One year ago investors were heavily overweight cyclical sectors while shunning utilities, healthcare and consumer staples. Cyclicals are showing large losses for 2011 while defensive groups are showing large gains. I don't believe sector positioning is as lopsided as it was a year ago but it seems investors are slightly tilted towards defensive sectors now.
Valuations are attractive and investors are positioned conservatively, which is generally a good combination for a higher market. However, there are huge imbalances in the global economy that cannot be ignored. Valuations are pricing in some turmoil as earnings would be able to miss expectations by 10% and the S&P 500 would still be reasonably priced. However, a large scale disaster is not priced in and the potential for one exists.
Heading into 2011, I was not very optimistic about the market or the economy. The giddy sentiment and global imbalances worried me. I believed the economy would slow. The economy performed as I expected but corporate profits performed much better than I could ever have imagined given a slowing economy. A combination of my bearish outlook and excellent valuations had me positioned in defensive sectors, with my largest holdings being in healthcare. Being positioned in defensive sectors made my year.
Heading into 2012, I am not very optimistic about the economy but valuations make me somewhat constructive on the market. In the early part of the year I am planning to maintain a medium sized net long posture (short term trades not included). I will be reluctant to get aggressive other than for short term trades given all the imbalances in the world economy. I still like select defensive stocks like Vodafone, given the still good valuations and slow economy. I also like certain cyclical stocks such as in software, where valuations are already pricing in a lot of pain (ORCL, CA, BMC).
We have an overbought reading but the market has the potential to get more overbought in the coming days. Looking at the 10 day moving average of the advance-decline line we could get more overbought through Wednesday. Looking at the 10 day moving average of the put/call ratio, we could get more overbought through Tuesday.
A strong move early next week would have us overbought and looking at more neutral seasonality. That would likely be a decent place to pare back some exposure.
The market will be overbought at the end of the day today but can get more overbought through Wednesday of next week. Seasonality remains very positive although we have seen weakness on the last day of the year the past few years. Had we rallied through today I would have reduced positions. However, I believe yesterday's correction is setting us up for one more move higher before a better overbought reading.
Given the seasonality I am inclined to give the market the benefit of the doubt for as long as possible. This is proving difficult because the market has gone straight up. Typically when a market goes from oversold to overbought there is a dip somewhere in between but we have not seen one.
If we were to rally through tomorrow I would be inclined to reduce positions. However, if we were to see a pullback I would be more inclined to give the market until the middle of next week.
The first thing that one must understand is that even the so called smartest investors in the world are illogical. Higher prices turn people bullish even if little has changed fundamentally. At some point these larger players will be forced to chase the market. Being underweight ones benchmark feels like being short when the market is rising and the easiest way to make the pain stop is to buy.
I don't know where this magical level is that will force these large investors to capitulate and buy but I know its there. I have seen it time and time again. I don't know if we will reach that level but the risk that we will is out there. When large market participants are bullish, like they were early this year, this upside risk does not exist because they are already overweight equities. For this reason I have no desire to go to a net short posture even if we were to get overbought and see a little too much bullishness. At most I would be willing to go to a neutral stance.
A rally generally starts showing some divergences before it fails. This is only the first sign that the rally is starting to tire. The positives are that seasonality remains very strong, the market will not be overbought until later this week or early next week and that large market participants remain underinvested. I still believe the bulls have the advantage but we are no longer in the early innings of the current rally.
The biggest anomaly I see is the discount that safe stocks trade at compared to economically sensitive stocks. It seems like a no brainer to be in defensive stocks.
I wrote the above on February 25, days before defensive stocks began to massively outperform economically sensitive stocks. While my quote was timely, I was early in positioning myself in defensive stocks as I had been suffering in them for months prior. I had to watch economically sensitive stocks shoot to the moon while my holdings languished. Eventually, I was paid in spades but it was not easy to stick with my conviction as the market told me I was wrong every day.
We are now seeing the complete opposite as defensive stocks shoot to the moon while economically sensitive stocks languish. I am not very optimistic about the economy but at some valuation difference it makes sense to own software instead of consumer staples.
I am slowly shifting some of my exposure from more defensive, staple like companies to software. I realize that I am likely to be early again as stock market participants never learn and always take things too far. But I know that I will not be able to pick the exact turning point either. This does not mean that I don't believe defensive stocks have a place in one's portfolio. They still have a large place in mine. I am just now willing to have more economically sensitive exposure because the price is right. I'm also willing to part with my defensive holdings at the right price.
I have a healthy weighting of software in my portfolio, which has gotten killed since Oracle reported earnings. In the meantime the market has risen. I am sitting on a loss for the past three days while the market is rising.
I have been trading for a long time and have learned to control my emotions, but this is one I cannot get over. I logically understand that as a stockpicker and a contrarian this is bound to happen. In the end I'm just an overgrown, emotional primate.
Yesterday, Oracle went from hero to goat and the same people who loved Oracle at $36 hate it at $25. In conjunction with earnings Oracle announced a $5 billion repurchase plan in addition to their existing $2 billion authorization, signalling they want to be buyers of the stock at these levels.
