Archive for August, 2010

What Happens in Vegas, Stays on Wall Street

What happens in Vegas, stays in Vegas, unless it’s a habit of betting, in which case that habit will follow you back to Wall Street. Just as there are a million ways to make or lose money by investing or speculating in the market, the same principles apply to sports betting as well.  Anybody who has been to Las Vegas and gone to the sportsbook knows how incredibly and insanely accurate the oddsmakers are – I speak from immature experience having traveled there for a healthy number of investment conferences and vacations. The oddsmakers are so accurate; you could say they are almost “efficient” at what they do.

 But like the market, in the sports world too, efficiency has a tendency to breakdown occasionally and form bubbles. This dynamic leaves both a huge threat of substantial losses and a potential for windfall gains. Where there are bubbles forming, you are bound to find a large number of excited individuals jumping on a bandwagon. Now, let’s take a look at how the worlds of Wall Street and wagers collide and see if any lessons can be learned.

Jumping on the Stock Bandwagon

band·wag·on [band-wag-uhn]: a party, cause, movement, etc., that by its mass appeal or strength readily attracts many followers.

Photo source: Freshpics.blogspot.com

Everybody loves a winner and no one more so than a fresh fan jumping on the bandwagon. Living in Southern California, the bandwagon is presently fully-loaded with proclaimed Los Angeles Laker fans and USC fans, although the Trojan wagon is currently undergoing repair. It’s easy to identify bandwagoners in sports – just find the face painter, guy with a rainbow afro, Boston native sporting a Kobe Bryant jersey, or the fanatic betting on the team favored by three touchdowns. In the game of stocks, identifying the fickle but passionate followers is a little more subtle. Bandwagon status is not measured by the extent of point spreads (predicted scoring differential between two opponents), but rather by level of P/E ratios (Price-Earnings ratio) or other valuation metric of choice.

While it is clear sports bandwagoners root for the “favorites,” in the realm of investing this translates into piling onto the “growth or momentum” stocks (see Momentum Investing article) – I hate generalizing terms but that’s what we bloggers do. Value investors, on the other hand, root for (buy) the “underdogs.”

To illustrate my point, let’s take a look at a few past bandwagon momentum stocks:

  • JDS Uniphase Corp. (JDSU): In 2000 we saw these bandwagoners valuing investor favorites like JDS Uniphase at a whopping $99 billion – meaning investors were willingly paying over 100x’s revenues and 600 x’s trailing earnings to own the stock. At the time, JDSU was a “New Economy” stock that was going to revolutionize the proliferation of bandwidth around the globe with their proprietary optical laser components. For those of you keeping score at home, today JDSU’s stock is valued at approximately $2 billion ($9.97), or -98% less than the market value in March 2000 (split-adjusted peak share price of $1,227.38 per share). If it wasn’t for a 1-for-8 reverse stock split in 2006, then a share of JDSU would fetch you $1.25 today, or less than the amount needed to cover an out of network ATM penalty fee.
  • Crocs Inc. (CROX): Crox is another one of my favorite bandwagon stocks, because this loud plastic eyesore footwear was clearly a fad that couldn’t sustain its growth once popularity waned, despite my wife being a bandwagon-ee.  Like other fad product-related stocks, the company could no longer maintain its growth once they completed stuffing the channel and their customers cried uncle from choking on inventory. Making matters worse for CROX, knockoff versions were offered for a fraction of the cost at local grocery stores and mall kiosks. After about 20 months post its IPO (Initial Public Offering), the music stopped and within 13 months the stock cratered from a $75 per share peak to $0.79 in 2008. The stock never traded at the absurd dot-com levels, but the lofty 37x P/E in 2007 quickly turned negative after close to $200 million in losses were realized in 2008 and 2009. The stock has since rebounded to $12 and change, and maybe their new Crocs high-heel line of $99.00 shoes (see here) will propel the stock higher…cough, cough.

Point Spread, Point Spread, Point Spread

In sports betting the three most important factors in making a winning bet are point spread, point spread, and point spread. Unlike the March Madness college basketball pool in which you may have participated, in the real world the participant needs to do more than just pick the winning teams – the participant must determine by how much a team will win by. Let’s take a gander at a few actual examples.

