One of the beautiful things about being self-employed is that I get to pontificate on any issue I want and publish whatever I want. The attached paper is not something I could have written when working for major financial institutions. Given the events of the past two years, I thought this paper would be clarifying if not frightening on how much hazard there is out there even where people don’t think there is. This paper was originally written in June 2009.
The SEC and Goldman announced a settlement on the Abacus mortgage pool deal just minutes ago. This is a subject I wrote about weeks ago explaining it. I want to touch on an incredibly important aspect of the settlement that has broad market implications, but will not get the attention it deserves. Goldman while not admitting fraud, admitted its marketing materials lacked certain disclosures. This is the first time I know of that a Wall Street firm has been held liable for a disclosure item on a securities offering beyond the official offering documents. Essentially, what we in the business know as the “flip book” is now considered effectively part of the prospectus even though no one is saying that – that is effectively what happened.
Those of us in the business have been subject to the routine collection of those flip books after a roadshow because the bankers took the position incredible as it was that the mere collection of those books was their “out” that investors never relied on the flip book, when in point of fact most investors spend much more time with the flip book than the legal formalities like prospectuses and registration statements.
The biggest question here are road shows going forward to look differently. Typically flip books contain projections and other information that companies and their lawyers are not comfortable putting in the formal legal documents – will there be no more flip books? Will projections now only be oral and laden with caveats?
One last issue left unresolved by this settlement, it leaves investment banks and brokerage firms in the “no man’s land” of not knowing when and if they should disclose what client is on the other side of a transaction. Most of us always worked under the impression you could never disclose what another client was doing and this settlement calls that into question.
So far the early earnings reports have been good, yet the market is trading down since the beginning of earnings season. Why? Because we have mixed data and the market is still not willing to separate the winners from the losers in any meaningful way. In fact just yesterday CNBC had a chart showing correlation amongst stocks is the highest since the 1987 crash over 20 years ago.
We have positioned the portfolio to be net long on business to business and net short or simply absent from stocks with more direct consumer exposure. Intel reported a record quarter – it was a blowout – yes the stock went up some, but in almost any other year, a report like that would have caused a sharp rally in other tech stocks if not the whole market, but it did not. Now we did have a big run into earnings season, so it could be a little of sell on the news – but Intel a stock we own is incredibly cheap – in fact a large part of tech is incredibly cheap – and the only reason that would be wrong is if the “E” is wrong – but Intel thus far has shown the “E” was not wrong (too high). We will see what Google does, which announces after the close today. We have more net long market exposure in July than we had in June.
The Federal Reserve took down its growth forecast and the two year bond hit record low yields today. China is slowing, but it still growing robustly. In fact, China slowing is actually good in my mind – it implies that China is managing to engineer a soft landing to cool an overheated economy – no easy feat. Most reports from freight operators like CSX and Expeditors indicate strengthening economy activity. The JP Morgan results today show an easing of bad debt, but nothing to indicate growth and the company’s comments on the future were cautious. I should point out that they took a $550 million hit from the British banker bonus tax – the first hard proof that the political response to the financial meltdown is going to have a real financial impact on the sector, which is why we have little net exposure to banks, not to mention our concern on the consumer. If deflation is a real risk, that would explain a falling stock market. How do you know if deflation is real as some items like consumer electronics have historically had deflation? Watch your cable bill – if you ever start paying less for cable for the same package, there is no question we have deflation – nothing I have seen in cable company pricing indicates deflation however.
The market is selling off more today on weak data from the Philly Fed and the NY Fed. Though I don’t consider Alcoa a leading indicator, they just happen to report first, their prognosis in the face of falling aluminum prices is very bullish for commodities. It suggests that demand is still there and growing and increased volume will offset price declines.
What I think this all means is that China and other Asian economies still have growth and companies with exposure there will benefit. I think the US Consumer is in trouble and the stubborn high unemployment rate, rising taxes, a housing market that is not getting any better and may be getting worse, is a reason to avoid or short stocks in this sector and we are net short retail – Retail sales in June were down for a second consecutive month and yes most of June’s downturn was auto sales, but it is always the big ticket items that slow first. I would like to be more short, but have to respect that even retailers with poor fundamentals show tremendous resiliency and keep in mind with shorting there is infinite liability for losses, so one must always be more cautious with shorts than longs.
As for Apple all I have to say is this (they are having a press conference on iphone 4 antenna issues on Friday) - iphone users have not seemed in the past to care about reception issues having suffered their share of them being forced to use the AT&T network and this is particularly true in New York City. So I don’t see this antenna issue as being a big deal for Apple at all and they have been through a few of these type public relation problems before and managed through it. What I would worry more about longer term for Apple is that their hold on downloaded music may be slipping that keeps many users locked into them. This is more apparent in Europe than in the United States thus far. We are not there yet, but overtime with more apps, the Google Droid will be able to deliver an iphone like experience (it already does in many ways) and you have carrier choice including Verizon. Now it is widely anticipated that Apple will at least make the iphone available on T-Mobile, if not the CDMA carriers (Verizon and Sprint), but has yet to do so.
I have been saying for some time the meteoric rise in the stock market since March 2009 was not justified. In certain sectors it was justified like financials which were no longer facing the abyss. But the 100% move in some retail stocks anticipating a V shape recovery was fanciful. Most people failed to understand how different this slowdown was from the last deep one in the early 1980′s which we did have a sharp recovery from including that interest rates were dropping from very high levels then, they were not already low and heading for deflationary levels, like they are now.
There was a column just published in US News and World Report which I though offered an excellent explanation of what is going on:
I still don’t see an actual double dip even if we double dip in residential housing which is quite possible. If commercial real estate cracks as was widely expected but has not been as bad as feared, that could be something else. Double Dip is a technical term, it means two consecutive quarters of negative growth as opposed to just running in place – each represents a slow economy, but one is technically a recession and one is not. Some early earnings reports from companies like Oracle (because they have a non traditional fiscal year) have been pretty good. I think the earnings and the guidance will be pretty mixed from companies which would indicate a sluggish economy but not a recessionary one.
The amount of “stimulus” money that went to non-stimulus activities is truly a big problem. There is no support in Congress for a second wave of it as the first wave has failed to produce jobs. I want to clarify something that has been nationally debated. Keeping teachers and firefighters employed while laudable and while it keeps the economy more stable is not stimulus. Let me use this analogy – there is a difference keeping someone alive on a heart-lung machine than restarting their heart with defibrillation paddles where in the latter, their own heart starts beating on its own. That is the difference between paying public sector salaries and building bridges and infrastructure, because the infrastructure spending takes on a life of its own and leads to other economic activity that does not require government spending. Also much of the cost of the spending could have been used for deeper tax cuts which would give consumers a PERMANENT and SUSTAINABLE source of higher disposable income, but that didn’t happen and going forward taxes are going up on people with the most disposable income, which is not good for the economy.