It appears that CEO Daniel Bouton will keep his head, at least for a short period of time. The board wants him to complete a massive capital infusion program that will keep the bank afloat. However, long term everyone expects that he will go. The New York Times quoted one director as saying it is unclear if "the captain or the boat will sink first."
Bank Defies French Elite and Keeps Chief, for Now
The astounding part of the story is that the entire situation was brought about by a junior trader. Well, at least that is the story which Societe Generale is pushing in the media. The reality is that the entire fiasco is an example of the firm failing to have even the basic suitable practices in place pertaining to risk control. Even worse, this situation appears to be common place at major financial institutions. As long as a trading team is making money, all proper oversight regarding the risk of positions is commonly ignored.
It is interesting that Jerome Kerviel’s managers were hailing him as a hero in early January, and negotiating whether his bonus should be 300,000 or 600,000 euros. Within days of this – by Monday, February 21st – he was told to get lost as his long position from the 18th showed huge losses in a down market. The unwinding of this position led to a crisis.
Extraits des procès-verbaux des auditions de Jérôme Kerviel
The evidence chain at this point indicates that Mr. Kerviel’s sole motivation was to make money for the bank, and his bosses supported him in his endeavors since 2005 --- until he blew up. In the past the management team had covered up poor trading results, and the size of the trade that he put on in mid-January was not unusual. If the position had paid off instead of going against him, then Jerome Kerviel would have been hailed as a hero by his management team. Strangely enough, some of the audit trail manipulations performed by Mr. Kerviel were to cover-up the size of his obscene profits in late 2007 rather than to hide losses.
A recent article at Wall Street & Technology questions if the fraud could have been easily prevented by putting some basic risk control measures in place.
Societe Generale: Could it Have Prevented $7.2 billion fraud?
Thursday, January 31, 2008
It appears that CEO Daniel Bouton will keep his head, at least for a short period of time. The board wants him to complete a massive capital infusion program that will keep the bank afloat. However, long term everyone expects that he will go. The New York Times quoted one director as saying it is unclear if "the captain or the boat will sink first."
Wednesday, January 30, 2008
As expected, the Fed cut rates by ½ percent today bringing a rally in the afternoon market. The cut is not likely to act as an immediate antidote to the larger economic issues in plaguing the economy. There is always a lag before an interest rate remedy works itself through the business chain. This implies that the unprecedented rate cut of 1.25% over just a few days will not slow the pace towards a probable recession.
Some pundits question if these emergency rate cuts are useful or will simply drive new asset bubbles. The economy exhibited the worse economic growth in five years during the 4th quarter, only growing at a mere 0.6% rate. Some reports claim that the U.S. will avoid recession, while commentary today from Alan Greenspan indicates that we may already be in a recession. Hopefully the rate cuts will enable the recovery from a faltering economy down the road.
Other news stories at the top of the press show that broader economic concerns remain despite the action of the Fed. Sallie Mae (SLM) secured $31 billion in financing Monday; this did not however boost the stock or quiet the skeptics of this student loan entity. Even with the addition of this cash, the slide of Sallie Mae is likely to continue.
The collateral damage from the U.S. troubles continues to spread increasing the probability of a global recession. Internationally housing still looks bleak; many real estate markets have folded over outside of the U.S. One recent article (U.K. Housing Market Cracks) outlined the situation across the Atlantic.
Rising unemployment, higher prices, housing concerns, retirement plan anxiety, and weakening business outlook have weighed on U.S. consumer confidence. Most consumers are negative on conditions and are slowing their spending in response. This problem is reflected in the slowing activity that retailers are seeing at the store-front in January after a weak holiday spending season. In the end it will be the consumer, representing two-thirds of the economy, who will either drive the U.S. into recession or save us from one.
Let your voice be heard....
How will the Tech Sector perform in the 1st Quarter of 2008?
Come add your vote at the top left of the HingeFire blog!
Tuesday, January 29, 2008
Summer 2005 – Wall Street
“All swans are white” shouted the leader of the investment banking crowd.
“and what if a black one shows up,” countered the risk manager.
“Do you know how much money we are making on these CDOs? How can there be any risk. Risk is a thing of the past. This is the new generation of banking, risk is distributed," cried the room in chorus.
“The black swam is stalking you, and it is just a matter of time till it makes its appearance,” shouted the risk manager over the din.
“The quants have modeled this stuff over the last ten years. They assure me there is no risk and we are going to make a ton of money in fees. Don’t rock our rice bowl,” stated the lead derivative banker as the crowd rose to leave the room, “Let’s go make some bonus money!”
The risk manager sadly shook his head while staring directly at the black swan that was obviously sitting on the table.
The risk manager resigned the following week and was quickly replaced by one more pliable to the demands of the derivative structure crowd. The figurine of the three monkeys on the new risk manager’s desk was an evident sign of the impending future.
The combination of greed, poor modeling, and deliberate disregard of proper diligence practices has come home to roost in one of the largest catastrophes ever experienced by Wall Street. The events of the last six months are an outline of a history lesson that will be taught in business school classrooms a hundred years from today. The trail of wreckage is widespread and unprecedented. Adding liquidity from the Fed was not able to unwind the credit crisis, and the industry was not able to bail itself out. Many major financial institutions had to turn to foreign sovereign funds to provide cash to avoid being effectively left insolvent from a capital ratio perspective.
Value at risk is dead, a new model is needed that properly accounts for derivative risk on Wall Street. The new representation needs to take into account the expectation of six-sigma events and disregard the pressure from bankers focused on greed over common sense. The concept that firms can solely account for risk by defining the dollar amount at risk on any given day with 95% confidence is a failed relic of the past. The quantitative models from Wall Street wizards that cherry-pick ten year nonvolatile timeframes as evidence that no significant losses can ever occur for derivatives has been debunked. The fantasy in the brave new world of banking that risk can be distributed in the derivatives market and nobody will ever be left holding the bag has obviously crumbled into dust.
A recent article (Death of VaR Evoked as Risk-Taking Vim Meets Taleb's Black Swan) outlines these concerns with this opening:
"The risk-taking model that emboldened Wall Street to trade with impunity is broken and everyone from Merrill Lynch & Co. Chief Executive Officer John Thain to Morgan Stanley Chief Financial Officer Colm Kelleher is coming to the realization that no algorithm or triple-A rating can substitute for old-fashioned due diligence.
Value at risk, the measure banks use to calculate the maximum their trades can lose each day, failed to detect the scope of the U.S. subprime mortgage market's collapse as it triggered more than $130 billion of losses since June for the biggest securities firms led by Citigroup Inc., Merrill, Morgan Stanley and UBS AG."
A number of earlier articles at HingeFire talk about the Wall Street derivatives debacle:
Does the Securitization Model actually work?
The Derivative House of Cards: The “Shadow Banking” System falters
Will Someone tell the Financial Whiz Kids that their House is Built of Cards
Monday, January 28, 2008
Many times I am approached by people who have recently graduated from college who want to know how they can become a millionaire. Many chatter about some far-fetched scheme to strike it rich by the time they are thirty and retire to some lush tropical paradise.
The stark reality for many of these recent graduates is glummer; there is no ‘easy money’. Very few of these individuals will become executive VPs by age 25 or agents for Hollywood movie stars. Most college graduates will labor in companies in professional positions starting in the $40K to $60K range, and can only look forward to 40 more years of being a cube rat in their selected career path.
The good news; you can still easily become a millionaire while laboring in a standard job in corporate America. It simply requires some financial common sense. Most of the millionaires in America are not famous superstars but the older person laboring away in the cube just down the hallway.
The majority of millionaires in America achieved this goal by simply sticking to a few basic financial rules after they graduated.
Scratch the fancy car when you graduate
One of the most critical mistakes that many graduates make is rushing out to purchase a fancy $30K plus car immediately after they graduate. This normally sticks the new graduate with a $600 per month or greater car payment. Sure the car may look hot outside the bar on a Friday night, however you probably have wreaked havoc on your financial future the day you signed the lien papers. Purchasing an expensive car with a sizable loan or lease payment greatly reduces the income available that can be saved; while sticking the owner in an asset that drops in value each month.
When you graduate from college you should focus on purchasing a good used car or low-cost new car. The key is to keep the size of your loan and monthly payment to a minimum. The loan is useful from the perspective of building a credit history, but you don’t want the payments to gobble up the majority of your monthly take home.
If you are able to keep using a car that faithfully took you through your college years while enduring all the tailgating, then you should strongly consider of sticking with this fine automobile. Not only for the enduring memories it carries, but because it makes financial sense. As long as you are not spending a huge amount on repairs each month to keep the old jalopy running, then sticking with the old car after college many times is an excellent decision for you financial future.