  • Florida Gators vs. Charleston Southern Buccaneers (9/5/09): Without knowing a lot about the powerhouse squad from South Carolina, 99% of respondents, when asked before the game who would win, would select Florida – a consistently dominant national-powerhouse program. The question gets a little trickier when asked the question: “Will the Florida Gators win by more than 63 points?” That’s exactly the point spread sports bettors faced when deciding whether or not to place the bet – somewhat analogous to the question whether JDSU was a prudent investment at 600x’s earnings? Needless to say, although the Buccs kept it close in the first half, and only trailed by 42-3 at halftime, the Gators still managed to squeak by with a 62-3 victory. Worth noting, the 59 point margin of victory resulted in a losing wager for anyone picking the Gators.

  • USC Trojans vs. Stanford Cardinal (10/6/2007): Ranked as the presumptive #1 team of the country pre-season, and entering the game with a 35-0 home-game winning streak, USC was a whopping 41 point favorite over Stanford. On the flip side, the Cardinal came into the game fresh off of a 1-11 losing season the prior year, and in the previous year the Cardinal lost to the Trojans 42-0. Stanford ended up winning the 2007 match-up by a score of 24-23, not only pulling off one of the greatest upsets of all-time, but also spoiling USC’s chances of winning the national championship.

Read more about the greatest upsets of all-time.

Beyond the Point Spread

As you can surmise from our discussion, the same point spread standards apply to investing, but when discussing stocks the spread is measured by various valuation metrics based on earnings, cash flows, book value, EBITDA, sales, and other fundamental growth factors.

Of course, in Las Vegas and on Wall Street not everyone follows traditional fundamental analysis. Some gamblers and speculators will transact solely based on less conventional methods, for example quantitative models, technical analysis and trend review (read Technical Analysis: Astrology or Lob Wedge). For example in sports, handicappers may only wager on teams with five-game winning streaks and winning home records. Whereas on Wall Street, speculators may only trade stocks with positive earnings surprises or “head-and-shoulder” patterns. Hot technicians come and go, but very few real investors survive the long haul without using fundamental analysis and valuation as key components of their winning strategies.

As I have argued, there are many ways to make (and lose) money on Wall Street or in Las Vegas, and consistently jumping on the bandwagon is a sure way to lose. For the successful minority whose performance has endured the test of time, a common thread connecting the two disciplines is the ability to determine and profit from a prudently calculated point spread/valuation. History teaches us that the same effective handicapping skills happening in Las Vegas are the same abilities needed to stay on Wall Street and win.

Wade W. Slome, CFA, CFP®  

P.S. See how a pro handicapper conquered Las Vegas and placed sportsbooks on the run.  

Plan. Invest. Prosper.  

www.Sidoxia.com 

*DISCLOSURE: The undergraduate alma mater of Sidoxia Capital Management’s (SCM) President happens to be UCLA, so although I believe any reference to rival school USC is not provided with any malicious agenda, nonetheless there may exist an inherent conflict of interest. SCM and some of its clients own certain exchange traded funds, but at the time of publishing, SCM had no direct position in JDSU, CROX, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

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August 29, 2010 at 11:53 pm 1 comment

M&A: Top or Bottom?

James Stewart at Smart Money recently wrote a piece attempting to debunk the consensus view, which holds the belief that increased mergers and acquisitions (M&A) activities is a leading indicator of positive market returns. There is no doubt, in the desert of positive news headlines, the bulls are searching for signs of an oasis to rescue them. Temporarily quenching the thirst of the bulls were $90 billion of proposed deals last week, including the hefty $40 billion hostile takeover offer of Potash Corp. (POT) by BHP Billiton Ltd. (BHP).

Is this uptick in deal announcements the sign of greener pastures, or is it what Stewart calls a “reverse indicator” of the market’s direction?

Stewart buttresses his argument by showing how record deal activity occurs at peaks of the market. For example, global M&A activity crested at $4.3 trillion in 2007, right before the market cratered in 2008. This peak can be compared to the previous trough of $1.3 trillion in M&A transactions in 2002, just as the economy was freshly recovering out of the recession.  The trough to peak period for this M&A cycle lasted about five years (2002-2007), so I’m having a little trouble understanding how Stewart is claiming a peak is imminent after less than 1 year into the new M&A cycle (the recent M&A trough occurred in 2009 at $1.3 trillion)? Wouldn’t his analysis imply a gradual increase in deals until 2014? Well, for now, let’s just go with his rapid orgasm thesis and move onto his next points.

