GE: First Rain on the Parade

The clouds have been gathering for some time.
Oracle reported a slowdown in growth. JC Penny earnings were bad. So did other retailers including Saks. Circuit City reported lower sales. Nevermind the banks.

One by one, sectors have been turning negative, financials. Auto. Construction. Now retailers. Once the slowdown broke out of the housing sectors, investors are forced to wonder: what sector is next to get hit? Traditionally, IT and consumer non-durables.

GE looks to be the first sign of rain on this parade. GE is a bellwhether stock: it makes industrial products, it makes consumer products, it makes medical devices, and it has a major financing arm.

It's not just that GE announced that earnings would fall and miss expectations. GE swore 1 month ago (March 13th) that all was fine. If a company like GE can have this much bad visibility into the business, then what does that say about other companies?

* EPS dropped from $0.48 last year to $0.44 this year
* EPS expectations were for $0.51, a 15% miss
* Revenue increased 8% to $42B, $2B below GE's own guidance of $44B

The revenue miss and earnings miss are actually worse than they appear because GE does a lot of global business and should be enjoying favorable exchange rates from the weak dollar.

WHAT CAUSED THE MISS
GE is both a manufacturer and a bank. In fact, in 2006, GE was the largest commercial and consumer financial company in the US and it did extend mortgages. GE had amazingly good credit: AAA. this enabled it to borrow on fantastic terms. It could either lend on mortgages and credit cards or underwrite in-house business. This is important for a company involved in billion-dollar deals that are paid for over time.

Now GE is stung like all banks. Except that the damage will cascade if they lose their sterling ratings.

GE is also wounded because their business model is finally exposed: a middling manufacturing company dependent on financing games to show growth.

RESULTS BROKEN OUT
Infrastructure (33% of total business): Up 23%
Financial (33% of total business): Up 7%
NBC (11%): Flat
Healthcare (12%): Flat
Industrial (11%): Flat

Infrastructure = engines and energy (which is where we were with energy and PCP)
Industrial = appliances

In essence, GE is floundering.
* Expect more financial writeoffs and losses
* Expect more delinquencies on loans (delinquency rate shot up 70 basis points)
* Expect more sales slowdowns

OUR TAKEAWAY
Aviation remains strong (PCP)
Energy remains strong (MDR, FWLT, IO, ATW, etc)
Consumer services and goods are hurting
Business visibility is suspect for any company

We are short consumer services and consumer goods.

Don't Catch a Falling Knife

We've all been there. Maybe while shopping or at an auction.
The item we want to buy is discounted deeply relative to where it was. In fact, it now looks like a big bargain.

In reality, our frames of reference are skewed. It happens in a lot of places. Sales people call it anchoring. Here’s an example of how it works.

You go to buy a car. There’s the listed price or MSRP (Manufacturer Suggested Retail Price) and there’s the dealer’s invoice (what they paid for the car). An example: MSRP is $40,000 and dealer’s invoice is $30,000. If the Sales person starts at $40,000 and then offers a $36,000 price, it looks like a nice 10% discount. But if you start at dealer’s invoice $30,000, that 10% discount actually looks like a 20% premium.

We anchor ourselves when we buy a stock simply because it looks cheaper than it was.

Another factor that comes into play is our blind belief that a stock can’t possibly fall any further. If a stock is down 30%, we tell ourselves, it must be close to a bottom. Which means that it is safe to buy. But we forget what happens in economic downturns.

In 2000, Cisco was $80 and 9 months later was $13. In 2000 AAPL was $35 and fell to $7 within 9 months. In 2002 IBM was $123 and in 9 months it fell to $57.

We are pre-disposed to bargain shop but our frame of reference is where we were and not where we are heading. Worse, we forget that stock prices drop deeply in economic downturns.

Applying this knowledge, consider Goldman Sachs. Is GS cheap at $167 or does buying it now look premature?

In 2005, GS revenue was ~$11B per quarter and the stock was ~$100. In November, Revenue was $23B per quarter and the stock was $247. In March, GS revenue fell to $18B, a 20% drop from 2 quarters prior.
Compared to 6 months ago, the stock looks cheap: revenues dropped 22% and the stock price dropped ~32%
Compared to 2005, the stock looks fairly valued: a 67% jump in revenue and a 67% jump in stock price.

