Back on Track: Market Heading Down

Earlier in the week I presented this chart and wondered whether we were on the shallow or the steep down slope. The difference being how rapidly the market will unravel IF it is going to unravel. By Friday, it became clear that we are on the steep downward slope.

To revisit my Last Gasp Theory (first mentioned April 5th http://liverocket.blogspot.com/2008_03_30_archive.html)
1. The market bounces around in 10% cycles prior to one final surge – The Last Gasp
2. The Last Gasp is a large run-up of ~15%+
3. The surge continues as the recession officially starts, peaking within a few weeks of the recession’s beginning
4. The subsequent crash happens quickly and is much deeper than the run-up

The last few weeks look really, really like the the Last Gasp is playing out. In theory, we are out of whack with #3 because the Q1 GDP was revised up to 0.9%. My take: whether or not the Recession has begun may be less important than what people think. An dmost people think that we are in a recession.

(BTW hug apologies. I work for Cisco Systems and there is an investment community there. On Thursday, as the market was racing up, I shared my thoughts that it was a head-fake: a false rally. I was rightly criticized for not sharing those thoughts here. Going forward, I will post my thoughts here first, and then copy and paste there. You deserve to get the latest ideas first.)

Other than a neat chart, why do I think worse has yet to come? Start with the Dow’s P/E of 82. (http://online.wsj.com/mdc/public/page/2_3021-peyield.html?mod=topnav_2_3002)
That’s a clear sign that the market has over valued equities.

To understand what is about to happen, you have to consider the origins of the disconnect between economic fundamentals and the stock market’s prices.
For a few months, the Fed has been peddling the following story that
- outside of housing and banking, the economy isn’t that bad and it will be better by the 2nd half of 2008
- Exports will boost our economy

Clearly, both are wrong. As I showed before, latest export figures show a fall in exports. It’s hard to predict the trend. Pushing up exports will be the harvest season that just began. But pushing it right back down is the newly invigorated dollar (5% higher than in March) and the slowing European economies.
Bottom line – with the $2B pullback, the economy needs at least a $5B+ surge to bolster the broader economy. That's a lot of corn and wheat.

Meanwhile, the economy is doing worse not better. Unemployment and inflation are both up. Last week’s preliminary retail report for May showed consumer weakness. Spending went to food and gas, and not to discretionary items like clothes and durables. At this point, the question is not about Bull market or Bear market. We are in a Little Bear market. The question is: will the Little Bear become a Big Bear?

I think the market is about to react furiously, like the betrayed spouse who is waking up to the facts that they have been lied to and ignored the truth displayed before their eyes.

Beyond financial market behaviors and psychology, we have the very real problems of the investment banks and hedge funds. These are the players at the table who make the markets move. As pointed out previously, lately they have been rushing into cash (http://liverocket.blogspot.com/search?q=morgan). JP Morgan showed that the rush is happening at exactly the same rate as happened in previous recessions. Money sitting on the sidelines is money not pushing up stock prices.

March: Hedge Funds suddenly re-gain access to easy money. The Fed didn’t just lower lending rates to 2%, they also began lending to investment banks.

April: Hedge funds drive up bubbles in food, gas and commodity metals. The target is determined by two things: the only recession-proof investments are food and energy and, secondly, many commodities have less stringent margin requirements than equities.

May: Lenders face insolvency. The dominos from housing are falling: a terrible Spring season for housing sales means lenders are starved for liquidity: builders and homeowners aren’t paying back loans. Banks have capital/cash requirements and they aren’t meeting them. Meanwhile, their customers are facing the same problem: the collateral they put up has dropped in value. Banks are making margin calls.

June: Lenders and others begin panicking. They now have 4 weeks to get cash or begin fire sales. But banks are getting smacked around. Home builders are dropping prices even faster to raise cash to pay back the banks, but the new prices pressure home prices overall, hurting the individual homeowners that are behind payments or looking to re-finance.
Meanwhile, the consumer is not spending. The stimulus package fizzles.

I’ve mentioned the 90 day cycle wherein funds make investment decisions around 6 weeks before the end of the quarter. In this case, late May. Yep, the market started sagging exactly when you would expect the funds to start heading for the exits. Smart money began leaving 3 weeks ago. Next up: retail investors like you and me. Unless, like me, you have been in cash and short positions.

To make matters worse, the funds are getting pressured by their lenders, the banks, who need that cash back. Now. That pressures funds to sell even more.

So it's a convergence of liquidity an dfinancial pressures pulling money out of the stock market and a weaker than expected corporate earnings (thanks to the now-hibernating consumer). Unfortunate timing for longs.

Can the Fed do something to stop the slide? Not really. They can’t risk another rate cut. In fact, they want to stop the rampant speculation that is driving up inflation.

And then there is market psychology. The economic data will no longer be fuzzy – one week positive and the next week negative. Too much economic data is going to be released shows a sharp downturn. It’s not that the economy is slowing – it’s also that the Fed has been singing songs of good cheer, making investors feel foolish.
What are the steps? Denial, anger, and then acceptance? Something like that. We are exiting the denial stage, next up is anger. Angry investors are dis-investors. Which will add to the market plunge.

I've published my watch list. Next step: shorten the list and buy. I’m thinking about buying in Friday on the back of a bad week of economic data. I have been looking for my target stocks to pullback with the broader market. No such luck. I like Friday because I see bad news ahead.
- April export/import data (Tuesday)
- May Retail Sales (Thursday)
- May CPI (Friday)
- June Consumer Sentiment (Friday)

It's possible that retail data will continue to be both positive and negative. Sales could be up, but largely because of inflation. Strip out food and energy, and you’ll see falling spending on consumer durables. That will no doubt be echoed in the import/export figures in things like lower imports of clothes, cars, electronics, and so forth

BTW I am seriously thinking about jumping into silver. I think gold jewelry is too expensive for most folks, so retailers will be shifting to silver.

Housing Follow-up

My last post generated some questions that deserved their own focus:
1. Where do you make money from this popping housing bubble
2. Is it counter-intuitive to say the market will rise as housing falls





MAKING MONEY

I got burned in the Fall shorting housing related stocks too early. (I did do well only with BMHC puts). Even analysts belatedly seem to question the sector, but they are still mild in their assessment. That is, the gap between analyst estimates and reality is still huge. Part of that is driven by corporate statements that are equally out o ftouch. It's the blind leading the blind. Or liars leading the suckers - recall that executives at most construction companies cashed out their options 1 year ago, and also recall the JP Morgan analysts who said last month that the worst was over for housing construction.


My view: this is like 2001 and just when you think CSCO can't go any lower, it does.


I'll do some checking but the obvious targets start with sub-prime lenders. The entire housing boom rested on easy credit provided by subprime lenders. They sold the loans on but with obligations to buy them back if the loans underperformed. That is now happening and they don't have cash reserves set up to handle the buybacks. They unloaded the hot potato on someone else but it's being dumped on them. I'm talking about underperforming loans on property that is clearly worth 80% of the loan.


They'll go bankrupt first, sticking the investors (Merrill Lynch and Morgan Stanley, among others) with the bill.


The only lender to avoid as a target is Countrywide. I wouldn't short a bank that might be acquired.


Next in my sights are material suppliers. Lumber companies, dry wall companies, and so forth. (Lousiana Pacific and Gypsum come to mind). Again, they have dropped, but I see more dropping.


Next up, apartment REITs. The amount of vacant housing waiting to be sold is staggering. These units will convert into rentals, and they will pressure apartment prices. In the Fall I left a $1700 monthly apartment 1100 ft2 to rent a house for $2000 and it's 1500 ft2. Plus it's a house, in a neighborhood, etc. This will really show up as a big trend in the Summer as housing investors capitulate and try to stop the pain.



