Dead Men Walking

Too many Hedge Funds, banks and lenders are dead men walking. They continue to move and talk and walk but it is just a matter of time before the cord is cut.

Citigroup is probably one of the most zombie-like. The waited untl after markets closed friday to announce that they would include the SIV on its balance sheet. The SIV is the packaging around the CDOs which, in itself, is just a packaging of mortgages and associated loans.

Citi's SIV contains $58B in debt, $13B in cash, and $49B in CDOs. In essence, $107B of non-performing nightmares. Citi has $2.3T in assets, so this is ~5% of their position. They have to raise cash - which means selling assets, paring back expenses, and making fewer loans.

And then there is the Bank of America fund that refuses to let investors access their money. Some $31B is unavailable, meaning it is invested in CDOs that are worthless.

A third datapoint I want to raise is the clear inability of the Fed to influence the credit markets. In less than 3 months, the Fed has lowered interest rates a total of 100 basis points (1%). Yet mortgage rates stay flat.

The 30 year mortgage rates are flat and even up since the recent cut.
The 3 Year ARM rate is also up since the recent rate cut, and is down only 40 basis points.

Part of the rate flattening comes from the return of the risk premium. But the rest really has to do with inter-bank lending. Go back to the Citi group and BoA examples: both major lenders need cash to stay afloat. A mad scramble for credit is driving up lending rates. And with BoA, the bigger problem is that their investors ($25M is the minimum investment in that fund) can not get to their assets. Everybody needs cash but nobody has it.

This is the liquidity problem facing the world credit markets. But there are really 2 parts:
1. Access to cash and credit - This is handled easily. There is plenty of cash around, and the market is already responding to the higher demand. One way is to charge more for loans. The other is for Central Bankers to print and provide more cash.
2. Eradication of wealth. Much of the money that flows through today's sytem derives from leverage. A $1 deposit gets loaned out by Citi until it is $10 in loans. A market crash or default in loans erases assets (aka cash or wealth). The drop in a stock price should not be more than a loss of paper profits, except that hedge funds used the paper profits as leverage for more buying and lending.
The chain breaks. At the minimum, no more buying can take place. But generally a frenzy of raising cash occurs - Investors may demand money back, forcing the fund to sell assets, further eroding values. Or funds may want to borrow and their assets are not sufficient because the value has dropped.

At heart, this is actually a healthy thing. Assets inflated beyond common sense are returned to reality. So why the panic? Why is Mauldlin posting a panicky newsletter spreading doom and gloom? Money is very cheap and very available. If money were a problem, how could someone borrow $300B to buy ETrade assets last month?

Sure, money just got more expensive, but it is low in nominal terms, in absolute terms, and even historically. Sure, it isn't 1%, but neither is it 10% like it was in the recent past. And 6% is not that bad in absolute terms, especially considering the availability of gnerous terms (I get plenty of offers from credit agencies for 0% rates for 12 month loans). And speaking nominally, 6% is really just inflation plus 2% (I am, of course, speaking of real inflation rates that the economy faces and not the doctored CPI).

So the first part of the liquidity issue - scarcity of funds - is really a non issue. It's certainly tighter, but China, Russia and the Arab states have Trillions of dollars to spare.

The reason for the panic - fund managers are realizing that they are soon to be jobless. mauldlinand his chums atthe funds are scared for themselves, not the economy at large. For the broader economy, the liquidity problems are overstated. Let me repeat - there is plenty of money. It may be a tad more expensive, but there is plenty of it. And it's likely that there will be plenty of funds and money managers looking around desperate for investors.


The big losers are these funds and money managers. Asset value is the next big loser. Because fire sales erode prices. And with funds on the run, they will not be able to bid up stock prices. That was the defining moment of the dotcom crash - suddenly nobody was buying and stock prices aligned with actual sales and profits. Actually, they went below.

The outcome is simple to see:
1. Stock prices will ease without massive foreign investors
2. M&A activity will shift focus away from growth through acquisition and instead become a part of staying alive
3. Asset devaluation will make property values drop fast
4. Cash is King

Holding off for now

The market going below 13,400 has me concerned.