But GS is not a bargain price. Sure it looks like a bargain because of the 35% price cut, but in fact it is just aligning with current business realities. The stock price is tracking revenue, and if you believe that business is improving, then GS stock price will grow. I think that business is continuing to deteriorate, and that GS will continue to drop. What is to prevent it from returning to $11B per quarter in business? And if it does, will the stock drop further to $100?

Buy now and catch a falling knife.

The same phenomenon is playingout in housing. With prices now ~20% lower than they were at peak, housing looks like a bargain. Many folks will buy and prices will appear to be stabilizing. A few months later, prices will drop again.

Because folks have bought based on price drops relative to where they were and not relative to where they are heading.

Consolidation or Start of a Down Turn??

If it's just consolidation then, as SR commented, we should be buying Calls
(MVL, WLT, ACI among others).

Look at the Dow in the past 10 trading days:
March 31 +45
Apr 1 +391
Apr 2 -45
Apr 3 +17
Apr 4 -17
Apr 7 3
Apr 8 -36
Apr 9 -49
Apr 10 +55
Apr 11 -180 (so far)



I'm not a technical trader, but clearly the sentiment is negative when 5 out of 8 trading days are negative and the 3 remaining are barely positive (+3 on April 7th????).



Now look at the 1 month view: things look positive. The lows keep getting higher:

Since March 10th the lows keep moving higher. Which is a positive trend.

Another thing to note: for the last 3 months, the market oscillates around 12,400 (the dotted red line above).

My interpretation is negative: collapse is imminent. nothing is really movingth emarket up after 3 months. During that time rates have been cut deeply but the market isn't moving.

If the market isn't moving up, what is the likelihood that it will move down? I think the likelihood is very strong. Because the bad news is spreading. GE announced poor earnings today, mainly in consumer durables in the US. Now add in the raging inflation that was just reported. March import prices surged 2.8% (10% for oil alone). I mentioned that I think people are buying less but spending more and that's your proof.

http://www.marketwatch.com/news/story/us-march-import-prices-rise/story.aspx?guid=%7B818047B8-A4C5-46E0-96EA-7A339F68893E%7D&dist=msr_9

With the exception of oil services and agriculture, I doubt any companies will show strong earnings releases.

Further, I don't think that the current market P/E levels have baked in a string of lower earnings.

Meanwhile, the hope is that a downturn will reduce demand and thereby reduce inflation. Not likely. Oil and food are global in demand, and demand is rising. Furthermore, most of the price increases are tied to the weak dollar. that dollar will stay weak unless:

1. Trade deficit improves (imports drop and/or exports rise): not likely

2. Interest rates rise: possible, but the Fed would be run out of time

3. Europe, Chindia recession: very likely, but not for another year.

Inflation will continue and further weaken the economy.

Prepare for Stagflation: high interest rates and a weak economy

From the Trading Floor: SRS, TRID, ETFC, MGM, CF, AGN

SRS - Our Real Estate Short.
It has moved up 10% in the last week. Meanwhile, office vacany rates are increasing for the 1st time in 6 months
http://www.latimes.com/business/la-fi-briefs10apr10,1,3213520.story


TRID - It has dropped 10% and fallen below the critical $5 price. I am expecting a bad quarter - that was already assumed. We are in them based on new design wins that will begin hitting at the end of this year. They need to show traction on the turnaround.

ETFC - Down almost to the $4 price. We aren't losing money - far from it. But we do have covered calls expiring next Friday at $4. It would be interesting if ETFC dips below that $4 price and we get to write some more calls. The May $4 are currently selling for $0.40

CF - Looking good

MGM - Our Puts have popped up from $3.40 to $5.hold on them for now

AGN - no movement yet, but we'll wait

The MGM Put - An Update

http://www.lasvegassun.com/news/2008/apr/07/tourism-juggernaut-shows-signs-slowing-down/

"at a time of year when business conventioneers and tourists head to Vegas for near-perfect weather, the city’s economic engine isn’t firing on all eight cylinders."

and

"After three years of double digit increases in room rates, Las Vegas room rates were down 3 percent in January from a year ago, with occupancy down a percentage point, according to the visitors authority, which says it’s premature to draw conclusions from a month’s worth of data."

I heard that the place was empty for the NCAA tournaments. That's a major revenue generator.

Is this the Last Gasp? Did we just Peak?