Fully fund your 401K
At minimum always fund your 401K plan to get the full company match. The company match is free money. It is better to fund it up to the 401K limit ($15,500 in 2007), but understandably this is not possible for many graduates. However they should always attempt to save at least 10% of their salary in their corporate 401K plan. Going beyond 10% is a great bonus.
It is important that you probably diversify your 401K investments within the funds offered by the corporate plan to align with your age and risk tolerance. An earlier article discusses proper 401K diversification in detail.
Portfolio Diversification – 401K
Save 10% more
Outside of your 401K; you should put away an additional 10% of your monthly salary. It is best to place this money in an IRA if appropriate for long term tax-free savings, or put it in a taxable fund destined for the down payment on your first house. Have an investment plan based on the long-term and short-term objectives. Do not put the money into risky investments, but focus on a diversified portfolio that aligns with your time frame. For example, if you are considering the purchase of a house shortly then if makes sense to leave the down payment in an interest-bearing cash account.
It is important that you also drive to create a rainy day emergency fund. Over time you should drive to put six months of pay in this “rainy day” account. It can be used in crisis situations such as medical bills, auto collision repairs, and to cover expenses in case of job loss. Remember that you live in the age of corporate re-structuring; it is very likely that you will experience being dumped on the street with less then one month’s severance pay before you are thirty years old. Since 1999, over 70% of professional Americans under the age of 30 have been “re-structured” according to one survey.
Buy a home
If you plan to stay in a particular geographic area and want to settle down there, then you should work towards purchasing a house, townhouse, or condo. You should only purchase a home if you qualify for the loan under traditional lending standards with a 30 year fixed rate loan. Do not over-stretch yourself with interest-only and other exotic home loans. We are currently watching the foreclosure drama in America of what happens to a million plus households who over-extended themselves with adjustable rate loans. If you can not afford a home with a traditional loan then you must continue saving or find a place that is more affordable.
Homeownership provides some good tax breaks and allows you to build equity over time, even with all the cycles the housing market experiences. Money spent on rent is basically lost and does not build your financial future – a home you own acts as a leveraged asset that allows you to build equity over time.
The following calculator demonstrates the long-term financial advantages of owning over renting.
Should I Rent or Buy A Home?
Don’t purchase all that junk brand new
So now that you have a nice house or apartment, there is no need to run out and purchase every single item imaginable at the local stores to fill every corner. Why buy that dining room set for $5000 brand new on store credit when the people with the garage sale next door are selling a better quality used set for a mere $300? You should be willing to purchase items used or online in order to get great discounts off of the retail prices in local stores, or wait until desired items go on sale.
In our consumer driven nation, the money that you will save over time by buying products at a discount adds up quickly towards your bottom line. Always take the smart path in regards to purchasing stuff. First ask yourself if your really need it. If yes, then use common sense in obtaining major items and don’t buy on impulse in the store. Usually you will land up with just as nice stuff in your home as the guy next door who purchased everything at a premium, but unlike the neighbor you won’t be burdened with $50K in credit card debt.
No credit card debt - EVER!
Don’t ever run up debt on credit cards that you can not pay off at the end of the month. Repeat over and over again until this becomes mantra. There is not reason to ever run up a credit card bill with frivolous purchases that you can not pay off at the end of the month. If you can not afford it then don’t buy it. This applies to luxury items, electronics, exotic vacations, and all other purchases. Once again, if you can not afford it then don’t buy it.
This general rule of debt not only applies to credit card debt but all other similar debt such as personal loans, unsecured loans, boat loans, car loans, and unaffordable store credit situations. From a general fiscal perspective, the only things that you should take out loans for are home mortgages and money for starting a business. These are items that hopefully appreciate over time.
The sole possible exception to this hard rule should be medical emergency bills. However you should always try to work out a payment plan with a hospital or medical office rather then putting these charges on your credit card.
Pay off student loans
After you graduate if is probably too late to provide advice about obtaining the most affordable student loans, and as many grants and scholarships as possible. It is preferable to walk out of college with little to no debt; however this is not realistic for many students.
What can a graduate do about that mound of college debt that they have to start making payments on? One is to consider consolidating multiple student loans within six months of graduating in order to minimize your monthly payment. There are multiple resources on the web that discuss this. One good resource is the U.S. Department of Education which provides some good information about paying student loans.
Many students walk out of college with sizable debt. Students should take steps if possible to reduce interest rates on the debt and minimize their monthly payment. I would also urge graduates to consider accelerating the repayment of their student loan debt, especially high interest rate loans, if this is possible within their monthly budget.
Avoid car loans
It is usually difficult to get your first car out of college without a loan. However after your first car you should never take out a loan for an automobile. Cars are depreciating assets, they lose value the minute your drive off the dealership parking lot. It usually makes more sense to purchase good used cars with cash then buying brand new cars with lofty premiums.
My family drives Mercedes. Why did I select these high end expensive cars – it does not sound very frugal? The immediate answer is because they are safe, as a recent accident which totaled one of the cars demonstrated. The good news - everyone walked out of the car without any serious injuries. Many of my neighbors think these cars in our driveway are new because they are kept in great shape. None were purchased new and I drove my last diesel till it had over 220K miles then sold it to our neighbor for his son to use. The key point here is that you can enjoy all the benefits of luxury cars without going into debt paying for them, if you simply apply some basic financial common sense.
Use common sense in your lifestyle – the 80% rule
Use only 80% of your take home pay and save the rest! Most people can cover their housing and food expenses while still enjoying a lifestyle that includes dining, clubbing, and vacations while saving 20% of their pay. Live within your means. Don’t make huge frivolous purchases; that new 62 inch plasma TV may look neat but it sure is going to cause a hit to the budget before the Super Bowl party.
Effectively “living below your means” will allow you to put aside money for investing that will fuel your long term financial success. The good news is that it is not necessary to live like a miser and worry about every penny in order to do this. When I first got out of school and was socking away twenty percent of my cash, I was not overly concerned what my tab at the bar was over the weekend, it came out of the ‘80%’ dedicated to monthly living expenses.
This concept of saving 20% of your take home pay aligns with the idea of saving 10% of gross pay beyond your corporate 401K contribution when taxes are taken into consideration. However, the key concept to take-away is that for long term financial success you should live at 80% or below of your monthly take-home pay, and avoid large frivolous purchases.
Don’t ever use HELOC or other home loans as an ATM machine
We have recently watched a good number of homeowners in America using their homes as ATM machines while housing prices have risen quickly over the past few years. They used the increasing equity in their homes to purchases cars, boats, planes, and other costly luxury items. Now that home prices are dropping and the lending spigot has been cut off, the birds are coming home to roost. Many of these homeowners are stuck with loans that are worth more then the values of their houses, and are under stress to make the payments.
Homeowners should only use cash from HELOCs and other home loans to improve your house. This was the original intent of these types of loans. The concept was to build additions or re-modeling to your home that would add value, thereby maintaining your overall equity in your home.
For first time home buyers, HELOC and similar loans make common sense when they are used for the correct purposes.
Choose a partner with your values
Thinking of getting married? Some quick advice --- Be sure that your significant other is aligned with your values regarding money. I would urge couples to fully talk about finances before they tie the knot and define a plan of how to handle everything.
A good portion of the divorces in America are due to arguments over money. The average middle-class divorce now costs $187,000 when all factors are taken into consideration. This type of financial hit is nearly impossible to recover from when you are saving towards a long term objective.
Do these Principles work?
On a personal note, I can attest that following the principles listed above will enable people reach their goal of having a large net worth. Many of the concepts are not only applicable to those who just recently graduated from school but for people of any age. I am 43 and our family has a high net worth. Most of the money is in 401K plans, housing equity, and college money reserved for the kids. All saved while being a single-income family for the past 17 years. My wife had the really difficult job of focusing full time on our children and I would like to thank her for that very publicly; she has done a tremendous job! I got to escape to a cube each day doing software development.
I don’t feel ‘rich’ in the traditional monetary sense. I have three kids to put through college soon and am currently involved in founding a start-up with no revenue yet. Our family drives used cars, only has mortgage debt, and uses common sense in our spending. It is not as if we are misers, our family still enjoys nice cruises as vacations and goes on road trips around our region. Most people would not look at our family and think ‘they are rich’; I don’t have a leased $80,000 sports car in my driveway, nor can I brag about all the things I purchased with $120,000 worth of credit card debt. I expect most of the millionaires in America are like us; not ostentatious, but somewhat frugal and hard-working while living in middle-class neighborhoods.
I am probably more worried about money now then earlier in my life. I don’t really feel “wealthy” or financially comfortable despite being considered high net worth. My financial situation seems like a ‘bigger problem’ now then when I was only 22. This is because I currently have the responsibility of providing for an entire family and in those early post-college days I was more concerned about which night club to go to on Saturday.
