With the QE2 decision and his Op-ed in the Washington Post, Ben Bernanke took an aggressive stance because he knows that next year’s Board of Governors will consist of more QE critics. He’s certainly getting an earful of criticism from foreign creditors this week. I’ve spent a lot of time researching the international reaction to QE2, because this factor will probably dominate the direction of individual stocks and sectors in the coming months. Some sectors of the stock market will likely benefit from QE2, but most will suffer.

The market should soon start discounting other factors aside from the Federal Reserve’s behavior. That’s what we’re seeing today. Two of the biggest risk factors include:

1.    Continued stress in Euro-area sovereign credit (specifically Ireland)

2.    Slowing economic activity in China

Ireland will likely need a bailout from the EU in the coming months. I’m referring to an actual financing commitment, not just jawboning G-20 bureaucrats.

Spreads on Ireland’s sovereign debt have widened so far that the interest rates on future refinancing would be so high that they’d be self-defeating. The Irish government claims to have enough liquidity to last through mid-2011 without tapping the bond market — but this is a solvency issue, not a liquidity issue. This government has effectively hit the debt wall. So Ireland is another case study in how Keynesian economic policies ultimately lead to bankruptcy.

Ireland will eventually need to restructure its debts (including haircuts for bondholders) to avoid paying a politically unacceptable share of its GDP to bondholders. In “Ireland’s Fate Tied to Doomed Banks,” The Wall Street Journal highlights how rapidly the government’s financial health deteriorated in the wake of its bank bailouts. During its housing bubble, Ireland pulled too much future economic activity into the present. Now, not only is its suffering under the loss of that “pulled forward” economic activity, it’s also having to pay interest on the debt it incurred to finance the housing bubble.

Greece and Portugal will likely restructure as well. In my view, over the next 6-12 months, the Euro is at risk of another crash against the U.S. dollar as Germany’s export prowess is simply not enough to both support its own economy and continue to bailout its neighbors. Germany’s taxpayers don’t want to bail out lenders’ follies; they saw our experience with TARP, and don’t want to repeat the same mistake.

A haircut for PIIGS bondholders is coming, sooner or later. That, in turn, means trouble for the big European banks that hold those bonds. Germany and France will eventually realize that it makes more sense to save dry powder to recapitalize their banks, rather than squander it on delaying inevitable PIIGS defaults for just a couple of years. The longer bureaucrats and bank lobbyists delay this process, the more cash flow will be sucked out of the economy for the alleged benefits of propping up bondholders.

As sovereign budget stress remains in place, the Euro should start looking less like the old German mark and more like the Italian lira. The Euro/U.S. dollar exchange rate is highly correlated with the “risk on” trade, so as the Euro falls, U.S. stocks should correct — perhaps violently. The consensus clearly believes that “stocks can only go up during QE2,” so that makes a correction even more likely.

In Europe, the political will to sustain austerity programs in Greece and Ireland will wane, but probably not before we see disappointing GDP figures and more public protests. The U.K.’s austerity programs may not have a long shelf life either.

Meanwhile, on the other side of the globe, China’s massive credit bubble is starting to pressure prices. Even the heavily doctored Chinese economic stats can’t hide the obvious pricing pressure at the consumer level. Its stock market is selling off on fears that the central bank will raise rates. If that doesn’t help, perhaps China will accelerate the appreciation of the Yuan against the U.S. dollar — a move that in the short run would slow its GDP, but in the long run would make commodity imports cheaper for China (and more expensive for the U.S.).

There are numerous ways to profit from these risks on the short side. I promise to keep you updated as the affect of the QE2 continues to unfold.

Sincerely,
Dan Amoss
Penny Sleuth

November 15, 2010

Short Opportunity: QE2 Won’t Remove Risk was originally featured in the Penny Sleuth.

The Fed is boxing itself in, allowing the markets to dictate its decisions. Over the next few years, as a huge portion of the national debt needs to be rolled over, political pressure on the Fed to keep rates low will grow dramatically. With repeated doses of quantitative easing (QE), the Fed risks surrendering its remaining shreds of credibility and independence.

If bond investors lose confidence in the Fed, then financial markets will be in serious trouble. It may happen soon, depending on how aggressively QE2 is implemented. In his latest Investment Outlook, Bill Gross of PIMCO hits the nail on the head: “Check writing in the trillions is not a bondholder’s friend,” Gross writes; “it is, in fact, inflationary, and, if truth be told, somewhat of a Ponzi scheme. Public debt, actually, has always had a Ponzi-like characteristic.”

