A Genzyme Deal Would Be A Boon For Large Cap Biotech

Genzyme signed a confidentiality agreement with Sanofi signaling that the two sides are close to a deal. While a higher price would likely boost sentiment in the large cap biotech sector, I believe that a deal would be beneficial to the sector regardless of the price.

There are only five biotech stocks with a market cap greater than $10 billion and Genzyme is one of them. It makes up over 11% of the market cap of this group. The group consists of Amgen, Gilead, Celgene, Genzyme and Biogen. Amgen, Gilead and Biogen are are all buying back stock aggressively. The float of shares in the large cap biotech industry is shrinking quickly and  a Genzyme deal would speed up the process. I believe that an attractive valuation and a positive supply and demand profile for the shares will lead to higher prices for the entire sector.

I have bought Gilead and Amgen to take advantage of this dynamic. After the recent decline shares of Celgene are also attractively valued but I have not purchased them yet as there is a lot of momentum money fleeing the name and they are not aggressively repurchasing shares.

Commodities Breaking Out

Commodity prices are breaking out today with Brent Crude over $100 a barrel. While I will respect the seasonality for a few more days, if commodities continue to ramp I will start expanding my equity shorts. This is not what the bulls want to see. Lucky for us Bernanke says not to worry. From the FOMC Statement:
Although commodity prices have risen, longer-term inflation expectations have remained stable, and measures of underlying inflation have been trending downward.

No More Covered Calls

I bought back all the covered calls I wrote against Gilead. The position is now completely uncovered.

Bought More Gilead

Looking at the price and volume in Genzyme it seems a deal is happening. I bought more Gilead. I am loaded to the gills with large cap biotech exposure.

Bought Amgen

A Genzyme deal looks a lot likelier as they have now signed a confidentiality agreement with Sanofi. I believe a deal will boost the entire large cap biotech sector. As a result, I have taken a long position in AMGN.

Egypt Shmeegypyt

I remain of the belief that Egypt is an excuse for a much needed correction. We are headed into the seasonally strong turn of the month and we did see some fear enter the market on Friday. That may lead to some stability in the near term. However, after a five month run for the roses I suspect that this correction is not over yet.

The question I am grappling with is if this is a correction or the start of something more sinister. I am leaning towards the correction camp, given the positive seasonality for the next few months and the fact that corporations are still big buyers of their own stock. A spike in commodity prices, credit spreads or interest rates would likely change my mind.

Tom Demark's CNBC Appearance

Here is famed technician Tom Demark's CNBC appearance this week where he called the top in the market:

Egypt Is An Excuse

Even if the Egyptians overthrow their government I believe there will be little long term effect on world economies. Does that make today's beating a buying opportunity? Not necessarily. Whenever markets are this extended and sentiment is so lopsided, the market finds an excuse to correct. Can this be the excuse for a correction even if in the long term it means little? Its as good of an excuse for a correction as any.

Option Exacerbation

Options expiration can often exacerbate moves when there is a shock. Shorting volatility has been an easy trade for months on end and the VIX has recently been hanging out around 16. This all leads me to believe that there is a lot of shorting of vol going around.

I want to remind readers that there are now weekly expirations. Those who are short this week's volatility might be forced to cover and exacerbate the selling pressure. While looking out for individual bargains might be a good strategy, keep in mind there is potential for something uglier. The best time to step up and try to catch a falling knife might be the close.

Capital Observer Trivia

When was the last time people were scared to go home long for the weekend?

It Could Get Ugly

The market has the potential to get ugly. Everybody is long, the street is short vol and there currently is a shock in that the Suez Canal may get shut down.

Wrote SPY Puts

I have written the weekly 127 SPY Puts expiring next Friday against my long SPY Put position. The reason being that strong seasonality may help contain the downside. If we do rally for the turn of the month I plan on using this premium to expand my short positions.

Are Treasury Investors Dense

Government figures have recently shown that inflation is benign and economic growth is slow. One would think that with these type of headlines treasuries would be rallying. Instead, they are selling off. Are treasury investors dense? I would highly recommend reading Jeff Mathews' latest post.

Why Bother

Investor darlings, Ford and Amazon, missed estimates and are down hard in the pre-market. Normally, that would lead to a swoon in the futures. However, investors are not bothering to send the futures lower only to rally them later on. They are just rallying them higher now.

The market has made it through a normally seasonally weak period with little damage and we are now entering what is normally a seasonally strong period until the end of the day on Wednesday. Seasonality is not a be all, end all but it has worked extremely well in the past year. I remain modestly net short and the phrase, "thank you sir may I have another" comes to mind.

A Golden Example

A few short months ago investors were salivating over Gold the way they are now salivating over equities. The story was the same as investors believed the Fed printing money would send Gold to the moon. Yet, here we are correcting in a very hard fashion. The point is not to disparage gold as I believe we are nearing a tradeable bounce. It is only to point out that corrections still exist, even in a fed money printing World. Have a good night.

On Shorting Netflix and Salesforce.com

I was having dinner with a friend last night and we spoke about shorting stocks like Netflix and Salesforce.com. I have little doubt what the ultimate fate of these stocks will be. However, the chances of being left standing as a short seller when these stocks ultimately go down is not very high. I have had very bad experiences with these types of shorts.

In 2006 I came off of two very successful short selling campaigns. When GM was trading close to $50 I purchased leap Puts at the 30 strike. There was  a bankruptcy scare that year that allowed me to cash out of those Puts at many times my purchase price. That summer I also caught  the top in Toll Brothers, which made me dangerously confident.

Commercial real estate busts tend to follow residential busts by about six months and the residential market had clearly rolled over. I aggressively started shorting CB Richard Ellis' stock and buying puts. The company was trading at a high multiple of earnings that were dependent on a real estate bubble.

Despite the fact that I was ultimately correct, the stock tore me a new one and major damage was done to my account. I was forced to turn tail and puke up my position. Ultimately, the stock traded to $3 but I was not there to collect.