While the concept of becoming a millionaire slowly over time may not sound immediately exciting; it is the sure path to achieving this goal. The further good news is that is does not require tremendous personal sacrifice or the scaling back of your entire life to reach this objective – just follow the guidelines listed above and in time you will join the many households with over a million dollars in net worth.
What is “Rich”
It is important not to have stress over monetary issues spill over into relationships and your perspectives on life. In many ways, being ‘rich’ is not about how much money you have in the bank, but being involved with your community, family, and friends.
One of the things I have always promoted is "Giving back to the Community". In many ways this is one of the cornerstones of our family philosophy. Our family is active in local schools, non-profit boards, and other volunteer activities. Whether you are helping in a school, coaching a youth team, building a home with Habitat, running to raise money for the Food Bank, or any other activity; I would urge everyone to get out and get involved. It does not matter what age you are. Many of the best volunteers in our local youth sports, education initiatives, and athletic events for charity are recent college graduates!
Some of my most personally rewarding experiences occurred when I was involved in volunteer efforts. These are the days I look back at and say "Wow, that was great. I made a difference."
Invest in your community - many times it will bring more meaningful returns then your portfolio. Common sense in spending starting right out of college can make you a millionaire, being ‘rich’ however involves much more then money.
More U.S. millionaires are middle-class
Sunday, January 27, 2008
Sometimes a comic strip says it all.....
Friday, January 25, 2008
An astounding week on Wall Street with a wild roller-coaster ride in the market. The market started deeply down on Tuesday following significant drops in world markets on Monday, which was the MLK holiday in the U.S. By the end of the week, the markets have recovered most of their losses while rising in significant counter-trend rallies on Tuesday and Wednesday.
The business news flow this week was no less shocking; starting with the story about the lack of risk control at Societe Generale. This French bank revealed that a low level trader was able to cost the firm $7.2 Billion in unauthorized bets on stock markets. More interesting, the trader did not make any money off of his actions.
In the meantime, the 31-year-old employee at the center of the situation, Jerome Kerviel, has magically disappeared according to most press reports. Some reports claim he has fled while others state his lawyers say he will be available for questioning.
The major banks and brokerages have constantly harped on how they have improved risk control over time. Once again this appears to be a fantasy! First the CDO / SIV crisis, and now a situation where a low-level employee has perpetuated the largest financial fraud in history by an individual.
The absurdity of the situation has led many pundits to question if Societe Generale is being truthful about the situation, or if this “news” has just been cooked up to cover their CDO losses. It seems ludicrous that an employee would be able to by-pass even basic risk control systems at this level of magnitude. Especially since the sell-off earlier this week in European markets is now being tagged to the need of Societe Generale to exit these unauthorized positions.
In the meantime, the housing situation in the U.S. does not appear to be improving. Two key reports underlined the dismal condition of real estate. The sales of single family homes dropped by the largest amount in 25 years. The median price of a home fell for the first time in four decades, dropping 1.8% to $217K. The entire country has not experienced a decline in home prices for an entire year since the Great Depression.
The outlook is not pretty; the housing bottom is not likely to be reached for many months. In some reports, prices nationwide will fall by another 5%. This implies that the drop in hot speculative markets will be much greater. Lasting Housing Woes Paint a Grim Economic Picture
Hoping to improve the economy, law makers in Washington implemented a stimulus plan that will provide most tax payers an additional $600 to $1200 in their refund. The hope is that people will spend this money and stimulate the economy rather than simply paying off debt or shoving it into their bank account. The concept seems counter-intuitive, but with a consumption driven economy it is understandable. Some press questions if the American consumer is too strapped to spend.
Offsetting the news from Washington, the unemployment rate continues to increase. The major banks were at the front of the employment press; Citi announcing more cuts, Goldman Sach’s about to axe 1000, Morgan Stanley trimming another 1000, and the expectation that Bank of America & others will add to this trend.
The Bond insurance situation continues to play out with regulators from New York and other states urging that institutions rescue these firms which insure most municipal bonds. Most states are very concerned because their ratings on existing bonds will dive and cost to borrow additionally money will rise immediately when these insurers become insolvent. Wilbur Ross may be stepping up to purchase Ambac (ABK). MBIA Inc (MBI) appears to be treading water hoping for a deal of some type. ACA Capital Holdings (ACAH.PK) has a mere month to live after receiving a forbearance extension to February 19th from its creditors.
The question remains if the market has arrived at the bottom. Stock markets normally approach the bottom in a very volatile manner, with many violent upside counter-rallies over a period of months. Usually the bottom is re-tested multiple times before a new significant uptrend starts. This can be seen by studying the charts of past troughs in the markets. This also implies that the probability is that this week has not been the local bottom for the market; in light of weakening economic conditions there will be a further slide over the upcoming months. Only time will tell how the entire situation plays out.
In the meantime, investors should focus on the long term with their retirement savings and not attempt to trade the market. Maintain a properly diversified portfolio and understand that the stock market moves in cycles… and in due time will bounce back.
Thursday, January 24, 2008
Over the past days, I have received numerous emails that all start the same way “Help! My 401K is down 10% in ONE month…” Usually the investor then asks if they should go to nearly all cash to stop the red ink?
The market is certainly in turmoil and I can understand the concerns of investors. However it is important for investors to think LONG TERM, and not trade the market with their retirement funds.
The critical point is the need to have a properly diversified portfolio to ride out the market’s valleys and peaks over time. One excellent summary about 401K diversification can be found here.
A number of investors have stashed a large bulk of their retirement funds in overseas funds because these stocks have outperformed the market over the past couple of years.
Unfortunately their decisions to not properly diversify may be coming home to roost shortly. Traditionally international stocks tend to have large swings; while also facing currency exchange risks and other issues. It is important for these investors to properly re-balance their portfolios to align with their age and risk tolerance.
While the 300+ point roller coaster each day is exciting… and stomach churning, it is no justification to alter a properly diversified retirement portfolio. There is no need to suddenly switch everything to cash or bonds Think long term with your 401K !
Wednesday, January 23, 2008
The saga of bond insurer ACA Capital (ACAH.PK) continues. The firm just received new forbearance agreement which gives the company another month to live. ACA wrote insurance on about $69B in corporate and mortgage debt securities, but can only pay claims of $425M. With the subprime meltdown, claims are already well above this level and rising. At this point investment banks may have to write off $10.1B of the $12.7B in bonds that they have insured with ACA.
ACA Capital is just one of the bond insurers in trouble. MBIA (MBI) and Ambac (ABK) face a similar cloud. Both insurers have risen in recent days on the thin hope that either regulators or acquisitions will salvage them. Only time will tell if these scenarios play out. In the mean time, the actual value of insurance on Muni Bonds and many other debt instruments is very much in doubt.
ACA wins more time from trading partners
The market appears poised for another lower open. As outlined in the last paragraph of the “Quick Takes: World markets remain coupled to US economy” post from Monday - traders looked to play the long side of the market after the sharply lower open on Tuesday.
Today is a different story most traders will be looking to sell into any rallies due to the weakness demonstrated by yet another lower opening. The current market conditions with high volatility represent conditions where traders can make a considerable amount of money playing the short-term momentum-driven long and short sides. The expectation is that traders will sell into most rallies and short most peaks; as the overall market declines in a volatile stair-case manner. Markets do not decline in a straight line, there are often violent short-term rallies as the market seeks a bottom. One example of this is the behavior in 2002.
U.S. Stocks Head for Another Lower Open
Tuesday, January 22, 2008
What a difference a month makes. A mere 43% of Americans expected a recession in December; this figure is now up to 75%. In the survey by Fortune, 19 percent believe the nation is already in a recession – they are most likely right.
In response, many Americans have cut back on spending. This is of great concern because it has been consumer spending which has held up the economy. The survey results were ‘far gloomier outlook than economists anticipated’.
‘"Those are pretty striking results, a pretty stark assessment," said Dean Baker, who is the co-director of the Center for Economic and Policy Research, and one of the economists who believes that the nation may have slipped into a recession in December. He said that if Americans are this worried about the economy, it could cause an even sharper downturn than many economists expect.’
The Fed announced an emergency 3/4 percent rate cut less than an hour ago. The cut caused the futures to increase slightly before sliding. The Dow futures increased from being 480 down to 300 down after the announcement before diving to 480 down again.
Many pundits believe that the Fed move is “too-little-too-late” and also empties their bag of future ammo. The move is likely to rally the market slightly before the slide continues.
The next question is “Where is the Plunge Protection Team?’ Traditionally as part of a market oversight committee, the Fed made cash available to large banks that would then turn around and purchase into the market to prevent large scale downside events. With the majority of the banks facing low capital ratios and trying the raise cash overseas, the banks are effectively muzzled and not able to act. The Plunge Protection Team is unlikely to step in with any scale to prevent the slide of this market, especially since it is the condition of the financial sector causing most of the distress.