PIMCO’s opinion matters, as it’s the largest bond manager in the world.

Gross concludes with his view that the 30-year bull market in bonds is over, or nearly so. This is huge news. He’s essentially saying that PIMCO will look to hit the Fed’s bid for the Treasuries currently sitting in PIMCO’s inventory. Then PIMCO is likely to sit on its hands in the Treasury market until yields are much higher.

This may represent a prudent course of action for the PIMCOs of the world, but what of other Treasury bond holders — banks, insurance companies, and foreign central banks? What if they look for the exits? If so, the Fed would have to print much more money than it expects in order to “cap” or “target” long-term Treasury yields.

This is why the Fed is playing with fire starting next week. It was one thing to open the “liquidity” floodgates in 2008 when everyone wanted to dash to cash, no matter how cheap the assets they had been holding. It’s another thing entirely to try to use monetary policy to lower unemployment. This notion is so ridiculous that only an academic in an ivory tower could dream it up. It’s very likely to fail, and when it does, the financial markets won’t like it. The bond market could start looking more like it did in the late 1970s than in did in the 1930s.

Gross lays blame for reaching this unpleasant state on the spendthrifts we elect to Congress. That’s only partly true. Past Congresses could not have spent nearly as much if it weren’t for the Federal Reserve.

Since the end of the gold standard, we’ve been left with a Ponzi paper currency system — one without any guarantee that its value will be safeguarded by constraints on its supply. The concept of funding investments with savings went out the window a long time ago. Now, new credit largely funds investments. The mantra of propping “demand” up — by any means necessary — is the mainstream economist view. This begs the question: How can you have demand without supply? The answer is you cannot — not for very long, anyway.

A country that consumes far more than it produces can live off its accumulated capital for a while, until it self-cannibalizes. Claims on production and capital can be handed out with gusto. Today, they take the form of new Treasury notes and new U.S. dollars. But sooner or later, producers begin to question the value of those paper claims. At that point, they require a few more currency units to part with a unit of their production. Saudi Arabia lifting its target range for crude oil prices would be just one example.

Control over the world’s reserve currency is a privilege that shouldn’t be abused. Yet the Fed has abused it, and doesn’t look to be letting up.

Savers and investors could choose to implement their own monetary policy. It’s pretty certain that more and more people with capital will shift a percentage of their assets to gold, as insurance against a bonfire of fiat currencies.

Savers and investors must cooperate if central banks are to achieve their absurd “goals” of tweaking the economy here and there. If Ben Bernanke is giving savers no reason to treat the U.S. dollar as a store of value, then it should be no surprise that they will not.

If QE2 backfires, resulting in continued price strength in “undesirable” items (i.e., food and energy), then the Fed will be compelled to tap on the monetary brakes.

Meanwhile, in the wake of the market’s “QE2 anticipation rally,” technical trading conditions are signaling danger for bulls in the near future.

Sincerely,
Dan Amoss

Penny Sleuth

November 2, 2010

How the Fed Playing with Matches Can Affect Your Investments was originally featured in the Penny Sleuth.

Here’s a look at how to profit from the coming decline in the trucking business.

You see, some capital spending mistakes are obvious (including supply gluts in residential and commercial real estate). But mistakes were made in asset classes you might not expect, like building too much capacity in the trucking industry.

If businesses react to misleading price signals, they can easily make capital spending errors. Credit bubbles cause misleading price signals. These signals are unhealthy because they act to pull future demand into the present.

This artificially boosted demand sends the signal to businesses to add capacity. Then, once the growth in credit slows, or even reverses, demand can fall far below supply. The industries that were most aggressive during the boom are left with excess capacity. Even the best businesses within each industry suffer from the investment enthusiasm of their peers, which winds up suppressing prices and profits.

Governments implemented huge stimulus programs, which ease and delay the adjustment process. This temporarily restores some of the earlier boom conditions. But sooner or later, prices adjust until supply and demand fall into balance. In 2011, when the fading stimulus plan stops boosting GDP and state governments continue their necessary restructuring, we’re going to see more adjustment in the U.S. economy. Prices and volumes in the trucking business should head south.

