The technical case for a short trade in NUE

NUE looks good technically only on a short term basis. Positives include – October 08 lows held in November and late feb/early march 09 retest held well above the prior lows. Its also technically positive that the recent move came on solid volume and exhibited good relative strength. The stock’s short term moving averages have also turned up. The best one should say about this chart is that the longer term downtrend has lost its momentum and the shares have perhaps (and I stress the perhaps) stopped going down so one might conclude that new lows are unlikely at this point. But even that might be presumptuous as if you view this chart on a longer term basis (like on the weekly chart) the chart looks like the primary trend is still down. The way I see it, it appears that a 5 year uptrend has reversed and a major top has been completed. There was major support in the $46 to $48 area which failed last year. That failure was subsequently retested and failed. Since then, the sell off accelerated and came on higher volume and worsened relative strength. The shares proceed to get cut in half after trading down over 50%. The whole peak to trough move took roughly 70% off the shares. The shares have since exhibited impressive support below $30 (bouncing sharply from that level a number of times). Now the action since the October low and today has measured a roughly 70% and in my opinion represents not a reversal of a primary trend but a consolidation of a hard and fast 70% peak to trough decline. The shares are up almost 70% off that October low and the latest move (since the beginning of march) equate to a roughly 38% move. And that retracement has now traced out a 3 lower highs on a weekly and coincidentally a daily.

Thus I think that taking a short trade here is a good risk/reward. On a short term basis, it stands to my technical reasoning that $37.60-$37 area is the next stop, and I expect that level to find fleeting support which ultimately fails. Given the recent momentum and sentiment shift I don’t expect this to be a lay-up so I would go small initially and/or look to cut a sizeable position in half on a move above the recent high near $44 (say $44.60), because major resistance is in the $46-$48 area. I would however lay it out in size north of $45 because I do have confidence that there would be no fundamental justification for long buyers anywhere near $45. I think NUE is the best house in a bad neighborhood and I think they’ll struggle to earn $3 in 2010, so a $4.50+/share earnings estimate for 2010 has nowhere to go but down.

Misplaced hope is Steel and Energy yields opportunity on the short side

Energy demand continues to deteriorate beyond bearish expectations, yet the ranks of the bulls have swelled as many look past near term supply demand imbalances on the idea that significant and rapid declines in rig counts will lead to equilibrium in supply and demand such that inventories will decline to levels closer to 5 year averages. I don't doubt that will ultimately happen but I do strongly doubt that it happpens as fast as most think. Furthermore, I'm confident that any recovery will be gradual and less vigorous than most suspect as I think a new normal, inconsistent with inventory levels during the recent period of strong global growth. We'll need a rapid and substantial economic recovery for crude and distillate prices to make meaningfully higher price moves and we'll need growth and hurricane related supply disruption for natural gas to find its new equilibrium anytime soon.

I continue to think that natural gas production, supply and inventories are not likely to fall as much as declines in rig counts suggest. I expect natural gas prices to remain soft until late this year and think that rallies can be significant but are likely to be short lived as fundamental support fails to manifest. Industrial demand continues to surprise on the downside. Demand from manufacturing, steel and chemical industries continue to weaken. We remain in the grips of a global inventory de-stocking dynamic which appears to have reversed in Asia as what I believe is opportunistic purchasing of raw materials like scrap steel, copper, lead and zinc by the Chinese. I think that raw material stocking is apt to subside going forward as it is unsupported by sufficient end market demand. Demand though likely stronger and more responsive to Chinese stimulus given the more rapid and proportional measures is likely in my opinion only to soften the blow of the current global recession rather than leading to a resumption of rapid growth.

Similarly, consumer demand for gasoline continues to soften, so refinery utilization is low and unlikely to rebound meaningfully as distillate inventories are also on the high side. And continued ramping of low cost middle eastern natural gas and LNG production is likely to keep natural gas prices under pressure globally. In this context, hope related to an economic recovery driven by infrastructure development supported by U.S., Chinese and Eurozone stimulus should fade. Thus I think the time is right to press the short side in steel and energhy once again as it appears a reality check is imminent. In this context, NUE, DVN, XTO appear particularly vulnerable to me.

Time to get less long and more short

Think the time has come to step off the offensive accelerator and reduce long exposure and increase short exposure; in other words, position more market neutral. The market is up 20% in a month and extended on a short term basis with many economically sensitive names with poor near term prospects and unclear longer term prospects up significantly. The bulls are out in force and shorts are being forced to cover. The move from 666 to 800 was understandable as cataclysm risks faded when the treasury moved on asset purchase programs and committed to save too big to fail banks equity investors by any means necessary.

Moves to effectively force a preferred for equity swap with a signal that the treasury would also push a move up the capital structure and swap debt for equity as necessary to effectively share the capital burdens between debt and equity investors to keep the banks in the private sector put the screws to the shorts as they effectively changed the game. Regulators also moved to ease the balance sheet pressure levied by mark to market rules.

Clearly positives for equity investors in banks and to the extent that they fostered viability (perhaps regardless of solvency), these moves were a positives and understandable improved sentiment and forced short covering. What these moves don’t do however is make all well and good in the world. Credit markets are still under pressure, consumer spending, incomes, wealth, business spending, capex, and corporate earnings are all still under pressure. European macro fundamentals appear to be deteriorating fast. There is no reason that I can see to believe that consumers or businesses will be in a position to spend more anytime soon. And at some point soon, equities will need fundamental support.

For all those reasons, I’ll be stepping up the short exposure today. I recognize the technical momentum at hand so I’ll do it slowly and expect to deal with a little pain in the short run. The fundamentals, earnings and valuations are my shepherd but the volatility and countertrend moves in an uncertain but hope induced market are a killer so I must continue to adjust market exposure accordingly.

I’m still very bearish on natural gas and still bearish on steel. I let a very nice gain in NUE disappear by only covering half on a terribly negative preannouncement and letting the other half go 10 points against me. That always sucks because I thought about covering the whole thing and putting it back on a few points higher. But I didn’t so that’s spilled milk and some pain in the PA as they say and I’m not going to cry about it. That said, I’m going to short more this morning as the fundamentals have turned from incredibly good to disaster yet hope reigns supreme as investors look to NUE as a play on early cycle macro sensitivity as well as global stimulus related infrastructure. That’s optimistic to put it mildly, naive might be a better description. Anyway you cut it I'm still betting that estimates still have to come down more for the balance of the year and next year and think the shares would be under pressure as that happens because they aint cheap.

I continue to think that NUE is clearly the best house in a bad neighborhood that is going to stay bad for many months to come. NUE’s residential and commercial construction, auto, infrastructure end markets are not coming back nearly as fast as bulls hope. Although NUE typically benefits from scrap declining more than end market pricing, as well as lower energy (natural gas) costs, costs can not decline fast enough to stave off severe margin pressure because volumes have plummeted. NUE and most of its competitors are suddenly operating at 40-45% utilization rates. At such levels, companies like NUE simply are overwhelmed by negative operating leverage. Demand and pricing would have to recover significantly to change the revenue and margin pressure dynamics and I don’t see that happening anytime soon. Pricing might stabilize as the industry has done a great job of making regional and product markets less competitive through consolidation and have now move to shut capacity quickly so inventories don’t balloon. However, volumes need demand to recover in a big way and there are too many end markets under severe pressure to expect that to happen soon. That’s my call on I’m sticking to it.

The case for being short Natural Gas equities

Oil and Natural Gas equities have rallied on the prospect of an economic recovery, reflation gaining traction and dollar weakness. Although I do understand (and agree) that dollar weakness should act to support all commodities in general, I’m confident that the fundamentals on the whole favor sustained weakness in prices as supply, demand and inventories are all likely to pressure prices both short and long term. If the emerging view that rapidly declining land rig activity signals a speedy return to balance in natural gas supply and demand as inventories get drawn faster than is generally expected is incorrect (as I believe it is); then you have an excellent opportunity to short natural gas levered equities like DVN, XTO, CRK and RRC.

If I’m right, then sustained natural gas price weakness is apt to weigh on profitability, cash flow and multiples. Estimates for 2010 would have to come in considerably and multiples would compress such that shares of most nat gas producers would decline significantly. And I have little doubt that the bulls, which hang their hat on significant rig activity declines leading to meaningful production declines, will be wrong. They'll be wrong because although land rigs are coming offline at a rapid rate, the production decline is likely to be less sensitive than generally believed and has historically been the case. I think production will remain high for several reasons but the most under appreciated in my view has to do with the nature of recent production increases. Its going to take many more rigs coming offline than most think in order to re balance this market and get prices going up meaningfully.

Recent production increases have come from relatively low cost shale plays which have been, in many cases financed with increased debt on balance sheets of companies which, in many cases, bet their balance sheets on sustained high prices. In prior cycles, it had been the case that relatively high cost resources (which required high prices to be profitable) came on line in the late stages of a bull market in energy. Similar to what has happened to oil sands and the like. In the current cycle, unconventional gas plays like the Barnett, Fayetteville, Marcellus and Horn River Basin shale plays have ramped at a higher rate and faster pace and have done so on favorable unit costs and overall superior economics. The Finding and Development costs have surprised to the downside as the initial production has been much better than expected in most cases while improved technology has also led to a lower initial decline rate, as well as, a fatter tail with regard to out year decline rates.