Finally, smaller home construction companies. I actually think the big boys are almost past the bad pain. They are showing business maturity: writing down the land options and pressuring suppliers. In essence, they will probably do another round of major write-offs between now and the Summer and position their books to look healthy for 2008. The smaller players, however, don't have the same deep pockets.


I'll see what I can do to find some good companies to consider shorting.





MARKET UP WHEN HOUSING DROPS?

There is no denying the breadth and depth of impact when the bubble really pops.
Consumer spending will drop when 1 million people are fired and when homeowners face retreating home prices and tougher financing.



The pain will be felt in many places: retailers and restaurants as well as high-end toy makers (cars, jet skis, boats).



But there is a lot of money in this world, and it has to flow somewhere. There aren't that many places to turn, and I think a prime destination will be the US equity market for three reasons:


1. Economy still growing
2. Undervalued Equity markets
3. Debt market implosion



The latest news shows a strong US economy.
* GDP at 3.5% for the Q4 2006

* Consumer confidence up
* Manufacturing up




Relatively low historical P/E.

The current S&P P/E is at a 10 year low of 18. The 100 year historical average is 14.5 and a few years back we were at 30. And the P/E is still dropping. Some folks want to remove energy from the equation, but there is always something that will distort the picture: today it's oil, in the 90s it was the dot.com companies.

Bottom line, the US equity market is priced nicely for a still growing economy. Especially if the world grows faster and that helps US companies.

Where else can money flow? The housing market will translate into a global debt fiasco. That will drive money away from the bond markets and back to equity markets.

TRID & Other thoughts

TRID sank hard today. I shake my head in dumbfounded wonder (and at the loss I am facing on my call options).
Down on no news suggests that there are fears about pricing pressure.

Other stocks under pressure include TIE, ESV, & ILMN
TIE - As of Jan 5th, the #1 Russian Titanium maker (VSNMPO) is banned from doing business with US companies due to its Iran/Syrian business ties. Boeing gets 50% of titanium from them, and Airbus 80%. This is incredible for TIE. If Bush allows it - it is a good stick over Putin at a time when Russia is dragging feet over Iran
The fact that TIE has had nothing but incredible good news lately (major cost reductions from titanium sponge production, reduction in competitive threats from Russia) and the fact that the stock continues to fall tells me to accumulate.

ESV - Downgraded within 1 week by JP Morgan and Wachovia (JPM was today). A conspiracy nut would suggest that the rumors of an ESV buyout are true, that JP Morgan and Wachovia are underwriting part of it, and these downgrades are part of getting a lower price. More likely, there is general concern about natural gas and ESV's exposure to NG drilling in the Gulf of Mexico. the facts show that ESV has very minimal exposure to NG drilling and that its GOM exposure is small and shrinking.
In fact, a smart investor would recognize that most companies are moving the drilling fleets out of the GOM, which will lead to substantially lower NG drilling (25% of NG comes from GOM). That means higher NG prices in 2007 Winter.
Which brings me back to my conspiracy theory. Many other drilling firms are much, much more exposed to GOM and NG weakness. So why did JPM single out ESV? Bash the company to get a better price and do the Seadrill acquisition.
As a value guy, I see a company selling for 7x contracted 2007 earnings. Buying out this company today would drive a 15% annual return on investment. That's hard to ignore.

ILMN - revisiting lows before earnings releases. This stock, as a small-cap, will surge on earnings.

OCN and NUAN are showing strength. Good sign. As did CTSH and CSH.
PCP - Big bounce back after their acquisition announcement of another Boeing related company.
CLB - Nice bounce back today on no news.
MDR - Nice bounce back. This one is so undervalued that I see a large jump i nthe next 3 months.

How does all of this affect the portfolio?
Well, we are very weighted in small caps, so I accept volatility.
Winners so far - UCTT, PCPand NUAN
Losers so far - TRID, CLB, MDR, ESV (a bit) and TIE (a bit)
The rest are stuck in the middle - a little up, a little down, although more down than up.

What to do about the losers? I don't see any reasons to hop out and hop back in (missed that on TRID).
TRID - Technically, this is a broken stock with no support. In barely 2 months it has fallen from $25 to $17 - a 30% drop. Fundamentally, though, this company is fantastic. Sales are through the roof and better than expected. CES is all about LCD TVs. And TRID dominates the market. They have ~16 P/E (which is according to estimates for the last 2 unreported quarters). The only weakness is falling consumer spending as it affects TV purchases. Well, I think falling prices translates into higher sales. I am staying put. I will be contrary on this one.

ESV - Staying put.
MDR - Like I am going to leave a company growing 100%+ and accelerating their earnings and margins. And has a 20 P/E. Bear in mind that the rest of the world is on a spending spree for energy infrastructure. US economic developments will not stop Indian electricity investments, for example.
CLB - I am going to wait for the earnings release. We are down a lot - 13% - but lets hold on. It is the one stock that looks riskiest.
TIE - I think investors will rediscover TIE in 2007. There is absolutely no weak spots in this company's armor. The stock is no longer trading at the discount it was last year because contracts are not re-setting at the phenomenally higher prices. (Contracts expiring in 2005/6 re-set prices from an average $8 to $30+, creating a massive profit surge). However, they will get upside from more production and moderating energy prices. Demand is not going away, unlike copper.

UCTT downgraded

A JP Morgan analyst downgraded UCTT from overweight to neutral based on the recent price surge.

My respect for JP Morgan recently hit a new low when their housing analyst predicted that the housing market had stabilized and housing stocks were a good investment (yeah, tell that to WAMU which completely missed earnings because of the housing collapse).

We will re-enter: I think UCTT has mammoth opportunities.

LiveRocket Week 19 Performance - Up 2.5%

Either I have a lot more readers than I thought, or I was right this week more than once.
First, I said “UCTT I think will drift before firming up and rising again.” I was right about the drifting, and I’m waiting for the rising part.
Second, “I do suspect that we will see a shock next week. The market is overbought - it's up 10% in 8 weeks. Time for a correction and the Fed meeting may be exactly what the doctor ordered.” The market dropped ~2% the day after the Fed’s meeting.

My prediction next week is for a lot of short squeezing, pushing prices up a bit. But in general, it’s time to exit the market a bit and re-enter in late June. No, that is not the sell-in-May-go-away plan. We’re 2 weeks overdue for that. This is part of my theory that stocks drift post-earnings season and then they pick up again about 4 weeks before next earning season. That’s when the hedge funds put down their bets and buy in. Get in 6 weeks before earnings season starts in early July.

I also wonder about the Fed and interest rates. A lot of traders may stick around in case they need to move fast because the Fed drops rates.

Now for a quick review of our performance this week. We are up 2.5% against a flat market. That’s a big opposite from last week when we were flat and the market was up. However, while I should be pleased, I am not. Most stocks were down, with TIE, PCP and MDR the only ones pushing us up.
Several stocks have softened and we need to make some decisive moves.


HIGH TECH
AMX – Up 0.75% and another 52 week high. This is 3 weeks in a row that we’ve seen a new high.
CTSH – Down 3.9%. Horrible. It is drifting and we are now even for our investment. So much for driving to $95 and selling. The positives are that they are moving in synch with their peers like INFY. Also, they bounced off their 200 DMA, so they have reached a bottom.
NUAN – Down 1.7%. Nothing new. When you look beyond the pre-earnings run-up to $16.8, we have some positives. We are up 3% since pre-earnings. The lows are higher and we seem to be headed to a base of $16. Then it’s up from there.
PWR – Down 1%.
TRID– Down 2.9%. I am a true believer and I see nothing wrong with the company’s stellar performance, only with the stock price. That in turn is driven by the options overhang. I do think something criminal happened and they are doing their very best to postpone the day of reckoning. But so is every other company accused of the options backdating. Clear that up and this will be a $40 stock. So I’m going to wait.
Because sales are booming. WMT reported huge sales in flat panel TVs. I see no downside risk anymore, only upside. Accumulate if it sinks below $20.
UCTT – Down 3.6%. Well, the damage is done and there is no downside risk. Better yet, JP Morgan calls them overweight. Shorties are having a great time: ~13% of the shares are shorted. At some point this reverses and they get squeezed. Forget cut and run, I’m thinking of adding

OIL SERVICES/EQUIPMENT
I think the oil drillers and equipment companies have demonstrated strength and the market is trying to decide what’s next. Also, the petroleum reports are showing that the US oil consumption is up 5% in volume terms since last year.