That feeling of knowing I was right but having no choice but to take a huge loss is still etched in my mind and I try to avoid putting myself in that situation again at all costs. So when I look at Salesforce.com trading at 100 times 2012 earnings I think about selling it short and then the flashbacks kick in.


Market tops are often sideways affairs that shake out all but the most fervent bears. I would be remiss not to mention that I am having doubts myself about the downside. I don't see the potential for meaningful upside, but we could get a bump higher due to the turn of the month. I don't believe any such bump would be the beginning of a new move higher but rather just just more fluff for when a correction finally arrives.

I have been modestly net short and wrong for over four weeks now. Luckily, the long side of my portfolio has performed fantastically and I have done fine, even though I have not been keeping up with the Dow Joneses. If we get a move lower today or tomorrow I am considering going mostly to cash and taking a fresh look after the turn of the month. Hopefully, this post marks a market top. It wouldn't be the first time.

New Position

I started a new position in Computer Associates today. It trades at less than ten times free cash flow, net of cash. It is  a stock I have done some homework on in the past few weeks. I passed on it but saw it down over $2 today and decided to take another look. Have a good night.

Investors Voting With Their Feet

After a very dovish Fed statement that did not even pay lip service to inflation concerns, investors are voting with their feet and selling treasuries and buying commodities. This is not yet a problem but if this move catches a head of steam it might be a problem soon.

Sold More Covered Calls

I have sold covered calls on the balance of my Gilead position.

Sold Gilead Covered Calls

I sold some covered calls on part of my Gilead position.

Sold Overage In Gilead

I sold the overage in GILD that I bought last night. I remain long the stock.

The Unshakable, Unbreakable Market

The current market environment is very difficult for me as I see very little value out there. I am not opposed to paying high teen multiples for stocks if I believe the future is bright, but there are many unresolved imbalances out there that have not yet been dealt with.

There are cheap stocks out there with low price to earnings ratios (P/Es) but most of them have real issues. Many pharmaceuticals like Pfizer trade at a single digit P/Es, but have patent cliffs that likely mean that a much higher P/E is not warranted. There are technology stocks like hard drive maker, Seagate, which trades at seven times next year's earnings. However, their products might become obsolete as flash memory gains. I don't want to disparage these low P/E stocks as I have considered them both for investment, but they are not without risk. Many financials trade at low P/Es to expected earnings but I cannot get comfortable with the balance sheets. The low P/E stocks are that way for a reason and the companies with less issues tend to trade at high teen multiples.

A correction would really help from a sentiment and valuation standpoint but the market does not seem to want to oblige me. This means I will be playing defense and trying to hit singles until better opportunities arrive. 

Missing The Forest For The Trees

Gilead Sciences reported revenue and earnings that beat analysts estimates yesterday as sales trends are strong. The company added an additional $5 billion to its share buyback authorization for a total of nearly $7 billion. At current prices that would represent about 23% of the shares outstanding. They have committed to buying back at least $2 billion worth of shares during 2011 which at current prices amounts to over 6% of shares outstanding.

There was a setback in their pipeline as a manufacturing issue caused the FDA to ask for more information, pushing back Gilead's B-Tripla drug by three to four months according to the company. More analysts actually raised estimates for Gilead rather than lowering them despite this setback.

Gilead would probably be trading closer to $39 this morning were it not for this minor setback that will likely mean little in the bigger picture. I was able to pick up a decent amount of shares in the after hours session down over a dollar from yesterday's close because of the scary headline of an FDA delay. I believe sellers at that level are missing the forest for the trees.

Gilead Beating Too Severe

I added to my position in Gilead when it was down over a dollar in after hours. Earnings beat but they announced a delay in one of their drugs. The drug is not of vital importance to Gilead and hopefully it will only be a delay of a few months.

Bonus Season

As a result of the financial crisis a large amount of financial companies decided to pay bonuses in restricted stock.  Employee selling of restricted stock can have a large effect on stock prices and it makes sense to pay attention to lock up periods. Many employees do not want their entire financial future tied to their employer and look to diversify when their stock vests and the insider trading window opens. That might put pressure on financial stocks in the days following earnings, especially in January.

During my days at Goldman Sachs we were restricted from selling stock starting from a few weeks before the end of the quarter until 3 days after earnings. I am assuming this is the way it works at most financial firms. Additionally, restricted stock generally vests in year increments and restricted stock is likely given out during bonus season. Hence, the period after January earnings might see a lot of employee selling. While earnings from financial companies were far from stellar this might explain some of the recent weakness. I will try and remember this in a year from now.

Its Do Or Die

The turn of the month seasonality has been very strong for the past few years and we are fast approaching the month of February. If the bears are going to make their move now is the time as there are still a few days left before we hit the turn of the month. Seasonality is not the be all, end all but the bears don't need an additional obstacle at this point.

Strength in the periphery of Europe has helped markets in the past week and this morning we are seeing weakness. The bears have the ball and the key will be to break last week's lows sometime in the next few days. I continue to give the bears the benefit of the doubt for now.

Nothing Done

If we gap up in the morning I will likely add to my short positions but for now I am sticking with my small net short position. Have a good night.

Looking For A Reason

Given my belief that we are likely to see lower prices this week I am looking for a reason to expand my short positions. Unfortunately for the bears stocks have done nothing wrong today. Breadth is strong and the call buying at the ISE is subdued. I am holding off for now.

Bye Bye Medtronic

I lost my Medtronic position to option expiration and cannot bring myself to buy it back at the current price even though I still see value. That is the downside of a covered call/short put strategy.

The Ostrich Approach

My view has not changed that the risk this week for the market is to the downside. I wanted to take a step back and look at the bigger picture this morning.

The economy has a cyclical head of steam led by improved consumer confidence and strong cash flow by corporations. Generally, it would be too early to look for a turn less than two years into a cyclical recovery. However, many of the imbalances of the last recovery were swept under the rug instead of being dealt with during the last recession. As such there is a greater than average chance that one of these imbalances might come back to haunt us and derail the recovery.

