Market Passion - Macros.Fundamentals.

Fishing for value - some good picks in retail

2010-09-11T12:30:00.001-04:00

Since hitting their highs in March-April, the retail sector has taken a strong beating over the past several months. A significant correction was bound to happen since the uptick in the first 3 quarters in stocks in this sector was way too steep to be sustainable! However, by any stretch of logic, the current valuation levels are too low, unless you are a firm believer of a clear double-dip recession.

Let's start with the economy - as i opined in my last article, there are simply no clear indicators of a double dip - despite the fact that employment stats would remain depressing for quite some time. Recent indicators on home sales, manufacturing and retail have been very mixed too, indicating a slow but choppy recovery. Neither the government nor the private sector can afford a double dip at this point, and given the speed with which stakeholders have acted to quell any fears of a slip-back in to recession, there is little reason to worry about a double-dip actuyally happening. More over, many real indicators are so depressed that there is not too much room to move down from here. Given this, I would put my bets on at least a minor-to-moderate rally in the retail sector over the next quarter, especially with back-to-school and holiday seasons perking up sales.

In fact, August numbers from several retailers beat analyst expectations, helped by increased promotions, and a pickup in back-to-school sales. Overall same-store sales (Retail Metrics index culled from 30 retailers) rose 3.5% as against an analyst expectation of 2.8% - this is the first time since Q1 that there has been a positive surprise. Several retaliers had positive same-store sales suprises - from Costco (7%) to Nordstrom (6.3%) to Zumiez and Wet Seal, numbers were good pretty much across the board, though not for all names.September results will be critical to guage overall trend, as the back-to-school season is the next biggest period after the holiday season, and is often a good barometer of Q4 peformance. Just looking at the lines in front of retailers like ANF, M, JCP, it is hard to doubt the fact that it is going to be a better Q3 and probably an even better Q4. My wife went in for the Macy's one-day sales today here at Boston, and from her words, it feels like it's Thanksgiving weekend already - clearly there is enough steam left in consumer spending to present positive surprises on currently depressed expectations!

Some names are interesting in specific:American Eagle (AEO), Aeropostale (ARO) are decent picks to ride this season, given current valuation levels. However, among all the good picks, i would put my money on JCP and KIRK.

JCP is trading close to its 52-week low at about 21, and not too far from its 5 year low. At a P/E of ~16+, with its value-for-money merchandise positioning, i do not see much of a downside. If initial back-to-school trends are an indication (August sales up 2.3% as against an analyst estimate of 1.6%), it should see reasonably healthy Q3 numbers and a good Q4. Given the choppiness of the market and the high stock beta (1.7), i would not bet on near-term options though...would either go long on the stock or Jan '11 options. From a timing perspective, note that Q3 results will be out in mid-November.

KIRK is trading at 12+, close to its 52-week low of ~10 and far below its high of 25.3! Given the spread and uniqueness of the merchandise they carry, i would jump on this stock at its current P/E of sub-7! The stock has been hammerred badly ever since May primarily because same-store and overall numbers failed to keep the abnormal growth trend shown over the previous year. Q2 2010 revenue numbers were only 2% higher Y-o-Y and same-store numbers were only 1% higher...it was a case of expectations going way above normal, and a correction to reflect reality - however, the downward correction has been clearly overdone, and i would bet on a level of atleast 16-17 by Q4. As mentioned earlier, i would rather go long on the stock or longer-term options as against near-term options. Again, from a timing perspective, note that Q3 results will be out in mid-November.

Volatility still rules - but do we need to necessarily be on cash?

2010-07-02T15:51:00.004-04:00

Ever since Q1 '10 calm was broken by the Greek crisis, markets have struggled to remain steady. VIX, VSTOXX and other volatility indices around the world are near 52-week highs and there is a very heavy sense of uncertainty across markets globally. The DJIA has already fallen close to 9% from the 10,500 levels in early January to 9600 levels as of today. Emerging market indices have also been as badly affected - the MSCI emerging market index for example is down over 8% YTD and the Shanghai index is down over 27%! It is perhaps safest to be in cash during this period of high volatility; but there might be an attractive risk-return play at current market levels.

It is important to understand macro trends at this point:

Europe
Budget tightening prompted by high deficits will cause restrained growth/slow down across Italy, Greece, Spain, UK; and this would mean subdued growth in the near term for the Euro region as a whole. However, valuations across Europe are at one of the most attractive levels in the last decade [STOXX (P/E - 12.1), FTSE (P/E - 13.2), DAX (P/E - 14.5) etc], and hence there is little room for heavy downward correction in the short-term. Also, the quickness of response from Euro region countries during the Greek crisis earlier this year showed that there is enough governmental support to prevent any drastic fall out.

China
Property price pressures will continue to affect China. However, the correction in the market YTD have dragged valuations on the Shanghai index to less than 17 times reported earnings, compared with 37 times in July 2009. This is while economic growth is still expected to be 10.2 percent in 2010 and over 9 percent in 2011! Thus, there is not enough fundamental pressure to push stocks downward - and an upward correction in this quarter is highly likely. In fact, many investment banks including Morgan Stanley, BNP Paribas SA and Nomura Holdings have predicted that stocks will rally - especially since China’s recent decision to end the yuan’s two-year 6.83/dollar peg to the dollar will help curb inflation and asset bubbles.

Other emerging markets
Most other emerging markets have dropped heavily YTD too, except India (BSE Sensex) which has stayed closed to
neutral). Brazil’s Bovespa index dropped over 10 percent YTD and Russia’s Micex slipped over 8.5%. However, economic growth projections are still strong across most emerging markets, ranging from 3% in Russia to 9%+ in India. And its
important to note that most of these (except perhaps Russia) are cases where growth is driven by domestic demand and not necessarily deeply tied to global trade flows.

US
Job growth in the US is still constrained with unemployment rate projected to stay in the high 9% range till end of 2010 and probably well in to 2011. Partly due to the same, the housing market would continue to face pressures - the recent bill (to extend the date for the 8K rebate to Sep) not withstanding. However, projected economic growth across Asian and Latin American markets should continue to drive manufacturing exports. Banking balance sheets are much cleaner too - though regulatory pressures to add capital would continue, increased trading revenue due to high volatility, gradual pick up in consumer and corporate credit, and a moderate revival in the wealth management space, would help earnings. Retail stocks should also look up after the heavy sell off during last 2 months, which have left valuations at very attractive levels.

Thus, there clearly are enough factors to sustain market volatility - risk of further sovereign downgrades in Europe, potential of aggravated property price corrections in China, speed of US economic growth and job creation, sustainability of growth in other emerging markets etc. Any balanced investment strategy should hence favor heavier weightage towards cash. However, there are more valuation and macro economic factors pointing to a market reversal than a continued downturn. It is definitely not an easy call considering the continued volatility, but a thought-out riks-reward play should favor going long on emerging markets and the US. Index bets are safer than individual stock bets due to aggravated volatility though.

Financial stocks - Trouble is not over yet!

2010-05-16T06:47:00.011-04:00

After a couple of weeks where every one was more focused on the VIX and the VSTOXX than any thing else, it is interesting to sit back and try predict where the markets are going to move for the rest of the year. We can be sure about a few things - the European debt crisis is far from over, property (and hence stock) price correction in China still has quite some way to go and the banking sector in US and Europe hasn't seen the last of regulatory changes! Considering the above, any long-term directional strategies are prone to extreme volatility...it's much safer to sit on cash and watch from the sidelines! But, if you have the appetite and energy to track and play index funds, there is more money to be made than any other time - provided one doesn't get greedy enough to try and catch the rock bottom or time the peaks!

If there is one sector to avoid jumping in to invest at this point, it is financials. A combination of factors would make good returns on equity extremely difficult to achieve in this sector. A simplistic way to look at how ROE can be impacted for this sector is the way Dupont model looks at it:
Return on Equity = Net Income/Equity = Net Income/Sales * Sales/Assets * Assets/Equity

Factor 1 - Corporate and investment banks would be forced to move out of more and more of their propreitary trading functions out of the banking entity if not stop some forms of propreitary trading altogether. The recent news on Goldman stopping prop trading on CLOs should come as no surprise. Though the regulation to carve out swap desks from FDIC-covered entities would probably not see the light of the day (and would be a shame if implemented!), there is still the looming possibility of regulatory restrictions forcing banks to curtail some of their most lucrative revenue streams. If not regulatory changes, the very fact that the more complex, and hence in most cases more profitable, instruments would face higher capital charges would force banks to be much more selective in the new product area than they ever have been. Winning banks would however find a way to manage capital risk and liquidity risk well while still forging ahead with products that provide greater-than-normal returns. That's why GS and JPM are still good bets in the medium term despite any negative publicity and legal risk that stares in their face!

Factor 2 - Key drivers for this factor goes hand in hand with some of the drivers from factor 1. The ability to increase sales on assets is severely constrained if banks are forced to depend more on revenue streams from traditional net interest and fee income streams. Trading shops get an unfair advantage in this area - though covering settlement risk and liquidity risk are more important than ever, banks with strong trading desks would continue to exploit volatility to generate maximum spread revenue from trading across different asset classses, while locking up poportionately lower capital than traditional banking functions. Though the last couple of quarters saw low volatility and hence lower spread income than the same period in 2009, the spike in volatility (which i bet is going to sustain itself for some time) would boost trading revenues again for the best trading desks in the industry. Traditional financial entities focused on retail and commercial lending, asset management or for that matter trust and custody, would on the other hand face severe challenges to increase sales on assets. Asset managers would especially see more and more end customers preferring less-lucrative passive strategies instead of higher-spread active strategies. Again, GS, JPM and maybe even MS has an advantage.

Factor 3 - This is an area where every one from the best to the worst in the industry would be hard hit. There simply is no more appetite for abnormal leverage - Tier 1 capital as a proportion of total capital would need to increase significantly from current levels. This combined with the fact that Tier 1 would be defined much more striclty - no hybrid instruments, netting of minority interest components etc for example - would force several banks to raise more capital. The recent directive from the Swiss government to UBS and CS for curtailing risk taking and increasing capital (www.bloomberg.com/apps/news?pid=20601110&sid=aCGxFLs8FV64) is a sign of things to come in this area. There are some analysts who have predicted that US and European banks would have to raise over USD 250 bn in additional capital over the next 12-18 months to meet more stringent rules on risk weighting assets and Tier 1 capital as a proportion of total capital.

A combination of these factors would make it extremely difficult for most, if not all banks, to maintain and increase ROE at or above the pre-crisis 15%+ levels. This, combined with lower options for fueling top line growth, would mean that there is not much room for share prices to go up! I would still bet on GS in specific since it is going to be new product ingenuity and smart strategies that are going to be even more important for driving shareholder value in the immediate future.

But, if governments and regulators go ballistic and blame banks for all the ills in the world (the Greek PM blaming US and European banks for 'misleading them' for example!!), God help even Goldman! It is difficult to find any logic in any kind of mob-mentality driven regulatory action though - blaming Goldman or Citi or JPM for making some propreitary profits on shorting MBS while some clients lost money on it is like blaming your stock broker for increase in value of his personal portfolio while you suffered losses on yours!! It's you who got to take care of your own money! Just to make it clear, i am not talking about asset managers here, but the traditional sell-side part of the industry.

Having said that, GS at 140 or even C at sub-4 is still defintely worth putting your money in!

High-risk (yield) debt markets - Swing back to irrational exuberance?

2010-04-10T12:14:00.004-04:00

Leveraged/high-yield market prices have risen up drastically over the last 6 months, prompting questions on whether the industry is again building up some of the toxicity that caused the previous melt-down. Reports show that leveraged loan prices rose to as high as 92 cents on the dollar per the S&P U.S. Leveraged Loan 100 index, the highest level since late 2008. Global high-yield debt sales has touched over USD 90 bn this year while US issuances have crossed USD 70+ bn, over 5 times 2009 levels for the same period. In line with high demand for leveraged loan issues, spreads have dropped to record lows, with below-CCC categories trading at just over 9 percent - as compared to the long term average of 12+ percent. Also, the trend has not been limited to issuers from specific sectors, but pretty much across the manufacturing and services spectrum.

Though the economy is definitely better placed now as compared to 2009, it is difficult to imagine that risks associated with the most risky borrowers have dropped that low, especially at this stage in the economic cycle...assuming there in fact is a correlation the market is placing between risk and return!

Just to prove a point, let's take a look at a another activity that is not directly tied, but driven by some of the same growth fundamentals - Leveraged Buy Outs (LBOs). LBO funds have raised the least capital over the latest period since 2004 and large funds including those from Caryle and Madison Dearborne have struggled to close LBO funds. Average fund raising length for buyout funds seeking more than $1 billion is as high as 19 months now as compared to 16 months in 2009 and less than 5 months in 2004, per Bloomberg reports...deal closures have been even slower, resulting in firms sitting on massive piles of uncommitted capital. It is safe to argue that there is greater investor sophistication and 'better' due diligence that happens as part of LBO fund raising and deal closure as compared to traditional credit market activity. Also, given the fact that LBO deals arguably involve better reference credit as compared to that associated with high-yield issuers in the primary market, indicators from a tepid LBO market do not augur well for the high-yield credit market. Unless there is a perverse logic that issuers with the highest risk will see faster pick-up in activity during a period of weak economic growth! Just to clarify, I agree there is no direct correlation in the reference entities for credit in both cases (high-yield credit markets and LBO deals), but it should be the same fundamentals - economic growth and recovery prospects - that logically should underpin both markets.

Perhaps, capital market participants have extremely short memory spans - as this article on a recent BCG study points out,
(http://www.businessspectator.com.au/bs.nsf/Article/Boston-Consulting-Group-investment-banks-revenue-G-pd20100325-3V3FW?OpenDocument),
sliding revenues are possibly making profit-driven firms focus on the next stop for immediate super-profits...despite all the talk on risk-aligned performance measurement and deferred bonuses!

View on April earnings calls - Financials

2010-04-01T17:10:00.003-04:00

Quite unlike what many (myself included) expected, markets have continued to rally over the
past couple of weeks. Though not unidirectional through the period, the DJIA has inched almost close to the 11K mark and emerging market indices have continued to rise...the MSCI emerging markets index in fact shot up 1.3%+ yesterday! I still hold on to the view that there has been too much-too fast in terms of market rebound and a short-term correction is imminent.

Having said that, there are some interesting picks worth looking among financial stocks -
with a bunch of earnings announcements expected the weeks of April 12 and 19. Let's take a quick look:

JPM/JPMC - Earnings expected 14th April. Trading at 45 levels, close to the 52-week high of 47.5 and 5-year high of 52.6. P/E at 20. Though Jamie Dimon's shop weathered the crash better than most others, most of the upside has been factored in and i don't think there is still enough upside left medium-term. However, trading and asset management revenues should look up though credit card losses may moderate profits. Neutral/no directional view.
BAC/Bank Am - Earnings expected 16th April. Trading at 17-18 levels, close to the 52-week high of 19.1; 5 year number not relevant due to equity dilution post bail-out. P/E NA. Bank Am should show significant gains due to trading and investment banking revenues and loan loss provisions should be tempered enough to beat street estimates. Bullish - can touch 20 post-earnings - watch May strike 17 call options.
BK/BNY Mellon - Earnings expected 19th April. Trading at 30-31 levels, close to the 52-week high of 33.6, 37% below 5-year high of 49. P/E NA. Custody segment should show growth while international revenues will gain from Mellon's share of business. BNY also has lower loan loass provisions as compared to some of its peers. Bullish - watch May strike 30 call options.
C/Citi - Earnings expected 19th April. Trading at 4 levels, away from the 52-week high of
5.4; 5 year number not relevant due to equity dilution post bail-out. P/E NA. Though the US Treasury has announced its intent to sell of its Citi stake (27 and odd %) this year, 7.7
billion shares on a daily volume of 500 million+ shouldn't cause undue pressure on shares.
It is reasonable to expect loan loss provisions to moderate & investment banking revenues to climb...though credit card losses can still renmain at high levels. Citi might show good
margin improvements due to cost rationalization too. Bullish - May strike 4 call options at
~0.25 is a good bet.
GS/Goldman - Earnings expected 20th April. Trading at 170 levels, down from its 52-week high of 193, 25% below 5-year high of 229. P/E of 8.5. Higher fixed income revenues, higher trading revenues in general, stronger M&A and advisory revenues etc should continue to propel growth - though it's difficult to replicate '09 numbers due to lower market volatility/lower spreads. Bullish - May strike 175 call options at ~5.1 is a good bet
SS/State Street - Earnings expected 20th April. Trading at 45 levels, down from its 52-week high of 56, 43% below 5-year high of 78. P/E of 13. Custody and outsourced securities services should show strong growth while asset management should see gains due to a market trend favoring exchange traded funds. Loss provisions associated with conduits should taper down. Bullish long-term - May strike 44 call options at ~2.7 is a good bet.
WFC/Wells Fargo - Earnings expected 20th April. Trading at 31 levels, close to its 52-week high of 32 and 21% below 5-year high of 39. P/E of 18. Wells does not have a strong trading desk, and on the other hand has a loan portfolio heavy in optional ARMs and commercial mortgages. This doesn't provide enough reason for any optimism in the short-medium term, and considering current levels, there is a very strong chance of downward movement in the stock price. Bearish - May strike 31 put options at ~1.2 is a good bet.
CS/Credit Suisse - Earnings expected 20th April. Trading at 51 levels, down from its 52-week high of 60, 32% below 5-year high of 75. P/E of 10. Apart from gains due to significantly reduced exposure to leveraged finance, commercial & residential mortgages, CS should see gains in wealth management, clearly an area which continues to show long-term growth. Neutral-to-bullish - watch May strike 50 call options.