This down-market is likely to mirror the scale and scope of problems in your grandfather’s generation. Pundits are already talking about today being the “most important market day ever”. However this story will extend beyond a single day. The excesses in the global economy will have to be washed out, this may take months or last for years.
The recent “No Place to Hide” commentary discussed the economic conditions. The market conditions simply reflect the broader issues. Hold on for the ride.
Monday, January 21, 2008
EWI is offering a free investment webinar on January 23 at 4:00PM Eastern taught by Wayne Gorman. Press here to sign up for EWI for FREE and attend the session. An outline is provided below:
Have you ever looked back on an investment and asked yourself, "What in the world was I thinking?!" The obvious reply is "Yes!", and that is because...
...Every investor makes mistakes. It always has and always will be true. But even so, some mistakes hurt you more than others. When it comes to successful investing, what matters is to keep your mistakes small and make few of them.
That is simple, but it's not easy. The most critical step you can take is to identify your mistakes and, more important, understand why you make those mistakes.
You can learn how to do just that by participating in a unique webinar with EWI's Senior Tutorial Instructor, Wayne Gorman. He knows a thing or two about avoiding investment mistakes; he's been doing it (trying to, anyway) for 30+ years!
Join Wayne LIVE on the web, Jan. 23 at 4:30PM Eastern, for his rapid-fire explanation of why these five factors lead to costly investment mistakes, and how you can avoid falling victim:
- The News
- The Fed
- The "Easy Way"
Join Club EWI Now to reserve your FREE virtual seat for this webinar now! Club EWI is the world's largest Elliott Wave Community with more than 125,000 members. It only takes a minute to sign up and it's absolutely free.
While the U.S markets are closed in observance of the Martin Luther King holiday, foreign markets nose-dived today. European and Asian stock markets plunged on the fear of a US recession. Even the Chinese markets, which many times appear to be uncorrelated with the remainder of the world, recorded the largest percentage drops since the September 11th terrorist attacks. Leading the downside, India’s markets dived 7.4%. Most other markets were not far behind; the DAX index in Germany closed off 7.16 percent and the CAC 40 in France lost 6.83 percent. British stocks fared less badly; the FTSE 100 lost 5.48 percent. Canadian and Mexican stocks were off sharply at midday.
How will Wall Street play this on Tuesday? The U.S. market is likely to open lower, but most traders will attempt to play the market to the long side during the day on the expectation that excess fear has placed the markets in an oversold condition.
European, Asian Markets Plunge
Sunday, January 20, 2008
There is now an alternative to oil exchange traded funds, Van Eck's recently launched the Market Vectors Coal ETF (KOL).
KOL tracks the Stowe Coal Index, which covers 60 companies from around the world that are involved in the coal industry. The index was up over 103% in 2007 and has a three-year annualized return of 43.81%. Pretty impressive performance – and the global demand for energy continues to grow. Global use of coal has risen 65% in the past decade, with much of the increase coming from the Asia-Pacific region. Coal supplies a quarter of the world's energy and is the source of 40% of the world's electricity.
On the other side of the coin, using coal for energy is a significant cause of pollution. Burning coal is proven to be a leading cause of smog, acid rain, and air toxins. Investors with an environmental mindset may pan the KOL ETF.
The index includes stocks from 12 countries. The components companies are involved in five areas of the coal industry; mining and production (73.1%), mining equipment (9.0%), transportation (0.7%), technology (2.3%), and power generation (14.9%). The top five components include China Coal Energy, 8.91%; Bumi Resources, 8.62%; China Shenhua Energy Co., 8.22%; CONSOL Energy Inc., 7.52%; and Peabody Energy, 7.31%.
The overall expense ratio is listed as 1.09%, however the expenses are capped contractually to 0.65% until the end of April for KOL. These figures are expensive for an ETF, but cheaper than most energy focused mutual funds. The fact sheet for KOL can be found at Van Eck's website.
The KOL ETF is likely to continue to rise as the demand for energy continues to grow worldwide over the upcoming years. Many countries continue to strive for an alternative to oil – however only coal is the only economical alternative besides nuclear energy available on a mass scale. Alternative energy programs such as solar and wind still face a significant ramp before they can be economically deployed in scale. The prospects for continued appreciation of the Market Vectors Coal ETF appear to be solid – only time will tell if the performance over the upcoming months matches the previous performance of the index in 2007.
Disclosure: The author does not have a position in any of the equities mentioned in this article. The information provided does not constitute a solicitation to buy, or an offer to sell securities.
Friday, January 18, 2008
The entire market endured a painful week; it is difficult to find a price chart which is looking good. This leaves the bad and the ugly to dwell on. One major mega-cap in a down draft is CSCO. The recent chart is an excellent illustration of agony from a technical perspective.
On Thursday, CSCO plunged 3.26% to $24.33 reaching a 52 week low on high volume. The fall greatly exceeded that of the NASDAQ (down 1.99%) and DOW (2.46%). The stock has recently adopted the unfortunate habit of regularly underperforming the broader market on both upside and downside days.
Despite the robust fundamental valuation characteristics offered by Cisco, the technical indicators present a rock-solid bear case. Fundamentals drive the long term prospects of a company; while technical indicators mirror short term price action reflecting the fear & greed in the market.
When viewed from any angle, the chart for CSCO does not spin a good story for the upcoming months. A complete chart for CSCO with many technical indicators is displayed in the figure. At first glance the entire array of information is daunting; however commentary below will break down each of the technical indicators pane-by-pane and explain their significance in context of the price action for Cisco.
There is an old expression that “bears live below the 200 day moving average”, the top pane of the chart shows that the CSCO stock price is under both the 200 day and 50 day moving averages. Even worse the 50 day moving average (black line in top pane) has recently dived below the 200 day (red line) reinforcing the bearish price action (see Screening to Win: Moving Averages for more information). The recent lows were reached on high volume adding emphasis to their significance. A horizontal line drawn across the chart at the $25.25 level will show the stock has broken below the previous support in the March to June timeframe. (Outlook: Bearish – for moving averages, new 52 week lows on high volume, and break below support levels)
The Relative Strength Indicator (RSI) has continued to trend down to lows near the 30 level demonstrating the lack of strength of the stock. The trend is down with no reversal seen which would indicate potential for a new uptrend. (See Screening to Win: RSI for more information). (Outlook: Bearish)
The Moving Average Convergence Divergence (MACD) indicator is below the Center Line (zero level). The black line indicator is below the signal line, these are both bearish indicators. Furthermore both the MACD signal and indicator lines are in a downtrend, never a good sign. (See Screening to Win: MACD for more information). (Outlook: Bearish)
Chaikin Money Flow (CMF) shows that money is effectively flowing out of the stock. While CMF has come off of its lows, it remains at levels below -0.2 demonstrating little conviction for improving pricing. (Outlook: Bearish)
The Rate of Change (ROC) indicator remains below the zero level showing that the short term pricing momentum is negative. The reading near the -10 level underlines the lack in strength in recent pricing. (Outlook: Bearish)
The Stochastic Indicators (STO) exhibits some hope for CSCO stock pricing. Readings below 20 are generally considered oversold. This indicates that the stock price may bounce in the short term after all the recent selling action (See Screening to Win: Fast and Slow Stochastic for more information). However the bounce is not likely to be strong or long-lived unless the other indicators start demonstrating improvement. (Outlook: Neutral)
The Money Flow Index (MFI) is not below the 20 oversold level, eliminating hope for a bounce. MFI is in a downtrend and falling rapidly (See Screening to Win: MFI for more information). This leads to the expectation of more negative price action for the stock as money “flows out”. (Outlook: Bearish)
Williams %R is an oscillator which is presented on a inverted scale. Levels below 80 are generally considered oversold. The level below for a significant period of time increases the probability for a short-term positive bounce in the pricing of CSCO stock (See Screening to Win: Williams %R for more information). However this would have to be correlated with other indicators to show any possibility of a long term trend. (Outlook: Neutral)
The Average Directional Movement indicator (ADX) shows the price trend for CSCO stock is strongly negative. The black ADX line now above 30 shows the strength of the movement and the red –DI line shows that the momentum is very negative. (Outlook: Bearish)
The Aroon Oscillator is normally choppy but shows the trend in price action. The level below -50 with a oscillator continuing to fall to new negative levels is a bearish sign for upcoming price action. (Outlook: Bearish)
In summary, the price chart and technical indicators all present a case that further downside price action will occur over the upcoming weeks. Nearly all the technical indicators can only be considered to reflect a bearish case, and the couple of indicators which evaluated as neutral merely indicate the possibility of a short term price bounce, which is likely to be under $2. Keep in mind that technical indicators are normally only reflective of short term price action in the market. However a large number of bearish indicators build the case that price recovery over the next 90 days is unlikely.