Stewart proceeds to rationalize the spate of new deal announcements with the following reasons:

  • Higher Prices Perk Up Previously Reluctant Sellers: The general price rebound in the market from the nadir in March 2009 is one major contributing factor to why previously reluctant targets are now warming up to fresh overtures.
  • Suitors More Comfortable: In 2009, buyers weren’t in the mood for paying top dollar for companies experiencing deteriorating fundamentals. Prices may be higher in 2010, but the Armageddon scenarios of early 2009 have momentarily been put on hold.
  • Money Can’t Get Any Tighter: The cheap, loosey-goosy lending standards in the pre-2008 M&A golden era no longer exist,  but conditions can’t get much worse than the log-jammed lending standards practiced in 2009.

The Real Reason for Deals Rising

Source: The Wall Street Journal

One word…cash. About $1.8 trillion of it is just piling up on the non-financial balance sheets of domestic companies (Financial Times). The tribes are getting restless with the obscene amounts of money earning 1% or less (read Steve Jobs: Gluttonous Hog article) and shareholders want to see more productive strategies applied to their capital. Frankly, I much prefer organic investment (e.g., R&D and marketing), share buybacks, and dividends over large destructive acquisitions any day. Just ask the executives at AOL/Time Warner, Mercedes Benz/Chrysler, and Sprint/Nextel how those large deals worked out for them. For some reason, many men like driving big macho trucks, just as many CEOs like controlling big companies.

One Reason to Buy and Many Reasons to Sell

I can’t disagree with James’s thesis that M&A markets get overheated near market tops, but I think there is a lot of room in deal announcements between the $90 billion in deals announced last week and the $4.3 trillion peak.  I also agree that one good week of M&A announcements should not be extrapolated into eternity.

Worth noting as well, I believe there is a substantial difference in the financing market today versus the prior peak. In the BHP/Potash deal for example, BHP offered $40 billion in cash…not stock. BHP is putting its money where its mouth is, particularly its $18 billion in annual cash flow and its healthy balance sheet. Internal financing wasn’t the main priority in the mid-2000s, when companies (including private equity) were more cavalier with OPM (other people’s money), specifically with the endless pools of cheap bank financing.

Currently, companies have deep pockets, but very short arms, and as a result, companies have been very stingy with their capital. However, if we continue to see more internally financed cash deals, I will view that trend as a tremendously positive signal of longer-term fundamental confidence, a characteristic which was absent last year.

On the topic of insider buying, Peter Lynch pointed out “there is only one reason to buy and many reasons to sell” – the only real reason to purchase is the belief stock prices will move higher. Since the availability of cheap capital has been severely hampered, a wide swath of companies will have to rely on their own cash generation – not OPM. Since outside capital is scarce, the companies with cash flexibility will be more prudent in their M&A due diligence.

Overall, James Stewart may be right about the sustainability of M&A going into next year. However, in the short-run, as the gargantuan corporate cash piles get put to use through more M&A, and share buybacks, simple supply-demand economics indicate a shrinking equity base should bode well for market prices, all else equal. Uncertainty is available in large quantities right now, so time will tell if deal making will diminish into a market top, or gain momentum into a bull market. With all that cash sitting on the sidelines, my guess is we are closer to the trough of the M&A wave versus the top. If I’m wrong, don’t hold your breath for a Microsoft-Google (MSFT/GOOG) or Exxon-Chevron (XOM/CVX) merger anytime soon.

Read Full Smart Money M&A Article Here (Hat-Tip Josh Brown TRB)

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper.  

www.Sidoxia.com 

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, GOOG, and AAPL, but at the time of publishing SCM had no direct position in BHP, POT, MSFT, XOM, CVX, AOL/Time Warner (TWX), Mercedes Benz/Chrysler, and Sprint/Nextel (S) or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

August 27, 2010 at 1:53 am 1 comment

Productivity & Trade: Pins, Cars, Coconuts & Chips

The concepts of productivity and free trade go all the way back to Adam Smith, widely considered the “father of economics,” who wrote the original capitalism Bible called the Wealth of Nations. Many of the same principles discussed in Smith’s historic book are just as applicable today as they were in 1776 when it was first published.

Economics at its core is the thirst for efficiency and productivity for the sake of profits. Ultimately, for the countries that successfully practice these principles, a higher standard of living can be achieved for its population. For the U.S. to thrive in the 21st century like we did in the 20th century, we need to embrace productive technology and efficiently integrate proven complex systems. To illustrate the benefits of productivity in a factory setting, Smith wrote about the division of labor in a pin factory. Murray N. Rothbard, an economic historian, and political philosopher summed up the takeaways here:

“A small pin-factory where ten workers, each specializing in a different aspect of the work [18 steps], could produce over 48,000 pins a day, whereas if each of these ten had made the entire pin on his own, they might not have made even one pin a day, and certainly not more than 20.”