ATW – Down 8%. They missed earnings by 7%, so that’s a reasonable correction. They hit a new 52 week high before earnings. I don’t care – this stock is incredibly undervalued. Besides, the stock surged 75% in 4 months, so some contraction is okay.
CLB – Down 1%. I’m not seeing the growth I want to see here. They are now on my Watch list for selling.
ESV – Down 0.5%
MDR – Up 20% on 2.5X average volume and a new 52 week high.

BIOTECH
DIGE – Down 9% and erasing our gains. This is dead in the water until or unless Europe or the US adopts the treatment for HPV. We are even here and we only put in $4K, so I am going to walk away and come back on a down day.
HOLX – Down 2.7%. A little post earnings pullback.
IMA – Up 3.5%. They upped their Biosite bid from $90 to $92.5.

OTHER
KSU – Up 0.5%
OCN – Up 0.5%
PCP – Up 5.3%.
TIE – Up 17.5%. I said that they would hit $0.41 and they did. Buyout rumors persist.

Fed Desperation grows - markets to tumble

Didn't the S&P just say that the worst was behind us? LOL
Bear Sterns technically went bankrupt Friday, surviving on a $30B Fed purchase of toxic loans and a nominal buyout by JP Morgan (so long 15,000 BS employees).

That makes $330B so far that the Fed has dumped into the marketplace. To lower the carrying costs, they also conveniently lowered the borrowing rates - again.

The message is simple: the Fed is abandoning the dollar in favor of saving banks, whatver the cost (including inflation). This is causing massive panic overseas in countries that export to the US. The yen is now 96 yen to the dollar - a 15% drop in 3 weeks. The Dollar/Euro as of Friday was down 10%, probably will be even more Monday.

This will also lead to massive, heart-rending inflation and margin hits to every company importing fuel and products.

The Fed's efforts to date are not accomplishing much. A major investment bank just went belly up weeks after $200B was made available. What the Fed has accomplished is massive dollar weakness, loss of faith in the dollar, guaranteed double-digit inflation, and global recession. The Fed clearly has no gameplan and is just winging it. Yikes.

This is leading to panic. Lots of dollar dumping and Central Bank intervention, but the result is the same: a weak dollar.

I expect our SRS shares to vault on this - everyone will bail on banks now.

Gonna be a rocky week ahead. Especially with options expiration - no such thing as a short squeeze this week.

LiveRocket Week 18 Performance - Up 2.5%

Either I have a lot more readers than I thought, or I was right this week more than once.
First, I said “UCTT I think will drift before firming up and rising again.” I was right about the drifting, and I’m waiting for the rising part.
Second, “I do suspect that we will see a shock next week. The market is overbought - it's up 10% in 8 weeks. Time for a correction and the Fed meeting may be exactly what the doctor ordered.” The market dropped ~2% the day after the Fed’s meeting.

My prediction next week is for a lot of short squeezing, pushing prices up a bit. But in general, it’s time to exit the market a bit and re-enter in late June. No, that is not the sell-in-May-go-away plan. We’re 2 weeks overdue for that. This is part of my theory that stocks drift post-earnings season and then they pick up again about 4 weeks before next earning season. That’s when the hedge funds put down their bets and buy in. Get in 6 weeks before earnings season starts in early July.

I also wonder about the Fed and interest rates. A lot of traders may stick around in case they need to move fast because the Fed drops rates.

Now for a quick review of our performance this week. We are up 2.5% against a flat market. That’s a big opposite from last week when we were flat and the market was up. However, while I should be pleased, I am not. Most stocks were down, with TIE, PCP and MDR the only ones pushing us up.
Several stocks have softened and we need to make some decisive moves.


HIGH TECH
AMX – Up 0.75% and another 52 week high. This is 3 weeks in a row that we’ve seen a new high.
CTSH – Down 3.9%. Horrible. It is drifting and we are now even for our investment. So much for driving to $95 and selling. The positives are that they are moving in synch with their peers like INFY. Also, they bounced off their 200 DMA, so they have reached a bottom.
NUAN – Down 1.7%. Nothing new. When you look beyond the pre-earnings run-up to $16.8, we have some positives. We are up 3% since pre-earnings. The lows are higher and we seem to be headed to a base of $16. Then it’s up from there.
PWR – Down 1%.
TRID– Down 2.9%. I am a true believer and I see nothing wrong with the company’s stellar performance, only with the stock price. That in turn is driven by the options overhang. I do think something criminal happened and they are doing their very best to postpone the day of reckoning. But so is every other company accused of the options backdating. Clear that up and this will be a $40 stock. So I’m going to wait.
Because sales are booming. WMT reported huge sales in flat panel TVs. I see no downside risk anymore, only upside. Accumulate if it sinks below $20.
UCTT – Down 3.6%. Well, the damage is done and there is no downside risk. Better yet, JP Morgan calls them overweight. Shorties are having a great time: ~13% of the shares are shorted. At some point this reverses and they get squeezed. Forget cut and run, I’m thinking of adding

OIL SERVICES/EQUIPMENT
I think the oil drillers and equipment companies have demonstrated strength and the market is trying to decide what’s next. Also, the petroleum reports are showing that the US oil consumption is up 5% in volume terms since last year.

ATW – Down 8%. They missed earnings by 7%, so that’s a reasonable correction. They hit a new 52 week high before earnings. I don’t care – this stock is incredibly undervalued. Besides, the stock surged 75% in 4 months, so some contraction is okay.
CLB – Down 1%. I’m not seeing the growth I want to see here. They are now on my Watch list for selling.
ESV – Down 0.5%
MDR – Up 20% on 2.5X average volume and a new 52 week high.

BIOTECH
DIGE – Down 9% and erasing our gains. This is dead in the water until or unless Europe or the US adopts the treatment for HPV. We are even here and we only put in $4K, so I am going to walk away and come back on a down day.
HOLX – Down 2.7%. A little post earnings pullback.
IMA – Up 3.5%. They upped their Biosite bid from $90 to $92.5.

OTHER
KSU – Up 0.5%
OCN – Up 0.5%
PCP – Up 5.3%.
TIE – Up 17.5%. I said that they would hit $0.41 and they did. Buyout rumors persist.

Is energy my South Ossetia?

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.html

If 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=rss

In 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.

The Week Ahead: Stormy Weather

I expect the markets to be very upset as we get news about inflation, retail sales, and a slate of bad earnings releases.

This is the bedtime story the Fed is telling the markets: inflation will soften as the economy cools, but the economy will only cool slightly. Nice fairy tale, but it isn't true.

For this to be true, we have to see tame inflation (less than 0.2%), inflation is running high for food and energy, but it isn’t clear about the rest. The trend is inflationary (the cost of imports has shot up), but companies may not be passing it on to the consumer. So PPI could be up but CPI flat. CPI is the big dog here because anything >0.3% means that (1) the Fed is wrong and (2) inflation is high and further interest rate cuts may not be happening.

retail sales may look strong because of dramatically higher prices of food and gas. But the underlying message will be a reduction in spending. Industrial production may be higher due to exports and a slowdown in imports that will drive more domestic sales.

Monday: Retail Sales. Analysts expect an increase 0.2% excluding autos & parts
Tuesday: PPI, Home builders Index
Wednesday: Housing starts, Industrial Production, CPI. Analysts expect CPI to grow just 0.3% for all and 0% less energy and food. They also expect no change in industrial production.

