This week's pullback is just a test

After some lofty gains, the market has pulled back sharply the past 2 days. I actually see this as a normal pull back after a large run up. The DOW surged 3% since August 1st and the NASDAQ 4%. Also, note the resistance today - the NASDAQ has climbed back to almost even.

Part of the problem is that there is very little real news and data until Friday the 15th. Meanwhile, the conflicting signals from the cooling economy and the tight jobs market is making the market jittery. It's all about the Fed. Will he or won't he.

I could spin any number of scenarios that would justify a rate hike or continued pauses. I certainly don't see a rate reduction in the face of job inflationary pressures and continued consumer spending.

I will point out that low unemployment and wage pressures are classic signs of the last phase of a business cycle. And wage pressure matters because salaries are the biggest inflationary contributor. Oil prices have surged 50% in the past year, but the impact on prices has been neglible. CPI is running at less than 3%.

So we can stack on one side a list of inflationary signs (wage pressure, higher than desired CPI, tight job market) and we can stack on another side deflationary signs (falling steel prices, softening oil prices, negative CPI last month, falling housing prices). I think that the Fed knows the housing market will drag the economy down and that will temper inflationary pressures more than a 0.25% increase in interest rates.

Meanwhile, I like the resistance I've seen the past five days in certain stocks:
DO - Still up 5% (and up today all day)
ESV - Up 5%
GRP - Up 2.5%
GLBL - Up 1% (and up another 1.5% today)
ILMN - Flat
JLG - Up 6%
KSU - Up 1.5% and up 0.5% today
OCN - Flat
ZOLT - Up 5% (and up 2.3% today)
TTI - Up 4%

And so on. Notice that the oil equipment companies are doing very well.

Short WM (Washington Mutual)

This comes from Barron's. Lon Witter wrote that there has not been a housing bubble but a lending bubble.

• 32.6% of new mortgages and home-equity loans in 2005 were interest only, up from 0.6% in 2000;
• 43% of first-time home buyers in 2005 put no money down;
• 15.2% of 2005 buyers owe at least 10% more than their home is worth (negative equity);
• 10% of all home owners with mortgages have no equity in their homes (zero equity);
• $2.7 trillion dollars in loans will adjust to higher rates in 2006 and 2007.

I actually believe that this understates the nature of the problem. I believe that all homeowners who bought 2004-2006 will find that they owe more than their home is worth. I base this on the fact that year-over-year prices will be negative. That is, 2006 prices will be lower than 2005 prices....which means that they are at 2004 prices. And dropping.

Many folks say - this is not a problem. It's paper money until they have to sell.
Those folks are incredibly wrong. Because the mortgage payments are not flat but rising. Almsot everyone who bought in the last 3 years is financially overextended - they used ARMs to get the most house they could afford. Now those mortgages are racing up. If they sell, they sell at a loss.

I look at WAMU and I see major problems. WAMU is at the heart of the home financing game. Also, WAMU has some major accounting exposure. The issue is an accounting method called accrual accounting. In accrual accounting, a bank can book profits based on contracted payments and not actual cash.

That is, if a homeowner borrows money and agrees to pay an amount of money but actually pays less, the bank books the full amount owed and NOT what was paid. They book the payment plus the IOU. In other businesses, an IOU is not booked - it's an IOU. banks book it as payments.

It has two impacts. It pushes up profits in the near term. If the payment doesn't happen, it pushes profits down even deeper. That larger swing is what concerns me.

How widespread is this issue? Consider Interest Only Loans and Option ARMs. In both loans, the Bank books the contracted amount an dnot what is actually paid. Option ARM borrowers, for example, can pay a minimum amount that is less than the full amount and that difference gets added to the total loan amount. About 80% of Option ARM borrowers pay only the minimum.

Interest Only loans also offer low payments today in return for an ever increasing loan value. What you don't pay today gets added to the total payment at a compounded rate. A great idea for borrowers when the housing market was surging and the asset price was growing fsater than the loan amount.

WAMU can book as profit today the difference between the original loan amount and the growing loan amount.

You don't have to analyze this too much. Borrowers can pay more, default, or re-finance at high costs ($10K refinancing penalty and a mortgage about 40%+ higher than original). These are all just versions of bad, worse, and terrible for WAMU. Because no matter what, WAMU's profits will drop.

