No Bounce

I was expecting some sort of a bounce in the past few days after the S&P 500 dropped by a quick 50 points. The market has instead traded sideways. Most of the sentiment indicators I look at are mixed but some are starting to move towards excess bearishness. We are entering a seasonally strong part of the year where we don't generally see extreme bearishness unless there is a crisis.

The highs in the market came a little over six weeks ago making us oversold in the intermediate term. Its not a great oversold reading because we chopped around for a while after the market made a  high. If we get some turmoil into the election we will likely get a better oversold reading and sentiment is likely to be excessively bearish. That would likely prove to be a good buying opportunity.

At this time of year I make an effort to have  a positive bias. I have used the recent weakness to build a medium sized net long position. If we do get a further decline into the election I will likely take a more aggressive stance on the long side.

 

More Constructive

We finally saw some signs yesterday of investors throwing in the towel:

  • The ISE equity showed the most put buying since early June.

  • The VIX popped

  • The TRIN reading was extreme

  • We broke below widely watched support levels that likely cleared out some weak hands.


All this should lead to some sort of a bounce, which we are seeing this morning. Its possible that this bounce will be the beginning of a bottom but the intermediate term sentiment and oversold  indicators are not extreme enough to have  a strong conviction that this was  a bottom.

An Update On Yahoo!

I recently wrote up Yahoo! and explained why I bought the stock. Last night Yahoo CEO Marissa Mayer announced that she was going to return $3 billion to shareholders through a share repurchase. At the current price that amounts to well over 15% of the company. With such a large buyer in the market and a decent quarter it is difficult to see how Yahoo has much downside.  I believe Yahoo has limited downside and should outperform the market in the months ahead.

Swinging Back Towards Pessimism

Earnings continue to come in weak with guidance being lowered. Investors have finally responded to the negative news and the sentiment indicators are starting to reflect that. Rydex traders have lowered their exposure to the lowest levels in a couple of months. Most sentiment indicators are in neutral territory but no longer in the extreme optimism territory we saw after QE Infinity was announced.

We are seeing a break this morning below widely watched technical levels. This could lead to a decent washout and accelerate the move towards extreme pessimism.  I continue to believe that the best course of action is to buy extreme pessimism and sell optimism. It looks like we are on our way to an oversold reading combined with excess pessimism.

Not Easy

Earning are coming in weak, the economy is slow and there will be some sort of fiscal cliff at year end that will likely slow growth further. The only question is the size of the fiscal cliff. Combined with valuations near the historical average its difficult to be overly bullish.

Companies and private equity firms are borrowing at the lowest levels in history in order to repurchase shares and take over other companies. With yield scarce everywhere the only place left to get yield has become the stock market. In addition, we are heading into a typically strong part of the year. This makes it difficult to be overly bearish as well.

Given this backdrop it is difficult for me to have  a strong view on intermediate term market direction. My best guess is that we are in some sort of range where it will pay to buy oversold and sell overbought.

Don't Chase

It never ceases to amaze me how investors turn positive after the market has already rallied. Investors had the opportunity to buy the S&P 500 over 30 points lower on Friday but instead were fretting over moving averages. Two trading days later and with the market more expensive they were clamoring for calls yesterday.

The Nasdaq was down something like six days in a row before Monday so an oversold bounce was not unexpected. However, now that we have bounced and investors have once again turned optimistic the risk/reward is more muddled. The market has only rallied for two days so its too soon to turn bearish with any conviction.

I believe the most likely outcome for the next few weeks will be some sort of a trading range. I would not chase the market either lower or higher.

Chimera At A Discount: Part 2

There are two issues I wanted to address in response to my writeup yesterday of Chimera. How can I trust the book value of a company that is not up to date on their financials?  What about their agency mortgage exposure?