On one side of the trade we have the reactive investing public and their reactive money managers. On the other side of the trade we have Oracle headed by self made billionaire Larry Ellison. Who is the smart money?
The bulls will point to the fact that despite the earnings disappointment, earnings are still growing. Oracle now trades at less than ten times forward earnings estimates, once one considers the $3 of cash per share Oracle holds. After building cash for years, Oracle announced a $5 billion share repurchase plan last night. The savvy Larry Ellison was not interested in repurchasing shares when they traded above $36 a few months back but at $26 he is a buyer. Investors should follow suit and buy low for a change.
I am torn by both the bull and bear arguments as they both have merit. I believe that one can only buy cheap when the news is bad and buying cheap is the best predictor of long run returns. At the same time I recognize the unprecedented headwinds. Oracle's earnings exemplifies the dilemma that investors face. The debate goes on.
I am very tempted to buy Oracle but there are two things that are holding me back. The first is that I have a lot of exposure to the software space via BMC and CA. The second is that Oracle is unclear about their capital allocation plans. I like to know what companies I own plan to do with their money. I am somewhat comforted by the fact that Larry Ellison has been a good allocator of capital. I am very seriously debating whether to make a purchase.
Looking at yesterday's put/call ratios and Rydex data one does not see much fear. Anecdotally, I saw widespread fear and despair late yesterday. Normally, I would tilt towards going with the the numbers, but the level of disgust I saw late yesterday with the market was so high that in this case I am trusting my instinct.
To summarize, sentiment is negative, the market is just about oversold and seasonality is positive. I think I am starting to see Santa Claus on the horizon, although he looks a little thinned out due to the austerity program the ECB forced upon him.
"Better to remain silent and be thought a fool than to speak out and remove all doubt"
Past rallies have been built on the hope that the ECB might wake up and realize that they are the only possible buyers for European peripheral debt. After recent speeches it is difficult to fathom this occurring as they have displayed how utterly clueless they are. It will likely take a worsening of the situation in order for them to act.
I believe the market is set up to rally into year end but the ECB is making it a challenge. It is difficult to buy without even the hope that the situation in Europe could get better. That said, I still believe we will get a rally starting some time this week.
I view IPO's and secondaries as supply into the market. Last week we saw about $4 billion in IPOs and secondaries. $4 billion that could have gone into other stocks was needed to absorb this supply. In the future it will now be much more difficult for bankers to price their junkier supply. This should lead to less supply.
For every Amazon during the internet boom in the nineties there were 10 Webvans, Globe.com, etc.. During the internet boom everybody was being priced like a winner, even though the vast majority of the stocks went to zero or thereabouts. We are seeing a similar dynamic in social media. There will be winners but right now everybody is being priced like a big winner. Zynga is a video game maker that happens to make video games for social media. These video games are far less sophisticated than what companies like Electronic Arts make yet the valuations are not even in the same stratosphere. There are no barriers to entry and these games are relatively simple to make.
In the long run the only people who benefit from unsustainable bubble valuations are those selling and the bankers getting a commission. Investors that get burned no longer want to invest, whether they get burned directly or through a mutual fund. Hopefully, the fall in Zynga will lead to less junk supply from bankers and more rational valuations.
It is difficult to argue that sentiment is bullish right now. The overarching sentiment that I am seeing is despondency. I do believe that we are closer to bearishness and another down day is likely to get us closer to excess bearishness. The secondary market is now closed for the year, so there will be no more supply via IPOs and secondaries. Europe is likely to continue to dominate market direction but barring a severe worsening of the crisid I believe further weakness can be bought into for a year end rally.
It comes as little surprise that self made billionaire Carl Icahn triumphed and Wall Street analysts were wrong. Amgen is up 11% since the tender while Gilead is down 5% since their acquisition.
I remain at a medium sized net long position despite the sales I made this morning. I believe sentiment is a net positive for the market as hope at the beginning of the week has morphed into skepticism. Large investors are under invested, we are no longer overbought, valuations are reasonable and seasonality is positive. Europe is a big risk. EU leaders are whistling past the graveyard but stop short of allowing us fall into the abyss.
In the short run we are overbought and will remain so through Wednesday. The overbought reading will likely put a lid on the upside in the early portion of this week.
Unfortunately, I did not heed my indicators as I did not expect a decline of this magnitude. Rather than go on another rant about the ECB I will focus this post on what my indicators are saying now.
The good news is that we are no longer overbought. Unfortunately, we are not yet at a good oversold reading either. The reason being that we had a lot of chopiness in recent weeks. In the very short term we should see a bounce as is usually the case after three hard down days. But both sentiment and the overbought/oversold indicators are not calling for much more. Once we get a bounce we will likely be back in no man's land in terms of short term indicators.
ECB officials are spouting utter nonsense on a daily basis. Their statements are the equivalent of saying that water is not wet. We are stretched on the downside so it is very possible that we will see a snapback rally. However, it is difficult for me to imagine the type of rally we have seen in recent months unless the ECB acts. Nobody is going to believe the ECB will act until they do. The boy has cried wolf one too many times.
