She was immediately attacked by the man who never met a stock he did not like at some time or another - Jim Cramer - the world's worst stock picker. His attack not only lends credence to her views, it proves this is a trader's market that can only escape fundamentals for so long.
I met Ms. Whitney on a fateful day - the day she broke the bank stocks soon after she put out a report on Citicorp in October of 2007. Our conversation in the green room at Fox had me do my own research on the large banks - I had been recommending shorting the home builders and sunbelt banks since February of 2007 in my service, ChangeWave Shorts, and her passion and data convinced me the money center banks were next. She is what we all need - an agnostic - a fundamentals driven analyst. She was then and she is now -- and, over time, fundamentals did not lie - they drive stocks and markets.
In her interview with Ms. Bartiromo she pointed out facts known and ignored on Wall Street:
• Consumer credit continues to contract - credit lines are down $1.5 trillion, contraction is accelerating again and this will have a demonstrable impact on consumer spending this holiday season and the future.
• Home ownership is still at 67.8% of households as opposed to the pre-bubble, historical norm of 65% - I believe the real number is 63% - it does not matter, more and more people are going to become renters in the coming years. This means more foreclosed homes, more inventory, a continuing fall in consumer wealth. She did not say when housing prices will stabilize - I am a super-bear on this one and nationally I do not see real stability until the period between Q4 2011 and Q2 2012. She did mention that less than 1% of temporary loan modifications have resulted in successful permanent loan modifications.
• The Fed is now the mortgage market - they are the only buyer of mortgage backed securities (MBS) - and when they end their program, which is supposed to happen soon, rates will go up as there will no buyers. The money on the sidelines that may or may not be appearing in gold and in the stock market is certainly not coming back into mortgages for homes.
• The value of bank stocks will go back to tangible book value and that is not going to be nearly as high as expectations on Wall Street due to a weaker 2010 than expected. Banks also need to raise capital to pay back the TARP and cover future losses. Banks exposed to the consumer market are most needy and at risk as investments.
• Ms. Whitney expects a double dip recession - a W shaped, as I have called for as well.
The critics are already all over her and the market barely moved after her comments. Even supportive critics seem to willfully ignore the obvious going on around them. I have three close family members out of work and two three with reduced hours. My Saab buying neighbor just bought is daughter a Kia. My annual holiday trip to New York is going to be in a borrowed apartment, not a hotel. My credit lines have been pulled - fortunately I do not use them - and I had trouble getting a car lease because the lines have been pulled, reducing my credit score, even though I have never missed a bill payment in thirty two years of holding credit cards. A former neighbor - a real estate broker - who built a new home around the corner on one of the most desirable neighborhoods outside of Washington DC just rented her unsold, prior home for several years - a vote on her view of the market. And so on.
I am not unbiased -- my subscribers made unspeakable amounts of money in 2007 and 2008, first on the home builders and banks, then on the banks and the market, and the irrationality of the current market has cost them since I stick with fundamentals. And it took me too long to realize the government and the Fed would do whatever it takes -- fake stress tests, eliminate mark to market accounting rules, change regulatory treatment of commercial real estate loans and so on - to keep the big banks from failing as there was no more money to be had from Congress. Use this as a basis for going forward -- the big banks will not fail but the government is out of money, including the willingness of the Fed to stretch its balance sheet barring a major financial meltdown.
Back to Ms. Whitney - I hate when people call her Meredith as if they were friends, the same way they called Michael Jordan "Michael" as if he were a next door neighbor - listen to her even if the market is not - right now. The market rallied in July based on her comments - even then she said only the second half of 2009 would be good for the banks not 2010, and unemployment would hit at least 13% but no one listened. They need to listen now. Bottom line: traders need quicker trigger fingers if they are long and cash needs to be ready to short the money center banks most exposed to the consumer - BAC, WFC, and C - and over time the market in general.
It can -- and it is in Europe - not in the United States, just yet. The technology is found in the INTERCEPT system invented and marketed by Cerus (CERS). Simply put, INTERCEPT systems clean blood for eventual use as blood platelets, eliminating virtually all known pathogens - including HIV and swine flu. INTERCEPT systems make the collection (and tracking) of blood platelets nearly donor independent. Each collection of donor blood requires a disposable product used by the INTERCEPT system, so the company has a razor and blade business model with sales and margins expanding in an almost geometric pattern once a system is installed at a blood facility.
The product is approved in many European countries, is being deployed in earnest in France and on the verge of deployment in Germany. And typically the regulators there are tougher, on blood, than regulators here.
Cerus put together what they thought was a successful Phase III trial for INTERCEPT in the US a few years back, hit their primary endpoint and, statistically, their endpoints for safety as well. A subset of patients had a pulmonary problem on a very short term basis that did not push them past their final safety objective. No matter - some weenie at the FDA, and I am one of the few big fans of that overworked and under-resourced agency - said no good and the company turned its back on the US and focused on Europe.
On Monday, Cerus is back before the FDA presenting a Phase III trial design that looks pretty good to me. The panel will meet Monday and Tuesday and say yes or no. I believe they will get a green light to begin the trial, and given the success of the product in Europe, it is hard to imagine they will fail again in the US. What about another weenie at the FDA? Not this time - the current commissioner, Margaret Hamburg, is a former Commissioner of Health of the City of New York and has great expertise in pandemic preparedness. It is hard to believe she would let this one get away from her agency again - assuming they have told her about the panel meeting. This is, after all, Washington.
Approval of the trial design and, over time, a successful trial are major catalysts for the stock. But the company should become cashflow positive - real cashflow, not accounting cashflow - late next year without any help from US sales and has a bright future in Europe alone.
There are other positive wild cards for the company and the stock - things that could happen, which, as citizens, we do not want to happen. If swine flu or another pathogen gets in the blood supply, the FDA could exercise the powers they just used to give emergency approval for Peramivir (a treatment for flu) from Biocryst (BCRX) and do the same for INTERCEPT. Emergency approval is that, before final data and staff approval are in. Cerus management is not currently pursuing this - God knows why. Or, management could wake up and ask the Department of Homeland Security for funding for facilities or the trials - something Homeland Security is doing for Biocryst. Ditto on the God knows why comment. Both of these are real if remote possibilities dependent on a national emergency with the blood supply similar to the HIV tragedies of the 1980s.
Another wild card is the Pentagon - they have, in the past, let several contracts to Cerus for research but are barred from using INTERCEPT - remember, it is not approved by the FDA. They collect blood in the field that is not treated with pathogen inactivation technology. You think one or two of our soldiers might have an infectious disease, such as HIV, the soldiers unaware of the problem, soldiers giving blood that is not treated? Can you imagine the headlines if a pregnant Iraqi woman gets tainted blood and mother and child contract HIV from American supplied blood?
A last positive wild card is finding a marketing partner in the US if they get approval for INTERCEPT by the FDA. This makes sense - we are a big country with a fragmented blood industry - and a partnership with a major player would be a big deal for the company and the stock.
Yes, all wishful thinking but isn't that what you are supposed to do with emerging companies set to dominate their market? And they will - once an INTERCEPT system is in place, there is essentially a moat around that blood supplier and only a new, radically better technology - something no other company has or seems to be working on - could break through. Cerus has a multi year lead over competitors and once in place will stay in place, reinforcing their razor and blade business model.
Back to the present - Cerus is also working on early trials to modify its technology to treat whole blood, a huge market.
Oh, how big is the current Cerus? About $4.8MM in sales in Q3, probably $25-$27mm in sales next year, losing money but probably have positive cashflow by yearend 2010.
So, a very short term catalyst is near - next week's panel to approve or disapprove their trial design. Over time, and independent of US approval, quarterly sales and earnings are fundamental catalysts that will drive the stock. And any contamination of the blood supply, here or elsewhere, something I see as bound to happen, somewhere, sometime.
For purposes of disclosure, I am quite long Cerus.
]]>The company in question is Open Table, a terrific service, a slowing company, a completely ridiculous stock.
Let me begin by saying I and my wife love the service, use it all the time, has simplified going out in our home town and when we travel. No knock on the service - in fact, the efficacy of the service has made OPEN something of a cult stock.
Where can I start? With management and early investors that cashed out through a secondary offering - generating roughly $200 million from investors, for previous investors, not the company. Smart move in a rough economy eh? Not to mention how much it shows current investors and management have in the stock price.
How about the end of the lock up agreement from the IPO in May - May 21 - in a few days. Think anybody who owns the stock at $20 might want to bag a 40% profit in light of all the private investors and senior managers who sold through the secondary offering? Including Benchmark Capital, which owns (or owned) 3.3 million shares, you think they might want to distribute the stock to investors/LPs (a rumor) and book the profit on paper before the stock crashes?