In looking at the data, timing the market's crash seems to be less mysterious and more easily predicted.
1. Shortly after the recession starts
2. Following a major run-up. That is, the market doesn't move sideways and then suddenly down - it lurches up.

Are we in recession? If GDP was 0.6% in Q4 2007, we are probably very close to recession.
The recession is clearly not the trigger for the onset of the crash because the markets continu eto rise. But we never know exactly when we enter a recession, only in hindsight do we know. So, when the market crashes, it must be while the economy is very sluggish but the proof - the official numbers - are not yet out.

Do the GDP releases act as a trigger? certainly markets anticipate the releases with great interest.
The 1990 crash - started the 3rd week of July, just after the Q2 1990 numbers were released.
The 2001 crash - started the 3rd week of May, when April preliminary figures were released and setting the tone for Q2 2001

But that doesn't tell the full picture. Using government figures (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=1&FirstYear=2006&LastYear=2007&Freq=Qtr)
Look at 1990:
1Q 1990 GDP 4.7%
2Q 1990 GDP 1%
3Q 1990 GDP 0%

Real GDP may be a quarterly figure but monthly updates are released. While the official numbers confirming recession would not be released for a few more months, some preliminary figures must have been released that spooked the markets.

I don't have the time machine to go back and read the articles of the day. But I suspect that in order for GDP to fall from 4.7%+ to 1%, June must have been pretty dismal. Spending doesn't just stop, it drifts down - so June must have been announced as a bad month. The preliminary June figures would have been released in mid-July, right when th emarket tanked.

Looking at 2001:
Q3 2000 -0.5%
Q4 2000 2.1%
Q1 2001 -0.5%
Q2 2001 1.2%

What happened from April, when the Q1 2001 GDP figures were released and May? that is, why the 1 month delay? Again, without newspapers, I can't say for certain. I suspect that the preliminary figures at the start of Q2 were causing confusion, but by May things were clearly worsening.

The Q1 GDP data releases April 30th - 3 weeks away. I am planning on that being a trigger for a market collapse. The markets aren't stupid: we just went from 4% growth to 0.6% growth. They know that the economy is anemic. They are just waiting for the official numbers.

It's no guarantee that we'll wake up April 30th to see a market diving for cover. The Fed could drop interest rates a further 0.5%, for example. But it is likely that this month or May will bring the hammer down.

Buying puts

MGM Sept $50 Puts 5 contracts @ 3.40 each
AGN July $55 Puts 5 contracts @ $2.1 each

CF play revisited

2 weeks, 5% IF CF stays above $130

This week - pullback?

A pullback should be in the cards after 5 up-ish days last week.

I still want
ACI
GNK
WLT
MVL
among others and my cheapness meant I missed each one by $1 with my limit orders.
*sigh* Now they're up 20%

They are some of the few stocks I would own long

return of home gardening

With food prices getting ridiculously expensive, could home gardeing become the next big thing?

Who would benefit? MON most definitely, but not on a scale that matters. Is there any company out there which would see a sizeable increase?

It could be the new chic thing - organic, home grown vegetables

Buying CF and writing calls

Buying 100 shares CF @ 130.20
Writing April $130 covered calls $6.2

Why I like the HOG Puts

http://www.marketwatch.com/news/story/consumers-may-riding-different-debt/story.aspx?guid=%7B32A11AFA%2D0991%2D4BE5%2D80AB%2DFEE3D4A66F23%7D

Fun article

LR Week 14 Performance - revised

I neglected to add the additional ETFC April Covered calls.

LR Performance Week 14

I overweighted the bear too soon. But I wasn’t sure, so, to be on the safe side, I made sure to remove the time factor. The puts expire in January – 9 months away. Prior to that time, a 15%~20% drop in prices puts us a bit ahead. I fully expect that.
Moreover, the ETFs don’t expire.

Time is on our side without having to worry about timing.

But the impact on value is high – the bear move comes at a 20% drop in price. Fortunately, we are doing well on the other half of the equation: short-term long positions.
Yet again, the STOPs hurt us and got us out of stocks prematurely. So I used that cash to buy options – the best way to get fast returns when a market is moving strongly – up or down, it doesn’t matter. If you notice, the puts are 9 months out (closer to 10 when bought). But the calls are 1.5 months (ETFC) and 4 months (CF).

