more than the complete and utter debasement of the USD.
My advice to anyone who would listen was to be very cautious heading into today's announcement. Positioning with too much of a directional bias is unnecessary while the stakes are so high...
Also today, we saw the majority of the results of the midterm elections. The Republicans have not surprisingly taken control of the House and have gained seats in the Senate. With gridlock guaranteed, we can all forget about the idea of having another round of fiscal stimulus, which is still what I believe the country most desparately needs. Sure, QE2 may add to the bonus pool at Goldman Sachs, but fiscal stimulus might actually be able to create jobs, rebuild the nation's crumbling infrastructure, launch the US into the race (against China) for green tech, etc. But alas, we will have at least two years of a do-nothing Congress that will likely be focused more on finding a way to smear our president (Remember Newt's '94 Congress?) than it will be on creating jobs and economic relief for suffering Americans.
The market is down a touch this morning. Probably the result of profit taking ahead of an uncertain Fed announcement and also an acknowledgment of congressional gridlock.
Wednesday, October 27, 2010
Market Update
With no POMO on the calendar today and the WSJ suggesting that QE2 may be a couple of hundred billion over several months, but by most measures a disappointment for the bulls who were using it as an excuse to run up the market over the past two months, futures are looking down big this morning.
Yesterday, William Dudley, the president of the FRB NY said the central bank cannot fix the sluggish economy. If you recall from the special report I wrote on QE2, Dudley has been one of the largest advocates of loosening monetary policy. Perhaps with currency wars and protectionism, angry allies who have been forced into currency interventions of their own as a result of our actions, and an American electorate who has by now somewhat begun to understood the risks of more Fed action, Dudley has decided that it may be time to back it off a bit.
Yesterday, William Dudley, the president of the FRB NY said the central bank cannot fix the sluggish economy. If you recall from the special report I wrote on QE2, Dudley has been one of the largest advocates of loosening monetary policy. Perhaps with currency wars and protectionism, angry allies who have been forced into currency interventions of their own as a result of our actions, and an American electorate who has by now somewhat begun to understood the risks of more Fed action, Dudley has decided that it may be time to back it off a bit.
Tuesday, October 26, 2010
Market Update
Futures are pointing down this morning after disappointing earnings from ArcelorMittal (MT) and UBS. UBS beat estimates with the help of an 825M franc tax credit, but its investment banking unit posted a surprise pretax loss of 406M francs due to 'very low levels of client activity' and a charge on the bank's own debt.
Meanwhile, UK GDP grew twice as fast as expected in Q3 at 0.8% and S&P reaffirmed the U.K.'s AAA credit rating and revised its outlook to stable from negative. Interestingly though, this could pressure the BOE to delay additional bond purchases. Goodbye stimulus?
The U.S. will report 3Q GDP on Friday this week, just ahead of the FOMC meeting on November 3rd. If we posted a better than expected 3Q GDP (unlikely given the durable goods orders data, etc over the past few months) on Friday, would QE2 expectations have to come way down, and in the process, bring the market way down?
Another two signs that expectations for further monetary stimulus in the U.S. may be overdone include comments from Nissan COO Toshiyuki Shiga this morning, "we can't adequately express our concern about the sharp yen rise on our earnings by simply saying...we are worried about it. The company is now working with a sense of crisis."
And, a 5-year TIPS auction yesterday was done at a negative yield for the first time ever. Investors bought $10B at (0.55%) on expectations for higher inflation (monetary stimulus). It will end up being a shame if these investors end up paying the government to loan it money...
On today's economic calendar we will have the Case Shiller 20 city home index and Consumer Confidence.
We will also have another round of POMO. The target of which will be longer dated treasuries.
Remember that the market tends to see its apex on POMO days at 8:30 PST. So, if we sell of hard in the morning, you might buy a few beaten down names going into the POMO (if they be tech or materials names...with MT down 5% pre-market, that could be a decent candidate...) and cover your shorts.
Meanwhile, UK GDP grew twice as fast as expected in Q3 at 0.8% and S&P reaffirmed the U.K.'s AAA credit rating and revised its outlook to stable from negative. Interestingly though, this could pressure the BOE to delay additional bond purchases. Goodbye stimulus?
The U.S. will report 3Q GDP on Friday this week, just ahead of the FOMC meeting on November 3rd. If we posted a better than expected 3Q GDP (unlikely given the durable goods orders data, etc over the past few months) on Friday, would QE2 expectations have to come way down, and in the process, bring the market way down?
Another two signs that expectations for further monetary stimulus in the U.S. may be overdone include comments from Nissan COO Toshiyuki Shiga this morning, "we can't adequately express our concern about the sharp yen rise on our earnings by simply saying...we are worried about it. The company is now working with a sense of crisis."
And, a 5-year TIPS auction yesterday was done at a negative yield for the first time ever. Investors bought $10B at (0.55%) on expectations for higher inflation (monetary stimulus). It will end up being a shame if these investors end up paying the government to loan it money...
On today's economic calendar we will have the Case Shiller 20 city home index and Consumer Confidence.
We will also have another round of POMO. The target of which will be longer dated treasuries.
Remember that the market tends to see its apex on POMO days at 8:30 PST. So, if we sell of hard in the morning, you might buy a few beaten down names going into the POMO (if they be tech or materials names...with MT down 5% pre-market, that could be a decent candidate...) and cover your shorts.
Wednesday, October 20, 2010
France, Germany, Currencies, G20 and QE2
Reuters paraphrases Angel Merkel today as having said that 'the vulnerability of the euro has not yet been lastingly overcome and the currency is being shielded at the moment by the euro zone's safety net.' Relatedly, the German chambers of industry and commerce said today that if the Euro rises to $1.50 that the German economy will come under pressure.
This is a not so subtle demand for the US to cease devaluation plans.
Sarkozy is calling for currency manipuliaton to be on the docket at the G20.
Brazil is boycotting the events and has been forced recently to play vigorous defense to offset the impacts of USD moves on the Real.
The Yen is flying.
Those believing the Fed will still announce a full QE2 effort on November 3rd may be mistaken.
For the Fed to turn around only two weeks after the G20 and in defiance of an almost global insistence on stopping the dollar slide, I can't imagine we move forward with massive monetary stimulus. I'm not ruling out the possibility for a morsel of monetary stimulus to be announced, but even voting Fed governors (Dallas Fed's Fisher for ex) are starting to suggest they have questions about both the efficacy of another round of monetary stimulus and also the Fed's ability to implement it without taking extraordinary risks (hyperinflation, currency wars, increased protectionism, destroying purchasing power of American consumer who could be bogged down by high food and fuel costs, etc).
This is a not so subtle demand for the US to cease devaluation plans.
Sarkozy is calling for currency manipuliaton to be on the docket at the G20.
Brazil is boycotting the events and has been forced recently to play vigorous defense to offset the impacts of USD moves on the Real.
The Yen is flying.
Those believing the Fed will still announce a full QE2 effort on November 3rd may be mistaken.
For the Fed to turn around only two weeks after the G20 and in defiance of an almost global insistence on stopping the dollar slide, I can't imagine we move forward with massive monetary stimulus. I'm not ruling out the possibility for a morsel of monetary stimulus to be announced, but even voting Fed governors (Dallas Fed's Fisher for ex) are starting to suggest they have questions about both the efficacy of another round of monetary stimulus and also the Fed's ability to implement it without taking extraordinary risks (hyperinflation, currency wars, increased protectionism, destroying purchasing power of American consumer who could be bogged down by high food and fuel costs, etc).
Market Update: POMO
Today's POMO was a mere $660M (after Monday's massive $6.26B). Dow is up 120 at its completion.
Market Update: BAC Thoughts
Two hours into the trading session, the Dow is up 115 points, the S&P up 10, and the Nasdaq up 20. High beta stocks are off and running. This is a POMO day afterall.
Meanwhile, BAC is getting hammered on the threat of mortgage put-backs. Paul Miller at FBR says the amount of pushbacks might be nearly unquantifiable. Stifel Nicholas downgraded BAC this morning with an apologetic tone given it was downgrading one of the four horsemen at a time when the stock is trading below its just-announced TBV (BAC 11.39, -0.40, -3.5%) of 12.91. At some point, BAC is probably a buy for a trade, especially if the selling takes this even a little bit further. We are now at 0.9x TBV. At 10.30, we'd be at 0.8x. How much BV could the mortgages pushed-back actually consume....? No one knows, hence the sell-off. But, TBV is approx $128.673B. The market cap is now $114.74B. So, the market has already essentially sliced off $13.9B. The headline articles suggest BAC would be on the hook for put-backs on securitizations with total value of $46B. So, 30% of the loans in the securitizations being delinquent/fradulent, etc. has already been priced into the stock. I'd caution against trying to catch a falling knife, but at some point this becomes interesting. At 10.30, or at 0.8x TBV, we'd see ~$26B taken off (or 56% of the securitizations' total value).
Disclosures & Disclaimers: This post is intended for informational purposes only and is not a recommendation to buy or sell any security.
Meanwhile, BAC is getting hammered on the threat of mortgage put-backs. Paul Miller at FBR says the amount of pushbacks might be nearly unquantifiable. Stifel Nicholas downgraded BAC this morning with an apologetic tone given it was downgrading one of the four horsemen at a time when the stock is trading below its just-announced TBV (BAC 11.39, -0.40, -3.5%) of 12.91. At some point, BAC is probably a buy for a trade, especially if the selling takes this even a little bit further. We are now at 0.9x TBV. At 10.30, we'd be at 0.8x. How much BV could the mortgages pushed-back actually consume....? No one knows, hence the sell-off. But, TBV is approx $128.673B. The market cap is now $114.74B. So, the market has already essentially sliced off $13.9B. The headline articles suggest BAC would be on the hook for put-backs on securitizations with total value of $46B. So, 30% of the loans in the securitizations being delinquent/fradulent, etc. has already been priced into the stock. I'd caution against trying to catch a falling knife, but at some point this becomes interesting. At 10.30, or at 0.8x TBV, we'd see ~$26B taken off (or 56% of the securitizations' total value).
Disclosures & Disclaimers: This post is intended for informational purposes only and is not a recommendation to buy or sell any security.
BHP/POT and Meryvn King on Protectionism and Global Co-op on Policy
WFC reported record profits this morning as credit improved. $0.60 vs. $0.56 consensus on $20.9B of revenue. USB also reported this morning, and saw its 3Q profit rise 51% YoY, to post $0.45 vs. $0.43 expected. (Incidentally, these reports should bode well for Fairfax which owns large stakes in both banks.)
Bloomberg has a story out this morning detailing the deepest budget cuts in British history as Chancellor of the Exchequer, George Osborne, outlined austerity measures designed to virtually eliminate a $245B budget deficit. These plans include eliminating approx 490,000 public-sector jobs, putting a permanent maximum sustainable tax revenue on the financial services sector, cuts to the royal family's funding from the 'civil list', a 7.1% decrease in funds for local governments by 2015, a 24% cut to the Foreign Office budget, and a 6% cut to the Ministry of Justice. The pound is little changed this morning on the announcement.
BHP's offer to Saskatchewan of $360M for infrastructure investment was turned down by the province, as BHP's offer doesn't come close to offsetting the C$3B in revenue thed province would lose if BHP is successful in its attempted acquisition of POT. Saskatchewan Premier Brad Wall will lay out the province's position on the hostile offer in a speech today. Canada has until Nov. 3 to block the bid if it doesn't provide a net benefit to the country. (Bloomberg)
Bank of England Governor Mervyn King gave a speech yesterday ahead of this weekend's G20 meeting discussing the dire need for globally coordinated policy decisions in order to keep the level of protectionism from rising to a point where it would slow global output. “The risk is that unless agreement on a common path of adjustment is reached, conflicting policies will result in an undesirably low level of world output, with all countries worse off as a result,” King said. “The need to act in the collective interest has yet to be recognized, and, unless it is, it will be only a matter of time before one or more countries resort to trade protectionism.” Mr. King went on to discuss how countries with floating exchange rates are 'innocent victims' and how Brazil has had to retaliate and even how India is considering intervening in the market if the rupee appreciates past 43 to the dollar. His most troubling statement however was when he said that a real agreement at the G20 would require a "revolution". (Bloomberg)
Bloomberg has a story out this morning detailing the deepest budget cuts in British history as Chancellor of the Exchequer, George Osborne, outlined austerity measures designed to virtually eliminate a $245B budget deficit. These plans include eliminating approx 490,000 public-sector jobs, putting a permanent maximum sustainable tax revenue on the financial services sector, cuts to the royal family's funding from the 'civil list', a 7.1% decrease in funds for local governments by 2015, a 24% cut to the Foreign Office budget, and a 6% cut to the Ministry of Justice. The pound is little changed this morning on the announcement.
BHP's offer to Saskatchewan of $360M for infrastructure investment was turned down by the province, as BHP's offer doesn't come close to offsetting the C$3B in revenue thed province would lose if BHP is successful in its attempted acquisition of POT. Saskatchewan Premier Brad Wall will lay out the province's position on the hostile offer in a speech today. Canada has until Nov. 3 to block the bid if it doesn't provide a net benefit to the country. (Bloomberg)
Bank of England Governor Mervyn King gave a speech yesterday ahead of this weekend's G20 meeting discussing the dire need for globally coordinated policy decisions in order to keep the level of protectionism from rising to a point where it would slow global output. “The risk is that unless agreement on a common path of adjustment is reached, conflicting policies will result in an undesirably low level of world output, with all countries worse off as a result,” King said. “The need to act in the collective interest has yet to be recognized, and, unless it is, it will be only a matter of time before one or more countries resort to trade protectionism.” Mr. King went on to discuss how countries with floating exchange rates are 'innocent victims' and how Brazil has had to retaliate and even how India is considering intervening in the market if the rupee appreciates past 43 to the dollar. His most troubling statement however was when he said that a real agreement at the G20 would require a "revolution". (Bloomberg)
Tuesday, October 19, 2010
Dallas Fed's Fisher on Monetary Policy
"In my darkest moments, I have begun to wonder if the monetary accommodation we have already engineered might even be working in the wrong places."