 

Dividing up the 18 pin making steps (i.e., pull wire, cut wire, straighten wire, put on head, paint, etc.) lead to massive productivity improvements.

Another economic genius that changed the world we live in is the father of mass production…Henry Ford. He revolutionized the car industry by starting the Ford Motor Company in 1903 with $100,000 in capital and 12 shareholders. By the beginning of 1904, Ford Motors had sold about 600 cars and by 1924 Ford reached a peak production of more than 2,000,000 cars, trucks, and tractors per year. Although, Ford had a dominant market share here in the U.S., the innovative technology and manufacturing processes allowed him to profit even more by exporting cars internationally. This transformation of the automobile industry allowed Ford to hire thousands of workers with handsome wages and spread 15 million of his cars around the globe from 1908 to 1927.

Comparative Advantage: Lessons from Smith & Ford

Foreign trade has continually been a hot button issue – especially during periods of softer global economic activity. Here is what Adam Smith had to add on the subject:

“If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage.”

Smith believed that parties with an “absolute advantage” in manufacturing would benefit by trading with other partners. Today, it’s fairly clear the U.S. has an absolute advantage in creating biotech drugs, Hollywood movies, and internet technologies (i.e., Google), however in other industries, such as industrial manufacturing, the U.S. has lost its dominant position.

David Ricardo, an English economist who authored the famous work On the Principles of Political Economy and Taxation, is attributed with extending Smith’s “absolute advantage” concept one step further by introducing the idea of “comparative advantage.”

Producing Coconuts and Computer Chips

Let’s explore the comparative advantage concept some more by investigating coconuts and computer chips. As we hemorrhage jobs to other countries that can accomplish work more cheaply and efficiently, increasingly discussions shift to a more protectionist stance with dreams of higher import tariffs. Is this a healthy approach? Consider a two nation island able to produce only two goods (coconuts and computer “chips”), with the U.S. on one half of the island, and the Rest of the World (R.O.W.) on the other half.  

Next, let’s assume the following production profile: The R.O.W. can choose to produce 10 coconuts or 10 chips AND the U.S. can produce 4 coconuts or 8 chips.

 

Scenario #1 (No Trade): If we assume both the R.O.W. and the U.S. each spend half their time producing coconuts and chips, then the R.O.W.’s production will create 5 coconuts/5 chips and the U.S. 2 coconuts/4 chips for a combined total of 7 coconuts and 9 chips (16 overall units).

If we were to contemplate the ability of trade between R.O.W. and the U.S., coupled with the concept of comparative advantage, we may see overall productivity of the nation island improve. Despite the R.O.W. having an “absolute advantage” over the U.S. in producing both coconuts (10 vs. 4) and chips (10 vs. 8), the next example demonstrates trade is indeed beneficial.

Scenario #2 (With Trade): If R.O.W. uses its comparative advantage (“more better”) to produce 10 coconuts and the U.S. uses its comparative advantage (“less worse”) to produce 8 chips for a combined total of 10 coconuts and 8 chips (18 overall units). Relative to Scenario #1, this example produces 12.5% more units (18 vs. 16) and with the ability of trade, the U.S. and R.O.W. should be able to optimize the 18 units to meet their individual country preferences.

If we can successfully escape from the island and paddle back to modern times, we can better understand the challenges we face as a country in the current flat global world we live in. Our lack of investment into education, innovation, and next generation infrastructure is making us less competitive in legacy rustbelt industries, such as in automobiles and general manufacturing. If the goal is to maximize productivity, efficiency, and our country’s standard of living, then it makes sense to select trade scenario #2 (even if it means producing zero coconuts and lots of computer chips). The coconut lobby may not be happy under this scenario, but more jobs will be created from higher output and trade while our citizens continue on a path to a higher standard of living.

The free trade strategy will only work if we can motivate, train, and educate enough people into higher paying jobs that produce higher value added products and services (e.g., computer chips and computer consulting). There is a woeful shortage of engineers and scientists in our country, and if we want to compete successfully in the modern world against the billions of people scratching and clawing for our standard of living, then we need to openly accept the productivity and trade principles taught to us by the Adam Smiths and Henry Fords of the world. Otherwise, be prepared to live on a remote, isolated island with a steady diet of coconuts for breakfast, lunch, and dinner.