I believe that inflation is the greatest threat to the recovery, as governments seem inclined to paper all of the other imbalances. Food prices are rising, oil prices are rising, prices of goods coming from China and other emerging market countries are rising and we are still early in the recovery. In a finance driven economy much higher interest rates would be a death knell.

While a lot of lip service is being paid to inflation, very little action is being taken as policy makers hope it just goes away. Emerging market countries are talking tough and making symbolic moves. However, they are insisting that their currency not appreciate against the dollar. They simply cannot have it both ways. They can either fight inflation or stay pegged to the dollar and the 0% interest rate it carries, but not both. Europe is talking tough against inflation but at the same time is conducting infinite bailouts of countries and banks. How can they tighten money and conduct bailouts at the same time?

Ben Bernanke is taking the most creative approach, the ostrich approach. He is denying that there is any inflation and still fighting deflation. My understanding of economics is that when interest rates are being held too low that inflation only worsens yet that is the approach being taken by most central banks around the world.

This does not mean that the bull market is over. This problem can stay under the rug or can come out at any time. The housing bubble persisted for years before becoming a problem yet still managed to surprise everybody. The key is to not be a die hard bull or bear but to realize this risk  and be prepared for all outcomes.

China Inflation

For decades we have been importing deflation from China. The recent bout of inflation over there might soon mean we will be importing inflation. From Barron's (emphasis mine):

A nifty report by Bank of America/Merrill Lynch's crack Asian economics team describes how Chinese inflation is going global. In particular, prices of manufactured exports are now rising apace with quotes on commodities. In the latest Canton Fair in October-November 2010, the analysts report, export prices were hiked 3%-5% (in dollar terms) from those exacted from foreign buyers at the same fair held in the spring, while labor-intensive goods -- apparel, shoes, luggage -- were boosted an immodest 10%-20%.
The rises reflect, among other things, an increasingly restive labor force, especially migrant workers who got an 18.7% raise in wages in the first three quarters of last year, and the shrinkage of the supply of rural surplus workers younger than 40, which had provided a steady flow of cheap labor. Rising paychecks also have lifted food prices, which account for about 75% of the rise in the country's consumer price index.
As the BofA/Merrill analysts sum it up, "Inflation in China's headline CPI -- as well as manufactured prices -- suggests that we have reached a key inflection point in the China story. The supply of low-wage, surplus labor has probably disappeared. This could be the end of a disinflationary force on the global economy."

Wait Til Next Week

For over four months the bears have been taking it on the chin. Next week they finally have the chance to hit back. They managed to land a punch this week and instill doubt into the bulls. They finally have seasonality in their favor. If they ever are going to make a move than next week should be the time. Have a great weekend.

Expiration Friday Thoughts

  • How many times will Bank of America write down assets and still not be able to show a profit the following quarter. How psyched will the investor community be when they finally write up those assets and "beat" expectations? 
  • If only I could write down my portfolio one quarter, write it up the following quarter and get paid a multiple on those earnings?
  • I had a sense of dejavu' when I saw the headline GE Beats On GE Financial profits.What multiple are those earnings worth?
  • Is there anything more annoying than having to listen to a bull market genius?
  • Why the overdose of cynicism today? I'm under the weather and really don't want to be in front of the computer but its Expiration Friday.

Uh Oh

I try not to make much of the action on expiration because there are too many factors influencing prices. That said, in a vacuum the fact that we are seeing call buying today and the market is not able to hold its gains is a negative for the bulls.

Why I Disagree With David Tepper

David Tepper appeared on CNBC this morning and while he was more cautious than in his last appearance he was optimistic. He said the New York Post misrepresented his views yesterday. The main cause of his optimism was the health of the US economy and US corporations.

It is impossible to claim that economic activity in the US has not improved but that does not make the US economy healthy. Current levels of economic activity are dependent on a trillion dollar deficit, artificially low rates and money printing. What would the US economy and corporate profits look like without all this?

The US depends on the rest of the World to finance its deficits and accept US Dollars. The rest of the World has shown willingness to do this for decades and is likely still willing to do so. However, we are starting to see the side effects of this in emerging market economies. Inflation is becoming a serious issue over there and as long as central banks keep their currencies artificially low against the dollar it is unlikely they will win the war against inflation.

A star running back that is injured can play like a star in a game if he is drugged up. But when assessing the long term value of that running back one needs to take into consideration the injury. US investors are focused on current economic activity but are ignoring the artificial forces that helped create this activity and the potential side effects. Investors made the same mistake between 2004 and 2007 when they failed to appreciate the artificial  effect that the housing and debt bubble was having on the economy.

Even if I am correct in my assessment this does not mean that the stock market will not continue higher before this all plays out. However, with sentiment and the market stretched I don't see a good risk/reward in the near term even if this bull market lasts a little longer. There are corrections within bull markets.

Hold The Champagne: Part Two

Apologies for the late start but just as I was writing my opener David Tepper popped up on CNBC. I will have more later on what I thought about his comments. Yesterday, in the late morning I thought the market would stabilize and was debating how aggressively to cover some shorts. Ultimately, I was not that aggressive as I only wrote covered puts.

Normally, tops are processes and the market does not fall out of bed all at once. But given the way the market climbed relentlessly on the way up I thought that there was a better than average chance that the downside might look similar and didn't want to get too cute. It now appears that we are looking at more of a process.

I still believe we are in a corrective period that should last until late next week at best and until late February at worst. I will give the market some room here but might look to expand my shorts at the end of the day. Sentiment is still overly bullish and the post expiration period in January has not been kind to markets.

Two Way Action

While there was not a lot of change in the large cap indexes today there were some intra-day swings. This is a big change from the paint drying sessions we have gotten used to for the past few months. I am hoping to see more two way action in the coming months. Have a good night.

Strange Action In Treasuries

It is quite strange to see treasuries down over the past two days, with the market down as well. As I wrote earlier it is important for interest rates and commodities to correct with the market. Commodities are doing their part but interest rates are stubbornly higher. It could be that too many hedged their long equity exposure with long treasuries and are now bleeding from both ends. Regardless of the reason the bulls would like to see this reverse soon as higher rates are a headwind.

