Four Investment Ideas With Upcoming Catalysts : Part 2

In this two part post I outline four value investments that I own with catalysts in the first quarter of 2014.  In part 1 of this post I reviewed Air Products and Chemicals (APD) and Annaly Capital Management (NLY). Here are my final two picks:


Eastman Chemical (EMN)
Catalyst: Aggressive share repurchase plan starting in Q1 2014

I laid out a detailed case for owning Eastman Chemical in late October. In summary, over the past decade Eastman has transformed itself from a maker of commodity chemicals into a specialty chemical maker with among the highest margins in the group. Specialty chemical makers tend to trade for a large premium to their commodity peers yet Eastman is among the cheapest stocks in its sector. Eastman has one of the highest free cash flow yields, lowest P/Es and lowest EV/EBITDA ratios in the chemical sector.

Eastman has spent the past few quarters paying down debt that resulted from an acquisition and will be done paying it down by the end of 2013. I believe that starting in the first quarter of 2014 Eastman will direct free cash flow towards shareholders in the form of an aggressive share repurchase.

Eastman management has stated numerous times that they will use their balance sheet and ample free cash flow to reach their earnings goal of $7 in 2014 and $8 in 2015. They have also said that acquisition targets are too expensive now, which points towards share repurchases to increase earnings. Management also mentioned in passing on a recent webcast that share repurchases have a larger effect on EPS when done earlier in the year. This leads me to believe that Eastman will start repurchasing shares aggressively in the first quarter of 2014, getting the ball rolling on a re-rating of the stock. I am long EMN short ALB CE DD DOW FMC

Muni Bond Closed End Funds
Catalyst: End of tax loss selling

Municipal bond closed end funds (muni CEFs) are down as much as 30% from their highs in some cases. Fed tapering and headlines from Puerto Rico and Detroit have brutalized the municipal bond market and muni CEFs even more so. This leaves many muni CEFs trading at high single digit discounts to NAV and yielding nearly 7%, which is the taxable equivalent of over 10%.

I believe that scary headlines like those in Puerto Rico and Detroit are outliers. For the most part municipal finances have improved over the past year as tax receipts have grown along with the economy. One could even argue that municipal bonds value versus treasuries should be higher than ever as tax rates are higher so the tax advantage has grown. Municipal bonds offer the best after tax, risk adjusted return of any asset class. Once tax loss selling ends the market should begin to recognize this. I am long NRK VMO VKQ PMO NAN

Four Investment Ideas With Upcoming Catalysts : Part 1

Earlier in the week I outlined the difficult environment facing value investors. Finding new investments meeting a value criteria has not been easy after a nearly tripling of markets in less than five years. A couple of months ago my cash pile was growing as many of my investments reached their target and I could not find new investments to replace them. Much to my own surprise I have recently been able to put money to work and am excited about my portfolio. Four of my investments, which I will outline, have catalysts coming up in the first quarter of 2014.

Two of the investment ideas came along as a result of tax loss selling. Tax rates have gone up this year and many market participants have large gains. Those looking to offset gains with losses have very few choices this year, so a small group of losing stocks have bore the brunt of this selling. Tax loss selling is similar to forced selling in that sellers are not basing their sell decision on the merits of the stock. The good news is that there are less than four trading days left in the year and tax loss selling will soon be over. The other two ideas are are long/short ideas with company specific catalysts. Without further ado here are my four investment ideas:

Air Products and Chemicals (APD)
Catalyst: Announcement of new CEO

Bill Ackman took an activist position in Air Products and Chemicals earlier this summer. He was quickly able to gain board seats and remove the CEO. Normally, this would cause the stock to fly but due to the adverse publicity Bill Ackman has received from Herbalife and J.C. Penney the stock has barely outperformed its peers. Bill Ackman has had many successful activist campaigns and a small handful of failures. Air Products and Chemicals has a lot more in common with his successful campaigns.

Air Products has strong, recurring free cash flow that is being masked by a capex binge. Only $300-$350 million of Air Product's $1.52 billion a year in capex is maintenance capex, while the rest is expansion. New plants take three years before they are built and operating at the capacity needed to create strong cash flow. The benefits of the capex binge of the past few years has not been realized but will be realized over the next few years, resulting in higher cash flow. The new CEO is likely to reduce capex spending on new projects and direct more of free cash flow to investors.

Air Products has the lowest margins in its industry. It largest competitor, Praxair, has margins nearly 50% higher. There is a lot of room for cost cutting and increased sales productivity to improve margins. With modest margin improvement and the realization of the benefits of their capex binge, Air Products could see over $14 in free cash flow per share annually some time in the next few years.