Having said that, it is safer to take bullish bets closer to the earnings dates since a downward market correction (long over-due) might put overall selling pressure interim.

Unsustainable rally and valuations - a correction on the way?

2010-03-21T16:48:00.004-04:00

A look at how some of the retail picks from my last blog performed clearly indicates the rally that this sector has seen in the past month or so.
Walmart from 52.90 to 55.34; March 52.5 options - from 1.4 to 2.9
JCP from 24.89 to 31.42; March 26.0 options from 0.7 to 5.4.
ROST from 46.43 to 54.07; March 45 options - from 2.2 to 8.8.
KIRK from 16.67 to 20.07; March 17.5 options - from 0.5 to 2.5.

Though some of the above are longer-term value plays too, i believe the sector in general has seen too much of a rally considering how fundamentals driving the sector has moved - (un)employment levels, wages...and consumer confidence as a leading indicator. The same probably applies from a broader market perspective too - we have seen a steep rally from early year lows and the DJIA has already touched close to 10,800, a massive rebound from the 6500 levels touched at its worst point. Fundamental indicators on the other hand have yet to show sustained improvement:

Job losses have significantly reduced from 300K per month levels 6 months back to sub-100K per month levels; however that's only arresting the decline and not really driving positive growth
Manufacturing & supply side indices have not budged a lot over the past 6 months - the ISM PMI index for example has only inched up from 52.5 levels 6 months back to around 56. More importantly, there has been some deterioration over the past 2 months
Housing market inventory remain reasonably high at 7-8 months of sales nationally and hasn't budged from that levels for the past 6-9 months. This is despite continuation of the tax credit in to 2010.
Personal consumption expenditure has improved, but consumer confidence indices are not showing sustained improvement
Bank lending/credit has still not improved significantly over the past 6 months

Having said that about the US market, emerging market stocks have seen an even larger share of action, leading to valuations almost near unsustainable levels - especially considering risks associated with price bubbles (China), inflation (India), commodity prices/demand (Brazil, Russia) etc. Friday's move by the Indian central bank to raise repo and reverse repo rates show clearly that rate tightening and hence tempering of growth can be expected over the next 12 months...analysts in fact predict an over 200 basis point increase in bank rates in India over this period.

Considering this backdrop at this point in the economic cycle, there probably is more down side than upside from a short-term (3 month) perspective - except for financial sector stocks, there could be little positive news over and above what has been factored in to the recent rally. Prudence would demand pruning investments in emerging market picks, retail, real estate holding companies to name a few - all of which are slated for a correction.

Having said that, there still are some medium and large-cap picks in technology (ADBE is an interesting pick) , Consumer staples (GIS, CPB, DLM etc), Financials (like C) which can continue to deliver - but except for staples, its safer to wait than to jump in yet.

Some interesting retail option picks for Feb/March

2010-02-15T13:27:00.002-05:00

Though the market's still catching up with New Year blues and the Dubai-Greece debt story, there has been little to change the belief that a fundamental improvement in business and consumer sentiment is still underway. Except for a few aberrations, statistics related to Industrial supply, inventory, home sales and retail spending has been showing clear signs of improvement. Though employment numbers are not picking up as fast as one would wish for, consumer confidence has clearly reversed the downward trend - I would hence see the recent DJIA fall to 10K levels as an opportunity to increase exposure to some retail stock plays.

Having said that, there's little reason to hurry and increase/build exposure to high-end retail...that is, I would still not bet on abercrombie or American Eagle or Saks at this point! In line with the notion of a new normal for the economy, i am willing to bet on a continued trend of increased spending on discount stores and value-for-money plays as against higher-end retail.

Some interesting picks in value-for-money retail players in the current market scenario:

Walmart @ 52.90 - 25% below 52 week high, P/E of 15.29 (PEG 5-year of 1.24) is interesting. Even after we move back to sustained positive economic growth, consumers would stick to their new found buying pattern. With quarterly results expected on Feb 18, March options at 52.5 are attractive at ~1.40. COSTCO is also attractive, but i am not as upbeat considerable its near its 52 week high and trades at a PE of 24 (PEG of over 1.5).

JCP @ 24.89 - 48% below 52 week high, P/E of 21.54 (High PEG though of 2.5+) might be worth a look. In line with its recent drop from the 35-levels, Godlman moved JCP to the buy list as of early January. Though it might not be a long-term bet, recent weakness means there's enough upside potential short-to-medium term. With quarterly results expected on Feb 19, feb options at 25.0 are attractive at 0.5 levels and March options at 26.0 are attractive at ~0.70.

I am even more bullish on two other niche plays - Ross Stores and Kirkland:

ROST @ 46.43 - 19% below 52-week high, P/E of 14.75 (PEG of 0.89!) is a strong pick. Their strong value-for-money positioning has led to an increasing base of loyal clientele, and i would bet on richer valuations. With quarterly results expected on Mar 18, March 45 options at 2.2 and March 47.5 options at 1.05 are attractive.

KIRK @ 16.67 - 16% below 52-week high, P/E of 11.89 (PEG of 1.01) is a very strong pick. With quarterly results expected on March 12, March 15 options at 2.2 (though they have doubled in the last week) and March 17.5 options at 0.50-levels are attarctive.

A view - The new normal & impact on Retail over the next 12 months

2009-12-06T11:31:00.004-05:00

As compared to earlier expectations, the main indices saw a remarkable rally over the last 2 months, fuelled by arguably good third quarter results from a majority of companies across sectors. Now that the DJIA hovers around the 10,400 mark and emerging markets have mostly recovered from the Dubai World impact, the rest of the year and early 2010 does look rosy for the optimists. Especially given the reasonably welcoming statistics on unemployment released last Friday, which saw unemployment dropping to 10% (the first ever drop in the last several quarters i guess) and employers cutting fewer jobs than in prior months.

I do personally believe and agree to the fact that a recovery is very well underway - but still stick to the view point that we are going to continue to see a new normal with lower consumer spending, greater savings & investments and a more tempered retail and construction growth. WIth unemployment still set to stay above 9% at least for the next 12 months & the impact that the down turn has had on consumer psyche, i will bet on a few trends continuing to hold momentum [as compared to averages over the 5 years pre-recession]. Just to highlight a few:

A higher proportion will continue to shop for perishables and consumer durables from lower-prices department chains (read Walmart, Costco, BJ, Aldi etc). But niche health-oriented stores like Whole Foods should continue to draw new customers though.
Given the significant price differentials, online retailers like Amazon and to a lower extent ebay will continue to build their consumer base across segments - but, especially on consumer electronics and even some high-value retail items like perfumes!
In the broadline retail segment, low-price should still continue to draw customers - JC Penney should hold ground against a Macys for example
Though the teen segment still has some strength in higher-priced apparel, i still would bet on an Aeropostale (P/E of below-10!) as against Abercrombie & Fitch or American Eagle for example
On the Food sector, food-at-home players like General Mills, Campbell should see increased growth (globally in this case) as compared to restaurant chains.

Having said that, there still is enough steam in the very high end to perk up valuations further - Tiffany's, Saks for example. It's the higher-priced mass-market retailers that should underperform if a new normal is indeed the reality. With the same view, housing prices in the low-to-mid and extremely high end should see a higher uptick over the next year as against the upper middle segment - the incentive expiring by April 2010 will create a big 'non-seasonal' fluctuation though.

On a more-macro angle, discretion is probably the better option. Like Dubai World was an eye opener to bulls in the high-yield/high-risk bond market, there are probably several skeletons to come out in many sectors, especially commercial real estate for example. To sum up, it's still better to bet on price-value plays and fundamentals as against exuberant growth in higher-end sectors which rely on a rapid uptick in consumer spending.

Need for a balanced and practical approach - Regulating the OTC Derivatives market

2009-10-16T18:56:00.002-04:00

As legislators prepare to move ahead in debating the recently introduced draft bill on regulating OTC derivatives, several observers have questioned the need for the bill to be diluted, both in terms of coverage and in terms of regulatory oversight mandated. With over USD 600 trillion in notional amount & the stigma attached to CDS instruments (thanks to AIG) due to the current financial crisis, it is easy for one to be led astray and push for a total clamp-down on the market. However, we need to ensure this is looked at from the right perspective.

Regulation is very much needed and so is enhanced reporting and disclosure - without going in to an argument on Value at Risk Vs notional amounts, the very fact that US financial firms make over USD 30-40 billion+ in annual profits from such instruments gives an idea of the level of implied risk in this segment of the financial market. However, it is to be noted that not all of the volume is driven by speculative positions. To put this in perspective, a majority (65%+) of the USD 600 trillion notional pertains to Interest Rate Swaps (IRS) and close to 10% pertains to Currency swaps; and only about USD 60 trillion pertains to the much-vilified CDS bucket. And this is not to say that CDS as an instrument has any inherent flaws - it is as much necessary to create a vibrant credit market as is oil futures and options for a vibrant crude oil market.

More over, close to USD 60 trillion of the USD 600 trillion notional pertains to positions by non-financial firms, where they are hedging real risk associated with variables like interest rates, foreign exchange rates and commodity prices to reduce profit volatility related to factors not linked to their core business. Also, a significant portion of the IRS market would be covered swaps with hedged counter-positions on the books of financial services firms (banks using a pay floating-receive fixed swap to hedge interest rate risk on their floating rate loan pools for example).

To put it in a nut shell, the OTC derivatives market plays a significant role in maintaining a well-oiled financial services world. Over-regulation without understanding the true nature of the market kills the industry and reduces liquidity from the financial services market as a whole. The very nature of customization associated with loan tenures, currency positions etc is what makes the market so difficult to be managed through a pure exchange-driven mechanism. This is the very reason for large delays between trade execution and settlement, and hence accumulation of settlement risk. A regulatory push towards enhanced disclosure and reporting, and hence supervisory review of systemic risk, is a good idea - but draconian rules related to reporting or margining will add disproportionate costs and hence eventually strangles the industry.

Having said this, the directive towards moving a larger portion of the OTC Derivatives volume to central clearing houses is laudable. This is as much a solution to industry woes as for regulators' woes - the positive industry response to DTCC's Trade Information Warehouse a few years back & success of other service providers like Markit and TriOptima clearly shows that there is proven business value attached to central parties which can facilitate information exchange and drive information accuracy. However, a few points need to be noted:

Centralized clearing houses do create systematic risk due to aggregation of risk to a single counterparty. So, unless strict norms around capitalization of these clearing houses is part of the mandate, the move could be counter-productive in the longer term.
What is more important than centralized information is how regulators and industry uses this information. Unless there is a good mechanism to roll up exposures across related parties and highlight areas of risk concentration, along with a clear mechanism of regualting the same by supervisory oversight, the central clearing house solution doesn't provide any real relief. For example, several large US firms had exposures to multiple Lehman entities (collateral pledged with Lehman US and Lehman UK separately for example) and since analysis of rolled-up exposures to Lehman group as a whole was not done or acted upon, realization of the overall exposure happenned only post-event.
Margining requirements have to be as tight on non-financial firms as on financial services firms. I do not personally agree with the opinion that stricter margining requirements dilutes business value for firms using it as a true hedge. I agree that it does entail added costs to doing business, but if the regulation is lax towards non-financial firms in this area, it leaves a big loop hole. Nothing stops rogue financial arms of oil companies or any others from creating Enron-like situations due to unregulated open exposures in derivative positions.

To summarize, we do need fresh regulations on facilitating centralized counterparty driven clearing, enhanced reporting and stricter margin requirements; however, regulators need to work closely with industry leaders and industry SROs to ensure that we create an environment for controlled growth and not lead to total market constriction. On the same note, we have to be careful on diluting rules for select areas of the market - since loop holes almost always are exploited by smart players in the market!

Do we have a sustainable economic recovery yet?

2009-10-10T17:22:00.010-04:00

Forecasts and projections galore over the past 3-4 months as the DJIA (read market indicators) gradually worked its way almost inching up to the 10,000 mark. Thankfully, unlike the all-pervading gloominess in early March, the biggest question currently in the minds of market pundits and investors is whether the rally is sustainable. Led from the front by Roubini, there are several economists forecasting a double dip recession and the market reverting back to pre-rally levels. Though I personally agree more with Summers than Roubini, it's difficult to stretch the optimism at this point to say that the market is completely on track to a V-shaped reversal.

A quick look a factors which support the sustained rally camp:

Job losses are stabilizing - by labor department statistics, total nonfarm payroll employment declined by 263,000 in September. From May through September, job losses averaged 307,000 per month, compared with lossses averaging 645,000 per month from November 2008 to April 2009.
Manufacturing supplier and purchaser indexes are up - for example, the Institute of Supply Management PMI index has gradually increased from 40.1 in April 2009 to 52.6 in Sep 2009, showing an uptick in 4 out of 5 month-to-month instances.
Home price decline has been stopped across all major regions, with month-on-month price ncreases reported for Sep 09. Also, both new and existing home inventory are down to the 7-8 month levels as compared to the 11+ months inventory in Q4 2008 and Q1 2009.

On the other hand, those forecasting a double dip recession point to lack of fundamental strength in key indicators:

Corporate budgets are generally flat and employers have not started hiring. This is supported by continued increase in unemployment, reduction in hours worked and lack of strong private sector new employment generation
Manufacturing stats are just showing a blip to shore up inventories back to minimum levels
Home foreclosure rates have not slowed down and home prices have not yet shown a consistent upward trend

Let's take a look at some of the key numbers from April to Sep 09 (wherever data is available):

Apr May Jun Jul Aug Sep

Personal consumption expenditure (USD trillion) 9.18 9.19 9.20 9.22 9.31
Unemployment rate (%) 8.90 9.40 9.50 9.40 9.70 9.80
ISM index 40.10 42.80 44.80 48.90 52.90 52.60
Bank lending (USD btrillion) 9.25 9.34 9.33 9.26 9.20 9.11
New home sales (annualized in '000s) 352 346 384 429 426

(sorry for the mess up on the table - could not get it in neatly!)

As can be seen clearly, while new home sales and manufacturing indicators (using PMI as a proxy) has shown notable progress over the past 6 months, bank lending has yet to show any progress of improvement and so is the unemployment rate. This probably confirms the view that there is still quite some way to move forward for a sustainable recovery. Also, considering near-flat trends for personal consumption expenditure and hence fundamental demand drivers in general, it is perhaps easier to agree with the view that manufacturing stats are up primarily due to re-stocking pressure - due to drastic production cuts and abnormally low inventory levels during the past few quarters as against demand-driven growth.

Unless increased bank lending and government driven spending initiatives create enough employment, personal consumption expenditure would not pick up sufficiently to drive back demand for products and services. This, along with a sustained uptick in both personal and business confidence indices, is required to pave the way to recovery over the next few quarters.

Finally, i personally think that we are more on the way to a 'New normal' as against the pre-crisis economy - as I opined in the previous article too. The impact created due to the crisis is significant enough to affect long-term trends in spending and saving patterns, if not financial services lending patterns too! This will prevent a drastic v-shaped reversal hoped by early-mover market bulls. However, there is enough initial momentum to continue a path to recovery and hence there is no reason to expect a decline of market indicators back to the Q1 2009 levels. From a numbers perspective, assuming continued Fed and government support, I would rather bet on a slow, but volatile climb of the DJIA to 11,000 levels by Q3 2010 as against a move to 7000 or a 14000!

Due to the same reality, there is not enough fundamental strength for the drastic surge in retail stocks. Manufacturing stocks should see a tempered rise while home builder stocks, especially luxury builders, have quite a way to go before high multipliers are justified. I would personally bet on financial services picks with healthier balance sheets or consumer non-durables, and not retail at this point!

The case for a new normal

2009-08-16T18:12:00.003-04:00

Market movements and direction of key economic indicators over the last 2-3 months clearly points to a tempering of the current down-turn and possibly a quick uptick in activity across most sectors. THough the market's overexuberance is not supported by any facts pointing to a drastic return to growth and profits, there are many economists who support this view. Last week, James Glassman at JP Morgan opined that 'Whenever we have plunged off a cliff and fallen into a deep hole in the past, for a while the economy has a tendency to bounce back very quickly' - a view supported by some others including Lauirence Meyer, formal Fed governor. And contradicted by several others who predict a slower, uptick, and that too to a 'new normal' where we would see higher savings rates, reduced consumer spending and tempered growth. I would sincerely hope the latter is true, despite all the immediate benefits and gains from the former trajectory!

As compared to what has been traditionally decade long recession-boom cycles, we are probably seeing a series of heightened, but faster cycles during this decade. Without too much of doubt, we can say that the US central government responses to both the 2000-'01 downturn and the 2008-'09 downturn has been led/driven by monetary policy. Not often have we seen Fed rates fall, rise and then fall so drastically in a span of 8-9 years - this coupled with a consistently loose fiscal policy has perhaps exacerbated the speed of economc cycles. I am not saying that one should find fault with the Fed's rapid response to the current down-turn - in fact, i agree with the view that nothing short of such a reponse would have helped push the economy out of a recession spiral faster this time around. To understand this, we have to compare the Fed's response to the Japanese central bank's response to their down-turn which started in January 1990. Bank of Japan took 17 months to make its first interest rate cut, and even after that, it relied more on fiscal policy and government funded projects rather than use monetary policy as a tool to steer the economy. The success/failure of such a strategy is known to all of us - it created a prolonged period of stagnation, though it did manage to avoid a recession. Having said that, should we say the current direction of US monetary and fiscal policy would take the economy in the right direction long-term - it's doubtful to say the least.