The net net of this is that the recent industry production additions are profitable on lower prices. The important drivers as I see them are all have risks to the bearish side. On the demand side, industrial and residential demand both have risk to the downside in my view. Utility demand might increase slightly but it is likely to happen as utilities let lower prices come to them. And even at $4/mcf, coal is competitive and often hedged more so than other utility raw materials. If you also consider competition from alternative energy sources this cycle, its reasonable to expect sustained price weakness.

On the industrial side, demand related to chemicals, steel, fertilizers and other industrial end markets all have risk to the downside in my opinion. And if that wasn’t enough, there has been a tremendous amount of LNG capacity that has come online in recent months. Huge fields in the middle east, north sea and russia have ramped. Some of the largest fields in the world (in Quatar and Kuwait). The north field in Qatar is huge (probably the largest ever) and it has ramped up, importantly with liquification capacity at a time when worldwide inventories are high and demand in Europe and North America are weakening significantly. With shipping rates down sharply, LNG can be delivered to North America at $1.50/mcf. With nat gas in the high $3s still and demand in Europe and Asia weakening, its quite likely that LNG imports to the U.S. will rise meaningfully, and take share from conventional gas.

Although I do agree that energy markets are self correcting, I think that the market is underestimating the duration of the adjustment phase. By all accounts, supply is likely to continue to surprise on the upside while demand surprises on the downside. There has been billions of dollar of capital invested in capacity expansion whose variable costs are relatively low and the associated debt must be serviced even though all in cost economics suggest such production is better shut in.

So a wash out is in the making and although I do think the market is likely to correct sometime in 2010, there will be a lot of pain in the meantime. First class companies like DVN will struggle to be profitable. Excellent operators like XTO will see their solid 2009 cash flow consumed by debt service and be forced to hedge 2010 production at substantially lower prices than 2009 was hedged at. Many of these companies managed to hedge the bulk of their 2009 production at $9+/mcf. Today, spot remains under pressure and the futures continue to flatten out through 2010. This suggests that bullish promoters like T. Bone Pickens and Aubrey McClendon are crazy to expect a return to $8 or 9/mcf anytime soon. More importantly, persistent price pressure and futures price weakness suggests that all substantially unhedged nat gas producers will have no choice but to eventually hedge 2010 production at prices less than $6/mcf at best. And at such prices, most natural gas companies are barely profitable. If that turns out to be the case, then estimates for 2010 are way too high and most if not all companies are going to guide down and/or miss expectations over the next few quarters. The current stock prices would thus be significantly overvalued.

Full Disclosure: Have been short CRK, for months and just put DVN on friday.

Of Dollars and Sense - Havent I've seen this movie before?

On January 29th of this year, I wrote a comment to a crowd of writers and readers at SeekingAlpha on the semantics of the many Milton Friedman disciples which were essentially arguing that inflation wasn’t inflation unless it was accompanied by simultaneous increase in money supply. Ridiculous I said, because the author wrote what seemed like a 10 page tome which not once mentioned purchasing power. My counter-argument was that purchasing power was what really mattered as that’s what dictated consumption which at the end of the day also dictated production, profits, incomes, spending, investment and everything that makes the world go round (or not).


I went on to say, “And I'll say upfront that I agree that the inflation we all know but don't love is apt to surge in a way that can put us in a banana republic sort of conundrum; I just am not convinced it's around the corner, because I think the current economic circumstance is likely to suppress demand more and longer than most think, credit has changed dramatically, and there is likely to be a transmission problem with regard to getting that credit into enough hands that can overwhelm the enormous amount of excess capacity in product, service and labor markets that have been created almost overnight. So there's no telling how long deflation (not the asset kind, but the kind that increases purchasing power meaningfully) is apt to persist because this is anything but a free market economy anymore - ie. the Fed is likely imo to be successful in keeping rates low and the dollar from collapsing in the near term. But some day in the not too distant future inflation will get going and it will inflict pain of the non-theoretical kind - your and my pocketbook and bank accounts and by extension our quality of life. It’s just near impossible to predict when and to what extent but also how far and long deflation goes before it turns. My guess is that wont happen until the economy here and globally improves - which I doubt happen anytime soon. People looking for a 2nd half recovery are way off; we'll be lucky if happens by year end 2010 IMO.”

Yesterday afternoon I saw what the fed announced and saw the dramatic movement in treasuries and sell off in the dollar and immediately thought that I might very well have to re-think how fast that inflation shows up. My reaction was to buy a couple of small positions in gold miners and try to fade treasuries via shorting the TLT. I had been looking to get long gold shares and thought the setup was upon me but I wanted to wait one more day because several gold related charts I saw looked as if they had developed mini head and shoulder tops and I thought they would try to complete those patterns before failing (in a downside break) and that would set off a sharp move higher (accompanied by short covering by early top callers) in gold equities. By the way, I like taking advantage of failed patterns; there are a few that I play whenever I see them, this is one of them. So I bought a little GG and AUY; and that came out of a toss up between NEM, GG and AUY. Actually thought that NEM might be the safest of the 3 but went with the 2 I thought might move most. I have long thought that the dollar must decline precipitously going forward as longer term fundamentals required that (as did the survival of our country’s manufacturing base). And when it started, I thought the Fed and Treasury would welcome the move and not look to thwart it, I just wasn’t so sure the moment was upon us in late January.

So that’s what I’m thinking now, long gold, U.S. equities should retain a bid, I’m not so sure the same is true for global equities. I am also looking to fade a couple of natural gas stocks as the commodities rally. I’ve been short a steel stock and a couple of nat gas stocks for a while now and will look to add to those positions as the move against subsides. I also put a small long on a refiner in order to hedge my negative nat gas bets in the very short run. I’m not so sure its time to go all in on the refiners yet but figured they should move on a vigorous dollar decline so I took a small shot there and it caught a nice bid. I plan on keeping that on a short leash, I’ll cut it as soon as it turns into a loser or 15% higher, whichever comes first.

Last thing I’ll say and I’ll comment more on this soon, is that yesterday’s moves reminded me of The early 1950’s (think it was 1951) Fed – Treasury accord, so I started to think this was a re-run of that episode and I wondered what the implications were, wondered if the dollar should really collapse fast and/or inflation might surge sooner and faster than I thought, and if it was in fact a re-run of that episode, would some sort of price and wage controls be necessary and what were the implications of that. I have to think more about that and get back to you on that but it really had me scratching my head.

A few thoughts on playing offense and defense as the world turns

Still doing my best to get the full site done as soon as I can – its been any day now for a month but I’m making good progress and at the point where I’m polishing it up, working out some programming kinks and testing a few features; it should be done and ready to launch this weekend. Pretty exciting as I think it will be good.

In the mean time, I figured I’d share a few quick thoughts on today’s massive rally. If you’ve read my posts you know that I’ve been very bearish for a long time now, especially on banks, energy, ag equipment and steel. I’ve been long a few healthcare names and building a position in an industrial name I will discuss in detail soon. In the last week, I tried to get a little cute and play for an oversold bounce and rally in crude which whipsawed me – got long, sold long, got short and covered short at the open today (thankfully did it small). I also have been buying a battery company, caught a nice quick move in GE (not typical for me b/c been avoiding troubled names no matter how apparently cheap; but thought I catch a 15-20% move in a couple of days so I took a shot with a 5% stop Friday and sold this morning), and a bought a small bank and japanese consumer electronic name at the open today.

I also covered half of 2 small positions in natural gas stocks I’ve been short for a while now (still negative), and covered half of a short position in a steel name. And yes, I wish I covered the whole thing but I’m committed to staying short some natural gas equities because I think many are still too bullish, the market is positioned to keep prices weaker, longer than most expect and sentiment is still not sufficiently bearish given fundamental developments in recent weeks and months. I’ll have more to say on that soon as I discuss more nat gas shorting opportunities in the coming days. I also covered my ag equipment short way too early (couple of weeks ago almost 5 points and 25% higher).

Even though I thought the economic and earnings backdrop are as bad as they’ve ever been, and most companies were likely to see earnings and outlooks under pressure, I started covering shorts and taking shots on the long side because I thought sentiment was catching up with reality and the reality of economic unraveling and its ramifications were finally becoming properly appreciated. Thus I felt that oversold conditions, coupled with heightened fear and the capitulation type selling in most names set the stage for a substantial bounce – something on the order of 15%-20%, which equates to a move back to 765 or as high as 800 in a best case (20%) scenario in the S&P500. How low a low this is remains to be seen.

Even though I thought we’d see a sharp rally today, I kept some of my shorts on because I didn’t think the bounces would be as strong as they were in energy and materials and I want to remain short some of these names for the next earnings report and thought it would be too difficult to be nimble enough to do much better trying to hop in and out and back in. Its typically the case that I catch a nice move lower in a short, cover on a 15%+ gain in a few weeks and avoid the couple day 10% bounce and miss getting back in fast enough to play the next leg down that I knew was coming.

So that’s how I played a few volatile days; where I felt the market was very oversold by all measures, and sentiment had gotten extremely bearish. Now the hard part, how long to stay as long as I’ve been since last July and when to add back more short exposure? The short answer (and of course this is subject to change without notice) is not so fast. Given the breadth and strength of the rally with solid participation from Techs, Financials, Industrials and Cyclicals, I plan on staying with a relatively net long position for at least tomorrow and probably the next few days.