In fact, according to the transportation analysts at Baird, conditions are already softening. Growth in the Baird Freight Index and the American Trucking Association index is slowing, after peaking in spring 2010:

In the Trucking Business, Inventories Matter

As the global economy adjusts to post-credit bubble reality, it remains to be seen how much inventory of physical goods is sustainable. The desire to hold inventory is critical for the trucking industry. Lower demand for inventory translates into less-frequent deliveries from 18-wheeler trucks. Inventory is in a constant state of flux, and reflects businesses’ estimates of their customers’ demand.

Most mainstream economists expected inventory replenishment to boost GDP growth in recent quarters. We doubted this in December 2009, and it’s turned out that inventories haven’t driven GDP, as was expected at the time. Inventory levels in 2006-2007 levels were simply unsustainable.

How much inventory do businesses really need? This is something that each business must decide for itself. But with hindsight, we know that retailers in particular held far too much inventory heading into the 2008 collapse in retail sales. Inventory planning has its trade-offs: Too much inventory leads to weak profit margins and returns on capital, while too little inventory leads to missed sales opportunities. Most retailers remain conservative, choosing to forgo some lost sales, but avoiding the potential for painful inventory liquidations. Many retailers and manufacturers went out of business and are no longer in need of trucking services.

The “great” recession forced every business involved with physical trade — from manufacturers to distributors to retailers — to reassess how much inventory is appropriate to hold. The inventory-to-sales ratio provides a rule of thumb. This ratio has historically trended downward as more businesses adopt just-in-time inventory management. But during the 2008 crisis, this ratio spiked as sales dropped much faster than inventories.

According to the U.S. Census Bureau, the economywide inventory-to-sales ratio was 1.26 at the end of July 2010, down from a 2009 peak of 1.45. This ratio is now back near the 2004-2007 average of 1.3, so unless final demand picks up dramatically, the expected inventory rebuilding cycle will be tame.

With many businesses still shell shocked from the crisis, it’s unlikely that we’ll see a rush to preemptively build more speculative inventories. Yet the trucking stocks are still trading at valuations that require robust recoveries in freight volumes and pricing.

That mispricing gives us a good opportunity to bet against trucking right now…

[Ed. Note: The iShares Dow Jones Transport ETF (NYSE: IYT) provides an accessible way to bet on tucking exposure. But I’d strongly recommend taking a look at Dan’s research on one specific trucking stock – and his exact recommendation on how to bet against it for potential 150% returns.]

Regards,
Dan Amoss
Penny Sleuth

October 12, 2010

How You Could Make 150% Gains as Trucking Stocks Decline in 2010 was originally featured in the Penny Sleuth.

As I write, Greece is paralyzed by strikes. Greece is not likely to stabilize its ratio of sovereign debt- to-GDP, as bailout planners now anticipate. Austerity plans will add pressure on GDP. A less costly, more efficient way of dealing with this bankruptcy-like situation would have been for creditor German and French banks to take haircuts on Club Med bonds, and then go to their respective governments for painful, dilutive equity infusions.

Instead, last May’s $1 trillion bailout bluff from a loose coalition of EU finance ministers involved even moral hazard than the U.S. TARP program; it involves cross-border bailouts of reckless behavior.

The Greeks were extended a temporary financial lifeline, and now seem unwilling to make any sacrifices. We haven’t seen the end of this problem. There’s no way to know when it’ll flare up once again — when the market will call the $1 trillion bluff. But the credit default swap market will be the “canary in the coalmine.” Taxpayers in creditor countries will not be happy and the Euro experiment will weaken further.

Shining more light on the subject was Michael Lewis’ latest piece in Vanity Fair, “Beware of Greeks Bearing Bonds.” Lewis describes the complete basket case that is the Greek economy and government. Bribery, fraudulent government accounting (is there any other kind?), and tax evasion are rampant.

A society wanting a tiny tax burden is fine — great, in fact, if it wants a thriving private sector in the libertarian context of respect for contracts and private property rights; but if that same society wants an enormous welfare state, we have problems — and a financing gap.

That financing gap for many years was filled by a rapidly growing Greek government debt. Most Greek citizens seem to want to live at someone else’s expense, via subsidies or welfare. A modern economy cannot function under such a system.