Since Tuesday the Market has been trying to drop below 13,400
Tuesday - dropped from 13,850 to 13,375 before closing at 13,433
Wednesday - dropped from 13,779 to 13,367 before suddenly lurching up in the last 15 minutes to close at 13,474
Thursday - dropped to 13,379 and surged 115 points in the last 2 hours
Friday - dropped 100 points at opening to 13,400...and is continuing to tread there

Does that speak to underlying strength and building a base at 13,400? It could be a sign of healthy consolidation. The last big run-up from August-October also had a series of ups and downs, but each down was progressively higher than the previous dip.

In this latest move up since the 11/26 crash, we have had one dip: 12/4 the market went from 13,371 to 13,248. Whereupon it moved over the next few days to 13,727.
We are experiencing a pullback that remains above the last dip: 13,400 vs. 13,248.

That seems positive. My only concern is that the way the trading is going does not suggest broad based buying but sudden, targeted moves to buy stock and get the market up.

That is:
Positive: consolidation
Negative: Recent rally over Fed moves is over. The move up since 11/26 was a dead cat bounce. We are heading back to 12,700

I will wait til Monday it seems

The Fed's desperation: Trying to Prop up Housing Again

What do you call it when assets double in a few short years? Most folks call it hyperinflation. That's what happened with housing. As the mess unwinds, a few folks are caught out: new homebuyers, construction companies and lenders. Other folks, like the overwhelming majority of Americans, would actually benefit from home price deflation.

To begin with, raw materials would get cheaper. More importantly, folks who really can afford housing would be able to buy in. Lets face it, the economy benefits when the stakeholders are stable.

But, alas, the Fed just can't keep their hands off. First, they reduced the cost of borrowing by 1%. Citigroup and other lenders now have lower costs to service the loans that they took out to cover their positions. That helps cash flow dramatically. But the underlying problem remains: what do you do with $1T of debt that won't get paid back anytime soon?

The Japanese faced the same dilemna in 1990 when their housing market bubble burst. EXACTLY. THE. SAME. Lenders had tons of non-performing loans on their books. So the Central bank of Japan created a fund and bought these underperforming loans. The idea was that banks - no longer weighed down by bad debt - would start lending again. Instead, Japan fell into a ~15 year economic malaise. This was primarily due to folks living under the massive debt.

Interestingly enough, because of the safety net, Japanese banks continued to make loans that had weak chances of being repaid.

At the end, Japanese homes were worth 1/10 of their value at the height of the boom.
The Japanese consumer reduced spending and Japan entered a deflationary spiral.

I was there throughout the late 80s and into the 90s. I saw the excess first hand. I was a Research Fellow at the Kyoto University Institute of Economic Research from 1989-1990. My area of study was Japanese consumer spending trends. I studied the conspicuous spending habits and I was able to speak with Industry leaders, all of whom felt the Japanese consumer would never be price sensitive. Ooops.

It is from this experience that I am able to look at the US market. The US economy is a lot different from Japan's. Our economic system is a lot more stable. But we are also a lot more dependent on debt and on services, whereas the Japanese had lots of cash and actually made things.

The point I am making: a severe reduction of wealth coupled with massive debt will occur and will affect a great many consumers and thereby push down the US economy. That is a fact. The other side is that anyone with cash and patience will find themselves much wealthier.

The cornerstone is individual debt. Nothing the Fed or the White House is doing will in any way change that debt load. The only thing that will help out the homeowner is for prices to increase 20%+ and that isn't going to happen. And folks who think that they are rolling in the paper profits because they bought back in 2001 - you better think again. We are heading for 1999 prices in nominal terms. You will be underwater as well.

The problem for the individual debtholder is different from the lender debt holders. An individual homeowner has debt and a house. They can liquidate the house and use the proceeds to pay off all or most of the debt. Lenders face the liquidity problem. They have debt and then they these pieces of paper that are backed by housing property. Those are often called CDOs.

The problem is that there is no market for CDOs. Nobody is buying, so they have no value.
http://www.bloomberg.com/apps/news?pid=20601087&sid=ameYYjeqjIDA&refer=home
All CDO sales are down by over half and Subprime CDOs don't exist.

And now lenders face a fire sale. First, they have to increase capital in reserve because - by law - they must maintain a ratio of capital to loans. With the CDO value down, their capital position is down. It's now a downward spiral: the more they declare the CDOs are reduced in value, the more cash they need. And the more urgently they need to sell the CDOs.