Sold Covered Puts

I sold the SPY 126 Puts expiring tomorrow against my higher strike February SPY Puts.

Put Buying

We are finally seeing some put buying. This is an incremental positive for the bulls but I would note that after many months of call buying it is not yet a buy signal. It could lead to some stabilization.

Tepper Turning Cautious

It appears David Tepper has turned cautious. From Market Folly:
It appears that Appaloosa Management founder David Tepper has turned cautious on the markets. In a recent interview with the NY Post, Tepper has interjected some common sense and says that "when things go up too high, they will go down."

The hedge fund manager seems to be advocating taking some profits and reducing risk, or at the very least, bracing for any potential impact. From the NY Post, "Tepper said while 'the biggest opportunities' will remain in equities, 2011 will be 'harder and not without risk.' "

What To Look For

In my final post of the day yesterday I spoke about the time frame for a correction. The following is what I will be looking for in terms of sentiment and fundamentals to try and judge when its safe to jump back in.
  • Sentiment is too lopsided right now. The economy has improved but a 28% rally off the Summer lows discounts that. The bear camp needs to grow a little larger in order to make the risk/reward more attractive on the long side. 
  • The more commodity prices and interest rates come down with the market the better. If the stock market corrects but commodities and interest rates don't than they will be a major headwind on any subsequent rally.
  • Credit spreads have been fueling buyback and M&A activity. They are very tight and as long as they don't widen that much they should remain supportive of the market.
  • While I believe the market as a whole holds little value at current levels, it would be nice if during a correction some individual stocks came down to value levels.
The economy currently has a cyclical head of steam. However, there are a lot of imbalances which can derail the recovery, which is why I am looking out for the warning signs outlined above.

Is It Over Yet

It appears that the market is entering a corrective phase. I have found that the most important aspect of corrections is time and not price. The earliest one should be looking for a bounce is late next week as we approach month end. Today is only day one of this decline. That does not mean that we cannot or will not bounce, only that it is not a high probability bet.

The market has been going up for well over four months now, with nary a correction. There is a decent chance that we will see an intermediate term decline. In that case we might not see a sustainable advance until late February. For now I am withholding judgment on whether we are in a short term correction or an intermediate term one. Either way it is too early to buy.

Back To Small Net Short

I have sold my lower strike SPY Puts. I will look to reload on a rally. I am shorter than where I started the day yesterday but my net short position is once again small.

Demark Indicators

I am not a technician but it might be important that Tom Demark, the famed technician, has turned bearish. From Bloomberg:
U.S. stocks are within a week of “a significant market top” that is likely to precede a drop of at least 11 percent in the Standard & Poor’s 500 Index, said Tom DeMark, creator of a set of market-timing indicators.
Tom Demark has a tremendous institutional following. According to Wikipedia:
Mr. DeMark is the president and founder of Market Studies LLC[5]. In 2008 Steve Cohen (SAC Capital) and John Burbank (Passport Capital) became partners in Market Studies Llc.
 With followers like Steve Cohen it is not difficult to see how his opinion might influence markets.

Hold The Champagne

While many are celebrating blowout earnings, this is your friendly reminder that bull moves tend to end on good news, not bad. The day is beginning with a gap up and a festive mood. I would not be surprised to see the day end with a whimper.

I am of the firm belief that what everybody already knows is not worth knowing. Who does not believe earnings will be better than expected? Who is not bullish already? Will today's earnings reports really change anybody's mind? My trading experience is that when such a strong consensus has formed, a trade becomes very dangerous.

Raised My Short Profile

I have significantly raised my short profile into this after hours ramp by purchasing SPY Puts. Have a good night.

Interest Rates Are Reaching Critical Levels

Treasuries are testing multi-month lows this morning. I believe we are reaching critical levels where higher interest rates will start to negatively effect stocks and the economy. We are not at a make or break point yet, but I believe we are getting there.

What many fail to appreciate is that we are no longer in control of our own destiny. For years China and emerging markets have had a deflationary effect on us as we imported deflation. Now that they face inflation we might import inflation even if our economy is weak.

Many are hung up on the weak jobs market here insisting that it means inflation cannot happen to us. It is not our demand leading to higher commodity prices, it is theirs and it is not our rising labor costs leading to higher costs for manufactured products, it is theirs.

I do not claim to know whether inflationary or deflationary forces will ultimately win out. But I do recognize that inflation and interest rates are a risk and we are reaching the point where they might start causing problems.

Time For A Change

I have been lugging a modest net short position but plan on becoming more aggressive on the short side this week. What has changed?
  • Although put/call ratios have failed as signals since mid December, we are seeing even more extreme readings. I have had to reformat the axis on my charts to account for the recent put/call readings because the lines were literally off the charts.

  • The bears on the Investors Intelligence survey have finally fallen below 20%. Of all the signals that these sentiment surveys throw off I have found that the bears falling below 20% on the II survey to be one of the most reliable sell signals.
  • Rydex traders recently set a record for being positioned the most bullishly ever.
  • I have seen sentiment become extreme and stay extreme through year end and the beginning of the year before. However, January options expiration has been a turning point in many of these instances.  Last year was one of those instances. January expiration is four short trading days away. 
My vehicle of choice for expanding my net short position will likely be put options on the SPY.

    Pricing Pressure

    Last week I wrote about the pricing pressures in the food business because of rising commodity prices (here and here). An article in the Wall Street Journal highlights some of the pricing pressures the apparel industry is facing. From the Wall Street Journal:

    Going forward, apparel companies are in a particularly tough spot, caught between uncertainty about the consumer and a sharp increase in raw material costs.
    Benchmark cotton prices have more than doubled over the past year, leading retailers to raise prices on spring-season merchandise starting to hit stores now—even though they're not sure if shoppers will stomach the increases. 
    ...Teen retailer Aeropostale Inc. is also keeping inventories lean. "Spring is tight," CEO Tom Johnson said this week. Aeropostale lost market share during the holiday because of steep discounting at higher-priced brands such as Abercrombie & Fitch Co. The company expects to raise its prices between 3% and 5% for spring, Mr. Johnson said. 
    Phillips-Van Heusen Corp., which includes Tommy Hilfiger and Izod, said this week its prices could increase by as much as 15% in the second half of the year. Warnaco Group Inc., maker of Calvin Klein jeans and underwear, also expects some price increases.