It’s not surprising that this type of system leads to a breakdown in trust and a rise in suspicion of neighbors. Lewis explains:

“The Greek state was not just corrupt but also corrupting. Once you saw how it worked you could understand a phenomenon which otherwise made no sense at all: the difficulty Greek people have saying a kind word about one another. Individual Greeks are delightful: funny, warm, smart, and good company. I left two dozen interviews saying to myself, “What great people!” They do not share the sentiment about one another: the hardest thing to do in Greece is to get one Greek to compliment another behind his back. No success of any kind is regarded without suspicion. Everyone is pretty sure everyone is cheating on his taxes, or bribing politicians, or taking bribes, or lying about the value of his real estate. And this total absence of faith in one another is self-reinforcing. The epidemic of lying and cheating and stealing makes any sort of civic life impossible; the collapse of civic life only encourages more lying, cheating, and stealing. Lacking faith in one another, they fall back on themselves and their families.”

Lewis’ article reinforces that the European bank “stress test” results announced in July were a humorless joke. The Financial Times recently reported that treasurers at several large European industrial companies are running their own stress tests, and as a result, not transacting with suspect banks.

Greece is going to default and restructure its sovereign debt. It’s a matter on when — not if. With so much Greek sovereign debt racked up by corrupt and incompetent governments, the political momentum behind defaulting will grow. Greeks will see no point in suffering under austerity programs in order to make bondholders — German and French banks — whole.

Default is not ideal. It effectively rewards borrowers who behaved recklessly. But at least it would spread losses to those who foolishly financed this recklessness, rather than have the overwhelming weight of those embedded credit losses foisted onto the debtor.

This week, I’ve been refining my list of attractive short candidates. There are many to choose from — especially after the stock market’s recent, super-light volume rally.

Regards,
Dan Amoss, CFA
Penny Sleuth

September 13, 2010

Why Greece’s Debt Problems Are Far from Over was originally featured in the Penny Sleuth.

Last week, the Bureau of Labor Statistics estimated that private sector payrolls grew by 67,000 in August (including the impact of fewer census workers, the headline number was a loss of 54,000 jobs).

The “birth/death” model, which never makes it into the press release, added 115,000 private sector jobs from new businesses that were assumed “born” in August. Subtracting this “birth/death” figure yields a loss of 48,000 private sector jobs — a reasonable adjustment since new small businesses aren’t exactly sprouting up rapidly these days.

State and local governments, whose budgets remain under severe stress, cut an estimated 10,000 positions. As money from the 2009 federal stimulus package dissipates, the stress on state and local budgets will worsen over the next few quarters. Many will have no choice but to cut jobs. This area of the labor market — state and local government jobs — is one of the few that has yet to adjust to post-credit bubble reality.

You know the labor market is unhealthy when many pundits are calling for the Federal Reserve to “spur” job growth. With the Fed’s Jackson Hole conference in the headlines lately, this is a relevant topic for financial markets.

If wheat and other raw food prices keep soaring, does anyone really expect the Fed to tighten policy? I doubt it. The Fed is actively trying to devalue savings and recapitalize the banking system at the expense of savers. It can print a years’ worth of honest labor in a millisecond, and might eventually seek to bypass the banking system if it remains lethargic in its role of transmitting easy credit. Considering the current state of government policy and central banking, should we really be surprised that the private sector economy seems to be malfunctioning?

We’ve probably reached the point where further Fed easing will cause more negative consequences than so-called “benefits.” For example, can the Fed really keep long-term Treasury yields pegged to low levels if existing Treasury holders want to sell? How much new money creation might it take to keep long-term Treasury yields pegged to a desired level? If it went down this path, the Fed might have to create several trillion new dollars to hold bond prices up (yields down). This new money creation, in turn, would heighten fear of future inflation. At this point, the Fed would lose the small bit of credibility it has left.

Some sort of government debt restructuring is likely in the coming years. There is good news about this scenario, at least for Americans: Japan is likely to reach this point — the total revulsion of government bonds that cannot possibly be repaid in honest money — far sooner than the U.S.

Such is the folly of central planning. It’s not a good idea to manipulate market prices far from their natural state. In this case, the Fed is trying to keep the Treasury’s cost of borrowing at artificially low levels. Eventually, holders of Treasury securities might realize that they’re artificially propped up, and all hit the Fed’s bid at the same time.

By the way, this scenario argues for gold having a place in your portfolio. Those who say they “don’t understand” gold (and there are far too many of them right now for gold to be in a bubble) are implicitly agreeing that the current fiscal and monetary regime is sane. It’s clearly insane, and will eventually have to change.