Or let's look at growth potential - true, excellent growth, 20% per annum - down from something like 100% - and at this rate, assuming profits climb half again as fast, the company will only need to grow 20% a year for 10 years to trade at the current market multiple.
I usually prepare longer analyses - and could do so here, tearing apart all their statements and whatever but there is no point. A wonderful service - but with management and early investors cashing out, a lock up ending on November 21 and a valuation multiple greater than that ever held by Microsoft in its great growth years, well, it is time to start thinking about shorting the stock. A fair price based on growth above the economy and the current market multiple is between $.50 and $5.00. As I write this the stock is trading at $27 and change.
Take a look, now - short interest is rising quickly but with the lock up expiring, a successful locate is going to much easier for those of you who take action.
Statistically, we will see a rise in GDP in Q3 and in Q4. This is anticipated and meaningless data, but the numbers will hit headlines.
In the real world, the double dip has begun. Here is why - no one seems to be willing to pull things together in one short argument, perhaps for fear of being bored by a bull wearing green shoots. Simply put, all the core factors in driving an economy upward are broken other than pundit comments talking about "it must turn upward base on historical data." My historical note - we exited the Depression due to Hitler and Tojo, not a return to historical norms.
Unemployment: The reported unemployment number is 9.8%; real unemployment is 20% if you include those who have stopped looking and part time workers wanting to work full time. And the labor force participation rate is at a 23 year low.
National Income: Wages are falling and work hours are stagnant, according to this morning's jobs report, and combine these data with a shrinking work force and rising unemployment and you continue to have a sharp downturn in national income.
Consumer Spending: National income drives consumer spending, which is contracting due not just due to falling national income but rapidly contracting credit lines and a near 40% loss of accumulated wealth in the property and equity markets. And while consumer spending ostensibly is 70% of the economy, this includes spending on health care - love those government statisticians - so contraction has an incredibly outsized impact on consumer discretionary spending - luxury goods, travel, restaurants, unnecessary goods, expensive goods - anything you can trade down from to a lower level of price with equivalent functionality.
Credit Contraction: The credit contraction has been ferocious for consumers and small businesses as noted this morning by uber analyst Meredith Whitney (one of my favorites) in the Wall Street Journal. Depending on how you slice data, almost all increases in consumer spending since either 2002-2003 or 1997 has been due to credit. Trillions have been withdrawn and Ms. Whitney postulates another $1.5 trillion dollars will disappear in the coming months due to banking caution and changes in regulations. Given the total lack of credit to small business, and this segment is 38% of GDP and 50% of new job creation, there cannot be a recovery until credit begins to flow.
Zombie Banks: Nothing has changed with toxic assets and zombie banks - nothing, and even the IMF said this - and another $1.5 trillion needs to be written down, at least. Just because these assets are not in the headlines, and the Fed, the Treasury and the FASB faked stress tests and changed accounting rules, this does not mean the banks are or will be lending in a meaningful way in the near future. The Fed prints money, the banks sit on it to shore up busted balance sheets.
Business Investment: There are too many factories around the world, too many shopping malls an stores, too much commercial real estate - and at levels beyond all historical norms or comparisons. The first several legs of a rebound needed to absorb this capacity before we see any uptick in business investment that materially helps the economy.
The End of Stimulus: The buy gold and build a bomb shelter types have been screaming about the Fed printing money - what the Fed did was print enough money (they added a trillion to their balance sheet) to replace what was lost in the shadow and real banking systems - but not enough to replace what will be lost in the next 12-24 months. That being said, there is no political support for more stimulus. Deficits and a Congressional election preclude another stimulus package next year and the Fed and Uncle Sam have already said they are definitely pulling back, beginning November 1. We saw what happened to auto sales after Cash for Clunkers ended; ditto for home sales data in the coming weeks as the $8K tax credit expires. The bottom line: the economy will be much on its own next year.
Corporate Earnings: Corporate earnings follow the economy and they may be all right for Q3 and perhaps Q4 but they are going to disappoint the Street in 2010, big time. You can only cut costs so much - you need some top line growth - and it is only going to be there next year.
Markets: And one historical norm I like is the regressing of markets to the mean of corporate earnings. Translation - the market should be coming down next year or perhaps in 2011.
What to Do: If you like to short, consider the following - short the S+P (puts on the SPY), long term; short consumer discretionary spending via puts on the XLY; short the companies making stuff know one needs, like Harley Davidson (HOG) and Brunswick (BC); short companies making things no one can get credit to buy, such as new homes, via puts on the XHB ETF; short business spending via travel companies, the first thing to be cut in a business cutback, via puts on Avis (CAR); short retailers with terrible balance sheets, notably Macys (M).
And Lewis leaving means it is time, once the charts are on your side, to short BOA.
Lewis, the second best cry baby among the bank CEOs (John Stumpf of Wells Fargo is in a class by himself), is leaving not because he wants to re-grow his beard or get out of the spotlight. He is leaving because the bank faces years, not quarters, of trouble ahead.
• A weakening balance sheet due to bad loans and more bad loans - more on that in another post.
• Continuing government ownership via TARP funds - I may be wrong but given their balance sheet issues, deteriorating loan quality and he size I do not see them getting permission to pay back their government money soon.
• Lawsuits and investigations related to Merrill Lynch bonuses and the Merrill Lynch acquisition.
• A future - one to twenty quarters - of declining or stagnant earnings, depending on how much they want to legally cook their books. In the real world, earnings will be troublesome for three to five years.
• A need to raise capital that puts the CEO in the spotlight answering too many of the wrong questions with the wrong answers.
These are all reasons to avoid the stock. Many investors - well, traders - have bought in, due to the charts and a consumer franchise second to none. That too is taking a hit. Up until six months ago I cold easily say BOA had the best customer service of any company I dealt with other than Amazon - I was and still am a BOA Premier Banking customer. I am leaving -- they kicked me out of the Premier Banking Program by form letter and assigned me to a Merrill Lynch broker, saying I cold stay in with a quarter of a million brokerage account and getting rid of my private banker for fifteen years. A Merrill Lynch broker is not the guy or gal you want to talk to when discussing mortgages or home equity lines of credit. Bad move, that - an indicator of things to come.
Why short the stock? Most big banks are getting by on government largesse and legal but bogus accounting - totally unfriendly and opaque to investors - and 2010 will see the end of one offs, such as mortgage refis and the sale of assets, that boost earnings. Real earnings, declining home values, more than 10% unemployment and the other parts of the Great Recession will take center stage. More home equity lines will default, more commercial mortgages, more regular mortgages, more credit cards - and this will hit the income statement as reserves are set aside. And for BOA, it will also hit the balance sheet as write downs increase, making it necessary and expensive to raise capital, diluting shareholders.
So, if you believe fundamentals eventually take over the movement of a stock, watch the charts - when BOA turns it will be a good time to consider shorting the stock.
Where to start? How about the quotes common on the Street for the past twenty five years - "when new home starts fall below a million, they are at a bottom, cannot get worse." Housing starts have been at a half million and change for a long time. How about this one - "when inventories are above six months, the home builders will start to fall." Inventories are at nine and a half months, not including all the foreclosed homes not on the market, and the stocks have not really fallen. So, conflicting data based on historical norms.
And that is the thing to base your short position on - historical normal's do not count any more, at least not any from the past twenty years, perhaps more. Here is why. A brief summary:
• Home prices have never fallen this far, or this fast - and will continue to fall, I believe another 15%, so does banking analyst and diva- a real one, not a flash in the pan CNBC pundit - she earned it - Meredith Whitney. Housing analysts Ivy Zelman is also still very bearish.
• Foreclosures have never been so high, and are climbing, and will not peak, based on mortgage origination data, until the middle of 2011. And that means....
• Inventories will continue near all time highs and prices will continue to fall.
• Oh, did I mention, one third of all Americans would like to sell their house if they could get the right price. Makes sense - about one sixth want to every year and the market has been frozen for at least a year, more in many places.
• Combine this all with the tightest mortgage standards in living memory and you have the next chapter of home builder Armageddon.
Let's do this with some detail.
Supply
Inventory - Like all markets, the housing market for new homes is driven by the supply of new and existing homes and demand for these homes. The supply of homes, despite two years of very low rates of home building, is still way above historical norms despite the headlines. Drops in inventory do not account for the number of homes yet to hit the market but already foreclosed or in the foreclosure process. The 3.6 million existing homes in inventory represents and 8.5 month supply. Add foreclosures being held off the market - my estimate is 600,000, minimum, lowball, whatever and the 8.5 month supply is 10 months, near historical highs.