Many people I have discussed Air Products with have been scratching their heads as to why Bill Ackman has chosen the company. Bill Ackman has still not laid out a detailed case for this purchase,as he is likely waiting for the new CEO to be announced. A new CEO has not been chosen yet but is likely to be chosen in the first quarter of 2014. The appointment of the new CEO is likely to act as a catalyst for the stock as the new CEO lays out his strategy and Bill Ackman lays out his investing case. I am long APD / short PX ARG

Annaly Capital Management (NLY)
Catalyst: End of tax loss selling

I recently laid out a detailed case for owning Annaly Capital Management. In summary, Annaly trades for an unwarranted 20% discount to book value. Annaly has lowered leverage, hedged and diversified into commercial mortgage backed securities. Annaly is positioned well to withstand  future interest rate increases with minimal damage to book value. I believe the reason for this deep discount is primarily end of the year tax loss selling and the fear of the effects tapering will have on Annaly's book value. Tax loss selling will soon end and as time passes the market will eventually become more comfortable with the effect tapering has on Annaly's book value. I am long Annaly.

Click here for part 2

The Current Value Investing Environment

I don't believe I am making a bold statement when I say that the US stock market is not cheap. Even if one takes earnings at face value and uses the bulls optimistic estimates for 2014, multiples are 10%-20% higher than average. If it turns out that artificially low rates have been boosting earnings and that five years into an expansion we may be close to peak earnings than the stock market is expensive.

For value investors whose primary goal is avoiding the loss of capital, the current market environment hardly provides a margin of safety. Of course, the overall market matters less if one is able to find individual securities with a margin of safety. Even in the year 2000, during the biggest stock market bubble in US history, there were bargains as many small cap & "Old Economy" stocks were being discarded in favor of "New Economy" stocks and blue chips. 

Finding bargains in the current market might be even harder than in the year 2000 as small caps trade at record valuations and dispersion in the S&P 500 is at an all time low. The lowest dispersion ever means that the difference between the most and least expensive stocks is smaller than ever. In some sense value investing has become a victim of its own success as "cheaper" stocks have been bid up. The cheapest part of the market, where value investors tend to fish, is as expensive as it has ever been.

What is a value investor to do in such an environment? This makes it much more difficult for a value investor but not impossible. I believe the most important thing is not to force investments or lower ones standards in any environment. If that means holding more cash so be it. 

(As an aside I am actually quite optimistic about my portfolio for the new year, although my positions are largely not traditional value investments (ie. long common stocks). I plan to write about why I'm optimistic about my portfolio some time in the next week.)

If there is anything that I have learned having lived through two bubbles its that expensive can become more expensive. I have also learned that few who say "I will dance until the music stops" find a chair when the music ultimately comes to an abrupt halt. Unless one believes that we are in a new paradigm where cycles have been eradicated than there will be better opportunities some time in the future for value investors. Will you have cash to invest when that happens?

Annaly For The New Year

SUMMARY

Annaly Capital Management trades at nearly a 20% discount to its book value, which is comprised of highly liquid securities. Annaly has recently delevered and hedged, which should limit further losses. The stock is currently priced for a disaster and anything short of that should lead to attractive gains. An end to tax loss selling season or putting the taper behind us could be the catalyst for gains.

BUSINESS

Annaly Capital Management is a mortgage REIT that primarily owns a levered portfolio of agency securities. Through Annaly’s acquisition of its subsidiary, Crexus, Annaly has diversified modestly into CMBS as well. Annaly now deploys 11% of its capital in the CMBS market. Additionally, Annaly owns a small asset management business.

Annaly has been in the agency RMBS business for over 15 years. The way the business works is that Annaly owns a levered portfolio of agency securities. Annaly makes money through two spreads, the spread between longer rates and shorter rates and the spread between agency securities and treasuries. This is a very simplified explanation of the business. Annaly has to choose what securities to own, how much leverage to employ, how to fund the portfolio and how to hedge based on the current environment.

WHAT HAPPENED

For nearly 15 years Annaly had been in a great business with some minor bumps along the way. Over this period Annaly was able to offer a dividend that averaged in the double digits plus capital appreciation. When QE came along it compressed both the spreads that Annaly was profiting off of. QE succeeded in lowering interest rates and the spread between agency securities and treasuries collapsed.