The idea of a U.S. dollar as a store of value is now based more on faith than on being compensated with a positive, real rate of interest. When faith in the dollar as a store of value diminishes, the only option the Fed will have is to tighten monetary policy and restore positive, real interest rates. Such a policy tightening would quickly end myriad carry trades and banking strategies depending entirely on a near-zero cost of funds.

Regards,
Dan Amoss, CFA
Penny Sleuth

September 8, 2010

The Truth About Last Week’s Jobs Report was originally featured in the Penny Sleuth.

I listened to several presentations at the Enercom conference this week. One important message from companies operating in the Gulf of Mexico: in the wake of the Minerals Management Service reshuffling, the regulatory framework is in chaos. Nobody among the regulatory bureaucracy seems to want to take responsibility for approving any drilling permits. This is needlessly ruining many investment plans and hurting the region’s labor market.

Producers of goods and services, whether they are in oil and gas, farming, or manufacturing, or transportation, keep prices low (in contrast, the Fed is cooking up new ideas to raise prices of goods and services by printing and distributing new, unearned claims on the economy’s production). Producers respond to shifts in consumer preferences by expanding or contracting capacity.

It looks like we’re facing a temporary supply glut in natural gas (in storage, not necessarily in the ground). Now that we’re past the peak of cooling season in North America, producers might find themselves competing for storage at lower and lower prices.

This is getting reflected in the price of the front-month natural gas futures contract, recently breaking below $4 per million BTU (MMbtu):

Here is a chart of the spread (or difference) between the front month price and the price for the 12-month futures contract. This is far more important for producers because they rely heavily on hedging to mitigate price risk. The chart shows that as recently as a year ago, producers could sell forward their gas at a $3 per MMbtu premium to the spot market. Recently, this premium fell to just a 50 cent premium:

This collapsing premium will drive the gas rig count lower. Only the very lowest-cost producers will be able to drill gas wells profitably with prices for delivery in mid-2011 at $4.50 per MMbtu.

I’m looking at short ideas in natural gas service industry — specifically, drilling and completion — because I don’t think the stocks have yet discounted how sharply earnings could fall in a weaker rig count environment.

If you’re interested in taking the short-side trade against natural gas servicers, not all opportunities are created equal. I’m still working on my due diligence right now, but I’ll share my latest insights with you in the near future.

Best regards,
Dan Amoss, CFA
Penny Sleuth

September 1, 2010

A New Natural Gas Short Opportunity was originally featured in the Penny Sleuth.

Banks are among the worst offenders. On the downside of the biggest credit cycle in history, many banks are slowing the pace at which they’re provisioning for credit losses. Some are even releasing reserves into the income statement.

These are the reserves that banks had been building up to absorb credit losses. In other words, bank executives are employing the “mark-to-model” accounting framework to justify reporting higher earnings by employing subjective (usually rosy) estimates about the future.

If it turns out that we’re not, in fact, past the peak of credit losses in the banking system, banks will have to once again rebuild loss reserves, and perhaps even write off the earnings they’ve been reporting in recent quarters. Bullish banking analysts are certain we’ve seen the worst of earnings performance in the banking system. This from the analysts who didn’t recognize the risks in 2006-07 posed by the macro environment, which wound up wiping out most of the bubble-era earnings during the 2008 write-off tsunami. Furthermore, bank earnings will keep shrinking as both the size of balance sheets and net interest margins shrink as the Fed-engineered ZIRP flattens the yield curve like a pancake.

Another area to look for lower-quality earnings is any company with plant, equipment, and inventories. Lately, it’s become popular to slow capital expenditures to levels far below depreciation and amortization expense. This temporarily boosts free cash flow, but does so at the expense of future earnings. Companies with shrinking asset bases eventually deliver shrinking earnings power and risk erosion of their competitive position. As asset bases shrink, depreciation and amortization expense will also shrink, which temporarily boosts pretax income. I’ve seen several examples of this phenomenon in recent earnings reports.

Sharp swings in inventory can also push earnings up and down. Overbuilding of inventory sows the seeds of future earnings disappointment. During the late 2008/early 2009 liquidation of excess inventories, many companies suffered a squeeze in gross margins in a fire sale environment.

This phenomenon changed by the middle of 2009. Many companies had taken inventory liquidation too far. After the worst of the financial panic had passed, bottlenecks started clogging up the technology supply chain in particular. Since then, the tech supply chain has rebuilt inventories — in many cases, at a rate that exceeds sales growth.