So the moral of the story is that I think you have to stay true to well reasoned secular views but also be conscious of market conditions and sentiment and thus ready and willing to act somewhat nimbly (yes I know that’s oxymoronic) when a reversal has a relatively high probability. The high volatility makes it difficult to do wholesale so I scale in and out of positions and net market exposure. So I’m not up as much as I could be on a day like this, but I can usually add risk adjusted out performance on day 2 through 5 or 7.

I think it could take another 3-4 days to get to 765 and think 800 in the next couple of weeks wouldn’t be a shocker so I’ll look to get more long in the first half hour tomorrow (mostly at the open), and I’ll look to scale into some shorts and out of some longs as we approach 765 or more. My biggest mistake in the last year have been not staying short as long as I would have liked to; trying to be too nimble. In recent weeks, and months I've dealt with that by not completely covering shorts which I'd like to stay in and putting on longs, in spite of my longer term market view. And thats worked very well.

On another note, a friend (who knows I’ve been a gold bug for a while now, but out as of 2 weeks ago) asked me about shorting gold here and my reply was that although I wouldn’t, I wouldn’t be surprised if that worked for a couple of days but I’m not doing that because I don’t think the party is over. I think there is at least one more leg higher, thinking $1150/oz. by year end so I’ll be looking to get long some (of the equities, not the GLD if/when gold hits $850 because I think it can find support there and is very likely to find support near $800. This entry is going to be really tough I think because I'll want to chase strength which could be fleeting in the very short run; we’ll see.

Response to American Labor Arbitragers Everywhere

This is a response to an economist who suggested that we weren't really losing many manufacturing jobs and it wasn't a big economic deal to begin with. the guys went on about how we would focus on solid productivity as trumping both massive manufacturing job losses and ewer well paying jobs domestically. Both naive views in my mind so I had to do my best to enlighten the easily convinced:

Less people making less to produce more (productivity) is great for the business owner, but it is not in the best interest of us as a nation. When you forsake the ability to produce labor intensive goods you also give up the ability to innovate in the future and create value accordingly. You give up the ability to add value (however small) at each step in the value chain. You can bet your half baked theory that someone will create significant innovations in autos, machinery and the like at some point and it wont be us

There are universities in China that have majors in things like bra engineering - and they now produce differentiated, value added bras that our wives spend $50 and $60 in Vicki's hush hush. For now that value creation is being split nicely in the retailer's favor but its a matter of time till there are bootlegs available for half that price and it then becomes the beginning of the end of another American company. Once upon a time the brits were good manufacturers and had a strong economy, as were the Germans, as were the Japanese and others. As their manufacturing base lost its luster, so too did the economic growth, and real incomes. These countries became second rate economies where too many battle for too few jobs and wages and standards of living collapse. It isn't long till too few are left who can afford the few things still produced domestically. Don't lose sight of the fact that one's spending is another's revenue. The view that we will retain high value added, high paying jobs is naive. The Chinese, Indian's and Brazilians amogst other now have not only cheap labor, but also knowledge, technology and capital to knock off almost everything. As they do, they will put more U.S. businesses and consumers out of commission.

Of course we are using technology and a better educated, more industrious workforce to produce more efficiently and that much is a good thing. But make no mistake about it, the driving force of much of this is little more than labor arbitrage with unintended consequences that will haunt us for years to come because those jobs arent coming back and we aren't manufacturing jobs to replace them.

Employing more Americans which earn a better living than walmart cashiers and greeters, to produce more goods to sell to everyone else globally is a better economic situation for most Americans and us as a nation in the long run than the opposite scenario. If you agree with that, then you ought to agree that we should be promoting policies designed to encourage investment in manufacturing that creates jobs here instead of doing exactly the opposite

Follow-up on a show me story that’s showing up doubters – MYL

Mylan’s comeback is on track! Mylan reported 4Q earnings late last week and the results were excellent. At a time when most long investment theses are deteriorating, this one (http://seekingalpha.com/article/108343-mylan-on-the-comeback-trail) is intact if not strengthened. EPS of $0.26 came on better than expected revenues, margins and cash flow. Although the tax rate was lower than expected, this was a quality beat.

The integration of Merck KG assets is proceeding as planned and there’s now talk of better than initially projected synergies (previously guided at $120M, but now likely materially higher, perhaps as much as $150-160M). Base (generic) revenues are strong and expected to continue growing high single digits (ex-currency) and Mylan expects to generate at least $450M (and as much as $500M) in operating cash flow this year, which appears very doable given $135M generated in the quarter. Both Matrix and Dey also appear to be doing well.

Its hard to poke holes in a clear over deliver like that, but I suspect bears will persist. Sentiment, although not as bad as it was a few months ago, is still pretty bad. Short interest was almost 64m shares as of 1/7 and that was up in the prior few weeks. Although many surely covered on the earnings beat, a good amount are apt to remain in hopes of a stumble in the current quarter. That said, there should be no doubt that Mylan is executing as management has guided, so I have to believe that the burden of proof is shifting to the bears.

Management reiterated EPS guidance of $0.90-$1.10 in 2009 and $1.50-$1.70 in 2010. Despite solid execution on FDA filings and approvals, better sales, solid operating cash flow, and accelerated debt pay down, consensus remains well below guidance for 2010, and the shares trade on a substantial discount to peers as well as its historical range on cash flow and earnings; even though they’ve now doubled off their lows. A few months ago, I argued that the shares should at a conservative 12 times 09’ earnings in the coming months and thought if the company could execute as promised over the next few quarters, investors would start thinking about 12 times the low end of the 2010 guidance ($18).

Although I think it’s still a bit premature to have great confidence in 2010 (especially in light of heightened macro and forex headwinds), I think it is reasonable to expect the shares garner a 13-14 multiple on current year estimates if they can meet expectations and reiterate guidance when they report in May. Furthermore, I do think it reasonable to expect that continued execution, free cash flow (exp. ~$350mm this year and $500mm+ in 2010 by the way) and pay down of debt taken on to do the Merck KG deal should lead to confidence that the low end of management’s 2010 guidance is doable and thus a move to $14 or $15 by year end appears reasonable.

As confidence in management increases and visibility on 2010 improves, then estimates and the multiple can increase, and we might see that $15 sooner than you think. Although I don't recommend chasing anything in this market, I think buying pullbacks in this name makes sense. If it keeps on keeping on near term, put the next earnings date on your calendar and look to take advantage of an opportunity should it arise then.

Comment on Barrons predicting golden age of Activist Investing

I submitted this to another site last week and neglected to post here so here goes.

The article's premise is a joke. There were a ton of new activist investors that thought they could buy a big stake and convince operators of businesses to take a shortcut to value creation via some form of financial engineering or another. Most of these guys have gotten smoked many times over because the game is not played on paper. Blocking and tackling is a little harder than it looks. These twenty something hedge fund geniuses assume that managements of companies who generate buckets of cash the old fashioned way (through earning it) can't do the math of share repurchase or are too stupid to realize that they can put their firms on the precipice of bankruptcy by leveraging it to the hilt in order to increase EPS and return on equity without increasing net income or return on capital.

Of course there are companies out there with potentially greater intrinsic values were it not for dumb managements that pay themselves excessively not to create value or allocate capital well. But those are not where most activist attention is focused. Then you have the activists who play a glorified game of pump and dump - acquire a large stake in an apparent value, pump out a few press releases, and hit he CNBC circuit and then sell as copycats fall over themselves to piggyback these.

The problem with thinking we are on the cusp of a golden age in activist investing is that's its all much easier said than done AND current macro conditions are apt to buy many managements time, while otherwise valuable franchise managements will be reluctant to sell on cyclically depressed multiples. Furthermore, if low valuation is your first reason, then why not be a passive investor in better managed companies which are inherently significantly less risky.

In the real world there are many more bad businesses than most want to believe and industry and macroeconomic forces are bigger than either management or hedge funds that want to fancy themselves activist investors. Its amazing how many grand opportunities hedge funds can burn other peoples money on. Activist investing will remain a niche. There's a lot of playboy centerfolds out there who like the average joe the plumber, are more desperate than ever, good luck finding one with a big bank account that will cook, clean, pay your bills and faithfully love you long time. Again, the game is not played on paper; you have to block and tackle and overcome all kinds of seen and unseen obstacles to score.

Deflation semantics are useless - purchasing power pays the bills

I see a lot of people talking about inflation and deflation being "exclusively a monetary phenomenon" The old Milton Friedman line of reasoning has become an extreme exercise in semantics. These dogmatic economic philosophers preach that persistent general price level increases are not inflation unless accompanied by a substantial increase in money supply. This lacks grounding in truth and reality and is a disservice to converts who don't know any better.

I'll say upfront that I actually agree with their conclusion that inflation ( the kind we all know but don't love is apt to surge in a way that can put us in a banana republic sort of conundrum; I just am not convinced the bogeyman is around the corner, because I think the current economic circumstances are likely to suppress demand more and longer than most think, credit has changed dramatically, and there is likely to be a transmission problem with regard to getting that credit into enough hands that can overwhelm the enormous amount of excess capacity in product, service and labor markets that have been created almost overnight.