In the Fed's last rate-setting meeting, the board of governors almost unanimously supported a dove-ish monetary policy - this essentially means an unwritten commitment from the Fed to keep rates near sub-zero levels, helping a rapid pick up in the credit cycle - that assuming inflation stays within 'acceptable limits'. On the fiscal policy front, though there has been quite a lot of lip-service to fiscal discipline from the current government, we haven't yet seen any concerete action/plan yet. The latest in a series of 'government-funded' initiatives, the health care plan, sees an additional 2 trillion USD of spend over the next 10 years - and apart from either a possible drop in service/care levels or a rise in taxes, the only 'funding' mechanism we have seen is a piddly USD 80 billion deal that the White House supposedly has ironed out with the big pharma manfacturers! If we combine the above stands on monetary and fiscal policy, we have the stage set for another cycle of unreasonable growth backed by high fiscal deficits and loose credit standards. Based on advances in distressed bonds, corporate bonds and munis over the last quarter, it already seems that the financial sector has picked on the thread. Add to that an agonisingly slow pace of regulatory reform - and there is a significant risk of a too-rapid turn around before we fix some of the fundamentals.

Why can the Fed not set an internal target for economic and market activity (economic growth, market indicators etc) and rigidly follow a monetary policy which can control expansionary cycles and curtail market booms? Instead of using inflation as the sole leading indicator for monetary policy, the Fed should play a more active role in tracking key indicators and not restrain itself from pulling the trigger if it sees unreasonable moves. Pure free market advocates would loath such a Fed avatar, but we have already seen what happens if the Fed stays in its Greenspan mode. It's amply clear that the current market culture driven by quarterly results, bloated profits and huge bonuses can never be self-correcting or self-regulated. Uni-directional Fed policies targeted at avoiding recessions and fueling growth cycles can only lead to unbridled activity in one or more of the asset markets. We probably need a more 'range'bound', directional fed policy for the next many years to help temper cycles and avoid asset bubbles.

On the fiscal front, an ever-expanding government reach is definitely not the solution to all ills. When comparing government-run programs in other countries, we often forget the size and nature of the beast here - most markets are too big in size and volume for the government to play an active role without compromising fiscal reponsibility. Government-run programs are fine provided it is targeted only at tha wekest links in soceity and provided there are clear stakeholders who fund the plan. Else, rising deficits would soon push external debt to over half of the national GDP and threaten the credibility of US treasuries. Many would point to an intermediate uptick in interest in treasuries and opine that foreign economies would continue pumping back money in to the US given clear signs of economic revival. However, we cannot
expect this to be sustainable if central authorities continue with a loose monetary policy and a fiscal policy which promotes deficit spending without a clear plan of future curtailment. This can only yield one result long-term - a gradual move away from the dollar as the reserve currency and subsequent struggle in funding deficts through foreign money. Its difficult to ever assume that consumer savings would rise to a level that can fund such gargantuan deficits!

Regulatory reform is the third pillar which needs utmost attention. Among the broad outline of financial services regulatory reform moves that the Treasury Secretary announced months back, very few have seen implementation yet. A few of these are critical to be implemented befoire any serious market/economic uptick occurs:

Disclosure and regulatory guidelines for credit rating agencies
Market governance framework for OTC instruments, especially credit default swaps
Increased disclosure norms for non-bank financial services entities like hedge funds and private equity funds
Continued monitoring and regulation of financial services firm practices as related to consumer products/services (the only area we have seen some conceret action so far)
Policy outlining broad principles and limits for compensation policies at financial services firms (going beyond Ken Feinstein!)

Among the above, the last one would see the highest amount of debate and opposition. But unless there is either a central regulatory or self-regulatory control of compensation principles, top management & trader (key profit-driving) compensations would continue to be driven by immediate profits, which would in turn forec minimal alignment between risk management principles and corporate reward/compensation norms. Because irrespective of the nature and volume of regulatory overhaul and international guidelines like Basel II, there is enough ingenuity in the financial system to unearth loopholes and drive short-term profit and compensation maximization. And that combined with loose federal monetary/fiscal oversight would prevent any sustainability of economic growth long-term.

Early exuberance - are we getting ahead of ourselves?

2009-06-20T14:47:00.005-04:00

It's suprising that merely two months after the PPIP was announced, with foul play cries from critics on 'too much of government/tax payer support', there is already indications of a lack of interest in the program from larger banks. The treasury secretary himself referred to this in a recent interview. This is primarily due to a rapid 30-45 day surge in stock market indicators, with early talks of the recession slowing down.

It's indeed glad to see early-stage trend changes in unemployment, housing stats (new & existing), consumer spending, industrial spending - a possible early signal that the steepness of the downturn has been arrested. But that's just about it at this point - the economy as a whole is still showing negative growth, housing prices are still showing no signs of any significant bounce & overall consumer sentiment is still negative. Given this background, it would be suprising if banks bask in the short term uptick in stock market indicators and show lax interest in participation in the PPIP program. None of the basic drivers - house prices, unemployment rate - have shown a marked movement towards positive territory, and hence its too early to expect quick reduction in credit card delinquencies, loan write-offs or foreclosures. Also, the credit market as a whole has been next-to-inaccessible for a larger part of the population due to extremely stringent lending norms and a sudden uptick in lending (especially mortgage) rates. This is dangerous - it increases the risk of at-the-brink consumers stepping in to delinquency due to insufficient means for availing short-term increases in credit, and thus flexibly manage their debt.

Another reason for the early exuberance, and hence perceived lack of interest in PPIP, might be the result of the bank stress tests that was announced in early May. However, one needs to understand that the 'stress' parameter values used were pretty mild by current standards - looks at this:
The stress test’s “more adverse” scenario, factored in ONLY the following worst case scenarios for GDP, unemployment and housing prices (as described in detail in The Supervisory Capital Assessment Program, Design and Implementation released by the Fed on April 24, 2009):

GDP:
- a decline of -3.3% in 2009
- increase of 0.5% in 2010

Unemployment:
- civilian unemployment of 8.9% in 2009
- civilian unemployment of 10.3% in 2010

House prices:
- declines of -22% during 2009
-7% in 2010

Given the nature of the downturn and the depth of the crisis, the worstcase values used for GDP are pretty mild - especially 2010 numbers. Also, unemployment numbers assumed in worstcase are way too mild - we are already close to 8.5% in Q2 2009! House price decline numbers are probably realistic even in worst case scenario considering the decline that this parameter
has already seen over the past 30 months! On top of this, only a 2-year stress scenario was used as against a more stringment 5 or 10 year scenario - we are talking of 'stress testing' and hence scenarios need to assume worst case numbers/assumptions.

The fact that the Fed/Treasury allowed many large TARP recipients to repay the money in light of the above stress test results does park serious concern. I agree that some of these institutions are fundamentally sound even in this environment, but not all. Letting banks with pass marks after a mild stress test and then allowing them to ease out of regulatory control (especially on executive compensation) by allowing TARP money repayments show serious laxness on the regulators.

Just to sum it up, we should all be happy to see an uptick in indicators and see the economy reviving. I also believe in the government needing to support this economy and market in ways that are mandated by the current environment. But its not common sense to let go of this opportunity to clean up bank/financial company balance sheets and forge a stronger culture of risk management. This can only lead to future peril and a possible relapse of recessionary trends. The current situation was clearly caused by lax risk management and poor regulatory and governance framework - and unless this fundamental issue is corrected, we are never going to come out of the rut clean.

Also, the situation has to be seen in an even larger context - treasury funding itself might be constrained due to a drastic increase in federal debt. Several of the large sovereign investors in treasuries (notably the BRIC countries) have already expressed serious concerns of the high-level of treasury debt floated these days, lack of focus on reigning in deficits longer term, and hence the risk posed due to an over-reliance on the US dollar as the reserve currency! This limits future treasury/governmant ability to fund and support the market, and hence it is all the more imperative to do it right this time!

PPIP moves in to execution mode...

2009-04-26T22:09:00.000-04:00

With Blackrock, TCW and most probably PIMCO submitting bids as Asset Managers for the legacy securities program, the PPIP program has definitely gotten the kick start it needed!

There is definitely still a lot of skepticism in the program - however some provisions that have become clearer as the program reaches execution phase should give some comfort to skeptics.
Again, to reiterate fundamentals, this US program is far better than similar programs - unlike the UK Asset protection Program (see: http://www.hm-treasury...) for bad assets where exposure is not clearly ring-fenced, the US program has definite quantifiable upside and downside. Also, executive compensation restrictions for entities which invest money and avail government funding/debt for the same ensure asset managers clearly segregate agency functions and principal functions.

However, the complex structure (of both the legacy loan and securities programs) and other parallel government initiatives in the credit markets make program administration tricky if not tough.

For example, the Home Mortgage Modification program under which the Treasury has earmarked money for mortgage servicers (see article: http://online.wsj.com/...) will pose questions on applicability of the subsidy to investors in the PPIP program - since the subsidy is targeted at servicers and not loan/asset owners. Similar programs would potentially increase book value of the loan pools and raise acquisition price for PPIP investors, but the actual subsidy is tied to servicers and would be lost to investors unless the servicing contract with the same servicer is retained durign period of ownership.

Another example of uncertaintly/complexity is the extent to which ongoing asset management strategies for the pool (as employed by selected asset managers), and management of the program in general would be subject to Treasury oversight, is not known yet. Some or all of these will become clearer as the program unfolds, but some amount of fluidity is unfortunately bound to prevail.

There's a lot of money and time invested in this program - and enough and more stakes for all parties to ensure it helps revive the distressed securities market and hence credit markets in general! The onus is on the Treasury to continue effective articulation of program logistics/operating model and also interlinkages with other credit market initiatives!

Government intervention - do we really have alternatives at this point?

2009-04-12T08:53:00.003-04:00

My last post on the PPIP drew strong opinions - on the government's strategy behind the plan.

The key reasons for the opposition are:
1) How can the government 'waste' tax payer money on helping unfreeze MBS/ABS/CMO and other securities and asset markets, and hence proppping up the same set of institutions that has caused the market crash in the first place?
2) How will the government ensure its not taken for a ride - through participants in the plan colluding and creating flawed price discovery?
3) It's a better long-term option to let the situation play out i.e. let weaker banks fall, let asset prices find their true values etc - isn't that a more balanced long-term strategy?

Let's take the points in the inverse order above - first looking at the option of letting the crisis play out in its 'normal course'. Apart from the agony associated with prolonged recession and persistently high unemployment, i would question the very premise between this argument.

Take a look at the Japanese economic crisis of the 90's - Bank of Japan took 7-9 years to meaningfully relax interest rates, and close to 8 years to meaningfully inject public money to help banks; while there were changes in rules and regulations in the interim. Thus, BoJ basically played 'prudent and waited/allowed the crisis to play its course. Though many observers quote the Japanese and US crisis to show case the evils of deregulation, the parallels hopefully stop there. Because apart from what's commonly known as 'the lost decade', we didn't see any medium term gains from BoJ's wait-and-watch plan. On the other hand, if we can have a counter-balancing force of strong regulatory supervision and revival of corporate governance and risk monitoring, a government-facilitated resuscitation can help the economy revive short-term while laying the foundation for more meaningful growth longer-term.

In a different kind of comparison, some including Roubini have been advocating a repeat of the bank nationalization that happenned in Sweden in the early 90's. However, the size of the Swedish economy (less than 3% of the US economy) and the relative size of the banking institutions clearly means we are not comparing apples to apples. As an example, our mortgage debt book size itself is 12 trillion plus - as compared to the Treasury balance sheet of USD 9 trillion. This is only a part (if not tip) of the iceberg - if we add notionals on derivative instruments, it reaches gargantuan proportions. To presume that the US government has the appetite to nationalize and turn around at such scale is being naive.

As for flawed price discovery and the government being taken for a ride, i don't think there is more at stake compared to what has been already done - or forced to be done rather.

A realistic assessment would tell us that the worst case downside is probably USD 200-250 bn (asset and securitiy prices falling a further 50% from current levels, and the government losing its equity investments apart from losses on guarantees/debt). The amount is not trivial; but not as large if we compare current stake that the government has already assumed, the impact that the lack of a forceful plan would have on (continued) depletion in asset prices, further bank delinguencies (and hence FDIC money-on-the-table), continued slump in the economy and a long period of depleted tax revenues.

Taking a look at the dynamics of price collusion and flawed price discovery, there are enough reasons why this should/would not happen in a rampant fashion. To presume that institutions which have already taken a severe jolt would further collude to take more risk is basically assuming there's a total lack of regulatory oversight, share holder vigilance and corporate governance. More over, if the treasury can get the right financial expertise (we are already seeing increased recruitment of such kind from all govt agencies including the SEC), its common sense to assume that it can have a fairer estimate of the valuation to prevent participants from playing foul!

Lastly, on the point that tax payer money is lost, the counter argument is - who else bears the brunt of the crisis if it is prolonged? Are we saying we can live with a 5-year recessionary cycle, 10%+ unemployment and every thing else that comes with it? I hope not - unless there's a meaningful (&practical) alternate option where frozen markets can be resuscitated without heavy government intervention. Also, to look at it from another angle, the government has majority equity stakes in AIG, Freddie & Fannie, a significant stake (with inbuilt clauses for expanded stake) in institutions like Citi and several such. So, tax payers are assured of a similar share in the upside. Going back to the Swedish example, this is similar to what the Swedish governmant did too - resulting in a net total (tax payer) cost of less than 1-2% of GDP at steady state.

Having said the above, I cannot agree more with the opinion that any revival not built on a stronger strategic/long-term foundation of risk monitoring, regulatory oversight and fiscal prudence is unsustainable. Though we haven't seen a lot of details on this front yet from the government, we did see an outline of upcoming changes - strong monitoring of systemic risk, stronger liquidity monitoring for bigger banks, increased capital cushions for the bigger banks, mandatory stress tests for bailout package recipient banks, increased regulatory oversight and reporting norms for alternative investments etc.

There might be some who say we need the above first and every thing else later i.e. effect stronger regulations, let the market play out its course and then think about fiscally-prudent long-term growth. But considering the impact that the crisis had on institions like AIG and Citi, and hence the larger US and global economy, this approach is very text-book by nature. Nor are other stakeholders (EU, Japan, China) going to abide by such a long-drawn out plan.

To put it in simple terms, unless we have key large participants in the system functioning normally, we cannot either talk about revival or sustainable growth. Because we need to first stand up before we can run or even walk!

Making sense of the Public-Private Investment Program

2009-03-29T00:52:00.003-04:00

Tim Geithner unveiled a good amount of detail on the much-awaited financial sector resuscitation package over the last week. Apart from addressing the core issue of unfreezing the credit market and hence imrpoving liquidity, the Treasury also clearly articulated the broad guidelines of new financial sector regulation.

Let's try to make sense of the PPIP - the plan basically envisages the government putting its skin-in-the-game to push/incentivize private sector participants (read money managers) to take that elusive step forward - buy distressed assets and securities. The government's share of risk is through a mix of FDIC guarantees, direct Fed loans and Equity participation. To make sense of the program, let's look at the Legacy Assets and Legacy Securities program separately.

Legacy Assets PPIP program - This envisages private parties (meeting certain eligibility criteria) to bid for defined pools of troubled assets as made available by banks. Once the best bidder is decided for each pool, the government would match equity contribution. But the bigger piece of the puzzle here is the FDIC guarantee - FDIC would employ consultants to value each pool and provide debt guarantees up to 85% of the total bid value of the pool. The actual guarantee percentage for each pool (85% or lesser) would eventually determine total credit risk assumed by the government. Assume a USD 100 million RMBS pool with a bid value of USD 80 million (to account for potential losses in the portfolio), if the FDIC provides a debt guarantee up to 85% of bid value, it basically means the government is taking a risk of USD 6.0 mn in Equity + additional losses if the actual realizable value of the asset pool is lesser than 68 million. This is fine in case the overall PPIP plan does turn back the market to normalcy; but its a significant risk to the Treasury's balance sheet otherwise...another 12 million (15%) value drop on the portfolio is not beyond practicality! In a nut shell, there is enough risk sharing from the government to bring in private investment - but on the same note, an ineffective execution can expose the treasury balance sheet signficantly. Considering the vary nature of the base asset (loans as against negotiable securities), initial participation is bound to be tepid, unless the securties PPIP program picks up speed and loosens the secondary market.

Legacy Securities PPIP program - The basic premise of the plan is similar to the assets program described above, but the modus operandi is a bit different. It starts with the treasury inviting bids from large assets managers (again, defined eligibility criteria) to select up to 5 asset managers to run the program. These managers would form distressed securities funds with disclosure on fund amount, investor mix, asset selection strategy, asset management strategy, fees etc. The treasury would commit an equal share of equity and on top of that, provide a matching share or in some cases (based on analysis of target investment pool, strategy etc) even twice the matching share in the form of senior debt. Assuming the maximum share of senior debt from the treasury/FDIC, this basically means, there's an open risk beyond a value depletion of 25% on the base assesses value of the securities pool. Given the fact that several large global funds have already raised significant money targeted at distressed securities, this plan should drive active participation and free up liquidity in the market.

From the above, its clear that its a well-thought out plan from the Treasury, but its no magic wand. As in any other solution, it does assume rational markets (and market participants) and hence does imply significant balance sheet risks to the treasury - up to 800+ billion, a large number considering the 9 trillion + balance sheet size. But, given the already-distressed value of the base assets and latent investor appetite for such assets, i would bet my money on the plan gradually unleashing liquidity over the next few quarters. The dark horse here is the impact that freshly unveiled regulatory changes (read registration, increased disclosures and hence constariend investment strategies) will have on the existence and volumes associated with critical participants like hedge funds, venture capital funds and private equity funds.