Dow is down 200
Dow is down 200
Long Idea - Fairfax Financial
Fairfax Financial Holdings Ltd (FRFHF.PK)
Basic Company Overview
Fairfax Financial is a financial holding company that, through its subsidiaries, writes commercial property and casualty insurance and reinsurance. The company now operates in 100 countries worldwide through its wholly owned subsidiaires:
Northbridge - Canadian insurance underwriter
Crum & Forster - US P&C Insurance underwriter
Zenith National - US Workers' Compensation Specialist
OdysseyRe - Worldwide underwriter of P&C Reinsurance & Specialty Insurance
Advent - US Property Insurance
Fairfax Asia - Consists of two P&C insurers: First Capital, based in Singapore and Falcon Insurance which is based in Hong Kong.
Fairfax Brasil Seguros Corporativos S.A. - Brazil P&C Insurer, founded in March 2010
And JV Partners:
15% Interest in Alltrust Insurance Company of China (a leading Chinese insurer)
JV in India with ICICI Lombard General Insurance
Fairfax also owns a leading North American animal nutrition business, Ridley.
The float is managed by Hamblin Watsa Investment Council (HWIC). Hamblin has gained significant notoriety for betting against the subprime housing market through CDS positions with an $18.5B notional amount on 25-30 bond insurers and mortgage lenders. The net realized gain since inception has been $2.1B vs. original acquisition costs of $433.B. (Note: CEO and Chairman Prem Watsa is quick to note in his most recent letter to shareholders, "Our adventure with credit default swaps is over (Emphasis Mine)- but we will remember it as of one of the the more significant events in our history!" He also notes, "...it is highly unlikely we will ever repeat [these investment results] in the future!" Have to love this guy.)
HWIC has helped take the company from its original $30M in assets and $7.6M in common equity in 1985 to end 2009 with $28B in assets and $7.4B in common equity - an almost 1,000 fold increase. BVPS has compounded 26% per year, while the common stock has gained 22% per year.
Interest and Dividend Income has Grown Substantially As Well:
1985 - $0.70/share
1990 - $2.35/share
2000 - $40.54/share
2009 - $38.94/share
At the end of 2009, the combined float was $579/share. Combined with $370/share in BV and $115/share in net debt, there is approx $1,064 in investments per share.
Also, importantly, float actually increases as the dollar depreciates at no cost to Fairfax as a result of its foreign subsidiaries. Given the dollar depreciation in September, one would expect earnings from Fairfax on October 28th to show a very positive benefit in this regard.
Watsa is a disciple of Benjamin Graham and has been compared to Warren Buffett (largely because of the compound annual growth rates, the constant references to Security Analysis, his holding company structure, and his colorful letters to shareholders.) As a conservative, long-term oriented value-investor (ditto for HWIC), Watsa in my mind is probably as good an asset manager as any should the market begin to behave, shall we say, erratically.
HWIC has large positions in WFC, J&J, USB, and KFT. Watsa notes that KFT has 1,000 stores in India after its acquisition of Cadbury. This is the type of diversification into growing markets that I for one can be excited about.
HWIC hedges its equity exposure to a great extent through swaps and other derivatives. The net exposure to equities has been higher than in previous years, which actually should provide another tailwind into earnings.
Turning to Insurance
Compound Annual Growth Rates from 2001 - 2009 in its insurance subsidiaries:
Northbridge - 18.6%
Crum & Forster - 19%
OdysseyRe - 22.7%
Fairfax Asia - 24.8% (since 2002)
Brazil has just begun and the India and China joint ventures should also provide robust growth and additional diversification.
The consolidated combined ratio for YE09 was 99.8%. Watsa is focused on underwriting at a profit or not at all, causing net premiums written to shrink on a consolidated basis by 1.1% through YE09. The markets will eventually harden and cost of acquisition of new business will go down. It may take some time, but in the meantime, Fairfax can earn excellent ROEs on its existing float. Also, the underwriting environment especially in the US has been very difficult which may account for why Fairfax appears to be so undervalued at this time. To want to own this company however, you'd have to think like Watsa. If that is the case, the lumpiness in the insurance and investment businesses should not be a deterrent to ownership, but actually should be viewed as an opportunity to buy the company at a VERY reasonable 1.1x BV. Fairfax took sizable hits (6.2 combined ratio points) on insurance exposures to Deepwater Horizon and the Chilean Earthquake, without which, Fairfax's consolidated combined ratio in 1H10 would have been 98.4%. This is the natural result of writing insurance around the globe, but even these events did nothing to keep Watsa from his goal of compounding annual BVPS by 15% per annum over the long term. Additioanlly, Fairfax Asia's combined ratio of 82.6% at YE09 and the newly open for business Brazilian unit should provide not only nice additions in net premium growth but also make correspondingly high contributions to the size of the parent company float.
1H10, the company earned $29.64/share. If the company earns $60/share for 2010, then Fairfax is trading at 9x TTM and 1.11 TTM BV for long term 26% annual compounded growth. This company is one that I intend to own for the long term.
It was recently mentioned by Mohnish Pabrai of Pabrai Investment Fund and Zeke Ashton of Centaur Capital Partners at the Value Investors Conference (VIC) which should draw additional attention to the company in the coming weeks/months.
Disclosures & Disclaimers: This article should not be taken as advice to buy or sell any security. It is intended for informational purposes only. The author owns shares in FRFHF.PK and may choose to buy more or sell the current holding at any time without notice.
Basic Company Overview
Fairfax Financial is a financial holding company that, through its subsidiaries, writes commercial property and casualty insurance and reinsurance. The company now operates in 100 countries worldwide through its wholly owned subsidiaires:
Northbridge - Canadian insurance underwriter
Crum & Forster - US P&C Insurance underwriter
Zenith National - US Workers' Compensation Specialist
OdysseyRe - Worldwide underwriter of P&C Reinsurance & Specialty Insurance
Advent - US Property Insurance
Fairfax Asia - Consists of two P&C insurers: First Capital, based in Singapore and Falcon Insurance which is based in Hong Kong.
Fairfax Brasil Seguros Corporativos S.A. - Brazil P&C Insurer, founded in March 2010
And JV Partners:
15% Interest in Alltrust Insurance Company of China (a leading Chinese insurer)
JV in India with ICICI Lombard General Insurance
Fairfax also owns a leading North American animal nutrition business, Ridley.
The float is managed by Hamblin Watsa Investment Council (HWIC). Hamblin has gained significant notoriety for betting against the subprime housing market through CDS positions with an $18.5B notional amount on 25-30 bond insurers and mortgage lenders. The net realized gain since inception has been $2.1B vs. original acquisition costs of $433.B. (Note: CEO and Chairman Prem Watsa is quick to note in his most recent letter to shareholders, "Our adventure with credit default swaps is over (Emphasis Mine)- but we will remember it as of one of the the more significant events in our history!" He also notes, "...it is highly unlikely we will ever repeat [these investment results] in the future!" Have to love this guy.)
HWIC has helped take the company from its original $30M in assets and $7.6M in common equity in 1985 to end 2009 with $28B in assets and $7.4B in common equity - an almost 1,000 fold increase. BVPS has compounded 26% per year, while the common stock has gained 22% per year.
Interest and Dividend Income has Grown Substantially As Well:
1985 - $0.70/share
1990 - $2.35/share
2000 - $40.54/share
2009 - $38.94/share
At the end of 2009, the combined float was $579/share. Combined with $370/share in BV and $115/share in net debt, there is approx $1,064 in investments per share.
Also, importantly, float actually increases as the dollar depreciates at no cost to Fairfax as a result of its foreign subsidiaries. Given the dollar depreciation in September, one would expect earnings from Fairfax on October 28th to show a very positive benefit in this regard.
Watsa is a disciple of Benjamin Graham and has been compared to Warren Buffett (largely because of the compound annual growth rates, the constant references to Security Analysis, his holding company structure, and his colorful letters to shareholders.) As a conservative, long-term oriented value-investor (ditto for HWIC), Watsa in my mind is probably as good an asset manager as any should the market begin to behave, shall we say, erratically.
HWIC has large positions in WFC, J&J, USB, and KFT. Watsa notes that KFT has 1,000 stores in India after its acquisition of Cadbury. This is the type of diversification into growing markets that I for one can be excited about.
HWIC hedges its equity exposure to a great extent through swaps and other derivatives. The net exposure to equities has been higher than in previous years, which actually should provide another tailwind into earnings.
Turning to Insurance
Compound Annual Growth Rates from 2001 - 2009 in its insurance subsidiaries:
Northbridge - 18.6%
Crum & Forster - 19%
OdysseyRe - 22.7%
Fairfax Asia - 24.8% (since 2002)
Brazil has just begun and the India and China joint ventures should also provide robust growth and additional diversification.
The consolidated combined ratio for YE09 was 99.8%. Watsa is focused on underwriting at a profit or not at all, causing net premiums written to shrink on a consolidated basis by 1.1% through YE09. The markets will eventually harden and cost of acquisition of new business will go down. It may take some time, but in the meantime, Fairfax can earn excellent ROEs on its existing float. Also, the underwriting environment especially in the US has been very difficult which may account for why Fairfax appears to be so undervalued at this time. To want to own this company however, you'd have to think like Watsa. If that is the case, the lumpiness in the insurance and investment businesses should not be a deterrent to ownership, but actually should be viewed as an opportunity to buy the company at a VERY reasonable 1.1x BV. Fairfax took sizable hits (6.2 combined ratio points) on insurance exposures to Deepwater Horizon and the Chilean Earthquake, without which, Fairfax's consolidated combined ratio in 1H10 would have been 98.4%. This is the natural result of writing insurance around the globe, but even these events did nothing to keep Watsa from his goal of compounding annual BVPS by 15% per annum over the long term. Additioanlly, Fairfax Asia's combined ratio of 82.6% at YE09 and the newly open for business Brazilian unit should provide not only nice additions in net premium growth but also make correspondingly high contributions to the size of the parent company float.
1H10, the company earned $29.64/share. If the company earns $60/share for 2010, then Fairfax is trading at 9x TTM and 1.11 TTM BV for long term 26% annual compounded growth. This company is one that I intend to own for the long term.
It was recently mentioned by Mohnish Pabrai of Pabrai Investment Fund and Zeke Ashton of Centaur Capital Partners at the Value Investors Conference (VIC) which should draw additional attention to the company in the coming weeks/months.
Disclosures & Disclaimers: This article should not be taken as advice to buy or sell any security. It is intended for informational purposes only. The author owns shares in FRFHF.PK and may choose to buy more or sell the current holding at any time without notice.
Dollar to lose reserve status? Geithner, "Not in our lifetime"
The sad thing about this 4 word response is that it does a fabulous job of summarizing the current attitude of our policymakers and other officials. "Not in our lifetime." While I do not propose to argue with the veracity of that statement as forecasting such a thing is virtually impossible (and thus somewhat mitigating the strength of meaning of his off-the-cuff remark), it still strikes me that the focus on the short term by our leaders is going to have serious consequences for both my own and future generations. We haven't really begun fixing the systemic failures that have lead us into this morass. A great deal of the current and mounting frustration by the electorate is the direct result of the notion that the stop loss measures taken by the Fed, Treasury, Congress, etc were aligned more closely with protecting the wealth of the wealthy rather than ending a morally and financially bankrupt banking cartel, pushing into renewables to create jobs, improving the enforcement powers of the various federal agencies (see Deepwater Horizon, Bernie Madoff, etc), protect US jobs from moving overseas, etc, etc, etc.
We need to start considering the long term ramifications of allowing policy drift and generational favoritism to dominate our political landscape.
We need to start considering the long term ramifications of allowing policy drift and generational favoritism to dominate our political landscape.
"Geithner vows U.S. will not devalue dollar"
Reuters reports this morning that Treasury Secretary Tim Geitner told an audience of the Commonwealth Club of California in Palo Alto, "It is very important for people to understand that the United States of America and no country around the world can devalue its way to prosperity, to (be) competitive," Geithner added. "It is not a viable, feasible strategy and we will not engage in it."
These remarks come ahead of this weekend's G20 meeting in South Korea. China this morning raised its base lending rate 25 bps to try to curb lending and also perhaps to make a symbolic gesture re: the 'weak' remnimbi ahead of the G20.
Elsewhere this morning, various news agenies are reporting that Brazil has backed out of this weekend's G20 meeting, and tried to offset the rally in the real on Monday by raising taxes for foreigners buying local bonds to 6% from 4%.
Reuters also reports that, "Argentina's Minister of Economy and Public Finance Amado Boudou on Monday called on developed nations to focus on creating jobs rather than actions that weaken their currencies, saying a "true currency war" was underway."
Dow is down 150 pts after first 30 mins of trading. Sub-11,000. While I hate to say it, this sell-off should probably be bought. After all, its POMO tomorrow.
These remarks come ahead of this weekend's G20 meeting in South Korea. China this morning raised its base lending rate 25 bps to try to curb lending and also perhaps to make a symbolic gesture re: the 'weak' remnimbi ahead of the G20.
Elsewhere this morning, various news agenies are reporting that Brazil has backed out of this weekend's G20 meeting, and tried to offset the rally in the real on Monday by raising taxes for foreigners buying local bonds to 6% from 4%.
Reuters also reports that, "Argentina's Minister of Economy and Public Finance Amado Boudou on Monday called on developed nations to focus on creating jobs rather than actions that weaken their currencies, saying a "true currency war" was underway."
Dow is down 150 pts after first 30 mins of trading. Sub-11,000. While I hate to say it, this sell-off should probably be bought. After all, its POMO tomorrow.
IBM and AAPL reported yesterday after the market close.
AAPL reported fiscal Q4 revenue of $20.34B vs. estimates of $18.9B and EPS of $4.64 vs. expectations of $4.08. The company however did not sell as many iPad's as analysts predicted and its margins and guidance disappointed. AAPL is down $15.83 or 5% to $302.17 in pre-market trading.