So there's no telling how long deflation (not the asset kind, but the kind that increases purchasing power meaningfully) is apt to persist because this is anything but a free market economy anymore - ie. the Fed is likely (IMO) to be successful in keeping rates low and the dollar from collapsing in the near term. But some day in the not too distant future inflation will get going and it will inflict pain of the non-theoretical kind - on your and my pocketbook and bank accounts and by extension our quality of life. Its just near impossible to predict when and to what extent but also how far and long deflation goes before it turns.

My guess is that wont happen until the economy here and globally improves - which I doubt happen anytime soon. People looking for a 2nd half recovery are way off; we'll be lucky if happens by year end 2010 IMO. Although I also expect the USD to be under longer term pressure, I'm not sure that triggers immediate rampant inflation because I think it also is likely to hurt global purchasing power. I think we clearly need a lower dollar and reflation if we are to have any hope of avoiding a lost decade economically, I'm not sure that its going to mean oil or gold must go up because gold and oil typically go down in protracted recessions regardless of what M-whatever is doing. People, the IMF, all central banks, the GLD and any other big holder will hope to hit any bid that comes and most will simply not have enough cash (on lower cash flow from un&underemployment, broken balance sheets and reduced purchasing power) to buy much gold. Sorry, but I really doubt that the gold that the guy "is holding in his hands and touching on the table" is likely to go to $166,000.

Folks that reiterate the line about inflation is always and everywhere a monetary phenomenon and then declare that a general, persistent rise in price levels do not constitute inflation if not accompanied by a simultaneous increase in M2, M3 or modified M whatever miss the point that the real world does not care about that type of deflation is their purchasing power (ability to buy food, shelter, fuel, healthcare and other service is not compromised. These "what is is" deflation rants are cute but not very useful.

I have actually been looking at buying a little Gold Corp again on the next pullback because I want to have a little skin in the game when gold surges. Problem is I'm very reluctant to go all in yet because I honestly have little conviction regarding the timing of a move. I've been an on and off mini gold bug (trading the long side since 2002 in and out of Barrick, Gold Corp, Desert Sun, Yamana, NEM and the GLD) and also dabbled in a few silver names. I might even pair a Barrick or Mewmont short against GG long. I'll follow up when the whole situation is a little clearer to me.

Is that all you got? There’s got to be a better way than TARP 1!

The whole idea of using taxpayer money at the Treasury to stabilize the economy and arrest the collateral economic damage which wall street has wrought on main street is either naïve or sinister. Naïve if Paulson and congress really thought this was the most efficient and effective way to restore liquidity and viability to the banking system and thus circumvent unnecessary business failures. But sinister if Wall Street intentionally conned congress into buying an economic Armageddon (by the time the Asian markets opened if we didn’t do this) scenario so they could effectively rob the Treasury.

Although they would never admit it publicly, you have to believe that these bank CEOs were smart enough to understand that they had screwed up the risk management and leverage to a point where they were in no position to use the lion’s share of the cash they received from Treasury to make loans. Surely they knew that this capital would be used to plug holes in severely over levered balance sheets and make good on some counterparty claims rather than make new loans in a stimulative fashion or renew revolving credit to creditworthy and current borrowers reliant on bank lines to run their businesses effectively.

Most of the $80B that AIG took went to counterparties like Goldman Sachs, UBS and Merrill Lynch and statutory capital requirements that should have been met all along. And most of the rest of the TARP money has effectively gone to bail out bond investors which made bad investments in over levered financials. Recall that in most of these instances, even though equity holders can slammed (and rightfully so), bondholders got taxpayer financed guarantees. Where are the anti-socialist free marketeers when you need them?

The reason banks haven’t loaned the TARP monies as expected is simple as I understand it: when you are way over levered and under provisioned and credit losses are surging, as your revenues are collapsing, you have to shrink your balance sheet asap or risk having the little tangible equity capital disappear as a result of additional charge offs. The problem with that is that shrinking your balance sheet is inconsistent with extending incremental credit. The math is in some ways simple and in other ways complicated. Simple because a bank levered 30 to 1 has little room for error before their capital is wiped out to an extent where solvency becomes an issue. But complicated due to a lack of transparency where assets had to be marked incorrectly, which distorted book values dramatically. Either way, the balance sheet got way too big, the assets way too risky and the transparency way too murky.

So the net of it is that most of our largest banks are in no position to lend more or take more risk; and the economic ramifications of what’s happened now make virtually all lending more risky. This should be clear as despite huge capital injections, banks struggle to meet regulatory capital requirements. And if meeting regulatory capital requirements are a priority, then how do you expect that capital to get translated into credit or investment that might mitigate the economic meltdown underway. So what to do now? More of the same? I don’t think so. We must do much better.

I understand that if the banks could shed some of the garbage assets they have on their books at above market prices then they would be in better shape to lend and I understand that given the lack of transparency and a most uncertain and dire economic outlook, that serious bids from the private sector are largely absent. So I understand the temptation to rationalize taxpayer financed welfare for the banking dregs amongst us; especially when you consider the audacity of these bank managements in the first place. This is not the best way to underwrite the costs of fixing our credit market problems, and its not the best way to get liquidity to the many solvent companies that need it to maintain employment and consumption (by both consumers and businesses. We truly need more novel approaches, so I thought I’d mention a few that I’ve thought of.

Now I’m not as smart as Paulson, Bernanke and Geithner so forgive me if this sounds a bit crazy or technically unfeasible. Although I’m not an expert here, I do have a cursory understanding of how the business and the economy works so here goes. You can always do conservatorship coupled with direct lending (which as far as the goal of increased lending is concerned seems to be a better option than TARP as its been administered to date). But I think present circumstances call for a more creative approach and probably more than one.

Why not have government employed securitization experts repackage some of the less than most toxic assets and couple them with a European style put option (written by the Treasury) which exercises a couple of years out. Or I guess it could be American style by application if necessary. Encouraging a longer term holder here would seem preferable so I think it makes sense to structure and incentivize accordingly. A sort of structured product priced to offer a chance to make a better than average return for a nominal but quantifiable risk and only make this available to banks that were responsible enough not to over leverage themselves in the first place. You could also incentivize and subsidize banks that put assets into such vehicles such that making new loans with their refunding was an attractive economic option.

Why not have the Treasury and/or Fed also subsidize restructuring and refinancing of mortgages such that the Treasury and the creditor share a principal reduction while the terms are extended a number of years AND a newly formed government agency funded by TARP money also subsidizes the mortgage rate for homeowners with cash flow sufficient to finance their primary residence if only the terms were better. Make it a needs based program with stiff penalties for fraud to prevent abuse. This would not only help lenders with more cash flow and less credit losses but also stabilize home values and residential mortgage backed securities valuations – which would buy extension lift the value of assets on bank balance sheet and their book values and thus not only lift capital ratios (which ultimately improve a bank’s lending capacity) but also make it easier and cheaper to raise additional capital from the private sector.

I thought this might be necessary a year ago and I’m shocked that it hasn’t been seriously considered. The reason it hasn’t is due to political ideology related to contract law. What’s crazy is you could have made this voluntary – some smart banks would do it and others would follow if/when it proved successful. The charges wouldn’t be as great because the treasury or fed would take half the hit so the bank’s book value, capital ratios etc. would be impacted substantially less, and the banks liquidity position would be better than otherwise the case. Loan to value ratios would also improve so credit worth would improve. And the incentive to not walk away would thus also be strengthened. The irony is that by not doing something like this the damage to creditors has been magnitudes worse as cash flow has disappeared and collateral values pummeled. It’s also ironic that the only way a bank would be otherwise worse off is if borrowers became healthier quickly and/or home values surged – both high class problems in comparison.

Another option I thought of was allowing substantial holders of U.S. Treasuries to swap Treasuries at bubble like valuations for bank asset pools with puts attached that would again limit losses in return for a chance of a reasonable return commensurate with the risk that would be realized if the buyer would have to exercise their put option. This too should not be structured in a risk free way but some risk would be necessary AND this risk could also be collared in a way that the Treasury would realize upside beyond some predetermined level in the event that the structured product performed exceptionally well. This would free up capital banks could lend and transfer some re-priced risks to foreign central banks with stronger balance sheets.

All of these things can be done with more direct government lending. The direct government lending should be underwritten sensibly (such that the taxpayer cost is minimizes yet borrower capacity to remain current maximized. And any such direct government lending could be done in a way that minimizes potential competitive damage to private sector lending by allowing banks to either participate in syndication or by subsidizing the loans to some degree so that the private sector can take down such loans at say a percentage point above where the government would do it and that extra percent would be paid by the government. This would incentivize the private sector to lend more because they would get better than market terms. In instances no private sector offers came to the market, the government would do the lending. Thus more lending would occur and it would get done on better terms with or without private sector participation.

Subsidies should not be permanent -they should remain in effect only for such time as necessary to restore the banking system. Congress could set up an agency to administer this for say a 2 year period and it could be renewed if necessary. And discretion should be paramount – although increased lending is necessary the last thing we need is more “unintended consequences”. Underwriters should be compensated and incentivzed accordingly – with back end bonuses to the extent that they increase lending and the loans perform such that cost to taxpayers is minimized. One way or another we need to try to stabilize home values, support solvent businesses with credit and create jobs. Drastic times call for drastic measures; but the more creative the measures then less drastic they might be. We must do better than we’ve done thus far or we’ll face a depressed lost decade.