Meanwhile, we have a slew of financial earnings releases, as well as a smattering of consumer and IT releases.
* Financial – Until last Friday's GE report, the market imagined that the bad news was out. Now the fear is that the bad news will continue. WAMU on Tuesday will set the tone.
* IT – There are two types of IT: the consumer (Sandisk, Intel, Seagate) and the Corporate (IBM, Infosys, Seagate, etc). Both are forms of discretionary spending and I think we’re going to see the first strong indicators that companies are slowing their IT spend.
IT spending is usually a lagging indicator because companies have long-term contracts and they can't turn of the spending spigot quite as fast as consumers. I suspect that business has been slowing for 5 months, so it’s time for that slowdown in IT spending to emerge. Nevermind that layoffs hit PC sales or that the squeeze on financial companies means they will push out IT projects to preserve capital. I am talking about a more widespread trend that will confirm slowdown.

Thursday brings 2 companies of consequence to us: E Trade and Harley Davidson (HOG).
E Trade: a lot of recent weakness thanks to GE. There could be further softness, but we can always write more calls.
HOG: should get hit hard from sales slowdowns and delinquency rates (GE showed that delinquency rates are surging – and if folks are getting behind on dishwashers, those $20K bikes must be straining resources even harder). Plus I've heard used Harleys are starting to show up.
-------------------------------
Tuesday: Infosys (gauge of IT services both US and EU), Intel (IT gauge), Linear Tech (IT), J&J (consumer and health), Seagate (IT), WAMU (Financial), US Bancorp (Financial)

Wednesday: Illinois Tool Works (Manufacturing), IBM (IT), JP Morgan (Financial), Wells Fargo (Financial)

Thursday: AMD (IT), Bank of NY (Financial), Capital One (Financial), ETrade (Financial), Harley Davidson (Auto & Consumer), KeyCorp (Financial), Marriot (Travel), Merril Lynch (Financial), MGIC (Financial), Nucor (Steel), Sandisk (IT), Zions Bancorp (Financial)

Friday: caterpillar (construction), Citigroup (Financial), Schlumberger (energy infrastructure), Wachovia (Financial)

The Week Ahead - Expect More Market Weakness

My reasoning for a market slowdown is a combination of psychology and reality. I think, globally, everyone now expects recession. Meanwhile, money is flowing away from investments and into cash
Recessions and moving into cash tend to move hand in hand. And every dollar going into money markets is a dollar that is moving away from the stock market.

The world in recession
According to a recent report by JP Morgan, ~85% of global GDP is in the hands of the US (31%), Japan (14%) and Europe (40%). http://www.ism.ws/files/ISMReport/JPMorgan/JPMorganMfg-Svcs050608.pdf
These countries are also expected to face recession in the next 12 months, if not sooner.

The impact of a slowdown will affect China as well, but maybe not in the way you imagine. Exports are not the major driver of China's GDP: investment is. Exports are 10% of GDP while investments are 40%. http://www.economist.com/finance/displaystory.cfm?story_id=10429271 But if the world suffers a slowdown in consumption, that investment will slow as well. And let’s not forget that post-Olympics, government spending will slow.

I focus on a slowdown because it strikes me that the current picture of stagflation (runaway inflation and recession) may morph into plain old recession. That is: inflation will go away.

My thinking is that inflation in food, energy, and steel is more about speculation than demand. Yes, demand is there and it is strong and growing. There is no denying that Chinese consumption of meat is rising, a long term trend. But the recent and sudden price surge is speculative driven. Food and oil are the new bubble mania.

The assumption is that, in a downturn, people have to eat and use energy. Moreover, demand for these is inelastic in the short-run. Charge anything and people will still pay. But that thinking is wrong.

Look at US consumers and oil. According to recent reports, US drivers drove 11 billion fewer miles in April 2008 than April 2007.
http://www.marketwatch.com/news/story/americans-drive-11-billion-fewer/story.aspx?guid=%7B93E83ED2-0EE6-48BF-B104-D82FE8A93D70%7D
At 4.3%, that's the largest drop on record. If this trend continues, global oil tips into oversupply. Add in slackening demand in other countries, and we have ongoing oversupply. Suppliers are more addicted to selling oil than we are to buying it.

The rules of supply & demand won't drop prices for a while, assuming even that consumption drops. Speculators have contracts locking in higher prices. Which means it’s too soon to short oil (DUG).

The same with food and other commodities like steel. A slowdown in consumption will ease demand. Meanwhile, production is surging for all commodities. Expect major oversupply in one year.

But today, not a year from now, the boom continues in agriculture and energy. The problem I am facing is that the stocks I want are over bought. I’d prefer to wait for a pullback, and I think this week will provide one.

What is the deal with all the banks taking write downs?

Takestock asks: What is the deal with all the banks taking write downs?

WHAT IS THE VALUE OF THE US MORTGAGE LOAN PORTFOLIO
WHAT HAPPENS IF THAT VALUE FALLS
HOW WILL OWNERS OF THOSE LOANS RECORD A LOSS

The mortgage value of US residential property is $10 Trillion. In 1998, US residential property was worth ~$10 Trillion. Today it is worth $20 Trillion. If you connect the dots, you realize that the value of housing is exactly the value of loans.

If defaults on those loans reaches 10%, that's $1 Trillion in losses. As long as the housing market stays strong, defaults can be covered by claiming the collateral (the house) and selling it. The lender recovers the loan one way or another.

Unless the housing market collapses. In which case there are losses.

When banks switched from being loan holders to being middlemen, they loosened standards. Mortgages were packaged and re-sold as CLO or CDO (collateralized loan or debt obligations). Banks made more money on loan processing - the more loans, the more money. The consequence of which was that banks and other lenders had looser and looser standards as they sought more and more loan activity.

Asset prices always rise when money is cheap. Housing prices rose as easy lending terms and low rates brought in investors and potential homeowners. Housing prices rose, and started to become self fulfilling - drawing in more investors and flippers.

Loan activity soared and with it the average value of each loan.

Meanwhile, the CDOs/CLOs were sold to investment houses, insurance companies, and foreign investors. An important thing to be aware of is that many of these CDOs/CLOs carried an interesting condition: loan writers had to buy back the CLO/CDO if the value fell.

Of the $10 Trillion in loans, $1.5T is held by the government (Fannie Mae and Fannie Mac). Of the remaining $8.5T, about $2T is subprime. As ARM's reset, borrowers began to default. And - surprise - that home is not worth as much anymore.

Today's defult rate on subprime is a movingtarget, but it's at least 15% nationwide. So ~$300B in CDOs will be written off. Ouch.
Except that these CDOs are currently trading for 25% of face value. In effect, $1.5 Trillion in loan value is gone. Now throw in Alt A and other tiers where defaults are also happening and we are looking at a $2 Trillion writeoff. (BTW that figure is about what Goldman Sachs recently said we'd be seeing.)

The consequence of these mounting losses is that Lenders aren't in the mood to provide easy money when they are looking at $2 Trillion in losses. That hurts hedge funds and others, and leads to a reduction in leverage. Put differently, M&A activity and general investment activity slows down.

Back to writedowns. If a company owns gold then the value of that investment is today's gold price. That's called marking to market - the act of assigning a value to an investment or portfolio based on the current market value. But not every investment can be so clearly valued. An investment in a start-up company, for example, could be worth the original investment, more, less, who knows. There may not be a current market for that investment.

Into that hole falls CDOs/CLOs. US accounting lets the owners of CDOs/CLOs to declare their value based on whatever the owner says it's worth. That $1B CDO could be worth $1.5B or $100M, but the owner gets to state the value. In a post-Enron environment, and with massive scrutiny, accounting firms are not going to play along with that game.

A mark to market approach would have subprime CDOs worth only 25% of original investment value. These CDO owners face massive losses and they want to play for time in the hope that this is just a fire sale and the current values will rise. A fine strategy, but it's not kosher if a company is going to report current value of investments.

