It’s hard not to feel alarmed. The market rally is crushing my Ultrashorts and the Commodity oil drop is crushing the calls. Where did I go wrong?
It’s hard for me to find any single event that drove the turnaround. At some point, around July 15th, commodities started to drop, the dollar started to firm and in response the stock markets surged.
Frankly, I suspect that what happened was simply options expiration day July 15th. That is, prior to the 15th, a lot of funds had to cover short positions that were due to expire on the 15th. They were buying up oil and gold and so forth. Once they covered, commodity prices eased and so did the pressure on the stock markets.
And as they eased, suddenly, there were no buyers. And worse – there were lots more sellers.
http://www.bloomberg.com/apps/news?pid=20601087&sid=aYsD4ZNMER4c&refer=home
“For the past three weeks, the number of short positions, or traders selling futures, is greater than the long positions, U.S. government data has showed.
Speculative short positions, or bets that prices will fall, outnumbered long positions by 5,550 contracts on the New York Mercantile Exchange in the week ended Aug. 5, the Commodity Futures Trading Commission said in its Commitments of Traders report on Aug. 8. Net-short positions rose by 4,890 contracts, or 741 percent, from a week earlier.”
In other words, speculation drove up the prices. When it went away, prices started to come down. And then funds started pushing them down. Pump and dump action.
Maybe there is also a bit of coordinated dollar buying as well. Because if you look at the economic data over the last few weeks, it only says inflation and dollar weakness
July 14th - the Fed & Treasury lay out plans to backstop Fannie Mae and Freddie Mac
July 14th - Bernanke says things are tough but economy should turn around in the 2nd half
July 16th – Core CPI more than expected
July 23rd – Housing bill moves through Congress and Bush signals he will sign
July 28th – Record Budget deficit
Aug 1st – Unemployment at 4.5 year high
August 5th – Fed leaves rates alone
But sentiment has changed to the positive as well, adding reinforcement to the trend. The thinking now is that, yes the US economy is weak, but now so is the EU and Japan’s (Japan just announced that their economy shrank -2.4%). German industrial orders slowed in June, unexpectedly. ECB held interest rates.
http://www.ft.com/cms/s/0/e19cad80-6172-11dd-af94-000077b07658.htmlIf everybody is heading to a recession, then, relatively speaking, the dollar looks stronger because the yen and the Euro will be weakening too. And then there’s the flight to the dollar in times of financial uncertainty. “European Central Bank left its key lending rates unchanged and bank President Jean-Claude Trichet said "annual inflation rates are likely to remain well above levels consistent with price stability."
The International Herald Tribune reported.
"Until now, the severity of Europe's problems have been outweighed by what happened in the United States," Stephen Jen, global head of currency research at Morgan Stanley in London told the newspaper. The euro reached a record at $1.60 in mid July after the ECB raised interest rates to 4.25 percent -- a move made while most other central banks were lowering rates.
Some analysts believe the ECB will likely lower rates next year, when inflation in the Eurozone is expected to slow from its current rate above 4 percent to closer to the target rate of 2 percent, the Herald reported.”
Expectations are for a slowdown in Q2 for Europe
http://www.nytimes.com/2008/08/09/business/worldbusiness/09euro.html?partner=rssnyt&emc=rssIn other words, the dollar may be standing still, but it looks good compared to a stumbling EU. A cut in the interest rates in Europe reduce the attractiveness of investing there and increases the dollar attractiveness.
This eliminates the race to hedge inflation. A firmer dollar drives down commodities both as inflation hedge and from pricing power
So we take away the commodity price speculation that has been driving up inflation, and we add dollar strength, and we see that future inflation will be easing. The markets like that.
Now add in earnings results. Did you notice that Cisco had terrible earnings results? No? Well they did, but it was spun as a positive. (Cisco latest EPS grew only 4%, forward guidance is only 8%, they lowered guidance and have no visibility to growth after 2 quarters).
There is a sentiment that things could be worse. “At least Cisco grew and continues to predict growth.” That sentiment is not exactly misplaced, but it is very short sighted.
I reviewed the earnings released from July 21-August 11th, and what I found was that results were pretty good: 54% of companies reported growth year-over-year. How does that stack up against last year’s results? I don’t know. But the majority of companies are showing growth of some kind.