The second cause of the fire sale is the tax year is over in a few weeks. They have to clear the books up. Now. Not in a year. And nobody will buy these CDOs, so they are worth $0.

Imagine the pandemonium if Citigroup had to declare $49B of CDOs were worthless. Assuming that the $49B in CDOs was used for lending, pandemonium will occur. Citi needs to find $49B to back up their loan positions. That means massive selling of assets, and no lending. For world markets, that means a great day - companies will get assets on the cheap. Other lenders can step in where Citi vacates. But Citi gets hurt. Boo hoo.

I am not exaggerating, by the way. Citigroup has $49B in subprime CDOs. Citi hasd to put a value on them or face the consequences I describe. It really is that bad. Major lenders will be goin gunder and absorbed. The markets will be roiled.

To try and soften the blow, the Fed is now going to buy Citi's assets. Just like Japan did in the 1990s.
http://news.bbc.co.uk/1/hi/business/7143823.stm

The Fed is going to loan Citi money and allow the CDOs to be used as collateral. They are pricing the CDOs at 85% face value. Now, this is obviously chicanery at its finest - the market value for the CDOs is 30% of face value for subprime (I know, I said the CDOs were worth $0, but I was exaggerating a bit).

In being generous, the Fed accomplishes a few things.
1. Citi gets maximum cash - they really need cash and they wil lget what they need
2. A value is placed on the CDO. Suddenly, there is a market for the debt and an artificial floor is created
3. The worthless asset is moved (temporarily) off the books

Technically, the isn't buying the debt. But they have created a value for it.
The government has to avoid the stigma of bailing out the lenders from their own self inflicted stupidity. Whether or not it is a good thing, folks do not want the taxpayer to foot a $1T bill for banks. And the US budget can't afford it.

So the Fed is only making a loan and at some point Citi will repay it. Maybe like Chrysler did. But this is really accounting chicanery. The entire premise is built on the faulty concept that housing prices will stabilize. They won't. So the CDOs will fall in value.

I doubt that Citibank will default. But a few years down the road, maybe the $49B loan is re-negotiated to $10B.

I won't say if this is good or bad. It does prevent a very painful scenario. I do think it postpones the day of reckoning, and that we will see economic malaise.

Most folks are starting to get the message. They shouldn't buy houses that are 10x their salaries. To remind them of this concept, lenders are back to setting stricter terms. I don't think we'll see very many $40K salaried secretaries buying $1M homes because they will need a $200K downpayment.

The only guarantee is this: come next year, bankers will be back to giving themselves huge bonuses.

Black & Decker sinks

http://sev.prnewswire.com/construction-building/20071214/NEF014A14122007-1.html
I said to avoid tools and anything construction related....

Everyday, one of these major companies will be revealing the truth about the massive downturn caused by the artificial housing boom

Aha - Foreign Money IS flowing in

Connect these dots:

• Citibank - money from an oil country
• HSBC - Money from Singapore and another oil country
• JetBlue - Money from Lufthansa
• Genesis - Money from Germany (STM)

On a one-off basis, maybe nothing. I've been saying for years that at some point JetBlue would partner with an overseas airline. And GNSS was waiting to get acquired.

But dig deeper and you'll see the pattern - foreign money. I've been saying that we would see foreign acquisitions and it's starting.
That makes me very excited. Now I understand why our stocks aren't dropping - foreigners see how cheap many of our companies are.

And this is a great way to recycle dollars just sitting around and eroding. I bet China is spreading dollars around like crazy, albeit under the radar.

I am excited because this points to a bottom.

I had expected another down day and indeed, it was heading that way: at 2pm NASDAQ qas down 1% and the Dow was down 0.5%. Then BOOM a massive buying spree shoves both up 1%. That's huge. I think it's partly the Fed buying as well as other Central banks.

So here's the thing. The Market clearly is feeling negative. It's shrugged off the ridiculous Fed and White House moves. Yet again, LIBOR rates are flat after a Fed rate drop. Yet another day and yet another announcement by a bank or lender that they need another few $ billion to cover losses tied to housing. Yet again we are seeing early signs of negative economic performance: inflation is double expectations and surged the highest in 34 years, and retail sales were flat after excluding gas price hikes - and that's after major sales promotions and other forms of manipulation.