Why are we wasting our energy - and getting so pseudo-moralistic?

2009-03-21T15:04:00.005-04:00

Last week saw an unprecendented amount of corporate CXO-bashing from politicians, public and the media in general. A sudden surge of moral anger seem to have been generated by the AIG bonus news. I don't personally support the AIG bonuses, but none the less, i cannot fathom the logic behind doing a witch hunt for the bonus recipients. We are living in a capitalistic economy and hence there's little merit in arguing on the lines of rich-getting-richer/ poor-getting- poorer.

Let's try to look at it from another angle. The past few decades saw unprecendented growth and as a result, an accumulation of personal wealth and a consistent increase in personal spending across most classes in society. This unfortunately came at the cost of lax supervisory oversight and poor market discipline. Every one shared the gains, but leaders in the financial services space which drove or at least facilitated most of the economic expansion reaped the largest gains through windfall corporate profits and hence astronomical bonuses. We are seeing a drastic correction, which is forcing us to look at the value of fiscal prudence, savings and long-term sustainability. So, all of a sudden the same media and public voices which ga-ga-ed at Bill Clinton's talk of 'we do it large because we can afford it' turns around and moves to a position of extreme fiscal prudence and conservatism.

I am not saying the correction's not warranted - but whole heartedly agree with the 'back-to-the-basics' move towards increased savings, financial prudence and controlled markets. However, it has to stop being a witch hunt - if we go over board with governmental oversight and regulations, we would be committing a big mistake. What gain will come out of revealing the names of individual bonus recipients at Merril Lynch or for that matter AIG? Even worser, you have state AGs investigating why tax payer money went to honor counter-party obligations of AIG related to its CDS portfolios!! The government can and should use more subtle means to discipline firms who received tax payer funds - but stop at being moralistic. Do we REALLY expect businesses to stop honoring legal commitments, contractual norms and focus on reviving the economy and ensuring money flow? I hope not...there's a lot else that's left to be done before we spend our collective energies on discussions around economic philosophy.

- By now, we know that no stimulus/bail out package can succeed unless flow of money is restored in the larger economy - but we haven't YET seen anything substantial/serious from Tim Geithner and team to revive the financial services sector. While we saw individual firms like Citi forming 'bad money' banks and trying to separate out the wheat from the chaff, we still haven't seen any further light on the ambiguously termed larger 'public-private' partnership that was announced many weeks back. This is imperative to re-energize bank balance sheets and enable them to work 'normally'and do what they are supposed to do - lend money and facilitate money flow.
- We haven't seen any details on revised accounting norms for mark-to-market valuation.
- Nor have we seen any serious/informed discussion on the nature and form of regulations for the Securities and Investments industry that can prevent what happenned.

As a result, we have a financial services sector that's still stuck in a quagmire, with out either the ability or the willigness to circulate government and tax-payer funded money that's flowing in! While the government, media and many others have litle time but to debate whether CXOs deserve to earn their million dollar bonuses!

Devil lies in the details - the importance of financial sector resuscitation

2009-02-22T18:39:00.011-05:00

Despite the House passing the Recovery and Reinvestment act over the past week, there's been a persistent sense of doom and gloom in the US and global markets. Though it is a fallacy to predict the effectiveness of such an initiative using a short-term stock market reaction, we cannot ignore the natue of the stick market reaction and the sector which bore all the brunt - financials. Let's take a quick look at the numbers.

The recovery and reinvestment act, in terms of size, looks quite dwarfed in context of overall macro economic numbers (all numbers as of end Q3 2008):
Domestic financial sector debt: USD 16.9 trillion
Domestic home mortgage debt: USD 10.5 trillion
Domestic consumer credit: USD 2.6 trillion
Domestic Federal debt: USD 5.8 trillion
In comparison, the act would add to budgetary deficits by USD 185 billion in 2009, USD 399 billion in 2010 and USD 787 billion cumulatively over the next few years. So, despite all the hoopla over the size of the package and the fiscal profligacy tag imposed by fiscal conservatives (if there is such a class at all!), the size of the package is quite moderate! Let's look at it another way: Federal debt increased by over USD 770 billion over Q3 2007 to Q3 2008 (15.2% increase). In comparison, the stimulus act would add over USD 584 billion (9.9% increase) over 2009-'10.

From the above, its clear that the stimulus act by itself does not pose a fatal threat to the fiscal state of the US economy. As long as there's a foundation of fiscal discipline (read avoidance of unfettered tax cuts and freebies), the economy will be able to absorb the fiscal bump to reach a mangeable steady state.

However, as can be easily seen from the above macro-economic numbers, there's little that the stimulus act can achieve unless there is a very focused and directed effort to 'unfreeze' the money flow in the financial sector, with special emphasis on 'directed' mortgage lending.

TARP Phase 1 obviously didn't achieve it, neither did any efforts from the Federal Reserve for driving additional liquidity. During the past few months, while Federal Reserve lending to banks increased by over USD 800 billion, deposits from banks with the Fed increased by almost the same amount - what a sheer fallacy! The basic problem with the above efforts was the same - as long as the mortgage freeze persists and banks continue to face the risk of further write-offs on newer assets, no amount of additional money in the system wil help ensure free flow of credit!

Phase 2 of the financial and mortgage sector revitalization act has to do all of the below to be effective (as highlighted in some of my write-ups earlier too):

1) Until the credit market freeze is significantly overcome, its difficult to ensure free credit flow without altering the rules of the game. In some form or fashion, there need to be a dilution of the mark-to-market rule - i hate to advocate a core principle behind conservative/realistic accounting, but a temporary 2-year moratorium on mark-to-market provisions related to assets in high-priority sectors would not be too bad. For the sake of argument, lets say we enforce a 2-year moratorium on mark-to-market provisions for new mortgage-related assets, including mortgage loans, MBS, CDOs and CMOs with residential and commercial real estate assets as collateral for the base reference credit. Considering the potential danger associated with rule-interpretation, derivatives (CDS) should be kept out of this moratorium and continue to be subject to mark-to-market norms. This has to be complimented by a mechanism to rid the bank balance sheets of existing written down/troubled assets, through some federal participation, as has been already discussed.

2) Even if the above is done, money flow to sectors deserving the highest priority cannot be ensured without a new dose of targeted/priority lending norms. This can be either through carved out priority lending funds or clear provisions to channel a specified percentage of government funding to new loans in targeted sectors (including obviously residential and commercial mortgage)!

3) A thorough revamp of the regulatory and compliance scenario. Tim Geithner already referred to mandatory stress testing for banks receiving (above a certain threshold limit of) TARP funds, but we probably need to go much deeper and broader beyond that. The US has been unfortunately lagging in implementation of Basel II as compared to Europe and Asia - some would question the efficacy of these norms by pointing out the failure of several banks in Europe, but as in many other cases, the mode and manner of implementing such norms/guidelines is even more important that the risk/regulatory oversight that it mandates. Even if banks compute capital norms per Basel II norms and practice market disclosure, true risk assessment often lies in some areas where rules are not as explicit - risk aggregation, stress testing and scenario analysis. Also, goal alignment between business groups and risk management groups through risk-aligned performance measurements and the like is equally critical.

More over, central and regulatory oversight would not be complete without a fresh complementary dose of self-regulatory guidelines, principles and institutions focusing on oversight of equity and credit rating agencies, enhanced market disclosures and fostering market discipline.

A lot depends of the finer print of the financial sector package that Tim Geithner would hopefully announce over this week and next - what it addresses and how! I am personally sure there would be enough meat in the proposal, given how the current administration has conducted itself so far.

Stimulus package - ensuring efficiency and sustainability

2009-02-08T13:06:00.004-05:00

The Senate is closer to signing of the stimulus bill, after a short hiatus of introspection and wrangling. Though one does feel that the package is spread out a bit too thin - in terms of areas it tries to cover - it never the less provides a much-need lever for trying to stem the current economic decline. Sceptics would question the relevance of another 850-odd billion 'stimulus package' when the earlier 700 billion kitty (TARP) did little to either ease money supply or contain fincnail sector turmoil! This could very well be true unless administration and execution of the package is done in a business-like fashion. Adding the money remaining from the TARP package, the government has a ~USD 1 trillion pool now to spark economic activity.

Despite all the goodwill and long term benefits that green energy spending and healthcare spending would bring, we probably cannot pull ourselves out of the rut unless there is targeted efforts at improving money supply. Government spending in infrastructure would drive some downstream activity in construction and ancilliary sectors; but this cannot result in sustainable business acticity unless the core issue of liquidity and money supply is addressed. We need to address the root problem for this - ongoing mark-to-market impairment on the balance sheets of fincancial services firms and resulting squeeze for meeting regulatory and economic capital norms. This cannot be achieved without both of the following:
1) I would absolutely hate to advocate scrapping of the mark-to-market rule, but a temporary 2-year moratorium on mark-to-market provisions related to assets in high-priority sectors would not be too bad. For the sake of argument, lets say we enforce a 2-year moratorium on mark-to-market provisions for new mortgage-related assets, including mortgage loans, MBS, CDOs and CMOs with residential and commercial real estate assets as collateral for the base reference credit. Considering the potential danger associated with rule-interpretation, derivatives (CDS) should be kept out of this moratorium and continue to be subject to mark-to-market norms.
2) There should be explicit provisions for emergency priority lending provisions targeted at residential/commercial mortgage and commercial lending. This can be either through carved out priority lending funds or clear provisions to channel a specified percentage of government funding to new loans in targeted sectors.
With steps like the above, banks can continue to build core-sector assets without undue downside risk, and also beef up interest income since base treasury funding rates would be low enough to provide decent margins even at low lending rates.

None of the above would ensure sutainability unless backed by strong regulatory changes as advocated in some of my earlier notes - oversight on credit rating agencies, enhancement of supervisory oversight on risk management, stronger corporate governance norms...among other things.

Retail spending, bleak statistics - but is it a good forecast for 2009?

2009-01-11T10:01:00.007-05:00

Economic statistics have been pointing only one way since the past 3-4 quarters - down! Though the NBER announced a few months back that we 'technically' entered recession some time in Q4 2007, we really didn't feel the intensity of the slow down till Q3 2008, especially after the Lehman-Merrill day in September '08. Almost all indicators are very bleak by now - retail sales fell by 1.8 and 1.2 percent respectively in November and December, with same store sales falling close to 2.2 percent on the average as compared to the same period in 2007. This, along with an exteremly depressing unemployment rate of 7.2%, paints the picture of a deep, gloomy slow down period. The big question in every one's mind is - is this the start of a deeper recession or is the worst behind us?

WIthout doubt, the slow down has deeply impacted consumer sentiment and thus damaged the trend of the single largest factor which drives over 2/3rd of this nations GDP - consumer spending. However, I would personally argue this is more of a reversal of the exuberant trends seen from '05-'07 rather than point to anything that's inherently unhealthy in this sector. The consumer hasn't stopped spending - just to illustrate this point, let me mention an interesting experience i had when i was at an outlet mall south of Boston recently along with my spouse. We saw a long line of 15+ people waiting outside the door of an Uggs store and was curious as to why - apparently, Uggs was offering some good deals, and there were more than enough people interested...to make the folks who run the store 'control' intake of customers to prevent over crowding! We saw pretty much the same at a nearby Coach outlet...they were offering 50%+ discounts (which still doesn't make the purchase price reasonable for many!) and there were throngs of women pouring over their handbags, clutches and other accessories on sale. I have heard the same from many of my colleagues and friends across the region - which all points to the fact that the consumer is still willing to spend money, provided the deals are 'right'. So, what's happening is more of a change in the way consumers approach spending than any doomsday no-spending behavior as many would expect us to believe. If people prefer buying at Walmart and pay less dollar for exactly the same merchandise as compared to the fancy department store locally, or if they switch from Saks to Gap for a larger percentage of their clothing purchases, it's probably for the good. We saw a long period of (close to) reckless spending, depleted savings rates and bloated same-store retail numbers...a period where 'value' took a backseat and the consumer stretched savings and on-paper home equity values to splurge on not-so-necessities. We are just seeing a 'good' reversal of these trends - this is exactly the same psyche that led consumers to (hopefully) permenently alter their outlook on fuel-related spending when oil touched 147 a barrel in Q3 '08...despite prices crashing down to 40 a barrel levels, consumers have continued to stay more 'conscious' of the money that are spending on running their cars and heating up their homes. As i had said earlier, this was probably one of the best things to happen from the oil price shock in late '08. And probably this retail spending 'pattern change' is a better thing for the consumer in the long run too!

My basic argument is that there is still some 'sentiment' around and consumers are not sitting at their homes and looking out of their windows altogether - which means good for the economy. As i had mentioned in one of my blogs in late '08, the only way to step up from this slow down is to loosen fiscal prudence for a brief while and indulge in drastic government spending. Don't get me wrong - i am not typically a demand-side economics supporter, but the current unprecendented situation warrants unusual strength in fiscal and monetary actions. We don't have much of a leverage in monetary policy, with fed rates already close to zero - thus there's no option but to use the fiscal lever! If Obama does succeed, even moderately in targeting fresh money in to areas like construction, healthcare, green energy and education, the very impact of this in down stream sectors and resulting gains in employment would be more than enough to crank the engine back. From what he's said so far, it looks very much like it's going to be a very common-sensical approach - every one cannot expect taxes to be cut and sops to be given , but still expect the economy to be revived...sops can only be targetd at the right sectors (high-employment industry areas and low-income population). Once we see early signals in the US, there would be downstream impact across global markets and a synchronized global recession can probably be turned around! There are many who opine that history points to a longer period of slow-down, but when we compare this slow down to earlier slowdowns, what we should note is that everything's been played in pretty much fast forward so far - and a pickup in trends would be quite quick too, given the right stimulus. Advances in economic theory and fiscal and monetary tools and policies have just made economic cycles more drastic! But hopefully we should see some thing even better - if policy makers can use this opportunity to drive permanent shifts in trends towards increased savings, tempered leverage and fiscal prudence (long-term), we should see a more stable growth trend once a turn-around happens!

Even by risking the probability of being wrong, i would stick out my neck and say that we should be back to near-sanity conditions by mid-to-late Q3 2009. We shoud see unemployment trends slowly reverting, housing and real estate stabilizing, and manufacturing looking up from it's trough. So, we are still looking at another 2 quarters of bad statistics and sad news on the unemployment and consumer spending fronts, but there's light at the end of the tunnel. That is assuming Obama and his team does not flounder completely - the chances of which look pretty grim. Here's promising and hoping a more cheerful look-back blog for late 2009!

Mumbai terror strike, global economy and more...

2008-11-27T17:51:00.006-05:00

This has been an year not to remember so far - not from a personal view point, but from what's transpiring globally.

What started off as a weak year with clear hints of a slowing global economy is winding down as one of the worst ever years in a life time (I sincerely hope this is the case!). The sub-prime lending fallout in US drastically led the global economy to a grinding halt - strung by a global credit crunch, gargantuan write-offs at financial firms, massive lay-offs, depressed consumer sentiment, a drastic fall in consumer spending and almost surely a global recessionary scenario...Japan, China, the US (by 4th quarter, even by technical definition) and many to come in the Euro region. What started off in the US has probably to be fixed here too - with firm central/federal steps, be it demand side or supply side! In the current scenario, it probably takes some strong demand-side measures by the new government post Jan 2009 (similar to the 30's when government-led infrastructure spending helped escape the rut)...there has been enough supply-side measures without much avail. Though quite uncommon in the free-market era, we would probably/surely see a strong switch to central regulation and state-led measures to pump-prime the economy back in to shape, but in a measured manner. The industry has little option, but to comply...but every one sincerely hopes this doesn't throw us back to a pre-free market state regime!

We didn't need anything more to spread further gloom to the year - but the terror attack which unreeled in Mumbai on Nov 26 did exactly the same. Its suprising to see 7-8 terror attacks in India over the course of 12 months (almost surely unprecedented due to nature of the attacks) pass by without any firm counter-steps. 9/11 in the US was replied by a strong counter-lash - though the direction and intent of the measures ever since then might be debatable, the nature and tone of the response delivered an equivocal message. Nov 26 probably delivers a repeated warning without any doubt...the world cannot sit and wait for more attacks to respond. India (and the world) needs a very pro-active and firm approach to tackle terrorism - we probably need a multi-pronged approach involving political means, economic means, advanced global warning systems and last but not least brute force! The right approach has to a) identify the funding means of terrorist groups and stifle funding sources (we can do this at least partly by strongly promoting green energy for what you know!) b) orchestrate political and diplomatic forces globally to isolate and target such forces and c) enforce counter-terrorism measures with complete conviction and force. This again calls for an approach which is unique to the times, driven centrally, but towards the right direction.

Regulations, Risk Management & financial sector ails...

2008-09-17T20:31:00.002-04:00

Its difficult to write anything on the economy or the market in the midst of such a horrendous week! However the very fact that 3 of the top 5 stand-alone investment banks cease to exist independently (and probably one more in the offing) - all with in a span of 3 months - shows how ridiculously leveraged and reckless most of these shops would have been. And seeing an insurer the stature of AIG in such massive trouble makes it even more dreadful.

Every one's now talking about regulation and the need for supervisory oversight - including the 2 presidential candidates - though more in populist terms! When the credit crisis unravelled (the early Citi and Merill write-offs), I had written about the need to regulate the credit rating agencies, to avoid conflict of interest situations and also to ensure a robust methodology for ensuring forward-looking ratings. This week proves beyond doubt that we need this and much more to lend some credibility back to the financial services sector.