Now, what’s interesting is that 45% of the companies missed expectations by more than a penny and only 35% beat by more than a penny. Given that companies are guiding analyst expectations, who can lower estimates during the quarter, for almost half of the companies to still miss – that’s a sign of distress.
While we still have growth, far too many companies are not growing as much as expected. That will change, but for now the tone is definitely a positive spin: we didn’t go over the cliff. The market is saying: things aren’t horrible today, so let’s get excited. But the reality is that the distant early warning signs are all flashing red.
Start with corporate earnings. If the EU and Japan are going down, that is bad news for earnings. To begin with, who will buy our exports if their economies are also hurting? And the stronger dollar will reduce corporate EPS.
As I’ve pointed out,
most multinational companies have achieved their EPS on the back of currency translation: re-stating their yen and Euro business into a dollar that was 15% weaker than it was the previous year and achieving an automatic pop. Well, a 5% rise in the dollar eliminates that profit magnifier. By October, the dollar will be at parity with last year. No more EPS juicing.
The nitro is no longer available to juice up the engine, and that’s the only way most of these players have been able to cross the finishing line.
I also notice that the stock market volume is down, which is also indicative of a falling market. Volumes are down 20% (Something we need to watch for ETFC)
Meanwhile, non-Federal government spending is definitely coming down, both state and consumer.
State budget deficits http://www.cbpp.org/1-15-08sfp.htm
29 States face deficits for a total $49B shortfall. I suspect that number will just increase. Any actions taken by the states – cut expenditures or raise taxes – will decrease the economy. Interestingly enough, California is almost half of the collective shortfall. At $22B and rising, this presents a particularly sharp problem. California is the largest economic engine in the US, and it is already dealing with being the largest foreclosure state. Further economic distress will hurt the State and the rest of the country’s economy
Alt A loan defaults rising - http://www.nytimes.com/2008/08/04/business/04lend.html?ref=realestate
“The percentage of mortgages in arrears in the category of loans one rung above subprime, so-called alternative-A mortgages, quadrupled to 12 percent in April from a year earlier. Delinquencies among prime loans, which account for most of the $12 trillion market, doubled to 2.7 percent in that time.”
That means another $300B in prime loans will default this year. This means two things. Not only are higher end properties shedding value, but wealthier people are in financial distress. And it’s accelerating. Why?
“some borrowers could see their payments jump 50 percent or more, and they may not be able to sell their properties for as much as they owe.”
And unemployment is soaring. unemployment rose to level of last recession (March 2002). Worse than expected http://www.usatoday.com/money/economy/2008-08-07-jobless_N.htm
To net it out – we can expect to see only a reduction in economic activity among the world’s largest economies. How can that possibly be good for the stock markets?
So this is why I am okay riding out the rally and staying with the puts and the Ultrashorts.
As for the energy calls, that is trickier. I like to go long on companies that are growing and have the potential for upside surprises. When these companies pulled back, I saw an opportunity. Indeed, I have been mostly right: most of these companies have enjoyed massive growth and upside surprises. But their stock prices are down. The market no longer believes that forward earnings will be as strong, either because commodity prices will be drastically lower (they are) or because future demand will dry up.
I have decided to push out my decision until after options expiration week this Friday. If this is pump and dump, it is possible that we will see pump again. Also, with 6 weeks left in the quarter, funds will begin placing their bets in the next 2 weeks. I suspect that they will look around and acknowledge that energy is the last growing sector.
Indeed, when I go back to my earnings result analysis, 75% of the top performing companies were tied to commodities (steel, agriculture, energy). When I survey the last 3 weeks of earnings results, the top 25 growth companies were
Bunge Limited
CF Industries
United States Steel Corp.
iPCS, Inc.
DOLAN MEDIA CO
Innophos
Apache Corporation
ArcelorMittal
Potash Corporation of Saskatchewan Inc.
Fording Canadian Coal Trust
Olympic Steel
Cimarex Energy Co.
Cleveland-Cliffs
Occidental Petroleum Corporation
Transocean Inc.
OSG
Murphy Oil Corporation
Plains Exploration
Whiting Petroleum Corp.
The Mosaic Company
I wouldn’t be surprised if analysts start upgrading many energy companies because they will look good for valuation reasons.