Foreclosures - The blow dried experts on CNBC with a coupe of exceptions, are all saying we are nearing a bottom - we must, new home starts are so low! They have it backwards - new home starts are low because inventories show no sign of bottoming due to foreclosures, many of them of relatively new homes. Foreclosures are accelerating as moratoriums on foreclosures, resets, and unemployment hit home owners harder and harder. To quote my favorite housing analysts, Ivy Zelman (on the CNBC blog Realty Check) "Over the past several months, we have witnessed many data points indicating stabilization and improvement in the housing market. While these data points are certainly a welcome reprieve after three long years into the housing downturn, we cannot help but focus on the elephant in the room - the ever-growing pent-up supply of foreclosures in-process... the next wave of foreclosures is not a myth, but is instead the key to the direction of the housing market over the next 6-12 months..... In total, foreclosures in-process are 88% higher than the year ago, led by prime non-jumbo (up 159%) and prime jumbo (up 152%) mortgages."" Actually, this is going to go on far longer than 6-12 months. According to Amherst Capital, seven million homes are going to be foreclosed in the coming year or two - 16 months supply at the current rate of sale, not including all other homes to go up for sale. And if you trace mortgage originations by type of mortgage, geographic area, and classification - subprime, Alt-A, prime, etc - it is easy to see foreclosures will not peak until the middle of 2011. Even if I am off six months, that is a year long than most optimists. Once a house is foreclosed, it takes 3-12 months to get it on the market - right now, it is taking longer but I am assuming this speeds up - so assume six months. That puts peak foreclosed homes into the market around the middle or end of 2011 - and with 3-6 months to sell them, you are looking for a market bottom in the first half of 2012 and inventories will not adjust until the end of that year - maybe.
Back to Inventories - As foreclosures peak, then begin to decline, and prices firm, pent up demand to sell existing homes will hit the market - remember that one third number? By 2011/2012 it will be 40% or more - four in ten Americans that own a home will want to sell it. This will add homes to inventories, depressing demand for new homes and home prices - for five to ten years.
Demand
These inventories will face vastly reduced demand for homes across the United States due to an end to massive speculation in second homes, a slowdown in hew household formation due to lingering unemployment, tightened credit standards and a much smaller shadow market for jumbo mortgages. The little blip up in home sales this past summer was due, in part, to the $8K tax credit you and I are providing to people - some analysts estimate one third of demand these past four months has been due to this credit.
Speculators: In 2006, using Freddie and Fannie and third party data, more than 40% of mortgages were for subprime and/or second homes, most of them speculative. That market is gone - for at least a decade, maybe more.
Credit Standards: At present, credit standards for mortgages other than those originated through the FHA - our money - are the toughest in a generation, perhaps more. And that is for conventional or conforming loans insured by those two paragons of financial management, Freddie Mac and Fannie Mae. The jumbo mortgage market has completely disappeared when the shadow banking market evaporated after Lehman collapsed. It ain't coming back any time soon - a few days ago the world's most highly paid cry baby, John Stumpf, asked the Feds to leave him and his bank alone, and he would figure out to how to pay them back, doggoneit - but please use Fed and taxpayer money to buy jumbos because I need the mortgage origination fees, fast. I know a two times seven figure a year attorney who cannot get a home renovation loan. This tightening of credit will cut another 10%-20% from core demand for homes from the 2006 level.
Core Demand: Real demand - people wanting to buy homes - is also shrinking as unemployment takes its toll on hopes and dreams - not to mention national income. Forget the affordability index the real estate industry mouthpieces tout on TV - it is not just what you can afford based on government statistics, it is also what you can afford if you think you might lose your job, have your hours reduced, your commissions cut or your health insurance premiums increased. It is also based on what you can put down - and if you have less equity your current house, have less ability to save because of the recession, well, the house you want is not as affordable as the real estate flaks are saying they are "RIGHT NOW!." I think reduced demand by customers is about 10% of the demand we saw in 2006 for homes.
Bottom line - core demand for housing - new homes - by people who qualify for a mortgage will be less than half of peak demand in 2006 for 3-5 years.
Home Prices
Too much supply and too little demand means fewer new homes built and lower margins. Meredith Whitney says home prices will fall another 25% -- she has been right about everything else, why not now? Barclays says 13%. Split the difference you get 19% or the median home price falling to roughly $145K. That is a very low target for many home builders. In August, home prices for new homes fell 12% year over year.
The Builders
The builders problems can be found in operating earnings - or lack thereof - and their balance sheets.
Earnings: In the last quarter of published financial data, the seven largest publicly held home builders lost $1.2 BN - and that includes $376 million in tax rebates from Uncle Sam. Since they have all refinanced recently, it is hard to measure real cashflow from operations and after interest expense. That being said, the long term debt is $16.72 billion and this should cost them at least $500 billion - perhaps more than twice that - in interest expense per year.
Balance Sheets: The balance sheets are much worse. They are, simply put, a wreck.
• The balance sheets of seven publicly held home builders shows $16.72 billion in long term against $5.4 billion in cash (cash plus AR minus AP). The current market cap is $13.96 billion - so these seven companies are worth, in the market, about $30 billion. As I mentioned, debt service will soon rise significantly - at current rates - and will rise again as rates rise. A good deal of this debt has been re-done recently but a good deal needs to be re-financed in the next 1-3 years.
• Many home builders are now carrying land on their books at the price they paid for it because this land is supposedly under development. Drive to a home site near you and take a look at what accounting driven development looks like - three people with the names Mo, Larry and Curly are working on a fence surrounding a 500 home site plot with tow homes built and a model home that has no electricity. And they have been working on that fence for two years - I have seen this three summers in a row at the same home sites in North Myrtle Beach, in Ft. Myers, in Orlando. Well, someday this land has to be written down to its real value and the builders will not only take a hit on their balance sheet but stand a good chance of violating loan covenants.
• Since you and I as happy taxpayers love paying for greed and incompetence, Congress and the IRS obliged us by letting the home builders apply for tax rebates for taxes on profits they made during the boom. These rebates supplied vital cash in 2009 and are ending. No more free cash from illusory profits made by selling homes financed by mortgages we, as taxpayers, now own also!
• The bottom line - many home builders are nearing a point in time where write downs and operating losses will lead to negative equity and to an end to liquidity - and home builders, like banks, need to borrow to build and to survive.
Of course, Wall Street traders have ignored most of this as green shoots (scallions to my mind) and momentum and technical indicators and flashing technical indicators have primed the Buy side of trades in home building stocks. Well, as Bob Zimmerman and now Will I Am sing, the Times They Are-A Changin'. And it may be a good time to short the home builders.
Let's go back to the market cap plus long term debt number - that is $30 billion. Value analysts and other people thinking Winston Churchill is still alive say this is a low price for their collective assets. Sure, right - these assets are being held at inflated values and no one knows what their current holdings are worth in the real world. These same analysts are ignoring the reality not just of no current earnings but no earnings power going forward, a coming rise in interest payments,
more write offs against current assets, not to mention falling demand for homes for a long time.
Biggest Losers
Which ones? Balance sheets and high end homes point out the first potential losers and/or bankruptcies. I measure balance sheet like the simpleton I am - long term debt divided by net cash. Hovnanian has nine times long term debt to net cash, Pulte 6 to 1, KB Homes 5.5/1, Beazer is at 3 to 1, DR Horton at 2.5 to 1, Toll Brothers at 2.2 to 1 and Lennar at 1.8 to 1.
And Hovnanian has a focus on high end homes. Best place to go short - short term.
Other candidates - those companies who have lived and breathed in the starter market - a market to be dominated by foreclosed homes in the coming 1-3 years. That puts Pulte and Beazer in harms way, medium and long term.
Longer term, the XHB, the home builders index (which does include building suppliers and like companies) should go down.
And the bank I really don't understand - excuse me, the bank stock I don't understand - is Wells Fargo, an $8-$10 stock masquerading as a $28 plus stock and trading at a multiple well beyond the rest of the banking segment. It isn't that Wells should be valued alongside the segment; it should be valued lower than the segment due to current and future problems in its business, led by its balance sheet.
I have spent weeks pulling apart their balance sheet and reading other analysts deciphering of their financial Esperanto - a universal language no one understands. And what I present below may include mistakes but they are not of my own making - they are due to what at best can be considered willful obfuscation - a time honored practice in most financial reports - of extremely complex financial statements. But I gave it a shot using my fourth grade math and common sense.