Read Full NetMBA Article on “Comparative Advantage”

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper.  

www.Sidoxia.com 

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and GOOG, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

August 24, 2010 at 11:17 pm Leave a comment

Does Double-Dip Pass Duck Test?

If it looks like a duck, walks like a duck, and quacks like a duck, then chances are it is a duck. Regrettably, not everything passes the common “duck test” when it comes to judging the state of the economy. The prevailing opinion is the economy is on the brink of falling into another double-dip recession. Driving this sentiment has been the relentless focus on the softening short-term data (e.g., weekly jobless claims, monthly retail sales, daily dollar index, etc.). I’m no prophet or Nostradamus when it comes to picking the direction of the market, but if you consider the status of the steep Treasury yield curve, the perceived sitting duck economy may actually just be something completely different – perhaps one of those oily birds recovering from the BP oil spill.

Pictures Worth Thousands of Words

Despite all the talk of “double-dip”, the curve’s extreme slope is still near record levels achieved over the last quarter century. Here’s what the Treasury snapshot looks like now:

Graph source: The Financial Times

Does this look like an inverted yield curve, which ordinarily precedes an economy falling into recession? Quite the opposite – this picture looks more like a ramp from which Evel Knievel is about to jump. Maybe Federal Reserve Chairman Ben Bernanke is actually the daredevil himself by setting artificially low interest rates for extended periods of time? If so, it’s possible the economy will suffer a fate like Mr. Knievel’s at Caesar’s Palace, but my guess is we are closer to the take-off than landing based on the yield curve.

I’ve recently harped on the wide range of “double-dip” guesses made by economists and strategists (see Probably” Wrong article), but if that was not enough for you, here are a few more cheery views taken from this weekend’s Barron’s magazine and a few other publications of choice:

Kopin Tan (Barron’s): “The Treasuries camp is expecting another recession… In reality, with retailers and customers alike eyeing a second recession this year, it’s a season of anxiety.”

John Crudele (NY Post): “We’ll get a correction that’ll put the words ‘double-dip’ back into the headlines… When the final figures are produced years from now, historians might just decide that this was just one long downturn — not a series of dips.”

Jeremy Cook (Chief Economist-World First): “This will further heighten fears that the US economy is careening into the dreaded double-dip recession.”

How can the double-dippers be wrong? For starters, as I alluded to earlier, we are nowhere near an inverted yield curve. The 10-Year Treasury Note currently yields 2.62% while the T-Bill a measly 0.15%, creating a spread of about +2.47% (a long distance from negative).

As this chart implies, and others confirm, over the last 50 years or so, the yield curve has turned negative (or near 0% in the late 1950s and early 1960s) before every recession. Admittedly, before the soft-patch in economic data-points, the steepness was even greater than now (closer to 3.5%). Maybe the double-dippers are just more prescient than history has been as a guide, but until we start flirting with sub-1% spreads, I’ll hold off on sweating bullets. Less talked about now is the possibility of stagflation (stagnant inflation). I’m not in that camp, but down the road I see this as a larger risk than the imminent double-dip scenario.

I’m not in the business of forecasting the economy, and history books are littered with economists that come and go in glory and humiliation. And although it’s fun guessing on what will or will not happen with the economy, I rather choose to follow the philosophy of the great Peter Lynch (see my profile of Lynch):

“If you spend more than 13 minutes analyzing economic and market forecasts, you’ve wasted 10 minutes.”

Along those same lines, he adds:

“Assume the market [economy] is going nowhere and invest accordingly.”

I choose to spend my time hunting and investing in opportunities all over the map. With fear and anxiety high, fortunately for me and my clients, I am finding more attractive prospects. While some get in the stale debate of stocks versus bonds, there are appealing openings across the whole capital structure, geographies, and the broad spectrum of asset classes. So, as others look to test whether the economic animal is a bear, bull, or duck, I’ll continue sniffing away for opportunities like a bloodhound.

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper. 

www.Sidoxia.com

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in BP or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

August 22, 2010 at 11:22 pm 5 comments

Siegel & Co. See “Bubblicious” Bonds

Source: Wall Street Journal - March 14, 2000

Siegel compares 1999 stock prices with 2010 bonds

Unlike a lot of economists, Jeremy Siegel, Professor at the Wharton School of Business, is not bashful about making contrarian calls (see other Siegel article). Just days after the Nasdaq index peaked 10 years ago at a level above 5,000 (below 2,200 today), Siegel called the large capitalization technology market a “Sucker’s Bet” in a Wall Street Journal article dated March 14, 2000. Investors were smitten with large-cap technology stocks at the time, paying balloon-like P/E (Price-Earnings) ratios in excess of 100 times trailing earnings (see table above).