I have been moving between a moderate to aggressive net long position in recent months. At the extremes I have become more aggressive and I have lightened up into rallies. I currently stand at a medium sized net long position and I am a lot more hesitant to increase my longs. Hopefully, this hesitancy is a good contrary indicator as I would still much prefer a higher market.
ECB's Weidmann says losing AAA rating is not the end of the world
ECB's Weidmann opposes boosting bond buys, coy on IMF
WEIDMANN, ON IDEA OF UNLIMITED ECB BOND BUYS, SAYS FINDS IT ASTONISHING PEOPLE THINK CAN WIN CONFIDENCE BY BREAKING RULES
Weidmann:Preventative Intervention Via Bond Buys Unproductive
Weidmann Says Don't Think Aid Program Is Needed For Italy
The Euro promptly toppled and our futures followed when these headlines hit. The ECB continues to ignore reality with its idealism. This will likely change but the only question is how much damage needs to be done first. We should be approaching a rally shortly but it will be difficult for it to progress much as long as the idealism from the ECB continues.
I am remaining at a medium sized net long position because I believe the ECB will ultimately do what is necessary to stop a meltdown. However, in order to get more aggressive I would like to see them actually do something or I would like to see more extremes in the market.
Assuming that we continue in this state of limbo, we are likely to be stuck in a trading range. Another down day tomorrow would likely be a decent entry point for a long trade within our range. At the end of tomorrow we will no longer be overbought, short term sentiment has turned negative and we are getting stretched on the downside. Have a good night.
Banks are being told delever in Europe. This means they have to sell assets, regardless of what measures governments are taking. It does not matter what budget Italy puts in place or what austerity measures it takes. Banks still need to sell assets. That is the reason sovereign spreads continue to blow out. There are simply no buyers for these assets (in the size necessary) other than the ECB. Everybody seems to realize this except for the ECB themselves and some German lawmakers.
The peripheral countries have agreed to the measures Germany and the ECB have asked for. It is time for the ECB to act. I apologize for the late posting but I don't know how many times I can repeat the same thing. There is simply nothing new to say. Hopefully, something will change soon but I'm not holding my breath.
In recent months I have done an about face and have spoken extensively about the situation in Europe. On days where the ECB decides not to buy peripheral bonds, spreads blow out and we go lower. When the ECB decides to intervene we go higher. While the indicators have worked well at the extremes, in between it has been all about Europe.
Many prefer a pure fundamental or a pure technical approach. There are dangers in mixing the approaches as confirmation bias comes into play. It is much harder to be objective when mixing approaches as if one does not find the data they are looking for in one approach they can look to the other. I have kept this in the back of my mind at all times and try not to let this happen.
The chart below from Bloomberg depicts today's roller coaster in Italian ten year yields.
Unfortunately, the EU summit brought more of the same. The Germans managed to squeeze more austerity and budgetary controls out of EU nations in return for more rescue plans that have no way of getting funded. The tricky part of analyzing these rescues is that the ECB has the power to aggressively intervene in bond markets. It was not unreasonable to believe that in return for further budgetary discipline, the ECB would intervene more aggressively. This is not the case as the ECB is allowing spreads to blow out again today. Further complicating the issue is the fact that every time we face the abyss they finally do intervene, but just enough to keep us in limbo.
In the short run we are overbought and will remain so through Wednesday. The overbought reading will likely put a lid on the upside in the early portion of this week. While the very short term might be challenging, I believe that the odds favor the bulls in the coming weeks. However, if the situation in the EU does not improve it will likely be a rally to sell into.
In many cases it is not the hedge funds fault as clients split at the first sign of any draw down. Taking a stand becomes a life or death gamble for a hedge fund. I know a few people that recently have started hedge funds. I have been told that nearly every prospective investor wants to know about risk management strategies. My risk management strategy is to buy cheap. That type of answer would not fly with most institutional investors. They want to hear about stop losses and other strategies that essentially turn a hedge fund into a glorified momentum fund.
I believe that a primary reason for the volatility we have been seeing is that there are so many momentum strategies out there. While the news flow has been volatile the moves get amplified by momentum strategies. This volatility offers excellent opportunities for value investors who use prices to their advantage or mean reversion traders who buy at points of pessimism and sell at optimism.
The bull case is that with the big, bad event out of the way we can finally enjoy the positive seasonality. The Santa Claus rally could be exacerbated by the fact that so many are under invested. The supply/demand equation greatly favors the bulls as corporations are aggressively repurchasing shares while the window for IPOs and secondaries closes towards the end of the year.
Today's news was not inspiring, even with very low expectations. I will withhold judgement until next week when we get the full details of the plan and see how aggressive ECB actions are.
I don't believe the pattern will play out this time. I don't believe we have seen the same level of exuberance as previous times. There is an almost unanimously negative view heading into the EU summit that has kept sentiment from reaching an extreme. Additionally, there are only so many times people can panic in anticipation of a catastrophic event. While I could see another down day I believe the decline will be short lived.