This is further reinforced by running models based on Monte Carlo, standard deviation, options modeling, momentum, mean returns, and other quantitative factors. Many studies utilize quantitative spreadsheets which combine many of these factors to evaluate the price potential of stocks over the upcoming 60 or 90 day timeframe. A recent run on CSCO shows an 18% probability of hitting $20 within the next 90 days and a mere 4% probability of hitting $30 in the same timeframe.
The basic spreadsheet building blocks for quantitative price modeling are available at http://www.gummy-stuff.org/ This website, put together by professor Peter Ponzo, is an excellent resource. Some useful price modeling spreadsheets at the site include:
Price Prediction – Options Modeling
Price Probability - Modeling
LaPlace Transforms – Price Predictions
Predicting Prices – Standard Deviation / Mean Returns
Naturally there are upcoming events that hold the potential to disrupt the current negative price trend. Cisco stock tends to move dramatically around the quarterly conference calls; the next call is coming up February 6th. Many times these calls serve to mark a change in trend. However there are several fundamental factors conspiring against Cisco for 2008. The domestic market sales to financial institutions and other troubled sectors are likely to drop as the economy slows. Many of the good figures relative to international sales in the past year were driven by the weakening dollar. This trend is likely to reverse in 2008; a strengthening dollar will have a negative impact on the reported international revenues for most multi-national firms.
The Cisco story also indicates why it is important pay attention to insider sales. When CSCO stock was over $28 during the past year, there was an obvious increase in executive stock sales based on the regular press announcements. The quarterly reports also appeared to show that the rank & file employees were also executing stock options at an unprecedented rate. Many fundamental analysts view this type of activity as a potential leading indicator for stock price underperformance.
Certainly Cisco has some tremendous valuation attributes which makes the company the envy of the Tech Industry. The admirable cash flow, market strength, reasonable ratios, and other attributes exemplify a company with excellent long term potential. Technical indicators are good for evaluating short-term price action; however the long term price of a company's stock is always driven by the underlying fundamental factors.
Thursday, January 17, 2008
Most investors continually search for the next “ten-bagger” which will explode with enormous returns. Many of these opportunities are found in small company stocks. Typically small caps as a group outperform larger companies. However significant risks must be navigated when selecting individual small cap stocks.
A dearth of analyst coverage means that small-cap stocks are more likely to be priced inefficiently. The majority of the growth and stock price acceleration occurs when companies are still small. Most institutional investors avoid small caps, at least until they grow larger; this leaves many small caps as yet undiscovered champions.
While the market has taken a dive in recent weeks, there are still a number of small cap stocks that appear to offer excellent growth potential. The recent market turmoil has the advantage of now offering these stocks at a discount from previous prices.
Several growth oriented small caps show outstanding potential for future returns. In the hardware, software and service sectors, five promising candidates include; Concur Technologies (CNQR), HMS Holdings (HMSY), Sigma Designs (SIGM), Synchronoss Technologies (SNCR), and Synaptics (SYNA).
These stocks were initially found in using the HingeFire stock screener to search for growth-oriented stocks capitalized between 500M to 2B. Further comprehensive assessment revealed strong balance sheets, growth outlooks, and stock price potential for these companies. Importantly, the firms also have the attractive attribute of being engaged in rapidly growing market segments.
Concur Technologies (CNQR)
Most companies are going to great lengths to reduce employee travel and business expenses. In many cases, the reporting of this non-core activity is being outsourced to outside firms or companies utilize third party software packages to track this information. Concur Technologies is a leading provider of employee spending management solutions.
The business of outsourced travel and entertainment accounting is expected to grow to $7 billion over the next five years. Concur Technologies is positioned directly in the middle of this growth segment.
Concur Technologies recently acquired its primary competitor, Gelco, through the acquisition of H-G Holdings in a $160 million cash deal in October. The firm has a 1.3 billion market cap with a 2008 sales estimate of $200 million. The company has minimal debt and strong operating cash flow.
Even at $30, Concur is not cheaply priced. The company sports a trailing P/E of nearly 150 and a forward P/E of 50. CNQR will have to execute perfectly to hit expectations of growth and earnings to maintain these rich valuations. However there is a strong belief in the analyst community that the company will hit the expectations of 55% growth expectations for revenue and income.
Concur Technologies shows the attributes of a stock with exceptional price potential – a strong balance sheet, excellent growth prospects in a booming industry, and a history of solid execution.
HMS Holdings (HMSY)
HMS Holdings Corp recently hit 52 week highs. The company provides cost containment and coordination of benefits to government healthcare programs. The administration and cost containment of healthcare benefits in the United States has become an increasing concern for government agencies. The outsourcing service market for this activity has experienced solid growth over the past years, which is expected to continue into the future.
HMS Holdings is experiencing increasing analyst coverage, normally a positive sign for a company. Bank of America Securities recently initiated coverage.
The company has an $850 million market cap with minimal debt, solid cash flow, and recent revenue of $138M. The trailing P/E of 70 and forward P/E of 45 shows that the firm is handsomely valued, however the recent quarterly revenue growth (78.7%) and earnings growth support these high expectations.
HMSY has a history of increasing guidance in its conference calls as it did in the recent Q3 call when it announced raising the 2008 full year revenue guidance to $170 million, an increase of 17.2% above 2007 guidance, and adjusted EBITDA to $49 million, an increase of 22.5% over 2007 guidance.
HMS Holdings has to navigate a maze of government regulations while providing coordination of benefits and cost containment to agencies, however this is a service that the government very much needs and the firm is excellent at providing. With the U.S government continuing to increase this type of outsourcing activity, the potential for HMSY stock looks bright.
Sigma Designs (SIGM)
Sigma Designs, Inc. is best known as maker of microprocessors for digital media products such as DVD players, set-top boxes and high-definition televisions. The company has a dominant market share in IPTV and HD DVD; these two markets are expected to explode over the upcoming years as more video is provided over the Internet and the United States broadly rolls out high definition television.
Sigma Designs faces growing competition from other players such as Broadcom Corp. (BRCM) and Zoran Corp. (ZRAN). However these competitors have not eaten into their growth or margins. Sigma Designs reported third-quarter sales of $66 million, a 56% sequential growth, easily trouncing Wall Street projections.
The company has reasonable P/E ratios (trailing: 26.74 / forward: 14.9), excellent earnings growth, no debt, a growth estimate over 29%, and a market cap of $1.14 billion. For a technology company in hot market segment, it is hard not to view Sigma Designs as an exceptional value. A recent company investor presentation can be found at Sigma Designs Investor Presentation – Jan 2008.
Synchronoss Technologies (SNCR)
Synchronoss Technologies is more than just an iPhone activation story. The iPhone release was a great setting for Synchronoss to demonstrate to mobile carriers what it is capable of doing. This is likely to prime the pump for many other carriers to pick up their on-demand, multi-channel transaction management solution technology.
With the iPhone activations fueling it, AT&T (T) generated 78% of the firm's revenue in the recent quarter, so diversification of revenue source is a significant concern for investors in this company. Making inroads in the carrier market takes time; however Synchronoss is seeing traction with Clearwire, Cablevision, and Vonage (VG). It is expected that the company is also working with overseas carriers such Deutsche Telekom's T-Mobile, France Telecom's (FTE) Orange, and Telefonica's (TEF) O2 on rollouts of the iPhone in foreign markets.
For the third quarter, Synchronoss reported net income of $8 million, or 24 cents per share, compared with $3.1 million, or 10 cents per share, last year. Quarterly revenue jumped to $34.5 million from $18.9 million. The company has a market cap of $736M, minuscule debt, a forward P/E ratio under 25, good cash flow, and a history of excellent earnings growth in 2007.
The long term success of Synchronoss is dependent on its ability to penetrate other carrier accounts beyond AT&T with its management technology. Investors should focus on announcements of additional carriers deploying the solution. Assuming that SNCR makes these inroads, the stock price is likely to climb significantly from the current levels.
Synaptics Incorporated (SYNA)
Synaptics Incorporated develops user interfaces for mobile devices like notebook computers and cell phones. Dominating the market, Synaptics makes 60% of all touch pads for portable computers and has a customer list which includes 9 of the top 10 notebook vendors. IDC has forecasted annualized growth of 16.1% for notebook PCs from now until 2010. Synaptics also has excellent presence in the handheld market, including design wins for Apple (AAPL) Nano & Classic iPods and several new smartphones.