Citigroup and JP Morgan recently tried an Enron-esque scheme whereby these CDOs could be shoved into a separate entity and then traded by - surprise - Citigroup et al. In essence, they were trying to create a market and manipulate the pricing higher by playing the role of buyer. They hoped that they could create a price that was much higher than the 25%.

That scheme went nowhere.

These entities are facing a very real scenario where the value of their investments is worth a lot less and they have to be honest about it.

How much less? The current view is that lenders will write off amounts that approximate default rates. After all, the loan still has value as long as someone is paying the interest and principal. That default rate varies, but it's at least 15% on subprime, or $300B. That $300B equals 1 Million residences. Or 500K residences at California prices. Interestingly enough, 100,000 notices of default have been issued this year in California.

So far, I think we've seen maybe $100B of writedowns. Which means there is a lot more coming. And that assumes that others won't default. I think that we are facing $2T in defaults and the associated downward spiral of the wealth effect.

LiveRocket Week 19 Performance - Up 2.5%

Either I have a lot more readers than I thought, or I was right this week more than once.
First, I said “UCTT I think will drift before firming up and rising again.” I was right about the drifting, and I’m waiting for the rising part.
Second, “I do suspect that we will see a shock next week. The market is overbought - it's up 10% in 8 weeks. Time for a correction and the Fed meeting may be exactly what the doctor ordered.” The market dropped ~2% the day after the Fed’s meeting.

My prediction next week is for a lot of short squeezing, pushing prices up a bit. But in general, it’s time to exit the market a bit and re-enter in late June. No, that is not the sell-in-May-go-away plan. We’re 2 weeks overdue for that. This is part of my theory that stocks drift post-earnings season and then they pick up again about 4 weeks before next earning season. That’s when the hedge funds put down their bets and buy in. Get in 6 weeks before earnings season starts in early July.

I also wonder about the Fed and interest rates. A lot of traders may stick around in case they need to move fast because the Fed drops rates.

Now for a quick review of our performance this week. We are up 2.5% against a flat market. That’s a big opposite from last week when we were flat and the market was up. However, while I should be pleased, I am not. Most stocks were down, with TIE, PCP and MDR the only ones pushing us up.
Several stocks have softened and we need to make some decisive moves.


HIGH TECH
AMX – Up 0.75% and another 52 week high. This is 3 weeks in a row that we’ve seen a new high.
CTSH – Down 3.9%. Horrible. It is drifting and we are now even for our investment. So much for driving to $95 and selling. The positives are that they are moving in synch with their peers like INFY. Also, they bounced off their 200 DMA, so they have reached a bottom.
NUAN – Down 1.7%. Nothing new. When you look beyond the pre-earnings run-up to $16.8, we have some positives. We are up 3% since pre-earnings. The lows are higher and we seem to be headed to a base of $16. Then it’s up from there.
PWR – Down 1%.
TRID– Down 2.9%. I am a true believer and I see nothing wrong with the company’s stellar performance, only with the stock price. That in turn is driven by the options overhang. I do think something criminal happened and they are doing their very best to postpone the day of reckoning. But so is every other company accused of the options backdating. Clear that up and this will be a $40 stock. So I’m going to wait.
Because sales are booming. WMT reported huge sales in flat panel TVs. I see no downside risk anymore, only upside. Accumulate if it sinks below $20.
UCTT – Down 3.6%. Well, the damage is done and there is no downside risk. Better yet, JP Morgan calls them overweight. Shorties are having a great time: ~13% of the shares are shorted. At some point this reverses and they get squeezed. Forget cut and run, I’m thinking of adding

OIL SERVICES/EQUIPMENT
I think the oil drillers and equipment companies have demonstrated strength and the market is trying to decide what’s next. Also, the petroleum reports are showing that the US oil consumption is up 5% in volume terms since last year.

ATW – Down 8%. They missed earnings by 7%, so that’s a reasonable correction. They hit a new 52 week high before earnings. I don’t care – this stock is incredibly undervalued. Besides, the stock surged 75% in 4 months, so some contraction is okay.
CLB – Down 1%. I’m not seeing the growth I want to see here. They are now on my Watch list for selling.
ESV – Down 0.5%
MDR – Up 20% on 2.5X average volume and a new 52 week high.

BIOTECH
DIGE – Down 9% and erasing our gains. This is dead in the water until or unless Europe or the US adopts the treatment for HPV. We are even here and we only put in $4K, so I am going to walk away and come back on a down day.
HOLX – Down 2.7%. A little post earnings pullback.
IMA – Up 3.5%. They upped their Biosite bid from $90 to $92.5.

OTHER
KSU – Up 0.5%
OCN – Up 0.5%
PCP – Up 5.3%.
TIE – Up 17.5%. I said that they would hit $0.41 and they did. Buyout rumors persist.

Housing - The numbers only

Why are folks panicking about the housing market?
It has 2 parts, really:
1. Financial market turmoil not seen since the last financial S&L turmoil
2. Millions of people kicked out of their homes
Obviously, both add up to major economic consequences.

But how much of this is realistic and how much is just for the media circus?
To understand that, we need to understand what kinds of loans are collapsing and how much they represent.

WHAT IS THE DIFFERENCE BETWEEN ALT-A AND SUBPRIME
Answer: not much

Subprime – debt ridden, have no liquidity, and have a history of defaulting. Subprime have either a proven history of defaulting or will topple over if the winds change even slightly.
Alt-A – No documented income, stated income, or not owner occupied. The abuse of the stated income is quite rampant and often target speculators (second homes)

IT'S ALL ABOUT TIMING
Fannie Mae estimates ~ $3T in ARMs were written over the past 5 years (out of $10T since 2000). In fact, ARMs were 30% of all mortgages from 2004~2006 - higher in some markets like California. That's important because folks opt for ARMs typically because they can't afford the house at normal rates. Of the $3T in ARMs, almost all re-set in 2007 and 2008.

The average loan amount is $260K, but we’ll use $300K because of the California skewing. That’s 10M homes facing higher rates.

ZEROING IN ON THE ALT-A/SUBPRIME EXPOSURE
According to most estimates, the suprime and Alt-A share of the resets:
Subprime = 47% of resets or $1.4T (4.7M homes)
Alt A = 25% of resets or $800B (2.5M homes)

The Subprime default rate has risen to 15% and is still rising (Countrywide had 20% in August). That means at least $210B in loans will default.
The Alt-A default rate is now 5% (6% at Countrywide). That’s $40B in loans that will default.

A combined $250B in losses for 2007/2008. How well are lenders covered? Here are loss reserves so far:
Citigroup $11,000,000,000
Merrill Lynch $8,400,000,000
Barclays Capital £1,300,000,000
HSBC $3,400,000,000
Swiss Re $ 1,070,000,000
UBS AG $3,600,000,000
Deutsche Bank €2,200,000,000
Bear Stearns $1,200,000,000
Morgan Stanley $3,700,000,000
Lehman Brothers $700,000,000
Freddie Mac $3,600,000,000

Against $250B of likely losses in just 24 months, not even $45B has been put into loss reserves. Even if the homes can be re-sold for 50% of loan value, that’s $80B more that must be put into reserves ($250B * 50% - $45B).

A fraction of that exposure is also held by pension funds and insurance companies, but these companies are a major source of lending, so they might as well be considered lenders.

So it's two issues here: more creditor losses and a general shrinking of funds available to lend. Nobody can shrug off $250B in losses. And given that these funds are leveraged in the marketplace, the financial investing impact is at least $1 Trillion.