Bubblicious Boom

 

Today, Siegel has now switched his focus from overpriced tech-stock bubbles to “Bubblicious” bonds, which may burst at any moment. Bolstering his view of the current “Great American Bond Bubble” is the fact that average investors are wheelbarrowing money into bond funds. Siegel highlights recent Investment Company Institute data to make his point:

“From January 2008 through June 2010, outflows from equity funds totaled $232 billion while bond funds have seen a massive $559 billion of inflows.”

 

The professor goes on to make the stretch that some government bonds (i.e., 10-year Treasury Inflation-Protected Securities or TIPS) are priced so egregiously that the 1% TIPS yield (or 100 times the payout ratio) equates to the crazy tech stock valuations 10 years earlier. Conceptually the comparison of old stock and new bond bubbles may make some sense, but let’s not lose sight of the fact that tech stocks virtually had a 0% payout (no dividends). The risk of permanent investment loss is much lower with a bond as compared to a 100-plus multiple tech stock.

Making Rate History No Mystery

What makes Siegel so nervous about bonds? Well for one thing, take a look at what interest rates have done over the last 30 years, with the Federal Funds rate cresting over 20%+ in 1981 (View RED LINE & BLUE LINE or click to enlarge):

Source: dshort.com

As I have commented before, there is only one real direction for interest rates to go, since we currently sit watching rates at a generational low. Rates have a minute amount of wiggle room, but Siegel rightfully understands there is very little wiggle room for rates to go lower. How bad could the pain be? Siegel outlines the following scenario:

“If over the next year, 10-year interest rates, which are now 2.8%, rise to 3.15%, bondholders will suffer a capital loss equal to the current yield. If rates rise to 4% as they did last spring, the capital loss will be more than three times the current yield.”

 

Siegel is not the only observer who sees relatively less value in bonds (especially government bonds) versus stocks. Scott Grannis, author of the Calafia Report artfully shows the comparisons of the 10-Year Treasury Note yield relative to the earnings yield on the S&P 500 index:

Source: Calafia Report (Scott Grannis)

As you can see, rarely have there been periods over the last five decades where bonds were so poorly attractive relative to equities.

Grannis mirrors Siegel’s view on government bond prices through his chart on TIPS pricing:

Source: Calafia Report (Scott Grannis)

Pricey Treasuries is not a new unearthed theme, however, Siegel and Grannis make compelling points to highlight bond risks. Certainly, the economy could soften further, and trying to time the bottom to a multi-decade bond bubble can be hazardous to your investing health. Having said that, effectively everyone should desire some exposure to fixed income securities, depending on their objectives and constraints (retirees obviously more). The key is managing duration and the risk of inflation in a prudent fashion. If you believe Siegel is correct about an impending bond bubble bursting, you may consider lightening your Treasury bond load. Otherwise, don’t be surprised if you do not collect on another “sucker’s bet.”

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper.  

www.Sidoxia.com 

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including TIP and other fixed income ETFs), but at the time of publishing SCM had no direct position in any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

August 20, 2010 at 2:02 am 10 comments

Professional Double-Dip Guesses are “Probably” Wrong

As you may have noticed from previous articles, I take a significant grain (or pound) of salt when listening to economists and strategists like Peter Schiff, Nouriel Roubini, Meredith Whitney, John Mauldin, et.al. Typically, these financial astrologists weave together convincing, elaborate, grand guesses that extrapolate every short-term, fleeting economic data point into an imposing (or magnificent) long-term secular trend.

With all this talk of “double-dip” recession, I cannot help but notice the latest verbal tool implemented by every Tom, Dick, and Harry economist when discussing this topic… the word probability. Rather than honestly saying I have no clue on what the economy will do, many strategists place a squishy numericalprobability around the possibility of a “double-dip” recession consistent with the news du jour. Over recent weeks, unstable U.S. economic data have been coming in softer than expectations. So, guess what? Economists have become more pessimistic about the economy and raised the “probability” of a double dip recession. Thanks Mr. Professor “Obvious!” I’m going to go out on a limb, and say the probability of a double-dip recession will likely go down if economic data improves. Geez…thanks.