Instead of backing off the trade as the spreads became narrower many agency mortgage REITs increased or maintained leverage in order to sustain returns. When the Fed announced a possible taper in May this caused rates to go higher & spreads to widen. This led to losses across these leveraged portfolios. Most agency mREITs have locked in these losses and delevered their portfolios since.

PRESENT

Annaly’s book value has fallen from $15.85 at the beginning of the year to $12.70 at the end of the most recent quarter. This is partially due to the large dividend they continued to pay out despite losses but mostly due to the increase in rates and spreads. In reaction to these large losses Annaly has delevered and hedged more aggressively. At the end of the latest reported quarter Annaly was levered 5.4 times, which is at the very low end historically. Annaly is 74% hedged, which is at the very high end historically. It is estimated that Annaly would lose 4.4% if yields were to go up by 100bps.

Annaly has historically traded at approximately a 10% premium to book value. After this past years missteps it currently trades at a roughly 19% discount to its book value. The most common response I get when pitching Annaly is that rates are likely to go higher and spreads are likely to widen as the Fed tapers. However, even if rates went up by 125 basis points and spreads widened its unlikely that book value would fall much more than 10%. If that were to occur the Annaly would still trade at a 10% discount to book and the spread would come back into the trade that they do, making it attractive again. All the while one is likely to be paid a 10% dividend to wait (currently the dividend is 14% but likely to go lower). In November four different insiders purchased shares in Annaly at prices higher than current levels.

CATALYST


It is likely that much of the recent selling has been tax loss selling as Annaly is down more than 45% from its highs. Tax loss selling ends at the end of December and these sellers will no longer be present in January, paving the way for a higher share price.  It seems that every time somebody mentions the word taper that Annaly gets hit. Getting the big, bad event behind us will likely be a positive as Annaly is hedged for higher rates and the fear of the taper is likely worse than the taper itself. 

Eastman Chemical : Specialty Chemical For A Commodity Price

In a little over a decade Eastman Chemical  has transformed itself from a producer of commodity chemicals into a producer of specialty chemicals. Despite Eastman's transformation the stock still trades at the valuation of a commodity chemical company. After paying down debt in 2013 Eastman will be able to use its strong free cash flow in 2014 for repurchases or accretive acquisitions that should lead to a rerating of the stock.

Read the rest at Seeking Alpha

Why Crimson Wine Group Could Be Worth $20

My original decision to purchase Crimson was primarily based on my assessment that the stock, which was trading at under $8, was trading at a big discount to the assets of the company (over $13). Additionally, savvy management seemed eager to own this asset. Since that time there have been a handful of transactions of wine estates that make my asset value estimate look conservative (here and here). While I saw the potential in Crimson’s business it required somewhat of a leap to understand how Crimson would translate its assets into earnings. With the release of second quarter earnings I am now more excited by the business than the assets and believe that Crimson could be worth more than $20 a share.

Revenue

In March Crimson President and CEO Erle Martin told the Napa Valley Register that he plans to double in size to half a million cases and roughly $100 million in sales by 2016. In the most recent quarter (Q2) Crimson reported 31% revenue growth over the previous year, which is well ahead of its plan to double revenue in four years. This was especially impressive because the rest of the industry did poorly as record bad weather hurt wine sales in the second quarter. Crimson is especially sensitive to weather as they rely on visits to their wineries to drive sales. Thus far weather has been excellent in the third quarter and it would not be surprising to see the sales momentum continue or even accelerate.

Gross Margins

In the longer term I expect gross margins to head from 51% in 2012 towards 60% as Crimson utilizes is full capacity. While 60% is unheard of for traditional wine companies it is the norm for well run, high end wineries (see NYT article and WVVI 10-Q). Crimson plans to increase production this year by 36% at existing facilities. This incremental production should have very high gross margins due to higher capacity utilization. The benefits of this increased production on gross margins should begin to be realized by the end of 2014.

SG&A

Crimson has shown tremendous leverage on SG&A. Sales grew by 31% in the second quarter while SG&A expenses excluding public company costs rose by a mere 5%.

Crimson’s $100 Million Goal

Crimson’s goal of $100 million in revenue by 2016 seems conservative given recent growth rates. At $100 million in revenue Crimson should be able to do at least $30 million in EBITDA and possibly as much as $35 million. If Crimson trades at its peers valuation the stock could reach $20 or higher, with a margin of safety from over $13 in asset value.  One could argue that Crimson should trade at a premium to its peers as it is the only pure play high end wine company with rapid growth.

