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Archive for February, 2007

Yesterday, My Troubles Were Not Far Away

Wednesday, February 28th, 2007

I don’t think my troubles are here to stay, either. I was down a little more than 3.3%, better than the S&P 500, but not by much. So what whacked me? Generally, cyclical companies: Cemex, Conoco, Barclays, Sappi, Jones Apparel, Sanamento [SBS], Lafarge, Magna International, Lyondell, Deerfield Triarc, Patterson-UTI Energy, Japan Smaller Capitalization Fund, and Lithia Automotive.
For the most part, these are companies with strong balance sheets where they will do well in the intermediate term, in my opinion.

As for my balanced mandates, I don’t have solid numbers yet, but I suspect I was down a little more than 1%. Not bad, but I hate to lose, period. I take some comfort, but not much, that I am still up a little less than 2% so far this year on the broad market portfolio. Let’s see if we can do better in the next trading session.
long CX, COP, BCS, SPP, JNY, SBS, LR, MGA, LYO, DFR, PTEN, JOF, LAD

Looking at my Indicators

Wednesday, February 28th, 2007

This will be kind of stream-of-consciousness as I go through my indicators. I have a lot of them so bear with me.

Gold, Copper, Oil, Gasoline, Heating Oil, and Natural Gas were all down. The yen and Swiss franc were up big, 2% and 1% respectively. (Nice hedges for me, I added them in the last month as a hedge for systemic risk. British pound flat. Canadian dollar lower. Yuan still appreciating… controlled appreciation there.

Shift at the tails of the of the distribution of stock returns, even if the mean has only moved 3%+. More new lows than highs, but still more stocks over the 200-day MA than under it.

Investment grade credit spreads in CDS gapped out 4.5 bp on the IBOXX 7 deal. 10 year swap spreads moved out 2 basis points, which is more notable when they usually tighten when yields fall, due to mortgage hedging. Bond volatility measures gapped out, but not severely.

The Merger Fund dropped 31 basis points — a very good indicator on how the arbs are doing. My oscillator, which is a knockoff of a famous one that Cramer refers to, had the worst single day that I have ever seen, but the 10-day MA indicates that we are not oversold yet.
Anticipated inflation during the 2012-2017 period fell like a stone to a 52-week low. The inversion at the short end of the curve deepened, while the long end lost some inversion. The TED spread jumped 7 bp. The VIX jumped more than it should have, given its ordinary relationship to returns on the S&P.
Okay, now. Putting it all together, yesterday was an expression of :

  • Decreased global demand from China.
  • Increased perception of systemic risk.
  • Increased likelihood of Fed loosening.

So what does this mean for today? Asian markets are down today, but Shanghai is holding its ground as I write. I would expect to see European markets flattish, and the US market to have a small volatile rally today. Treasury notes (excluding effects from the GDP report) should sell off.


We’ll see how it all works out by 4PM. I’ll have more for you later.

In Large, Red, Friendly Letters, It Reads “Don’t Panic!”

Tuesday, February 27th, 2007

With the long bond, Japanese Yen, Swiss Franc, and option implied volatility rising today, there is a panicky feel to the markets. Though this could be the start of a “big, bad event,” the odds are that it will not be so bad. One signal of panic that I see is that the VIX is up 21% today, against an S&P 500 down 1.5%. Under ordinary circumstances, that ratio is 10, rather than the 14 we are seeing today. if that ratio gets over 20, it is a sign that too many people are buying index puts to protect their portfolios. If it gets under 5, too few are doing so.

And, as with most investing, stick to your normal way of doing business. Don’t overreact to the markets. We haven’t had significant volatility in a while, and frankly, we need some to keep people from speculating overly. Don’t react to today; ask yourself what things will likely be like three years from now, and use that as your guide to investing. The manic Mr. Market may serve up some bargains. If so, my rebalancing discipline will edge me more into the markets, bit-by-bit in a measured way. This takes the emotion out of it, which leads to better overall performance.