Here is a partial list of double-dip “probabilities” spouted out by some well-known and relatively unknown economists:

  • Robert Shiller (Professor at Yale University): “The probability of that kind of double-dip is more than 50 percent.”
  • Bill Gross (Founder/Managing Director at PIMCO): The New York Times described Gross’s double-dip radar with the following, “He put the probability of a recession — and of an accompanying bout of deflation — at 25 to 35 percent.”
  • Mohamed El-Erian (CEO of PIMCO):  “If you wonder how meaningful 25 per cent is, ask yourself the following question: if I offered you that I drive you back to work, but there’s a one in four chance that I get into a big accident, would you come with me?”
  • David Rosenberg (Chief Economist at Gluskin Chef): In a recent newsletter, Rosenberg has raised the odds of a double-dip recession from 45 per cent a month ago to 67 per cent currently.
  • Nouriel Roubini (Professor at New York University): “As early as August 2009 I expressed concern in a Financial Times op-ed about the risk of a double-dip recession, even if my benchmark scenario characterizes the risk of a W as still a low probability event (20% probability) as opposed to a 60% probability for a U-shaped recovery.”
  • Robert Reich (Former Secretary of Labor): According to Martin Fridson, Global Credit Strategist at BNP Paribas, Robert Reich has assigned a 50% probability of a double dip, even if Reich believes we are actually in one “Long Dipper.”
  • Graeme Leach (Chief Economist at the Institute of Directors): “I would give a 40 per cent probability to what I call ‘one L of a recovery’, in other words a fairly weak flattish cycle over the next 12 months. A double-dip recession would get a 40 per cent probability as well.”
  • Ed McKelvey (Sr. U.S. Economist at Goldman Sachs): “We think the probability is unusually high — between 25 percent and 30 percent — but we do not see double dip as the base case.”
  • Avery Shenfeld (Chief Economist at CIBC): “The probability estimate is likely more consistent with a slowdown rather than a true double-dip recession but, given the uncertainties, fiscal tightening ahead and the potential for a slow economy to be vulnerable to shocks, we will keep an eye on our new indicator nevertheless.” This guy can’t even be pinned down for a number!
  • National Institute for Economic and Social Research (NIESR) : “The probability of seeing a contraction of output in 2011 as compared to 2010 has risen from 14 per cent to 19 per cent.”
  • New York Fed Treasury Spread Model (see chart below): Professor Mark J. Perry notes, “For July 2010, the recession probability is only 0.06% and by a year from now in June of next year the recession probability is only slightly higher, at only 0.3137% (less than 1/3 of 1%).”

Listening to these economic armchair quarterbacks predict the direction of the financial markets is as painful as watching Jim Gray’s agonizing hour-long interview of Lebron James’s NBA contract decision (see also Lebron: Buy, Sell, or Hold?). Just what I want to hear – a journalist that probably has never dribbled a ball in his life, inquiring about cutting edge questions like whether Lebron is still biting his nails? Most of these economists are no better than Jim Gray. In many instances these professionals don’t invest in accordance with their recommendations and their probability estimates are about as reliable as an estimate of the volatility index (see chart below)  or a prediction about Lindsay Lohan’s legal system status.

I can virtually guarantee you at least one of the previously mentioned economists will be correct on their forecasts. That isn’t much of an achievement, if you consider all the strategists’ guesses effectively cover every and any economic scenario possible. If enough guesses are thrown out there, one is bound to stick. And if they’re wrong, no problem, the economists can simply blame randomness of the lower probability event as the cause of the miscue.

Unlike Wayne Gretzky, who said, “I skate to where the puck is going to be, not where it has been,” economists skate right next to the puck. Because the economic data is constantly changing, this strategy allows every forecaster to constantly change their outlook in lock-step with the current conditions. This phenomenon is like me looking at the dark clouds outside my morning window and predicting a higher probability of rain, or conversely, like me looking at the blue skies outside and predicting a higher chance of sunshine.

Using this “probability” framework is a convenient B.S. means of saving face if a directional guess is wrong. By continually adjusting probability scenarios with the always transforming economic data, the strategist can persistently waffle with the market sentiment vicissitudes.

What would be very refreshing to see is a strategist on CNBC who declares he was dead wrong on his prediction, but acknowledges the world is inherently uncertain and confesses that nobody can predict the market with certainty. Instead, the rent-o-strategists consistently change their predictions in such a manner that it is difficult to measure their accuracy – especially when there is rarely hard numbers to hold these professional guessers accountable for.