It doesn't matter how much of their loans WAMU has sold on. Simply ending the high profit from these loans is a problem for WAMU.
WAMU has $12.5B of these loans on its books today, up from $2.5B in 2005. In 2005, these loans accounted for $31M in WAMU profit (I'm looking for the source of that figure). That would be $160M for this year. If these loans stop being written, that's a 5% drop in earnings.

Another area of weakness is the drop in mortgage activity. Home sales are down 30%+ year over year. That's thousands of dollars in fees per home sale that they are losing. I would say about $100M in lost revenue - which is about 100% margin. Another 3%~5% drop in earnings.

Next, if home prices drop, so does the value of the mortgages and therefore the value of WAMU's income.

It's easy to see a minimum earnings fall of 10%.

Meanwhile, notice that I haven't mentioned defaults at all. I am not discussing the future state of housing. I am merely talking about key revenue earners for WAMU that will be rapidly disappearing.

Now throw in defaulting loans, and WAMU is not sitting pretty. They have $351B in assets of which $306B is home mortgages. Coincidentally, that is also their debt. Some percentage of their loans will go bad. If even 1% default, that's a $3B loss. Spread that out over 3 years, and that's 30% drop in earnings.

Intel & JNPR

Intel is announcing major corporate changes today. Expect a jump in INTC share price because they are telling the market how they expect to improve.

If it is a large layoff (rumors are for 20,000), that probably means a shift to outsourcing. I expect large Indian companieds to benefit.

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JNPR is rumored to have a big win at Verizon. That is hurting our JNPR puts. Patience, though. JNPR needs a lot more than 1 deal to look good.

Intel & JNPR

Intel is announcing major corporate changes today. Expect a jump in INTC share price because they are telling the market how they expect to improve.

If it is a large layoff (rumors are for 20,000), that probably means a shift to outsourcing. I expect large Indian companieds to benefit.

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JNPR is rumored to have a big win at Verizon. That is hurting our JNPR puts. Patience, though. JNPR needs a lot more than 1 deal to look good.

LiveRocket Week 13 Turbo Performance - down 1.6%

Here is the bi-weekly update on the 2 week performance.
We have a portfolio value of $104,166. After Margin, that's $82,267. That's down $1K since 2 weeks ago.






Remember - this is a volatile portfolio. Especially the options. For that reason, I review only bi-weekly.

Here is a review of the stocks and options in the portfolio:
AMX: Still creeping up. They are susceptible to Mexican politics but overtime this should be a nice addition.
DO: Some improvement since 2 weeks ago. There was weakness until this week and suddenly the market renewed interest. In fact, the technicals are very hot.
GRP: Still flatlining. Neither up nor down. Still down 11%. Patience is the key here.
NUAN: Still flatlining. Neither up nor down. Still down 13%. The trend to go to voice is very much alive. The question is whether NUAN will get the most benefit. Blackberry announced their voice move http://yahoo.reuters.com/news/articlehybrid.aspx?storyID=urn:newsml:reuters.com:20060901:MTFH60034_2006-09-01_21-30-51_N01448384&type=comktNews&rpc=44
But they aren't using NUAN. In any event, cell phones and voice recognition make perfect sense. Text entry is a pain with cell phones. However, major market acceptance is still years away. There are also various rumors here regarding Microsoft entering the market with Vista and giving away voice technology. MS is no threat because PC voice-text is not competing with NUAN. If anything, MS will be accelerating market demand for voice based text entry by introducing it to millions of users. Also, NUAN targets the business users and they will not tolerate the faulty MS speech quality. It will be easier for them to move downmarket to GPS and cell phone devices.

STX: Nice recovery. We were down 8% and now down 3%. I think the slight downturn 2 weeks ago was caused by insiders selling 5M shares 2 weeks ago.

TTI: Some slight improvement. TTI seems stuck at $28. I guess we have to wait for another stellar quarter.

ZOLT A great rebound. We were down 37% and have recovered to being down 'only' 17%.
http://finance.yahoo.com/q/bc?s=ZOLT&t=5d&l=on&z=m&q=l&c=
The volume the last 2 days has been strong. Possibly some squeeze plays (it was the end of the month). I notice that several farms in Iowa are looking to build major windfarms. The largest user of ZOLT's carbon fibers is wind blades for wind farm wind mills. The economics of the windmill are driven by blade size. Bigger is better. And at a certain size, carbon fiber is the best material.

