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.