IBM reported Q3 EPS of $2.82/share vs. $2.75 expected on revenue of $24.3B vs. $24.1B expected. The outsourcing business did not perform as well as expected, but the company did raise its earnings forecast for the rest of the year. IBM is down $4.84 to $137.88 pre-market.
BAC reported this morning before the open. The banking giant lost $7.65B or $0.77/share in the 3Q due to a charge related to credit and debit card reform legislation passed over the summer. Excluding the one-time charge, BAC earned $3.1B or $0.27/share vs. $0.16 expected. A lower provision (see JPM and C earnings) was a main driver of the beat, coming in at a $5.4B addition vs. $11.71B in 3Q09. Credit improved as NCOs were $2.4B lower than 2Q10. Capital levels also improved and TBV moved to $12.91.
GS will also report earnings this morning.
Futures are down with the Dow posting a 31 pt drop, Nasdaq down 24, and the S&P down 6. There is no POMO scheduled for today, but there is one tomorrow. Timothy Geithner said yesterday that the US would not pursue a weak dollar position and said we must work hard to ensure the strength of the USD. Shorts are covering and the dollar is up for the 3rd session in a row. This is also particularly bad for technology companies, so we could be in for a sizable sell-off today unless Goldman's numbers are really impressive.
On the economic front, we will have housing start and building permit reports today.
UPDATE: GS beat on both the top and bottom line as reported revenue came in at $8.9B vs. $7.9B expected ($12.37B in 3Q09) and EPS of $2.98/share beat the $2.32 expected and $5.25 for 3Q09. TBV increased about 3% to $116.23.
The futures are showing no improvement based on GS' earnings just yet...The weaker dollar, Geithner's comments, disappointing AAPL guidance, and the IMF warning of potential bubbles and slowing growth in East Asia seem to be enough for the market to take a breather this morning. We could firm up going into the close however, as another POMO is scheduled for Wednesday and earnings after the bell should look ok.
AAPL reported fiscal Q4 revenue of $20.34B vs. estimates of $18.9B and EPS of $4.64 vs. expectations of $4.08. The company however did not sell as many iPad's as analysts predicted and its margins and guidance disappointed. AAPL is down $15.83 or 5% to $302.17 in pre-market trading.
IBM reported Q3 EPS of $2.82/share vs. $2.75 expected on revenue of $24.3B vs. $24.1B expected. The outsourcing business did not perform as well as expected, but the company did raise its earnings forecast for the rest of the year. IBM is down $4.84 to $137.88 pre-market.
BAC reported this morning before the open. The banking giant lost $7.65B or $0.77/share in the 3Q due to a charge related to credit and debit card reform legislation passed over the summer. Excluding the one-time charge, BAC earned $3.1B or $0.27/share vs. $0.16 expected. A lower provision (see JPM and C earnings) was a main driver of the beat, coming in at a $5.4B addition vs. $11.71B in 3Q09. Credit improved as NCOs were $2.4B lower than 2Q10. Capital levels also improved and TBV moved to $12.91.
GS will also report earnings this morning.
Futures are down with the Dow posting a 31 pt drop, Nasdaq down 24, and the S&P down 6. There is no POMO scheduled for today, but there is one tomorrow. Timothy Geithner said yesterday that the US would not pursue a weak dollar position and said we must work hard to ensure the strength of the USD. Shorts are covering and the dollar is up for the 3rd session in a row. This is also particularly bad for technology companies, so we could be in for a sizable sell-off today unless Goldman's numbers are really impressive.
On the economic front, we will have housing start and building permit reports today.
UPDATE: GS beat on both the top and bottom line as reported revenue came in at $8.9B vs. $7.9B expected ($12.37B in 3Q09) and EPS of $2.98/share beat the $2.32 expected and $5.25 for 3Q09. TBV increased about 3% to $116.23.
The futures are showing no improvement based on GS' earnings just yet...The weaker dollar, Geithner's comments, disappointing AAPL guidance, and the IMF warning of potential bubbles and slowing growth in East Asia seem to be enough for the market to take a breather this morning. We could firm up going into the close however, as another POMO is scheduled for Wednesday and earnings after the bell should look ok.
Monday, October 18, 2010
Despite the industrial production and capacity utilization declines (both large red flags regarding the state of the recovery), the Dow is up 40+ pts and the Nasdaq and S&P 500 each currently sport a small gain. One must assume this is the result of a demand for stocks ahead of AAPL's earnings release after the market close today, and also a belief that worsening economic data virtually guarantees Fed action.
The US dollar is up 0.3% this morning from a 10 month low against a basket of currencies after Fed Chairman Bernanke's comments on Friday softened views re: the possible size and implementation of QE2.
Citigroup (C) reported $0.07/share vs. $0.06 expected this morning. Citi was just a bit light on the top line, coming in at $20.7B vs. the $21B consensus expectation. Much of this bottom line beat is attributable to a $1.99B drop in provisions for loan losses.
Industrial production fell 0.2% in September which was the first time IP fell since the 'recession ended'. This seems to confirm the thesis that much of the ramped production over the past year or so was not being absorbed by consumers.
Capacity utilization came in at 74.7% in September, down 0.1% from August. This is also the first decline in utilization since June 2009.
NAHB issues October housing market index at 7 am PST. 14 is expected vs. 13 in September.
"This multicultural approach, saying that we simply live side by side and live happily with each other has failed. Utterly failed," Angela Merkel said regarding Turks and other immigrants living in Germany. It's both unfortunate and frightening to see xenophobia on the rise around the globe.
China's new five-year plan has been issued, but will await final approval early next year. The Chinese economy is forecast to grow 50% in the next five years to $7.5T. A key focus of the Plan will be to shrink the income gap by improving the distribution of the national income in order to drive long term domestic consumer demand for goods and services. "Expanding domestic demand is the guiding long-term strategy of our country's economic and social development," said Zhang Ping, head of the National Development and Reform Commission. Meanwhile a NYT article from this weekend entitled, "Income Inequality: Too Big to Ignore" states, "The share of total income going to the top 1 percent of earners, which stood at 8.9 percent in 1976, rose to 23.5 percent by 2007, but during the same period, the average inflation-adjusted hourly wage declined by more than 7 percent." When will US policy makers and economists address the rising income gap in the U.S.?
AAPL and IBM report after the close.
The US dollar is up 0.3% this morning from a 10 month low against a basket of currencies after Fed Chairman Bernanke's comments on Friday softened views re: the possible size and implementation of QE2.
Citigroup (C) reported $0.07/share vs. $0.06 expected this morning. Citi was just a bit light on the top line, coming in at $20.7B vs. the $21B consensus expectation. Much of this bottom line beat is attributable to a $1.99B drop in provisions for loan losses.
Industrial production fell 0.2% in September which was the first time IP fell since the 'recession ended'. This seems to confirm the thesis that much of the ramped production over the past year or so was not being absorbed by consumers.
Capacity utilization came in at 74.7% in September, down 0.1% from August. This is also the first decline in utilization since June 2009.
NAHB issues October housing market index at 7 am PST. 14 is expected vs. 13 in September.
"This multicultural approach, saying that we simply live side by side and live happily with each other has failed. Utterly failed," Angela Merkel said regarding Turks and other immigrants living in Germany. It's both unfortunate and frightening to see xenophobia on the rise around the globe.
China's new five-year plan has been issued, but will await final approval early next year. The Chinese economy is forecast to grow 50% in the next five years to $7.5T. A key focus of the Plan will be to shrink the income gap by improving the distribution of the national income in order to drive long term domestic consumer demand for goods and services. "Expanding domestic demand is the guiding long-term strategy of our country's economic and social development," said Zhang Ping, head of the National Development and Reform Commission. Meanwhile a NYT article from this weekend entitled, "Income Inequality: Too Big to Ignore" states, "The share of total income going to the top 1 percent of earners, which stood at 8.9 percent in 1976, rose to 23.5 percent by 2007, but during the same period, the average inflation-adjusted hourly wage declined by more than 7 percent." When will US policy makers and economists address the rising income gap in the U.S.?
AAPL and IBM report after the close.
Friday, October 15, 2010
Bernanke Speech Spooks Market, Brian Sack Rides to the Rescue
The Dow is down 50 points, S&P down 3, and the Nasdaq is, of course, showing a gain of 8. This afterall being a POMO day, you didn't think that a GE top and bottom line miss or Bernanke throwing cool water on QE2 expectations could actually take down AAPL...did you? No, no. The primary dealers are busy using taxpayer dollars to bid up makers of hyper-discretionary electronic gadgets. Anyone who believes we need a formal QE2 announcement to continue this charade is being fooled. As long as the prospect is on the table and POMO actions inject liquidity into the PDs, the market will remain buoyant.
The real unwind in this Fed driven environment of coerced malinvestment would need to come from:
1) An external shock, such as military aggressions between sovereign nations. The flight to quality into the dollar would likely occur faster than anyone anticipates (given how oversold the dollar is ahead of a QE2 expectation) and would likely destroy risk appetite (at least in the short term.)
2) The couple of days sell-off we'd have with no QE2 announcement in November. In my opinion, it would likely give short-biased funds the opportunity to pick up some return before the end of the year, but then the mentality of, 'well if not now, then in Dec' will likely prevail and the market will resume its run higher.
3) A unexpected rise in the risk premium that indirect buyers of Treasury securities demand given the now universal understanding that the Fed intends to monetize US debt. If the 10 year started to march higher despite POMO/QE2, etc then we'd likely see a big unwind in risk as the Fed would lose both international credibility and domestic confidence in its ability to control all aspects of a globally interconnected market.
Things that will not, and have not taken the market down:
1) The technically overbought nature of the market.
2) The very high concentration of investors who are bullish.
3) The sub 20 VIX.
4) The rapidly weakening economic fundamentals.
5) The uncertain outcomes of FX wars and Smoot Hawley style protectionism.
6) European Sovereign Debt Crisis. Afterall, the ECB has stepped in to ensure that every bond auction coming out of the PIIGS gets filled.
7) The uncertainty surrounding US elections. If we have stalemate in Congress, then we obviously don't get any more of the fiscal stimulus (the job creating kind of stimulus, not the crush the middle class monetary kind...). But this fact doesn't seem to give anyone pause for thought.
8) Foreclosuregate. The financials are getting crushed this morning on heightened uncertainty surrounding liabilities related to fradulent foreclosure activity. The financials led us down in Fall 2008 and took us higher in spring 2009. Will we be back down in Fall 2010 on concerns over Financials? They tend to lead the market, and BAC, JPM, C, etc are down 5% this morning. No matter. Have no fear, Mr. Sack is here!
All of the above being said, it should be understood that the sheer size and type of challenges currently facing not just the US, but also pretty much the entire planet, virtually guarantee that:
1) No one is smart enough to reasonably handicapp all possible known unknowns and unknown unknowns. The world is awash in excess risk appetite right now. If you get one of the tails wrong, you could get slaughtered unless you are the first out the door...unlikely...
2) Policy decisions, decisions of the electorate, decisions of foreign dictators, decisions of buyers of assets and sellers of assets, etc are all the emotionally driven decisions of human beings. History has proved that human beings are falible and also at times irrational, self-destructive, short tempered, etc. When the 'fog' and confusion reaches these types of levels, people are bound to panic or do irrational things that they wouldn't do otherwise. The survivor is one who keeps a clear head when the shooting starts. Unfortunately it is very difficult to predict when the shooting will start or what will be the catalyst. It is because of this that it seems now that the most rational decision is to hold cash and wait for absolute home-runs. If we have a Black Monday (tues, whatever) then maybe its time to deploy some cash in blue chip dividend paying equities. If the S&P rises to 1350 on sustained expectation of a QE2 announcement that just isn't coming (the ultimate communication strategy...The Great Bernanke Bluff) then maybe its time to purchase a boatload of SPY puts. If gold pulls back sharply on a dollar run, then maybe its time to portfolio some of the shiny (non-cash-flowing-impossible-to-determine-appropriate- valuation) metal. If the EUR/USD goes to 1.50 maybe its time to buy the EUO. You get the point. But otherwise, unless certain special situations arise, why gamble in a HFT driven, volume-lite, government produced rally while your super ego screams for you to pay heed to reality?
In the meantime, enjoy the show.
The real unwind in this Fed driven environment of coerced malinvestment would need to come from:
1) An external shock, such as military aggressions between sovereign nations. The flight to quality into the dollar would likely occur faster than anyone anticipates (given how oversold the dollar is ahead of a QE2 expectation) and would likely destroy risk appetite (at least in the short term.)
2) The couple of days sell-off we'd have with no QE2 announcement in November. In my opinion, it would likely give short-biased funds the opportunity to pick up some return before the end of the year, but then the mentality of, 'well if not now, then in Dec' will likely prevail and the market will resume its run higher.
3) A unexpected rise in the risk premium that indirect buyers of Treasury securities demand given the now universal understanding that the Fed intends to monetize US debt. If the 10 year started to march higher despite POMO/QE2, etc then we'd likely see a big unwind in risk as the Fed would lose both international credibility and domestic confidence in its ability to control all aspects of a globally interconnected market.
Things that will not, and have not taken the market down:
1) The technically overbought nature of the market.
2) The very high concentration of investors who are bullish.
3) The sub 20 VIX.
4) The rapidly weakening economic fundamentals.
5) The uncertain outcomes of FX wars and Smoot Hawley style protectionism.
6) European Sovereign Debt Crisis. Afterall, the ECB has stepped in to ensure that every bond auction coming out of the PIIGS gets filled.
7) The uncertainty surrounding US elections. If we have stalemate in Congress, then we obviously don't get any more of the fiscal stimulus (the job creating kind of stimulus, not the crush the middle class monetary kind...). But this fact doesn't seem to give anyone pause for thought.