Late Update
Sold my TLT positions slightly after 3PM today and bought some QQQQs with the proceeds. I think that the short run selling is overdone, with the TRIN over 14, and my ratio mentioned above, which I call DeltaVIX over 17, I felt it was better to add a modest amount of equity exposure to my balanced mandates. We added some Hartford as well at the hedge fund. None of my broad market portfolio hit a rebalance point, so I didn’t do anything there, despite 32 out of my 35 stocks being down over 1%, and only one up. In aggregate, it looks like my braod market portfolio will be down 3% or so, and my balanced mandates down a little more than a percent.I’ll have more on this later this evening. I plan on reviewing all of my indicators tonight, and see what they suggest.

PS — a friend pinged me and suggested that today’s move in the VIX did not come from put buying, but from options selling. He cited the increased correlation of stocks to one another. I’ll have to think about this some more.


long FXY FXF QQQQ HIG (and apologies to the late Douglas Adams) and now after the update flat TLT

Nothing That Amazing Yesterday

Tuesday, February 27th, 2007

Away from Dow Chemical and Lyondell, which I mentioned yesterday, the rest of the broad market portfolio didn’t do much — we gained 25 bsasis points versus a loss of 13 basis points for the S&P 500. A good day, but nothing amazing. Would that I had more days like this.
Long DOW LYO

Covenants Are Getting Weaker (And Stronger?)

Tuesday, February 27th, 2007

At my hedge fund’s weekly macro meeting, I noted the divergent trends in covenants. For newly issued BBB bonds, there is an increase in change of control covenants, which would allow bondholders to sell their bonds at investment grade levels (if not better) in a takeover.

But in bank loans to entities acquiring corporations, the covenants are getting weaker. I’m afraid that banks care more about present earnings than future earnings. Risk is getting transferred from the public equity space to the bank loan and private equity spaces. Personally, I think the eventual result will be ugly, though the current set of deals does not seem outlandish.

Eat Dessert First?

Monday, February 26th, 2007

I want to give credit to Roger Nusbaum on his brief commentary on Dow Chemical. Too many people think short term about investing, and don’t consider how much a company might be worth over time, versus a buyout today.

I faced the same problem on National Atlantic Holdings. I believe it is more valuable as a going concern than as a buyout candidate at present. I was happy when the Commerce Group negotiations broke down, because Commerce wouldn’t pay up!

I don’t have to get all of my gains today. So long as I do well enough over the next 3-5 year period, I will be happy enough. I don’t have to make a killing today. Having slightly better than average performance over a moderate period of time is reward enough.

Long DOW NAHC (the firm I work for owns 17%)

Time To Take Allstate Private

Monday, February 26th, 2007

I remember once being at a First Boston Insurance conference and talking to the (now former) CEO Ed Liddy afterwards. I mentioned that we were shareholders and that I thought the stock was cheap (then around $40). He looked at me intently and said that he could not figure out why the market valued Allstate so cheaply. It was an incredible free cash flow machine.

With the hurricanes of 2004 and 2005 after that, one can see that the performance since then has been superb. But now we are in a soft pricing environment; profits will not rise rapidly, if at all. But even if profits remain level, Allstate looks cheap. EV/EBITDA is near 5x.
That should attract private equity. If one can take over Texas Utilities, Allstate should be easier. Here’s why: one can sell the life arm, Allstate Financial for $5 billion to one of the major life insurers. Along with that, the private equity buyers can lever up the holding company balance sheet to a BB- rating, which would leave the operating entities at a marginal investment grade of BBB-. The private equity buyers would use the free cash flow to repay the bank debt incurred, and five years from now, would IPO Allstate at a higher valuation.

Though I am not crazy about all of the increased leverage, a scenario like this could happen. It is just another ramification of interest rates that are too low.
Long ALL (the funds I work for and me personally)

The Right Chemistry, Driven By Leverage

Monday, February 26th, 2007

The two chemical names in my portfolio are both doing well on an otherwise tough day, supporting my broad market portfolio. Lyondell Chemical [LYO] sells its Titanium Dioxide business to the Saudi-owned National Titanium Dioxide Co. This will allow them to focus on petrochemicals and refining, and (what!) reduce debt. Looks like a good multiple on the sale and a good deal strategically.

Dow Chemical [DOW] is a buyout target?! I would have thought that it was too large. Strange times indeed, where any asset with a low EV/EBITDA not only can be bought and refinanced, but are almost required to be so. And, with less leverage and a simpler structure, might not Lyondell be a target also? It’s much smaller.