FORGET BANKS, HOW WILL PEOPLE BE AFFECTED
Go back to the home units that will enter default. The estimates are that 7.2M properties re-setting as Alt-A and subprime. If the default rates stay flat, almost 850K homes will be foreclosed on and re-enter the inventory stock. (For the 2 years 2007/2008)

How realistic is that? It’s actually on the low side: ~800K properties were already foreclosed on in the first 9 months of the year. There were ~450K foreclosures in the 3rd quarter alone. http://www.realtytrac.com/ContentManagement/pressrelease.aspx?ChannelID=9&ItemID=3567&accnt=64847
With ARM resets peaking in December, we might as well call it 1.5M homes for 2007. That’s ~3M homes for the period 2007/2008.

Of the 7.2M homes under re-set in 2007/2008, default rates seem to be ~40%. I think it’s higher, here’s why:
1. Pushing down that rate is the fact that not all foreclosed homes are these resetting loans.
2. Pushing it up is the fact that banks are being slow to pull the trigger on defaults. I would guesstimate that the true default rate is easily 60%.
3. Housing prices continue to drop, pushing out the likelihood of short sales and sales that would avoid defaulting

Also, notice how there are more filings (635K) to properties (446K). That’s indicative of the fact that most borrowers used multiple loans. In and of itself, that is proof that these folks could not afford the mortgage without tricking the system.

At 40% default rates, we will see a total 2.9M homes defaulting or $1.2T.
At 60% default rates, we will see 4.5M homes defaulting. That’s $1.8T in losses.
That’s millions of people tossed out of their homes.

Should you feel sorry for them? No way. First of all, under traditional borrowing standards, they'd be exactly where they are heading: renting apartments. Many others were gambling and lost. Others were simply living beyond their means. Or they took equity out of their house and blew it on cars and vacations.

Add it all up and you have millions thrown out of their homes and effectively removed from the consumer spending marketplace. You also have fortunes erased as individual speculators lose their investments. These are the fundamentals of a recession.

Adding to the pain of falling spending is the tightening of lending.

No amount of free ride on defaulting loans will restore the fortunes of investors and homeowners who can't even pay their property taxes. These folks will not suddenly feel comfortable enough to go out and buy new cars. They will be pinching pennies.

The scale of this is massive.

On the othe rhand, if you can weather the situation, this is a blessing coming your way. Anyone with cash and good credit will have an unparralleled opportunity to buy assets cheap.

Gearing up for Q2

What’s worse than being on the sidelines during a major rally? Being short during a rally.

It’s even harder when I watched my list of stocks to buy climb to amazing heights:
ATW +20%
CF +26%
WLT +40%
ACI +40%
MVL +30%
GNK +48%
ETFC +3%

I look at the last quarter and I have the following takeaways:
1. I am a damn good stock picker
2. I am too greedy sometimes. I tried to buy these stocks on the cheap and missed out.
3. I am wrong so far on the bear. I think it will bite and I’ll continue to wait.
4. I bought puts at one of the worst times last quarter. Fortunately, they are long term puts, but relying on a major market pullback for some of them

I followed the exact wrong approach to the market last quarter. So I ask myself, what do I do now, this quarter?

I think my big mistake was expecting Q1 to be the point where GDP reports showed negative growth and corporate earnings were bad. As it turned out, the GDP stayed in positive territory and most companies continued to show growth. Nevermind how they were able to show growth (for example, relying on dollar conversion rates), the fact is that earnings growth stayed positive. Well, except for banking and housing related (construction, retail, etc).

The fundamentals continue to point downward. Everyday more bad news is released. Today it was Walmart. Walmart grew, but at the expense of other retailers as consumers migrate spending to low priced retailers. And even mighty Walmart guided down for the rest of the year.

Does the market reflect these developments? At this time, the Dow is down 8% from its high 7 months ago. At the same time, the Dow Jones P/E has shot up to 86
http://online.wsj.com/mdc/public/page/2_3021-peyield.html?mod=topnav_2_3002
To put this in perspective, a year ago it was 18.

Here are the Dow Industrials:
3M
Alcoa
American Express
American International Group
AT&T
Bank of America
Boeing
Caterpillar
Chevron Corporation
Citigroup
Coca-Cola
DuPont
ExxonMobil
General Electric
General Motors
Hewlett-Packard
Home Depot
Intel
IBM
Johnson & Johnson
JPMorgan Chase
McDonald's
Merck
Microsoft
Pfizer
Procter & Gamble
United Technologies Corporation
Verizon Communications
Wal-Mart
Walt Disney

Could that Dow PE 86 be somewhat distorted by recent earnings due to the housing and financial sectors? That is, a sudden drop in the E would make the P/E race up. Financial companies: AIG, BoA, Citi, & JP Morgan
Housing: Home Depot

Certainly there is some impact, but countering it is the record setting gains at Chevron & Exxon.

So the Dow is high not because of math but because earnings are not keeping up. But the projections are for earnings to grow and for the Dow P/E to return to normal. Based on current forward projections, we should see a P/E of 14 if the Dow stays at 12,800 and earnings come in where they should.

That is, the market expects earnings to grow 500% in 12 months. Is that likely? Almost all of these companies are actually forecasting single digit growth. Walmart just guided down. And that’s based on projections of no US recession and no global recession.

It’s quite simple: either E must grow or P must come down or both.
Or, to put it a different way, growth in P doesn’t look very likely.

Consider the S&P. The S&P P/E is 22, historically it trades at 15. If forecasted growth is achieved, then it will hit targets. Again, growth in P doesn’t look likely.

At this point, the Dow is down only 8%.

Clearly Wall Street expects only good news. Zales has a P/E of 30 and a forward P/E of 17, despite sales growth of 6% after a major margin impacting promotional clearance sale. It is down 30% from its high. Harley is also down 30% from its high despite a drop in sales, worsening cash flow and slipping margins.

For these reasons, I am confident that the markets and stocks will drop. But it won’t drop until bad news materializes. That could be in July when GDP and quarterly earnings get released. 60 days away. I will stick with my strategy of being bearish, but I will also take a few long positions.

Also, I am sitting out ETFC this week. I think that Options expiration this Friday will play havoc with this stock. Next week is the week to move. As a reminder we have 1000 shares of ETFC and 2000 additional shares that have a covered call of $4, expiring this Friday. I want to write the June $4 or $5 on whatever shares we have next week.

Stock analysis

BLOW BY BLOW REVIEW
AN - GM and Carmax announcements undeniably point to a deeply troubled car market.
Another used car retailer released earnings last week. "Car-Mart admitted it is benefitting from higher-income customers feeling the economic squeeze and forgoing new car purchases in favor of a used automobile."
AN sells new cars and their market is disappearing. There is still the chance that Eddie Lampert could take them private (easier at $10 per share than it was at $14). That's one reason I want to exit. Another is that I doubt the puts will approach $2. That would mean the stock itself is approaching $8 ($10 strike minus the $2 option value). Shorts are piling in: short position rose from 10% to 12% in one month.

AGN - Puts expire in 3 weeks. I could see more pullback, so this is on day-to-day watch.

DUG - Yes, I went negative oil. And oil shot up ~5% and DUG still rose. Volume has been rising because many people (myself included) think that oil is going to pullback. I base this on a few variables:
1. Clear, concerted efforts to pull the price down. The Fed & SEC are trying to limit speculation, which will help.
2. Demand is down. US oil consumption has dropped 4% in the last 2 months. Apparently oil is elastic. Airplane flights and less car travel is changing the consumption landscape.
3. Supply is rising - At $130, lots of new supply is coming online
4. OPEC knows that we are heading back to oversupply. Libya and Saudi Arabia are not the only voices talking about reducing supply to keep prices high. The only question is can they manage to stop production when prices slow. It sounds almost contradictory, but Iran, Venezuela, Russia and others must pump as much oil as they can to sustain their economies. As prices dip closer to $120, they are encouraged to pump even more. The history of OPEC is the history of cheating by member states - producing above quota.
5. Summer ends soon - oil consumption will moderate. But capacity will stay high.

Rumors of an attack on Iran could make for problems, but those pass quickly. I think an actual attack would happen in November, after the elections and before the new US Commander-in-Chief takes charge.