8) Foreclosuregate. The financials are getting crushed this morning on heightened uncertainty surrounding liabilities related to fradulent foreclosure activity. The financials led us down in Fall 2008 and took us higher in spring 2009. Will we be back down in Fall 2010 on concerns over Financials? They tend to lead the market, and BAC, JPM, C, etc are down 5% this morning. No matter. Have no fear, Mr. Sack is here!
All of the above being said, it should be understood that the sheer size and type of challenges currently facing not just the US, but also pretty much the entire planet, virtually guarantee that:
1) No one is smart enough to reasonably handicapp all possible known unknowns and unknown unknowns. The world is awash in excess risk appetite right now. If you get one of the tails wrong, you could get slaughtered unless you are the first out the door...unlikely...
2) Policy decisions, decisions of the electorate, decisions of foreign dictators, decisions of buyers of assets and sellers of assets, etc are all the emotionally driven decisions of human beings. History has proved that human beings are falible and also at times irrational, self-destructive, short tempered, etc. When the 'fog' and confusion reaches these types of levels, people are bound to panic or do irrational things that they wouldn't do otherwise. The survivor is one who keeps a clear head when the shooting starts. Unfortunately it is very difficult to predict when the shooting will start or what will be the catalyst. It is because of this that it seems now that the most rational decision is to hold cash and wait for absolute home-runs. If we have a Black Monday (tues, whatever) then maybe its time to deploy some cash in blue chip dividend paying equities. If the S&P rises to 1350 on sustained expectation of a QE2 announcement that just isn't coming (the ultimate communication strategy...The Great Bernanke Bluff) then maybe its time to purchase a boatload of SPY puts. If gold pulls back sharply on a dollar run, then maybe its time to portfolio some of the shiny (non-cash-flowing-impossible-to-determine-appropriate- valuation) metal. If the EUR/USD goes to 1.50 maybe its time to buy the EUO. You get the point. But otherwise, unless certain special situations arise, why gamble in a HFT driven, volume-lite, government produced rally while your super ego screams for you to pay heed to reality?
In the meantime, enjoy the show.
Thursday, October 14, 2010
Market Update
The market is treading water this morning, for while the economic data was not what you might call 'encouraging', we have our first installment of the next round of POMO tomorrow. Thus anyone thinking of shorting or taking a profit has come to the conclusion that today is not the day. Volume is extremely light and gold continues to climb higher. The VIX is higher this morning in the mid 19's. I have postulated since last Spring that if the VIX goes sub-17 then one should look to buy long dated calls (22's, 23's, etc) and prepare for a market pullback. Complacency is definitely on the rise. 'The market will go up forever, because the economic data will improve or Ben Bernanke will drop a trillion dollars out of a helicopter...' While it may be wishful thinking on my part, something tells me that such arrogance almost always gets punished by the market. Stay tuned.
On to the day's economic data.
Initial claims rose for the first time in 3 weeks to 462K vs. 450K expected and 449K prior (revised up from 445K). Continuing claims fell to 4399K from 4511K prior (up from 4462K) and 4450K expected. As the figures are still hovering around the 450K mark, this doesn't come as too much of a surprise. Its obviously still bad, but not outrageously so versus the running average.
PPI came in at 0.4% vs. 0.2% exp'd and 0.4% prior. Core PPI was in-line at 0.1% vs. 0.1% prior and expected. The non-core PPI was higher due to increased prices for food and fuel. It would appear that Bernanke's inflationary regime is working...to at least drive up prices on consumer non-discretionaries. It doesn't take a genius to understand that this is a strong negative for the health of the American consumer.
The trade deficit widened to $46.3B in August, with the deficit with China at an all-time high. The deficit is running at an annual rate of $502.B, up 34% from last year's $374.9B, which of course was much lower than usual due to the ongoing recession. The higher than expected trade deficit suggests an even lower 3Q GDP and more rhetoric surrounding a revaluation of the remnimbi.
Nothing in the above comments should be taken as a recommendation to buy or sell any security.
On to the day's economic data.
Initial claims rose for the first time in 3 weeks to 462K vs. 450K expected and 449K prior (revised up from 445K). Continuing claims fell to 4399K from 4511K prior (up from 4462K) and 4450K expected. As the figures are still hovering around the 450K mark, this doesn't come as too much of a surprise. Its obviously still bad, but not outrageously so versus the running average.
PPI came in at 0.4% vs. 0.2% exp'd and 0.4% prior. Core PPI was in-line at 0.1% vs. 0.1% prior and expected. The non-core PPI was higher due to increased prices for food and fuel. It would appear that Bernanke's inflationary regime is working...to at least drive up prices on consumer non-discretionaries. It doesn't take a genius to understand that this is a strong negative for the health of the American consumer.
The trade deficit widened to $46.3B in August, with the deficit with China at an all-time high. The deficit is running at an annual rate of $502.B, up 34% from last year's $374.9B, which of course was much lower than usual due to the ongoing recession. The higher than expected trade deficit suggests an even lower 3Q GDP and more rhetoric surrounding a revaluation of the remnimbi.
Nothing in the above comments should be taken as a recommendation to buy or sell any security.
POMO Schedule: $32B through Nov 8th
Tentative Outright Treasury Operation Schedule
Across all operations in the schedule listed below, the Desk plans to purchase approximately $32 billion. This is the amount of principal payments from agency debt and agency MBS expected to be received between mid-October and mid-November.
October 15, 2010 Outright Treasury Coupon Purchase
October 18, 2010 Outright Treasury Coupon Purchase
October 20, 2010 Outright TIPS Purchase
October 22, 2010 Outright Treasury Coupon Purchase
October 26, 2010 Outright Treasury Coupon Purchase
October 28, 2010 Outright Treasury Coupon Purchase
November 1, 2010 Outright Treasury Coupon Purchase
November 4, 2010 Outright Treasury Coupon Purchase
November 8, 2010 Outright Treasury Coupon Purchase
Across all operations in the schedule listed below, the Desk plans to purchase approximately $32 billion. This is the amount of principal payments from agency debt and agency MBS expected to be received between mid-October and mid-November.
October 15, 2010 Outright Treasury Coupon Purchase
October 18, 2010 Outright Treasury Coupon Purchase
October 20, 2010 Outright TIPS Purchase
October 22, 2010 Outright Treasury Coupon Purchase
October 26, 2010 Outright Treasury Coupon Purchase
October 28, 2010 Outright Treasury Coupon Purchase
November 1, 2010 Outright Treasury Coupon Purchase
November 4, 2010 Outright Treasury Coupon Purchase
November 8, 2010 Outright Treasury Coupon Purchase
Wednesday, October 13, 2010
Market Update
JPM 3Q results came in at $1.01 vs. $0.90 consensus on lower provision in both the mortgage and credit card portfolios. Revenue missed at $24.3B vs. $24.6B expected which is 15.4% less than 3Q09. Loan losses remain high but are no longer growing at the pace they did during the recession. Provision remains high at 5.1%. Retail banking and credit card business improved, while investment banking and trading softened. Looking up this morning pre-market.
Intel beat forecasts on both the top and bottom lines. INTC had warned of a slowdown in PC sales in August, but the numbers looked strong and the fears of a slowdown are off the table from now. I find this all very curious. Did they sandbag the quarter on purpose?
The FOMC minutes released yesterday supported market speculation that a second round of QE will be coming soon. As expected, the committee cut its growth expectations for the remainder of 2010 and 2011. The minutes did indicate however that a return to recession is viewed as unlikely by the committee members (...why the stimulus then???)
The economic calendar is a bit light today. We have MBA Mortage Applications, Import/Export Prices, Treasury Budget, a speech from Bernanke after the close, and a speech by Lacker this evening.
Dow Futures are up 74 points and S&P is looking up 8.75 points.
Lastly, a reminder that we will get the POMO schedule for the next four weeks at 11 am PST today.
Intel beat forecasts on both the top and bottom lines. INTC had warned of a slowdown in PC sales in August, but the numbers looked strong and the fears of a slowdown are off the table from now. I find this all very curious. Did they sandbag the quarter on purpose?
The FOMC minutes released yesterday supported market speculation that a second round of QE will be coming soon. As expected, the committee cut its growth expectations for the remainder of 2010 and 2011. The minutes did indicate however that a return to recession is viewed as unlikely by the committee members (...why the stimulus then???)
The economic calendar is a bit light today. We have MBA Mortage Applications, Import/Export Prices, Treasury Budget, a speech from Bernanke after the close, and a speech by Lacker this evening.
Dow Futures are up 74 points and S&P is looking up 8.75 points.
Lastly, a reminder that we will get the POMO schedule for the next four weeks at 11 am PST today.
Tuesday, October 12, 2010
Market Update
Futures are looking down this morning as San Francisco Fed President, Janet Yellen, warned that excessively easy monetary policy could create bubbles in the future. "It is conceivable that accomodative monetary policy could provide tinder for a buildup of leverage and excessive risk-taking." Since the Fed has been involved in nearly every US bubble, it is probably a bit more concrete than it is merely 'conceivable' but I'm glad to see someone on the FOMC express concern.
Also weighing on the markets this morning is India's August industrial production miss that came in at 5.6% (a 15 month low.) The number is very volatile due to the lumpy nature of capital goods orders, but certainly a 5.6% print vs. expectations of 10%+ is something to keep an eye on.
China's auto sales slowed in September as tax breaks and subsidies began to roll off. Sales rose 17 percent YoY to 1.56M, down a bit from 18% in August. But July was 16% growth, and June was 21% growth so while the auto industry in China is being described as normalizing, it must be pointed out that a.) they are still selling more cars than we are domestically in the U.S. and b.) the absolute growth in China continues to be tremendous with sales of 13.6M vehicles in 2009 (45% growth) and on pace to do about 17M vehicles in 2010 (30% growth.) Of note, Ford saw sales in China rise 26%, up from 24% in August. Ford sales in China were up 40% in the first nine months of the year at 419,073 units. GM on the contrary rose 15%, down from 19% growth in August. For the first 9 months of the year, GM sold a record 1.78M vehicles.
Goldman Sachs reports that it has heard from bank employees in China who say that the government has told its largest banks that they must increase reserves to 17.5% (up 50 bps) in order to cool inflation and housing prices. There has been no formal announcement from the government in Beijing. Estimates suggest that this latest reserve hike would remove approx 200B yuan or $29B out of the lending pool. Banks will be allowed to lend a total of 7.5T yuan ($1.1T) this year vs. 9.6T yuan ($1.4T) in 2009.
Despite all the bad economic news this morning (summarizing...signs of slowing growth in China and India, INTC reporting after the close today after negatively pre-announcing a few weeks ago, Fed warning that QE2 expectations for November may be a bit premature, etc) there is nothing that will change the fact that until investors are disappointed by either earnings or the Fed fails to announce QE2 on November 3rd, the market will hold its level. That being said, I do expect earnings to be somewhat disappointing especially for the banks and brokers. We have JPM reporting earnings on Thursday. With a bad print possible, I wonder that when the Fed releases its POMO schedule for the coming weeks on Wednesday, if it doesn't include a healthy dose of Thursday and Friday this week???
FOMC minutes are due out at 11 am PST.
Also weighing on the markets this morning is India's August industrial production miss that came in at 5.6% (a 15 month low.) The number is very volatile due to the lumpy nature of capital goods orders, but certainly a 5.6% print vs. expectations of 10%+ is something to keep an eye on.
China's auto sales slowed in September as tax breaks and subsidies began to roll off. Sales rose 17 percent YoY to 1.56M, down a bit from 18% in August. But July was 16% growth, and June was 21% growth so while the auto industry in China is being described as normalizing, it must be pointed out that a.) they are still selling more cars than we are domestically in the U.S. and b.) the absolute growth in China continues to be tremendous with sales of 13.6M vehicles in 2009 (45% growth) and on pace to do about 17M vehicles in 2010 (30% growth.) Of note, Ford saw sales in China rise 26%, up from 24% in August. Ford sales in China were up 40% in the first nine months of the year at 419,073 units. GM on the contrary rose 15%, down from 19% growth in August. For the first 9 months of the year, GM sold a record 1.78M vehicles.
Goldman Sachs reports that it has heard from bank employees in China who say that the government has told its largest banks that they must increase reserves to 17.5% (up 50 bps) in order to cool inflation and housing prices. There has been no formal announcement from the government in Beijing. Estimates suggest that this latest reserve hike would remove approx 200B yuan or $29B out of the lending pool. Banks will be allowed to lend a total of 7.5T yuan ($1.1T) this year vs. 9.6T yuan ($1.4T) in 2009.
Despite all the bad economic news this morning (summarizing...signs of slowing growth in China and India, INTC reporting after the close today after negatively pre-announcing a few weeks ago, Fed warning that QE2 expectations for November may be a bit premature, etc) there is nothing that will change the fact that until investors are disappointed by either earnings or the Fed fails to announce QE2 on November 3rd, the market will hold its level. That being said, I do expect earnings to be somewhat disappointing especially for the banks and brokers. We have JPM reporting earnings on Thursday. With a bad print possible, I wonder that when the Fed releases its POMO schedule for the coming weeks on Wednesday, if it doesn't include a healthy dose of Thursday and Friday this week???
FOMC minutes are due out at 11 am PST.
Monday, October 11, 2010
Market Trading on a Policy Expectation Which No One Understands
Seeking Alpha contributor, Jeff Miller, whose 'Weighing the Week Ahead' piece I enjoy reading for its typically unique outlook on the coming weeks' events, wrote the following this morning:
"Before anyone is allowed to pontificate about the merits of quantitative easing, the pundit would have to demonstrate a minimal level of knowledge. Let us try the following:
In three sentences, please explan what quantitative is, how it is implemented, and what it is intended to accomplish. (slogans like "printing money" do not constitute an acceptable answer.)
This would probably eliminate nearly everyone, and confront CNBC with a major problem. How would they do any interviews if they could not ask people questions about things where they had no knowledge?
Meanwhile, the market continues to trade on expectations for Fed action, a policy which hardly anyone understands."
And this guy is bullish...?
