MF Global Leverage

This is a slide pulled from MF Global's most recent quarterly earnings call presentation highlighting the amount of leverage at the company.  What caught my eye was the way in which this slide demonstrates how Basel III encourages significant leverage as long as assets are "risk free" government debt.  Look at the discrepancy between the leverage at MF including sovereigns and excluding them.  30x vs. 6x--and the sovereign positions were what ultimately killed the company.  If this were a European Bank, MF would have reported a 16% Tier 1 ratio.

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Global Population Growth

According to the UN, the world's population hit 7 billion today.  It is a number that is at the same time remarkable and scary.  It is remarkable because of what it says about humanity's seemingly endless ability to support a greater population through technological advancement, but scary because of the Malthusian implications of a slowdown in that advance.

At its most simple level, the economy boils down to three inputs: Land, Labor and Capital.  Below are some of the UN's projections for Labor supply over the next 40 years.  To those who value absolute growth above all else (rather than growth per capita), the picture doesn't look especially pretty.  The growth in the labor pool is likely to slow as families have fewer children, which means that the whole world will look more and more like Japan.

As discussed in a previous post, this doesn't mean that there can't be per capita growth though (driven by expanding productivity).  Policy makers just need to recognize what's happening in the economy and allow the price mechanism to function properly.

Closer Look at Auto Sales

There seems to be a consensus forming that one of the few areas of the economy that is showing strength is the auto industry.  This is likely because sales rose 10% year over year in September.  Looking at year over year changes doesn't really paint a full picture though because the actual number of cars sold continues to be relatively depressed even if the number is rising.  There shouldn't be too much celebration over rising auto sales if the level that sales are rising to is the 1990s trough level.

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Behold, The New Bull Market!

Today's High: 1292.66

October 4 Low: 1074.77

A 20.27% increase in 19 trading days.

Credit Spreads

These should be a little tighter after today, but below are BBB and High-yield spreads as of yesterday night's close.  As you would expect, spreads have tightened as equities have rallied.  Relative to this year's tightest levels though, credit markets could still improve more.

Money Center Banks vs. Regional Banks

For most of the second half of 2009 and 2010, regional and money center banks traded at pretty similar valuations.  The chart below illustrates this as the value of the KBE (money center bank ETF) vs the KRE (regional bank ETF).

Over the past few months though, driven by Europe fears, money center banks have badly underperformed regional ones.

Now the price to book multiple for KBE is .71 vs. .90 for the regional banks.

If Europe's problems were really solved yesterday, then maybe it's time for these metrics to begin to converge again.

Deja Vu All Over Again

Today's 36 point S&P 500 rally is pretty spectacular, but it's not the first such move that's been triggered by talk of a European solution.  Remember May 2011?  Shortly after the flash crash the Germans and French announced the first iteration of the EFSF and the S&P 500 rallied almost 40 points.

The first EFSF obviously didn't solve the problem, but that's not to say that this one wont.

Just 1.5% to the New Bull Market

On October 4th we officially inaugurated a bear market by falling 20% from the May 1 peak on the S&P 500.  In the next 23 days we have rallied 18.5% meaning that we are only 1.5% away from rising 20% from the low.  This would traditionally signal a new bull.  

That was quick.

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Largest US Companies by Book Value

AAPL and XOM continue to fight for the title of largest US company by market value, but what about in terms of book value?  For the sake of alternative measures of value, below is the largest 20 US companies as judged by book value.  The list looks a lot different than the one sorted by market cap, especially because of the extremely depressed book multiples that banks trade at.

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Amazon Margin Comparison

Amazon is the latest super multiple stock to miss earnings and has gotten hurt in the aftermarket just like NFLX did yesterday.  Although AMZN's revenue growth continued to be strong in the 3rd quarter, the miss was driven by margins, which are being pressured by investment in new capacity.