    If commodity prices continue to rise in tandem with stock prices it will eventually cause problems. We are already seeing food riots in parts of the World. What would happen to our debt driven economy if inflation led to higher interest rates?

    TAM Capital Management Inc.

    Long time readers may have noticed that I have not been posting as frequently recently. I have been setting up an investment advisory business, TAM Capital Management Inc.. I am finally through most of the bureaucratic aspects of setting up the business and will have more time now to focus on what I like to do most, concentrate on investing. Please note I have put up a bio and as always I urge readers to review the disclaimer.

    The Endless Bid

    The bid in the market for the past few months seems to be insatiable. Today, we received news that the Chinese have finally fully invested their $300 billion sovereign wealth fund. They have been trying to invest this money for years but were making very slow progress. I was quite shocked to read that they were now done. This might explain some of the recent action as its difficult to invest that type of money without effecting markets. From the Wall Street Journal:
    China Investment Corp., the country's $300 billion sovereign-wealth fund, has requested more investment from the central government as it has already used up its current pool of money, a senior CIC official said Saturday.
    "There's no more money for new investment," Wang Jianxi, executive vice president of the CIC, said on the sidelines of a forum in Beijing.

    More Random Thoughts

    • I have been doubling down on research for when we finally do get a correction. The pickings are slim and it will have to be a doozy of a correction in order for valuations to become attractive again.
    • It feels so wrong and silly to be bearish that it has to be right. 
    • Its rare for a market to turn this close to expiration. Once a rally reaches this point the turning point usually happens after expiration.
    • The conversation going on in my head about when to lean hard against this market goes as follows: Me: "Just wait until expiration. If the rally reaches that point it will be a layup" Me: "The VIX is at 15 and the market is running on fumes. So what if you are a little early? Why even leave a chance for this opportunity to get away?"
    • A few years ago this type of market would have chewed me up and spit me out as I would have been all in short by now. What changed? Discipline and patience. 
    • When this market finally corrects, who won't it catch offsides?
    • A reader compared this market to late 2006. I agree that is the closest comparison but that rally made more sense to me because we were seeing a $10 billion LBO a week. Where is this endless demand coming from?
    • Have a great weekend.

    Random Thoughts

    I am having a hard time putting together a cohesive opener this morning so here are some random thoughts running through my head:
    • Intel is a stock that is not liked and has not gone up with the rest of the market. I don't believe one can read into the reaction to Intel. JPMorgan might be a better bellwether.
    • I absolutely hate conspiracy theories because they are unprovable and for the most part used as excuses for being wrong. That said, the food component of the CPI has come out at .1% for the month. There are food riots going on in the World because food prices are up so much. This simply does not compute for me and flies in the face of what is being said on every conference call in the food industry. 
    • That said, the "benign" CPI allows the Fed to keep printing, which in the short term is an incremental positive for stocks and commodities.
    • The Rydex bull/bear ratio reached another new high yesterday.
    • If we get another leg higher in the market I plan on aggressively shorting. I don't know when a correction will arrive but I am fairly certain one will. When it does the frothy part of the rally is typically erased. We are well into the froth.

    Lip Service

    Jean Claude Trichet voiced concern over inflation in the Eurozone today. That is likely the reason the Euro is up and commodities are down. Good luck to Trichet bailing out half the Eurozone and fighting inflation at the same time. Can somebody please explain to me how that would work?

    More Head Scratchers

    I mentioned earlier that I thought the action in the muni bond market was strange. There are some other strange things that I have been seeing:
    • SentimenTrader.com points out that the S&P 500 has not closed below its 10 day moving average for 30 days. That has never happened in 82 years of data. 
    • The dollar is getting clobbered but gold and commodities are slightly lower on the day.
    • The persistence with which even the tiniest dips are bought is something that I have never seen. 

    Head Scratcher

    While I am not an expert on the municipal bond market I thought that the Illinois decision to raise taxes should have been positive for the muni market. Instead municipal bonds are hitting new lows. Fiscal and municipal imbalances will not matter until one day they do. I believe the situation is worth monitoring.

    In Defense Of Contrarian and Value Investing

    "I believe the very best money is to be made at the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all the money by catching the trends in the middle. Well, for twelve years, I have often been missing the meat in the middle, but I have caught a lot of bottoms and tops"
    -Legendary investor and trader Paul Tudor Jones II in Market Wizards.
    This past year has been a trend followers dream. While the market has gone up and down it has done so in well defined trends. The blogosphere is full of Monday Morning Quaterbacking lauding anybody dumb enough not to see that it does not pay to fight the trend. I believe that being a contrarian and a value investor are not only valid but the most rewarding strategies if done properly. The reason I group value investing and contrarian investing together is that generally when a stock becomes a value it is because the stock is out of favor.

    Warren Buffett, is probably the most famous of contrarians and value investors. He famously averaged into Geico all the way down, in what was probably his best trade ever. John Paulson's, Greatest Trade Ever, was an out of consensus, contrarian call. Had he cut his losses when the trade initially went against him nobody would even recognize his name.

    Michael Steinhardt, has the best long term track record of any hedge fund manager and he is a famous contrarian. When an analyst would come to him with a stock idea he would famously ask, "what do you know that the market does not know"? David Einhorn famously fought Allied Capital even as the position went against him and continues to fight the market until this day. Other famous investors who are happy to buy assets when they become cheaper and fight the trend include Seth Klarman, John Templeton and Jean Marie Evillard.

    I can go on and on naming famous contrarian investors. It is the single quality that appears most often when looking at the most successful investors in history. Maybe being a successful contrarian is a more difficult skill to hone and most should stick to something simpler. But it can and has been done.