I think you can see how this could all go wrong quickly. Component suppliers are ramping capacities. Distributors are building inventories. Contract manufacturers are scrambling to increase inventories. The product suppliers themselves are adding to their inventories. Then, as has been intimated several times above, end product demand begins to ease (from Europe, from U.S. consumers, etc.). Then all [heck] breaks loose, up and down the supply chain.

This exercise highlights the folly of government stimulus programs. These programs send phony signals up and down the supply chain for manufactured goods. It’s a fool’s errand to try to restore the economic conditions we saw during the 2004-07 credit bubble. This effort to restart the credit cycle was a complete waste of scarce capital, as more investors will likely realize in the coming months.

We’re not going to restart the credit bubble, so if they’re going to do anything, policymakers should focus on minimizing the social shock of transitioning to a post-bubble environment. Unfortunately, hundreds of billions were wasted on propping up zombie banks that could have easily been recapitalized by cutting away the claims of shareholders and junior creditors in bankruptcy, and setting up a legal framework to tame and wind down over-the-counter derivatives — all without a penny of public funds. Policymakers had the entire spring and summer of 2008 to prepare such a plan in the months after Bear Stearns blew up in March 2008. Instead, U.S. taxpayers got “TARPed” in order to bail out reckless bank shareholders and bondholders.

In today’s market, we’re watching traders on Wall Street prop desks trying to make money by front-running the Federal Reserve into its planned Treasury bond buying program. We have a market dominated by carry trades that would blow up in spectacular fashion if the Fed even hinted at raising short-term interest rates.

Speculators with itchy trigger fingers dominate the stock market. The public is withdrawing from most mutual funds, taking the most stable pool of liquidity with it. Much of today’s stock buying is being done with borrowed money, which adds greatly to volatility.

Even worse, the market is expensive if you adjust for the widespread accounting gimmickry we’ve seen in recent quarters. So the next time you hear that the market is “cheap” — and you’ll hear it frequently in the mainstream financial press — remain skeptical about the quality of earnings in the P/E ratio.

Regards,
Dan Amoss, CFA
The Penny Sleuth

Red Flags for Earnings Season Investors was originally featured in the Penny Sleuth.

1.    The long-term trend back towards consumer frugality and higher savings rates remains in full force. This will dampen consumer spending.

2.    A double dip in housing prices is likely, because subsidies are ending and the backlog of foreclosure resolutions is about to accelerate.

3.    The impact of the Obama administration’s stimulus plan is fading, and is not leading to any real “multiplier” effects because most of it went to plug holes in state government budgets.

4.    European and Chinese GDP are slowing for well-publicized reasons.

5.    Those who create jobs in the U.S. fear rising tax rates rising in 2011, rising energy prices from cap-and-trade legislation, the pro-Wall Street “financial reform” bill, and a laundry list of other anti-business policies.

In short, if the status quo remains in place, the U.S. economy will be lucky if it experiences a fate similar to post-bubble Japan. The policies of addressing each collapsed credit bubble are similar: keep squandering taxpayer dollars on failed financial institutions, and prop up unaffordable federal and state spending programs.

The key difference: Japan’s competitive export-oriented manufacturing base was strong enough to prop up the Japanese welfare state (until now, at least). The U.S. manufacturing base is certainly powerful and efficient, but it’s nowhere near profitable enough to support both itself and the ever-growing U.S. welfare state. What policymakers seem not to understand: each dollar that funds so-called “stimulus” programs must be extracted out of the private sector. And they wonder why the private sector is not recovering! A far more effective Keynesian stimulus plan — as long as the bond market remains unworried about deficits — would have been to slash government spending and slash taxes even faster. While that would also have been fiscally irresponsible, at least we’d be seeing “multiplier” effects on GDP by now.

Big companies remain defensive for many reasons. The July 1 issue of The Economist ran a story on the growth in corporate savings. Capital spending at most big companies is running at a slower rate than depreciation, resulting in rising free cash flows (but at the expense of a deteriorating asset base):

Business investment is as low as it has ever been as a share of GDP. Firms run the risk that their stock of capital is too depleted to meet even sluggish growth in demand. The likeliest outcome is a hesitant recovery in business spending as firms balance the risks of inadequate investment and insufficient cash. If banks continue to be a blockage, firms may look for a way around them. This week Siemens, a big German engineering firm, said it would apply for a banking license so that it can use its cash reserves to lend to customers. Fine, but for the sake of the economy, better a borrower than a lender be.