He cites Art Hogan, chief market analyst at Jeffries, who recently mimicked David Tepper's comments, as most thoughtfully expressing his thesis. Art:
"The concept of a double-dip recession has been replaced with slow and steady improvement, and even if we don't get it, we have a Federal Reserve that's ready to step in and support the rally,"
Mr. Miller's reponse, "For me, this was hardly fresh news, but it is nice to see people joining in."[Emphasis Mine]
Does anyone else see this bubble for what it is? Has governing one's actions with a thoughtful prudence become a relic, a dinosaur? Perhaps the process of blowing and popping bubbles is something we've gotten comfortable with. At least it is dramatic, I suppose...
"Before anyone is allowed to pontificate about the merits of quantitative easing, the pundit would have to demonstrate a minimal level of knowledge. Let us try the following:
In three sentences, please explan what quantitative is, how it is implemented, and what it is intended to accomplish. (slogans like "printing money" do not constitute an acceptable answer.)
This would probably eliminate nearly everyone, and confront CNBC with a major problem. How would they do any interviews if they could not ask people questions about things where they had no knowledge?
Meanwhile, the market continues to trade on expectations for Fed action, a policy which hardly anyone understands."
And this guy is bullish...?
He cites Art Hogan, chief market analyst at Jeffries, who recently mimicked David Tepper's comments, as most thoughtfully expressing his thesis. Art:
"The concept of a double-dip recession has been replaced with slow and steady improvement, and even if we don't get it, we have a Federal Reserve that's ready to step in and support the rally,"
Mr. Miller's reponse, "For me, this was hardly fresh news, but it is nice to see people joining in."[Emphasis Mine]
Does anyone else see this bubble for what it is? Has governing one's actions with a thoughtful prudence become a relic, a dinosaur? Perhaps the process of blowing and popping bubbles is something we've gotten comfortable with. At least it is dramatic, I suppose...
The Week Ahead: 10/11-10/15
The Dow closed above 11,000 for the first time since May on Friday on a soft Unemployment report that indicated to some market participants that the Fed will commence QE2 on November 3rd. The dollar was weaker, and gold made new highs at $1,350.
With no already scheduled POMOs this week, we may have a chance to trade on economic data, earnings, etc (but we are the Smith Report aren't holding our breath!)
The schedule for the coming week's events is posted below.
Monday - Dudley and Bernanke speak Today. Both publicly in favor of QE2, so this should give the bulls a chance to run. We will likely hear things along the lines of, "more monetary stimulus appears necessary" and "inflation below mandate."
Tuesday - FOMC minutes from Sept 21st meeting. Everyone will be looking for clues re: QE2.
Wednesday - MBA Mortgage Applications, Export and Import Prices, Crude Inventories, and Treasury Budget, China Trade, Eurozone Industrial Production, POMO SCHEDULE FOR COMING MONTH out at 11 am PST. (Could anything be more important???).
Thursday - Initial and Continuing Claims, PPI, Trade Balance. PPI likely to continue to support deflationary trends or at least 'below mandate inflation' providing the Fed to continue to perpetuate idea that QE2 is acceptable because of low inflation. Ditto for the CPI report on Friday.
Friday - CPI, Retail Sales, NY Fed - Empire Manufacturing Survey, Michigan Sentiment, Business Inventories. Retail sales likely to come in fairly solid as both the most recent auto sales and chain store sales reports beat expectations.
With no already scheduled POMOs this week, we may have a chance to trade on economic data, earnings, etc (but we are the Smith Report aren't holding our breath!)
The schedule for the coming week's events is posted below.
Monday - Dudley and Bernanke speak Today. Both publicly in favor of QE2, so this should give the bulls a chance to run. We will likely hear things along the lines of, "more monetary stimulus appears necessary" and "inflation below mandate."
Tuesday - FOMC minutes from Sept 21st meeting. Everyone will be looking for clues re: QE2.
Wednesday - MBA Mortgage Applications, Export and Import Prices, Crude Inventories, and Treasury Budget, China Trade, Eurozone Industrial Production, POMO SCHEDULE FOR COMING MONTH out at 11 am PST. (Could anything be more important???).
Thursday - Initial and Continuing Claims, PPI, Trade Balance. PPI likely to continue to support deflationary trends or at least 'below mandate inflation' providing the Fed to continue to perpetuate idea that QE2 is acceptable because of low inflation. Ditto for the CPI report on Friday.
Friday - CPI, Retail Sales, NY Fed - Empire Manufacturing Survey, Michigan Sentiment, Business Inventories. Retail sales likely to come in fairly solid as both the most recent auto sales and chain store sales reports beat expectations.
Friday, October 8, 2010
St. Louis Fed President James Bullard on QE2 Today
"This upcoming FOMC meeting is going to be a tough call, because the economy has slowed but it hasn't slowed so much that it's an obvious case to do something."
"I do think the risk of a double-dip recession has probably receded some in the last six to eight weeks."
"I do think the risk of a double-dip recession has probably receded some in the last six to eight weeks."
Loss of 95K Jobs, Unemployment Rate Unchaged at 9.6%
The unemployment rate held steady at 9.6%, despite the net loss of 95,000 jobs in the month of September. The unemployment rate has now topped 9.5% for 14 consecutive months, which makes it the longest stretch since the 1930s.
Of course the market has rallied on the expectation of QE2. We broke the Dow 11,000 barrier this morning, but much like yesterday, have faded back below the line as the S&P can't seem to break above its 1163 resistance.
Volume is non-existent this morning as the last intelligent people still remaining are finally beginning to give up. Its an odd paradox to be bearish right now. For perhaps the first time in history, to be bearish means to hope for an economic recovery that develops organically. I was hoping for a good jobs number this morning, not just for the health of my PA, but for the health of the global economy, the economic security of my fellow countrymen, and the off-hand chance that Bernanke might not decide to destroy the purchasing power of the middle class. To be bullish on the market, you had to hope for the jobs number to be god-awful (which it was) so that we could rally above 11,000 on hopes that the rich get richer and the poor get shafted as the Fed launches round 2 of the currency wars.
Of course the market has rallied on the expectation of QE2. We broke the Dow 11,000 barrier this morning, but much like yesterday, have faded back below the line as the S&P can't seem to break above its 1163 resistance.
Volume is non-existent this morning as the last intelligent people still remaining are finally beginning to give up. Its an odd paradox to be bearish right now. For perhaps the first time in history, to be bearish means to hope for an economic recovery that develops organically. I was hoping for a good jobs number this morning, not just for the health of my PA, but for the health of the global economy, the economic security of my fellow countrymen, and the off-hand chance that Bernanke might not decide to destroy the purchasing power of the middle class. To be bullish on the market, you had to hope for the jobs number to be god-awful (which it was) so that we could rally above 11,000 on hopes that the rich get richer and the poor get shafted as the Fed launches round 2 of the currency wars.
Thursday, October 7, 2010
QE2 Special Feature: Exploring Hopes, Wishes, Dreams, and Realities
FOMC Members
Ben Bernanke
William Dudley, NY, Vice Chairman
James Bullard, St. Louis
Elizabeth Duke, BoG
Thomas Hoenig, Kansas City
Sandra Pianalto, Cleveland
Sarah Raskin, BoG
Eric Rosengren, Boston
Daniel K. Tarullo, BoG
Kevin M. Warsh, BoG
Janet L. Yellen, BoG
Alternate Members
Charles Evans, Chicago
Richard Fisher, Dallas
Narayana Kocherlakota, Minneapolis
Charles Plosser, Philadelphia
Christine Cumming, New York
Fed Opinions on QE2:
In Favor:
William Dudley: "Currently, my assessment is that both the current levels of unemployment and inflation and the timeframe over which they are likely to return to levels consistent with our mandate are unacceptable. In addition, the longer this situation prevails and the U.S. economy is stuck with the current level of slack and disinflationary pressure, the greater the likelihood that a further shock could push us still further from our dual mandate objectives and closer to outright deflation.
We have tools that can provide additional stimulus at costs that do not appear to be prohibitive. Thus, I conclude that further action is likely to be warranted unless the economic outlook evolves in a way that makes me more confident that we will see better outcomes for both employment and inflation before too long."
Charles Evans (Non-Voter, But will be a voter in 2011): "The unemployment rate is very high. Inflation is low. To me that means we need an accommodative stance of monetary policy."
"We need more accommodation. A lot of people respond that their take on monetary policy depends on the data coming in from here on out. For me, the data have spoken very clearly. As I stared at the forecast even before the August FOMC meeting, I had come to the conclusion that things were very different than what I had been expecting in previous meetings. This is a far grimmer forecast than we ought to have. So yes, I’m in favor of more accommodation."
On Bullard's idea of a contingent program, "I'm favorably disposed toward the approach that JIm has mentioned...I just think that far more accomodation is required."
Bullard (Voter): Believes we should have a contingent asset purchase program that has incremental purchases as the situation evolves, rather than a program which either pumps all the money into the system at once or that announces the full amount at the start of the program. That way changes can be made.
Against:
Thomas Hoenig (Voter): "I am convinced that the time is right to put the market on notice that it must again manage its risk, be acountable for its actions, and cease its reliance on assurances that the Federal Reserve, not they, will manage the risks they must deal with in a market economy." (April 7th in Sante Fe.)
Narayana Kocherlakota (Non-voter, but will vote in 2011): "I do not see why they [banks] would suddenly start to use the new ones [excess reserves] if they weren't using the old ones."
Charles Plosser (Non-voter, but will vote in 2011): "It is difficult, in my view, to see how additional asset purchases by the Fed, even if they move interest rates on long term bonds down by 10 or 20 bps, will have much impact on the near-term outlook for employment."
Reasons to Believe QE2 is not coming in November:
1. If economy went into double-dip recession, what then could the Fed do? They'd be literally out of ammunition.
2. Don't know the impact of additional asset purchases. This point has been repeatedly admitted by none other than the Fed members themselves.
Reasons to Hope QE2 is not coming:
1. Bubbles are forming in unproductive asset classes such as gold.
2. Companies are using excess liquidity for M&A which reduces employment.
3. Paul Volcker, the former Fed Chairman, and master stagnation fighter has said that just as a woman can't be a little bit pregnant, the Fed cannot create a little bit of inflation without running the risk of inflation becoming out of control.
4. Soaring commodity prices. $8/gallon gasoline. Heating oil and food prices rise. Americans have even less disposable income. The 70% of GDP that is consumer spend will be be negatively impacted. Recovery will be even weaker as a result. Possible class wars. A broken political system. Both larger and more frequent Tea Party-like political groups forming populist/anarchist/libertarian/mob-like coalitions.
5. New York Fed estimates that the Fed would need to purchase an additional $2T in Treasuries to push down the yield on the 10 year by 100 bps. So, if the worst happens and QE2 ends up being about $1T or 50% growth on our currently $2T monetary base, we will get a mere 50 bps decrease in the 10 year yield. This will have a virtually non-existent effect on the demand for credit, but will certainly provide a hefty blow to the value of the USD.
6. The Fed (along with HFTs, dark pools, etc) is destroying the ability for the market to trade based on fundamentals. With announcements of hiring freezes at Morgan Stanley, 22 straight weeks of equity outflows, rapidly diminishing volume, etc, it is becoming clear that a rigged market will destroy the credibility of what was once (I believe anyway...) a lawful, efficient market system, which in turn will result in job losses in the financial sector which in boom times accounted for some 20+% of GDP.
7. Growing concern over possible (partial-)loss of reserve currency status.
8. On the mere suggestion of possible QE2, the trade-weighted dollar has lost approximately 6% of its value in September alone. This could wreak havoc on global financial markets. The euro has been rising against the dollar, hitting multi-month highs this morning around $1.40. This will be very bad for the eurozone's recovery. Germany, an export led economy, will soon need to increase its rhetoric against competitive currency devaluations or suffer from weaker forward GDP growth. The Japanese look as though the nation could fall back into recession. Their QE2 impacted the Yen positively for all of two days when attempted in the face of US currency destruction. China will become increasingly less interested in purchasing soon to be monetized US Treasuries and in fact, ironically, will see the value of the remnimbi continue to fall as the USD falls.
Dreams regarding QE2
1. That a lower US dollar will increase US exports, assisting in domestic job creation, and leading the US out of slumping economic conditions. This might be true if our economy were not based 20% on manufacturing and 80% on services. Manufacturing might pick up, but not materially so, and again, the American consumer faced with higher commodity prices will see an offsetting drop in demand for discretionary items, further hurting actual export driven nations like China. Probably unwise to kick the stool out from under the emerging markets. For if we hope China, India, and Brazil to lead the world out of economic purgatory, we'd better not up the odds against them.
2. That a lower dollar, and higher stock prices will raise consumer optimism, and thus spending via the wealth effect. WRONG. Higher stock prices, bigger bonuses for executives, etc only create further divisions between the citizenry of the United States. The rich getting richer has been shown over the last thirty years to do nothing to help the poor get richer. If costs rise and quality of life for the bottom 80% starts to take a hit, then expect increased violent crime, theft, calls for secession, etc to begin to boil over. This may over a longer horizon provide an opportunity, as did the Civil War in the 19th Century, to create a more perfect union. But first, we'd have to suffer through a lot of unpalatable changes, especially given the level of 'me-ism' our population (especially amongst our young people) supports and nurtures. There is the possibility that many rude awakenings await our over-fed, under-read citizenry.
3. That lower rates will increase aggregate credit demand. US Households have been de-levering for the past 9 consecutive quarters. QE1 did not have an effect on credit demand, why should QE2?
4. That QE2 is a given. Bernanke was clear that it was on the table, but I think many overstate their talent for clairvoyance. Bernanke in the same comments at Jackson Hole mentioned that much of what the Fed was considering would be the Fed's communication strategy. And he was dead-on in his belief in the efficacy of spoken/written Fed communiques. He mentioned the possibility for QE2, the dollar got absolutely hammered in September, a worldwide currnecy war broke out, the stock market went up, and gold rallied. Probably not all of these consequences were intended (let that be a lesson to you Ben!) but just the suggestion of its possibility seemed to have a rather dramatic effect! Much of the supporting rhetoric driving the belief in QE2 has come from non-voting members of the FOMC including Brian Sack and Goldman Sachs, neither of which have an un-vested interest if you get my drift...?