I completely agree with experts who blame the Alan Greenspan era of deregulation and laissez-fare culture for creating this mess. Free market culture breeds unbridled capitalism, which in turn creates a business culture driven by short-term profit-taking...which leads to corporate decision-making power completely skewed to favor profit-generating functions. This is against the basic principle of risk management - a strong independent risk organization which mandates a firm-wide risk management policy, monitors and controls risk limits and promotes risk management-aligned business and compensation practices. It is apparent that none of this was happenning in most (if not all) of the broker dealers and investment banks. Financial innovation driven by exotic structured products and complex derivatives fueled an artificial boom whereby firms resorted to excessive leverage and focused on generating maximum returns on capital and thus maximum bonuses for revenue generating functions.

What is needed for financial services firms, especially investment banks, to win back the credibility that they have lost? Advanced modeling skills to price and value exotic products (like the so-called Level-3 'classified' assets)?? Even more efficient straight-through processing engines to avoid settlement risk and operational risk?? Multi-factor risk models to churn tons of data and help facilitate stress testing and scenario analysis? All of the above would probably help - but the root of the malaise is some thing more fundamental. Lack of corporate accountability and supervisory regulation are two very important factors; however the absence of a culture driven by risk-management principles is even more important. Look at some basic tenets - a) Independent and powerful risk management reporting to senior management, b) complete separation of duties between say, traders and back office folks, c) Defined risk exposure limits for lines of business and enforcement of the same. All of these were probably followed in letter, but not in spirit. There's absolutely no use having a compensation structure driven by risk-adjusted profits or for that matter trading policies controlled by VaR/Conditional VaR-driven exposure limits if fundamental principles on classifying assets by risk weights, defining sectoral or instrument-level exposure limits etc are not followed. For once, the focus has to shift away from unbridled financial 'innovation' to enforcement of basic risk management principles. But, having said all that, its difficult to blame the investment banks completely for the same - since a regulatory environment which promotes extreme free-market culture does not incentivize executive management to take any long-term decisions sacrificing short-term profits. The very fact that regulatory authorities gave a short-shrift to the level of enforcement/coverage and deadlines associated with applying Basel II norms shows how callous they have been!

As Basel II norms clearly stipulate, one pillar (capital adequacy norms - driven partly/wholly by internal risk models and subsequent capital allocation) cannot hold on its own without the other two - supervisory review and market discipline. There's a lot to be done - solve the issue of overlapping supervisory roles (SEC, FDIC, OCC etc), creation of regulatory bodies to monitor systemic risk and excessive risk concentration, formation of a regulatory body/SRO to supervise the risk monitoring and rating agencies etc. However, none of these would solve the problem in itself - we probably need strong compliance mandates for corporate accountability and oversight to ensure that internal management of firms are driven with a balanced risk-reward mindset. Because, with out it, we have enough ingenuity and brilliance in the system to thwart any regulatory oversight and exploit compliance loopholes!!

Paulson's rescue act & the need for better risk management regulations

2008-07-13T21:41:00.006-04:00

The Treasury Secretary did what every one expected - step in and propose a unfettered vote of confidence on Fannie Mae and Freddie Mac. If the Fed could react with such promptness to save Bear Stearns (which i feel was right anyway), there's no way any one could expect the Fed/govt reaction to be muted for these behemoths which together buy/package almost 50% of the 12 trillion+ mortgage loans outstanding. Any delay would further depress already low markets and cause more trouble for the already-shattered housing market.

Having said that, I personally don't agree with the whole trend that such moves set - though given such a situation, there's pretty much nothing else that the Fed/govt could have done. The real trouble lies in the market mechanism which let things come to such a state. Of course, many questions remain on the role that risk management groups play in even mid and large tier investment banks - however in a quarterly-result driven market, little different could be expected in terms of market dynamics that force firms to sacrifice prudent risk managemenmt for profit-maxmimizing strategies backed by hollow VaR-backed 'risk management policies'. The real blame lies elsewhere though - as I probably have written multiple times over the past 6 months (!), one of the primary reasons has to be the lack of self regulatory (SRO-driven) or central regulatory supervision on credit rating agencies.

Moody's latest faux-pas related to rating errors on European constant proportion debt obligations is probably only the tip of the ice berg. In a scenario where rating agencies rate debt for the same investment banks which form their key client base for fee revenues, conflict of interest is the (only) name of the game. The other driving factor could lack of senior rating analysts to cover the vast volume of debt that gets issued in today's market. A small bunch of analysts using basic senior management interviews and review of the entity's internal VaR/other risk management limits cannot do justice given the ingenuity that exists in ths system. For example, as long as regulations allow hidden buckets like 'Level 3 assets' to park illiquid assets (no rule book can ANY WAY be fool proof), its very difficult to look at a balance sheet, conduct interviews, review adherence to firm-level exposure limits and decide on current solvency or credit worthiness. Forced adherence to stronger risk management policies leveraging tougher measures like Condition VaR or extreme scenario-based stress testing and modeling need to be made an industry norm - with penalties proposed for non-adhering members through higher capital requirements. The SEC should show some urgency to forge a strong SRO culture that would do multiple things:
a) define best practices w.r.t rating methodology for rating agencies, especially with respect to exotic and structured instruments,
b) code of busines guidelines for addressing the conflict of interest inherent in the model,
c) define guidelines address extreme/tail-end risks in internal risk managemnet frameworks
being some of the key.

We already have seen a good amount of laxness in interpreting and implementing capital allocation rules per Basel II rules in the US for example - unless this trend is reversed and a stronger SRO-driven risk management focus emerges, we would continue to see more systemic market crashes!

Technically in Bear territory...

2008-06-28T22:53:00.003-04:00

Market volatility could not be stressed more - after a brief positive upsurge to the 13K levels by early May, the markets swung back to sub-12K levels as early as June mid. With the Dow currently at 11,300+, we are technically close to bear territory, about 20% below the last high. As in the early year fall, Financials were the worst affected...you can rarely see C at 17, WB at 16! Some of the big names are now trading at close to 1/3rd of their highs! Though I am tempted to say these are buys, would resist doing so considering what happpenned after the last such prediction. However, like the housing market, we are probably closer to the bottom.

The same cannot probably be said about the US equity market as a whole - Q3 and Q4 should see tough results too, especially retail, industrials and feeder service industries which bear the brunt of depressed consumer spending & unemployment highs. Drastic down turn in global stock markets like in India and China (The Mumbai Sensex is at 13,000 levels as against 20,000+ levels early this year!), fall in consumer confidence in Germany, UK and the rest of the Euro territory all means there is not a global growth story to counter domestic ails either!

Summer should see some positive news on increased consumer spending though, in line with seasonal cycles. Housing stats should see some relief too, aided by the seasonal pattern - though an upturn is probably still a way off, a perk in activity this summer should bring us closer to the bottom. The biggest spoiler could be Oil...any rise above the current stratospheric levels would make it next to impossible for the Fed not to further tighten monetary policy, which would further squeeze the housing and consumer markets. We should hopefully see some concerted action by the G-30 and OPEC in order to bring some sanity to spot and future crude prices. It's difficult to imagine busines and political powers not acting together to prevent any thing that could seriously affect economies globally.

I would rather not jump in to any contra-investments at this point, and take a wait and watch approach. Near-month call options on Financials might look pretty attractive, but not without associated downside risks. A normal turn of events should see oil prices cooling down, Fed keeping interest rates flat and summer activity giving the needed positive dose to this drab market.

The self-defeating oil surge

2008-05-25T06:00:00.002-04:00

After a brief spell of (unwarranted) upward bounce, last week saw the market erase most of its gains and swing back down to 12,600 levels. Though this is still significantly above the low touched on March 10, during the Fed-JPM-Bear Stearns drama.

OIl continued it's non chalant upward climb, touching as high as USD 133/barrell. It's difficult not to say that OPEC and the other supply side players are strethching their luck. Though there is no refuting the fact that industrial/consumer growth results in increased demand for several gas-guzzling 'instruments' across both the developed and developing worlds, an unreasonable spurt in prices raise red alarms. It's like a fore-warning of future danger due to over-reliance on oil - this in turn shifts tremendous amount of attention on alternative energy - solar being the flavor of the day. The spike in interest in solar shares has been over an year old (at least) by now, but this is probably the turning point for co-ordinated industry-led investments in solar. An example of the latest news on JPM & Wells Fargo funding large banks of solar thermal fields in the west coast and large players like Google and Chevron funding research for the same. If any thing positive is to come by the recent spike in oil prices (apart from bloated tressuries in the Middle East!), its this increased attention and serious focus on alternative energy.

Apart from the above trend, continued upward pressure will feed inflationary pressures which has already shown from the US to Europe to Asia. Inflationary pressures amidst a cooling global economy causes unwanted strain and would further slow growth, especially consumer growth. As has been pointed by almost every one from now, this will eventually create a drop in demand for oil and downward pressure in prices.

So, while the oil economies reap immediate gains, this spike is in a sense the worst thing they could ahve done to themselves longer term. Prices are bound to come back to saner sub-100 levels at least in the next 6-9 months and the longer term focus on alternative anergy gets a tremendous boost. To every one's benefit, reducing over-dependence on one single source of energy!

As for the stock picks to cash in on this wave, i frankly haven't done enough research. My brother's (he does private equity research for an India-based shop) favourite pick has been First Solar...i ignored the pick way back in its 180's! Now that its up in high 200's, i am still wary due to my P/E-driven view of this stock world. He's probably correct since every one from Citi to Jm Cramer has upped their targets on FSLR! And we have another star on the horizon with Evergreen solar - last week saw news of this player winning 2 contracts (from Germany & US) worth almost USD 1 billion - and the shares spiking over 20%!

The next 5-10 years is definitely the time for GREEN. Thanks to OPEC and their greed for helping every one realize that without doubt!

Shift in focus away from Financials

2008-05-11T08:16:00.002-04:00

The last 4 weeks saw a significant upward correction, with the market touching the 13K levels, albeit for a short while. Technology and Oil & gas led sectoral gains, with names like GOOG and AAPL recovering most of 2008 losses. Financials gained too - MER, LEH, GS etc have all recouped enough to say that there's not enough immediate upside left in them now, till the economy as a whole is back on the growth track. Citi (C) stands out though - it has been one of my perennial favourities in this recession cycle...Vikram Pandit's aggressive trim-down startegy across lines of business and asset segments should give it enough steam to demand far better valuations.

A quick look at S&P 500 sectoral swings the last 30 days:
- Technology up 10% [GOOG, AAPL up 25%; Intel, Cisco, HP, IBM up around 7-10%]
- Oil and gas up 8% [CHK up 20%; SLB up 15%]
- Industrials up 5% [CMI up 40%; BA, CAT up 10%]
- Consumer up 5% [DIS up 14%; TWX up 12%; MCD up 7%; WMT up 5%]
- Financials up 4% [GS, JPM, LEH, FRE, FNM up over 10%]
- Health care down [UNI, LLI down 8%; MRK, PFE down 5%]
...and a look at 3 month trends show an obvious trend - Oil & Gas and Commodities have gained the most [big ticket names like HAL, HLB, CVX, X, NUE, FCX have gained over 25%].

It is however very early in the economic cycle to be bullish on the whole market - we need to take a quick look at the macro picture to interpret the overall trend:
1)Real estate market hits peak in late 2006 and shows signs of buckling by mid 2007
2)#1 results in a bubble burst in the CDO/MBS market, with Bear's hedge funds leading the pack.
3) #2 in turn resulted in sustained panic on Financials...with higher foreclosures, more stress assets, depressed MBS/CDO values, failed auction rate markets, massive write-downs and tighter credit in general
4) Fed/govt responds to #3 with massive rate cuts (325 bps in 6+ months), fiscal stimulus packages and some dare-devil acts like the Bear Stearns rescue.
5) #4 results in some regaining of lost confidence in Financials and realization of the fact that its not the end of the world for any of the big financial firms. Also, Q1 results across most sectors did not show the level of weakness that analysts factored in. This is what probably played out the last few weeks.

However, while the above played out, there are a couple of core trends which stayed negative, to say the least:
- Housing market remains depressed (both new and resale)
- Oil pricess continue maddenning upward trend (125+/barrel as of last)

The above two has enough power to pull down consumer spending for quite some time...and considering that consumer spending accounts for 2/3rds of the economy, we should see sustained slowdown in most sectors as a result. It is just that the market focus will shift from Financials to Manufacturing and Service sectors. Depressed consumer spending would reduce demand for goods and services and this would reflect in earnings for these sectors over the next 2 quarters. What we have seen in Q1 earnings deceleration is probably just the start - in fact Q1 suprised many since probably the lag effect has not started kicking in to reflect in actual earnings for these sectors. Except for Healthcare, I am bearish on most sectors over the next 3 months...save some names in consumer and financials.

BULLISH: UNH, WLP, MRK, PFE, KO, PEP, PG, C
BEARISH: HAL, SLB, CVX, X, NUE, FCX, AA, AAPl, IBM, CSCO, ORCL, MER
NEUTRAL: JPM, GS, LEH

* I do not have positions in any of the stocks mentioned above.

The market as a whole will probably lose volatility in the coming months. Financials will remain flat to positive while heavy equipment, automobile, IT/networking will trend downwards. I would rather bet on a 12-12.5K range for the Dow than anything upwards of 13K!

Have we bottomed yet?

2008-04-07T06:27:00.002-04:00

That should be the question in every investor's mind now, after a fed-inspired run in the stock market over the past couple of weeks (post BSC).

Home stats showed there might be some perk up in activity aftre a prolonged slow down, though job loss indicators did not indicate any meaningful reversal of trends. Confidence indicators and economic stats across Europe (notably Germany) indicated that the situation is not as bad as it was thought - adding to selling pressure on the US dollar. Are we at a bottom yet?

I would presume no. There have been certain sectors like Financials and Home builders which have been beatee so badly that they were bound to bounce back a bit at least...especially after the beating Financials took around the $2-a-share-BSC playout. Stocks like C, LEH, JPM all had a pretty good run, and the overall DOW indicator is back to the 12,600+ levels. However, the current earnings season underway would probably confirm that growth has indeed slowed downand earnings momentum has been negatively affected across sectors. The after-effect of the financial squeeze/credit crunch is only starting to show on downstream sectors and it would take a few quarters to say we are out of the woods yet. This earnings season, Manufacturing would slowly start showing kinks in the armor and tech would re-affirm medium-term demand weakness. This would definitely cause a pull back to the 11,700-12,000 range in the next few weeks.

I am bearish on manufacturing and energy stocks at this point in the economic cycle. Stocks like CHK, for example, had a pretty good run...akin to the run heady commodity stocks like GG had in the commodities upswing rally. Demand weakness would slowly start to re-affirm very soon and valuations will take a beating. In Financials, there are stocks like MER which have not been punished fully yet - as the Wachovia analyst rightly ponted out, i think there's more downside to MER at this point since their exposure to this whole sub-prime thing is probably highest after C and BSC.

if you want to play short-term, the best play in this market is to bet against some Financials which have rallied heavy and bet for some retail (CROX?) and pharma stocks (SGP?) which have been relentlessly beaten up. Be long on Financials long-term though, getting in during down-turns in the market cycle. And, I would be positively short on energy stocks at this point.

The Bear Stearns confidence saga and fed's dilemma

2008-03-15T08:58:00.014-04:00

Bear Stearns covered the air waves all of Friday, with its 'significantly detriorated' liquidity position and the early morning announcement of a NY Fed-JPMC liquidity support package. The Fed has gone a step further now after its 200bn TSLF announced the past week - its taking a direct risk on MBS-heavy instruments that it will bank on as collateral for the indirect funding to Bear Stearns. Its indeed a daring step considering the state of the debt markets. However, nothing short of this would have helped either - BSC going bust would have caused irreparable damage to the financial world and probably cause a market freeze. Despite the Fed-JPMC intervention, apparently some capital market players found the liquidity situation so demanding that they couldn't even borrow money on Treasuries...how worser could it get?

Now that a significant part of market confidence over the short-term would depend on how the BSC saga will unfold, its important to have a view on this story.

BSC's 9bn+ revenues in 2006 came from a mix which included 4+bn from Fixed Income, 2+ bn from Equities trading & research, 1+bn investment banking underwriting and advisory, 1+ bn from Global clearing services/Prime brokerage and another 0.5bn each from Private Client services & asset management. The most seriously affected portion of the business is obviously the Fixed income division, which is heavily exposed to residential MBS (including a good component of securitized ARMs). Most of its securities and fund loans to hedge fund providers would probably be significanly impaired in terms of liquidity. It has over USD 350+bn in assets/liabilities riding on a shareholder capital of just over USD 12bn...this leverage of over 32:1 with about 15+bn of its debt maturing in the next 4 quarters exacerbates the short-to-medium term liquidity position. However, its prime brokerage infrastructure, equities trading & research depth and private client advisory business would still command good value despite current market conditions. Considering that the Friday EOD stock price of 30/share is just about 1/3rd of its 85/share+ book value, there's probably still enough value in this stock considering that there's still good potential in divisions that account for over 50% of its revenue stream. However, with its over-leveraged balance sheet, true value depends a lot on mark-to-market valuation of its huge MBS and CDO portfolios.