I sold my shares early but was able to profit off of the tender offer. I find it amazing what nonsense people trade off of, yet when there are situations like this where the odds clearly favor a trade they are largely ignored.
In the short term we are becoming overbought. A rally into the weekend would make us overbought, although it would not be a great reading as we have chopped around for the past week. Sentiment has turned bullish but is not extreme. The EU has yet to put forward any viable solutions making us dependent on vague statements. The short term seems like a coin toss to me.
Looking a little further out, I believe the odds favor the bulls. The biggest positive the bulls have going for them is the continued strength in corporate profits which has led to share repurchases and cash M&A. As long as this continues it is difficult to imagine much downside. Large market participants such as hedge funds are under-invested. If they ever decide to return to more normal exposure levels there will be a lot of money coming into the market. Seasonality is especially positive this month and continues to be so in January.
I don't want to belittle the intermediate term risks. Europe is slowing down. Taxes will likely rise in the US just as fiscal stimulus is removed. However, these effects are unlikely to be felt for a couple of months and I will put greater weight on them as we move out in time or as market participants turn more bullish.
This market has been a consensus killer all year. The most hurtful thing this market could have done is rally the financials at the expense of everything else. While it is hurting me, I cannot help but admire how sneaky this market is.
Sentiment has vastly improved from where it was a week ago. That said, we are not seeing giddiness yet. Market participants have been burned so bad recently chasing moves that I suspect they are distrustful. If we do see a pullback early next week followed by a rally later in the week I suspect we will see some giddiness right around the time the market gets overbought.
From a fundamental standpoint the news from Europe is improving. The ECB has been active in the sovereign debt market for three days in a row. The rescues being reported involve the ECB and aren't immediately being shot down.
Like CA, BMC has a mainframe business and some growth businesses in cloud and virtualization. BMC billed itself as a cloud computing company and attracted growth investors who are now fleeing after disappointing growth. BMC now trades at less than 7 times forward free cash flow (excluding net cash). That is a dirt cheap valuation and they are aggressively repurchasing shares.
BMC's CEO spoke at a conference on Tuesday. We are two months into the quarter and the CEO said growth is on track for the quarter. It is unlikely that we will get another disappointment in the near future. I started a position in BMC yesterday as the valuation is compelling. The cheap valuation combined with an aggressive share repurchase plan should keep the downside in the stock limited. I believe a conservative fair value for BMC is in the mid forties.
The good news is that ECB has been defending peripheral yields since yesterday morning. Yields on the Italian ten year bond have fallen by over 50 bps since yesterday morning. We have seen the ECB defend peripheral yields before only to back down and let them soar. It will be very important for the ECB to keep this up.
While a consolidation might be in order there is no reason the current rally cannot continue. We will not be overbought for a while as the rally is only three days old and sentiment is still skeptical of a rally. This can turn out to be another rally to sell or the start of a bigger move. I believe the key will be the actions of the ECB. If the ECB continues to intervene and lower peripheral yields or a plan that includes the ECB is announced we should continue higher. If the ECB steps away and more plans with no funding are announced than this is likely just another rally to sell. I will give the bulls the benefit of the doubt until we are closer to an overbought reading.
I have moved this week from being positioned aggressively long at the beginning of the week to having a medium amount of market exposure now. I would really like to see a more definitive plan out of Europe given how far we have come. Have a good night.
I reduced my net long exposure in case there needs to be another scare to get EU leaders moving. I still have a healthy net long exposure. Seasonality and the oversold reading are short term positives. Now we need to see some real progress and fewer statements and meetings. Have a good night.
Tactically, I will look to ratchet back my net long exposure into strength (after raising it last week) as long as there is no progress in Europe. I believe that ultimately Europe will do whatever it takes but there does not seem to be a sense of urgency. It might require another scare in order to get the EU to act. As such, once we are no longer oversold there is little justification for being aggressively long.
Thankfully, Angela Merkel has not held a press conference yet today telling everybody to go to hell. But other than that all that has changed is the mood. Sentiment became too negative last week and we are oversold. These excesses now being relieved. If we do not see real progress in Europe than I will likely look to reduce positions later this week. By progress I mean a plan that involves the ECB.
My philosophy towards the stock market is that I get paid to suffer, both in my market timing and individual stock selection. I generally buy stocks that people hate, especially Wall Street analysts. I generally buy during times when the market outlook is dark. Most of the time my positions start out a loss for me as I buy into negative momentum.
I don't believe that I get paid to be comfortable. I get paid to suffer. Last week, I added quite a few positions into the carnage. There was no reason to buy and nary an uptick. It was not comfortable as I felt exhausted and sick at the end of each day even though I sit at a desk. This morning it appears as if I will be looking at a profit on even my worst buy from last week.
My experience from last week typifies my experience in the stock market in general, although to an exaggerated degree. Many say that trading is easy. Just follow the trend and cut your losses quickly. I could never figure out how to do that. The only way I know to make money usually involves a lot of suffering.