A Tale Of Two Gas Stations

Susser Holdings (SUSS) and CST Brands (CST) both operate gas stations with convenience stores attached. Susser Holdings came public in 2006 with private equity backing, while CST Brands is a recent spin-off from Valero. On the surface a spin-off would seem far more attractive than a private equity backed IPO, but looks can be deceiving...    Read the rest of my write up at Market Folly

Dissecting A Losing Trade

Taking a loss in investing hurts. There is  a mourning period of a few days after I take a loss where a gloom seems to hang over me and I constantly think about what went wrong. Fortunately, losses are also the best way to become a better investor if the proper lessons are taken away.

I took a position in DOLE about two weeks ago upon the announcement of a $200 million share repurchase, which amounted to about a third of the float. I have had very positive experiences with companies that repurchase a large percentage of their shares. I have never seen a company announce a share repurchase for a third of their float.

Aside from the large share repurchase there appeared to be value in the shares of Dole. The market cap was less than a billion dollars and net debt very low. There is as much as $600 million in underutilized real estate that could be sold. Dole is cutting expenses and should be able to produce over $250 million in EBITDA once the cost cuts are in effect. In addition to the seemingly cheap stock and enormous repurchase, an insider owns over 30% of the shares. The upside seemed very compelling.

There were also some aspects of  Dole that I chose to overlook. I prefer to own companies whose businesses are less cyclical and produce steady free cash flow. As a commodity producer in the midst of a restructuring Dole did not meet either of these criteria.

Yesterday, Dole announced a suspension of their share repurchase  two weeks after it was announced. That sort of a  turnaround is unprecedented and could not be expected. However, it was the aspects of the company that I chose to overlook that led to this turnabout.

Was my purchase of Dole an unforced error or a case of  "shit happens"? It is possible to make  a case for both sides, which will probably lead to a few more days of contemplation.

Share Repurchase Fever

After a market rally that has lasted more than a half a year bullish sentiment recently reached the types of extremes seen once every few years. It used to be the case that this type of extreme sentiment would be a reliable indicator for an intermediate term market top. However, that does not seem to be the case this time around. The market pulled back for three days and now seems to be resuming its rally this morning. I believe the reason for this behavior is the historic level of stock repurchases we are seeing. From Bloomberg:
About 79 percent of buyback orders at Goldman Sachs Group Inc.’s corporate trading desk were active yesterday, the most this year, according to a note to clients obtained by Bloomberg News. Companies stepped up purchases as the Standard & Poor’s 500 Index fell as much as 3 percent from an intraday record reached May 22.

The buybacks may have limited losses in American equities after shares in Japan fell the most in two years and stock markets from London to Paris and Frankfurt saw declines of more than 2 percent.

In the current market environment it is crucial to monitor share repurchases.  Here are some things to be on the lookout for:

  • A change in the economic or interest rate backdrop that slows the pace of share repurchases.

  • As prices rise it takes an increasing amount of share repurchases to have the same effect. We could reach a point where share repurchases produce diminishing returns, although we do not seem to be there yet.

  • Insider selling and share issuance begins to outpace the share repurchases and cash M&A.


I used last week's decline to take in many of the shorts I had been scaling into and am now very modestly net long. The reason I did so was that it seems futile to fight these share repurchases, even though I believe the market has gotten ahead of itself.

As Long As The Music Is Playing

Credit Suisse reports that through last week there have been $320 billion in announced share repurchases in 2013. For reference announced repurchases  for the entire year of 2012 were $477 billion and 2012 was a strong year for repurchases. At the current pace there will be well over $800 billion in announced share repurchases in 2013. If indeed corporations repurchase that much stock it would amount to over $3 billion every trading day. I don't believe that corporations will be able to keep up the current pace but even at a somewhat more moderate pace these numbers are astounding.

In the short run a steady buyer of billions of dollars of shares a day cannot be painted any way other than extremely bullish. In the bigger picture this is creating valuations that are unsustainable and will eventually lead to the third reckoning since the new millennium.

Many point to the record cash on the balance sheets of US corporations as justification for the current binge. They ignore the other side of the balance sheet where debt has soared by far more than cash. JPMorgan reports that net debt at corporations ex-autos is at a record of over $1.9 trillion up from under $1.2 trillion at the beginning of 2007.

The S&P 500 is currently trading somewhere between 15 and 16 times forward earnings, well above the historical average. One can also argue that the earnings number is being artificially inflated by low interest costs and an economy artificially propped up by zero rates. However, there is nothing easily identifiable on the horizon that will derail the current share repurchase binge. All this places us squarely in a third game of musical chairs where the music is still playing.