DSX - Shipping. I will do a write-up on shipping another time. For now, my rational is
1. 10% dividend
2. Undervalued - they have a very small P/E given their massive growth expectations

ETFC - I think the drop is really in sympathy with all financials. Guilt by association.
Recall, however, that ETFC owned up to their mortgage and HELOC exposure back in September - 9 months ago. They had much more time to deal with the problem. And they seem to have been the only ones that have owned up to the problem (as opposed to C, MER, MS and others that continue to try and wait out the problem).
Meanwhile, they have poached a lot of business from Schwab and TD Ameritrade. They'll need them - people trade less in Bear markets.
It all comes down to showing an improvement in their loan portfolio.
In the near term, I do expect more down moves as other lenders show weakness and drag down the sector (IndyMac may go bankrupt, for example, & Morgan Stanley will get downgraded).

Interestingly enough, the Short position has fallen from 111M shares to 105M in 1 month. Of course, that may be why the price was above $4 last month.

Longer term, I am not very worried here:
1. Stock is already down 85%
2. Company is not on any rumor mill for bankruptcy, downgrades, or similar critical issues.

HOG - These guys are not a transportation company, they are a consumer product. Most people own Harley's as vanity items not for core transportation. It's an expensive luxury item too - requiring maintenance and insurance, at a time when most hog riders are cash strapped.

Some folks will argue that they are an oil play because motorcycles are more fuel efficient than cars. Several problems with that theory:
1. Not that much more fuel efficient
2. Other bikes are more efficient
3. They cost almost as much as a used car. Folks who are challenged to buy a car are not going to look at something almost as expensive

HOG is facing low demand, so they are shutting down several production lines.
Another core problem is financing, which has a double impact. First, delinquency rates are rising, meaning folks are returning their bikes to HOG. Second, they can't write new loans on new cycles.
Lastly, they have almost no International presence to bail them out.

MGM - Times must be difficult for Vegas: I have free offers being thrown at me every week.
MGM took a hard blow after getting downgraded by an analyst. They are a HOLD, which means SELL.
Not one aspect of their business is doing well, and it looks like Wall Street is noticing. Vegas is hurting and so is Macau (take note those of you who are banking on a strong China - even the Chinese are startingto show signs of exposure).

The chart looks ugly with more pain ahead. There are rumors now of bankruptcy because of the $13B City Center that looks like it won't even come close to being breakeven. A major writedown will occur in a few quarters. We have a September expiration (almost 3 months). So lets keep those puts for now.

MUR - A refinery. An oil retailer. A driller and oil producer. Every single one of these is a good business right now. What makes me favor MUR is that they sell gas at Walmarts. Recent news shows that consumers are buying much more cheap gas at Walmart - and that means MUR. I like the way they stayed above $90 for the past 2.5 months.
And they only have a 14 Forward P/E

NKE - I think storm clouds are ahead but they are not terribly overpriced, so I want to close out the position as soon as possible.

VMC - VMC is locked into long-term development contracts, and they are somewhat immune form current building demand.
They are not immune from the high cost of oil - asphalt is a big part of their business. Their margins are getting squeezed right now.
A second area of concern is new business. A large number of potential contracts are probably being deferred by both government and commercial developers.
A third and final problem for them is cement. Prices are dropping, further pressuring margins.

Resistance is strong at $60, which means that once it gets broken, the low 50s are next.

ZLC - this one puzzles me.
The competitors are hurting.
* Blue Nile announced US sales are slow
* Whitehall is declaring bankruptcy

I want to say that they may be rising because of the value of their gold inventory. Except that gold hasn't moved much in 6 months. With the exception of a 3 week spike in February/March, gold has traded around $880 an ounce +/- $40. And ZLC flushed its inventories the last 2 quarters by 15% - reducing their gold position.

Sales may be up thanks to the stimulus checks. But one-offs aren't going to save them. And they rely on too much private financing to make the sale: they actually use Citigroup and that must be starting to tighten.

To scare the shorts, management has announced a share buyback of $350M. They have the debt and have spent it already to reduce shares outstanding by ~9%.
But they are really short cash and I just don't see how long they can keep bleeding money.

In fact, I notice that short pressure is huge: 44% of shares are shorted and that's an increase of 4% since last month.

Choppy Week Ahead

Typically there wouldbe a rebound on Monday following a down week. It's hard to say.
One thing is clear, this week will show sluggishness in retail.

Other highlights will be
Bear Sterns & Morgan Stanley - good opportunity still to short these turkeys
Oracle - I suspect weakness from reduced IT spending
Best Buy - Probable an exception, they should be doing ok

ILMN up then down

ILMN gave up all of its 1 week gains today. Some of that gain probably came from JP Morgan's focus on ILMN announced Monday.

There was a lawsuit between 2 partners of ILMN over some code. But whichever one wins shouldn't matter to ILMN - it works with both.

No reason has been released so I can only make a conjecture that a big player got out.
This is evidenced by the almost 3X volume of shares - strong indication of a big move by a single player.
Timing - it comes after a big 10% breakout run (from 33 to 36.5)

At the same time, note that the CEO is increasing sales staff 50%. That means potential for rapid sales growth. In other words, an important shift in resources away from R&D and over to sales usually comes before sales acceleration.

Without any news, it could be a profit lock move or someone heard earnings release info and is running for cover. I hate big drops on heavy volume and no news.

I can't make a recommendation to buy or not at this time. Not enough info. The technicals look fine

TRID - Bad news continues

Downgraded today and dropped 17%
"San Francisco-based Thomas Weisel Partners downgraded Trident to "peer perform"' from "outperform" over concerns about increased competition"

In effect the stock dropped 17% on an expected 10% earnings drop. That's 50% in 3 months.

"The options-grant issue remains potentially expensive, time-consuming and will scare off some institutional investors, says Wedbush Morgan's Berger. But market trends in flat-screen TVs are the most important part of Trident's near-term story...."My response is, [if that happens], is that going to change how many TVs are people going to buy?" he says. "I don't think so."

So the question is - are TRID sales affected?
Because, at the revised and lowered valuation, TRID now has a 18 P/E. For a company still expected to grow 40%+.

We've seen how strong flat panel TV sales have been. We've seen how TRID has gained market share.
I am riding this out for now.

Barron's and GHL

Last week (feb 19th) I discussed why I like GHL over LAZ. Let me repeat what I wrote when comparing GHL and LAZ:

"* EPS is forecast much higher: 80% vs 50%
* Sales growth is forecast to be higher: 48% vs 32%
* EPS upside is much higher: analyst ranges call for up to 150% growth vs 65%

Here is what I see:GHL was founded by former Morgan Stanley’s top bankers. This is a trend: big brokerages are losing all of their top talent to boutique shops where the ownership opportunities (and upside) is much higher). Greenhill is one such boutique.
Margins are up 5.2% y/y, 10% q/q. Sales are growing 50%, current PE is 42, and earnings grew 70%. Revenue and earnings are accelerating."

Barron's is right up to a point. GHL is valued much more than LAZ. And there are great reasons why:
LAZ is losing sales (down 14%) whereas GHL is doubling
LAZ is sitting on a mountain of debt almost equal to it's sales ($1.2B). GHL is debt free
LAZ has a lower margin (30% vs 40% for GHL)
LAZ is built on disgruntled employees. GHL is building with excited employees. GHL is cherry picking its team.

It's the classic small cap vs big cap valuation.
The small cap company is growing almost 2X so.....it's P/E is 2X.
And $100M in upside means a hell of a lot more to GHL than it does to LAZ.

At the moment LAZ is playing in many big deals - Time Warner & Disney, for example.
GHL deals are smaller but notable: Maytag, 7-11.

I am assessing that there will be plenty of deals sloshing around.
Plus, there is a reason why bankers are valuing one of their own this highly.