The Ultimate Game Changer: Why 2009 Will Be Worse Than 2008 (Part 2)

I don’t want to belabor the point but wanted to stress the fact that credit, saving spending and investment will be changed for a generation. People will be forced to save more to buy stuff they could previously buy with little or no money down and low interest. Frugality will be a way of life, not just in consumer sector, but also in the business and government sector. And the government (federal that is) can not create enough jobs to mitigate the economic pain in any meaningful way b/c the private sector is likely to cut another 6 million jobs this year and state and local governments will cut more than the federal level is apt to create. I can’t see how and when consumers and businesses will be willing AND ABLE to spend more. Generation X & Y have pulled forward a lifetime of sales. Many hundreds of billions of dollars worth of stuff bought on credit in the last few years would have been bought in the period ahead if folks had to save for it. Instead, consumers and businesses alike have to retrench in order to pay overwhelming debt service burdens. And one man’s spending is another man’s revenue; and so it goes, the multiplier effect in reverse. These dynamics don’t change overnight.
And to the extent that you buy into the bull crap (pun intended) spoon fed to you by CNBC pundits employed by fees on your assets your net worth and quality of life will suffer for it. Understand that the Abby Joseph Cohen’s of the world will never implore you to take your money out of the Goldman Sach’s of the world because it means they get paid less or fired altogether. It’s not good business as they say; but if you ask me its bad business. Strategists putting a 1100 and 1200 targets on the S&P500 as 2009 started was flat out irresponsible at minimum and probably disingenuous as well. I say that because not only are they clueless about what the earnings on the S&P500 might have been if the constituents remained the same; but many names are being changed to protect the guilty as they say, so what does it mean to the market that the new constituents earn whatever. If I recall correctly, they mentioned $53-$55 in EPS this year (which interestingly was at the low end of the street) and $60 next but many of the top market caps have will have been replaced with companies with better balance sheets and earnings. Who in their right mind would take a skewed sample and put a high teen multiple on it and say that’s what they honestly expect. I’ll tell you who – its people with a vested interest in you not allocating capital away from equities.But that’s exactly what you ought to do.

Another reason why I doubt equities can snap back a lot anytime soon is because I can’t recall a time when equities have gotten pummeled to the extent they have and other assets are as attractive as they are. Investors that lost 50-60% in what was supposed to nimble “HEDGE” Funds (which didn’t hedge well) are going to be done with them in many cases and shift money back into the mutual funds (which have much less leverage) which never lost that kind of money for them. They will also buy debt securities, corporate bonds, munis, converts and real estate among other things. Sure there’s a lot of money that will come out of treasuries but it aint going into equities to the extent that it has historically. And that money on the sidelines is not all going back into the market either. Much of it will go to redemptions and other asset classes – I doubt many will underweight cash as much as they had in the past, regardless of what yields are.
As the market rallied a couple of weeks ago, I was shocked to see how many were sucked into the idea that the worst was over. Well educated money managers bought into the company line.

Many remain in a state of disbelief and think it can’t get much worse now. They think “I can’t sell now, it’s too late”. Wrong again, uncertainty has never been greater, our financial system is melting down and the meltdown is creating massive collateral damage. Otherwise good companies are seeing credit issues impair their operations; which are already under duress on the demand side. As corporate profits slide and the outlook for growth deteriorates so too will equity valuations. Earnings and Multiples will remain under pressure and equities will decline – if you don’t reallocate out of a long only overweight equities portfolio, the market will do it for you.
So the decline is apt to be more protracted than most think and the downside will be such that the comps can’t be easy enough. Retailers are a good example of this – things got bad retailers almost 2 years ago, they’ve been up against what should have been easy comps but still comping the high teens NEGATIVE for many. Sure we may be approaching a point where its hard to get MUCH worse (much being the key) but I think the disconnect here is that everyone is assuming that things bounce back as they did in past cycles when consumer balance sheets weren’t decimated and banks were healthy and lending. Generation X & Y have pulled forward a lifetime of sales (which would have gone to sales in the period ahead and would have been more money with interest instead of deficits and unmanageable debt service burdens. One consumer’s/business’ spending is another consumer’s/business’ revenue and the multiplier effect you heard about in econ 101 (when the butcher buys baked goods and the baker then buy candles etc.) works in reverse. That’s how a mild recession turns into a really bad one – the butcher and the baker cut back the spending and employment and the candlestick maker goes out of business.
My point in all of this is not to be doom and gloom for doom and gloom sake – I’m not trying to be Marc Faber or Jim Rogers talking my book on Bloomberg or CNBC. I’m saying all this to impress upon you how important it is to worry more about containing he risk in your portfolio than missing out on a rally that has a very low chance of happening in the first place. That Goldman Sach’s S&P500 target is now almost 45% away and the hurt is palpable. It’s not too late to reduce exposure to equities and increase exposure to cash, and high quality/much less risky debt. That doesn’t mean you shouldn’t hold equities at all, it means to hold less. Avoid the temptation to bottom-fish banks, brokers, cyclicals, industrials, transports, materials, techs and other relatively high beta, economically sensitive sectors and instead focus on well managed, well financed less cyclical names likely to survive this hell of a cycle. I think a names like DE and NUE are still good shorts. And am likely to put FSLR on short as well. I’ll be back to you soon with more names both short and long. But first I’ll tell you why I think TARP is a joke and I’ll suggest what I think is a much better way to stabilize the financial system in a much more cost effective way.

The "60 Minutes" story on oil speculation was spot on - facts, not shabby conjecture

Everyone seems to be bashing the 60 minutes story about speculation causing oil to surge to $147. After reading the articles published at SeekingAlpha.com I felt compelled to see how bad this segment was, so I went to the 60 minutes website to take a look see. I expected to see a chop job; but what I saw was an excellent laymen's explanation of how speculators and investors with fiduciary duties turned speculator contributed to a bubble which helped send billions of Americans hard earned money to Saudis, Iranians, Venezuelans and others who laughed all the way to the bank. These CBS bashers either have no idea how energy markets work or are spinning the truth because they have an axe to grind with CBS. It's a shame because for people that have a cursory interest, these clowns just effectively made a very enlightening report questionable to those honestly uninformed who would like to understand the issue better. And all they say to support their position is that the EIA has a graph that sort of makes it look like price tracks demand very closely. The truth is EIA estimates change with the wind - if your memory is that short you too should check the record. The EIA makes intermediate and long term energy supply and demand estimates that are awful - they failed to anticipate the CYCLICAL market tightness and failed to anticipate the cyclical downswing.

One of the first lines in the report asserted that the oil price spike was not caused by oil company CEOs or sheiks but speculators and other so called institutional investors like Hedge Funds (like Citadel, Amaranth and Ospraie), Commodity Traders in Chicago and Europe, Morgan Stanley, Goldman Sachs, J.P. Morgan, Barclays, Sovereign Wealth Funds, Yale, Harvard, as well as, Pension Funds like CALPERS and others. That this is debatable is crazy. It is a FACT that these entities entered the oil market in a big way during the bull market in oil. The story asserted that over a 5 year period the amount of energy futures traded went from $13B to $300B - this too is a fact. It is a fact that Enron lobbied aggressively for changing the rules so they could control the market more and got what they wanted. It is a fact that Morgan Stanley owns more pipeline, storage, production and refined product than most oil & gas companies; this wasn't the case in past cycles.

You don't have to be a forensic scientist to understand they did it because the asset class was going up for a long time. You can delude yourself with rationalizations if you please but this is no different than what pension funds did when they doubled and tripled their allocations to unseasoned and excessively leveraged "alternative investment" strategies. Yale did it first and looked like genius, everyone else felt either inadequate or couldn't deal with missing out. It really is that simple. Allocations to commodities increased because they did well for a long time. MBAs, CFAs and Quants everywhere fabricated a few correlations graphs and an articulate pitch and presto the blind followed the blind.

The story mentioned that there is very little physical demand in the futures market relative to the total and by far more than there has ever been. This too is a fact, bearish oil analysts which had seen a cycle before pointed this out many times. Sell side wall street analysts talked about this in research reports, Barrons did stories about it, analysts from Sanford Bernstein, Oppenheimer and ISI pointed this out at congressional hearings on the subject. A J.P. Morgan official denied speculation played any part at the same hearing, claiming it was pure supply and demand while another JPM strategist spoke about speculation taking over the energy markets in an email the same day. 60 minutes had the email and showed it. It was obvious to anyone who bothered to check. The 60 minutes story asserted that there were 27 barrels worth of futures contracts traded for every barrel of physical demand and a fraction of those ever took delivery. This too is a FACT - "60-70% of the futures contracts which were (as the story indicated) initially created to help users hedge were held by either small or large specs - I.e. CTAs, hedge funds commodity day traders. You can look at commercials as a percentage of open interest and see how bullishly involved speculators were. Not unlike the real estate market, easy money (institutions that could borrow easily and lever themselves up 20 to 1) and a market that never seemed to go down sucked the suckers in and they got what they deserved.