First, let's look at the garbage - excuse ne, am I being too negative? - on the balance sheet as it is written as of March 31 according to the TARP oversight folks. The garbage bin is called Level III assets, their dodgiest class of assets (the Brits know how to con a phrase, don't they?) which according to recently and frantically revised accounting rules, is an asset without a market, leaving management free to assess and declare its value based on a model. Wells had, as of March 31, and I am using these numbers because they have been blessed by regulators, $61.7 billion in Level III assets. What are they really worth? Who knows - but even if it is 50%, which I believe would be very high, that is 23% of the company's market cap.
Second, they are using arcane - and perfectly legal - rules of purchase accounting to mask loan losses. A Wall Street Journal article (September 21) had a nice discussion of these rules. Under the rules of purchase accounting, and these came into effect when Wells purchased Wachovia, losses must be accounted for in the purchase price and subsequent paper write off and cannot be incurred after an acquisition, with the loans on the books now set at a new and lower value to reflect the write off at the time of the Wachovia acquisition. They must have been busy with Christmas because this year they have adjusted these write offs and increased them by $7.1 billion in the first half of 2009 - write offs that do not hit current earnings. This wonderful accounting chicanery can continue for one year after the merger date, so they have until New Year's eve to "discover" new losses.
It gets better. The company acquired $110 billion in what it calls Pick and Pay and everyone else calls option ARM mortgages with the purchase of Wachovia. These were valued at $90 billion and change when the deal was closed. Wells shoved a big chunk under the umbrella of purchase accounting and using these rules then got rid of $20 billion in losses. Remember that write downs under these rules do not hit your current books. Some percentage of the remainder, $38.9 billion, can still be adjusted retroactively under purchase accounting - I think, I am not sure, don't quote me - and ain't life grand? Of the option ARM mortgages still held by the company the loan to value ratio based on quarterly adjustments is 87.2% but with home prices still falling I am willing to bet - as is Meredith Whitney, who is predicting another sharp drop in nationwide home values -- this is 100% in a year. And that means owners have no incentive to stay in their homes as mortgages reset. More importantly, while the company assumes future losses on these mortgages in a manner I literally cannot fathom, but I think they are assuming a 31%-35% default rate, analysts from Goldman Sachs see almost 61% of option ARMs originated in 2007 will fall into default. The Goldman guys assumed a 10% decline in home prices, and, over time, these same analysts estimate more than half of all option ARMs ever issued will eventually default. If Goldman is correct, or close, that is 25% of, well, what? They can write off a lot of this stuff via purchase accounting. But let's be kind to me and my hard work and say it will cost them $5 billion more than they are assuming.
Third, proposed accounting rule changes would force banks, including WFC, to put off balance sheet assets on their balance sheet. WFC has more than $2.0 trillion of this off balance sheet nonsense - using the same acronyms, I might add, used by Enron (and that other great bank, Citigroup). Some healthy percentage of these assets can be assumed to be headed to the balance sheet if the FDIC says they agree with the FASB rules and insist banks live by them. In theory, and based on history, WFC would then have to raise enormous amounts of capital or dump assets to stay within regulatory guidelines. They cannot dump assets - they would have done so if they could have - which means pounds of new shares and shareholder dilutions. Of course, the FDIC is free to ignore GAAP rules when creating regulatory requirements and it is possible they will do so again. But the cat, let's say the cat's name is transparency, will be out of the bag and lazy investors who have yet to consider Wells off balance sheet follies will now get a closer look at them.
The off balance sheet assets are almost impossible to decipher let alone explain. The company claims, in its second quarter financial statements, that only $155 billion - or maybe 7% - of off balance sheet assets will be forced onto their balance sheet. Games and more games, mainly due to the ability to loosely interpret the proposed FASB guidelines. They have concluded, and I quote their earnings statements, that "$1.1 trillion of conforming residential mortgage loans involved in securitizations are not subject to consolidation under FAS 166 and FAS 167." They do not say why--just because these are insured mortgages and they according to someone's interpretation of the new rules, do not have to hit the balance sheet (I was unable to locate an FDIC or FASB opinion on this). I spoke with someone on the staff of the Senate Banking Committee - in relation to the off balance sheet assets held by Citi - and the first thing I heard was government guarantees, which shut down the conversation, so it is possible this rule, when and if implemented, will be faked, like the stress tests. But investors will have a much better idea about WFC's real exposure to the real world. If $155 billion hit the balance sheet, that would be 12% of current assets and 19% of their current loan portfolio and to my mind that means the capital base would have to increase 12%.
The company does provide a caveat to what I view as their generous analysis of the new FASB regulations. Again, I quote their second quarter 10Q. "FAS 166 and 167 are principles based and limited interpretive guidance is currently available. We will continue to evaluate QSPE and VIE structures applicable to us, monitor interpretive guidance, and work with our external auditors and other appropriate interested parties to properly implement these standards. Accordingly, the amount of assets that actually become consolidated on our financial statements upon implementation of these standards on January 1, 2010, may differ materially from our preliminary analysis..."
What about the rest of their business? They hold $330 billion plus in commercial and commercial real estate loans - one third in California and Florida - and $450 billion plus in consumer loans, including more than $117 billion in home equity lines that are second tier to primary mortgage holders and end up in the junk bin after a foreclosure. And 37% of these home equity line are in California and Florida. Need I say more?
I do not want to go through their balance sheet and earnings statement ad nauseum so let's leave it at this - their loan loss reserves are, to my mind, completely out of whack with the reality facing these portfolios, as are consensus earnings estimates. I quote that second quarter 10Q again. "We believe our balance sheet is well positioned given the current economic environment. Our allowance for credit losses was $23.5 billion at June 30, 2009, compared with $21.7 billion at December 31, 2008. Our allowance covers expected consumer loan losses for approximately the next 12 months and inherent commercial and commercial real estate loan losses expected to emerge over approximately the next 24 months." Translation - on more than $800 billion in balance sheet assets, two trillion in off balance sheet assets and in the face of 10% unemployment and contracting GDP, an all time high for mortgage defaults, credit card defaults, home equity defaults, not to mention commercial real estate problems that are beginning to accelerate, they increased net reserves less than $2 billion.
Let's go on - I may be wrong because reading their SEC filings could give a dead man a migraine, they had $3 billion in non-performing loans in Q2 that they had yet to reserve against (see what these reports do to my grammar?). To simplify, let me quote one of the only clearly written parts of their report. "The ratio of the allowance for credit losses to total nonaccrual loans was 149% and 319% at June 30, 2009, and December 31, 2008, respectively...." They saw an increase of non-accrual loans - busted loans - of $5 billion in Q2 alone, which they blamed, perversely, on purchase accounting. True, but not of the real world. And Wells had $16.6 billion (with a b) in loans more than 90 days past due - more than $10 billion without guarantees by the taxpayers. So let's say the dearth of reserves is worth another $12 billion they need to raise this year or soon.
And what about operating earnings going forward to compensate for the probable need for far more reserves? It is hard to imagine they will duplicate the $3 billion in mortgage origination fees they had in 2Q - and even if they pull it off in Q3 it should not happen in Q4. Meredith Whitney said as much the day she turned the market around with her call on Goldman Sachs, the same market that missed the last half of here statements on CNBC saying bank earnings this year would not be matched next year. Stumpf recently pounded the table, calling out Uncle Sam for messing things up and saying they were going to pay Uncle Sam back and oh, by the way, can you have Freddie and Fannie buy jumbos so we can make more mortgage origination fees.
Wells was one of the companies told to raise capital after the fake stress test results showed you can only fake something so much. They claim they can raise that capital by the end of Q3 by internally generate d means - including, in Q2, $2.7 billion in deferred tax liabilities, the same accounting gimmick that bit Fannie Mae big time.
Do they think we are stupid? Yes - and they are pretty much right. Maybe it is Buffett- but remember he values businesses based on cash and cashflow and brand, and Wells is a great consumer bank, arguably the best in the country and has no problem with cash or cashflow. Maybe it is the bellicose statements by CEO Stumpf - maybe it is their legendary customer service - maybe it is fear - but no one is calling them out. Line up ten thousand more readers and maybe we can start the hue and cry.
What will we cry out?
You need more capital.
To write off more Level III assets, someday - maybe as much as $30 billion.
To support off balance sheet assets coming on - maybe as much as $15 billion.
For greater loan loss reserves - maybe as much as $12 billion.
For more option ARM losses - maybe as much as $5 billion.
To pay back Uncle Sam - no maybes, $25 billion.
Total: $87 billion. (Maybe)
I use the word maybe because this analysis is based on financial statements that make Vladimir Putin's inner soul seem transparent. November and beyond may provide some market support for this skeptic's view of their balance sheet as FDIC guarantees of bank bonds goes away and Wells will eventually go to short term capital markets and raise money based on what people know about Wells.