BSC would definitely have enough willing suitors, though valuation range is an unknown factor at this point. JP Morgan, being BSC's clearing and settlement service provider, would be at the best position to judge the true value of its debt portfolio. Its probably for the same reason that JPM was the conduit for the Fed-sponsored bailout package, architected between Lazard, NY Fed and JPM Thursday night. Interestingly, NY Times already mentions JC Flowers and RBS as being potential suitors too. There is already talk of some kind of a long-term deal in the next 48-72 hours. However, my personal feeling is that this might eventually take longer to play out - most likely the key players would want BSC to regain some confidence with its pre-poned Monday earnings conference. If Alan Schwartz and Sam Molinaro are able to manage the call focusing on key fundamental strengths of their global equities & prime brokerage business, and also articulate clear short-term and long-term revival strategies, we should see some revival of market confidence in Bear. To draw a comparison, Etrade's Jarrett Lilien did a reasonably good job at this - focusing on fundamentals stregnths of their trading platform. If the Monday call pans out well, we could see some rebound in the stock, followed by a possible long-term deal announcement over the next 3-4 weeks.

***
This whole analysis above seems irrelevant and out-of-the-whack considering the latest developments on this front - JPM supposedly acquiring BSC for just over USD 2 a share! Ths situation on the ground at BSC was obviosuly far more grave than any one could ever imagine!
***

The whole BSC development poses an even more tough situation for the Fed ahead of this week's FOMC meeting. Its 200bn package and sustained inflation would have given its enoygh reason to avoid a major (50 bps+) rate cut; but the situation's now changed back to panic mode now. I would now reduce my bets on a 50bps or lower rate cut....unless Modnay turns out to be unusually good for the market. This Fed has been reacting to market pressures so far and its difficult to imagine them takeing a longer-term balanced (inflation Vs growth) in this post-Friday market situation.

Fed's refreshing move

2008-03-11T20:00:00.001-04:00

How can i not blog today?

We had the best day of the year by far, with Dow up more than 400 points! In a refreshing move at unleashing much-needed liquidity to the system, the Fed announced a Term Securities Lending Facility (TLFS), which provides for a line of up to USD 200 bn in treasury securities against collateral from its 20 prime dealers (banks, agencies etc) in the form of MBS and other AAA paper. What does this mean?

1) For starters, this is literally a stamp of assurance from the Fed that it does not see the MBS/ABS securities go to zilch in value (which is what the market seemed to think apparently, given the run on Financial sector shares)
2) This also means big players like C, GS, MER and even smaller players (including troubled ones like Thornburg and Caryle) can loan treasury securities by providing AAA MBS paper (this includes paper sold by banks, Freddie Mae, Fannie Mac) as collateral. They in turn can loan these treasuries to investors in return for cash...thus providing much needed liquidity to these players.

This has been by far the best move by a central agency to address the situation in a sane manner. Rate cuts won't take us far and would in turn put us in danger of a staglation. Subsidies to in-difficulty borrowers would address part of the issue, but in a non-meritocratic way.This brilliant move by the Fed was even more powerful since it was coordinated with the ECB, Bank of England etc...each of them provding additional liquidity building measures totalling over USD 45 bn. There might be some feeling this Fed move is again reactive, but no one has been anyway good at predicting the depths to which the MBS and ABS markets have fallen...even the larger debt market in general. Who would have imagined economic confidence in US waning to such an extent that default swaps on German bunds start getting priced lower than that on US treasuries?? We are in an abnormal economic situation; and any balanced moves by the Fed to address the liquidity crunch will help stabilize the market and bring credit and lendign back on track. This would not remove credit issues, but would at least provide more breathing room for the large players.

Financials were up big time, with Citi leading with a 9%+ gain. Troubled players like Thornburg also saw big upside moves. I feel most of the financials have enough momentum now to erase the near-term decline they had over the past 2-3 weeks. However, the FOMC announcement on rate cut next week might provide a damper - I don't think a sane Fed would try to appease the market with a 50 bps+ cut. This might cause short term negative momentum. I just hope the Fed plays the move along with good forward looking commentary to ease market jitters.

In addition to the good news from the Fed, consumer confidence index measures from Germany and supply/ manufacturing indices from Germany and Japan provided enough hint that all's not bad. Europe and Japan still seem to keep enough momentum - meaning well for most of the large global US corporations and money center banks. Bad for the dollar perhaps, since stregnth in Europe means ECB or Bank of Engalnd would not be forced to come down form their hawkish rate stances. However, once the Fed controls unbridled rate cut expectations next week, the dollar should rally back to 1.45-1.48 levels against the Euro again.

On the micro-side, if you had locked on to January calls at strike 25 for C early today, its difficult to imagine you would lose money by year end!

As we move to FOMC time again!

2008-03-10T17:37:00.003-04:00

While the broad market, especially financials, continue to tread unchartered negative territory, crude rose to a new high - at over $108 a barrel! Personally, i feel both are extreme reactions to market scenarios and not backed by fundamentals.

Starting with Meredith Whitney (Oppenheimer), almost every analyst covering C, JPM, MER, BS, GS have been cutting earnings estimates for the year drastically. The continued turmoil in the MBS and ABS markets, along with sustained uncertainty over bond insurers future butress the analyst speak and add more gloom to the market. However, i feel the financials would move upwards in the medium term - i had the same view early January and have been proven wrong by the market so far; but i hold on to my views. Credit-related losses definitely pose significant short-to-medium term earnings impact, but not to the extent reflected in stock prices - especially those of C and GS. Citi's market value is just a wee bit over USD 100 bn - as against over 250 bn less than 12 months back.

However, there might be more downward pressure as we near the FOMC meeting next week - i for one would strongly believe the Fed's going to limit its rate move to a maximum of 25 bps. And the market would obvisouly not react positively to this. On another note, if the Fed does indeed cut rates by 50 bps or more, i would call it suicidal long-term...staglation risks are serious at this point.

Inflation worries continue to persist...

2008-03-01T22:00:00.041-05:00

Back in January when the Fed went ballistic by announcing a 75 bps cut & then a 50 bps rate cut within a span of 10 days, i thought it was over-reaction to the market-psychology.(http://invest4tomorrow.blogspot.com/2008/01/should-fed-get-as-aggressive-as-market.html)

A slew of recent economic developments indeed point to the risks associated with an over-liberal monetary policy. Per the latest price index releases, wholesale and consumer price indices continued to tread dangerous territory in January. Year-on-year, the January 2008 numbers are 4.6% over 2007 numbers! Oil continues to tread the 90-100 dollar range per barrel, and this does not create any room for inflationary pressures to ease. To add to the woes, the Euro broke a psychlogical barrier of 1.5 against the dollar last week (possibly accelerated by level-trigerred program trading by currency desks though!)...which means imported crude oil turns even more expensive.

Finally, after a slew of such signals, there seems to be some voices of dissent in the Fed against a liberal interest rate cut policy. Vice Chairamn Kohn and Chairman Bernanke continues to opine that growth is indeed the highest priority; but on Feb 29, Chicago Fed President Charles Evans mentioned that growth 'insurance' (read rate cuts) need to be possibly reversed if inflationary concerns persist.

For one, the massive rate cuts in January did not do much to either ease credit availability or bring down market rates. Auction-rate bond failures highlight the fact that credit remains scarce - most of the big banks, including Citi & UBS shied away from such auctions, forcing most issuers to abandon the effort. Mortgage rates haven't softened either - 30-year rates have fallen as little as 27 bps bpS (!) from 6.07 to 5.80 over the past 6 months & 1-year ARMs have only dropped by close to 90 bps.

Credit and the cost of credit in the current market environment is more being dictated by lender worries. The biggest worry for all the big lenders at this point are a) potential write-downs in CDOs, MBSs, ABSs and other instruments which are either backed by sub-prime mortgages, ALt-A mortgages, risky retail instalment/revolving debt etc & b) potential risk associated with bond insurer downgrades and resultant massive write-downs in sub-AAA debt insured by them. The only way to tackle this is to use a double-pronged strategy of multi-party financial support for bond-insurers & incentive-driven/regulatory-driven measures to ensure continued credit availability. Sustained Fed rate cuts in such an environment may not work as much as expected.

As we wait for the next FOMC session on March 14, most traders are betting another 50 or 75 bps cut. Chicago Borard of Trade numbers already indicate a 72% probability of a 75 bps cut in March! And if January was an inidcation of how well the traders predict the Fed, we might very well be seeing that. Hopefully not - a more balanced view would mean the Fed looks in to Feb CPI numbers (which get released by March 14) and then weigh inflation risks with growth risks. Continued inflationary pressures will then dictate a lower cut of say, 25 bps. The market might react negatively to such a step; but how should it matter? Has the market gained any stability after the last instalment of liberal rate cuts...defintely not. In the current economic situation, the Fed should continue to focus on long-term economic fundamentals and not play in to market-psyche by announcing another 50 or 75 bps rate cut. Because that might just put us in a bigger probleme of prolonged staglation - making Fed monetaryt policy toothless.

Lesser bond insurer worries!

2008-02-25T19:22:00.006-05:00

The market opened on a not-so-positive note despite some better than expected housing stats for Jan. It took the AAA rating affirmation on bond insurers to cheer the market and bring it back to significantly positive territory. With the Dow at 12,500+, I would say there's more downside than upside for the market indices at the current levels. Financials moved in pretty much the opposite direction most of the time during the last 2 weeks of market gain. A negative comment from analyst Meredith Whitney (Oppenheimer) on Citi, Goldman and other investment banks did not help it either. With 60-70% annual EPS impact estimated due to sub prime write-offs and other delinquency issues, you got to have nerves of steel to hold on. Medium term investors should remain on the sidelines; but long termers can keep chipping in at these levels.

DNA had soem good news today, with the FDA giving a go ahead on Avastin for breast cancer - i was always bullish on this one right from the beginning of the year. There's more positive news to come in the biotech and pharma sectors as the year unwinds. Big names like PFE, BMY, GENZ haven't really had a stellar ride this year so far!

GOOG dropped again - enter July or September calls at this point...it should give good gains and GOOG should see a rebound back to 520 levels sooner than later. I am happy i exited my MSFT March positions since the YHOO-MSFT saga seems to be posied for a long haul! Not too happy with my CROX or VDSI positions though - the wait is going to be longer, but these names should see some good action at least by next earnings call.

On the energy sector, i feel its time to be short on names like CHK - these are clearly in over bought terrirory!

CROX (again)...and VDSI

2008-02-21T17:17:00.000-05:00

VDSI
While the market picked back some volatility today (it was pretty flat and boring for the first few days of the week!), we saw a massive sell off in yet another good company which missed estimates - this time, it was VDSI. VDSI is a leading provider of information security solutions (read remote-token authentication). Due to delay in orders from 3 large customers (should be banking cistomers), the company missed Dec quarter estimates by a wide margin. Outlook for year 2008 was also not too rosy; coming in at USD 150-162 mn as against a street expectation of 163 mn. The market punished it with a 37% drop!!! - shares touching as low as 11.30 intra-day.

Stepping back and taking a broader view, the company has shown sustained revenue and profit growth over the past 3 years. 2005, 06, 07 revenues were 54.6, 76.1 and 120.0 mn repsectively and net profit was 7.7, 12.5 and 21.0 mn respectively. Even at a subdued 25-35% growth rate for '08 and '09, it is currently trading at a P/E of 15 to forward earnings. I see a clear upside here - lock in to Sep calls at $10 strike...which are trading at ~3 levels. This gives enough time for the stock to bounce back and absorb a couple of quarters of earnings reports! It should easily scale back to ~16 levels.

CROX
I was wrong on CROX for earnings day. Despite a great report, the market beat up CROX because of concern on high inventory levels...despite the fact that the company clarified its due to delays in European shipments. CROX definitely doesn't deserve the valuation it has in mid-2007, but its absurdly cheap at current levels. It is trading at a P/E of 10 while expected growth in EPS and revenues is easily over 30%! Again, i would lock in to Sep calls...and expect them to show reduced inventory levels in Q1 '08 and more notably Q2 '08. This should easily scale back to ~32 levels.

A couple of value picks - HANS & CROX

2008-02-18T19:34:00.000-05:00

February has not been too bad so far for the markets, after what was a horrific start to the year! The market continues to show tremendous amount of volatility, some thing we could expect for probably the next 3-6 months at the minimum! On the macro side, i still stand by big-ticket financials. Citi has dropped back to the 25-26 range after reaching 29+ in the post-January rally - January options look attractive. GS at 175 looks interesting too. Considering the uncertainty associated with further write-offs triggered by potential bond insurer rating cuts, I would not be overly aggressive though – and not bet on mid-year calls.

Looking across the market in stocks I love to track, a couple of picks look interesting:

CROX
An interesting product line with a focus on the ‘young’ casual/beach/action foot wear market, Crocs has enough ongoing traction in US and European markets to continue its growth story for a while. They sell through over 11,000 retail stores in the US and ~2000 stores internationally (primarily in US) – a commendable distribution coverage. Its diversification in to extension product lines including t-shirts, sweat shirts, hats etc also potentially offers continued revenue expansion possibilities beyond footwear.

Currently trading at the 33 levels as compared to its 52-week high of 75. Despite increased 2007 revenue guidance provided in early November, the stock simply hasn’t picked up enough steam so far. The revised full-year 2007 EPS projection of 1.94-1.98 puts it at a current P/E of ~17; with a forward P/E of ~12 on estimated 2008 earnings. Revenue guidance for 2007 is at USD 820-820 mn while 2008 revenue projection is close to USD 1.1bn+. Add to that an Operating margin of over 29% and a net margin of 20%, there’s enough of a fundamental strength in this stock to warrant better valuations. On the Insider trading side, the last sale has been way back in November at 51 levels; there has been some consistent buying activity by the CEO over the past 3 months or so.

I would bet on this prior to earnings – which is post-market closing Feb 19!

HANS
With both Coke and Pepsi beating estimates this past quarter, there’s very little reason to expect HANS to do anything different. HANS has a product portfolio focusing on the sweet spot of the beverage business – energy drinks (MONSTER), fruit-based health drinks, vitamin/enriched water. This segment would continue to beat the traditional carbonated beverage segment by a wide margin in the near future.

HANS did have its share of irrational exuberance with its stock more than quadrupling to its 200s in a short span of 9-12 months prior to the last stock split. However, the stock has taken a major beating and has tumbled from high 60s to the high 30s over the past 3 months. It did for a reason – 2 earnings misses in Q1 and Q3 2007. At a current P/E of ~31 and a forward P/E of low 20 based on 2008 estimates, the stock looks pretty attractive now – considering earnings growth of over 50% in the next few quarters. HANS’ operating margins at 25% and net margins at 16% are also above-par with industry average. Again, enough fundamental strength in this stock to demand a higher valuation! Interestingly, HANS was added to the NASDAQ 100 on Feb. 15. With Q4 earnings (estimated at 0.38) expected the week of Feb 25, it’s an interesting bet. If not too bullish on Q4 numbers, you could do September calls which also look reasonably attractive at current levels.

Buffet's offer, Project lifeline add some optimism

2008-02-12T20:35:00.001-05:00

Warren Buffet added some optimism to the market by proposing to re-insure the muncipal bond portfolios of bond insurers like MBIA, AMBAC and FGIC. Bond insurer stocks didn't react positively - which is perhaps obvious since the re-insurance offer covers only the least risky part of their portfolio...if you look at it from another angle, the offer can be judged as showing how desperate the insurers have become for capital-saving options. However, on the whole, Buffet's offer signals that it's not after all going to be a prolonged recession. Munis carry their own share of risk in prolonged recessions and Buffet's offer means he doesn't see as much of a risk as others do! The broader market did respond positively to this bit of news.

Meanwhile, Henry Paulson got the big 6 of the mortgage market - Citi, Bank Am, Wachovia, Wells Fargo, JPM & Country wide - to come together for 'Hope Now'...and roll out Project Lifeline. This would mean a 30-day moratorium for foreclosures while lenders re-jig loan terms for the borrower...meaning we will see the crisis managed better and soften the landing (to whatever extent we could at this point!). On a broader note, this is another whiff of positive news for a beaten market.

With the above, i re-iterate my earlier position on Financials. Bigger banks and many large investment banks dont probably hold much promise for shorts the rest of teh year. Pick of the lot - Citi. After some interim correction to reach 29+, its back in to the low 26. Don't expect a secular rise to 30+, but be patient and you will get rewarded!

Techs continued to tread tough ground - GOOG, AAPL both trudged down after an early rally. Not sure how long the tech crunch is going to last, but these are good buys for patient investors... i mean those with more than a 3-month horizon.

Regulating the Rating & Analyst community

2008-02-10T19:10:00.000-05:00

This is a continuation of the thoughts expressed in an earlier blog (IN DIRE NEED FOR ‘POSITIVE’ ECONOMICS dated Saturday, January 19, 2008).

As continued losses unwind in the mortgage sector, the resultant spillover has affected consumer loan portfolios, credit card portfolios and caused overall damage to the retail consumer psyche. It’s once again imperative that we at least reactively think of what could have help avoid this credit avalanche – and what can help in future.

One of the points discussed in the Jan 19 blog was the role played by credit rating agencies and equity research houses in the whole mess. With this context, it is interesting to analyze a recent Feb 8 news article related to potential SEC monitoring on credit rating agencies – “SEC May Propose New Rules for Credit-Rating”. The article mentions “The rules would increase disclosure about ‘past ratings' to help determine whether rankings successfully predicted the risk of default, SEC Chairman Christopher Cox said at a securities conference in Washington today. The regulations may also address the differences between ratings on structured debt and rankings for corporate and municipal bonds.” Even more interesting, the report states “Investors could then use the enhanced disclosure to ‘punish chronically poor and unreliable ratings,’ Cox told reporters after his speech. ‘The rules that we may consider would provide information to the markets in a way that facilitates comparisons’, he said.”