Synaptics recently endured an analyst downgrade from American Technology Research analyst Jeff Schreiner who downgraded the stock to "Neutral" from "Buy’ citing a slight loss in market share and the expectation of lower 2008 revenues. This drove the stock to a recent low of near $30, making the pricing attractive.
The company shows a trailing P/E of 25.89 and forward P/E of 10.43 leading to a small 0.83 PEG ratio. Both ratios are small for a tech sector stock. With low debt of $125M, a market cap of $950M, respectable cash flow, and history of earnings growth, SYNA has solid prospects.
The crucial question will be if the company can maintain its user interface market share dominance while growing sales at an exceptional rate over the upcoming couple of years. Assuming the company will hit or exceed the analyst projections; the stock price has significant potential to increase from the current levels.
As always - investing in small caps involves risk. Not all projections for colossal growth always pan out. Some small cap stocks will turn into the next “10-Bagger” which you will brag to your friends about for years, while others will fade into oblivion. The key is to screen for potential candidates, investigate them fully, and spread your “bets” across several stocks when seeking over-sized growth. There are never any sure winners, but solid research can put the market edge in your corner.
Disclosure: The author does not have a position in any of the equities mentioned in this article. The information provided does not constitute a solicitation to buy, or an offer to sell securities.
Wednesday, January 16, 2008
It is only Wednesday, but enough activity has already occurred this week to summarize it. This week has been all about the banks and probability that the churn seen in this sector will drive the economy into recession. The choke hold of tightening credit, inflationary prices for necessities, housing issues, increasing unemployment, and flagging confidence will shortly squeeze the consumer out of the game. The fallout from the wobbling bank sector will only add to the downside economic momentum.
The staggering Citigroup loss announced Tuesday raised the anxiety over the economy while clearly underlining the unresolved crisis in the financial sector. Stocks sold off sharply in reaction to the expected-but-disturbing Citi news. The only time in the past where the financial sector was seen moving from good profits to negative profits in a short period of time was the Great Depression.
The credit card sector is also rapidly diving. Capital One (COF) and American Express (AXP) recently issued profit warnings tied to rising consumer delinquencies. A recent Motley Fool article included Capital One as a Deathbed stock.
Commentary from the Fed chairman and governors was even less promising. Economists stated that the probability of recession has increased to 50-50 from 1/3, while the Ben Bernanke glumly agreed the economy is obviously slowing. The San Francisco Federal Reserve Bank came out and directly stated that 2008 growth will be at near recession levels in the “FedViews” newsletter. All the economic leading figures including the reduction in manufacturing over-time hours – point to a recession.
Some banks are taking proactive steps to exit risky business segments. Bank of America should be applauded this week for moving to re-focus on its core banking business. The firm took steps this week to exit the stock brokerage, investment banking, CDOs, and other risky segments. This demonstrates some common sense amid the carnage in the sector.
The easing of the Glass-Steagall Banking Act of 1933 over the last decade has allowed commercial banks to enter investing banking and other risky business segments. Clearly it is time to roll-back the inappropriate Gramm-Leach-Bliley Act enacted in 1999 to “open up competition”. Legislation must be put back in place to require commercial banks to strictly focus on standard banking activities for the safety of depositors. The Great Depression taught significant lessons on why commercial and investment banking activities should be separated, and the bank lobby should have never been allowed to roll-back these earlier protections. The risk of a complete financial meltdown due to the banks’ derivative speculation with a focus on fees remains high. Only the continued Federal lending at mechanisms such as the discount window and foreign capital investment are keeping many of the banks liquid.
This leads to the question – Is there any place to hide during a complete market meltdown? Even cash in the bank may be at risk – several money market funds with CDO exposure had to be propped up over the past months. Even investments normally considered safe have risks in an environment where existing credit ratings have no real meaning. Your money market fund backed by “AAA” fixed income investments may be downgraded to “C” junk overnight … with the probability of default within two weeks.
Unstable market environments offer plenty of risks, but can provide significant rewards for investors willing to effectively sell short. The question remains if the downside action is near a trough or should investors start to bottom pick. The most immediate sector of interest will be the financial industry once the fourth quarter earning cycle is completed.
Tuesday, January 15, 2008
Earlier summaries at HingeFire outlined the “race to downgrade” as one of the risk factors adversely impacting the economy. The continually downgrade cycle has become so prevalent that the financial press has now derived a name for it - the “Friday CDO downgrade bonanza”. It appears that Standard & Poors each Friday cuts the credit rating of another large group of CDO tranches.
In the most recent week, Standard & Poors lowered its rating on 149 tranches worth $8.7 billion, and put another 54 on credit watch. The total is now 1,290 tranches from 402 CDOs worth over $83.5 billion in just a few weeks with 726 tranches on credit watch.
Amazingly enough, most of these tranches have been downgraded to junk, many with a low “C” rating. Just a few weeks back most were ‘AAA” rated. The CDOs covered by credit rating agencies only represent a fraction of the total outstanding. The other rating agencies such as Moody’s are also in a rush to downgrade the CDO instruments they cover.
The mad rush to downgrade formerly pristine CDO instruments to junk over the course of the past few months should make people wonder if the entire credit rating industry was asleep at the wheel, or even worse - complicit in unsound risk practices.
Monday, January 14, 2008
The banking sector appears to be a desolate landscape, looking like a forest after the timbering crew has bull-dozed their way through it. The troubles in this industry are now well recognized which may be the starting point for a recovery.
Citi kicks off the bank reporting season on Tuesday morning. Few of the major banks expected to show rises in fourth-quarter profit when reporting over the next two weeks. Citi and WaMu, are anticipated to post large quarterly losses. Analysts hope the banks get all the bad news out in the fourth quarter reports so the beaten-down sector can recover over the upcoming months. Nevertheless the industry trends of consolidation and foreign capital investment are expected to continue.
Investors should expect to see further consolidation over the coming months. Bank of America (BAC) has kicked this off with their recently announced acquisition of Countrywide (CFC). Press reports late last week indicate that JPMorgan Chase (JPM) is in advanced talks to acquire the shipwreck Washington Mutual (see WaMu on the chopping block: Can JPMorgan Chase really turn this bank around?) The trend towards consolidation will continue as banks in distress are merged with stronger partners. The WaMu acquisition situation may present another merger arbitrage opportunity; however investors should proceed cautiously because even at a mere $14 the Washington Mutual stock price may already be above any proposed acquisition price.
Many banks such as Citi are still seeking investment from overseas Sovereign Wealth funds to shore up their capital ratios. Preliminary figures indicate Citi is seeking an additional $14 billion as they cut an additional 17,000 to 24,000 staff members while writing down up to $24 billion in the fourth quarter. Merrill Lynch is also seeking additional overseas funding.
Some of the stronger bank stocks are appearing attractive from a valuation perspective. There are a number of mid-sized banks with solid finances and minimal credit risk exposure. Of particular interest are Bank of New York Mellon (BK), State Street (STT), and US Bancorp (USB). With the recent market rout, USB touts an attractive 5.7% yield. All these banks offer strong balance sheets and will likely weather the financial sector crisis in good order.
Friday, January 11, 2008
Consumer confidence hit an all-time low in January of 56.3; the lowest reading since the index was started in 2002. The reading is down 41% from 95.3 one year ago. This trend of this index is usually a good leading read on where consumer spending is going. Consumer spending represents two-thirds of the U.S. economy, and is vital to holding the country back from a recession.
Consumers are being hit a by a combination of factors which are hitting their wallets and are causing wide-spread concern in households. These include:
- Increased fuel costs
- Increasing cost of food and necessities
- Dropping home values and increasing foreclosures
- Inability to get credit due to tightening market requirements
- Record Credit Card debt levels – The consumer is tapped out.
- Hiring stalling and unemployment rising.
- Lack of salary increases over the past 5 years that match inflation
With the press reflecting further bad financial news each day, it is little wonder that consumers are gloomy. The only question is “Will they hold back spending to the level that will trigger a recession?” An AP article today explores this in more detail - Consumer Confidence Sinks to Record Low
Apparently not many for CFC. A note on Tuesday asked “Countrywide: How many days are left?” A mere three days later the lead financial article is focused on Bank of America buying Countrywide.
As expected, CFC was sold for pennies on the dollar. Countrywide was in a financial position in if they did not find either 4 billion dollars in funding or a buyer in the next two weeks then the bank was going to have shutter the doors. All windows were shut to the bank for further borrowing; clearly the end was near. Bank of America purchased CFC for $4.1 billion in stock; the enterprise value of the Countrywide is around $89 billion according to most analysts. At 4.6 cents on the dollar, it is little wonder that BoA is stating that the pricing was “attractive”.
The deal is still seen as having significant risk for Bank of America. An immediate cash infusion of $4B is needed at Countrywide on top of the earlier preferred stock transaction that provided BoA as seat at the table to perform this deal. The Countrywide group is likely to be an unprofitable sink hole for a couple years before the operation can be turned around.