The bottom line: subtract current reserves of $23 billion and you get $64 billion in new capital of some sort. Sure, I am mixing apples and oranges but in the bars around the world where real analysts do their best work, this is how calculations are done and decisions made. Slightly less than half their market cap. Cut the stock in half and you get $15 and change. Bring the multiple down to the rest of the segment and voila - $8-$10.
Simple math - works for me.
Disclosure: I have recommended to subscribers to buy puts on Wells and I have no position in the stock.
What all investors and traders should be looking at is the net impact of any of these reports on national income and the ability of the consumer to spend. And these are still shrinking big time.
Net Employment Gains: We are still losing jobs, and even if the Street wants to trade the second derivative -- the decline in the rate of decline -- a quarter of a million jobs lost is five football stadiums fewer people working and spending less money than last month. Impact on the economy: quite negative.
Long-Term Unemployed: This jumped to more than five million, up 589,000. A terrible number indicating large pockets of the economy are toast -- and unable to spend almost anything except on necessities. Impact on the economy: also quite negative.
Income Gains: The increase in the work week was noise -- one-tenth of one percent -- and the income gains were 2.5%, which is less than the real rate of inflation due to increases in gasoline and healthcare costs. And since this is an average number, and millions fewer people are working, including a quarter of a million last month, national income continues to decline. Impact on the economy: no impact -- not a good thing when the economy needs a boost.
Labor Force Participation Rate: Since the country lost jobs and the unemployment rate stayed the same, fewer people are looking for work -- and therefore fewer people are looking to increase their income, holding back any potential gain in national income and consumer spending. This is not a good thing for the economy.
My focus is national income -- this recession is now being driven by a lack of consumer spending due to the recession, a staggering loss of consumer wealth in their homes and portfolios, and the incredible pullback in consumer credit we have seen in the past two years -- more than $4 trillion dollars by year-end.
Since 70% of the economy -- this number is shrinking, actually -- is consumer spending, the continuing declines in national income means the recession is still getting worse and the nonsense about the second derivative is just that, nonsense.
Am I being too negative? Maybe, in part due to the new mandates in the financial broadcast media to only smile and have upbeat commentators. Not one commentator I saw on CNBC, Fox Business or Bloomberg had a bad word to say.
What does that tell you?
It gets tiring and since these networks are posing as journalists, balance is needed for people interested in getting in or out of the market.
What does this mean for investors or traders? For investors who value any kind of fundamentals, the market, over time, will respond to a "W"-shaped recession or a bottom with no climb up -- which means it will go down.
There will be a statistical bump in GDP in either Q3 or Q4, but it will be just that, statistics based on inventory restocking, a one time event. And import and export flows and the market may go up in response to these numbers.
For traders, the play is bonds -- look at the TBT, the double inverse ETF on 10-year Treasuries. They are trading down right now as the Street assumes the Fed will respond to the end of the recession by ending interest rates. The Fed will do no such thing but that trade is there, right now.
Where was I? Oh, black shoots. My newsletter, ChangeWave Shorts, is published by Investor Place Media and we have an in house brand - ChangeWave - and in house survey group that has been doing sentiment surveys on everything from consumer purchases to oil exploration budgets for eight years plus. And they survey the same people, enabling them to create and use great baseline data. And they are never wrong - truly - my interpretation of their results may be wrong, but the data is always spot on and typically weeks if not months ahead of other data gatherers.
The last consumer survey, finished up earlier this week, tells us the slight uptick in some categories of consumer spending and the rebound in confidence was a head fake. My interpretation - brown shoots turning black. Simply put, consumers continue to spend less and plan to spend less heading into the rest of the summer.
Let me quote the report. "The mixed picture we reported back in June has worsened in ChangeWave's July consumer spending survey. And for the first time in four months we're seeing an actual pullback in the 90-day spending outlook going forward. The ChangeWave survey of 2,681 U.S. consumers, completed July 6th, has also picked up a significant worsening in consumer sentiment and expectations. Spending on travel/vacation, durable goods for the home, and consumer electronics all edged downward in the current survey, even as automobile and restaurant spending stayed flat."
"After three consecutive months of improvements, our July survey has registered a setback in U.S. consumer spending. Better than two-in-five U.S. respondents (45%) now say they'll spend less over the next 90 days - 2-pts worse than the previous survey in June. Only 22% now say they'll spend more - 3-pts worse than previously. The spending outlook is down across all income categories, with lower income households (under $50,000 per year) particularly hard hit."
The travel/vacation category was the biggest loser - only 26% of respondents are spending more and 35% less on these products and services - a six point shift, more versus less, in the past month.
I got these results on Tuesday and look what we saw this morning - very weak retail sales data from everyone from Macys to Costco - data Kudlow continues to scream at me to ignore. I guess the desire for celebrity and rankings is stronger than his ability to do third grade math. And that math says the consumer is dead and getting deader. At a macro level, let me summarize what you hopefully already know.
Housing: Dead and believe it or not, getting deader. Forget historical norms - the 2.6 million peak was fueled by funky mortgages and investors, perhaps 60% or more of demand - and 500,000 starts is still too many with 11 months inventory and more than two million foreclosures on the horizon. Maybe more. Home prices will not stabilize, nationally, until 2012 at the earliest - when foreclosures peak - and consumer confidence cannot seriously until that happens.
Consumer Spending: Dead, deader, dying again - besides the loss of wealth - housing and stock market crashes - take away more than $4 trillion in credit and more to come. No wealth, no cash due to falling incomes and unemployment, no credit - ain't no meaningful consumer spending rebound for as far as the eye can see. Don't believe me? I vacation mid way between Myrtle Beach and Wilmington every year for a generation and take, excuse me, took the kids for a movie, an ice cream and some shopping at a large enclosed mall - several department stores, food court, the works - in North Myrtle Beach. Wanna buy it? It is empty and on the market for $3.3 million - not $33 million, $3.3 million.
Banks: On the mend in the headlines, the big ones - Citi, Wells, BOA - broke and getting broker as delinquencies and defaults climb faster than anticipated - well ahead of reserves - and toxic assets sit there like a vacant lot in New Jersey. Citi keeps comparing its performance and capital to its $2 trillion dollar balance sheet - what about the $1.2 trillion in off balance sheet assets (last November's count) that are off balance sheet for a reason? Wells says it is fine, yet it has almost $350 billion in commercial real estate loans not to mention more than $90 billion in option ARMS on its balance sheet. And BOA still has Ken Lewis, a blind, deaf and dumb board and unknown liabilities from its purchase of Merrill. For purposes of full disclosures, most of my assets are at Citigroup and I bank at BOA.
Credit Markets: What credit markets? They do not exist for all but a couple of investment banks and AAA rated companies. Otherwise, it is all government backed borrowing. Trillions backed by Uncle Sam - and a few billion in private transactions.
I know you know all this - but I put it together with new consumer spending data to prove a point - optimistic anchors and pundits can talk up the market or the economy and Congress can re-write laws but no one can change the laws of math. And those laws tell me, and should tell you, consumers are right to pull back and they will do so throughout 2010.
So what to do now? The crazy value investors are looking at hotels - hotels! - I just stayed at a great Hilton in New York for less than half what I paid 20 years ago. Look at shorting hotels - Starwood looks ripe to see continuing problems in bookings and revenue - and maybe the booking sites like Expedia - they are going to take another hit this quarter and be in the doldrums for at least another 4-6 quarters.
This Thursday's unemployment report should not have been a surprise. I will not waste your time recounting numbers you can see or have seen elsewhere. But the sharp selloff means a) a lot of traders got in on the wrong side of the trade and ran in a hurry and b) there is still a historically high amount of cognitive dissonance on Wall Street. Cognitive dissonance may, in fact, explain the entire rally and is, if you like behavioral psychology, is central to understanding the behavior of markets that fly in the face of economic reality.
To quote part of the Wikipedia definition (a good one, to be found at http://en.wikipedia.org/wiki/Cognitive_dissonance), "Cognitive dissonance is an uncomfortable feeling caused by holding two contradictory ideas simultaneously. The "ideas" or "cognitions" in question may include attitudes and beliefs, and also the awareness of one's behavior. The theory of cognitive dissonance proposes that people have a motivational drive to reduce dissonance by changing their attitudes, beliefs, and behaviors, or by justifying or rationalizing their attitudes, beliefs, and behaviors."
Sounds like the Street to me.