Walgreen's is an important position for me as I own both stock and calls. There has been relentless selling in the stock as it has absorbed brokerage downgrade after downgrade. A former bull called the stock uninvestable. I find that statement incomprehensible. In a worst case scenario where Walgreen's does not make amends with Express Scripts the company should earn $2.75 next year. Trading at twelve times a worst case scenario and a nearly 3% dividend seems very investable to me.
A deal makes sense for both Express Scripts and Walgreen's and I believe this is the most likely outcome. Walgreen's is the most successful pharmacy in the US and Express Scripts is the most successful PBM. They did not become that way by cutting their noses off to spite their face. I still see a deal as the most likely outcome, but even without a deal Walgreen's has a margin of safety.
Yesterday, at a press conference Angela Merkel offered no remedies to the crisis but made certain to shoot down every possible solution. The most astonishing part was that Sarkozy and Monti stood by in agreement. I might believe that Merkel is this clueless but to believe that Sarkozy and Monti are as clueless is impossible. The most likely explanation is that they are playing along with Merkel until she can convince her supporters that she has tried every other route.
The choice is simple, print money or allow the Eurozone to break up. I have a hard time believing that the Europeans will give up on the Eurozone without even trying. The only question is how much more blood needs to flow first.
Even during the worst crises there are rallies. The market typically needs to get maximum oversold for a rally to occur during market turmoil. That will occur at the end of the day on Monday. We could be looking at another three down days before a rally by that measure. That said, it is fairly unusual not to see a bounce before we reach maximum oversold. We have yet to see a bounce during this decline so a bounce is not out of the question before reaching maximum oversold.
I have clearly been wrong by buying into this decline way too early. My plan is to tough it out until we get a bounce at which point I will likely cut positions if the EU still has their thumb up their ...
Gilead started aggressively repurchasing shares last Summer at $32. Analysts hated the stock and the downgrade parade began. Since then the stock jumped to over $40, outperforming both the market and its biotech peers by a wide margin. Yesterday, Gilead reversed its strategy and the stock gave up nearly half its gains since last Summer. Analysts loved the move and the upgrade parade began.
Carl Icahn recently won a board seat at Amgen. His fingerprints are all over this tender offer as it is the same strategy that Biogen underwent, another Icahn investment. Amgen will trade at a little over 9 times forward estimates after the repurchase. Analysts hate the strategy and are downgrading the stock to no end. They believe Amgen should make large acquisitions rather than returning cash to shareholders.
Carl Icahn's motivation is to make a profit on his investment. Analysts motivations are questionable as i-banking does not make money when cash is returned to shareholders but makes a fortune on takeovers. Who do you trust, Carl Icahn who made a fortune over the course of his life or Wall Street analysts who never managed money and are conflicted?
At current borrowing rates half the countries in the Eurozone are insolvent. Instead of trying to solve the problem, German officials make inflammatory statements on an hourly basis. I have been of the opinion that it will likely take a crisis but ultimately EU officials will act. The crisis is here and thus far we are not seeing any action. The longer they wait, the greater the action that will be required.
Gilead's $11 billion takeover will not allow them to repurchase shares any longer. Even though the stock now trades at less than eight times next year's earnings who is to say that management won't do the same thing again. Value investing is not as simple as finding cheap companies. One must also be confident management will not squander the money.
Normally I look for companies whose plan it is to return cash to shareholders. The tricky part of Gilead is that this was management's stated plan. I was actually considering buying Gilead this weekend based on Amgen's tender in two weeks. I decided to buy Amgen this morning based on the fact that Carl Icahn is on the board and it is likely the safest way ensure against dumb takeovers.
The chart below of traders using Rydex leveraged funds is close to where it was this Summer.
I was clearly wrong in assuming that the ECB and Germany would soften their stance after Italy did exactly what was asked of them. This morning, the ECB is once again doing the bare minimum as Italian ten year rates are only slightly lower than yesterday after blowing out the first half of the week.
I realized yesterday that the ECB was dithering and could have exited my new longs at a small gain. I told myself I would exit at the end of the day as I wanted a little more. We now sit nearly 30 S&P points lower and I now have a lot less.
At this point we are near the bottom of the recent range and I am not going to compound my mistake by selling here. I will look to use strength in the coming days to dispose of the longs I recently added. I plan to remain moderately long but unless the ECB acts more forcefully a more aggressive stance is uncalled for.
I believe the ECB will choose to buy like mad. Italy heeded the ECB by passing austerity measures and putting Mario Monti in charge. Greece passed austerity measures and backed off their referendum. Everybody did what was asked of them. The ECB has no excuse not to step in. Have a good night.
The S&P 500 has been stuck in a range for the past few weeks between 1220 and 1290. I believe it will be very difficult for the bulls to break out of this range without some sort of a resolution in Europe. I also believe it will be difficult to break down because when push comes to shove the EU will intervene.
My plan is to trim positions towards the top of the range and add closer to the bottom, while maintaining a net long position. The reason I want to maintain a net long position is because ultimately I believe there will be a rescue. Just don't hold your breath.