Most market pundits consider this as a bold risky step by Bank of America CEO Ken Lewis. BoA views the existing 9 million home loans and mortgage operations held by Countrywide as a valuable asset, which would be a valuable addition to the bank’s service portfolio. This is counter-balanced by the money, energy, and time needed to sort out the situation, and turn Countrywide around.
Regulators are breathing a sigh of relief and probably shipping a crate of champagne to Mr. Lewis’ office. Shortly regulators would have been in the difficult position of attempting to salvage the wreckage of Countrywide. The BoA deal averts this crisis. A number of market commentators deem that some sort of buy out deal was inevitable because an institution the size of Countrywide was “too big to fail”.
The purchase of Countrywide by BoA is likely to serve as a leading edge indicator that the banking sector will upturn shortly. Several major banks hold 4th quarter earnings reports next week and most are expected to announce significant write-downs. The proper disclosures of these impairments will probably clear the air for the banks and provide a positive change in momentum for many of the financial stocks after the reporting cycle.
Some readers viewed Tuesday’s HingeFire note as a great market opportunity. CFC stock soared 51% on Thursday afternoon to $7.75 when rumors of the BoA buyout spread. While the thank you emails are appreciated, I will disclose that I did not take advantage of this merger arbitrage opportunity.
Thursday, January 10, 2008
The interest in 130-30 fund concept continues to grow. Many mutual fund families have added 130-30 funds to their portfolio over the past year.
The “130-30” funds allow managers to short-sell up to 30% of their portfolios, and use the proceeds to buy an extra 30% long. The funds both use leverage and short, attributes which are usually embraced in hedge fund products rather than mutual fund offerings.
Conceptually the fund manager would go long strong stocks while shorting weaker stocks. The expectation is the mutual fund would outperform the market and generate excess alpha for investors. Other possible strategies include merger and instrument arbitrage. One of the concerns raised is how would the industry benchmark the performance of this type of fund.
A recent paper, by Andrew Lo of the Massachusetts Institute of Technology and Pankaj Patel of Credit Suisse, puts forward a proposed 130-30 index. The index uses a number of fundamental and momentum factors to access stocks. Those with the best scores are included in the index as longs and those with the weakest scores as shorts. The research defines a “dynamic bench-mark consisting of a plain-vanilla" 130/30 strategy”.
Note the HingeFire stock screener is excellent tool for identifying stocks utilizing the fundamental and technical criteria used in the type of model outlined in this paper. The model uses fundamental criteria such as P/E, P/S, and P/B as well as technical criteria such as Money Flow, MACD, and RSI. The HingeFire stock screener is one of the few products that offers a full complement of fundamental and technical indicators.
Naturally there are questions whether the type of mechanical approach proposed in the “130/30: The New Long-Only” paper actually represents a valuable index, or is simply another stock picking strategy. This leads to immediate questions about the value of comparing the returns of any particular 130-30 mutual fund against this index. There is an expectation that the market will either accept or reject the dynamic index model over time as the new 130-30 funds become more popular.
Wednesday, January 9, 2008
The advent of securitization by banks was promoted as the beginning of a new era. Suddenly due to the mathematical modeling of Wall Street wizards, risk could be distributed while profits would be increased.
This pipe dream has come to a shattering halt over the past few months; similar to the implosion of the tech bubble in 2000. The tech industry zealously believed that standard financial ratios did not matter anymore as stocks were bid up to obscene price levels, in the same manner the financial sector put forward that the old stoic ways of doing banking were a relic of the past. At least, until the house of cards started to collapse this past summer leaving many major institutions struggling for survival.
The Financial Times discussed this spectacle in a recent article titled Payback Time.
How large will the write-downs be at Citi? Citigroup reports next week and the write-offs are likely to be sizeable. Several firms have already provided projections, Merrill Lynch jumped aboard with a prediction of $16 billion, Goldman Sachs is sticking with $19 billion, while Sanford Bernstein is estimating a $12 billion loss. Any number pulled out of the air is likely to be good at this point. There is an expectation that Citi will want to get as much as the bad news off the books in the 4th quarter report. This will enable the new management team to make future quarters look comparatively glowing if minimal future write-downs need to be taken.
Tuesday, January 8, 2008
Countrywide Financial (CFC) came out today denying rumors that the firm had filed for bankruptcy protection. The stock dived 25% on the reports causing a halt in trading for a period of time.
At this point many analysts believe that either bankruptcy or selling the firm for pennies on the dollar is inevitable. The only question is “How many days are left?”
Another concern that has been raised in Congress is the recent large-scale borrowing of Countrywide from federal bank sources; in many reports cited at $50 billion or more. Apparently this level of funding was not enough to bail out CFC, increasing the likelihood that taxpayers will end up holding the bag.
Countrywide Denies Bankruptcy Rumors
Once again – I will urge depositors to withdraw their funds above the FDIC limit from this institution. The risk of losing your money is increasing rapidly for those who bank at Countrywide. Note that this concern does not impact households where Countrywide simply holds their mortgage, so there is no need to re-finance your loan due to the financial troubles at CFC.
Monday, January 7, 2008
The Wall Street Journal states that Bear Stearns CEO James Cayne is expected to resign, but remain as chairman. To many pundits watching the situation at Bear Stearns, it was just a matter of time until this step was taken. Cayne has been under intense scrutiny since a series of articles appeared showing that he was playing golf and bridge while a major crisis sunk two hedge funds at his firm. The subprime credit crisis caused Bear Stearns to write off billions of dollars of bad debt while its stock price dived nearly 50 percent. An earlier summary (Is Your Investment Bank Executive a Doper) provides some more details.
WSJ: Bear CEO Expected to Step Down
Over the weekend, I have had the pleasure of reading the free Independent Investor eBook from Elliott Wave International. I would urge everyone to check out this resource.
The Independent Investor eBook is a solid thought-provoking overview of the psychology driving the broader market. Referencing events over periods of time, it provides some solid insights to the crowd reaction which propels the indexes. At times bending traditional financial axioms, the book takes a look at economics from a behavioral and cycle perspective.
Even for those not focused on socionomics, the Independent Investor provides some solid insights which will help with your investing. It is provided at no cost in PDF format from Elliott Wave International and can be found here.
Sunday, January 6, 2008
The traditional province of ETFs are passively managed funds which match indexes with low fees. A new breed of actively-managed ETFs are rising. Many folks have questioned whether these ETFs are actually any different from closed-end funds which also trade on the exchanges. Another concern will be if actively-managed ETFs can meet regulatory requirements.
The ETF market exploded due to investors seeking low-fee vehicles which matched indexes; will the firms proposing these actively-managed units be able to exceed market performance while keeping fees low. Do actively-managed ETFs really serve the investor? A recent article from TheSteet.com explores this in more detail - A Push Is On for Actively Managed ETFs.
Saturday, January 5, 2008
Many investors focus on traditional yield-generating instruments such as muni-bonds and REITs when seeking income. Both of these investments have taken significant hits in the recent market turmoil and there is increasing concern over their expected performance in 2008. The underlying economic conditions that have caused their recent dismal performance during the past year have not changed, and investors should be aware of the risks facing these income vehicles.
At first glance the beaten-down municipal bond sector appears to be a solid alternative for income seekers. Proponents such as analysts from Nuveen have talked up the muni market recently stating that there should be a solid recovery into 2008. Others doubt this sunny outlook.
Due to their tax-exempt status, muni bonds usually have lower yields than comparable U.S. Treasuries. However due to the price dive in the muni sector, the yields are now in the same region. The typical triple-A rated 10-year muni bond is yielding 3.9%, while comparable 10-year Treasuries are yielding 4.2%. That means an investor in the 33% federal tax bracket would have to earn more than 5.8% in a taxable bond to beat the muni. Similarly with 30-year bonds, the muni (4.7%) and Treasury yields (4.6%) are virtually the same. To outperform the 4.7% muni, an investor would have to get more than 7% in a taxable bond.
Does this make muni-bonds a good income oriented investment for 2008 – not necessarily. The muni market is fraught with risk and the pricing is merely a reflection of the deteriorating situation. Traditionally muni bonds are thought of as safe because communities can normally increase taxes to cover payments, and local governments tend not to go bankrupt. These simple truths may no longer hold water in some instances, nor have they held true in the past; one example is New York City's fiscal problems of the 1970s and another is Orange County’s (CA) earlier bankruptcy situation.
The issues facing munis were discussed earlier in “ The Muni Bond dilemma". In summary, there are several notable risks facing munis which include:
- The pension payment crisis unfolding in many states and communities.
- Increasing budget shortfalls for basic infrastructure projects.