Wall Street does one thing quite well - math, usually reserved for bonus calculations, commissions, fees but occasionally used for analyses - and it knows the consumer is dead and getting deader, suppressing business behavior and employment. But it wants to go long - it longs to go long - and this tension is cognitive dissonance. It removes the tension by reconciling these two ideas with what it really wants--for the market to go up. Otherwise intelligent people go on TV and tell people things are fine with green shoots everywhere - I am not talking about screaming anchors who have traded ideology for intelligence like Larry Kudlow, nor am I referring to corrupted reporters now always optimistic as if they had a patriotic duty to be so - perhaps it is ratings? I am talking about money managers who are mostly long and want to stay that way. They are now telling people to "invest in the second derivative" - a decline in the rate of decline - and their reasoning "green shoots." So if you are going to willfully deceive yourself and resolve cognitive dissonance, you might as well pull some sucker along for the ride.
This optimism extends to individual market segments and companies. In the good old days, pre Bear Stearns, when housing starts hit one million per year it was a "bottom" and time to buy the home builders. We are down to half of that rate with no rebound in sight but pundits are talking up the companies, most of them kept alive by billions in tax rebates that end this year. Not one investment bank, not to mention a major money center bank, has earnings power remotely approaching their capability five years ago but the stocks have risen sharply based on accounting metrics the Street knows are on paper, not the real world. Not to mention all of the money center banks cannot exist without Fed guarantees of their bonds. And within this group, look at Citigroup - worthless balance sheet, some great businesses, but having no real shareholder value and if and when forced to properly (I don't mean legally, what they do with their books is legal) account for assets, they are wroth nothing. And how about GM trading above a buck?
There is another variant to this optimism - honest optimism based on a mis-reading of data. My favorite TV analyst, Ron Insana, a brilliant and painfully honest man, not quite fully pulled back into all of CNBC's mantras about green shoots, thinks we have hit bottom in the market with the overwhelming reason being the amount of liquidity the Fed has injected into world markets. Yet, if you look at the circulation of "new money" - its velocity - how much it circulates - against what the Fed has metaphorically printed you can see the money supply may have actually declined in the past year. No kidding. And even if I am partially wrong, where is the liquidity? It is now showing up in margin accounts of hedge funds or trading desks - it is sitting in bank mattresses, ready to be used to balance out future losses.
So there is optimism from cognitive dissonance, know one thing, think another, reconcile this by sticking with a belief even if you know the belief is wrong. Or you are getting it wrong because you are using historical norms to analyze something far less than normal - today's economy and markets.
I am not complaining - well, I guess I am, sort of, since I live on fundamentals even though I only recommend options position in my service, ChangeWave Shorts - but a day of at least partial reckoning is coming. Either a blow up or a slide that defeats even the hardiest if bulls. And even if I am wrong, based on the history I am trying hard not to use, the economy will inhibit corporate profits and at best keep the market going sideways for several to many years. Even Congress cannot change how the market value corporate profits - and the market is way overpriced based on the next 2-12 quarters of economic and profit growth.
The bottom line? Whatever trades you make, they need to be in the face of an economy that is not bottoming and when it does, facing a recovery that could take as much as a decade. And, seriously, take a look at Citi as a short - if they are forced to move their off balance sheet assets on their books, well, lots and lots of these. Check out page 21 of the town hall presentation they half for employees last November. And if you are long Citi, have a drink before you get to that page, and that can be found at http://74.125.47.132/search?q=cache:xSvJ_3VrNX8J:www.citigroup.com/citi/fin/data/p081117a.pdf+citigroup+november+2008+town+hall+meeting+pdf&cd=1&hl=en&ct=clnk&gl=us&client=firefox-a
And now that calm is here, and his policies and proposals are more rather than less important than his ability to re-assure the American people about their own strengths, it may be time to, metaphorically and literally, short Obama. Specifically his health plan, whatever shape it may take. At least some of the profits can be used to pay the extra taxes we are going to pay for next 25-50 years. (For purposes of full disclosure, I voted for Obama.)
The problem for Obama, and why it is possible to develop a short view of his administration going forward, is his loss of control of Congress. Most Senators and handful of Congressmen know something of money, the budget, deficits and markets. But most members of the House do not - and they are showing way too much influence and power in the setting of policy. That means a make believe energy bill/cap and trade bill, because they don't want the cost of energy to go up; too much support for a housing market that would best be left to itself, to correct itself quickly; and a health care bill that has its heart in the right place and its head up, well, this is a family blog - a health care bill that sets the nation on an untenable course.
And that is where it is best to start looking for short and long opportunities - health care. Health care bill will probably pass; it will probably mandate everyone have or buy health care insurance; it will include thousands of pages of regulations that will not work as planned; it will be based on cooked data about cost reductions that will never happen; and when it all gets too expensive, 12-18 months after enactment, medical care for those dependent on the government will be further rationed and medical care paid for by the private sector will become increasingly expensive as private payors subsidy of government programs increases. And then 3-5 years after that, something will blow, led by the need for Medicare to dip into the general tax fund, roughly around 2016.
Short something that will blow up in 2016? No.
But look at short positions in companies that will be first in line to be seriously squeezed - some with merit, others not.
Who will be squeezed? And when?
The squeeze will begin about six nanoseconds after the health care bill is passed and the remaining responsible adults in Washington - there are a few - take a look around and go "omigod." They will be seeing an obese, aging population unwilling or unable to take care of itself hurtling towards government paid health care with frightening speed. And an industry still used to printing money at will with new products or fees and in control of their local Congressman or Senator. And they will go after the unusual suspects first -- and then some not so usual ones.
So, who gets squeezed?
Big Pharma: I follow the industry more closely than most, used to write a biotech letter, Big Pharma was my comic relief whenever I got too serious. This industry deserves to be squeezed if not on economic principles but everyday idiocy and a total inability to match real consumer needs with their business model and product development. For example, if you talk to doctors, the best proton pump inhibitor around is Aciphex (I take it, it changed my life, no kidding). It runs almost $300 a month without insurance while generic Prilosec costs less than it does to feed someone at Chipotle (well, maybe not my sons). If ihad the best product, I would hire the right people and go head to head with Prilosec. Nope - just jack prices and milk profits until the patent runs out. And this is the preferred mode of business in the entire, traditional Big Pharma industry. And Congress knows this as well - so you can expect a big squeeze on drugs that do not directly save lives. For short sellers, this intersects with the greatest, most cost saving patent expiration ever - Lipitor, November 2010 - so take a hard look at Pfizer. They are facing a revenue downturn of up to $9 billion in Lipitor sales within 12-18 months of patent expiration. That would require 9-10 blockbusters to emerge - and they have none in the pipeline worth mentioning. In my book Sell Short, which is about process, not specific recommendations, the Lipitor expiraton and Pfizer are central to explaining how one can find and use great short opportunities. (check out MichaelShulmanSellShort.com for more info.)
Other candidates? I have a personal bias against the frequently overprescribed Aranesp and Procrit (an anemia drug) from Amgen - way overprescribed compared to Europe, where people typically live longer. Mind you, Pfizer and Amgen print cash, they are simply overvalued and it will take a while for the market to catch up with them. Between the two of them, and hundreds of billions in R&D over the past twenty years, they have produced, I believe, one blockbuster in their labs.
Devices: Medical devices routinely get approved by the FDA - when effective - then a hyperactive sales force pushes them onto the market and patients pay for them. The 10% better widget results in a 100% increase in fees to the hospital or center - endorsed by Medicare, who sets the price for the new procedure that is copied and used as a floor by the private sector. Well, according to Bob Dylan, the "times they be a changin." It is easy to see Medicare and then insurance companies balking at new devices that sell well here, barely sell in Europe and do little to actually improve patient outcomes. This includes services for treatment and for diagnosis. Who look ripe for trouble? Medtronic. Unlike Pfizer and Amgen, this is a well managed company with a great product development organization - but they are in the wrong place at the wrong time and their size means they need a great deal of success with new products to move the needle on sales and continue as a growth company. Other losers are the big imaging players - GE, Toshiba and Siemens - but these huge multinationals are so diversified you cannot consider shorting them based on this thesis alone.
Payors: Stay away - long or short - who knows what is going to happen to them.
Providers: Ditto for providers - price pressures will be offset by increased business and reduced or eliminated bad debt - but a lot of their billing nonsense is going to get squeezed - a friend was just billed $26 for one spoon of Pepto Bismol - impossible to say where this will end up.
Biotechs: If you want to go long, look at the great biotech's will real live saving products and start with Gilead Sciences. Bets managed biopharma company on the planet - by a mile. They own the HIV marketplace and are pushing into pulmonary and also have a promising, high risk hypertension drug. They are also a great stock to hedge - very high premiums on their calls. If there is a buy and hold company left on the market, they are it.