Does Sentiment Still Matter

I have spent far less time discussing market sentiment this year than in previous years. The reason being that I believe that the marginal buyers of stocks have been corporations repurchasing stock and buying other companies for cash. The level of float shrinkage is setting records. Corporations repurchasing shares have no sentiment. They just keep buying steadily on a daily basis.

I still believe that market sentiment matters but in the current environment it matters less than usual. It takes larger extremes in bullish sentiment to knock down the market when there is an underlying bid from corporations. I believe that we are nearing a point where sentiment is extreme enough to matter. The vast majority of the sentiment indicators I track are now urging caution and the market is stretched:

  • Investors Intelligence bears are below 20% while the bulls are at 54%

  • Newsletter writers tracked by Hulbert are recommending the largest long position in stocks since January 2002.

  • Rydex traders are positioned at a bullish extreme

  • Investment advisers tracked by NAAIM stock exposure remains at the upper end of historical allocations.

  • The most speculative of stocks are flying.

  • Margin debt is nearing record levels.


While sentiment has not mattered all year there are now a confluence of indicators in extreme territory. At the same time breadth has been lagging in recent days. If sentiment still matters at all this should be the time when it asserts itself. Normally, I would expect an intermediate term top under these conditions. But with the underlying bid from corporations still present I would not be shocked to only see a shorter term correction.  I am expecting a 3% to 5% pullback at a minimum leading me to take a net short position in the market.

 

Technology To Take The Lead

Technology has been one of the poorest performing sectors in 2013 and over the past 12 months. The S&P 500 has returned 13.98% over the past 12 months while the S&P 500 Information Technology sector has returned -2.93%, lagging by nearly 17%. The two main drivers of the market rally have been a chase for yield and the float shrinkage that has been occurring through cash M&A and share repurchases. Technology has not been one of the main beneficiaries of these trends but I believe the record cash return by Apple will mark a turning point.

The stock market has been shrinking. In February there was over $100 billion in share repurchases & cash M&A announced. This float shrinkage has helped propel the overall market higher but has been less prevalent in the technology sector. For the most part technology companies have continued to stockpile cash, with the Dell LBO having been an exception. That all changed this week when Apple announced the largest cash return in history.  Apple has pledged to return $100 billion to shareholders before the end of 2015. That works out to over $33 billion a year, a little over 8.6% of its current market cap. With this announcement technology has joined the float shrinkage party and the sector is likely to play catch up. Its also possible that Apple's technology peers will follow its example.

The poor performance in the technology sector does have some fundamental justification. There is a large amount of disruption occurring in technology. The PC related companies have been disrupted by tablets. The tablet and mobile device markets are becoming more competitive. The enterprise software companies are feeling the slowdown in global GDP as well as the move to open source and cheaper alternatives. However, there has always been disruption in technology and the lower valuations already account for this. Its not like everything is perfect in consumer staples, one of the best performing sectors. Companies like Coca Cola and Procter & Gamble have barely seen any revenue growth yet the stocks are flying.  The same can be said for pharmaceutical companies like Pfizer.

I believe that technology will be the best performing sector between now and year end and have positioned myself that way. Technology is by far my highest allocation with Check Point Software, Amdocs and Apple being my largest tech positions. All trade at greater than 10% free cash flow yields (to enterprise value) and all are returning cash to shareholders.

 

Rally On Fumes

I believe that the current rally is running on fumes. Before I get to the bearish side of the ledger I want to acknowledge the positives. The large float shrink (ie. share repurchases & cash M&A) is an undeniable positive. As long as the share repurchases and cash M&A continue at the current pace it is difficult to imagine much more than a correction. The second positive is seasonality. April is one of the stronger months of the year for stocks. Extended markets often become more extended during seasonally positive periods. The negative side of this is that in another month we enter the weaker part of the year where we have seen market corrections in each of the past 3 years.

Investor sentiment is troubling as the vast majority of the sentiment indicators I follow are showing excessive optimism. Whether it be hedge fund managers, investment advisers or newsletter writers the consensus in unanimously bullish. Former "Chicken Littles" suddenly have  a greater appetite for beta. The following excerpt from an article in the WSJ captures the current mood:
The market's record-breaking spree has raised a new fear in many American households—dread that they are missing out on big gains.

When stock prices collapsed in 2008, the bear market wiped out half of the savings of Lucie White and her husband, both doctors in Houston. Feeling "sucker punched," she says, they swore off stocks and put their remaining money in a bank.