    Still Very Bullish On Gilead

    I remain long and very optimistic about the prospects for Gilead Sciences' stock. One of the reasons for my bullishness was a likely Genzyme deal. A deal now looks even more likely given recent developments, as the two parties are holding friendly talks.

    The higher the price of the deal the better short term sentiment will be, but I do not believe that is the most important aspect of the deal. If Genzyme gets taken out more than ten percent of the large cap biotech sector will disappear. I believe that decrease in supply is bullish for the entire sector.

    Gilead had over $2.5 billion remaining on its share repurchase plan as of the end of the third quarter. At the JPMorgan Healthcare Conference Gilead management reiterated their intention to finish the repurchase by the end of 2011. That would amount to buying approximately 8% of their shares outstanding at current prices. I believe the attractive valuation combined with the favorable supply/demand equation for Gilead's shares will equal higher prices.

    Investors Intelligence Bears

    The Investors Intelligence bears have fallen below 20% to 19.1%. I have found over the years that the bears being below 20% is the most important aspect of the indicator when looking for a top. The level of bulls is less important. We have been hovering very slightly above 20% for weeks and there is nothing magical about the round number 20% but this raises my conviction level ever so slightly that there is trouble ahead. I am contemplating getting a little more aggressive if we rally through the end of the day.

    Stock and Commodity Twins

    While stock indices are pushing to new highs so are commodities. Brent crude is trading at $98 a barrel. Either commodities and stocks will need to decouple or I believe we will see inflation and higher rates. We live in an economy dependent on low rates. What would the effect of higher rates be on real estate prices, corporate borrowing, sovereign and municipal borrowing etc.?

    I don't know who originally said it but it bears repeating "Give me a trillion dollars and I will throw one hell of a party as well". There are side effects to printing money and trillion dollar deficits. With everybody so bullish few are prepared for anything to go wrong.

    Funny You Should Mention That

    A reader in the comment section mentioned his/her trip to Costco as proof there is no inflation. Thats funny because the CEO of Costco believes otherwise. From the most recent Costco earnings call courtesy of Seeking Alpha:
    Again, we are seeing some inflationary pressures impacting fresh food prices. Our buyers in that area estimating that in Q1 that represented perhaps up to 3% of inflationary pressures.
    Anecdotally, steak prices up year-over-year over 15% per pound. The entire, what they call the beef complex which is everything, both imported, exported and all parts of beef was up about 4% on average. So steaks, which is what our strength is, has had the most inflationary pressure. Poultry not up yet a lot but coming. Overall beef, chicken, pork, the estimates are that you'd expect over the next six months to see perhaps inflation in the 5 to 10% range.
    On the bakery side, soybeans and soy oil were up 50 to 60% year-over-year. Sugar up 20%. Butter up 5% and wheat up 30% year-over-year. So the raw materials in Bakery are good and Bakery we've been trying to hold the prices as long as we can so we've actually incurred lower margins in Q1 in the Bakery. Notwithstanding that the strength in margins in meat and produce more than offset that so overall fresh foods margins in Q1 that were up year-over-year.

    From The Horse's Mouth

    The CEO of Supervalue, a large supermarket chain said the following today, from Reuters:
    What we have seen .(are increases) in a lot of commodities. I mentioned in the call that we have from a low of two- to three-(percentage)-point increases but there are some commodities like cooking oils where we have seen price increases in the low double-digit percents.
    I know. I know. There is no inflation. The CPI says so.

    What Was That

    At 1:08 the S&P 500 sunk fast and Treasuries shot up. If that was an asset allocator it was pretty sloppy.

    Nothing Good Can Come Out Of The CPI

    The CPI is going to come out Friday morning. Nothing good can come out of the report as it is being viewed as a non-event. However, regular unleaded gas has gone up to $3.40 is my neighborhood at the cheap station, food prices are up, import prices from China have been rising, REIS is reporting that apartment rents are rising etc. One day this data might miraculously make its way into government figures. If the CPI comes out hot some may start looking for the end of QE.

    Bears Are Sorry

    As a reader pointed out, What does it say when a bear has to apologize for being a bear? ie. John Hussman. David Rosenberg started taking a softer tone as did John Mauldin. What would Yogi say? Is he still a bear?

    Rainy Days Have Been Banned

    Long time readers might have noticed that the number of posts I write a day has declined recently. While I have been busier than usual the main reason is that all analysis recently has been for naught. The market just creeps higher regardless of any analysis.

    We have not seen a real down day in over a month. There was only a single down day greater than a half of percent since December 1 and we were down just about a half percent that day. There are only so many times a day I can say that caution is warranted.

    With everybody certain that the coast is clear, I believe the risks are high because of that. When people are worried a great deal of bad news is built in to stock prices. When they are unanimously optimistic, little bad news is priced in and at times even good news can lead to a correction. That said I am only slightly short because I am having a hard time seeing a turn. Hopefully, I will be able to see when the bulls push too far and add to my shorts at that point.

    Hussman's Mistake

    John Hussman has issued a mea culpa in his latest missive. He managed to avoid the bear market but has also completely missed the recent bull market. He blames his underestimation of investors willingness to return to risk taking. In other post-bubble environments it took longer before investors embraced risk again.

    I must disagree with John Hussman in what his mistake was. By his own estimate, the fair value of the S&P 500 was 900 around the time of the bear market lows, using normalized profit margins and normalized P/E ratios. However, he thought that the market would get even more undervalued because after past bubbles that is what occurred.

    At the bear market lows the S&P 500 was nearly 25% below John Hussman's own estimate of fair value and he did not add any market exposure. He is managing long term money in a mutual fund and there is little excuse not to have any market exposure under those conditions, especially when his main guide is valuation.

    M&A That Doesn't Matter

    Today's big headline was that there was $20 billion worth of M&A. I would note that the Progress Energy deal was all stock and the Dupont deal was an acquisition of a foreign company. Both have little to no effect on the overall US market.