ZRAN Still down 33%. The recent class action lawsuit didn't help. I don't think these lawsuits will go very far. Meanwhile, ZRAN will continue to hit afterburners.

Notes: 1 - an option contract equals 100 shares and the listed prices are per share
2 - Current option price is the bid price (the price you would get, which is lower than the price you would pay)

TIE Calls (Dec 50) 21 contracts @ $4. These are almost worthless, so we are going to hold on to them. I think TIE is poised to make a solid run up, which would make these recover a bit.

TRID Calls (Jan 22.50) 20 contracts @ $4.1 What a difference 2 weeks makes. TRID almost hit $22. And on strong volume. We have 5 months of life here and I can see $30 before January easily. That would be a good pop up.

BMHC Puts (Dec $25) 40 contracts @ $2.2. BMHC keeps staying above $25, which is ridiculous. Patience will be in our favor. We are up some, but I see us being up a lot more.

JNPR Puts (Oct $14) 109 contracts @ $0.55. JNPR has remained at $14 after falling towards $12. I expect them to lower expectations between now and October, and we will be ahead again.

CFFN Oct $30 puts 100 contracts @ $0.3. Now at $0.2. Ridiculous. I feel stupid for not finding a better sub-prime bank to short. I think we will just accept the loss and look at shorting WAMU.

ETH - Nov $30 Puts 50 contracts @ $0.8. This stock has surprised me. It is resilient, but it will crash back down. It has only bad news to offer investors.

WHR -Dec $70 puts 15 contracts @ $3.5. Same as ETH. Patience will pay off.

CPWM - Nov $12.50 Puts 50 contracts @ $0.6. CPWM recovered a bit but that's in the short term. There is no goo dnews as we head into the holidays.

NVL - Dec $20 Puts 20 Contracts @ $1.9. It droppde below $19 this week before rebounding 10%. More bad news but the stock moves up. The CEO was fired. They are closing some European offices and taking a write off. Earnings for 2006 were lowered even further. But this dog moves up. It's only a matter of time.....I think the <$19 drop was a sign or more to come as they test the downside and bigger investors pull out.

RSH - Jan $15 Puts 25 contracts @ 1.15. They got some publicity this week for firing headquarters staff via email. Meanwhile, the stock moved up - people like to see a leader take charge and do some house cleaning. I think it is just lipstick on a pig, and we have a few months to see.
Supposedly there is a bid to take RSH private. That rumor helped investors even though it was strongly denied.

Overview of Key Trends

A few thoughts on major market trends.

Housing continues a death spiral and the extended players are getting affected. The stocks have recovered a bit from recent housing news, but the trend is obvious.

Home building - Home builders are in a unique situation. A slowdown in housing construction immediately leads to an inventory buildup in construction materials. Builders are able to maintain margins by squeezing suppliers. Subcontractors like BMHC are in their sights as well. TOL has a solid cash position but BMHC has $800M debt and $742M cash and assets, of which almost $200M is inventory. They are leveraged, their key assets have deteriorating value, and they are not creating much cash. BMHC hopes to survive thanks to economies of scale, but none exist when the market turns down.

Furniture - ETH announced that sales are slower than they expected barely 1 month ago. Interestingly enough, Yahoo news includes under ETH headlines a reference to a fabric company that is firing 225 employees. Demand must be really dropping. Indeed, Williams Sonoma announced that Pottery Barn sales are slowing faster than expected. "The consumer response in Pottery Barn is continuing to trend well below our expectations, causing us to approach the third and fourth quarters with an extremely cautious outlook," said Chairman and Chief Executive Howard Lester.
Watch them go after sales by sacrificing margins. Retailers will squeeze vendors very hard to recover that free interest being offered.

Home furnishings - CPWM pulled back from a low because of some positive news from Target. The problem is that Target is eating into CPWM's sales. I am thinking FO is also very much at risk except that they are so diversified, a slowdown in faucets won't stop their march significantly.

Consumer Durables - Despite obvious signs of weakening sales, WHR and others are maintaining stock strength. WHR look sparticularly vulnerable to LG's (Korean company LuckyGoldstar) foray into the heart of their business. The LG washing machines are both cheaper and better rated than WHR's. It is noteworthy that the EU just fined LG for dumping - that indicates aggressive competitive pricing. http://biz.yahoo.com/ap/060831/eu_south_korea_refrigerators.html?.v=3
"Average prices fell 5 percent while the South Koreans undercut European manufacturers -- such as Electrolux AB and Siemens AG -- by between 34.4 percent and 42 percent."
WHR's margins are under pressure and it has announced that in the face of slowing unit sales in the US, that the company will preserve margins by raising prices. Price increases are hard in the face of aggressive competition.
It is remarkable that WHR tried to be part of the EU duty impact, except the EU pointed out that WHR products are not made in the EU and so can not be a victim of dumping in the EU.