While it makes sense that margins would be pressured by rapid expansion, it's interesting that Amazon's have been pressured so much.  Compared to brick and mortar retailers, Amazon is supposed to be much more efficient, but so far its margins paint an opposite picture.  On both a gross and operating margin basis, AMZN significantly lags its brick and mortar peers.

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If Amazon's model is so great, then why are expenses growing just as fast as revenues?  Shouldn't there be more operating leverage?

Home Price Appreciation Over the Last 20 Years

The monthly Case Shiller home price index was reported today.  It showed that in the 20 cities that make up the broad index, house prices were down 3.8% y/y.  This means that home prices are back to 2003 levels according to this index.

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Looking at the above chart, it's clear that home prices haven't changed much for the last couple years.  Over the last 20 years though, home prices have still appreciated significantly.  Below is a comparison of annualized home price increases over the last 20 years.  Interestingly, the S&P 500 has handily beaten the returns on owning a home over that time period.

Home Price Increase Over the Last 20 Years (Annualized)

Troubling Comment on Asia From UPS

UPS has spent a lot of money (like most companies) betting that the future growth of the company will come from the Asia Pacific region.  While one quarter should never be taken too seriously, the following comment from the 3Q conference call probably doesn't give UPS investors the warm and fuzzies.

"The bottom line is we built a network [in Asia] expecting certain levels of growth that did not materialize" in the third quarter.

Of Course NFLX is Down 25% After Hours.

Welcome to the new normal, same as the old normal--another victim of the bubble economy.

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NFLX is now down 51% YTD.  For contrast, BAC is down 49% YTD.

Like Yin and Yang, the intersection of NFLX and BAC is where two diametrically opposed investment philosophies (unrelenting momentum vs. deep value) end in the same result--a 50% loss of value.

11% Equity Rally Can't Keep Pace With Oil

As discussed previously, the S&P 500 could be on pace to break a multi decade record for largest gain in a single month.  Even though stocks are up almost 11% for October though, measured in terms of oil, financial assets haven't made the average holder any wealthier.  Below is the ratio of the S&P 500 to the price of a barrel of Brent Crude oil.  One could also describe this relationship as the number of barrels of oil that one "S&P 500" could buy.  Today, the number is 11, which is pretty much exactly where it was at the beginning of the month.

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If the dollar value of a portfolio rises, but you can't buy more "stuff" with it, then what's the point?

GE Cash Balance

Analysts have been talking about companies hoarding cash on their balance sheets since 2008.  GE, which reported earnings last week, happens to be a great example.  Below is a chart of GE's cash holdings since 2000.  GE now holds $91B in cash, up significantly from the $10B that it held at the beginning of the decade.

General Electric Company Cash and Equivalents Chart by YCharts

S&P 500 Largest Monthly Gains

Earlier this month I posted that after a five month losing streak for the S&P 500, the probability of a 6th month is pretty low.  In fact, that had only happened twice in six opportunities since 1957.  Given that the S&P 500 is now up 9.44% for October with six trading days remaining, it looks pretty likely that the probabilities will hold and the losing streak will end at 5.

As was noted in the earlier post, when the S&P 500 snaps a 5+ month losing streak, it typically does so in a spectacular fashion.  The average gain for the S&P 500 following the end of a 5+ month losing streak is 6.77%.  In fact, the largest monthly gain for the S&P 500 came in October 1974, which ended the only 9 month losing streak equities have had since 1957.

To put this month in context relative to the others, if the S&P 500 stays flat from now until the end of the month, the current gain of 9.44% would be the 12th largest monthly gain for the S&P 500 in the last 54 years.

S&P 500's Largest Monthly Gains Since 1957

And the month isn't over yet.  If the S&P continues to climb at its current pace, the index would end up by about 13.4%, the second highest monthly gain over the same time frame.  Of course, since there have only been 10 double digit return months out of 650 opportunities since 1957, the odds of a continued climb are not in investors' favor.  Perhaps it would be wise to prepare for some choppiness in the days ahead.

Of Course GMCR is a Short.