Siemens is expanding its vendor financing activities; this highlights one of the problems of an undercapitalized banking system. We rescued the banks with TARP and zero interest rates so they could “keep lending,” right? Well, it turns out that most are remaining defensive and hoping to earn their way out of their undisclosed capital hole by playing carry trades in government bonds.

The article in The Economist has the Keynesian characteristic of oversimplifying reality into a static equation. Businesses aren’t reinvesting just due to “deficient demand.” Demand is only limited by human desire; it’s what consumers earn that really determines sustainable demand. I’m sure everyone’s demand for almost everything would rise if it weren’t for the complicating factor of having to produce something of value before consuming.

So why don’t policymakers start focusing their attention on enhancing the productive capacity of the economy, rather that trying to prop up an amorphous, incalculable Keynesian equation plug called “demand?”

Some businesses aren’t reinvesting due to hostile government policies; some aren’t investing because they dramatically overbuilt during the boom; still others aren’t investing because their customers are broke — all entirely rational, albeit painful action to free up capital for its highest and best uses.

The end result of it all suggests that stocks could have further to fall in 2010. Of course, that doesn’t mean that your portfolio’s value has to dwindle in kind – there are score of profitable plays to be made as weak stocks stumble – but it does mean that shrewd investors should focus their capital on stocks that have the best staying power in tough times.

Regards,
Dan Amoss
Penny Sleuth

August 3, 2010

5 Reasons for a Slowing Economy in 2010 was originally featured in the Penny Sleuth.

The more leveraged a company’s balance sheet, the faster shareholder claims evaporate when asset values deflate and cash flow dries up. That should come as a surprise to few, but for banks in particular, credit risk often accelerates out of nowhere. The growing comfort with the slow pace of working out unaffordable residential mortgages has fed the popular view that the banking sector earnings have bottomed.

Earnings may have bottomed from a sector-wide perspective, but there are hundreds of billions in future credit losses that have yet to be booked. The Fed and Treasury are hoping that the carry trade they’re engineering (i.e., borrow near zero from the Fed and buy Treasuries) will be profitable enough to offset these embedded, but unrecognized credit losses.

Banks are hoping to avoid having to provision for these losses in the hopes that the typical “postwar” rebound in house prices and employment comes to fruition. But the mainstream economists are ignoring the elephant in the room: weak balance sheets that exist throughout most levels of society.

Corporations and wealthy small business owners may have healthy balance sheets, but if their customers do not, then their sales will suffer. On top of this challenge, one would expect rational entrepreneurs to expect tax rates on any future productive economic activity will soar. Unless the Feds want to risk destroying confidence in the dollar, tomorrow’s taxes will likely be raised in order to pay for today’s government spending binge.

Foreclosure activity is crucial to the outlook for bank earnings. Mortgage losses will be a growing problem for bank stocks in 2010. Bank stock bulls repeatedly point to the huge “pretax, pre-provision” earnings banks are generating. This is like valuing a software company based only on its gross profit; SG&A is a big, important expense for software shareholders, just like credit losses are important for bank shareholders.

We could soon see a reacceleration of credit provisioning in the banking sector, which would act against any further appreciation in all risky assets. Since the suspension of mark-to-market accounting, banks have gained much more control over timing their credit losses, but they cannot get away with completely ignoring them when the evidence is overwhelming that credit losses are real. Increases in the frequency and severity of mortgage losses would add to this evidence.

This is much too long if the U.S. housing market is going to return to anything resembling a free market over the next decade. So instead of a continuation of slow foreclosure processing, Hanson argues in favor of an imminent acceleration.

It’s fairly obvious that the backlog of foreclosures has built up like water behind a dam. The feds are trying to control the amount of water flowing through the dam. But it remains to be seen if they can keep controlling it to the degree that they have.

Once the dam gives way, the market may be shocked at how quickly the headline foreclosure numbers accelerate. A saying you often hear in the banking business is: “the first loss is the best loss.” (The same saying will eventually apply when banks as a group rush resolve their zombie commercial real estate mortgages).

The likelihood of this development argues for continuation of the “deflation” or risk-averse trade (basically, short all stocks, long Treasuries). But we shouldn’t ignore the likelihood that central banks are holding their dry powder for another overwhelming burst of quantitative easing in response to deflation fears.

If you’re looking to take a passive approach to protecting your investments, there are a number of Treasury ETFs out there that offer exposure to Treasuries with the liquidity and lower capital requirements of an exchange traded fund.