This week, as the Dow Jones Industrial Average and Standard & Poor's 500-stock index pushed to record highs, Ms. White and her husband hired a financial adviser and took the plunge back into the market.

The economy is stumbling along and profit growth has slowed to crawl. The full effects of the tax hikes and the sequester have yet to be felt as spending habits do not change on a dime. A slowing economy with more headwinds ahead is not the ideal environment for profit growth. Valuations are full even with profit margins at record levels. It is difficult to see where further profit growth will come from.

Up until now the large float shrink has kept me from getting too bearish. But as we approach the seasonally weaker part of the year with the market even more stretched I am more likely to act on my bearish inclinations. The bears, if there are any left, may be coming out of hibernation soon.

A Tidbit From The Oracle Conference Call

Amdocs (DOX) and Comverse (CNSI) both provide billing software and services for telcos. As a shareholder of both I found a portion of the Oracle Q&A very interesting. The following is a portion of the Oracle conference call on Wednesday from Seeking Alpha (my emphasis added):
Larry Ellison

We have a very, very significant presence in billing systems, in provisioning systems, in the telco space. And what we’d like to become is one of the most strategic suppliers to telcos overall, which involves broadening our footprint of what we supply them.

So you’re going to see us, through our own engineering, through innovation and acquisitions, greatly broaden our footprint as our ambition is to be the primary technology provider to the telecommunications industry. So that’s an area where we’ve been very successful, in certain parts of it, and we think we can expand that business by adding to the footprint.

Crimson Wine Group: Bull Case on a Unique Spin-off Opportunity

My write-up on Crimson Wine Group (CWGL) is up at Market Folly. I explain why the stock may have 70% upside.

Doing Less

As the market has risen it has become increasingly difficult for me to find stocks that meet my value criteria. I look for companies with predictable free cash flows at a low price. These companies suddenly seem few and far between. I tend to stay away from companies that are highly levered, capital intensive or cyclical.

During 2010, 2011 & 2012 there were periods when the market got ahead of itself but I was still able to find bargains. During that period healthcare, select consumer staples and enterprise software companies were trading cheap even when the market became expensive. Even though there were periods when the market as a whole became unattractive I did not have  a hard time finding individual securities. Currently, I can hardly find any new stocks to buy that meet my criteria.

The reason I believe this has occurred is that the market has rightfully put a premium on companies with more predictable free cash flows. But I cannot help but wonder if I am becoming more complacent and not looking hard enough. This weekend I came across  a chart that argues for the former. Defensive stocks are more expensive than they have been to cyclicals in forty years.



I have made some adjustments to my strategy by buying select cheap, cyclical stocks but carefully hedging out the cyclical risk by shorting similar companies. However, for the most part I have been selling off positions as they reach my targets without being able to replace them.  The past few years have been ideal for my strategy but the current environment argues for doing less and that is precisely what I am doing.

A History Lesson From 2006 and 2007

It was obvious by late 2006 that the real estate bubble was beginning to deflate. Leveraged speculators were starting to get into trouble and the housing market was slowing down. With all the leverage in the system it was a certainty that the collapse would be massive. Let me refresh your memory if you forgot: 108% no money down mortgages, liar loans, janitors getting $500,000 mortgages, no doc, no problem.

Despite the writing on the wall the market steadily climbed through late 2006 and all the way until the summer of 2007. There were some hiccups during the year when a number of subprime lenders collapsed but the market recovered quickly each time. There were some bigger hiccups that Summer when problems began to surface at larger banks but the market still did not not put in a high until October of 2007.

By October of 2007 the problems were painfully obvious. The economy was slowing and the real estate bubble was quickly deflating. Shouldn't the market have realized this instead of making new all time highs? Isn't the market a discounting mechanism? What was the reason the market kept climbing?

The answer to this mystery was quite simple. There was a boom happening in M&A, LBO and share repurchases. The supply of stock was quickly shrinking. It seemed like every other day there was a massive share repurchase, LBO or M&A announcement.

I remember this period very clearly because I was short. My saving grace was that I bought SPY leap puts when the VIX was at 10 so it allowed me to weather the market going against me. While this trade turned out to be the trade of my lifetime it was a grueling experience. Knowing for certain that the economy was collapsing, yet watching the market go against me every day was painful. If I were managing OPM at the time I likely would not have been left with much money.

This period ingrained into my head the power of share repurchases and cash M&A. The market was able to shrug off subprime companies collapsing, banks running into trouble and a slowing economy. It wasn't until the economy choked off the M&A and share repurchases that the market collapsed.