Realities regarding QE2
1. It is likely that the Fed will take a wait and see approach, which in my mind probably amounts to the start of QE2 sometime late in the year, but in small increments so as not to draw too much populist ire and also to allow for the Fed to change its mind and keep at least some amount of its remaining ammunition on the sidelines, in case of negative GDP in 2011 (for example.)
2. The rhetoric coming from the Fed over the intermediate term will likely continue to show that the Bernanke Put, even if not fully in use, is at the ready.
3. No one knows what exactly will result from QE2. It is not a given that it will have all of even its positive intended consequences. Foreigners may see its very possibility as a need to begin demanding higher rates, otherwise we may begin to see indirect buyers fall as a percentage of Treasury buyers, leaving only the Fed to finance our debt.
Pop quiz: Where does the Fed get the funds it uses to monetize US Treasury debt???
Ben Bernanke
William Dudley, NY, Vice Chairman
James Bullard, St. Louis
Elizabeth Duke, BoG
Thomas Hoenig, Kansas City
Sandra Pianalto, Cleveland
Sarah Raskin, BoG
Eric Rosengren, Boston
Daniel K. Tarullo, BoG
Kevin M. Warsh, BoG
Janet L. Yellen, BoG
Alternate Members
Charles Evans, Chicago
Richard Fisher, Dallas
Narayana Kocherlakota, Minneapolis
Charles Plosser, Philadelphia
Christine Cumming, New York
Fed Opinions on QE2:
In Favor:
William Dudley: "Currently, my assessment is that both the current levels of unemployment and inflation and the timeframe over which they are likely to return to levels consistent with our mandate are unacceptable. In addition, the longer this situation prevails and the U.S. economy is stuck with the current level of slack and disinflationary pressure, the greater the likelihood that a further shock could push us still further from our dual mandate objectives and closer to outright deflation.
We have tools that can provide additional stimulus at costs that do not appear to be prohibitive. Thus, I conclude that further action is likely to be warranted unless the economic outlook evolves in a way that makes me more confident that we will see better outcomes for both employment and inflation before too long."
Charles Evans (Non-Voter, But will be a voter in 2011): "The unemployment rate is very high. Inflation is low. To me that means we need an accommodative stance of monetary policy."
"We need more accommodation. A lot of people respond that their take on monetary policy depends on the data coming in from here on out. For me, the data have spoken very clearly. As I stared at the forecast even before the August FOMC meeting, I had come to the conclusion that things were very different than what I had been expecting in previous meetings. This is a far grimmer forecast than we ought to have. So yes, I’m in favor of more accommodation."
On Bullard's idea of a contingent program, "I'm favorably disposed toward the approach that JIm has mentioned...I just think that far more accomodation is required."
Bullard (Voter): Believes we should have a contingent asset purchase program that has incremental purchases as the situation evolves, rather than a program which either pumps all the money into the system at once or that announces the full amount at the start of the program. That way changes can be made.
Against:
Thomas Hoenig (Voter): "I am convinced that the time is right to put the market on notice that it must again manage its risk, be acountable for its actions, and cease its reliance on assurances that the Federal Reserve, not they, will manage the risks they must deal with in a market economy." (April 7th in Sante Fe.)
Narayana Kocherlakota (Non-voter, but will vote in 2011): "I do not see why they [banks] would suddenly start to use the new ones [excess reserves] if they weren't using the old ones."
Charles Plosser (Non-voter, but will vote in 2011): "It is difficult, in my view, to see how additional asset purchases by the Fed, even if they move interest rates on long term bonds down by 10 or 20 bps, will have much impact on the near-term outlook for employment."
Reasons to Believe QE2 is not coming in November:
1. If economy went into double-dip recession, what then could the Fed do? They'd be literally out of ammunition.
2. Don't know the impact of additional asset purchases. This point has been repeatedly admitted by none other than the Fed members themselves.
Reasons to Hope QE2 is not coming:
1. Bubbles are forming in unproductive asset classes such as gold.
2. Companies are using excess liquidity for M&A which reduces employment.
3. Paul Volcker, the former Fed Chairman, and master stagnation fighter has said that just as a woman can't be a little bit pregnant, the Fed cannot create a little bit of inflation without running the risk of inflation becoming out of control.
4. Soaring commodity prices. $8/gallon gasoline. Heating oil and food prices rise. Americans have even less disposable income. The 70% of GDP that is consumer spend will be be negatively impacted. Recovery will be even weaker as a result. Possible class wars. A broken political system. Both larger and more frequent Tea Party-like political groups forming populist/anarchist/libertarian/mob-like coalitions.
5. New York Fed estimates that the Fed would need to purchase an additional $2T in Treasuries to push down the yield on the 10 year by 100 bps. So, if the worst happens and QE2 ends up being about $1T or 50% growth on our currently $2T monetary base, we will get a mere 50 bps decrease in the 10 year yield. This will have a virtually non-existent effect on the demand for credit, but will certainly provide a hefty blow to the value of the USD.
6. The Fed (along with HFTs, dark pools, etc) is destroying the ability for the market to trade based on fundamentals. With announcements of hiring freezes at Morgan Stanley, 22 straight weeks of equity outflows, rapidly diminishing volume, etc, it is becoming clear that a rigged market will destroy the credibility of what was once (I believe anyway...) a lawful, efficient market system, which in turn will result in job losses in the financial sector which in boom times accounted for some 20+% of GDP.
7. Growing concern over possible (partial-)loss of reserve currency status.
8. On the mere suggestion of possible QE2, the trade-weighted dollar has lost approximately 6% of its value in September alone. This could wreak havoc on global financial markets. The euro has been rising against the dollar, hitting multi-month highs this morning around $1.40. This will be very bad for the eurozone's recovery. Germany, an export led economy, will soon need to increase its rhetoric against competitive currency devaluations or suffer from weaker forward GDP growth. The Japanese look as though the nation could fall back into recession. Their QE2 impacted the Yen positively for all of two days when attempted in the face of US currency destruction. China will become increasingly less interested in purchasing soon to be monetized US Treasuries and in fact, ironically, will see the value of the remnimbi continue to fall as the USD falls.
Dreams regarding QE2
1. That a lower US dollar will increase US exports, assisting in domestic job creation, and leading the US out of slumping economic conditions. This might be true if our economy were not based 20% on manufacturing and 80% on services. Manufacturing might pick up, but not materially so, and again, the American consumer faced with higher commodity prices will see an offsetting drop in demand for discretionary items, further hurting actual export driven nations like China. Probably unwise to kick the stool out from under the emerging markets. For if we hope China, India, and Brazil to lead the world out of economic purgatory, we'd better not up the odds against them.
2. That a lower dollar, and higher stock prices will raise consumer optimism, and thus spending via the wealth effect. WRONG. Higher stock prices, bigger bonuses for executives, etc only create further divisions between the citizenry of the United States. The rich getting richer has been shown over the last thirty years to do nothing to help the poor get richer. If costs rise and quality of life for the bottom 80% starts to take a hit, then expect increased violent crime, theft, calls for secession, etc to begin to boil over. This may over a longer horizon provide an opportunity, as did the Civil War in the 19th Century, to create a more perfect union. But first, we'd have to suffer through a lot of unpalatable changes, especially given the level of 'me-ism' our population (especially amongst our young people) supports and nurtures. There is the possibility that many rude awakenings await our over-fed, under-read citizenry.
3. That lower rates will increase aggregate credit demand. US Households have been de-levering for the past 9 consecutive quarters. QE1 did not have an effect on credit demand, why should QE2?
4. That QE2 is a given. Bernanke was clear that it was on the table, but I think many overstate their talent for clairvoyance. Bernanke in the same comments at Jackson Hole mentioned that much of what the Fed was considering would be the Fed's communication strategy. And he was dead-on in his belief in the efficacy of spoken/written Fed communiques. He mentioned the possibility for QE2, the dollar got absolutely hammered in September, a worldwide currnecy war broke out, the stock market went up, and gold rallied. Probably not all of these consequences were intended (let that be a lesson to you Ben!) but just the suggestion of its possibility seemed to have a rather dramatic effect! Much of the supporting rhetoric driving the belief in QE2 has come from non-voting members of the FOMC including Brian Sack and Goldman Sachs, neither of which have an un-vested interest if you get my drift...?
Realities regarding QE2
1. It is likely that the Fed will take a wait and see approach, which in my mind probably amounts to the start of QE2 sometime late in the year, but in small increments so as not to draw too much populist ire and also to allow for the Fed to change its mind and keep at least some amount of its remaining ammunition on the sidelines, in case of negative GDP in 2011 (for example.)
2. The rhetoric coming from the Fed over the intermediate term will likely continue to show that the Bernanke Put, even if not fully in use, is at the ready.
3. No one knows what exactly will result from QE2. It is not a given that it will have all of even its positive intended consequences. Foreigners may see its very possibility as a need to begin demanding higher rates, otherwise we may begin to see indirect buyers fall as a percentage of Treasury buyers, leaving only the Fed to finance our debt.
Pop quiz: Where does the Fed get the funds it uses to monetize US Treasury debt???
NFP Number Tomorrow, QE2 Expectations, AA after the market close
Markets are down somewhat this morning ahead of two very critical events over the next 24 hours.
1. Alcoa reports earnings today after the close.
2. Tomorrow morning we will get the Nonfarm Payroll Number for September.
With virtually the entire market fixated on how soon the Fed will launch QE2, tomorrow's NFP number will be a critical factor for determing the market's direction over the coming weeks. The consensus is for no change in jobs on the aggregate from the prior month, but with jobs coming from the private sector to see an increase of 74K, with the unemployment rate to tick up 0.01% to 9.7%.
What is going to be fascinating however, is seeing how the market reacts to this number. If the report is better than expected, will the market necessarily have to sell-off on good news? Surely a good number must be read as a mitigating factor against the current Goldman Sachs (and therefore market consensus) expectation of a Nov. 3rd launch of QE2.
If the number is bad, we will likely rally through Dow 11,000 as it will be assured that Bernanke will officially declare war on the middle class on election day.
If the number is in-line, then we will likely trade off of Alcoa's numbers from this afternoon.
Alcoa is expected to report EPS of $0.05 on revenue of $4.95B. The consensus ranges are $0.01-$0.12 and $4.52B-$5.36B. The stock has risen from $10 to $12 in September. With the stock already up 20%, investors appear nervous heading into earnings with good news already somewhat priced-in, AA trading down $0.14 or 1.21% at the time of this writing. Also creating anxiety is an article on Bloomberg this morning which notes that Alcoa's profits may drop 20% as the weak dollar offsets the higher realized spot aluminum prices. Alcoa's revenue is in USD but pays costs in its non-US operations in local currencies. The largest source of revenue after the US is Australia, whose currency is up 14% against the USD this quarter alone. Alcoa also has sizable operations in Brazil, and the real has climbed 7% this quarter (Thanks BB!)
1. Alcoa reports earnings today after the close.
2. Tomorrow morning we will get the Nonfarm Payroll Number for September.
With virtually the entire market fixated on how soon the Fed will launch QE2, tomorrow's NFP number will be a critical factor for determing the market's direction over the coming weeks. The consensus is for no change in jobs on the aggregate from the prior month, but with jobs coming from the private sector to see an increase of 74K, with the unemployment rate to tick up 0.01% to 9.7%.
What is going to be fascinating however, is seeing how the market reacts to this number. If the report is better than expected, will the market necessarily have to sell-off on good news? Surely a good number must be read as a mitigating factor against the current Goldman Sachs (and therefore market consensus) expectation of a Nov. 3rd launch of QE2.
If the number is bad, we will likely rally through Dow 11,000 as it will be assured that Bernanke will officially declare war on the middle class on election day.
If the number is in-line, then we will likely trade off of Alcoa's numbers from this afternoon.
Alcoa is expected to report EPS of $0.05 on revenue of $4.95B. The consensus ranges are $0.01-$0.12 and $4.52B-$5.36B. The stock has risen from $10 to $12 in September. With the stock already up 20%, investors appear nervous heading into earnings with good news already somewhat priced-in, AA trading down $0.14 or 1.21% at the time of this writing. Also creating anxiety is an article on Bloomberg this morning which notes that Alcoa's profits may drop 20% as the weak dollar offsets the higher realized spot aluminum prices. Alcoa's revenue is in USD but pays costs in its non-US operations in local currencies. The largest source of revenue after the US is Australia, whose currency is up 14% against the USD this quarter alone. Alcoa also has sizable operations in Brazil, and the real has climbed 7% this quarter (Thanks BB!)
Wednesday, October 6, 2010
Guest Post: Duoyuan Global Water (DGW): Chinese Water (Long idea)
Duoyuan Global Water (DGW): Despite concerns, a cheap pure play on water and Chinese urbanization
By Josh Rowe
Introduction
On September 13, American depository shares of Duoyuan Global Water (DGW) were cut in half on worries over an accounting scandal at DGW’s sister company, Duoyuan Printing (DYP). Duoyuan Water and Printing share a chairman, Wenhua Guo, but have separate management teams; the CEO and CFO of DYP have been replaced. DYP also fired its auditor, Deloitte, and instituted an internal review of possible irregularities in its filings to the SEC. At the time of writing, it was not clear which numbers were in question, or whether, as some have speculated, DPY withheld information such as bank statements, distributor contracts, or expense accounts from its auditor. Notwithstanding the meltdown in the stock, there is nothing to link the controversy at DPY to Duoyuan Global Water, apart from Mr. Guo’s role as chairman of both companies. DGW is undertaking a preemptive third-party review of accounting standards, which may entail future headline risk. Regardless, with its market cap cut in half, fears are likely overblown.