- Reduced tax collection due to foreclosures.
- Rejection of tax increases by voters in communities facing economic stress.
- Probable insolvency of bond insurance firms (ACA Capital, MBIA, Ambac Financial)
- Falling revenue from community projects.
- Impending court rulings about state tax interest deductibility.
- Community investment fund losses (see Will State SIV Funds bankrupt local communities?).
- An increasing number of bond downgrades from rating agencies.
For those investors evaluating new municipal bond investments, the focus should be on quality and the general financial strength of the backing community. Avoid bonds from areas with high levels of foreclosures, projects with single sources of revenue (theaters, stadiums, etc.), and those insured by agencies on the edge of failure.
REITs are in no better shape. The average apartment REIT was down 27% during 2007. Despite the expectation that many people will move from owning homes to renting, apartment REITs are normally the worst performers during a recession.
Many other REIT segments have not fared much better. The outlook for the coming year shows no improvement. Hotel REITs such as Sunstone Hotel Investors Inc. (SHO) have recently endured down-grades and sunk to new lows. Office and Industrial REITs have demonstrated slowing growth expectations; capitalization leaders such as Boston Properties Inc. (BXP) are down over 24% over the past year. Retail property owners are down over 20%, the Simon Property Group Inc. (SPG) hit new lows recently. While the drop in price makes the valuation on some REITs appear attractive, there is an increasing risk that the dividend payouts may be cut.
One bright spot is Health Care REITs. This REIT sector has more upbeat outlook than others even in the face of a slowing economy. There is a growing demand for health care office space and the lending credit crunch has not slowed build-out. An article from December outlined some of the leaders - Sector Glance: Health Care REITs Rise.
Another sub-sector of REITs that normally holds up in down markets is apartments for college students. The growing demand for college housing is likely not to be impacted by the economic cycle. One REIT focused on this segment is Education Realty Trust (EDR) with a 7.60% yield.
In summary, Muni-Bonds and REITs have numerous headwinds looking forward into 2008. Other yield oriented investments in the energy and natural resource sectors may offer better performance with lower economic risk (see In Search of Yield) Investors should carefully evaluate the potential risks before allocating money to Muni and REIT investments over the upcoming months.
Disclosure: The author does not have a position in any of the income equities mentioned in this article. The information provided does not constitute a solicitation to buy, or an offer to sell securities.
Thursday, January 3, 2008
Risk free yield is shrinking, as many investors have been finding out when recently logging into their on-line bank accounts. The interest rate on many “high yield” bank accounts has shrunk to near 4%. Leaders such ING Direct (4.10%), EmigrantDirect (4.65%), and HSBC Direct (4.25%) have reduced rates over the past months. While these rates are not dreadful for FDIC insured deposits, the yields are significantly down from the 5% region before the Fed started to drop the short term rates.
The situation at your neighborhood brick & mortar bank is even bleaker, many money market funds are back to yielding below 1%. Heaping further injury on banking customers, most local corner institutions have been busy increasing fees for every imaginable service. This combination has left many investors seeking opportunities for better yield.
The current environment is a challenging time for income seekers to be focused on yield, investors must navigate the turmoil of bond downgrades, shrinking dividends, falling interest rates, falling real estate, and a financial sector immersed in the subprime fallout. Fortunately a few solid income opportunities are available in less utilized instruments such as Master Limited Partnerships (MLPs), Trust Preferred Securities (TruPS), and Canadian Royalty Trusts. Many of these opportunities are directly associated with the natural resources sector which is hot. Energy and commodities are likely to see growth over the upcoming years.
As always there is no such thing as a free lunch, attempting to increase yield will amplify your portfolio risk. The theory is to select high-grade investments that have minimal risk relative to the generated income. The best policy to decrease overall risk is to select different instruments across various sectors. This minimizes the risk relative to sector performance, individual company credit rating, and taxation changes.
Another key consideration is taxation. Most of these yield focused investments are taxed as your standard tax rate rather then the 15% dividend rate. If possible it is usually preferred to place income generating securities in a tax sheltered account such as an IRA.
Many of MLP and TruPS securities are unloved on Wall Street and out of the mainstream. The majority are under-valued relative to their yield. These securities trade like stocks so as the price goes down the effective yield increases. Most are currently trading below their issue value as most investors are not informed about their income potential.
Master Limited Partnerships (MLPs)
Master Limited Partnerships (MLPs) offer investors yields up to 9%. MLPs, which are primarily focused in the oil and gas sector, must pay out most or all of their cash flow in distributions. Typically MLP investors pay regular income tax rates on 20% of their cash distributions; for many partnership products taxes on the remaining 80% or so are usually deferred until the investor sells.
Many income-oriented investment advisors recommend energy-focused MLPs such as Enterprise Products Partners (EPD – 6.1% Yield) and Kinder Morgan Energy Partners (KMP – 6.5% Yield). These instruments offer solid yields with possible share appreciation. Additionally both have demonstrated strong insider buying.
One excellent resource for researching income focused investments is quantumonline.com (QOL). The site is free to those that register. QOL is “unbiased information on preferred stocks and other exchange-traded income investments.” The site allows you to research MLPs, TruPS, Royal Income Trusts, and many other instruments. Solid information is provided about taxation, distributions, and limitations of the various yield-focused securities.
Trust Preferred Securities (TruPS)
Trust Preferred Securities (TruPS) are sometimes called “bonds for the masses” These instruments normally trade at a face value of around $25 instead of the $1,000 price tag needed to purchase a bond. TruPS come from many different issuers; most are originated from well-know companies such as General Motors, Citi Corp, and American Airlines. Most TruPS are taxable at your standard income rate, a number are only taxed at the 15% dividend yield rate. A list of the TruPS taxed at the 15% dividend rate can be found at the QOL site.
Some investment advisors consider these preferred securities to be the worst of both worlds. From an equity perspective they do not rise as quickly as the common stocks of the companies, and from a debt-market angle TruPS are considered riskier than bonds. Other advisors view TruPS as a valuable addition to an income-oriented portfolio.
The majority of available TruPS are from financial sector firms. Naturally with the current sector turmoil investors should avoid this sector except for banks that have limited sub-prime exposure such as US Bancorp (USB). US Bancorp offers a preferred security yielding 6.9% and listed under USBH (or USB-PH in Yahoo).
With many sectors beaten down in the last months, many industries are offering excellent yields on preferred stock. It is best to avoid the financials and focus on preferred securities from major manufacturers (GM, Ford, etc), utilities (DTE, Duke), and conglomerates (General Electric). These are all companies that will likely survive any recession and continue paying their preferred payments for many years into the future.
General Motors (GM) has a good number of preferred offerings that are now yielding over 11%. These can be found listed as BGM, RGM, GMW, XGM, GMS, and HGM on the NYSE. While the auto industry certainly has faced challenges which have battered the credit ratings of most manufacturers over the past years, it is unlikely that GM will stop paying dividends on these preferred securities.
A comprehensive table of preferred securities can be found at the WSJ online site.
Canadian Royalty Trusts
Another income investment to consider is Canadian Royalty Trusts. Most of these instruments are focused on the natural resource industry. The yield on many is above 9%. However the taxation situation is difficult to sort out; investors must deal with a tax withholding situation in Canada and unclear requirements about the U.S. taxation rate. Due to the taxation situation, it is best to avoid putting Canadian Royalty Trusts in an IRA or other qualified plan. Investors should see their tax advisor before diving into these instruments.
One leading Canadian Royalty Trust is Canadian Oil Sands Trust Units (COS-UN.TO) which recently raised its quarterly distribution by 38% at the end of October. Another prominent trust is Provident Energy Trust (PVX) which is listed on the NYSE and is yielding 14.4%.
One summary of leading Canadian Royalty Trusts can be found at DividendDetective. QOL also provides a solid summary of the Canadian Royalty Trusts listed in the U.S. market.
Summary – Understand the Risks before jumping in
Keep in mind that income-focused securities are only appropriate for a portion of most investors’ portfolios. The key focus is normally to replace the income-oriented component of the portfolio with higher yielding instruments. Recognize that a capital depreciation risk exists when buying preferred equities; their price can go down just like common stock.
Certainly these investments offer better yields than CDs and money market funds. Interest rates on most traded equity-based instruments are above 6%, some have eye-popping yields of over 14%. An investor should evaluate the credit rating of the issuers prior to jumping in, while diversifying across multiple vehicles to control risk. When utilized properly MLPs, TruPS, and Canadian Royalty Trusts can boost income yields within a portfolio significantly above standard bank interest rates – without causing a loss of sleep over the safety of the principle.
Disclosure: The author does not have a position in any of the income equities mentioned in this article. The information provided does not constitute a solicitation to buy, or an offer to sell securities.