So what is propping up this market?
Partly the December rally.
Partly the continued belief that if it isn't in writing, it isn't real (aka denial).
And - apparently - foreign buying sprees.

I have been holding back because I thought there would be pullback even more. Now, I don't think it matters. Tomorrow we buy in - thi stime I mean it.

Dow up, then down - but our target stocks rise

Well, I was right that the market would open high and then pull back.
Unfortunately, it doesn't seem to matter with our target stocks - they are just up.

Retail sales weak

November retail sales figures came in pretty strong, or so it was reported.

In fact, Goldman Sachs pointed out that major retailers included an extra week in this year's November calculation (this year, Thanksgiving happened on the 22nd, allowing a full week after to be included). Distorting those figures helped but will hurt in December. In effect, they borrowed from December Sales relative to last year. Ooops.

As Goldman said "The corollary of better November data is a headwind for December retail sales reports. If the effect of over two percentage points is symmetric, then December same-store sales stand a good chance of coming in at or below zero."

We are entering a death-by-a-million-cuts as consumers and small stores begin to feel the pain. Folks will start to cut back first on holiday gift giving. Vacations will be more modest. Big ticket item spending wil lget postponed. Then services will get trimmed - those pedicures and manicures become less essential, the termite maintenance can be skipped once in a while, home insurance will be scaled back, and so on.

Now, since folks won't believe anything until they read it, the stocks will not take major hits yet. I would expect guidance to be fuzzy in the next earnings reports.

Taxpayers to bail out banks

http://news.yahoo.com/s/ft/20071212/bs_ft/fto121220070025397966;_ylt=AhDFjg4hn7TsXlPoT5uII7Os0NUE
And there you have it.

The Fed will announce a plan today to "provide funds directly to a much larger group of banks than the limited number of primary dealers who participate in open market operations, against a wide range of collateral"

Guess what collateral will be used? Dud home loans. So, in effect, the Fed will be buying these dud loans because far too many of these larger group of banks will not survive.

The objective of the Fed is to keep the banks alive and lending money. The problem is that Cheap lending is what got us here in the first place. More importantly, consumer appetite for debt is dropping.

The Fed is trying to hand the alcoholic adrink, without realizing that the guy is already passed out.

Take advantage of the pullback

I think we should FINALLY consider buying in today.

I held off, missing much of the rally, because I did not think the Fed would do 0.5% rate cut.
Wall Street did not like the results but I think that they will respect that the Fed is running a balancing act between helping the economy, dealing with the banking crisis, and not alllowing inflation to spike.

I figure the market will rebound a bit today, but ease by the afternoon.

The Fed move was very telling. It revealed that, despite claims to the contrary, the economy is a lot weaker than they thought. Last month, the 0.25% rate cut was highly contentious with several not voting for it and 1 voting against it. This month, it was unanimous AND 1 Governor wanted it to be higher.

Considering that the Q3 GDP was revised upwards just 2 weeks ago, that means even more recent data shows Q4 to be a problem.

And, indeed, anecdotes are suggesting that retailers are struggling a bit. JC Penney announced problems. I was shopping and noticed that several high end clothing manufacturers (Armani, Gucci) are participating in sales: they never do, according to sales clerks. Even Apple had to have a special sale. Add it up and it says that things aren't as strong as these retailers would like.

The January retail earnings will probably hit revenue targets but the guidance will be awful. This will be the necessary writing on the wall that consumers are belt tightening.
http://www.msnbc.msn.com/id/22147235/
Consumer sentiment is at a 15 year low after falling 3 months in a row. This level is strongly correlated to a recession (in fact, it is only at this level just before and just after a recession).

I've written a lot about my theory that this is a blue collar recession. Look at this choice nugget from that article:
"'The survey also revealed a widening gap in sentiment between rich and poor. 'Additional losses among lower-income households more than offset the gains among upper-income households"
Blue collar workers are already in a recession, white collar workers are not. Will professionals be spared? Not likely. As we get past the holidays, a lot of pink slips will be given to more and more financial folks, among others.

MVL & TRID

I last mentioned MVL in March.

MVL is a comic book company. Their comics have spawned a multi-billion dollar movie empire through Spiderman and the Xmen, not to mention Blade and the Fantastic Four.