For a more active short-side play, I’ve already recommended a handful of potentially high-yielding trades to my Strategic Short Report readers. To see how my bear market strategy works, just click here…

Regards,
Dan Amoss
Penny Sleuth

June 2, 2010

Bet on Treasuries to Avoid the Next Mortgage Meltdown was originally featured in the Penny Sleuth.

This is what happens when a market with no investment merit at current valuations runs out of speculative fuel:

Investors may finally be turning their attention to quaint concepts like valuation and risk.

Computerized trading, which is driven by similarly programmed algorithms, is the main culprit. Here are my thoughts on last Thursday’s crash, and how it might change things going forward:

1. When the governments and central banks manufacture the illusion of an economic recovery driven by deficit spending and money printing, the faith in the sustainability of that recovery is — not surprisingly — weak. Now, after two crashes in the space of a decade, the list of greater fools is shorter. Mom and Pop investors have wisely chosen to remain skeptical throughout this bear market rally, making it very narrow and jittery, rather than broad and sustainable. After last week’s drama, I think we can forget about the widely anticipated surge in mutual fund inflows.

2. Thursday’s market was one of many consequences of watering down accounting standards in the banking system in spring 2009. Poor accounting quality introduces an element of Ponzi psychology in the trading of financial stocks. In other words, if everyone owning these stocks knows that earnings are very fudge-able, and embedded credit losses are being stretched way out into the future, they’ll aggressively dump these stocks on any correction.

3. Someone must hold every share of stock that’s been issued. This is why the notion of central bank money printing holding up the stock market forever is too simple. If primary dealers “repo” Treasuries at the Fed, and use the cash proceeds to buy stocks and corporate bonds, they are by definition not strong hands. They close out these trades quickly on days like yesterday. The strategy probably involves paying ever-higher prices into rising, calm markets, and unwinding violently when volatility picks up. This doesn’t make for a healthy stock market. Perhaps Congressional hearings should target the influence of primary dealers borrowing from the Fed to finance risky carry trades.

4. The market has too many impatient, trend-following traders, who sell when “support” levels get hit. They aren’t buying stocks with the view that stocks are fractional ownerships in businesses on sale. Technical analysis loses its value when every technician uses the same strategies, and has similar stop losses, as yesterday showed us.

5. The market doesn’t have enough patient, skeptical investors. This makes bubbles and crashes more likely. The good news is it creates buying and shorting opportunities for contrarians.

6. After last week’s market gyrations, it’s becoming even more apparent that “quant,” or computerized trading exacerbates market swings. Rather than supply cash to the market during panics — and supply stock to the market during melt-ups — it appears that these funds do the opposite. Quant trading relies on the same garbage-in-garbage-out models that created such wonders as “triple-A” CDOs. The physics and math Ph.D.s who create and modify these models should apply this math where it’s actually appropriate and predictive — in engineering problems — rather than markets heavily influenced by emotion. Quants seem to know the price of everything with each passing nanosecond, and the value of nothing. We should seek to take advantage of mispricing caused by quant trading — primarily by adopting a longer time horizon for trades. The less often you trade or invest, the more time you have to think.

7. Crashing markets cause everyone to have a “deer in the headlights” reaction. But it helps calm your nerves if you’re confident in the value and earnings power of the stocks you own. Only computers without an understanding of valuation and market history could have been selling quality stocks at 20-30% of intrinsic value aggressively at the 2008 market lows — which was clearly the case.

8. This isn’t just in stocks. We’re seeing risk aversion in currencies, commodities, and corporate bonds. If the crash in the Euro keeps spiraling out of control, look for Ben Bernanke to set up a massive swap line with the ECB to provide dollar liquidity to leveraged speculators looking to unwinding carry trades.

9. In today’s investment culture, the vast majority of fund managers don’t stay in business if they think too independently. If money managers decide to not participate in a rally because they judge the fundamentals as weak, they often get fired. A few decades of this investing culture has resulted in scary levels of groupthink. The less that fund managers can think and act independently, according to their best judgment, the less efficient the market becomes. Another way of saying “less efficient” is “more prone to bubbles.” Career risk forces otherwise rational, sober managers to buy into an expensive, rising market.

Regards,
Dan Amoss
Penny Sleuth

May 11, 2010

9 Takeaways from May’s Market Crash was originally featured in the Penny Sleuth.