We’ll be doing more of that when the time is right: in and out. Using 20% of the portfolio, I will be jumping in and out of options with one goal: a 10% profit. The CF play yielded ~100% return or $14K in 1 week. I don’t think we’ll repeat that anytime soon, but I think we can achieve 10% from time to time. That will contribute 2% to our performance. This is very risky: I firmly believe that this rally will end and I don’t want to be stuck. Meaning: covered calls may not be the play of choice.

An important note on how I am accounting for ETFC. We own the shares and sold the calls. I am booking the calls and will add to cash (which it is) next update. I will continue to record the ETFC at current market price until expiration or exercise. There is always the chance that it could be <$4 in May. I am also targeting MVL calls. The June $30 calls are $1.25. MVL trades for $27. That’s 4.5% of the underlying stock. The $25 calls are $3.50 or $1.50 minus cash for the $27 price. (The extra $0.25 or 1% is the reduced risk premium because the option is so far in the money.) MVL hasn’t seen $30 in a year, much less the $31.25 that is needed to breakeven. I think we are heading to a breakout to $29 in the next 6 weeks. Why? IRON MAN releases May 2nd, 3 weeks away. Now, MVL is not a big studio that releases 10 or more movies a year, and so a dud is balanced out. MVL is depending on 2 movies this year: HULK 2 and IRON MAN. Failure will be a problem from the standpoint of expectations. That is, the financial downside is capped: MVL borrowed the money and the collateral is future IRON MAN movies. That is – they have no losses to record. Heads – they make cash and tails, they lose no cash. But if it isn’t a flop, they get all the profit. ALL OF IT. DVD sales, TV rights, a new cartoon for the kids. And especially Toys. SPIDERMAN is a billion dollar franchise. If they can do IRON MAN at 20% of that, they are ahead. MVL had ~$500M in sales last year. A $200M movie increases sales 40%. That will pop the stock really hard. Unlike the rest of the movie industry, MVL will probably be very forthcoming about the film’s profitability because it enhances their stature and the opportunities on future movies. Then, in June, the next HULK releases. Now, here’s the kicker: current 2008 earnings/sales estimates do not include IRON MAN. From the last earnings release: “As announced last November, Marvel's 2008 financial guidance does not include revenues or expenses related to the box office, home video/DVD, TV or media sales performance of its self-produced Iron Man and The Incredible Hulk films. Marvel's 2008 financial guidance does reflect the overhead costs related to its film production business” Current estimates have 2008 earnings contracting 5% on flat sales. Which is absolutely moronic: IRON MAN will do at least $100M in sales: action movies always do. The TRANSFORMERS movie grossed $700M. Assume that IRON MAN cost $150M to make (the same as FX heavy TRANSFORMERS). SPIDERMAN generates $150M opening weekend. IRON MAN could do half as well, and that will juice up the stock. And there’s the HULK 1 month later: more sales.

Even a lame movie like THE PUNISHER earned $34M. And it had no real special effects, unless you consider Travolta’s acting to be computer generated.

MVL will top $1B in sales by virtue of these new movies and related merchandising. What about earnings? With 78M shares, a $40M profit adds $1 to EPS. That’s a 60% jump

Surely between THE HULK and IRON MAN, MVL can add $40M in profit in the next year.
So bring it back to the options. The buzz happens in May and then June, when the movies release. A sign of a hit will jazz the stock. Going out to June locks in 2 movies. We only need 1 hit to get folks excited.

I sure am excited.
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Over the past few years, we have been a nation whose economy was driven by people buying and selling homes to each other. We imported and borrowed to enjoy the gains that really weren’t there. Massive amounts of capital and resources were misallocated to housing and the financing.

In essence, the last 6 years were a joke economy – we produced very little and ran up a lot of debt. Now we have to pay that back. No amount of window dressing by Congress of the Fed can possibly change this. The best that can be hoped for is a delay or a softer crash.

Right now, the current belief is that this will be a soft and short recession.
Well, maybe it will be and maybe it won’t be. If it is not a soft crash, imagine the pandemonium and fear.

Meanwhile, what makes us think this will be a soft crash? Are companies and consumers going to spend?
1. US Housing market continues to crash. What can prop up prices?
* Interest rates aren’t dropping: the Fed has cut rates from 5.2% to 2.25%. Mortgage rates haven’t budged.
* Prices are dropping and will continue to drop as foreclosures rise and homebuilders slash prices.