Until 1 year ago, MVL was actually in the licensing business. Spidey t-shirts, X-men video games, and so on. MVL made very little money off th emovies because they were paid a flat fee.

Again, until now. Two things have changed. The first is that the Spidey & X-men movie deals only covered 3 movies each. Subsequent sequels are not covered. Expect the next ones to have much more generous terms including a cut of the net profit.
Other ongoing movie series like the Hulk and Fantastic Four have or are about to have their 2nd movies. Only one more to go before that deal runs out.

The second thing to have changed is that MVL entered the movie making business itself. They cut a VERY smart deal.
1. Borrowed cash to make the movie
2. For collateral, the movie rights to the sequel
Either the movie soars, and the debt goes away or it bombs, and MVL loses some future rights. Their cash exposure is limited. It helps to have a bunch of movies throwing out billions of dollars based on your stories.

The first movie will be debuting in the Summer. IRON MAN. I have seen clips. It looks very, very good. It has the right blend of actors and story and directing. And there doesn't seem to be much competition.

To put this in perspective, they currently do ~$470M in total revenues. One solid movie like IRON MAN would generate a $100M net.

I posted in March that buying was premature - the Iron Movie and $ results were too far in the future. I think that sometime in the next 3 months is a good time to get in.
Meanwhile, they are pretty heavily shorted.

--------------------------
TRID found its floor. I am in.
They are trendinghigher since they got back into NASD compliance 11/28.

My target list of stocks

In putting together my list of stocks, I followed a few basic threads

1. Assume a US recession (slowdown in consumer spending, construction and associated services and materials)
2. Assume continued global strength
3. Look for supply constrained sectors and find growth
4. Assume Russia and China will launch an acquisition initiative to get technology and raw materials


Sectors to Avoid
Capital Goods - This is a very polarized space. Agricultural demand is soaring, because of ethanol boosters and general problems of insufficient food and inefficient farming. Conversely, US construction & construction raw materials are nosediving. I would be shorting construction services and Mobile Homes/RVs. RV makers have had the snot beat out of them this year, and I don't think it's going to stop. They get hit with a triple whammy: expensive gas, tougher lending, and tighter consumer spending.

Consumer Cyclical - This is the #1 sector to avoid. Consumers will still buy clothes, but no more new trucks for a while. Same with tools. I would short:
Appliance & Tool
Auto & Truck Manufacturers
Auto & Truck Parts - May be ok if people do more fix-it-up instead of buy a new car
Furniture & Fixtures - They may make sales targets but only by bombing margins. For example, 0% financing for 2 or 3 years
Tires

Consumer Non-Cyclical - The Coca Cola's of the world. These folks are getting squeezed by rising material costs. People will still continue to buy, but earnings may stagger a bit. I don't think that they will have a lot of success passing costs on. Recreation and entertainment will actually do well as folks look closer to home for cheaper recreation.

Financial - Do not get near it

Services - Services never do well in a recession. Exceptions exist, like casinos. Others are hard to predict, like real estate management: will rents go up or down if folks are forced out of their houses?

Sectors to target

Basic Materials - I think this still has legs, but nowhere near the boom that it had. Certain categories like precious metals, iron, & mining look strong. These are really China oriented (Coal and iron are being shipped to China in record volumes)

Energy - Buy big. Coal continues to be a steady performer. I prefer services and Equipment over the actual oil producers.

Healthcare - Like consumer non-cyclicals, demand will continue here. I don't like drug makers unless they are generic drug makers. Healthcare may also suffer if unemployment increases. On the other hand, cost management and access to cheaper generic drugs may help...eventually. Bottom line, where does the growth come from - simply raising prices? Will that work under a Democratic White House? Better to stick with medical equipment and supplies.

Transportation - Any exposure to higher fuel costs is already baked in. Some problem areas like US exposure to Mexican trucking. But international shipping and transportation is hot. Especially in China - ZNH has settled down a bit after going ballistic.



The recent bust and run-up was very helpful. It showed me which of my target stocks had strong underlying support.
The Dow peaked at ~14,200 in early October and it sank to 12,700 in late November. So I wanted stocks that withstood that huge drop.