With GMCR down almost 40% since mid September, many are crediting David Einhorn's 100 slide powerpoint presentation as the cause of the coffee company's decline.  While Einhorn is great, and I'm sure his presentation was compelling, there really was only one thing you needed to know about GMCR.  It was selling at 100x earnings--a coffee machine company--selling at 100x earnings.  It's still at 68x.

With NFLX and GMCR down who's next?  CRM? LNKD? CMG?

Companies Apple Couldn't Buy For Cash

Apple's earnings beat streak may have ended today after 26 straight quarters, but one thing that hasn't changed for the tech giant is its huge pile of cash.  Below is a list of the companies that Apple couldn't buy with its $82 billion war-chest.  The list isn't long.  There are only 25 US domiciled companies that are too expensive for the house that Jobs built.

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Among the companies that Apple could buy for cash are two of the four largest US banks (BAC and C), UPS, Disney, Kraft foods, Caterpillar, Home Depot and Boeing.

EFSF Would be 46% of France and Germany's GDP

There are reports flying around that France and Germany are close to agreeing to a 2T Euro, or $2.7T backstop to the EFSF.  While that sounds great in theory, in practice, it should be noted that the combined GDP of France and Germany is 5.84T.  In other words, the country's leaders are pledging 46% of their combined GDPs to bailing out Europe.  With such a huge pledge, it's hard to believe that if the guarantee had to be enforced that the money would be there.

Bank of America's Capital Levels

One of the more pertinent slides from BAC's earnings call this morning.  If you believe the numbers, it's really tough to see how this is a $6 stock.

PPI up 6.9% y/y

The 10 year treasury yield is at 2.13% today, but for the last 6 months in a row, the producer price index has increased at greater than 6% year over year.  At some point, one would think that these price increases would make their way into consumer prices.

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Comparing S&P 500 Declines

As an addendum to the previous post, below is a chart comparing the decline of the S&P 500 beginning in October '07 to the decline beginning in May '11.  So far they seem to be following almost the exact same path.

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This Pattern Seems Familiar...

There has been no shortage of recession talk over the last several months, but the bears' conviction has waned somewhat with the recent 13% rally in the S&P 500.  Still, the trading pattern of the S&P 500 has been remarkably similar to the last time that we went into a recession in October 2007.  Back then, we had a 5 month 20% decline from October 07 through March 08.  That was followed by a strong 15% rally which ultimately faded.  Everyone knows what happened in late 2008...

October 07-July 08. Click to Enlarge.

This time around, we've had another 5 month, 20% decline followed by a 13% rally.  Even the internal structure of the 20% decline (in terms of timing of relief rallies) is eerily similar to '07-'08.  What happens next?

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Google Trends Recession-watch

In honor of Google's 3rd Quarter report, below is the google trends chart for "recession" searches.  If I didn't know better, i'd think this was a chart of the VIX or High Yield credit spreads.

It's interesting how the number of searches for "recession" spiked in late 07.  NBER didn't declare that the recession started in 07 until much later, but google trends caught it right away.

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Here are two other trends I played around with:

1) Depression:  It looks like searches for depression are in secular decline (I would have assumed the opposite).  The seasonality of depression searches is stunning though--always dipping in the summer and rising in the winter.

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2) Angry: Apparently people are getting pretty pissed off about stuff.

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More google trends fun can be had here

UPDATE:

I think I may have found the source of the world's anger problems.  (It was the birds--thanks Rovio).

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S&P 500 October Pace

The S&P 500 is up another 1.61% today, which means that for October the index is now up 7.32%.  We are in the 8th trading day of a month that contains 21, so if the S&P continues on this pace we will be up about 20% at month end.  Needless to say, this seems pretty unlikely.  That could be a sign that this rally is getting a bit long in the tooth in the near term.

Largest Stock Gains Since October 4th

Since the bear market was officially crowned on October 4th, the S&P 500 is up over 13%, knocking on the door of a brand new bull.  Below are the 15 stocks with the largest gains between October 3rd and yesterday's close.  The S&P 500 is up 8.76% since then.