Weeks 14 & 15 Update - New stocks to buy this week

Week 14 Week 15 YTD Since Inception
Dow 1.17% 0.53% 3.71% 5.6%
S&P 0.24% 1.8% 3.13% 5.6%
NASDAQ 0% 1.58% 3.49% 5.2%
LiveRocket -1.45% 1.14% 8.58% 18.92%


In Week 14 we stopped out of the following stocks
JOYG $52.8
MDR $47
AKAM $21.8
GRP $47.5
That yielded $47,715 on a $42,31.45 investment. That’s a 12.8% yield on 6 week investment

In Week 15 we stopped out of MRVL $63 and sold SNDK $59
That yielded $$22,925 on a $22,053.5 investment, or a 4% yield. The MRVL 28.9% yield on 3 month investment was almost completely lost to the SNDK buy back.

CURRENT PORTFOLIO
JLG 263 shares
STX 597 shares
ET 500 shares
NTRI 115 shares
Cash $70,642.71

OVERVIEW
We are less than the market the past two weeks because I decided that indicators were pointing to a possible downturn. We stayed out and the market advanced. The underlying market trend is upwards, and the only reason to stay out is because of the potential to buy in at substantially better prices. Again, I still see us at an inflection point – it could go up but it traditionally has gone down.

It’s all about oil. Dell and Agilent had great earnings, but it didn’t really spark the market. HP and others will release this week, and that will add to generally positive sentiment. Oil dropped, and the market surged.

There are rebounds going on in Technology, Finance, and Energy/Mining equipment.
NEXT MOVES -
Energy/Mining Equipment: Adding aggressively
GRP – The bottom has been established (~$40). This is a screaming buy - they have a PEG of 0.63 and a backlog of $814M compared to last year’s sales of $1.35B. We just wanted to buy in at a lower price. Adding this week.
MDR – The bottom has been established (~$45). As discussed previously, the coal industry and utilities are growing and turning to MDR for equipment. Margins are up 4.5% q/q and 8% y/y
We’ll buy back in before earnings release in next 2 weeks
TIE – Offshore oil exploration requires titanium tubes (steel corrodes). That’s how I found this company. But they are much more, and I am hugely impressed. This is a quintuple play: specialty metals, energy, healthcare, aerospace, military.
Specialty metals - I don’t like commodities at this point in the business cycle. Commodity steel is dropping in price. But niche metals and alloys are doing fine.
Specialty metals – as demand grows for more metals, remaining a specialty item helps to slow the commoditization and price drops.
Energy play - With oil likely to stay this high, future planes in particular will use more titanium. Also, as oil extraction becomes tougher, pumping seawater into older wells is the premier methodology and this requires titanium equipment (steel corrodes in seawater). And much exploration in general is in the ocean as well.
Healthcare – More aging boomers require more titanium implants. This demand is slight in terms of volume, of course, but growing nevertheless.
Aerospace - The average plane requires 45+ tons of titanium today. Plane manufacturing is increasing to meet Chinese and Indian demand, and more titanium will be used.
Military – More weapons are being ordered. Titanium is a major component of these because it is lighter than and stronger than steel (tanks) and resistant to seawater corrosion (battleships, submarines). One submarine uses 240,000 tons of titanium. Bush recently announced an increase in defense spending for large ticket items.
As a result, prices are up 31%~50% and plant utilization has gone from 72% to 80%+.
The end result: margins are up 12.5% y/y and 6.5% q/q.
Of strong interest to me is the strong institutional buying and insider buying. Yep, insiders are snapping up the stock.
The company is incredibly dependent on aerospace. Historically, titanium has a longer cycle than steel, typically 6-7 years. 2006 is the 3rd year of the up cycle.
Market expansion is proceeding geographically and via increased product portfolio. With a presence in Europe and the US (airbus and Boeing), the major markets, TIE has begun operations in China – clearly the next big market. TIE is active in the auto market where aluminum is disadvantaged because it can’t be worked in the same tool and die equipment used for steel. Titanium can. Although titanium is ~8x the price of steel, the weight and fuel economy benefits may create additional demand.
Most interesting is that several long term contracts are expiring, and that will allow TIE to raise prices based on higher market prices.
With a headlock on the US, competitive imports have a 15% import tax. So that helps too.
They just split so I want to see if we can wait and capitalize on a post-split softening (if any).

I own GRP, MDR, and TIE.

Finance: Adding GHL
ET is doing well. January trading hit a new level – up 33% since December. Next, we want to add M&A. At this point in the cycle, companies will grow through consolidation (STX, Mittal, etc). The choices are LAZ or GHL. I favor GHL:
* EPS is forecast much higher: 80% vs 50%
* Sales growth is forecast to be higher: 48% vs 32%
* EPS upside is much higher: analyst ranges call for up to 150% growth vs 65%
Here is what I see:
GHL was founded by former Morgan Stanley’s top bankers. This is a trend: big brokerages are losing all of their top talent to boutique shops where the ownership opportunities (and upside) is much higher). Greenhill is one such boutique.
Margins are up 5.2% y/y, 10% q/q.
Sales are growing 50%, current PE is 42, and earnings grew 70%. Revenue and earnings are accelerating.
I own ET and GHL.

Technology: Adding
AKAM continues to look tasty, and we’ll probably get back in when it looks right. Probably close to $25

Trident (TRID) – Designer of chips for HDTVs. If you watched the Superbowl, was it on a flat panel TV? Have you been in a Best Buy lately and seen the floor space given up to these products? Sales were up 112% Y/Y and inventory is tight. Look to the 4th quarter for more supply and lower prices. That’s actually a good thing: TVs are very price elastic.
Hot sales, growing sales. Where is the play?
TRID has a headlock on the graphics in flat panel screens: Sony, Samsung, and Haier all depend on their chips. Sharp is designing them in. Their competitive advantage was basic semiconductor technique: they combined several chips onto one (so-called system on a chip). Systems-on-a-chip deliver cost and power advantages. Plus the companies don’t have to source 3 different chips, possibly from different vendors.
The competition is Genesis, which has dropped the ball. GNSS focused on PC oriented flat screens. Also, I have heard that their TV chips don’t perform very well.
OEMs like to stay with one vendor for several generations. Dislodging TRID will be hard and require enormous price/performance advantages not to mention time.
Sales - gargantuan and expected to continue growing fast
Margins – Grew 4%+ sequentially and 1% Y/Y
PEG – The ratio is 0.93
I like the accelerating sales and earnings

A chief concern is valuation: P/E of 600%+
But that includes 2 quarters (Q1 & Q2) of combined $0.07 earnings
The last 2 quarters (Q3 & Q4) had a combined $0.30 earnings. (BTW earnings surprises have been strong to the upside for the last 3 quarters).
If earnings stay flat, that would be $0.68 next year. That’s a 42 P/E on a forward basis. And that’s reasonable for a high tech company in a market growing 100%+ annually.

I own TRID.

Nuance (NUAN) – The business is speech recognition. Most customer relationship systems follow the old fashioned style of entering numbers for a selection. The new systems are voice enabled. An example is when you call the airlines for automated arrival/departure information and the system gets the information instead of an operator. For large companies, this is a major cost savings – trading system costs for salaries.

Until recently, most systems were proprietary. Nuance created an XML system that handles various dialects. Their system is used by the market leaders (Tellme & BeVocal). Sales and earnings are projected to grow 50% this year.

Solid earnings upside surprises show the adoption of the technology is taking off. Tellme, for example, handles 3 million calls daily using Nuance’s technology. I believe that Nuance could pull a Google to Tellme’s Yahoo. Essentially, everyone depends on Nuance, and there is no reason that they couldn’t vertically integrate and cut out the middleman. A sign of the potential is the purchase of Dictaphone – a healthcare voice recording system used by doctors to handle records.

Nuance sued Tellme on Friday for infringement.
Meanwhile, reporting as of 12/31/05 showed massive institutional buying.