I was reminded of this experience in the past week as TrimTabs reported that there was nearly $100 billion in cash M&A and share repurchases in the last 2 weeks. Than on Friday it leaked that Wal-Mart, the nations largest retailer, was having one of their worst starts to a month ever. The main culprit being the payroll tax hike. The market dived at first but by the end of the day the Dow was up.

I don't believe a collapse is imminent like I did in 2007, even though there are no shortage of imbalances and risks. The reason I tell this story is that if the share repurchases and cash M&A continue at the recent pace it is likely to trump any fundamental factors.

Light My Fire

In my outlook for 2013 I wrote:
The level of cash M&A, LBOs and share repurchases have been on the low side considering where rates are. A buyout boom fueled by low rates is a real possibility. The fuel is there. Somebody just needs to light a match.

In the past two weeks there has been $97.5 billion in cash M&A and share repurchase announcements. TrimTabs has done extensive studies on what they call float shrink. This extreme level of float shrink is very bullish in the short term. It is intuitive that less supply of stocks should lead to higher prices.

Unfortunately, other factors are not as rosy for the market. Sentiment is excessively bullish and valuations are full. At the same time we are about to see the effects of the payroll tax hike. Many Americans live paycheck to paycheck and a broad tax hike is likely to effect the economy. There are also likely to be spending cuts even if we don't see a sequester.

It seems that the market is setting up for a third bubble. In the same way that artificially low rates have driven up real estate prices it seems the same is now happening to stock prices. This will likely not end well but being early to try and fight this is the same as being wrong.  The facts have changed with the massive amount of M&A and share buybacks announced in the past 2 weeks. I have bitten the bullet and removed some of my hedges, accepting a very low level of market risk.

Changes

There has been an undeniable change in recent weeks but it is not an economic change. The economy continues to muddle through while corporate profit growth is slowing. The major change has been one of psychology. Investors are suddenly feeling comfortable with more risk and have been shifting their exposure towards equities. After years of obsessing over risk management investors have shifted their attention towards rewards.

Hedge fund managers have been increasing their gross and net exposure as every survey and prime broker report has shown. Large asset allocators  such as family offices and pension funds are suddenly more comfortable with long only exposure as assets have been exiting bonds and hedge funds.

I prefer to buy at times when uncertainty is high and stocks are cheap. While in the long run this strategy has worked for me there can be long periods of time where I miss the party. There is no reason the  market cant stay overvalued and participants remain over bullish. In the past the market has stayed overvalued for years at a time and it can happen again. In a relative performance world these sort of rallies tend to persist until they suck everybody in.

I continue to remain patient and am finding very little to buy. I have been selling stocks when they reach my price target but have not been able to replace many of them. The winds have indeed shifted but I am remaining patient. If one thing is for certain is that sentiment will one day cycle back to excess pessimism and when that happens I will be ready to buy.

The Great Rotation Myth

The rallying cry of the bulls has been a "Great Rotation" out of "safer" assets like bonds and into "riskier" like stocks. The argument goes that stocks trade at fair valuations but are relatively cheap compared to bonds of all stripes. There are many flaws in this argument but the main reason I don't believe we are at the beginning of a "Great Rotation" is demographics. The baby boomers are in or near retirement and a secular move into riskier assets is unlikely to occur under these conditions.

It is undeniable that there has been a rotation into riskier assets in recent months. Hedge fund surveys and actual positioning reports from broker dealers show higher gross and net exposures from hedge funds. Sentiment surveys like the NAAIM & AAII combined with inflows into stock funds show that advisers and the public have had a  stronger risk appetite as well. While data on institutions is sparse, I have been hearing anecdotal evidence that they are feeling more comfortable with riskier assets. I believe this is  a cyclical rotation seen in the latter parts of a bull market rather than the beginning of a secular move.

The following excerpt on baby boomers comes from Wikipedia:
baby boomer is a person who was born during the demographic post-World War II baby boom between the years 1946 and 1964, according to the U.S. Census Bureau

... Baby boomers control over 80% of personal financial assets and more than half of all consumer spending

The oldest baby boomer is now 67 years old. By 2020 more than half of baby boomers will be over the age of 65. The vast majority of pension assets are for the retirement of the baby boomer generation. A great secular move towards risk seems highly unlikely to me when the group that controls the majority of assets are heading towards retirement or already in it.

