Reasonably Thinking

Hussman’s opening two paragraphs knocked me off my chair.  Marvelous.

http://www.hussmanfunds.com/wmc/wmc090824.htm

A short excerpt from the piece…

“Meanwhile, Harvard economist Martin Feldstein (who was the likely alternative for Fed Chairman when Bernanke was appointed) noted last week “I think we’ll see a positive number in the third quarter, but what will it be driven by? Fiscal stimulus, Cash for Clunkers, and some inventory building. But the question is what happens next – in the fourth quarter and into next year – and I think there’s a real danger of a double dip.””

Sold HAL

I sold my 60 shares of Halliburton (HAL) today at $24.30, which were originally purchased on 2/17/09 for $16.75. Reason being, the market (and oil) was up today, and I am still trying to reduce long exposure. With regard to energy, I was willing to sell either HAL or CHK (which I bought pre 2009). My thesis with HAL is just not as strong as it was back in February, now that oil has risen significantly.

Here’s my take on valuation…

Just like a doctor takes into account various symptoms before making a diagnosis, I like to look at different valuation metrics from different financial statements. I loosely calculate from the income statement earnings yield, and earnings before interest and taxes (EBIT) yield; from the balance sheet (and income statement) return on invested capital (ROIC); from the statement of cash flows cash return yield; and dividend yield. I am interested in the earnings on the income statement as well as where the cash is going. Further, what amount of earnings is made relative to the capital required, and how much of a dividend am I getting while waiting for the thesis to play out.

With HAL at $24.30, investors are getting less than a 3% cash return, and under a 7% earnings return. ROIC and EBIT yield are fair, but the dividend yield is only 1.5%. These returns just aren’t that attractive, and I’m not getting paid much (in dividends) to wait. (In hindsight, had I done a more extensive calculation on these metrics, I am unsure if I would have even bought HAL, though I would have purchased something else levered to oil).

http://www.hussmanfunds.com/wmc/wmc090817.htm

“…depressed valuations have historically been predictably followed by above-average total returns over the following 7-10 year period (though not necessarily over very short periods of time), while elevated valuations have been predictably followed by below-average total returns.

…there is no structural reason to expect economic growth to be a major driver of investment returns in the years ahead. With valuations now elevated above historical norms, there is no reason to expect strong total returns on an investment basis either.

…Investors are presently anticipating the good things that have historically accompanied the end of recessions (strong investment returns and sustained economic growth), without having in hand the factors that have made those things possible (excellent valuations and a large output gap coupled with strong structural growth in potential GDP).”

Increased Exposure to SDS

Trade:  I sold 1 $46 Dec Put on SDS yesterday, for $6.10.  (I was unable to post this yesterday as I had limited computer access).

Why:  The thesis still remains that the market is overvalued.  I also want to increase my short exposure as a percentage of my portfolio.

Tools:  This is a complicated trade, but one I’ve executed before.  SDS is a double inverse exchange traded fund.  So, SDS will rise by ~200% of a market decline; likewise, SDS will fall by ~200% of a market advance.  By selling a put, I essentially sold an insurance policy that SDS will fall (selling a market advance).

Reasonably Thinking:  I am betting that SDS will be greater than $46 come December expiration.  For this to happen, the market would only have to fall about 1.6% (to 996) over the next four months.

My breakeven (after commission and excluding time) is about SDS at $40.  Here, the market would have to rise 5.1% (to 1065).  Granted this is possible, but clearly a risk I’m willing to take.  At 1065, the market would have a P/E ratio north of 15 with an implied return of 6.6%.  I would not be a buyer.  Any lower of a return (6.6%) and I would consider paying down my car loan (6.25%) rather than investing money.

For the math conscious, the implied volatility on this option was just north of 50%.

I still owe 1 $60 Sep SDS Put; I am about $700 down on that position (taken in late May).  This new position should offset some of the loss.  In both instances, I still feel like I’m getting free money at the expense of time decay.  If the market continues its advance, I may consider buying SDS outright.

While I am generally not a huge fan of Fortune Magazine, I was struck back by this week’s cover story.  The author, Allan Sloan, states that although Social Security is projected to be cash flow positive through 2016, it could go negative THIS YEAR.  The main culprit is that unemployment is worse than originally projected (even from last year’s projections), which has significant cash flow impacts.

Recent Highlights, August 2009

Here are some of the recent highlights I have come across over the past week or so.  I remain bearish and hope the market continues to inch higher, which would prompt me to continue selling/shorting this rally.  (I am paraphrasing here, yet still giving credit to the original authors).

1>      There is an overhang of deteriorating mortgage and commercial debt (John Hussman).  Meanwhile, unemployment continues to drag on, which may be the catalyst that brings the market back to its senses.

2>     There are material effects from continuing delinquencies and foreclosures.  In addition, the Fed is creating more base dollars in one year than in the entire US history (Hussman).

3>     Economic expansion depends on gross domestic investment.  Right now, there is continued deterioration in private demand and investment (Hussman).  The ongoing deleveraging process further reduces near term GDI.