    Weekend Reading

    I came across a few interesting articles this weekend that I thought were important to share. The first is from Barron's regarding Citi's institutional survey. The same participants were very bullish at the April top, very bearish at the July lows and are now very bullish once again. From Barron's:
    Levkovich said that as a whole respondents were upbeat, as they expect an approximately 9.0% gain for the S&P 500 in 2011. Only 5% expect a flat-to-down market, with almost 69% thinking a 20% rally is more likely than a 20% pullback.

    ...The survey shows that cash as a proportion of assets have declined to 6.4% from the 7.5% reading in the October survey and are well below July 2010’s 11.0% when investors were fearful of an economic double dip. The current position is still above April 2010’s 6.0% but dramatically below December 2008’s 17.0% cash position.
    The first column I read each week in Barron's is Michael Santoli's Streetwise. He tends to be correct more often than wrong and errs on the side of bullishness. I find it interesting that has also turned cautious. From Barron's:
    The past two quarters of stock-market gains, combined with a stubbornly positive investor outlook, suggest that this is a time for caution.
    The third article I wanted to share has nothing to do with the stock market but I found it extremely interesting. It is on Chinese parenting from the Wall Street Journal:
    First, I've noticed that Western parents are extremely anxious about their children's self-esteem. They worry about how their children will feel if they fail at something, and they constantly try to reassure their children about how good they are notwithstanding a mediocre performance on a test or at a recital. In other words, Western parents are concerned about their children's psyches. Chinese parents aren't. They assume strength, not fragility, and as a result they behave very differently.
    For example, if a child comes home with an A-minus on a test, a Western parent will most likely praise the child. The Chinese mother will gasp in horror and ask what went wrong. If the child comes home with a B on the test, some Western parents will still praise the child. Other Western parents will sit their child down and express disapproval, but they will be careful not to make their child feel inadequate or insecure, and they will not call their child "stupid," "worthless" or "a disgrace." Privately, the Western parents may worry that their child does not test well or have aptitude in the subject or that there is something wrong with the curriculum and possibly the whole school. If the child's grades do not improve, they may eventually schedule a meeting with the school principal to challenge the way the subject is being taught or to call into question the teacher's credentials.

    The Bluff

    When I saw the headline employment print, my first thought was that it was great for the bulls because it will keep rates and commodities in check, which I believe are the biggest threat to the recovery. The ADP survey, unemployment claims, the household survey and anecdotal data all point to a better jobs market. The non farms payroll number is subject to great revision and not much better than a random number generator. That means that the bulls get to have a stronger economy that goes unnoticed by the bond and commodity markets. Let QEII continue.

    However, the commodities markets have reversed to the upside and are recognizing the situation for what it is. Treasuries seem to be confused. I believe the reaction in those markets will determine the longer term direction of the market.

    Even In Bull Markets

    Even the most fervent bears have to admit that there has been economic improvement. David Rosenberg actually sounded somewhat less grizzly in his January 4 Breakfast With Dave missive. But I want to remind readers that the economy is not the stock market. And even in bull markets there are steep corrections.

    I believe the way this recovery has come about threatens to derail it as commodities and interest rates tick higher, but that is a discussion for another post. For now, let's assume that we are in a bull market. Bull markets are not straight up affairs and there are corrections within bull markets. Current levels of extreme bullishness have led to poor returns even in the context of bull markets.

    The steady gains with little volatility in the market  have been historic. I would note that these type of rallies tend to end with very swift and sudden corrections. Many of the risk on trades like Gold and the Euro have reversed in a very hard fashion. Equities could do the same, even in a bull market.

    Gross Says It Best

    If you have not read it yet Bill Gross put out a great piece on why the answer to our debt problem is not cutting taxes and creating yet more debt.

    From Pimco:
    Unlike Euroland or the United Kingdom, which appear to have gone on an extreme fiscal diet, the American answer to a bulging waistline is always “maƱana.” Debt commission recommendations are tossed in the trashcan, tea party election rhetoric eventually focuses on miniscule and merely symbolic earmarks, and both Democrats and Republicans congratulate each other on their ability to reach a bipartisan agreement for the good of the nation. Munch! Munch! Off with our heads!
     Have a good night.

    Bravo To Paul Volcker

    Paul Volcker is leaving the Obama Administration. Barack Obama used Paul Volcker to gain credibility, but paid him very little attention. Instead, he listened to cronies. Bravo to Paul Volcker for walking away from Barack Obama and his reckless economic policies. Just so nobody thinks this is political, the Republicans are just as reckless and hypocrites as well because they claim to be fiscally conservative.

    Tic, Toc

    With each tick higher in the stock market, interest rates and commodities I see a better setup on the short side. I view a stiff correction as a question of when, not if. That said, my net short position remains small for two reasons. Gilead took a dive late in 2010 and I decided to scoop it up, which lowered my net short exposure. Secondly, I am having a hard time wrapping my arms around the timing of a move.

    I believe that yesterday's trading has brought us a lot closer to a correction. The news of 300,000 jobs was as good as it gets and call buying was exuberant, even considering recent history. Treasuries are now dangerously close to a level that I believe will start to effect the stock market and economy and  commodity indexes are perched at multi year highs.

    The VIX is sitting at extremely low levels which allows one to achieve a significant degree of leverage without having to risk a large portion of money. I am stalking the short side and am getting very excited about the potential.

    Ignoring Reality

    Last month I bought TLT for a trade when we probed this area and I am considering buying for a trade once again if we go under 90. However, I want to see rates at the short end of the curve move up first. After today's data I would have expected to see a bear flattener, meaning short rates going up more than long rates. But the holders of short term paper are remarkably complacent. The possibility of higher rates anytime soon are not being priced in by the short end of the curve. It could be quite a shock once reality sets in.

    Commodities Higher, Treasuries Lower

    Stocks typically rise when commodity prices go higher and treasuries go lower. However, at some point higher commodity prices and higher interest rates become a headwind. I don't think we are there yet but I believe we are nearing that point.