The two weeks on the road were spent in very different economies - the "posh" but understated part of Long Island, the North Fork; Hartford, Connecticut (family); Maine (need to eat some serious fresh lobster); Nova Scotia (gorgeous); Maine again (got to get back home); and then four days in New York City including a book part for my new title, Sell Short.
What did I see? There were two or three other guests in my luxury hotel in Greenport, empty restaurants with great food. We had no problems walking in to one of the most popular restaurants in Hartford; ditto for the most popular lobster in Bar Harbor (I copped out and got a small one but I did manage to ruin my shirt); a near empty hotel in Nova Scotia, one of the three luxury resorts capitalized by the Canadian government and the most popular destinations in prior seasons. And in Nova Scotia, same day reservations for a special whale watching exhibition in a zodiac that only holds a dozen nerdy tourists. Driving back through Maine, I stayed at a Wyndham in Portland filled with airline personnel and no one else, across from the very, very empty Mall of Maine. And I concluded my trip at a very busy Hilton in New York - busy, busy you say? - filled with tourists taking advantage of radically discounted priced rooms, buying what was available at the half price theater ticket booth or just walking the streets. We found same day tickets available for almost all shows, including for Mary Stuart (terrific play) and In the Heights (great musical, hottest dance chorus since Pippin, yes, I am that old). All of this during tourist season.
And a book party with guests from all parts of the economy, all discussing an uncertain future and all pulling in their spending. Except for the teacher at a prep school and the television producer working the Bernie Madoff case.
Are anecdotes worth investing in? Just as Peter Lynch - you can start with these anecdotes - but first you must ask yourself why is Wall Street so adamant about green shoots and the "bottom." Simple - Wall Street is congenitally biased to the upside, we were coming off a very sharp decline in the markets and Obama has a great ability to lead, convincing us and then remind us the world is not ending.
So, are we at a bottom? Perhaps - but my concern, my observations are about the lack of a rebound. And the current market is now beginning to look for signs of a rebound. So brown shoots mean a lot as the market starts looking to Christmas and beyond.
The tricky part is the definition of a rebound. I read this morning about the big turnaround in auto sales - they are "only" going to be down 20% at Ford and call option activity is accelerating (I am long, in my service, Ford calls). Turnaround? A year of 55 million in sales with worldwide capacity to make 100 million cars? The auto industry is representative of the debate - we may bottom at 55 million but when will sales support current stock valuations? And that is true for most if not all consumer discretionary stocks, from Tiffany to the Cheesecake Factory.
So, short term, you can play the short term optimism - as I said, I am long Ford in my service - but what about the longer term?
For a longer term trade, assuming you agree with me and the summer will be a bust, so look to short travel related stocks. And if you sense Christmas will see Santa stuck in the chimney, look to short names that people will continue to trade down from - Cheesecake Factory, P.F. Changs, Macys -- - avoid names people will trade down to - Dollar Tree, Wal-Mart, Darden (Olive Garden). Look for real discretionary spending stocks - Harley Davidson, Tiffanys, Coach, Nordstrom - and look for underpriced products that will see increased demand in the winter - natural gas (the UNG).
Think about it - all this news, any of it mind blowing and market cracking a year ago - and now we accept it, reminding of something a science teacher taught me way back when. If you put a frog in hot water, it jumps out. If you put a frog in room temperature water, and slowly heat it up, the frog stays there and boils to death. The markets are behaving like frogs right now - each week, news gets hotter and hotter, worse and worse about the economy, but it does not seem so bad, so the market either stays put or goes up.
Is the water eventually going to boil? Ask the consumer.
They will tell you - we are broke. And getting broker. And consumers that are broke, feel broke or afraid gong broke do not spend money - or as much money as they used to. Given that 65% to 70% of the US economy depends on consumer spending, the broke consumer means a broken economy.
In the 1970s federal law changed and said banks could charge interest in credit cards up to the rate allowed in the state where the bank ostensibly did business. In a nanosecond the banks found high interest rate states - ever wonder why your Citibank Mastercard is issued in South Dakota? - and the credit boom was on. Fast forward to 9/11 and the president, rather than raise taxes to pay for a war or two, told us to shopping, with credit of course. To buy stuff probably made in China. And by the end of last year the American consumer had amassed more than $13 trillion in debt - or more than 130% of disposable income, on average.
Well, if you don't want to use credit, spend some of your accumulated wealth. What wealth - the recent meltdown in hosing and equity markets has reduced personal wealth by roughly $13 trillion and the number is climbing. The psychological toll is greater - you feel poorer because you are, and you probably feel worse than you really are, and you pull back on spending.
Well, if you don't use credit or wealth, use your current income. What current income? Unemployment is 9.4%; real unemployment, including the discouraged and part timers wanting to work full time, is almost 20%; hours worked per week are falling; and after tax personal income, or the nation, is falling.
Well, get some more credit card and hope for the best. Not an option - banks are on a pace to pull back more than $2.5 trillion in credit lines this year. Re-finance or increase that home equity line. Nope - 67% of mortgage holders have less than 15% equity in their house and that number is falling alongside home prices.
One last note -- gasoline hit $2.62 nationally this week, up a buck in the past 12 months.
OK - no credit, fallen wealth, falling incomes rising gasoline prices. And in the face of all this, what has Wall Street done? The XLY - the Exchange Traded Fund representing consumer discretionary spending -- and the RTH - the Exchange Traded fund representing retailers - are both up year to date. The Street is expecting and pricing in a recovery from the bottom - which we have not reached - and I cannot tell you where they think the consumer will find money to spend.
Think head fake - momentum feeding momentum - and a bear trap if ever there was one. Is there a trade here? An investment? Not yet - the momentum has slowed down but this trade - consumer led economic recovery - is still in play, a game for very short term traders. Stick with fundamentals and wait - when the Street wakes up, there could be a great opportunity on the short side to make money on the whole segment through an ETF or the purchase of puts on the ETFs mentioned, the XLY and the RTH.
Specific names? Look for companies that were in deep yogurt before the consumer went broke. Two come to mind -- classic, long term shorts - Sears (SHLD) -- and the GAP. Been in a Sears lately? Been in a Gap lately? Even a consumer rebound -- the one that is not coming -- will leave these two gasping for air. Sears will spin off or sell K Mart, Gap will spin off or sell Old Navy, in last gasp moves, perhaps one to two years from now and then, nothing.
Among the luxury retailers, check out Coach (COH) -- good managment, too many stores, not one product anyone has to buy.
]]>• Housing has been, for more than two generations, the segment of the economy the Fed could manipulate through interest rate management and in turn stimulate the economy when needed. This is no longer the case -- even with recent increases mortgage rates are very low, with no discernible impact on the sector or economy.
• Housing, for the past two decades, had been a growing source of credit for consumers and in the pat five years was virtually the piggy bank of the consumer through the increased use of home equity credit lines. This is no longer the case - with so many homes under water; 67% of mortgage holders have less than 15% equity in their homes at yearend 2008 home values, credit standards are tightening and banks are, in general, pulling back.
• Housing continues to be the largest single component of credit exposure for banks quasi-banks, government supported banks and any other bank you can think of - and the quality of these assets is declining minute by minute. As long as housing suffers, and asset quality not only does not improve but declines, the banks will continue to reserve too little and lend too little to add to reserves.
Why do I think housing is in the tank for the long term?
First, I listen to people smarter than I am - a key to success from investing to recreation league baseball. When my rec team had its first losing season - after twelve consecutive great seasons (two per year) I did the logical and hired a professional coach. They were winners the next season. Ditto for analyzing stuff - and I follow Ivy Zelman (http://www.zelmanassociates.com/default.aspx) and Whitney Tilson (http://www.tilsonfunds.com/). They have been dead on about the mortgage meltdown - and see a larger one coming.
Listening to them, reading data ad being objective has led me to see the key to a rebound in housing is clearing inventory - too much supply and too little demand, and since lower than five percent interest rates have not spurred buying, supply is the issue. Supply comes from the sale of existing homes; the sale of new homes; and the sale of foreclosed homes.
• Typically ten to fifteen percent of Americans sell or want to sell their home in a given year. Recent survey data shows the number is now 30%. Keep that in mind.
• New home sales are incredibly low. Market wisdom said home building stocks would rise once the new housing start rate hit a million and inventory became tight. New home starts are roughly half of that and there ain't no rebound. As the poet said, times, they be a changing.
• People are not selling, and builders are not building, not just because people are not buying - it is because prices are low and going lower and the driver here is foreclosures. Data can be fond here, there and everywhere but the salient data points are a) banks are accelerating foreclosures b) the next wave of resets of mortgages, the cause of most foreclosures, does not peak until the summer of 2011 c) banks are already sitting on more than half a million homes they have not listed for sale and the whopper is d) the New York Times has reported that there are nineteen million empty housing units and only six million are listed for sale.