People told me I was crazy when I told them that demand destruction was already taking hold and the economy was already slowing so it was a matter of time till oil collapsed. I looked like an idiot as I told my friends that I thought we'd fizzle a little past par; figuring that oil would look like it lost momentum near $100, suck some premature shorts in and then proceed to spank us on a move to $110. So I got cute and shorted some black gold at $109 and covered at $117. I got lucky there as I should have also known that we'd go parabolic before the collapse. I could have easily got smoked. But that's another story. $25/bbl increase in a day on NO significant news? $10 moves in each direction? That's not the sort of volatility you see in the middle of moves but rather at tops and bottoms of speculative exhaustion. It seems to always happen that way. Markets that go parabolic are almost always driven by speculation. Permanent supply and demand shocks are rare.

My message is that if it looks like a duck, quacks like a duck and acts like a duck, don't let some clown who cant or wont deal with the facts tell you different. If you didn't watch the story, go see it for yourself. If we were running out of oil or couldn't produce enough to meet demand, you would see the kind of lines and rationing we saw in the 70s. Anyone who was around back then recalls what shortages look like - people waiting for an hour or more in line at gas stations and couldn't even fill up. To even suggest it was all supply and demand is laughable. The crash is proof in and of itself - markets driven by fundamentals do better to sustain price advances.

Nothing in the 60 minutes story was news to anyone with a clue. I'm really shocked at how it came across and appalled at how some "professional money managers" writing here spun it - super weak arguments that by and large missed the point. So I felt compelled to try to set the record straight so others less versed wouldn't get bamboozled. The fact is that no one really knows when the world will run out of oil. Many factors influence energy prices over the long run, including production costs, the dollar, supply, demand and competition from alternatives, etc. But bubbles are usually borne of cyclical (and ALWAYS temporary) supply/demand imbalances exacerbated by analysts and pundits who con otherwise unsuspecting investors and traders with new paradigm type stories. There's a saying in the commodity markets that goes "price cures price", in other words, high prices are the cure for high prices. This has been and always will be true because of the economic sensitivity of commodities and the ability of commodity producers to always race to make hay while the sun shines. OPEC didn't cut production while prices surged. The laws of supply and demand are called laws for good reason.

The ultimate game changer – why 2009 will be worse than 2008 (part 1)

In the last 2 weeks it seems that the bulls are coming out of the woodwork. Don’t get sucked into the idea that you should chase this rally! What may appear to be a light at the end of the tunnel is probably a train. No one seems to have a good idea of what earnings might be, yet all of a sudden, bullishness abounds. Very well managed companies are guiding down multiple times early in a quarter, with no improvement in sight, yet the fast money crowd doesn’t seem worried.

I’ve watched the credit bubble popping events unfold in the context of a volatile history. I’m cognizant of the fact that is has never paid to stay very bearish for long as America is a remarkably resilient nation – we’ve overcome Herculean challenges like the depression and WW1 and Korea and Vietnam and oil embargoes and gulf wars and internet bubbles and more. However, none of these challenges compare to what decimation this credit bubble popping has wrought.

I view the stock market game as a probabilistic field of sorts. We effectively consider what’s known and unknown and try to estimate the expectancy of the potential outcomes with our incomplete information. Looking at what’s happening economically is scary – the pace and magnitude of decline in economic activity and leading indicators has been historic.

Perhaps an arguably crude analogy can put this in the proper light. The first analogy I could think of is the initial phase of hurricane Katrina. Strong winds struck and rattled a lot but the damage appeared to be well contained and surmountable initially. It wasn’t until the insurance in the form of a levy failed that we realized that we were in a heap of trouble and needed to do something about a potential catastrophe turning probable, however, we had no reference point to help us understand the magnitude and the duration of the destruction and its painful aftermath.

Today the big question revolves around how bad earnings will get and what the nature and timing of a recovery might be so we can decide whether the market is cheap or expensive relative to such a base case scenario so we know how aggressive we should be and how much market risk we should take on. The idea being that if we reasonably estimate/approximate what the next 12 months earnings yield and longer term growth rate might be, we can also craft reasonable expectations of what the central tendency of stock prices might be in the year or two ahead.

What’s more is that none of the bulls seem to have a clue as to how and when the personal incomes and corporate earnings (which I assume would support a sustainable stock market recovery) is likely to manifest. And it also seems as if everyone is expecting that multiples should be similar to what we’ve experienced in recent history, despite the glaring fact that the game has changed such that when the growth needle moves noticeably it wont be very significant unless we start from lower bases still.

In prior bear markets and recessions, much damage was done but the lifeblood of markets, (ie. Liquidity and credit) remained in tact. Credit markets remained functional and countercyclical monetary and fiscal policy acted upon the supply side and demand sides of the economy and helped get the cogs of capitalism turning again. Textbook Keynesian dynamics – when consumers and the private sector lack the will or ability to spend, Uncle Sam increases everyone’s allowance and the Fed makes financing your spending easier and cheaper.

Meanwhile, the banking system facilitates stability and an eventual recovery as enterprising Americans take advantage of apparently depressed asset prices, goods and services prices, labor prices and capital prices. That, more or less, is how the cycle plays out and a new growth cycle is born in the ashes of the last bust. The key here is that the banking system is willing and able to facilitate commerce and inject the lifeblood of the economic growth to markets. It’s not only about keeping otherwise viable businesses solvent with the help of credit; but also sowing the seeds of economic expansion which yields jobs, income, wealth creation, and improved asset prices.

The credit bubble that has popped changes the game more than most appreciate. Many think it is a matter of time that things return to whatever normal they thought was in the markets but I’m afraid that is more than a tad presumptuous. Our economy is in a literal downward spiral and the conventional countercyclical remedies are either impotent or insufficient to mitigate the seemingly exponential headwinds because the banking system has become dysfunctional and permanently impaired. Life as we knew it is over because the real pie is actually much smaller than anyone thought and it will not grow like it did in the past because credit, lending, saving, risk taking and investing behaviors will change for a generation. You are likely to see less, more costly credit, more saving itself constrained by real income, less risk taking and less, and more conservative investing.

If you further consider that the government sector may not spend as much as everyone thinks; the outlook dims even more. It seems that everyone thinks that the federal government will spend without limit and backstop anything and everything such that a recovery is likely to come much sooner than leading economic indicators seem to suggest. I hate to burst your bubble but I think that as conditions deteriorate further in the next 3-6 months, it will become increasingly clear that government spending levels are also unsustainable and the focus is thus likely to turn to smarter/more efficient spending which will “shift priorities” and “limit waste”. So a lot of the incremental new deal type spending is likely to be offset but budget cuts elsewhere. Additionally, I think many are underestimating the extent of belt tightening at the state and local level.

At the same time individuals are likely to voluntarily and involuntarily curtail spending because the game of lending anything to anyone is also over. A great deal of economic activity happens because credit is available – no credit means that business, spending or investment doesn’t get done. A generation that was enabled to spend well in excess of its means will have to learn how to save. People will still want to buy houses, cars and other big ticket items but the no money down game has changed such that saving will increase which is good longer term but obviously will defer consumption accordingly. Surprisingly few Americans have the ability to put 20% down on a $300,000 home. One of the scariest things (because I don’t know how to quantify it) is the idea that in order to manage the massive credit expansion from a personal balance sheet perspective, the pie must continue to grow meaningfully. This generation has accumulated very significant debt service burdens which are obviously unmanageable from a cash flow perspective but also will act to crowd out future spending and investment. This is likely to act as an another albatross of sorts; especially if baby boomers try to salvage whats left of their retirement nest eggs/prospects by saving more.

Yet market pundit after market strategist after CNBC guest seems to think the “THE” bottom is in. Very oversold in the context of time such that a very sizeable rally on the order of a good stock market years returns sure, but “THE” bottom? I doubt that very much – it’s possible but highly unlikely in my view. I certainly wouldn’t bet on it because I think it’s much more likely that the next big move from here is NOT up. Don’t believe the hype! Focus more on managing your risk instead of missing out on something unlikely to happen. Stocks don’t typically do well when guidance and estimates are being missed.

I’ll be back soon with some more ideas which I hope make my points clearer and also a few ideas both long and short that I think can do well to make your stay in the house of pain more comfortable. To be continued (in part 2)….

Garpy health care ldea - MYL

Growth at a reasonable price in healthcare – Mylan on the comeback trail
By Allen Phatimer

Thinking about ideas that are somewhat countercyclical in nature but also have a good chance of support from industry specific trends and/or company specific dynamics which can yield cash flow and earnings acceleration lead to me like Mylan (MYL).  I view this as an out of favor name in an out of favor sector; a contrarian idea which would effectively surprise positively if they simply met guidance or a consensus) of non-belief) below management's guidance.  Expectations are very low in my opinion, and its understandable given the history; but Mylan suddenly appears positioned to beat expectations and gets no credit for that prospect.  Management sounds very confident regarding their financial prospects yet the street says single digit forward multiple until Mylan shows us the money.

The history for those of you that don't know is that a couple of years ago the company had improving new product momentum, was valued cheaply and primed to fly as they blew out estimates for the first time in a while.  Instead of leaving well enough alone, they did a pharmaceutical ingredient co. acquisition which made sense strategically and was bought at an arguably fair price but then quickly got into a bidding war for Merck KG's generic drug business.  Merck KG was more than twice their size and also made sense from a longer run strategic perspective as it gave MYL access to new faster growing markets in Europe and Asia and effectively would make them a global player which would leverage the new ingredients, lower cost manufacturing capacity and distribution.