The market clearly wants to go higher but there is a limit to what it can do with the news so negative. We are nearing the point where the ECB will have to choose between printing or letting the EU disintegrate. There are clearly no buyers for sovereign debt and the problem will not get better by wishing upon a star. I believe they will choose to print but call it something else. Have a good night.
For the coming quarter Home Depot is guiding to same store sales less than 1% better than Lowe's. It seems the companies are beginning to perform more inline. In addition, Home Depot is slowing down its repurchase while Lowe's is accelerating its repurchase. Here is a link to Bill Ackman's slides on Lowe's. (hat tip Barbarian Capital)
I expected the ECB to defend spreads this week as a reward for reforms but spreads continue to blow out and the ECB continues to be reactive. I have come to realize that there is no method to their madness. They are simply waiting until Europe is on the edge of the abyss to react at which point they do the minimum to save it. The ECB, especially hawks in Germany, do not understand a simple concept. If banks try to delever and sell trillions of dollars of debt somebody needs to buy that debt. All the reform in the World will not buy that debt.
There are some pieces of good news in this. It is unlikely that Europe will be allowed to fall into the abyss at this point. The other piece of good news is that we are once again nearing a crisis point so this will likely spur the EU and ECB into action very soon.
- Sales seem to have stabilized.
- They are slowing down expansion and focusing on improving current stores.
- They are returning more cash to shareholders via repurchases.
I believe management at Lowe's are taking the right steps and have faith that the valuation gap between Lowe's and Home Depot will continue to close. The valuation gap has shrunk by over 7% since I put the trade on. I am pressing my bet and believe there is at least 20% more.
There are some worrying signs in sentiment such as Rydex trader positioning and the AAII survey, which are showing high levels of bullishness. However, more broadly the sentiment indicators are not showing excessive bullish sentiment. The 10 day moving averages of the put/call ratio's are showing high levels of puts.
We have seen higher levels of insider selling, IPO's and secondaries in recent weeks. This supply of new stock does not help the market but is pretty typical after a strong rebound. High levels of share repurchases and cash M&A help offset this supply.
I believe the appointment of Mario Monti as Italian Prime Minister takes the worst case scenario in Europe off the table for now. This should appease the hawks in Europe and buys Italy time. I believe the path of least resistance and maximum frustration is higher.
If we rally next week towards the upper half of the range I believe the odds would shift back to neutral. I would want to assess sentiment at that point to see where we stand to ultimately make a decision.
The sub-story today has been the complete carnage in many momentum favorites. The 39% drop in Green Mountain Coffee carried over to many other momentum names. Growth managers are having a very difficult year and there is a danger of a puke-fest. Have a good night.
The Goodrich deal offers a 4% spread and the deal is very likely to go through. In years past this deal might have been going at a 1%-2% spread. I am long Goodrich.
The oversold reading is not registering big on the charts, largely because a lot of the downside was seen in a small number of days. If breadth is flat today the reading would be -200, which doesn't seem very oversold for a 50 point decline in the S&P 500.
The reason I believe the oversold indicator works is that after 10 days of the market mainly going down many give up hope. I saw a big change in sentiment yesterday. I have been saying we would be oversold today for a week now. Yet, after a huge drop yesterday suddenly many took issue with this. While the oversold reading is not great, it is oversold no less.
I added some more long exposure late in the day as we will be oversold at the close tomorrow. My plan has been to slowly add exposure as we approach the oversold reading, which is exactly what I have been doing.
Unfortunately, the only way anything gets done in Europe is when they are looking into the abyss. Ultimately they are unlikely to allow the system to implode but that doesn't mean markets won't need to freak out first. Have a good night.
Fast forward to today and the stocks have traded places. Now Wall Street loves CVS and hates Walgreen's. I am once again focusing on the valuations and taking the other side of Wall Street.
If there were any doubt yesterday about Italy needing help from the EU, that doubt is gone today as Italian bond yields are trading well above 7%. It was a matter of time before we reached this point. We are now likely to see the EU demand reforms in exchange for a bailout. There is likely to be a song and dance but at the end Italy has little choice.
Vodafone trades at a 10% free cash flow yield and at almost an 8% dividend yield despite the durability of the business. I am not selling any of my position and will look to add on weakness.
There are many issues that bother me. With that said, I believe the market is more likely to head higher than lower into year end. Seasonality is strong at this time of year. While that may seem simplistic, seasonality works more often than it doesn't. Hedge funds are under invested, underperforming and my sense is that they are getting very anxious and are about to chase. Corporate profits are holding up and corporations are repurchasing stock and engaging in cash takeovers. Amgen initiated a $5 billion tender offer for its own shares yesterday.
The economic outlook is scary. But the stock market is not the economy and at the present I believe they are headed in opposite directions. I remain bullish and worried.
The street low estimate for next fiscal year (August 2013) earnings is $2.88. Before the Express Scripts dispute analysts were expecting $3.50. Even if this worst case scenario comes to pass the stock is now trading at a 12 multiple to a worst case scenario. Walgreen's also pay a 2.7% dividend.