Economists and strategists may be well-intentioned people, just as is the schizophrenic trading advice of Jim Cramer of CNBC’s Mad Money, but the “probability” of them being right over relevant investing  time horizons is best left to an experienced long-term investor that understands the pitfalls of professional guessing.

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper. 

www.Sidoxia.com

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in GS, NYT or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

August 17, 2010 at 11:42 pm 15 comments

Private Equity: Hitting Maturity Cliff

Photo source: 1Funny.com

Wow, those were the days when money was as cheap and available as that fragile, sandpaper-like toilet paper you find at gas stations. Private equity took advantage of this near-free, pervasive capital and used it to the greatest extent possible. The firms proceeded to lever up and gorge themselves on a never-ending list of target companies with reckless abandon (see also Private Equity Shooting Blanks). Now the glory days of abundant, ultra-cheap capital are history.

Rather than rely on low-cost bank debt, private equity firms are now turning to the fixed income markets – specifically the high yield market (a.k.a. junk bonds). As The Financial Times points out, more than $170 billion of junk bonds have been issued this year, in large part to refinance debt issued in the mid-2000s that has gone sour due to overoptimistic projections and a flailing U.S. economy. In special instances, private equity owners are fattening their own wallets by declaring special dividends for themselves.  

Even though some of these over-levered, private equity portfolio companies have received a temporary reprieve from facing the harsh economic realities thanks to these refinancings, the cliff of maturing debt in 2012 is fast approaching. Some have estimated that $1 trillion in maturing debt will roll through the market in the 2012-2014 timeframe. Either the economy (or operating performance) improves enough for these companies to service their debt, or these companies will find themselves falling off these maturity cliffs into bankruptcy.

Junk is Not Risk-Free

Driving this trend of loan recycling is risk aversion to stocks and a voracious appetite for yield in a yield desert. Stuffing the money under the mattress, earning next to nothing on CDs (Certificates of Deposit) and money market accounts, will not help in meeting many investors’ long-term objectives. The “uncertain uncertainty” swirling around global equity markets has nervous investors flocking to bonds. The opening of liquidity in the high yield markets has served as a life preserver for these levered companies desperate to refinance their impending debt. This high-yield debt refinancing window is also an opportunity for companies to lower their interest expense burden because of the current, near record-low interest rates.

But as the name implies, these “junk bonds” are not risk free. For starters, embedded in these bonds is interest rate risk – with a Federal Funds rate at effectively zero, there is only one upward direction for interest rates to go (bad for bond prices). In addition, credit risk is a concern as well. In the midst of the financial crisis, many of these high-yield bonds corrected by more than -40% from their highs in 2008 until the bottom achieved in early 2009. If the economy regresses back into a double-dip recession, many of these bonds stand to get pummeled as default rates escalate (see also, bond risks).

Pace Not Slowing

Source: Dealogic via WSJ

Does the appetite for high yield appear to be slowing? Au contraire. In the most recent week, Dealogic noted $15.4 billion in junk bonds were sold. The FT sees the pace of junk deals handily outpacing the record of $185.4 billion set in 2006.

The Wall Street Journal used the following deals to provide a flavor of how companies are using high-yield debt in the present market:

“First Data Corp. sold $510 million of 10-year notes this week, at 9.125%, to pay down bank debt due in 2014. Peabody Energy sold $650 million of 6.5%, 10-year notes to pay off the same amount of higher-priced debt due in three years. MultiPlan Inc., a health-care cost-management provider, sold $675 million of notes this week, at 9.875%, to help fund a buyout of the company. Cott Corp., a maker of store-branded soft drinks, sold $375 million of debt at 8.125% to fund its purchase of another company, Cliffstar Corp.”

 

The roads on the junk bond highway appear to be pothole free at the moment, however a cliff of debt is rapidly approaching over the next few years, so high-yield investors should travel carefully as conditions in the junk market potentially worsen. As we witnessed in 2008-2009, it can take a while to hit rock bottom in the riskier areas of the credit spectrum.

Read full Financial Times and Wall Street Journal articles on the high yield market.  

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper.  

www.Sidoxia.com 

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including HYG and JNK), but at the time of publishing SCM had no direct position in First Data Corp., Peabody Energy (BTU), MultiPlan Inc., Cott Corp. (COT), Cliffstar Corp.,  or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

August 16, 2010 at 12:38 am Leave a comment

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