I believe it is far more likely that we are in the latter part of a cyclical bull market than at the beginning of a "Great Rotation" and secular move into risk assets. We have had a four year bull market where the S&P 500 has had a total return of roughly 135%. This "Great Rotation" argument is a rationalization for those who have missed the move to follow their primal instinct to herd. "The Internet Is The Future" was the rationale for throwing caution to the wind during 1999. While the slogan was true the investment implications were disastrous. With that said, the market did not top out for another year after we started hearing that catch phrase.

 

Bears Give Up

Prominent bears, Alan Abelson and Nouriel Roubini, have thrown in the towel and are no longer bearish. They are not the only ones as it is difficult to find any prominent bears these days. $55 billion flowed into equity mutual funds and ETFs in January, the most since February 2000. John Paulson, David Tepper and Ray Dalio have all come out bullishly recently. There is a very positive mood towards stocks from pundits, the general public and professionals.

This unanimous bullish sentiment is not generally seen at great buying points. When sentiment is this bullish there is usually a better buying opportunity ahead but it could take a while to get there. Extreme sentiment can persist for months and trying to fight it is a grueling process. While I am roughly market neutral I have not decided to fight this yet. If I do it will likely be via puts. With the VIX under 13 puts are cheap and give defined risk in case this rally keeps grinding higher.

They Won't Get Fooled Again

After a brutal bear market from late 2007 to early 2009 investors were traumatized. In the ensuing four year bull market there have been numerous false alarms where investors thought they were headed for another 2008. The fear of the double dip, the Euro crisis, the US downgrade, the BP oil spill, the flash crash etc.. Each time investors panicked and were made to regret it. It seems that investors have finally learned their lesson and are determined not to get fooled again.

Two weeks into the New Year sentiment is nearing a bullish extreme as investors have been trained not to get shaken. At the same time many of the stocks I own are reaching my price target and I am having a difficult time finding new ones to buy that meet my value criteria. This combination has brought my portfolio to a market neutral posture.

Each time during this bull market when sentiment went to a bullish extreme there eventually was a better entry point for patient investors. Sometimes the exuberance lasted for months but eventually there was a better buying opportunity. It is possible that this time will be different. Maybe investors won’t get scared out this time. Maybe corporations will finally take advantage of the cheap money and lever up. Maybe this bull market will finally reach a level of exuberance typically seen in the late stages of a bull market.

I recognize that this time could be different but I will not invest that way. Sitting on the sidelines while everybody is making money is difficult and not enjoyable. But permanently losing money is even less enjoyable. Buying when there are values and investors are fearful has served me well over the years. That is what I intend to do even though the party seems like a lot of fun.

Removing Emotion From Investing

I recently wrote a post for Amazon's Money & Markets blog about removing emotion from investing. Please visit Amazon to read.

Late In The Game

Investors poured over $20 billion into equity mutual funds & ETFs in the first week of January, one of the highest inflows on record. Many sentiment indicators I look at are approaching extreme levels of bullishness although are not quite there yet. Anecdotally, I am seeing a  lot of bullishness out there. These are not the conditions I prefer to invest under.

There is very little worry out there even though we are about to see the largest tax hike in decades. While one can argue that the tax hikes on the rich will not effect the economy, the payroll tax hike will hit everybody and will be an incremental negative. There will also likely be cuts in government spending come March. Its possible that the economy will continue to chug along despite these headwinds but this is not a time that I want to make big bets.

I have been reducing my long exposure and am now only very modestly net long. I don't generally play for the last few percent of a rally and that is where I believe we are. Have  a great weekend.

My Outlook For 2013

Heading into 2013 it is possible to make both a convincing bull and bear case. When I have felt strongly about the direction of the market I have not been afraid to communicate it here. This is not one of those times.

The bear case is that the current bull market is almost four years old, which is already longer than the average bull market. Taxes will be going up and its likely that there will be some spending cuts. This will create a fiscal drag on an economy that is already in slow growth mode.  We are seeing slow growth around the world as well which increases the chance of an economic accident.

The bull case is that we have still not seen the euphoria phase of this bull market. Valuations remain reasonable and market participants stock allocations are on the conservative side. Corporate borrowing rates are at record lows yet we have not yet seen companies take full advantage of these rates. The level of cash M&A, LBOs and share repurchases have been on the low side considering where rates are. A buyout boom fueled by low rates is a real possibility. The fuel is there. Somebody just needs to light a match.

If the economy manages to stumble along investors are likely to be rewarded with a fifth year of this bull market. However, there are many risks out there that can tip us into a recession. My plan is to stick with companies that are less dependent on a strong economy, buy fear and sell euphoria.