It’s heartening to see this finally taking shape, though it has been pretty late already – way back during the 1997 South East Asian crisis, there was already intense criticism of the lack of fore-warnings provided by the rating agencies. There is obviously a classic case of conflict of interest, with rating fees being paid by the borrowers and not investors. We probably need a combination of 2 drivers – One, an incentive mechanism that rewards agencies based on past performance & Two, regulatory disclosures like the above mentioned which would help monitor this industry. One interesting approach:
· Set up an “Investors’ Rating Fund”, with oversight by either a market consortium or by a rating ombudsman. This would be funded by a 0.1 bps charge on any rated debt floated in the market – this can be paid for partly from rating agency fees and partly from borrower money. This would build a significant pool of money, considering that high-grade corporate debt issuance a year in US totals over USD 900 billion per year. This could be used to ‘reward’ best performing rating agencies based on rating performance comparisons as indicated by debt performance within 12 months immediately following lat rating.

The above idea is clearly indicative, with the need to flush out a lot of details related to performance comparison model, Rating Fund administration and ownership etc. Though there would be significant opposition by many market participants, it would help foster safer debt markets in the future and to a certain extent balance inherent conflicts of interest in the industry model.

If rating agencies can be regulated (either by an ombudsman or by a market-driven fund like that mentioned above), why not apply the same to equity rating agencies? Apart from the overall inability of equity rating agencies to predict the sub-prime bust and potential bank stock revaluations, we have had several close-to-irresponsible analyst comments recently, including the controversial ‘potential bankruptcy’ call on E*Trade. There is an urgent need to evolve a regulatory or market driven mechanism to monitor and publish prediction-ability of rating models. Agreed that credit ratings and equity ratings differ widely in their inherent ability to predict the marker, however, it should be possible to evolve a model which would evaluate equity rating effectiveness based on a quarterly performance indicator, excluding effect of (unpredictable) significant political and natural events which might impact stock performance. There could even be a similar fund sent up for Equity Investor protection, though the very act of monitoring and publishing rating effectiveness indicators would have a salutary effect on the overall market.

Again, I am not an advocate of central regulatory policing of free-market agencies; however, its high time that industry forces joined hands with regulators, as needed, to imbibe discipline to credit rating and equity rating industries.

Rare buying opportunity in the Tech sector

2008-02-04T19:45:00.000-05:00

We had some big action last week in the tech sector - bad results from GOOG and MSFT proposing an acquisiton for YHOO.

I do repent for not picking on the relentless runours on a YHOO M&A upside...in fact Pete Najarian or Guy Adami (don't remember who...these folks from Fast Money, CNBC) re-iterated this prior to YHOO earnings day! The market reacted negatively to MSFT and pummelled it over 6% on Feb 1. YHOO is not cheap at a multiple of 40+ even at the pre-acquisition price, but the potential strength within the company is not small either! 500 million unique users - just imagine what wonders it could do to ad and content revenue if chanelled the right way! Also, look at it this way: In absolute terms, MSFT's offer is approx USD 16 bn over YHOO's market value of USD 25 bn prior to the acuqusition. As compared to this, MSFT's market value has dropped over USD 26 bn compared to pre-offer levels (which was already low at a multiple of 19-20). Also, the market's completely discounting the benefits that could accrue from a massive web audience that a MSN + Yahoo combination would have. A good way to play - MSFT March 27.5 options at 3 looks cheap. MSFT has to correct on the upside after probably a few more days of market jitter. Also, if anti-trust factors or competitor offers come in the way of the offer, MSFT would bounce back anyway! I dont see too much of a downside from this level - MSFT closed at 30.19 today.

GOOG - again, market over-reaction to a perceived threat from the MSFT-YHOO announcement. GOOG simply has too massive a search market % (57%+) and near-dominance in online ad revenues (over 75% market share) to get seriously impacted by an MSFT-YHOO combination. With its aggressive diversification (including the latest bid on wireless spectrum) and ubiquitous brand name, its difficult to pull them down any time soon. GOOG at 38.8 looks very attractive - again March options look good. I dont see too much of a downside here too - GOOG closed at 495.43 today as compared to its highs of over 700 as late as last December.

I also like AAPL at the low 130s - at a multiple of below 30!

Financials got a deserved pull back today - wait for a while more, and you might again have good buying opportunities at C, WB etc.

Should the Fed get as aggressive as the market?

2008-01-31T21:23:00.000-05:00

You know my answer - NO.

Fed acted rightly by doing an emergency 75 bps cut last week when global markets were in turmoil. Market reaction to the emergency cut was neutral to positive. However, most market pundits wanted another 50 bps or more during the planned FOMC meeting on Jan 30. It was suprising to see the Fed act in tandem, doing a massive 50 bps cut. We sure do need swift action to avoid a looming slowdown or recession, however Fed actions need to be viewed from a larger macro-economic perspective.

In an economy where most experts do not yet have a full idea of distressed debt in danger of being written off, its always safer to plan/space out/time monetary policy changes. One too many changes reduce the leeway available later to manage difficult situations that may come up later. Also, its is very dangerous to do drastic rate cuts in an environment where oil prices still hover at over USD 90 a barrell. Rate cuts would potentially cause further dollar depreciation (unless European and Asian economies see reduce rates at a similar rate, which seems unlikely), which in turn would further increase effective oil prices and flare up inflation. This poses some thing which would be most dangerous - stagflation.

Again, the beauty of a central banking authority is to a certain extent in being a bit 'enigmatic' and 'non-predictable' ...i mean on a lighter note. The markets never drove Alan Greenspan; Greenspan drove markets and the economy. The moment we have a Fed which is completely driven by short-term market conditions, we run the risk of monetary policy losing its effectiveness in times of greater crisis.

I for one am not advocating a stubborn monetary policy which ignores market signals. However, at the same time, if risks of inflation and potential stagflation are ignored, we might face tougher situations where monetary policy loses its effectiveness as a economic tool.

The market's moved upwards of 12,500; however we should be seeing heavy volatility in the months to come. Hold on to Financials though, assuming you have a 12 month horizon - we will see interim profit-taking moves though.

Trading on the Jan 30 FOMC meeting?

2008-01-29T20:54:00.000-05:00

The market continued its 2-week rally today, with financials and oil companies leading the rise. With, most large cap financials are over 25-30% up over the past 15 days - and that signals its time to cool down. All of us know the recession is not in the rear view mirror yet.

The market rally over the past 2 days has been factoring in a 50 bps cut from the Fed tomorrow. It is difficult to imagine the Fed doing another 50 bps cut after it did a 75 bps cut just about 1 week back. Unemployment numbers are not that bad yet, and durable goods numbers threw a positive surprise today. With that, I would bet a 0 bps to 25 bps cut tomorrow, most probably a 25 bps cut. Personally, i believe another 50 bps cut is an overkill and throws the door open for inflation and even potential stagflation! Fed needs to look after the economy first, then the stock market!

So, if you haven't booked your short term gains yet, tomorrow mornign is a good time to do that - Fed is going to make an announcement tomorrow afternoon and it will almost surely be taken negative to neutral for the market.

How does the market look like for the next 30 days?

2008-01-26T15:57:00.000-05:00

Helped by an emergency Fed rate cut of 75 bps, interim solace of bank and regulatory support for bond insurers & good news on an imminent fiscal package, markets rebounded albeit with high volatility in the week of Jan 21. Financials, Home builders and Retail did well on the equity front - a reminder to the shorts that many of these names are under valued at this point, but probably not indicating a bottom, especially in Retail.

How does the next 30 days look like? Neutral-to-Negative I would say. Do not expect much from the State of the Union address on Jan 28 - the market would probably pick any thing announced with a huge chunk of salt. Dont bet too much on the FOMC meeting on Jan 30th too. Its unlikely that the Fed would agree with the traders (who are betting with 100% probability) and give another 50 bps cut - a measured 25 bps cut seems most likely.

This would mean no immediate boosts to take the Dow beyond 12,500. It would probably trade in a 11,700-12,500 range with significant volatility.

Sector-wise strategy:

Bullish on Financials, though there would be some profit-taking after last week's gains. Mid-year '08 and Jan '09 call options for many Financial names still look interesting: C June call (25) at 3.40, GS July call (190) at 22.2, MBI Aug call (12.5) at 6.2, ETFC July call (4) at 0.95 all look interesting if you beleive we can avoid a recession (like i do)
Stay away from Retail/Consumer - its is too early yet for the retail party to kick back. Stay out from SKS, M and others which saw significant gains last week.
Accumulate healthcare, pharma, non-cyclicals: PFE, AMGN, DNA, GENZ, KO, MO

On the whole, expect a market with a lack of direction, trading with high volatility. Try accumulating Financials and non-cyclicals on low days. This would help if you agree we are slated for a 2-4 quarter slowdown and then a bounce back.

A day to smile...after long.

2008-01-23T18:28:00.001-05:00

The market finally shook some of the intense pessimism and bounced up on news that the bond insurers may not go bust after all. The NY state insurance regulatory agency facilitated a meeting between banks and the bond insurers to ensure some stop-gap funding to keep them floating. It didn't need extra-ordinary intelligence to realize that having MBIA or ABK go bust was as bad as having one of the big 5 banks declare risk of bankruptcy! The Fed, regulatory agencies, banks and insurance companies cannot simply let that happen.

With that good news, C was up 8%, WB up 10%, ABK up 70%+ and MBI up 30%+!! If you think whoa! its time to load up these stocks, please wait. As mentioned in one of the earlier blogs, you STILL need to have guts to hold on to this sector this year - but if you can hold on and not let be swayed by needless pessimism or optimism, you will reap rich gains. I mean a minimum of 25% upside on any of the big fin stocks by Q1-Q2 2009. Use some of the plunges to play in options on these stocks to add that flavor!

Merrill tried to add to the overall pessimism by reporting that home market prices will plunge 15% this year and 10% in 2009. That's way too pessimistic - it'd be good if MER has some thing in the middle ground - between loading up on sub prime one year & dumping mortgage altogether for the next 2 yrs!

IN DIRE NEED FOR ‘POSITIVE’ ECONOMICS

2008-01-19T18:44:00.000-05:00

The wild down turn in financial markets in the first 2 weeks this year has added fuel to talks of recession and has significantly dented already weakened consumer confidence. While almost none forecast a recession as late as Q2 2007, we have every one now, from Goldman Sachs to Alan Greenspan, talking about an inevitable recession in 2008. To understand the meaning and need for positive economics, its imperative that we take a quick look at how each of the market stake holders have acted/reacted in the recent past.

The Fed can be right…
Though many would argue, the Fed has been remarkably agile in responding to recent recessions. Back in 2000-01, Fed cut the funds rate from as high as 6.5% in early 2001 to 1.75% by December 2001, with as many as 6 rate cuts in the first half of the year. Similarly, we saw rate cuts in September, October and December last year. Its is important to note that the Fed faces the onerous task of balancing economic growth with inflation risks - fuel prices still stay at 90+ levels, and inflation remains relatively high at 3%+. Despite this, Ben Bernanke, in his recent testimony before the House Budget Committee, quite openly stressed on the need to expedite a fiscal stimulus package to counter the economic slow down. How does the market react to most of this – utter disdain! I, for one, am at a loss to understand why the market would cry foul when the Fed chairman speaks of the need for a fiscal stimulus package. In the current economic situation, what is needed is an all-out effort to contain the slow down and prevent a true recession. It’s really not the right time to speak true-capitalist lingo and paint this as a case of the government or the Fed trying to tamper with market dynamics!

Who’s to blame?
Let’s rewind a bit to get some perspective - who was responsible for the current mess in the first place? As real estate prices artificially rose through most of 2005, ’06 and ’07 from Nevada to California to Florida, market forces were truly responsible for an almost irresponsible build-up in home equity loan portfolios, predatory mortgage lending & heavy fund investments in MBS & mortgage-backed CDO instruments. Almost any asset management entity worth its name peddled ‘active’ Fixed Income funds, a nice-sounding pseudonym for funds focusing on current-flavor-of-the-market instruments – heavily on CDOs and MBS in this case. None of the rating agencies even barely raised concerns of credit quality or attempted down grades in this exuberant market that continued as late as Q2 2007. Fast forward to Jan 2008 and we now have every market participant hating sub-prime and writing off CDO and MBS portfolios like no one’s business. Some key questions come to mind:

· Despite all the data-driven analysis and risk simulation and modeling infrastructure available, why does it take one or multiple quarters of economic slow down before rating agencies raise caution signs and start rating mark downs? There definitely is scope for further improvements in forecasting and simulation technology, but there should be more to it than that! I don’t know the answer to this, except for potential conflict of interest situations and resultant sub-optimal rating calls.
· Along the same lines, none of the equity market researchers did as much as lower targets for the Citis and Merrills of the world till as late as Q3 2007. And when they started doing this AFTER the market showed clear signs of strain in Q4 2007, why was it over-the-board in many cases – take the infamous analyst comments on the ETFC downgrade in Q4 2007, for example. Shouldn’t there be an un-written code of conduct for analyst announcements?
· When every one’s aware of the importance of consumer sentiment and confidence indexes, why is there always a fight for one-upmanship to announce the slow down/recession – AFTER a slow down has started? Except for NBER, almost every other entity has ‘confirmed’ a recession in the last 4-6 weeks! NBER has a history of being very slow in ‘acknowledging’ recession, but at times this might be better than shouting from the roof top and hastening the slow-down process.
· Except for Larry Kudlow (notably), what role is the business media playing in this case? Akin to kicking the fallen opponent in a boxing ring, you have expert after expert predicting drastic market corrections and worser mortgage market conditions in 2008 – AFTER seeing the economy slowing down.
· Why does the market necessarily be on collision course with the Fed/government? When ever Ben Bernanke speaks, the market loves to hate him. If he announced (quite reasonably) that this economy needs a fiscal stimulus Viagra, why does the market cringe and crib?

The need for responsibility…
The key point is – doesn’t every true market participant have the right to temper market gyrations and at least strive for market sanity? The danger of self-fulfilling prophecies and the importance of market sanity are best apparent in the below case:

Thanks to a high level of integration (and hence, inter-dependence) of markets across asset classes and geographies, one (or was it two from Bear Stearns?) sub-prime fund bust causes the global high-yield debt market to panic. Financial institutions react with drastic cuts in non-prime lending and aggravate the already weakened mortgage market. This in turn caused increased defaults, and thus further depressed CDO and MBS papers backed by sub-prime debt…causing massive write-offs by major financial firms, lead by C & MER. With the potential defaults and losses on mortgage-related portfolios clearer, panic sets in on bond insurers and you see MBIA and AMBAC tumbling 70%+ plus in a span of weeks. This in turn triggers further write-downs in both CDO/MBS and mortgage loan portfolios of multiple financial entities. And the story continues – or does it?

We need to know that most of these write-offs can in fact reverse to profit bookings once some of the mortgage market fundamentals start picking up again and bad paper suddenly turns not-so-bad as collateral values inch back and LGD values decline. Now, how does the market rise back? Only through more mortgage market activity and hence, increased consumer confidence; this can be driven significantly by fiscal stimulus packages to aid delay/prevention of fore closures. I do agree that it’s wrong in principle to reward people who have been reckless in the first place by going for unaffordable loans and endangering their financial standing. But are they more at fault than sophisticated market players who willingly aided/led them in this path – that’s a difficult question indeed to answer for many market analysts.

‘Positive’ economics…
So, what’s the whole point? Simple – we need to embrace ‘positive’ (as against normative) economics and react with root-cause correction instead of following a throw-the-baby-with-the-bath-water approach. It would be a saner market if researchers (and analysts, if possible) focus on root cause analysis and highlighting risk factors, and hence risk mitigants, instead of making market-driven first-to-the-table judgement calls. Along the same lines, credit and capital market participants need to have self-governing code of conduct and ethics in analyst announcements and research publications that affect the broader market. The media needs to play a more constructive role by focusing on positive steps being taken by the Fed, government and market forces in facilitating a smoother landing (and a quicker take-off). The market needs to be more flexible to Fed and government tactics to counter recessions – and not stick to a stubborn ‘no-fiscal-policy’ stand. I am NOT a proponent of governmental control, but neither do I believe that a free market can always be self-correcting!

We all know the US market can really NEVER be on a firm footing with out correcting fundamental problems related to low consumer savings and high fiscal deficits – but that’s an altogether different discussion in itself! While our leaders strategize for that big battle, why not market and legislative forces work constructively to react to this slow down?

Quick note: The word ‘Positive economics’ is a bit loosely used here, not necessarily matching with Milton Friedman’s classic economic theory advocating free-market economy with high focus on monetary policy and low governmental influence

And the market tumbles again!

2008-01-17T19:58:00.000-05:00

Merrill posted one of the worst quarterly results you could ever imagine. On a much smaller asset base, it posted a write-off and loss as bad as Citi. I agree the fed shouldn't guide CEO salaries, but its ridiculous to have Stan O'Neal walk away with 140 mn (or was it 160 mn?!!) after such a pathetic mess! Corporate America needs to find a way to tie contract provisions on CEO/COO severance packages to current firm profits/performance at the time of severance!

Ben Bernanke talked about a fiscal stimulus package - a probable USD 150 bn rescue package consisting of financial support to the sub-prime mortgage market (to prevent / reduce foreclosures), tax cuts etc. Why the hell did the market react the way it did?? When you are facing a slow down with more than 80% of market pundits betting on recession, what else would Ben do - not come with any stimulus package and sit tight?...have the market to figure out a way to manage itself??? As expected, you had all the experts in CNBC bitching Bernanke again - what do these guys want? Stubborn adherence to a pure monetary policy strategy will NOT yield results in such a market scenario. More on this whole thing in my Saturday blog - i need more time to vent my anger!