    The Smart Money

    Recently, Berkshire Hathaway issued fixed rate debt to replace floating rate debt. This likely means Warren Buffet believes there is risk to short term rates.

    Annaly, with one of the most astute managements in understanding rates, decided to issue shares. Annaly's management has had pretty good timing in the past with their share issuance (ie they tend to issue shares closer to the top). Annaly makes a lot of money when short rates are at zero, likely meaning that management believe there is risk to short rates . The smart money is betting on higher short rates.

    Finance Based Economy

    We live in a finance based economy. High interest rates would wreak havoc on the economy. What would happen to home prices if mortgage rates were 7%? What would happen to commercial properties if commercial mortgage rates were closer to 10%? What would happen to corporations if they had to roll debt at those rates?

    We have already seen a run up in commodity prices and many goods coming from China in a weak economy. What would happen if the economy gains some steam? The Fed and other central banks are walking a tightrope. QE and easy money are not a win-win. There are dangers to it and we might soon find out what lies on the other side. I do not claim to know what will happen as the events of the past few years are truly unprecedented. But neither do the pundits on TV claiming the S&P 500 will be up precisely 12.7% next year. There are risks.

    Seasonal Influences Abating

    We have seen a number of seasonal influences in recent days, which should start to abate now. On the negative side we have had selling of winners, likely a result of investors delaying capital gains until 2011 and the undoing of year end markups. On the positive side we have had beginning of the year inflows. As these factors abate we should find out which way this market is headed.

    The S&P futures were selling off hard overnight but have pared the losses on a very positive ADP employment report. The report is clearly a surprise as treasuries are selling off. However, I would note that markets generally top out on good news, not bad.

    Just Buy The Dip Wins Again

    The first dip of 2011 has been bought and everybody is a winner once again. It is not uncommon for the first dip lower to be bought and that does not mean the bulls are out of the woods. But they are the winners today. Have a good night.


    This is the time of year when one cannot avoid seeing lists of predictions and New Year's resolutions. I even contributed by producing my own list of quasi-resolutions last week. By far the most common resolution or piece of market wisdom that I have been reading is some variation of don't try to outsmart the tape/the trend is your friend/don't fight the tape. Like many Wall Street sayings there is some validity to it. But I have found that when everybody is spouting the same truism or looking at the same indicator, there is a high probablity of it failing.

    The past year has been a boon for trend followers/momentum investors. The market has had very defined moves all year with little deviation from the prevailing trend. "After" this banner year for trend following everybody is now converted. There is a self reinforcing cycle as more and more people adopt a specific strategy but eventually it becomes a self defeating cycle as the hot money abandons the strategy.

    I make a living by fighting the trend. Most stocks I buy have charts only a mother can love. The reason I believe most people fail when trying to fight the trend is that they don't have a methodology for picking their spots. Before fighting a rising market I try to wait for bullish sentiment to become extreme and for the move to be exhausted. I employ similar tactics in buying a falling market. Many just go with their gut or data mine.

    2010 had opportunities for traders like myself because the extremes were very extreme and as long as one had patience and perseverance there were some good opportunities. But it was not the easiest year for mean reversion traders. While everybody is converting to trend following strategies, I am sticking with mean reversion.

    Game On

    Commodities have reversed hard and equities are the last man standing. In a "risk on/ risk off" world one could reasonably expect equities to follow. But its also a "just buy the F$@*ng dip" world. Who will win? We finally have a game on our hands.

    Short Supply

    While I remain net short there are two factors that are stopping me from getting aggressive. The first is that seasonality is still positive, although not to the extent that it has been. The second and more important factor is that the supply calendar is very light right now.

    I don't believe it is a coincidence that the S&P 500 pulled back 50 points right around the time that GM had its $20 billion IPO and Bank of America sold its $8 billion stake in Blackrock. That was a lot of supply to digest and I believe it helped cause the only hiccup in the market in over 4 months.

    Currently, the supply calendar is empty as is typical around this time of year. If we reached a time where the supply calendar starts to fill up and sentiment is still this extreme I would likely get more aggressive. The ideal situation would be if the government came to market with its stake in AIG, but that is not rumored to happen until March.

    The market cannot continue this ascent forever and eventually the market will fall on its own weight even if we don't see heavy supply. But, I would feel a lot more comfortable on the short side  if I knew that I was getting some help.

    Turnaround Tuesday

    The market's ascent is reaching the silly phase and it is becoming too easy for the bulls. Today was another day of hand over fist call buying and brave predictions of S&P 500 price targets well north of here. While its hard to find a catalyst for a decline, tomorrow is Turnaround Tuesday. Kumbaya my friend. Have a good night.

    Saut Cautious

    Jeff Saut is a rarity among Wall Street strategists. He actually gets bullish when prices go down and bearish when prices go up. He was correctly bullish until now. He has turned cautious in the near term. From Minyanville:

    While I, too, think any correction will likely be for buying, I'm becoming more cautious now that we're in January, worried about a repeat of January 2010. Recall what happened last year; I was cautious coming into the new year while the “crowd” was waxing bullishly. And just to make me look foolish, the S&P 500 rallied 3.2% from 2009’s year end to a short-term peak on January 19 of 1150.23. Accordingly, the cry went out: “So goes the first week of the new year, so goes the month, and so goes the year.” However, from that January peak, the SPX fell more than 9% into its February 5 low of 1044.50.

    Up and Out

    I have rolled my SPY Puts up in strike and out to February. I am tempted to add to the size of the position but am having a tough time on the timing of a decline. My net short position is still pretty small even though I am starting to feel very bearish.

    Silly Rabbit

    I feel very strongly that the market will need to work off the extreme sentiment readings in the coming weeks. In my experience, January has been a time where overheated markets often see a correction.

    2011 is starting off much in the same way 2010 did, with a large gap up. In 2010 we did not see a correction until after January expiration, which is quite common. I believe the market will have a tough time reaching January expiration without a correction. This year's rally has been going on longer than last year's was and sentiment is more extreme.

    The fact that I am starting to feel silly suggesting that we will see a correction likely means one is just around the corner.

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