* Government intervention. Freeze rates or foreclosures are some of the chatter, but it won’t happen. And if it does, it will drive away more foreign investors which makes mortgage writing more expensive.
* Global housing markets are starting to crash. Ireland, Britain, Spain, New Zealand, canda, Australia: the news is that prices are dropping in the double digits. So much for the global investor racing in to buy housing

2. Government aid
* $1,200 in taxes on the way. That’s nice, but it won’t do much
* Special tax leniency for companies: they could waive taxes on lenders, homebuilders and others. Not sure how this can help since all of these companies are reporting losses and won’t be paying taxes
* Free money to banks. This is actually helping in the short term. Helicopter Ben at the Fed has been giving money away to Investment Banks who are then speculating with it on Wall Street. This will help them in the short term: their assets look more profitable on the books, just in time for the close of the quarter (last week). They also get more action from retail investors, more money from transactions and margins, and even some cash profit potential.

A happier Wall Street has a way of making people feel more like spending (the Wealth Effect).
But these are all delaying tactics, at best. The core economy is slowing and nothing will stop that. The lending has gone to Wall Street gambling not to lending.

3. Consumer Spending is crashing
* Retailers report slowing business. First it was the low end: Target, Zales, and so forth. Then the higher end: Nordstroms, Tiffanys.

* Anecdotally slowing of discretionary spending. Ladies in LA and New York are putting off Botox treatments (AGN is a nice short right now for that reason.)
4. Manufacturing investment is slowing

Here’s a piece in the SF Chronicle. http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2008/04/05/MNI1VS96B.DTL
“As the nation’s housing market swoons, lenders are tightening their grip on their money. Last month, that credit crunch reached Brent Meyers.” “He owns a substantial investment portfolio and a million-dollar house in Moraga. He pays his bills on time and has no credit card debt. His credit score, he says, is around 800.”

“But in mid-March, Bank of America cut off his home equity credit line of a little more than $180,000, citing a decline in the value of his property. Meyers is now scrambling to come up with $75,000 to pay for a major landscaping project and is canceling other big spending plans.”

“‘My wife would like a new car, but that’s going to have to wait,’ he said. ‘We’re taking a $75,000 cash-flow hit, and I want to boost savings.’”

“As home prices started to sink…lenders including Bank of America, Washington Mutual and Countrywide Financial cut back on home equity loans to reduce their exposure to the housing market. ‘These are unprecedented market conditions,’ said Bank of America spokesman Terry Francisco.”

Tight lending is affecting the wealthier folks as well. According to the Fed, Home Equity Loans dropped from $185B in 2004 to an annualized $100B in late 2007. It is probably dropping further. That means retailers are going to get ~$100B less money this year than they did 3 years ago. That’s why we are short Consumer Services and Consumer Goods.

Take that debt servicing and add in rapidly rising unemployment and expect further belt tightening. Which becomes the usual recessionary spiral: business will stop investing. Yesterday, American airlines announced a hiring freeze. What comes after hiring freezes? Yep, layoffs. Expect accelerating unemployment to be widespread in 6 months and especially in January 2009 (American employers usually wait ‘til after the holidays).

There already is massive unemployment, but it is not recorded because it started with illegal Mexican immigrants. From construction crews to landscapers, the Mexican laborer has been hard at work. And starting last year, they began to get fired. Easily 500K Mexican workers have been laid off. There is a net outflow from California to the Midwest as workers trade construction jobs for farming (the only booming sector for manual laborers).

But that cushion has run its course and now legal workers are getting fired.

This is not a doom-and-gloom story. I’m not trying to paint an ugly picture. I am trying to be realistic and invest accordingly.

I don’t believe the official information because it is normalized – the US government does not use raw data but manipulated data to address seasonality. In a transitioning economy, however, that seasonality estimation fails. That is why the experts suddenly added 67,000 more unemployed workers to January and February and how they were surprised that March was 80,000 unemployed instead of 65,000.

The government data missed ~100,000 newly unemployed because of the way it estimates unemployment. It means that things are worse than government data shows.

So why invest as if things are rosy? Invest in places that benefit from a downturn. Be grateful that everyone else is betting that the bottom has been found – that makes the short opportunities even cheaper.