Meanwhile, i keep my view - th market is over sold! If you have guts, enter now and hold for 6-12 months. Else, wait till Jan end and plunge in.

Back to lower grounds for AAPL

2008-01-16T20:47:00.000-05:00

Despite all the hype about Macworld on Tuesday, AAPL lacked enough punch to stay afloat at the ethereal levels it reached last year. As guessed earlier in the year, these technology darlings will find it difficult to meet sky-high expectations and retain sky-high valuations in such a pessimistic market. AAPL might look attractive considering its 21% off its highs, but take a look at the P/E - 43! With a 24 bn revenue on high-end consumer electronics and a revenue CAGR of 33% over the last 5 years, it has sutained its run based on the huge margins from ipods, iphones and such stellar hits. Hats off to Steve Jobs for his audacity, vision and zeal. However, you cannot have an ipod or an iphone every year - the wafer thin PC does look pretty, but probably that's not enough to keep driving current valuations in these market conditions.

Same applies to GOOG....even MSFT, ORCL. My guess is we will see some corrections in these stellar names over the coming year. Meanwhile, ORCL's acquisition of BEAS is indeed notable. With its portfolio of acquisitions including Peoplesoft & JD Edwards (ERP/SCM) , Siebel (CRM), Hyperion (BI/Reporting), IFlex (Fin Serv solutions), BEAS (middleware/app servers), Larry has a very well rounded set of assets for ORCL, fitting it firmly against MSFT and IBM.

The above trend also means we would probably see more acquisitions of meaty stand-alone players in other areas too - like TIBX, WBSN, CTXS etc. Why not JAVA? In a beaten market, the Larrys of the world with big money will still look for value plays and acquisitions. Which means 'there's always a bull market some where out there'! (Trade mark rights for that with Jim Cramer of course!)

A random pick of 6 value and take-over plays

2008-01-14T20:45:00.000-05:00

The market's got another boost today, this time from the big old blue (IBM). There is a heightened sense of antiticipation in the markets this period with multiple plays expected:

1) Fed's rate drop announcement, expected for Jan 30 or earlier. Market's giving a 50% chance for a 75 bp cut, I wld stick with 25-50 bp only. Bernanke would not go ballistic on the rate cut considering oil is still in the high 90s (meaning inflation is not dead yet).
2) The government is expected to announce specific measures to contain the mortgage plunge and the slowing economy (possibly in the State of the Union address on Jan 28)
3) A slew of big financial plays, starting with C, would be announcing earnings starting Tuesday. I still bet on an upside for the big financial sector plays.
4) Steve Jobs speaks at the Macworld conference, with possible announcements on ultra-thin laptops or new service offerings leveraging its ipod/itunes legacy. I dont see much of an upside in this stock medium term, even if some thing spectacular is announced tomorrow...i mean apart from the customary blip in such case!

Meanwhile, a quick peek at some stocks across sectors - either value of take-over plays:

WBSN (at 17.19) - A leading provider of web security solutions. Trading at a 52-week low, near June 2004 levels. Steady positive upside on earnings estimates. Probably not a very cheap PE still, but its a good merger/take-over play - its hard to imagine this staying as a stand alone company for long.
CTSH (at 28.35) - Leading offshore service provider. Trading near 52-week lows, near Feb 2006 levels. Steady earnings surprises - only the subdued guidance in the last earnings call did the stock in. Attractive at PE of 28, with a historical profit CAGR of over 50%. Despite the dollar devaluation vis-a-vis the rupee and market slow down in some client sectors, a 30-35% CAGR should be achievable over the next 2 years.
AMGN (at 47.9) - Biotech therapeutics play with a focus on cancer care. Trading at 52-week lows, with an attractive PE of 17. This is a large sustianable play, and it could very well trade in the 60s in a short period from now.
VDSI (at 21.68) - Information security solution provider, focus on token-base user authentication. PE of 35 is not cheap; but trading off over 50% from its highs. Strong position in the market, i feel its a distinct take-over target considering what happenned with RSA last year.
WM (at 14.32) - WaMu cannot be that cheap. At a PE of just 5.57, it is trading at a 10-year low! Despite its high mortgage exposure, this is a definite value pick. Could evenm be a take over target for 2008, with its attractive West Coast coverage (JP Morgan? Wachovia?).
MBI (at 17.05) - Another one at a 10-year low, with a PE of 4. Credit insurers defintely will not have a smooth ride through 2008, but this one has been beaten up too hard, like many other financial plays. Could even see some private equity investment here.

As mentioned earlier, I am still bullish on many big-ticket financial plays which have been beaten up over the past 3-6 months; but would not mention any of these here, to avoid sounding repetitive!

Happy trading through 2008, and through a volatile January!

30 day mark sheets - Financials, Healthcare

2008-01-11T20:37:00.000-05:00

Did i not tell you that January's going to be volatile? This week proved that beyond any doubt... bad week for the market, with almost every sector treading 1-2% down. With good news from Genzyme, Celgene, ISIS and others, Healthcare did repay our trust amidst this troubled economy. And, the winner among all losers? - Financials! Though they have not seen any siginifcant correction given the beating they have taken over the past 2 months, Financials did bounce back. Despite good gains today for MBIA & Ambac (bond insurers), C, WB, MER, ETFC and others, this sector has still take way too much a beating in the last 30 days.

FINANCIALS
Let's see how Financials did in the last 30 days:
MBIA (MBI) down 48% - market over-reaction to bond insurers
ETrade (ETFC) down 25% - short sellers galore; last past 3 days did see some counter-action!
American Express (AXP) down 18% - Isn't lower guidance natural in this market?
JPMorgan (JPM), Ban Am (BAC), Citi (C), Wachovia (WB) all down 9%-11%!
Goldman Sachs (GS) down 7% - Why on earth punish GS?

Notable exceptions:
State Street (STT) up 6% - diversified business model with strong custodial services business
Fannie Mae (FNM) - more of a correction; its still down 44% past 3 months!

Though there would be more volatility this month, hold on to Financials and note entry opportunities! Its hard to believe any market crash can take out 26% of value from Bank Am and 40% from Citi!

HEALTHCARE
As expected, Healthcare beat the market tide. Let's see how some marquee names did over the past 30 days:

Humana (HUM) up 10% - Healthcare services will hold against the slow down
Genzyme (GENZ) up 7% - biotech holds strong. Not very sensitive to economic cycles
Pfizer (PFE) up 1% - Note this one - its going to go a long way. Still down 5% over past 90 days!

Notable 30 days losers are Amgen (AMGN) down 5% & United Healthcare down 3%

Hold on to big pharma names, load up PFE.

Among others, beware of Commodities (like GG, NEM), Oil (like XOM, CVX). Stay away unless you want a wild ride!

And, remember to hold tight through the January roller coaster!

Waiting for Bernanke...

2008-01-09T20:28:00.000-05:00

Dow up 140+ points, NASDAQ gets some releife too. Nothing much to write about in today's market. Sokme sanity returned with select reports indicating its not a recssion after all! This meant financial stocks got some reprive; but that didnt even remotely compensate for what has happenned over the past 2 months!
Now, get ready for earnings season. A lot of reports expected from behemoth financial firms. Bernanke speaking tomorrow - just hope he sends some clear soothing signals! The Fed is expected to meet on Jan 15...and its a question of 0.25 Vs 0.50 in terms of rate cut. I bet its 0.25, since oil prices and inflation are refusing to budge.

Back to picks for this tough year...apart from the ones mentioned earlier:
- PFE (Pfizer). Pharma's good in this down turn, P/E of 10 looks very attractive
- BMY (Briston Myers Squib). Pharma again, but at a higher P/E. Not as attractive as PFE though
- BUD (Anheuser Bush, of Budlight fame). Drink your way through the recession :-)

Some risky medium-term shorts: GG (Goldcorp), XOM (Exxon). I am still long on low-risk bonds, mainly of the longer tenure.

PS: And interestingly, E Trade management did wake up with their announcement of the USD 3 bn MBS sale and closing down of their institutioinal sales division!

The slide continues...while the primaries flourish!

2008-01-08T21:23:00.000-05:00

Another bad day at the market, with existing home sale numbers further pulling the market down. Added bad news on write-offs, CEO resignations and rumours of Countrywide's bankruptcy meant doom for the market.

Pharma stocks seem clearly poised to be one of the safe havens in this troubled market (apart from staple consumers like KO, MO etc i.e.)

Bad news still at the markets, but it's good to see massive turn outs for the New Hampshire primaries! The sheer enthusiam of the voting public (helped by unusually mild winter weather) is to be applauded. The betting market, which gave a 98% chance for a Barrack victory, might be proved wrong with Hillary leading numbers as of now...too close to predict though! I just wish there's more of a focus on the economy & global competitiveness as against Pakistan & Iraq in candidate debates. The media needs to do a better job at guiding public focus too!

Bigger worries?

2008-01-07T16:25:00.000-05:00

Unfortunately, good news takes longer to travel around - and bad news does spread like fire!

"Banks could lose as much as $242 billion from the mortgage crisis, leaving the industry in need of more capital, analysts at Friedman, Billings, Ramsey & Co. warned on Monday". Most of the losses posted so far by financial services firms relate to lack of liquidity in (high-risk) securities backed by loans and resultant lower mark-to-market valuation. Their analysis predicts another category - actual credit losses on book loans - to rise its head in 2008 and may be 2009...which means higher-than-expected write-downs.

My personal reaction (Disclaimer - I honestly dont have the data & analysis that these guys do, though!) - its a classic case of bad news designed to chase bad news. Like the S&Ps and Moodys of the world lowering ratings AFTER every market collapse, while they are supposed to do that BEFORE (if they are truly doing what they are supposed to do)!. The bad news has been factored in already & its now the turn of shorts in the market to depress things further. It just takes a whiff of positive news from a C, JPM or for that matter any of the biggies to turn the tide and have the shorts run for cover!

Now, let me touch on one of my earlier picks - ETFC. Its been pummelled from the 25s to 15s, from 15s to 8s and from 8s to 3s...and it ended at 2.83 today. It does take some courage to stand for this stock now; but i hold on to my view.
Look at this:
- USD 30 bn in mortgage and home equity loan assets and another USD 12 bn in MBS.
- Only USD 5 bn of the loan assets is with LTV > 80%
- Of the USD 16 bn in ABS and MBS, the Citadel deal has removed USD 3 bn of the worst ABS
This leaves us with a worst-case loss of USD 400 mn for the year. Assuming some revenue loss on the brokerage side due to bad press, we should still approx an EPS of 0.50. Even a price of 5 makes a P/E of hardly 10, pretty lean! Obviosuly there are a lot of variants here - but that's like a good guess. Wait for Jan 24 (earnings) and you should by all means see them doing better than what this market expects! They need to immediately do further to stop the negative press though. However, i do repeat - you got to have a 12 month holding period and closely watch the earnings announcement on the 24th to ensure there's nothing turning fundamentally weak there!

Uh...bad start for the year.

2008-01-05T00:22:00.000-05:00

I was travelling - in the East Coast, in frigid winter - hence couldn't pen down my thoughts after Thursday market close.

This week has been as bad as it could be! On top of the ISM data and oil price shock early this week, job data which came in on Friday confirmed every one's worst fears. 5% joblessness rates and a mere 18,000 addition in December (as against an average 110,000+ in normal times!) REALLY confirms economic slow down. On top of this, we had bad news from every end - National City cutting 800 more jobs, another prominent CEO quitting (State Street Global Advisors), Retail layoffs, projected lay offs in MER and C.

Enough is enough (was that Mike Huckabee's or John Edwards's - both speak the same hardline tone anyway!). C'mon, it cannot be that bad. It's hard to think that en economy cruising at 4.9% annual growth rate in 1 quarter falls to deep recession the next. It's the market over-racting, typical of a period when people realize growth wont be as rosy as it was for the past 10 or 12 quarters. Biggest losers...the usual suspects - Retail, Home construction, automobiles & worst of all, Financial Services.

C, WB, JPM, MER, GS (!) all pummelled. I would say it's time to ENTER some of these stocks provided you're patient to wait. This sector is set for serious rebound once the market gets its bearings right.

As a hedge, keep equal bets on a mix of the following: Quasi-sovereign income/bond funds, Large-cap pharma, Staple consumer (KO, MO, JNJ).

Always remember - rain or shine, you place your bets right and smart!

Bloodbath on Day 1 - does not mean immediate recession

2008-01-02T20:31:00.000-05:00

ISM's manufacturing index at 47.7
Downgrade on the chip sector by Bank Am
Oil (artificially) touches 100 a barrel!
Gold and commodities rally - Gold crosses the '80s high of 850/ounce!
Net result - Dow loses 220 points on day 1 of the new year! (worst opening ever)

If that does not worry an average investor, what else will?

But, I hold on to my view - the economy is NOT headed for a major recession. It will be a sustained slow down with ~1% growth rates for 4+ quarters. And for the financial sector, i still hold them (if you are in) & stay put - you won't repent! Don't expect 4 week gains, but hold tight for 6-12 months and you will be in for surprise.

Commodities - may look good. But dont tread in unless you are the proverbial fool - we WILL see a significant (read 15%+) correction in gold over the next 2-3 months. Gold will do good medium term, but get in after the next correction!

January is going to be a VOLATILE month (Capitals intended!). If you are in to sectors like Financials, hold on. But if you are trying to enter, cool down and wait till January end.

Where to Invest in 2008?

2008-01-01T11:18:00.000-05:00

Consider this - the US economy has slowed down from a quarterly annualized growth rate of 3-4% to about 1% in Q4 2007. With all my due respects to Larry Kudlow & company, I would bet safely that we are clearly facing the start of a period of economic slowdown in the US. If markets behave the way they usually do, here's my prognosis for 2008:

The US housing market would face prolonged slowdown atleast till end of Q3 2008. With more ARMs resetting over the next few quarters, subsequent delinquencies and further write-downs of bank Level 3/sub-prime assets as home prices continue to fall, there's enough negative momentum left for another 2-3 quarters.
Negative fall-out from the housing market will impact consumer spending in a bigger way in Q1 and Q2 2008. Consumer spending (accounts for 2/3rd of Gross GDP) slowdown will eventually affect corporate spending and capex, and the job market by Q2 2008. We should expect to see job market contraction around late Q1-mid Q2 2008.
Despite the magnified effect of the housing market on th eeconomy, global economic factors (continued growth in Europe, Asia & Japan) would help the US to avoid a recession next year. This would mean sustained 1-2% growth numbers for most of 2008.
Emerging markets, primarily India & China, would face significant stock market corrections around Q3 2008. Slow down in US growth will eventually affect certain sectors in these economies, forcing corrections in market valuations. Market PE in India, for example, would drop from ~22s to ~18-19 in the medium term.

What does this all mean - where to invest & where NOT to invest in 2008? [Stocks, Bonds, Real Estate....]

US STOCKS

Contrary to perception, the US financial services sector will infact MODERATELY OUTPERFORM the market in 2008. Most of the negative news has already been factored in, and any positive news would create significant upsides. Stocks to watch for significant gains: Citigroup (C - far more resilient due to global presence. Sub-prime write-down impact has been over-played by the market. Expect Vikram Pandit to take some drastic steps to address operational efficiency issues), E*Trade (ETFC - Inherent strength of the original business model will help hold customers. It's fire-sale of high-risk assets to Citadel will cushion earnings impact for the next 2-3 quarters and help ride over the current crisis). However, in this sector, you need to have a 6-12 month time horizon for Q1 investments!
Oil, Heavy Engineering, Automobile stocks will face significant pressure as the slow-down spreads to the broader economy. Avoid CAT, XOM.
Technology stocks including darlings like AAPL, MSFT will face pressure by Q2 2008 due to broader economy slow down - their continued strength in Q4 2007 is more due to lag effects associated with a slow down than anything else!
Commodity stocks (notable - Goldcorp:GG) MIGHT see significant gains over the next 4-8 quarters. However, the recent bull run in these segments will force near-term corrections. So, get in only after a significant correction - and only if you thrive in volatility!
As in any slowdown scenario, staple-consumer and pharma stocks will hold strong. Notables - JNJ, BMY, KO, PG.

OTHER INVESTMENTS

As you would have figured by now, stay OUT of the US housing market (from an investment perspective) till end of Q3 2008. We should see the bottom by late 2008, though it will be a slow climb up from there!
Avoid increased exposure to emerging market stocks and funds. As mentioned above, these markets would be negative-to-neutral on an annual basis in 2008, and will face significant medium term corrections. An interesting pick - Indian offshore providers (INFY, WIT, CTSH) will have positive momentum as rupee appreciation is contained in 2008 (~5%) and US economic slowdown pushes more offshoring to India and China.
The real estate sector correction in US & ripple effects on the global economy will force corrections to real estate market in emerging market economies (India being a notable example). However, we will see continued growth in Tier II/III business centers in these economies, as businesses relocate and overall demand remains stable/upward.
As the US economy slows down and its ripple effect on the global economy starts felt by Q3-Q4 2008, there will be a continued flight of money to safer quasi-sovereign investments. Expect to see abnormal returns on high-grade bond investments (treasuries, high-grade munis, AAA corporate etc) over the second half of 2008 and extending well in to 2009, as even emerging market and European economies are forced to cut benchmark rates to push continued growth. Try parking some money in income funds with a heavy focus on high-grade paper.

"As in everything, investing is an art & we learn more as we know more."

More to follow....stay with me to track markets as we step in to a brand new year!