Before the dispute Walgreen's traded as high as the the mid forties. The stock is now at a reasonable multiple to worst case scenario earnings, with a free call option embedded in the case where the dispute is settled. I still expect the dispute to be settled.
Spreads in Italy are blowing out again this morning and we are nearing the point where Italy will not be able to access capital markets. While this might seem like bad news, it is only under these conditions that I believe reforms will be passed. I believe that if Italy passes reforms, the EU will support Italy and the crisis will largely be over.
The seconds thing that would make me more bullish is if the market declined a bit next week and shook off some of the excess optimism we have seen build up recently. I want to get more bullish as this is generally a very good time of the year for the market. But the combination of excess optimism and a standstill in Europe are stopping me. Have a great weekend.
I have cited Rydex traders as showing too much optimism in recent days but it also seems that short term newsletter writers have turned optimistic, especially on the Nasdaq. From Marketwatch:
According to the Hulbert Financial Digest, the average recommended exposure levels among these timers is now 106 percentage points higher than where it stood a month ago. This is 12 percentage points higher than the week-ago level, even though the Nasdaq Composite Index is lower today than then.
Many of the intermediate term indicators are still stuck in neutral. The Investors Intelligence numbers are showing low levels of bullishness, as are positioning surveys such as the ISI survey. Hedge fund letters seem to confirm the high levels of caution.
All in all sentiment is painting a mixed picture. I would normally put more weight on the intermediate term sentiment but it is difficult to imagine hedge funds buying into the market in a big way without a resolution in Europe. I would feel more comfortable about increasing exposure if we would get a decline that would temper the optimism from short term traders.
The good news is that the Greek's bluff was called and it now appears that they are falling into place. The remaining hurdle is getting Italy to reform, which I believe they eventually will. We are now roughly half way through this correction in terms of time. If we can get another decline early next week, we will be set up to rally again.
Ideally what I would like to see is some sideways movement and possibly a test of yesterdays lows. This would achieve two things. Some newfound bulls will get shaken out and more time will pass. A correction is both a function of time and price and this correction is only 3 or 4 days old, depending where you start to count. We have had a correction in price, now it would be nice if some time passed.
Tactically, I remain net long but would like to see how the correction progresses before adding back the positions I shed into last week's strength.
The best thing the bulls have going for them is that earnings have held up despite the economic weakness. Corporations have been using much of the cash they earn to repurchase shares and for cash takeovers, which helps markets. As long as this continues it is unlikely the market will see much downside and this could spark a year end rally. We have been seeing earnings reductions from the more cyclical companies, but overall earnings are holding up well, for now.
The other factors that favor the market are seasonality and investor positioning. We are headed into the strongest months of the year. Despite the fact that everybody knows about seasonality and markets are supposed to be efficient, seasonality continues to work more often than not. While investors have recently increased equity allocations evidence suggests that investors are still positioned conservatively. The NAAIM survey, Investors Intelligence, AAII and ISI surveys all show equity allocations below average.
Unlike the Greek issue, a solution to Italy's borrowing problems must be found. Reading between the lines, the EU is demanding reforms out of Italy in exchange for a bailout. These reforms are bitter pills to swallow politically. The EU is asking that Italy raise the retirement age. Older people tend to vote so passing this will not be popular. They are asking to reduce the number of politicians so essentially the politicians are being asked to vote their jobs away. They are also asking that lifetime employment rules be abolished, which will anger unions.
These reforms need to be done but are likely to cost the politicians who pass them their jobs. If Italy ultimately lives up to its end of the bargain I believe the EU will live up to its end of the bargain, even if it means using the ECB. Ultimately this is the way I believe it is most likely to play out. But it will be a bumpy road and it is not a sure thing.
During the entire run up the majority of market participants were fighting the rally. By late last week it seemed the majority of market participants had finally embraced the rally. Rydex traders were positioned aggressively, the AAII survey showed individuals as optimistic as they have been all year and talk of a year end rally with new highs grew loud.
We find ourselves this morning with the market down nearly 6% from its highs on Thursday, with the consensus once again caught leaning the wrong way. This market has absolutely brutalized the consensus.
Sentiment analysis has been the only way to catch the twists and turns in the market. Right now it seems the crowd is caught bullish. From a pure sentiment standpoint it is likely too early to try and catch a bottom, although 70 S&P 500 points in less than 3 days could lead to a bounce.
In one of the largest executive paydays in recent years, Nabors Industries Ltd. is giving its chairman $100 million in cash in a severance-style deal, even though he isn't leaving the company.
... The stock of Nabors has fallen 19% this year, and has underperformed the S&P 500-stock index for the prior one-year, five-year and 10-year periods.
I couldn't help but think of Mel Brooks when I read this article
It is certainly possible that our markets will ignore Europe as they did for much of the past year, until June. We had a year end rally last year as the situation in Europe worsened. However, it will be more difficult as a recession in Europe is all but guaranteed and the effects will be felt by US businesses.