How can I trust the book value of a company that is not up to date on their financials? Before I tackle this I want to point out again that the book value is not at issue in the restatement. I view Chimeras portfolio as two separate portfolios: a levered agency portfolio and an unlevered non agency portfolio. On the agency side its difficult to see how the book value can be wrong as the securities are relatively simple to value. It is far more likely that any mispricings are on the non-agency side. Chimera has roughly $3.1 billion in equity. They hold roughly $2.6 billion in RMBS, mostly junior securities. The dealer marks on Chimera's portfolio are 67 bps lower than Chimera's marks. From speaking to people in the industry dealer marks on junior RMBS are very tough and conservative. In the current regulatory environment its difficult to see how the numbers could be that far off. Chimera also holds a roughly $285 million portfolio of securitized loans. These loans are prime, jumbo, first lien residential mortgages. This is a seasoned portfolio with average FICO scores of over 750 and 75% LTVs. They are priced slightly below the remaining loan balances. Its difficult to see how these loans are so mismarked as to drastically change the valuation of the company. If there is a drastic mispricing of Chimera's assets I cannot figure out where it could be.

I believe that pure play agency mortgage REITs such as Annaly Capital Management and America Capital Agency Corp. are at risk. Agency mortgage REITs make money two ways. The spread between agency securities and treasuries plus off of the yield curve. As a result of the Fed buying agency securities there is no more spread between agency and treasuries once one accounts for prepayment risks. There could even be losses if prepayments come in high. This leaves the agency mortgage REITs as a levered play on the yield curve. Agency mortgage REITs have already started to sell off and its possible that Chimera gets lopped in with them. Chimeras agency exposure is relatively small and any decline in sympathy with the agency mortgage REITs would be an opportunity. If one is worried about the agency mortgage exposure I would recommend shorting a pure play agency mortgage REIT against 15%-20% of the dollar value of this position.

Chimera At A Discount

Many people are familiar with Annaly Capital Management but fewer are familiar with its subsidiary Chimera Investment Corporation. Annaly only invests in agency mortgage securities while Chimera invests in private mortgages as well as agency securities. Chimera is managed by FIDAC, another subsidiary of Annaly.

Chimera pays a 13.4% dividend and I estimate that its economic book value is greater than $3.00 (GAAP book value is even greater but does not reflect reality). Chimera currently trades at $2.62 and would need to appreciate by 14.5%   in order to reach my estimate of economic book value. Chimera last reported economic book value of $2.87 as of June 30. The type of junior mortgage backed securities that Chimera holds have risen strongly since then and I estimate that the economic book value is now above $3.

What is the catch and why does such a discount exist ? Chimera has dropped precipitously in recent years as some of their securities had not performed as expected and they are delinquent in their SEC filings.

GAAP accounting treats investment grade securities and non investment grade securities differently. Chimera used the investment grade accounting treatment on non investment grade securities. The difference amounts to which line item the income flows through, interest income or other. The end result is the same. The book value and the cash flow are unaffected by this. Chimera is delinquent in their filings as they correct these errors going back a few years.

The securities that Chimera holds have underperformed other private label RMBS in recent years. This is reflected in the market value of those securities and in turn Chimera's economic book value. I don't believe an additional discount needs to be applied to Chimera.

Chimera trades with a large margin of safety due to its significant discount to economic book value. I believe that over time that it will trade back to economic book value. Investors are being paid 13.4% while they wait. This is an attractive risk/reward in a market with few bargains.

Back In The Saddle

I am trying to get my bearings as I have been out for the past week and a half. My wife and I had  a beautiful, healthy baby girl. When I last left I was looking for an oversold rally, which we saw last week. The rally lasted most of last week until right after the employment report. Since then we have been down for almost three trading days.

In the very short term we could see a bounce after a nasty day like yesterday but this is likely not the bottom. The decline is only three days old and a nasty day like yesterday that comes early in a decline usually sees some follow through. The intermediate term sentiment indicators are still showing excess optimism although they are no longer extreme. Ideally, I would like to see the market become more oversold and intermediate term sentiment turn more neutral or even negative.

My initial reaction is to do some buying on weakness but to leave plenty of room as a better opportunity is likely in the coming weeks.