It could have been brilliant; if only Mylan didn't over pay.  As it turned out Mylan got into a biding war with all the big global generic guys AND about 4 private equity investors.  The bidding got too rich for the publicly traded companies involved and private equity investors gave up shortly thereafter. MYL won and went from a company trading at 9 times earnings with sales momentum and operating leverage positioned to beat estimates for the first time in years, to one paying a big premium and diluting the hell out of its shareholders as they financed the deal (with stock and debt) after they stock went down significantly.

The company has since put up weak results and guided down a couple of times but now guides to significant improvement which no one seems to believe.  That now appears poised to change. Earnings out a couple of weeks ago look much better than expected and MYL reaffirmed guidance for both 2009 and 2010. Sales, margins and net income were substantially better than expected and synergy potential still lies ahead of them.  Management said they've realized $100M of the $300M in synergies they plan and expressed confidence that they achieve their target of $300M by year end 2010.

Furthermore, the co. detailed the pipeline; which includes 93 ANDAs related to about $65B in branded sales of which 22 are potential first to file opportunities related to roughly $12B in branded sales. First to file opportunities are a boon to generics, where companies have 180 day exclusivity and not only price much higher than competitors that join the fray on day 181; but also work to cement sales relationships in these new products before competition arrives.

The pipeline is key because new product momentum is what will offset pricing pressure which is a fact of life for generics.  In the quarter recently reported Mylan posted better sales and margins, mainly due to a improved mix of higher margin U.S. sales which more than offset pricing pressure in Europe and to a lesser extent Asia.  Mylan is very well positioned on this front; and the share price gets no credit for this in my opinion

Another key part of the investment case is that utilization increases at the same time that a lot more drugs go off patent in the next 3 years.  In 2009, 2010 and 2011, more branded drugs will lose patent protection than ever before.  And as more people across the globe have access to cheaper medicines and payers and governments push moves to generic alternatives to cut costs, utilization can also grow.  So this is really a long term investment call.

The idea is to be there in front of the potentially big earnings momentum in 2010 and 2011, when Mylan is launching new blockbuster generics and fully leveraging its leaner cost structure.  If spending is kept in check, free cash flow should grow nicely over that time and can really explode in 2011.   The few bulls in the name talk about opportunities in biologics although that can be another significant growth driver post the patent expiration bolus in 2011; that's too far out and too uncertain to hang your hat on in my opinion.

The company is looking for mid to high single digit revenue growth for both 2009 and 2010 and if you conservatively extrapolate what the co. expects in terms of R&D investment and SG&A, you get to roughly 200 basis points of operating margin expansion in 09' vs. 08' and another 100 basis points in 2010.  That translates into huge operating leverage as pre-tax earnings grow 40-50% in 09' and another 20% in 2010.  If you assume a constant 34% tax rate, you can get to $1 in 2009 and $1.40 to $1.50 in 2010.

It's worth noting that management guides to a range of $0.90-$1.10 in 2009 and $1.50-$1.70 in 2010. So, good execution and a modicum of pipeline success can easily make EPS $1.50-$1.60 or more in 2010.  If Mylan can do $1.50, I think its reasonable to expect a market multiple by year end 2010 (let's assume a conservative 12X's) and that gets you to $18.  That's a double ladies and gents.

On the flip side, there's little reason to expect any less than 10 times on a $1.40 number if execution is solid, so the margin of safety is substantial.  If on the other hand, estimates are topped and the number is closer to $1.60, investors are apt to get really excited and bid the multiple to 13 or 14, which would get you north of $20/share.

On a shorter term basis, I think a couple of marginal earnings beats can get this name 11 times the $1 expected in 2009.  That would amount to a 20%+ gain from here in the next 6 months and the street would likely look to roll that target multiple forward to a $1.40ish number for 2010 – which would get you north of $15 a year from now.

So the net-net here is that you have a decent company in an out of favor sector and industry that has stumbled and appears to be regaining traction at a time when secular trends are poised to improve and mitigate cyclical pressures in the years ahead.  Sentiment is bearish, management has a credibility issue and valuation at 9 times 2009 EPS reflects. Several things can go right in the next 2 years and MYL can standout as a margin and earnings growth story in a world where few exist.  Estimates appear to have stabilized, expectations are positioned to bottom and valuation multiple have minimal risk in my view, IF Mylan can simply hit its targets.

Meanwhile, huge amounts of patent expirations in the industry, a record number of first to file opportunities and yet to be realized merger synergies are reasons to be optimistic that Mylan can deliver better results. Some might question its balance sheet as the company put a lot of debt on to pay for the Merck KG assets.  Fair concern but the cash flow is relatively visible and stable and the interest expenses well covered in even a very bearish scenario for profitability in 2009 and 2010.  Thus I think the debt service burden very manageable and if the balance sheet is delivered faster than expected, which is quite possible; it would add additional support to EPS growth in 2010.

The shares are well off their recent lows and thus apt to give a little back in the days ahead. So you have time to build a position by buying a little here and adding on any meaningful pullback.  The recent trading action and very short run chart pattern seems to indicate that the shares are under accumulation so I doubt a big pullback is coming.  I'd expect pullback to find support in the $8.40 to $8.50 area and better support near $8.  If your approach requires one, I'd suggest using stop at $7.80.  If you can take a longer term view, I would look to buy a third here and third at $8 if it ever gets there and another third at $7 if that happened, all else was equal.  At an average cost of $8, I think you'd be getting well compensated for the risk and would stand to do very well if anything went right.

Hologic (HOLX) A Top Healthcare Pick for 2009

Hologic (HOLX): A top pick in Healthcare for 2009?

A quest for value and alpha in well financed, well managed defensive names with solid visibility, reasonable growth prospects and discount valuation leads me to digital mammography and Pap test leader Hologic. The shares are off to historical trough multiples at significant discounts to what appear to be lesser peers. But with a solid quarter, reset and achievable expectation and a call that detailed how upside to 09’ expectations is probable; I cant help but think about what can go right at this juncture.

The shares have been in a slide for the better part of a year in reaction to a major acquisition (Cytec) which looked suboptimal and expensive initially and proved naysayer right when the sales growth of the acquired product portfolio slowed profitability suffered and investors began to aggressively discount the expected sales and margin benefits the co. did the Cytec deal for in the first place. And then came the currency headwind. And then a sales miss. And did I mention the push out of a new sales and margin driving product?

Needless to say, the bears were vindicated and burden of proof shifted directly to management’s ability to execute on improving acquired sales growth and new product commercialization which looked increasingly difficult in the face of mounting macro and industry specific headwinds. Understandably, long time longs threw in the towel, shorts pressed their positions and the share price has gotten pummeled.

What’s the point you ask? To make a short story long, I think HOLX shares might now represent the kind of relative value associated with a stock with reasonable growth prospects and margin expansion opportunity in a world where few can grow or hold margins.

Sales were better than expected on strong organic unit sales growth. The company’s breast health sales were solid, orders were strong and management was somewhat optimistic about a rebound in acquired product sales. Gross Margin dollars were higher and operating expenses lower so operating income topped expectations. EPS was in-line.

Breast Health of sales of $221M were up 25%; guidance is for 5% in FY09’, Diagnostics revenue of $133.7M was up 11% y/y; guidance is for 15-16% growth in FY09’, and GYN/Surgical (which is essentially NovaSure) sales of $59.7M were up 2%; but that’s an improvement from the last couple of quarters and management is looking for 17-18% growth in FY09’ in that division. Management's new FY09 guidance is for 9-10% sales growth to $1.82-1.85B and non-GAAP EPS of $1.22-1.44.

All in all a solid quarter with excellent unit growth in profit driving digital mammo, steady Pap test sales and a rebound in Novasure (key products acquired from Cytec). And management lowered guidance to account for recession worsening, credit tightness, currency pressure, and slightly negative mix. Management removed any considerations for new product sales. And that only lowered numbers slightly – much less I think, than was feared. Exactly what you needed to see, in my opinion, in order to begin to exit the show me stock status Hologic earned.

It appears that the share price (at roughly 11 times forward earnings) discounts a substantially worse unit growth and pricing pressure in key cash flow drivers than management or most analysts do with no help from new products – i.e. what amounts to a worst case scenario. So risk (in the company specific sense) with respect to earnings and multiple appears relatively low if can make it’s numbers because the unusually low multiple should hold provided the market doesn’t continue to slide hard.

One might also think that risk (in a margin of safety sense) is relatively low if valuation on cash flow, margin potential and returns of such franchises as Hologic’s is low – as I believe it is. One might also conclude that a company that considers pressure on unit sales growth and margins that they are yet to realize, and omits likely incrementals in its guidance is being very conservative and thus risk to their estimates is low so that sort of risk appears to be relatively low.

Management considers the macro pressure (which they still say they haven’t seen) and no new product contribution in the $1.22 guidance, when there is a high likelihood of additional revenue streams ramping by year end 2009, and 9% revenue growth that is fairly visible (strong order growth, and substantial backlog) and stable margins that can expand as sales growth accelerates.

Management seems confident that digital mammography unit sales would be up in 09’ vs. 08’. They admitted average selling prices might be under slight pressure but suggested that the guidance took that into consideration. I can’t help but wonder is management is more bullish than they let on about unit sales.