In the short run, all of this is bullish for the market. Remember, bubbles are financing phenomena. Bubbles pop when cash flow is insufficient to continue financing them. We’re not there yet, but watch for signs of difficulty in these newly levered creations. Private equity is doing these deals at lower and lower IRRs from what I’ve heard, and eventually, that is not sustainable, given the levered up risks taken.

Long DOW LYO

Regulating Systemic Risk From Hedge Funds

Saturday, February 24th, 2007

I read with amusement this week the “Agreement Among PWG And U.S. Agency Principals On Principles And Guidelines Regarding Private Pools Of Capital.” Now, I think this is a serious issue; I’m not convinced that we are in a better position to deal with systemic risk than we were back in 1998. I think that many institutions are in better shape, but for the system as a whole, the degree of leverage, both implicit and explicit, is higher now.

Now, I can take two paths here. Path one: I like systemic risk, since I am a conservative investor. I like getting bargains that are screaming, as in the Fall of 1987, the Fall of 1998, and the Fall of 2002. What I wouldn’t like is the Fall of 1929 and its aftermath. My risk control methods would allow me to do relatively well even in that scenario, but great relative performance when you are down over 20% is not my idea of a fun time. I prefer scenarios where my neighbors aren’t getting harmed badly. That said, my best relative performance as an investor came during and immediately after panic periods like we have had in the past 20 years. (No guarantees about the future though.)

The second path is more interesting though. What if the government gathered all of data from every major investor? Say, for every firm managing more than $100 million, measured by assets, rather than equity, they asked for inventories of both the assets and the funding sources. For nonpublic assets, they would also need the counterparty data. The purpose of this would be to ascertain who owes cash to whom, and under what circumstances payment would need to be made. Ideally, with this data, one could identify where market players with weak balance sheets are overexposed to risks.
Now, this will never be done, but just imagine for a moment. What would the government do if it had data like this? At present, nothing, like the report that they put out. They wouldn’t know what to do with it. They don’t have the analytical meanpower to deal with the complexity of one derivative swap book, much less all of them, the hedge funds, the securitizations, the CDOs, etcAt best, they could contract it out, asking the investment banks as a consortium to set up a separate company to do the analysis for the New York Fed, and the Department of the Treasury. It takes a thief to catch a thief, but would the government be willing to shell out enough to get effective data and analysis? I would suspect not.

The same problem exists in the auditing of swap books at investment banks. Anytime an investment bank runs into an auditor smart enough to audit their books, they hire him and pay him ten times the salary. So, even if the government makes noises that they want to control systemic risk, I view it as kind of a joke. They don’t have the data or intellectual resources to even begin the project.

Let me put it another way: if the government wants to reduce systemic risk, let them create risk-based capital regulations for investment banks, and let them increase the capital requirements on loans to hedge funds and investment banks. Or, let the Fed change the margin requirements on stocks. These are simple things that are within their power to do now. In my opinion, they won’t do them; they are friends with too many people who benefit from the current setup. If they won’t use their existing powers, why would they ask for new ones?

We will have to wait for the next blowup for the Federal Government to get serious about systemic risk. They might not do it even then. Upshot: be aware of the companies that you own, and their exposure to systemic risk. You are your own best defender against systemic risk.

It Was A Pretty Good Week

Friday, February 23rd, 2007

The broad market fund was up 85 basis points this week, against a disappointing 25 bp loss for the S&P. My balanced mandates were up 40 basis points, also good. In general, my cyclical and foreign names outperformed.


On the insurance side, Conseco reported that it would be taking some middling charges — the reaction in the stock market was muted. My own estimate of reserve insufficiencies is higher than what they took, so if this cleans it all up, this is a net plus. I’m still waiting to hear back from Conseco IR, so I can’t really tell what is going on yet. From my recent conversation with James Prieur, the CEO, I think the company is on the right track; the only real question is how bad the old long term care [LTC] block is.

Lincoln National increased its buyback today. I appreciate the shareholder-friendly actions of many insurers. Rather than being hyper-competitive, many companies are returning capital in the soft part of the pricing cycle, and that is the right thing to do.

Long LNC CNO

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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