Lastly, what is the state of affairs with respect to consumer spending? This one is more mixed. A downturn in the US housing market will be more painful and widespread than expected. It will affect the high end and low end markets.

Most economists expect a housing slowdown to knock off 1% from GDP. They say this because construction drives a lot of employment and manufacturing (via the use of raw materials and machinery). Also, and especially in the past few years, homeowners dipped into the house equity as an ATM machine.

The GDP is running between 2%~3%. It averaged ~3% for 6 of the last 8 quarters, and the recent GDP is smack in the middle of 2005/2006 performance. While we are slowing from a frothy 5% in Q4 2005 and Q1 2006, we are not suddenly falling off the cliff.

We are trending down and the housing market will accelerate that trend. Consumer spending drops in these circumstances. However, I don't think that the damage will show itself until AFTER this holiday season. TRID, for example, will do well because flat panel TVs will be the item this year.

Other companies to consider shorting as we slow down:
Tiffany's (TIF) released earnings that show margin problems.
Sothebys (BID) as a business is not showing much strength: expected sales growth of 7% and earnings growth of 20%. With a forward P/E of 20+, BID is not overpriced. Unless there is a slowdown in wealth.

Week 42 LiveRocket Performance up 1.33%

We bought back in Thursday and our 2 day yield was pretty solid.

I mentioned that I wanted to buy LEAPs instead of shares and that would have been a very nice move for the week, probably adding 10% thanks to the oil/gas equipment companies. However (there's that dreaded H word) I keep thinking that LiveRocket should be strictly shares and Turbo is where we do more exotic option plays.

In addition to the shares, we still have ~$11K in cash

AET - Down on low volume. I like that one of the Sr VPs just bought $1M worth of shares in a Direct Purchase. Indeed, the MACD has turned positive for the first time since April - indicating a more positive environment.
EMT - EMT moves with the Latin American markets. In any case, we are going to lock in some gains and move on. There is an upper limit of $16 on this stock due to the buyout offer. We will earn ~7% in a few months.
ESV - Up 7% in 2 days and on solid volume. All oil rig companies are doing well. More contracts are showing a virtual bidding war for rigs. Also boding well for the future, the technical aspects of this stock have stabilized and may begin trending positive. Considering the 7% gain, that's exciting.
GLBL - Up 3.3% in 2 days and 5% in 1 week. Volume was also good. What I like about GLBL is the sizeable cash build up.
GRP - Up 5% in 2 days (after bouncing off $40). Of all the oil equipment companies, GRP seems to have the best cash position.
ILMN - Enjoyed a little bump up, possibly due to a Motley Fool mention. Remember, this is a risky choice not only because it is small and in a niche market, but there is a lawsuit.
ISIL - This baby is back. I meant to buy closer to $23 but wanted to see it bounce off and move up. It did.
KSU - Nothing to report.
OCN - We bought after a downgrade brought a 11% correction. The play here is the foreclosure market. OCN, for example, is the #1 handler of VA foreclosures. Sadly, many veterans are not on solid financial ground and are very exposed in a housing downturn. I think that this is the right play, but I want to be careful. This one is a risky choice.
T - In choosing between T and Q, I went with the dividend payer. Also, I like T's positioning with Cingular because cell phones seem undervalued to me. One thing about T - the MACD has been a powerful predictor for the past year. It is flattening out.
TRID - We are getting into their prime season. Lots of positive news should push it up strong. Especially if the GDP stays above 2%: investors won't be as worried about consumer products at that level. Strong volume and the technicals are also showing strong interest in TRID
UCTT - No news. This is a thinly traded, small cap stock. But Those are the ones that grow and offer us the earnings surprises

KSU Revisited

This is a great map for showing the KSU opportunity. The ability to take business away from the US West coast ports is a coordinated affair involving both the US and Mexican governments, the local state governments, as well as many global business players.

KSU will be the means by which Walmart, Home Depot and much of Chinese and Japanese manufacturers will reach their US markets. The scale of the endeavor is breathtaking as is the impact.