The scandal is the third shock to weigh on investor sentiment regarding DGW since its listing in 2009. The first was of its own making; following a run up to $45, the company announced a secondary offering of 3.5 million shares (increasing the float some 11%), to which investors reacted negatively. The second was the slowdown in Chinese stocks as the PBOC raised deposit reserve requirements for lenders, putting the brakes on the credit-fueled bull market of 2009. I believe that neither of these first two negatives poses a serious obstacle to the long-term performance of DGW’s shares. Water is a secular bull market in China, dependent less on the global business cycle than on internal demographics. DGW’s secondary was not as dilutive as the subsequent share price drop would suggest, and is not necessarily a token of future dilution. $211 million in cash ($8.50 share diluted) lends ample room for expansion of capacity without tapping the equity market.
The third concern represents an “unknown unknown.” Due to Western investors’ persistent uncertainty about standards of transparency and corporate governance in the People’s Republic, the mere whiff of an accounting scandal is sufficient to seriously impact the credibility of a Chinese firm’s financial reports. Because DGW is listed in America and subject to the reporting requirements of the Securities Exchange Act of 1934, and because its relationship with its auditor, Grant Thornton, appears to remain solid, these sorts of risks should be less worrisome than in stocks traded only on Mainland Chinese exchanges. If the accounting irregularities are confined to Duoyuan Printing, and if a prospective investor is willing to accept the increased volatility of a Chinese-originated ADR, DGW represents compelling value over a several year horizon. Though we must acknowledge concerns over slowing growth in China and DGW’s potentially dilutive capital markets strategy, my conclusion is that these risks should not greatly affect long-term holders of the stock. The following paragraphs present the bull case for shares of DGW, predicated on its highly competitive market position in an area of secular and state-supported growth.
Reasons for optimism
Above all, market dynamics support a rising demand for DGW’s products, both within the PRC, and potentially outside. As a rapidly industrializing, urbanizing economy, China’s water needs should grow far in excess of cheap, reusable supply. According to a recent series of reports in The Economist, China has 21% of the world’s population yet only 6% of its renewable fresh water. In the water-poor North and West, conditions are particularly problematic—80% of the country’s water is in the more developed South, and the North China Plain that sustains much of the country’s agriculture is currently in drought. 67% of Chinese cities are in deficit; this is a large and growing problem, as China currently has over 150 cities with greater than 1 million in population. The average Chinese citizen subsists on only one quarter of the water per person of the world average.
Market research cited by DGW indicates that demand for water treatment products is expected to grow 15.5% per annum to 2012, and faster thereafter. DGW should benefit from increases in demand for water for personal consumption, industrial use, agriculture, and municipal water treatment alike. At present, 38% of the company’s revenues come from circulating water treatment products used in cooling and refrigeration, 22% from water purification (drinking water, food processing, the electronics and pharmaceutical industries), and 41% from wastewater treatment and reuse (municipal sewage, petroleum, paper).
This last segment should see the most robust growth. The company itself projects 45.5% increases in sales due to increased urban demand, government regulations mandating water treatment, and tougher enforcement of environmental protection laws. The latter are becoming a higher priority in state policy as newly wealthy Chinese consumers awake (as did Americans in the 1950s and 1960s) to aesthetic and health consequences of environmental laxity. DGW’s ambitious projections are supported by a number of political considerations and by the secular dynamic of urbanization. The current national budget allocates more than ¥150 billion for mandatory water conservation. This number should form a minimum baseline in future years. DGW’s expanded production capacity reflects its anticipation of at least a robust upgrade cycle.
56% of China’s population still lives in rural communities, often constrained by a hereditary registration laws that define residency as rural or urban, and determine land allotments. These laws are likely to be further liberalized, and the standards of living and social mobility offered by urban life continue to attract young Chinese to the many fast-growing cities. The Ministry of Housing estimates that between 2010 and 2025 some 300 million Chinese will move from rural areas to urban. Residential property markets in Hong Kong and Shanghai have recently come under scrutiny as high-end properties have traded at spectacularly high valuations. In second and third-tier cities, however, property price rises continue unabated, driven on by a strong fundamental demand dynamic. Most China watchers believe that urban migration is a process that has not approached its peak; as it grows, demands for water treatment and reuse will as well. This is not a bubble; it is a powerful, sustainable trend.
Appealingly, municipal water treatment is also a high-margin business for DGW. All of its products in this segment earn over 40% gross (frequently more) and technological developments in quality and efficiency drive pricing power. DGW’s microporous aerator, a new product in 2009 that has seen high rates of adoption, is one example. Using oxygenation to kill more than 98% of germs in wastewater, the microporous aerator competes at the high-end of the market. One of the beneficiaries of DGW’s equity offering, projected 50% sales growth rates in this product should provide adequate returns on capital. In recent years, R&D has shrunk somewhat as a share of revenue, but has grown significantly in absolute terms (net sales have increased by more than 32% each of the past three years). Particularly among its domestic competitors, the company is a technology innovator, and links its future strategy to remaining such. In the medium term, DGW is exploring licensing agreements with Israeli and American firms to bring highly efficient drip irrigation and membrane-based desalinization technology to its product portfolio. Though it is not discounted in the stock price, management recognizes that agriculture represents an enormous untapped growth market. There has also been some preliminary talk of partnerships with distributors in India. I would adopt a “wait and see” approach.
DGW has several competitive advantages in all of its business segments. Compared to international offerings from Veolia, Suez, or Thames, DGW (thanks to cheap labor) is the low cost producer. Domestic competitors cannot offer the same diversity and complementarity of product offerings. RINO, which provides water to the iron and steel industries, was a popular name with Western smart money in 2009. By contrast, the wide range of DGW’s businesses make it a less cyclical, more secular play. Unlike niche manufacturers leveraged to growth in particular industries, DGW is a WalMart-like “one-stop shop.”
DGW evidently believes its U.S. listing give it better access to capital and more brand prestige than its Chinese rivals. One of its largest expenses is a 12 million RMB CCTV 4 advertising campaign to convince distributors of its superior product quality. Selling costs have risen slowly and steadily on the back of this and other campaigns. DGW operates with a network of over 80 regionally diverse independent distributors; international competitors are often limited to one. By agreeing with distributors to yearly contracts, DGW is highly flexible to regional demand shifts, and maintains tighter control over working capital. Like an industrial company, DGW’s vertical integration permits volume discounts on raw material, and improved workflow from standardized practices across segments. Like a high-tech company, its relative small size and investments in R&D give it an edge in energy efficient and non-chemical water treatment technologies.
Financial analysis
An analysis of DGW’s financial position (if it can be believed) reveals a pristine balance sheet, a strong platform for growth, and an excellent cash flow yield. I have attached a discounted cash flows model, with conservative assumptions, that can easily generate valuations at a 50 to 100% premium to the current price. The model is fairly rough and unconventional in places, but fairly self-explanatory. Thus, here, I will merely highlight some of DGW’s financial results that speak its compelling value at current levels. Full financial data are only available from 2009, at the time of DGW’s New York listing; still, this business is steady enough that a reliable picture can be drawn. As of Q2 2010, DGW carried no debt on its balance sheet. It has financed itself entirely through equity, which it has redeployed as capital expenditure, primarily to bring online a new manufacturing facility at Langfang, where many of its higher-margin products are made. This significant investment should reduce mandatory CAPEX in the near future. Elsewhere, the balance sheet has expanded at a rate above 50% for the last several years, though without significant growth in working capital. Inventory turn came down from 96 to 78 days over the previous FY. The company has weathered the rise in raw material costs since 2006 admirably, increasing gross margin from 35% in 2005 to 48% in 2009. Operating margin improved from 14% to 24% over the same time, and is on track to hit 32% for FY2010. A 2008 change in PRC corporate tax policy eliminated DGW’s privileged status and applied a standard rate of 25%, equity-financed CAPEX, reflected in long term asset growth, appears to be in the neighborhood of 10% of revenue. These charges have not materially harmed the bottom line; free cash flow is on track to grow 70% in 2010.
From a cash flow perspective, the company is doing even better than its statement of operations might indicate. In June 2009, in accordance with FASB rule 123r, DGW expensed the award of $12.6m in ordinary shares (2 are redeemable for 1 ADS) at par to its employees, making up a significant proportion of SG&A cost. This share-based compensation was a sub-CFO level award for services already rendered. Rather than an ongoing compensation expense, shareholders should view the award as a one-off, a reward made possible by the company’s American listing. Management claims, “Going forward, we anticipate employee share-based compensation expense to be minimal.” The effect was a large, non-cash hit to net income. The award was not tax deductible; excluding the impact of share-based compensation, net income would have risen pro forma 55.7% in 2009. Instead it declined 12.5%. Cash flow growth in 2009 was in excess of 30%.
Assuming flattening growth across all four business segments (circulating water treatment, purification, wastewater treatment, and spare parts), with wastewater gradually increasing its share of operations, it is reasonable to expect total sales growth over the next decade to range between 15% and 35% per annum. If we also assume that the company can maintain its recent operating averages both on the cost side and in stewarding its capital, it is likely that we will see consistent double-digit cash flow growth for the foreseeable future. There is a risk that management will find, as technology leaps forward, or as competitors enter the market, that this level of performance is more capital intensive than it has currently estimated. Duoyuan may take on debt; more likely there may be further dilution of existing shareholders. Further, the cost of being a market leader is increased competition. DGW may lose pricing power, or may be forced to invest more of the proceeds of growth in marketing. Fluctuating raw material costs pose another challenge; the company targets 40% or greater gross margin on all new products, but with most hard commodities in secular bull markets, this may be unattainable. Nevertheless, DGW has a number of structural advantages in sourcing, distribution, technology, and in its (so far) cozy relationship with the state. Economies of scale should mitigate some of the headwinds to profitability.
All told, assuming historical operating averages remain intact or decline somewhat (a fairly conservative assumption, in my view), a discounted cash flows analysis generates a ADR value of $28.55, more than a 100% premium to mid-September 2010 levels. If current growth and profitability trends persist, the value could be much higher. I have used a 10% (marginally below DGW’s WACC) discount rate that I believe is at least a fair opportunity cost of owning equities in a global slump. Chinese equities may deserve a higher discount rate; if so they probably deserve a perpetual growth rate above the 2% I have employed.
Catalysts
Besides being substantially oversold, there are a number of catalysts that make DGW an attractive play into the end of 2010. Firstly, because of the impact of 2009’s share-based compensation, net income for 2010 will have a relatively easy comp. The stock is not heavily covered; thus when the December 31 10K reports earnings growth of 120%, some heads on the Street may turn. DGW has beaten the EPS consensus three of the last five quarters. If there is to be any material appreciation in the renminbi (which looks unlikely at present), input costs at PPP will come down and the dollar value of American-listed shares will increase. At minimum DGW is insulated from adverse currency fluctuation. Finally, water is a theme that is attracting more and more institutional money managers as global shortages (this summer’s Russian fires being a key illustration) become more acute. Duoyuan is the clearest pure play on water in the PRC.
More compellingly, it is likely that the heft of political mandates for investment in wastewater treatment will increase in late 2010. Wastewater, now the largest revenue driver for DGW is the most important variable in cities’ water conservation efforts, and is an important health consideration. China’s 12th five-year-plan, to be released this year, is expected to heighten focus on efficient water use and environmentally sensitive development. Environmental protection occupies a new significance in the minds of China’s planners, who see leadership on environmental issues as critical to China’s economic development, the quality of life of a growing middle-class, and to its diplomatic position in the world. DGW stands to benefit from any explicit mention of water use in the forthcoming plan.
Conclusion
My bull position on DGW rests on the view that the market has mispriced the risk of owning a Chinese ADR listing, and views DGW as a higher beta play on the Chinese business cycle than it actually is. Its balance sheet is clean, its finances are conservative, and ROIC on the development of the manufacturing facility in Langfang (as well as R&D facilities planned near the Daxing headquarters) funded by IPO should be positive. Investors scared by the surprise and relative opacity of management’s share-based compensation award should not expect a repeat. The stock shows a cash flow yield of greater than 6% with respect to enterprise value, and FCF multiple of only 15 times based on my 2010 projections. Compare this to a 130x multiple for the Shanghai Composite, per Bloomberg in August 2010. Its enterprise multiple is below 3, while the Shanghai Composite averages near 7. If Duoyuan Global Water were not tarred by the brush of scandal at DPY, or by the froth of what Jim Chanos calls “the greatest credit excess of all time,” I believe value investors would be taking heed. The risk of an unknown unknown in Chinese stocks is always great. The perception of that risk, however, represents much of the downside, as rumors lead investors to fly to the exits. This has already happened in DGW. I would explore a small, non-core position, occupying no more than a few percentage points of my portfolio, at an entry below $14. It seems unlikely that a question over expense accounts at a separate company could shave 50% of the value off a name that was already cheaply valued. If the scandal blows over, and DGW’s numbers can be believed, the stock could trade in high twenties by early 2011.
DCF Model:
https://docs.google.com/leaf?id=0B_ipU5WJf9sJNGE1Yjc4NmUtYTg3Mi00YjZlLWFhYzQtZTc5NGQwODQ1MDc3&hl=en&authkey=CLOxhv8B
Disclosures and Disclaimers: This long idea should not be taken as a recommendation to buy or sell any security. This is an informational posting only. Both the author and the proprietor of this site have been and will cotinue to be invested in DGW at various points in time.
About the author: Josh Rowe is currently in the final stages of earning his PhD from Princeton University and will soon be looking for buyside employment in San Francisco.
By Josh Rowe
Introduction
On September 13, American depository shares of Duoyuan Global Water (DGW) were cut in half on worries over an accounting scandal at DGW’s sister company, Duoyuan Printing (DYP). Duoyuan Water and Printing share a chairman, Wenhua Guo, but have separate management teams; the CEO and CFO of DYP have been replaced. DYP also fired its auditor, Deloitte, and instituted an internal review of possible irregularities in its filings to the SEC. At the time of writing, it was not clear which numbers were in question, or whether, as some have speculated, DPY withheld information such as bank statements, distributor contracts, or expense accounts from its auditor. Notwithstanding the meltdown in the stock, there is nothing to link the controversy at DPY to Duoyuan Global Water, apart from Mr. Guo’s role as chairman of both companies. DGW is undertaking a preemptive third-party review of accounting standards, which may entail future headline risk. Regardless, with its market cap cut in half, fears are likely overblown.