Another interesting thing about this situation is that cash flow appears to be resilient in the face some level of the aforementioned macro headwinds, while the company has a few significant growth drivers and cost save opportunities (like the new products and ramping utilization in a new low cost facility or synergy from integrating Cytec). Thus you might think that adds more flexibility to meet numbers.

So as the market grows (however slowly) and penetration increases, revenue growth can accelerate and margins can increase a couple of hundred basis points by year end 2010. The 1.22 can turn into 1.30 which might get a 12 multiple (~$17), and 15% growth rate in 2010 can get you to 1.50 for 2010 and could be as high as 1.60-1.70 on such faster, higher margin sales growth and a little operating leverage. And that 1.65 might garner a 14-15 time multiple (when the co. is beating estimates and raising guidance) and that might get you to $23-$25 12-18 months out. If anyone knows how wrong I am, please do tell.

Don't call it a comeback

After writing my first few blog posts a good friend of mine suggested I turn it into something bigger and better than a blog full of market rambling. He suggested that incorporating technical and market timing insights and ideas to my fundamental value approach was a good idea and I agreed. Though my specialty is So I took a hiatus and started building a larger website and an almost done with the finishing touches. We hope to launch by December 1. We hope to see you back then. We'll be discussing equity, futures, options and system trades and investments. I'll be back to give you the new url soon. Thanks for you patience; it'll be worth the wait!

Know When To Hold em' Know When to Fold em'

A reader says/asks "Steel stocks look awfully cheap and commodities are running higher again, what do you think about getting long some steel here?" Thanks for the layup comment/question; here's the long and short of what I think.

My short answer is: in my opinion, if you are talking about a short term trade, you may be right to want to be long and steel take one more run higher before a substantial decline; however, if you're talking about a longer run commitment on the long side for an extended bull run then I'd have to disagree. Why? Simply because we are of the opinion that we are more likely than not in the late innings of the bull market in steel. We also think the industry's cyclicality is being underrated. Its quite possible that peak earnings are in the books and few want to admit that.

Now for the long answer:

The longer term technical trends are still favorable. Valuation (on Earnings, Cash Flow and Free Cash Flow) is still on the cheap side when you consider either trailing, current or forward earnings. The group and most of its members are still performing well on a relative basis. Most of the major steel companies have posted disappointing earnings for 2-3 quarters now. However, disappointing results were not very surprising and bottom lines have held up much better than bears would have guessed.

Expectations have been guided conservatively so bullish sentiment appears to be moderating. Nevertheless, I sense that sentiment is still tilted toward the bullish camp as most commodity prognosticators and market pundits seem to be either raging bulls or cautiously optimistic. So with technicals and fundamentals more supportive of the bull case, we think it makes most sense to either be on board the prevailing trend if you are a trader or stay long if you are an underweighted investor. If you are overweight metals and commodities as a longer term investor at this point, then I'd consider starting to scale out of some of that exposure; especially in steel.

Why be negative in the intermediate or longer term? Because we doubt that the next big move is up. Why? Because fundmentals have clearly deteriorated and may very well get worse sooner than most think. And because the sheer cyclicality of the steel industry seems to be underappreciated. Most seem to believe that steel companies are immune to the recent changes in U.S. and global macroeconomic conditions. We beg to differ.

Some of that has to do with demand being more resilient than expected, some of that has to do with the weak dollar, and some may have to do with the successful global capacity consolidation we've seen at the hands of the Mittals of the world. Some may have to do with cost inflation and higher shipping costs keeping prices more elevate than would otherwise be the case. All of which is understandable. Nevertheless, we still think the cyclical influences will have their say - it's just a matter of time.

If growth slows globally (as I expect), then it's only a matter of time until demand softens, inventories build, and shipments slow. Meanwhile, the cost side of the equation would likely lag on the downside. Since this is happening slowly, I would think that capacity and overproduction would also become an issue. If/when revenues slowed and costs could not be cut fast enough negative operating leverage would become an even bigger issue and profits would be under serious pressure. When estimates are reduced further, shares wouldnt look so cheap. Steel stocks would sell off and the trend and momentum would go the other way; and so would a trader's reasons to be getting long.

Good Night and Good Luck.

Chasing Powerful Profits & Timing Alpha Well (Hopefully)

Alphatiming is everything! Because of the inherent volatility and mean reversion, we are of the opinion that you are more often than not better off buying pullbacks when trying to get long and selling rallies when trying to get short. Buying break outs and selling breakdowns is fine when your directional bet is correct immediately; however, timing itself is generally a low win rate endeavor.

Thus the odds of being precisely correct are relatively low so you should try not to combine entry decisions with buying/selling overbought/oversold or chasing something unless the magnitude of your expected win can justify that risk. If you resisted the temptation to chase the market or your favorite stock in the last week, you're probably better off for it. If I had a nickel for every time I heard someone say "this volatility is good for traders", I'd have a small fortune. Volatiltity may be good for daytraders and market makers, but its probably overrated for swing traders and investors who either get shaken out of positions or influenced to act incorrectly.

That said I'd like to share a few thoughts about a company that has quietly been blocking and tackling against very formidable cost inflation which it finally appears poised to overcome. The name of the company is Exide (XIDE: $8.37 as of 2-6-2008 close). XIDE makes a range of batteries for a range of end markets including autos, trucks, telecom. Risks are plenty; ie. macro, automotive sector softness, telco spending moderation, incremental surges in lead or other raw materials; nevertheless, this is a company that was generating a ton of unprofitable revenue as a result of cost of it's key raw material skyrocketing. Now that revenue growth is stronger AND finally becoming substantially more profitable.

Sentiment is terrible. No one covers it, people that know it hate it – busted IPO that’s been a disaster for virtually every long since its IPO. Many are playing it short on lead price derivative (big short interest). But end markets seems solid on the demand side and not pushing back on price increases (unit growth solid mid single digit, in spite of weak auto sales). XIDE appears to be taking a little share, raising prices and cycling past bad contracts that didn’t reset fast enough to offset surging lead costs. XIDE hasn’t had a problem raising prices – both XIDE and competitor ENS have raised prices and haven’t lost customers. Most remaining bad contracts (whose pricing couldnt keep up with lead cost inflation) should be reset by next quarter, so profitability should continue to improve.

Additionally, Margins – both Gross and Operating Margins are improving. Manufacturing costs are declining and probably not done declining; doing a good job managing expenses. So productivity is improving. And Operating results, profitability and financials improving. Balance sheet somewhat levered but manageable because cash generation increasing. DSOs are also improving. XIDE recently did a $91M rights offering. Have sufficient Cash, Equivalents, and revolver, etc.

Earnings results indicate that XIDE's financial performance is quickly catching up with its market fundamentals. If lead prices could come in a bit more and not go higher and global economy does not slide into bad recession, EXIDE may generate significantly improving cash flow and earnings in the coming quarters. The operating leverage here is potentially huge - we love that. Tomorrow's action is sure to be interesting as the shares are trading at key technical levels and the market is under significant pressure of late. Alphatiming will tell; we should know know more by 11AM when the earnings call ends.

As always, this is not a recommendation to buy or sell. This post is for informational purposes only. The writer has no position in XIDE. The information, thoughts and ideas shared herein should not be construed as a recommendation or solicitation to buy or sell securities. Furthermore, the information, thoughts and ideas should not be interpreted as investment advice. The author of this blog is not a registered investment advisor. The ideas speculated upon and discussed herein may not be suitable for you. We recommend that you consult a financial advisor or registered stock broker before making any investment decisions. We in no way warrant the accuracy, veracity or completeness of any of the information posted on this blog.

Trying to Trade Signals in a Timely Fashion and Tune Out the Noise

A substantial move down, a substantial move up and now a game of hurry up and wait to see if we just witnessed a major low in several choice longer term buy candidates. Some think the bottom is in, others think the oversold rally has run its course and has already given way to a resumption of the bear trend.

As we discussed last week, its our view that major very tradable and investable lows are in for several names and groups so we will act accordingly and attempt to time entries and accumulation strategies. We continue to think that there are many compelling buy candidates available and think the next big move is not down in the case of several quality stocks we want to own as the pullback with the market in the coming days.

In the coming days, we'll be looking for confirmation that our view is likely to prove true in a few specific names. For increased confidence, we'll look to clues in volatility, relative strength, shorter term trading patterns and changes in volume - signals in the noise which 50 different pundits will try to explain 50 different ways.

In terms of industries, we are looking most closely at oil services, financials, chemicals, hotels and even semiconductors. We have several solid oil service, financial, hotel and chemical names in mind and are doing some work on a couple of semiconductor names we'd like to discuss soon. Interestingly, none of these industries can be bought wholesale as they are frought with risk and filled with companies more likely to disappoint than not. That's where the opportunity comes in: these groups have discounted a fairly dire scenario almost across the board - in some cases we think the discounting is overdone.


For now however, we'll tune out the noise and spend our time kicking more trade/investment candidate tires, and monitoring how our favorite charts and indicators are developing. We are waiting for more opportune entries to present themselves instead of getting are asses whooped my market makers, specialists and Mr. Market. Not to worry, we plan on having something good tomorrow. Tune in tomorrow for a couple of equity and option ideas we think are particularly interesting.

Alpha Timer