This is what I decided are my favorite stocks to buy in:

AGRICULTURE - US farmers are making a lot of money on crops. The crops are going to other countries. Farmers need fertilizer and equipment.
AGU, POT, TRA, MOS, or CF
AG

OIL Services & Equipment
IO - They don't have enough momentum. Time to take our money and run this quarter
FWLT (although MDR is looking cheap in comparison)
ATW, RIG, NE or DO

CELL PHONE
VIP
MICC

OTHER
MVL - I really like their story
PCP
TRID - yep
WFR
DSX or DRYS

Now, timing. The question in my mind for the past month was: is this really a rally or another stop on the way down?

To buy or not to buy?

Don't buy: Look at the 6 month chart: the low in November is much lower than the previous low in August. That suggests much greater volatility and potential downside. Also, the market is pricing in a Fed 0.5% cut already. It may get excited and then fall back again.

Buy now: At the same time, the rally is much stronger. I wanted to buy back in: I am a strong believer in rallies during the last month of every quarter. The funds are like gamblers standing around the tables in Vegas: after a while, they have to make a bet. Look at September: huge rally going into earnings reporting season. Same with June going into the July earnings reporting season.

Also, much of the market collapse is technical - the result of a liquidity squeeze.

As you can see, I am of two minds. I think the thing to do is to assume that my target stocks will beat earnings expectations and not to pay to omuch attention to short term swings.

What's next for Solar

bWhy are solar power companies so hot?
Everytime oil prices rise and stay high, solar power becomes the rage. This time, however, it's different. This time, it's a global phenomenon:
* China - Mandating more solar power
* India - Struggling to handle the massive cost of subsidizing oil and kerosene
* Germany - Aggressively subsidizing solar power
* Thailand ramping up solar power
* US MegaWatt output grew ~60% in 2007 (despite the lack of an energy policy)

Solar power represents a different proposition for the consumer. In essence, the consumer is asked to pay upfront for 30 years of energy cost. At $40K for a home, many homeowners hesitate.

Government subsidies are the primary way to reduce cost and have been very effective at boosting demand, especially in Germany which is driving 52% of world demand for panels. US federal and state incentives have dropped costs 30%.

Rising sales volumes lead to cost efficiencies as well. For example, using thinner wafers because the electricity is produced in the top portion only. But silicon prices are definitely putting a damper on things: prices have surged from $25/kg in 2004 to ~$220 today.

In response, established producers like MEMC are boosting supply. And Chinese makers are entering the market soon. Eventually the silicon shortage will end, possibly by 2010. Companies like nanosolar (private) and FSLR use other technologies, but for the next few years, silicon will dominate.
(Check out Phoenix silicon - they are a scrap silicon company)

The prospect of dropping costs makes solar power very attractive. I believe in this market, but I think that there are far too many players. Here's a list of companies making solar panels.
http://en.wikipedia.org/wiki/List_of_photovoltaics_companies

And here are the 2008 sales projections for a few of them:
stp $2300M
fslr $796M
ldk $970M
solf $4440M
ja solar $761M
canadian solar $713M
eslr $101M
trina solar $668M
Q cells $1760M
Sharp $2000M
That's ~$15B in sales for 2008, which would be a 50% jump in sales.

The reality is that sales is really concentrated in Japan, Germany and the US. Sure, China and India are growing, but the markets are limited. China is providing incentives of $1.5B.

At today's prices and supply constraints, sales is limited. I think there isn't enough to go around and many companies aren't going to meet their forecasts. Also, supply constraints will eat into both sales and margins. Trina Solar, for example, just reported a reduction in sales forecasts due to supply constraints.

So these are my takeaways:
1. Solid but concentrated market. Developing companies have enormous need but can not afford the panels. Demand continues to be driven by Japan, Germany, California, & to a lesser degree India and China.
2. Extremely sensitive to government incentives. US Federal incentives were $170M in 2007. California spendt ~$3B annually to offset costs. With the housing bubble bursting and home prices getting re-appraised, government tax revenues may not support these credits. Of course, the Democrats are proposing large boosts in solar power subsidies. The message is: government incentives drive this market
4. Silicon driven costs will ease in ~2 years (beware MEMC investors)

I haven't invested in these companies because I don't see much difference between them. I also believe that there are too many suppliers for the market.

But if I were to invest, I'd go with FSLR as a thin-film play. Then I would go with ESLR as an efficient producer. Otherwise stick to the large producers, because they get better supply and pricing from the wafer makers.