The scandal is the third shock to weigh on investor sentiment regarding DGW since its listing in 2009. The first was of its own making; following a run up to $45, the company announced a secondary offering of 3.5 million shares (increasing the float some 11%), to which investors reacted negatively. The second was the slowdown in Chinese stocks as the PBOC raised deposit reserve requirements for lenders, putting the brakes on the credit-fueled bull market of 2009. I believe that neither of these first two negatives poses a serious obstacle to the long-term performance of DGW’s shares. Water is a secular bull market in China, dependent less on the global business cycle than on internal demographics. DGW’s secondary was not as dilutive as the subsequent share price drop would suggest, and is not necessarily a token of future dilution. $211 million in cash ($8.50 share diluted) lends ample room for expansion of capacity without tapping the equity market.
The third concern represents an “unknown unknown.” Due to Western investors’ persistent uncertainty about standards of transparency and corporate governance in the People’s Republic, the mere whiff of an accounting scandal is sufficient to seriously impact the credibility of a Chinese firm’s financial reports. Because DGW is listed in America and subject to the reporting requirements of the Securities Exchange Act of 1934, and because its relationship with its auditor, Grant Thornton, appears to remain solid, these sorts of risks should be less worrisome than in stocks traded only on Mainland Chinese exchanges. If the accounting irregularities are confined to Duoyuan Printing, and if a prospective investor is willing to accept the increased volatility of a Chinese-originated ADR, DGW represents compelling value over a several year horizon. Though we must acknowledge concerns over slowing growth in China and DGW’s potentially dilutive capital markets strategy, my conclusion is that these risks should not greatly affect long-term holders of the stock. The following paragraphs present the bull case for shares of DGW, predicated on its highly competitive market position in an area of secular and state-supported growth.
Reasons for optimism
Above all, market dynamics support a rising demand for DGW’s products, both within the PRC, and potentially outside. As a rapidly industrializing, urbanizing economy, China’s water needs should grow far in excess of cheap, reusable supply. According to a recent series of reports in The Economist, China has 21% of the world’s population yet only 6% of its renewable fresh water. In the water-poor North and West, conditions are particularly problematic—80% of the country’s water is in the more developed South, and the North China Plain that sustains much of the country’s agriculture is currently in drought. 67% of Chinese cities are in deficit; this is a large and growing problem, as China currently has over 150 cities with greater than 1 million in population. The average Chinese citizen subsists on only one quarter of the water per person of the world average.
Market research cited by DGW indicates that demand for water treatment products is expected to grow 15.5% per annum to 2012, and faster thereafter. DGW should benefit from increases in demand for water for personal consumption, industrial use, agriculture, and municipal water treatment alike. At present, 38% of the company’s revenues come from circulating water treatment products used in cooling and refrigeration, 22% from water purification (drinking water, food processing, the electronics and pharmaceutical industries), and 41% from wastewater treatment and reuse (municipal sewage, petroleum, paper).
This last segment should see the most robust growth. The company itself projects 45.5% increases in sales due to increased urban demand, government regulations mandating water treatment, and tougher enforcement of environmental protection laws. The latter are becoming a higher priority in state policy as newly wealthy Chinese consumers awake (as did Americans in the 1950s and 1960s) to aesthetic and health consequences of environmental laxity. DGW’s ambitious projections are supported by a number of political considerations and by the secular dynamic of urbanization. The current national budget allocates more than ¥150 billion for mandatory water conservation. This number should form a minimum baseline in future years. DGW’s expanded production capacity reflects its anticipation of at least a robust upgrade cycle.
56% of China’s population still lives in rural communities, often constrained by a hereditary registration laws that define residency as rural or urban, and determine land allotments. These laws are likely to be further liberalized, and the standards of living and social mobility offered by urban life continue to attract young Chinese to the many fast-growing cities. The Ministry of Housing estimates that between 2010 and 2025 some 300 million Chinese will move from rural areas to urban. Residential property markets in Hong Kong and Shanghai have recently come under scrutiny as high-end properties have traded at spectacularly high valuations. In second and third-tier cities, however, property price rises continue unabated, driven on by a strong fundamental demand dynamic. Most China watchers believe that urban migration is a process that has not approached its peak; as it grows, demands for water treatment and reuse will as well. This is not a bubble; it is a powerful, sustainable trend.
Appealingly, municipal water treatment is also a high-margin business for DGW. All of its products in this segment earn over 40% gross (frequently more) and technological developments in quality and efficiency drive pricing power. DGW’s microporous aerator, a new product in 2009 that has seen high rates of adoption, is one example. Using oxygenation to kill more than 98% of germs in wastewater, the microporous aerator competes at the high-end of the market. One of the beneficiaries of DGW’s equity offering, projected 50% sales growth rates in this product should provide adequate returns on capital. In recent years, R&D has shrunk somewhat as a share of revenue, but has grown significantly in absolute terms (net sales have increased by more than 32% each of the past three years). Particularly among its domestic competitors, the company is a technology innovator, and links its future strategy to remaining such. In the medium term, DGW is exploring licensing agreements with Israeli and American firms to bring highly efficient drip irrigation and membrane-based desalinization technology to its product portfolio. Though it is not discounted in the stock price, management recognizes that agriculture represents an enormous untapped growth market. There has also been some preliminary talk of partnerships with distributors in India. I would adopt a “wait and see” approach.
DGW has several competitive advantages in all of its business segments. Compared to international offerings from Veolia, Suez, or Thames, DGW (thanks to cheap labor) is the low cost producer. Domestic competitors cannot offer the same diversity and complementarity of product offerings. RINO, which provides water to the iron and steel industries, was a popular name with Western smart money in 2009. By contrast, the wide range of DGW’s businesses make it a less cyclical, more secular play. Unlike niche manufacturers leveraged to growth in particular industries, DGW is a WalMart-like “one-stop shop.”
DGW evidently believes its U.S. listing give it better access to capital and more brand prestige than its Chinese rivals. One of its largest expenses is a 12 million RMB CCTV 4 advertising campaign to convince distributors of its superior product quality. Selling costs have risen slowly and steadily on the back of this and other campaigns. DGW operates with a network of over 80 regionally diverse independent distributors; international competitors are often limited to one. By agreeing with distributors to yearly contracts, DGW is highly flexible to regional demand shifts, and maintains tighter control over working capital. Like an industrial company, DGW’s vertical integration permits volume discounts on raw material, and improved workflow from standardized practices across segments. Like a high-tech company, its relative small size and investments in R&D give it an edge in energy efficient and non-chemical water treatment technologies.
Financial analysis
An analysis of DGW’s financial position (if it can be believed) reveals a pristine balance sheet, a strong platform for growth, and an excellent cash flow yield. I have attached a discounted cash flows model, with conservative assumptions, that can easily generate valuations at a 50 to 100% premium to the current price. The model is fairly rough and unconventional in places, but fairly self-explanatory. Thus, here, I will merely highlight some of DGW’s financial results that speak its compelling value at current levels. Full financial data are only available from 2009, at the time of DGW’s New York listing; still, this business is steady enough that a reliable picture can be drawn. As of Q2 2010, DGW carried no debt on its balance sheet. It has financed itself entirely through equity, which it has redeployed as capital expenditure, primarily to bring online a new manufacturing facility at Langfang, where many of its higher-margin products are made. This significant investment should reduce mandatory CAPEX in the near future. Elsewhere, the balance sheet has expanded at a rate above 50% for the last several years, though without significant growth in working capital. Inventory turn came down from 96 to 78 days over the previous FY. The company has weathered the rise in raw material costs since 2006 admirably, increasing gross margin from 35% in 2005 to 48% in 2009. Operating margin improved from 14% to 24% over the same time, and is on track to hit 32% for FY2010. A 2008 change in PRC corporate tax policy eliminated DGW’s privileged status and applied a standard rate of 25%, equity-financed CAPEX, reflected in long term asset growth, appears to be in the neighborhood of 10% of revenue. These charges have not materially harmed the bottom line; free cash flow is on track to grow 70% in 2010.
From a cash flow perspective, the company is doing even better than its statement of operations might indicate. In June 2009, in accordance with FASB rule 123r, DGW expensed the award of $12.6m in ordinary shares (2 are redeemable for 1 ADS) at par to its employees, making up a significant proportion of SG&A cost. This share-based compensation was a sub-CFO level award for services already rendered. Rather than an ongoing compensation expense, shareholders should view the award as a one-off, a reward made possible by the company’s American listing. Management claims, “Going forward, we anticipate employee share-based compensation expense to be minimal.” The effect was a large, non-cash hit to net income. The award was not tax deductible; excluding the impact of share-based compensation, net income would have risen pro forma 55.7% in 2009. Instead it declined 12.5%. Cash flow growth in 2009 was in excess of 30%.
Assuming flattening growth across all four business segments (circulating water treatment, purification, wastewater treatment, and spare parts), with wastewater gradually increasing its share of operations, it is reasonable to expect total sales growth over the next decade to range between 15% and 35% per annum. If we also assume that the company can maintain its recent operating averages both on the cost side and in stewarding its capital, it is likely that we will see consistent double-digit cash flow growth for the foreseeable future. There is a risk that management will find, as technology leaps forward, or as competitors enter the market, that this level of performance is more capital intensive than it has currently estimated. Duoyuan may take on debt; more likely there may be further dilution of existing shareholders. Further, the cost of being a market leader is increased competition. DGW may lose pricing power, or may be forced to invest more of the proceeds of growth in marketing. Fluctuating raw material costs pose another challenge; the company targets 40% or greater gross margin on all new products, but with most hard commodities in secular bull markets, this may be unattainable. Nevertheless, DGW has a number of structural advantages in sourcing, distribution, technology, and in its (so far) cozy relationship with the state. Economies of scale should mitigate some of the headwinds to profitability.
All told, assuming historical operating averages remain intact or decline somewhat (a fairly conservative assumption, in my view), a discounted cash flows analysis generates a ADR value of $28.55, more than a 100% premium to mid-September 2010 levels. If current growth and profitability trends persist, the value could be much higher. I have used a 10% (marginally below DGW’s WACC) discount rate that I believe is at least a fair opportunity cost of owning equities in a global slump. Chinese equities may deserve a higher discount rate; if so they probably deserve a perpetual growth rate above the 2% I have employed.
Catalysts
Besides being substantially oversold, there are a number of catalysts that make DGW an attractive play into the end of 2010. Firstly, because of the impact of 2009’s share-based compensation, net income for 2010 will have a relatively easy comp. The stock is not heavily covered; thus when the December 31 10K reports earnings growth of 120%, some heads on the Street may turn. DGW has beaten the EPS consensus three of the last five quarters. If there is to be any material appreciation in the renminbi (which looks unlikely at present), input costs at PPP will come down and the dollar value of American-listed shares will increase. At minimum DGW is insulated from adverse currency fluctuation. Finally, water is a theme that is attracting more and more institutional money managers as global shortages (this summer’s Russian fires being a key illustration) become more acute. Duoyuan is the clearest pure play on water in the PRC.
More compellingly, it is likely that the heft of political mandates for investment in wastewater treatment will increase in late 2010. Wastewater, now the largest revenue driver for DGW is the most important variable in cities’ water conservation efforts, and is an important health consideration. China’s 12th five-year-plan, to be released this year, is expected to heighten focus on efficient water use and environmentally sensitive development. Environmental protection occupies a new significance in the minds of China’s planners, who see leadership on environmental issues as critical to China’s economic development, the quality of life of a growing middle-class, and to its diplomatic position in the world. DGW stands to benefit from any explicit mention of water use in the forthcoming plan.
Conclusion
My bull position on DGW rests on the view that the market has mispriced the risk of owning a Chinese ADR listing, and views DGW as a higher beta play on the Chinese business cycle than it actually is. Its balance sheet is clean, its finances are conservative, and ROIC on the development of the manufacturing facility in Langfang (as well as R&D facilities planned near the Daxing headquarters) funded by IPO should be positive. Investors scared by the surprise and relative opacity of management’s share-based compensation award should not expect a repeat. The stock shows a cash flow yield of greater than 6% with respect to enterprise value, and FCF multiple of only 15 times based on my 2010 projections. Compare this to a 130x multiple for the Shanghai Composite, per Bloomberg in August 2010. Its enterprise multiple is below 3, while the Shanghai Composite averages near 7. If Duoyuan Global Water were not tarred by the brush of scandal at DPY, or by the froth of what Jim Chanos calls “the greatest credit excess of all time,” I believe value investors would be taking heed. The risk of an unknown unknown in Chinese stocks is always great. The perception of that risk, however, represents much of the downside, as rumors lead investors to fly to the exits. This has already happened in DGW. I would explore a small, non-core position, occupying no more than a few percentage points of my portfolio, at an entry below $14. It seems unlikely that a question over expense accounts at a separate company could shave 50% of the value off a name that was already cheaply valued. If the scandal blows over, and DGW’s numbers can be believed, the stock could trade in high twenties by early 2011.
DCF Model:
https://docs.google.com/leaf?id=0B_ipU5WJf9sJNGE1Yjc4NmUtYTg3Mi00YjZlLWFhYzQtZTc5NGQwODQ1MDc3&hl=en&authkey=CLOxhv8B
Disclosures and Disclaimers: This long idea should not be taken as a recommendation to buy or sell any security. This is an informational posting only. Both the author and the proprietor of this site have been and will cotinue to be invested in DGW at various points in time.
About the author: Josh Rowe is currently in the final stages of earning his PhD from Princeton University and will soon be looking for buyside employment in San Francisco.
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