This last point, when combined with another couple of million foreclosed homes, then with desire for people wanting to sell their home as soon as they can, means excess inventory for as far as the eye can see. I originally projected housing prices would, nationally, bottom at the end of 2011 and prices would begin to pick up in mid 2012. I may have been premature. With resets peaking in mid-2011, defaults will probably peak in early Q4 2011; this means foreclosure listings will peak in mid-summer 2012, after the peak selling season, not good for managing down inventory. Assuming demand picks up - a near heroic assumption at this time as interest rates will be higher and unemployment could be the same or higher at that time - you will start to see inventory declining in a meaningful way until 2013 at the earliest.
I have focused on supply - was I too cavalier about demand? Well, that is more problematic - resets, defaults and foreclosures are fourth grade math and although the only thing I knew about housing was my own mortgage before this mess started, I can do fourth grade math and very forecast I have made about foreclosures and inventory has been right within a 30-45 day period.
Using fourth grade math as our primary tool does have value in estimating demand. Roughly 40% of demand in the peak year - 2006 - was sub-prime or near sub-prime - and these buyers are out of the market for a considerable period of time. And a very large percentage - some analysts estimate as high as a third - of all sales were for investment and second homes. Most of this demand is gone for the foreseeable future. Add tightening credit standards, recession ravaged incomes and personal balance sheets, and a new frugality and it is hard to see demand in 2013 or 2014 climbing past 50% of demand in 2006. Even if the FHA does not go bust - which it will, requiring another Treasury bailout.
You will notice I am not using specific point estimates - that is an analyst's game. I am a stock picker and options guy - mostly on the short side. And I make recommendations based not on absolute values nut change - the relative movement of a stock or segment against other segments, the market and Wall Street expectations.
I recently had lunch with a very smart - truly - Wall Street type economist who mostly follows Uncle Sam and his cousins for institutional clients - and he is very good at what he does. He has been doing this for thirty years and I made this argument. He disagreed, I laid on the New York Times reported estimate of thirteen million vacant, unlisted dwellings and he laughed, waving his hand - and then stopped himself. "You know, I own two places that are vacant, I will sell but have not listed because prices are too low. My old place at the beach and my mother's place in Miami." Not investment properties - just properties waiting for a market comeback.
He also predicted the economy would bottom in Q4. We were having lunch at the Palm and as we left he looked around - it was a Thursday, second busiest day of the week - and noticed something. "I have never seen this place so empty." I punched him lightly in the arm and said, "can't wait for that recovery pal."
So, what to short?
Short term, traders are beginning to get weary of waiting for a rebound and short interest in many homebuilders is increasing driven this week by the sharp rise in mortgage rates. So, pick a publicly held homebuilder and take a look at the chart. Toll Brothers (TOL) and KB Homes (KBH) have weak balance sheets the shorts like. Longer term - two to eight quarters - play almost any of them or buy puts on the homebuilding index, the XHB.
Their suppliers have been crushed - Louisiana Pacific (LPX) and Masco (MAS) are the two big names. Check them out also - short interest is increasing and Masco's net cash - cash plus liquid securities plus accounts payable (assuming they will be paid) minus accounts receivable - wouldn't fill my gas tank for too long.
First, Wall Street sees a bottom at yearend and an upturn in Q4 GDP. The seriously foolish see this as a real bottom and a real upturn in GDP; the savvier fools see this as a statistical bottom they can trade and have done so for the past two months. This latter group is not really made of fools - they have just cost my subscribers a lot of money and I am mad at them.
Second, technicians and historians are using past market performance to say we hit a certain bottom, we are going through a retracement to his and a return to that. All based on rational history. Then you ask them about corporate earnings and the multiple of the market and they ask have you seen a good ball game lately. You then ask them if equity markets have ever risen in the face of rising interest rates and they cough and ask you to leave.
Third, the market is now behaving like on great day trading pit - a piece of news, let's rally or slide and let's hang on, if you get in before the pop, collect your winnings before the window closes and get ready for the next horse race.
But all of this would not hold and would to push the market up as fast and as fast as it has - if people did not want to believe in a good news story and want the market to go up - the history of the Street since trading was actually conducted in the street. Independent of your politics or how you view his initiatives, Obama has proven to be a remarkable, no, an extraordinary leader with outstanding ability to calm people - even those who dislike or hate him - and make them feel better about the future.
This may explain the current market. Now let me present the summary for the bearish view. It all begins - and will end - with housing.
Point Number One for the Great Short Trade: The feel good part of Obamanomics has people investors, traders, pundits and politicians believing housing will bottom this year or early next. Maybe in 2012 - just do the math on foreclosures (they are rising), unlisted and empty housing (as much many as 13 million units according to the New York Times), recent Case-Shiller data shows the worst decline in housing prices ever with more to come. When Americans feel good about the value of their home and can get a home equity line, they spend money. When they don't, they don't as much - and in this recession, they do not and will not. And as consumer spending goes, so goes the economy. And within that economy, good bye to any growth or serious profits from direct beneficiaries of residential and commercial construction (more on that later) - think Sherwin Williams, Whirlpool, Louisiana Pacific, other suppliers.
Point Number Two: The housing bubble was really the tail end of a credit bubble that is over for between a decade and a generation. Do I exaggerate? The nation's banks are on the way to pulling in two and a half trillion in credit lines via credit cards. Two thirds of people with a mortgage on their home had less than 15% equity in that home as of the end of last year so at the rate the Case Shiller index is going that will mean two thirds of all mortgage holders will have not equity in their homes by this time next year. Almost all increases in consumer spending were fueled by credit expansion since 2001 - remember, the cheerleader in chief did not ask for new taxes to pay for the war on terror, he told us to go shopping? That's leadership.
Point Number Three: The banks cannot lend more vigorously as they are, for the most part, based on real world accounting standards, broke and getting broker. For the next twelve quarters, at least, they will be carefully managing down existing toxic assets - anyone read anything about the PPIP program lately? - and using profits to offset write offs for these and newly made toxic assets. The new wave in toxicity will come from more mortgage meltdowns - worse than subprime according to many analysts - commercial property write downs - did you know Wells Fargo has almost $350 billion in commercial property loans - and private equity disasters - every here of Chrysler? Well, Chrysler has many smaller cousins. And as some banks disappear, Uncle Sam will use funds to prop up the FDIC and the longer we keep the zombies in business, the more expensive this will be.
Point Number Four: The bottom line is corporate profits are going to take a hit - Stephanie Pomboy, credit and market analyst extraordinaire, in an interview with Barrons, spoke to the big rise in corporate profits since 2003-2003 as being directly linked to the radical expansion in consumer and other credit. Contracting credit means contracting profits.
And - markets always regress, for some period of time, not just to the technical mean but to the mean of corporate earnings. Moderate analysts put S+P earnings this year at $55. This gives the market a current multiple of 18-20 - a multiple appropriate for a 3.5% plus growth economy. Put a recession multiple - 9 to 11 - and, well, you can do the math. Of course, I think corporate profits will be lower but even at $55 you get an S+P of 600 at best. Or a 33% decline from where are right now.
Bulls argue with interest rates so low there are no historical comparisons - the same bulls who use historical comparisons to support technical arguments. I guess we now know why bulls are called bulls.
So I, the great agnostic, believe the rally could last quite a while but the market cannot escape the economy and the economy cannot escape consumer spending and the banks and consumer spending and the banks cannot escape housing. And every time I make this argument I become persona non grata at yet another meeting or party.
Anything specific to short?
First, check out, and check the technical's and whether manic sentiment has left, the suppliers to new housing and remodeling - Whirlpool , Sherwin Williams - and some dodgy home builders like Toll and KBH.
Second, there are some banks still overvalued you can short - take a look at Wells Fargo, it selling at multiples well above the segment, has (or had at the end of last year) roughly $90 billion in option ARM mortgages and almost $350 billion in commercial property loans. And I still think Citigroup will break itself up and shareholders could get the shaft.
Third, the ultimate consumer discretionary stocks - luxury and unnecessary, companies like Tiffanys, Coach, Harley Davidson. HOG has just rolled over, it deserves special attention.
Last point - if you don't think housing will take at least two more years to bottom and want to write a comment - please do so - but please, prove your case. Mine is based on the dates mortgages were let, their dates for being re-set, which are in the middle of 2011, and given that defaults and foreclosures happen 3-6 months after re-sets, and then the foreclosed house hits the market - well, maybe it is 2013 after all.