The excess pessimism that has buffered the market is now gone. The fear of missing out on a rally has replaced the fear of losing money, although we are not yet at extreme optimism. The direction of the market is a difficult call, which is why I have reduced longs into recent strength. I prefer cheap, defensive stocks over the high beta cyclicals that have recently skyrocketed.
The economy is still likely to slow even if the stock market holds up. Spreads in peripheral Europe have not improved and they are about to undergo severe austerity measures. With Europe in recession and government spending about to decline in the US, we will be lucky to get muddle through growth.
I expect defensive value names to outperform. It is entirely possible that these wounded animals, fighting for their professional careers will continue to pile in to high beta stocks for a while, but I believe it will end in tears.
On a personal note, it feels so much better to have lowered my equity exposure. The last few months have been brutal in terms of stress and lack of sleep. Not to mention twenty trips to the bathroom a day. I wish I were exaggerating. This business is not easy, even when one is doing well.
Mark Hulbert writes that market timers have turned very bullish as well. From Marketwatch:
This water being thrown on the stock market’s parade comes from contrarian analysis. The wall of worry that existed at the correction low in early October has given way to a significant amount of enthusiasm and excitement — which does not bode well for the rally’s sustainability.
...In fact, the HNNSI is now nearly as high as where it stood in May, soon after the bull market hit what so far has been its high-water mark.
Hedge funds reduced bets that stocks will rise to almost the lowest level since 2009 this week, according to International Strategy & Investment Group.
ISI’s index of “net exposure” to stocks slipped to 44.7 yesterday, compared with its 2011 high of 54.2 in February, according to a note sent to clients. The measure climbed to 45.5 on Oct. 12 after declining to 44 on Sept. 21, the lowest level since April 2009.
If this survey is representative of hedge fund exposure and they decide to bring exposure to normal levels this rally could have a way to go.
We believe the cash generation of CA’s mainframe software and maintenance-like revenue will remain stable, and the net present value of this alone is around $33. The value of that cash flow is being discounted today, and we assume this has to do with investors’ assumptions of how that cash will be allocated.
- John Diffucci, JPMorgan Software Analyst
One of the best software analysts, John Diffucci of JPMorgan, believes that CA's mainframe business alone is worth $33. In addition, CA has $2 in net cash per share, a cloud computing business, a security business and a virtualization business. On a sum of the parts basis CA Technologies is worth over $40.
Mr. Diffucci believes that the reason CA trades at a discount is that investors fear a misallocation of capital. CA has embarked on an acquisition spree over the years that has yielded little, eroding investors confidence. What good is earnings if it is squandered away? I believe that management has found God and is finally on the right path. This should bring CA closer to its fair value over time.
At an Investors Day in late July CA management said that they were done with large acquisitions and that they will return more cash to shareholders. In the latest quarter CA Management delivered on that promise. They spent $200 million on repurchasing shares during the quarter, which works out to 8% of the shares outstanding on an annualized basis. Including the 1% dividend, they are returning cash to shareholders at a 9% annualized rate. CA announced that they repurchased nearly $50 million worth of additional shares since the quarter ended and the management once again stressed returning cash to shareholders on the conference call.
CA has been a value trap for a decade so investors are conditioned to expect little out of the stock. There has been a major change as management is now returning capital to shareholders. As long management continues to deliver on their promise the stock should go much higher.
I now believe the market is in its fair value range. We are trading at roughly 13 times next years earnings. That is on the low side but we are in a very high risk environment, so some sort of discount is justifiable.
While I believe the market is roughly fairly valued, the market often over shoots and will likely do so again. We had extreme negative sentiment a few weeks back. That is generally followed by extreme positive sentiment, which we have not seen yet. Market participants are underweight and we are headed into the strongest part of the year.
I have greatly reduced my long exposure into this 20% move but am remaining moderately long. The main reasons are that I believe there are stocks trading cheaply even though the market as a whole is not and the odds still favor more upside.
The bear case is quite simple. The bailout package is very unlikely to work in its current form because it requires trillions of dollars in funding from private investors. I don't believe they will get it. The EU will likely adjust the bailout package, but if history is a guide they will need to get hit over the head first.
The bull case is that even if this solution stops things from getting dramatically worse we should see a rally. We are entering the strongest part of the year with large investors underweight and underperforming. The recent pullback looks healthy in that it has caused much handwringing but not much damage was done.
I have decided to remain net long but am nowhere as long as I was in early October. The deciding factor in remaining long is the valuation of my longs. I am able to buy some great companies at very reasonable multiples of free cash flow, that have limited economic sensitivity.
While I still believe that hedge funds and larger investors are under-invested, I now believe that shorter term traders are long again. The latest Rydex data shows that traders have positioned themselves more aggressively.
Seasonality will be turning very positive in the coming days. With $100 in S&P 500 earnings projected for next year, current valuations (12.3 times 2012 earnings) are decent even if earnings come in slightly lower. Levels of share repurchases and cash M&A remain high. I still believe the market has more positives than negatives but I am less enthusiastic than I have been to this point.