4>     Stocks look expensive even if assuming peak 2007 profit margins (Hussman).

5>     Economic forecasts for both S&P 500 earnings and GDP would be a statistical outlier.  It is likely that only one of these forecasts will be accurate, although both could be wrong (Bill Hester http://www.hussmanfunds.com/rsi/expectationscontext.htm).

6>     In 2011, 48% of US homeowners with a mortgage will owe more than the property is worth (Deutsche Bank forecast).

7>     The all-inclusive unemployment rate published by the Bureau of Labor Statistics is 16.4% (Simon Maierhofer).  (Since his article was published, unemployment decreased from 9.5% to 9.4% in July, but the all-inclusive unemployment rate INCREASED from 16.4% to 16.5%).

8>     During prior bear market bottoms of historic proportions, P/E levels, dividend yields, and mutual fund cash reserves have always reached levels indicative of a market bottom.  Unless those indicators provide their stamp of approval, the market is overvalued and any rally will turn out to be short-lived.  Based on those indicators, the market is grossly overvalued, still (Maierhofer).

9>     There are fears that the Fed will monetize Obama’s ballooning budget deficits (future inflation); markets are fearful of the consequences of the Administration’s excessive spending; and the White House is broaching the idea of a value added tax, which substantially increases the price of everything (Steve Forbes).

10> The US has a one year adjustable rate mortgage on a $13M subprime mess.  Delinquencies in California are about 10% and will worsen (Peter Schiff).

The case for shorting CYN

When taking a position in an individual stock, I like to find as many solid arguments as possible.  This way, I only need one of them to really ring true to capture the move.  Here, I provide my many reasons for shorting City National Bank (CYN).  With CYN, the company has potential pitfalls at the macroeconomic, state, and firm level.

Argument 1, the market is overvalued at 1,000.  When the market falls, CYN will probably fall too.

Argument 2, provisions will drag on earnings.  Mortgage reset rates (Option-ARM & Alt-A) are set to jump again starting in 4Q09.  Though I do not believe it will be as severe as the subprime mess, it will probably be longer, lasting through 1Q12.  In addition, commercial real estate rents are falling.  This puts increased pressure on CYN’s commercial debtors, which ultimately appear as increased provisions on the income statement.  In my opinion, the loan book will definitely continue to worsen, over the short term and long term.  Increasing provisions, in my opinion, will put CYN in the red for 2009.

Argument 3, since I believe CYN will have negative earnings, they will miss management’s forecast (of positive year-end earnings).  A restatement, or flat out miss, lowers expectations about the stock and pushes the stock downward.

Argument 4, California is generally not a desirable place to conduct business.  This is reflected by the facts that the state has severe fiscal woes and rising unemployment.  A poor regional economy will hinder any bank’s performance.  Further, I have also read that the residential delinquency rate (0-90 days late) of homes in California is about 10%; that’s a huge number!  In normal times, a bank, in my view, has residential delinquencies of 2.5-6%.  From another perspective, non-current residential loans (90+ days late and non accruing loans) is at 5% for US Commercial banks (as of 3/31/09).  If debtors aren’t making payments, the bank is in trouble.

Argument 5, I would not rule out a dividend cut.  Now, I am not predicting this to happen imminently, nor have I conducted a thorough cash flow analysis.  Yet, with all the other factors in play, this should be a discussed catalyst.

Execution:  Since I am short CYN, I want to know how much cash cushion I’m working with.  If CYN increases 12.5% (from $40.66 to $45.75), I’d be down $210.  This is within my comfort range and probably where I’d revisit my thesis.  If the thesis holds, I would likely increase my position.  If CYN falls 6.5% (to about $38), I’d be up $100.  I would probably consider taking profits here.  (I prefer to take profits quicker in short and option positions relative to long positions; this is strictly about comfort level).

I sold my remaining stake of AXP today.  Read the Hussman and yahoo post from Monday, and combine that with Deutsche Bank’s report today, and you will realize that there will continue to be hurting consumers and probably rising unemployment.  Spending will be reduced, and AXP will have weaker cash flows than anticipated.

Though overall, this was a losing experience, I’m glad I can exit here, at $31.50.  The market was down today, but AXP along with some other financials were up on positive AIG news.  Also pushing it higher in the short term was an analyst upgrade yesterday.  A final note, AXP had an insider sell $1.8m last week.

Both of these were published on Bloomberg this week, yet I’m stunned that niether made the front headlines.  I am further upset that the second article was in the Opinion section.

http://www.bloomberg.com/apps/news?pid=20603037&sid=ac9y1xr7yNhQ

About half of US homeowners with a mortgage will owe more than their properties are worth in 2011.

http://www.bloomberg.com/apps/news?pid=20601039&sid=aBHGhk3_aakc

Explains Broken Window Fallacy using Cash for Clunkers as an example.

I shorted City National Bank (CYN) today (8/3/09).  I will provide a thesis later in the week (when I have time).  Since this is a new position for me, it will appear in the 2009 Performance section at the end of the quarter.

As a preview, Morningstar gives CYN 4 stars; S&P gives CYN 2 stars.