The Largest Bank in the US

By market value, Wells Fargo is now the largest bank in the US.  Even though it is a distant 4th in terms of assets and capital, WFC is the only mega-bank that trades at parity with its book value.  While WFC is a great bank, the relative valuation seems a bit off.  Under what economic scenario does Bank of America lose 71% of it's book value (as implied by its market cap) and WFC doesn't sustain any losses?

Wells Fargo Market Cap Chart by YCharts

Wells Fargo Total Assets Chart by YCharts

Wells Fargo Shareholders Equity Chart by YCharts

Bank Earnings Estimate Revisions 3Q11

JP Morgan will release 3rd quarter earnings this week, and while the bank was an investor darling throughout the credit crisis, lately it's getting lumped in with its peers.  3Q11 hasn't been kind to banks, particularly those involved in capital markets businesses.  Below is a list of 3Q earnings estimates for the 10 largest US banks and the amount that those estimates have been revised since 13 weeks ago.  All of the banks with capital markets businesses have seen their estimates revised lower during the quarter, while banks with less capital markets focus have actually all seen their estimates revised higher.

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Highest 2012 PE Multiples

The stocks below represent the 40 most expensive stocks in the Russell 1000 judged by PE multiple.  The group is ranked based on 2012 earnings estimates.  Despite the previous post highlighting NFLX's multiple, that company is no longer in the top 40; it has fallen to number 87 on this list.

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Netflix Earnings Multiple Still 26x

Netflix stock's stunning collapse continues even after the company decided not to break the company up into two pieces.  The stock is extremely close to breaking the $100 barrier, which is almost 70% lower than its peak.  Amazingly though, despite the drop, the stock still trades at a robust 26x earnings, suggesting that it could have further still to fall.

Long Term Chart S&P 500 in Terms of Gold

A few months ago I posted a chart of the S&P 500 priced in gold that showed that equities were cheaper then (priced in inflation-resistant gold) than they were in March of 2009.  Even though gold has had a pullback since then, equities still are below '09 levels.  In fact, they're below 1991 levels relative to an ounce of gold as shown below.  

This is one of my favorite charts (The S&P 500 priced in oz of gold) because it elegantly displays what has really gone on in our economy over the last two decades.  In the late 90s a stock market bubble pushed equity valuations to extremes.  Ever since that time, central banks have simply been trying to manipulate the value of our currency to dull the pain of the burst bubble.  These actions have manifest themselves in rapidly rising commodity prices as the real value of financial assets has plummeted.  The idea that we live in a deflationary environment is absurd.  We have been living in a hyper inflationary world for the last 10 years and this has destroyed the value of financial assets.  How much longer will this last?

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RIP Steve Jobs

In memoriam, two clips of Jobs: the first--about the think different campaign as Apple's soul and the second--on passion as the key to success.


Think Different:



On Success:

Avondale October Investment Letter

I write this letter monthly for the benefit of Avondale Asset Management's clients.  It is reproduced here for informational purposes for the readers of this blog.

Dear Investors,

Needless to say, September was another extremely difficult month for investors. The S&P 500 fell 7.18%, the 5^th straight monthly loss for the stock market.  During this 5-month period, the S&P 500 has lost 17% of its value, which (as shown below) is the second worst monthly losing streak since 1957.  The good news is that since 1957, there have only been 6 other times that the S&P 500 has fallen for 5+ straight months.  Only twice has that streak extended beyond the 5^th month.  That’s not to say that the streak wont extend this time, but at least the odds are in our favor for a positive bounce in October.

Longest S&P 500 Losing Streaks

	# Of Months	% Decline
January 1974-September 1974	9	-34.86%
January 1973-June 1973	6	-11.68%
April 1981-September 1981	5	-14.57%
May 1966-September 1966	5	-15.92%
June 1990-October 1990	5	-15.84%
November 2007-March 2008	5	-14.63%
May 2011-Present	5	-17.03%

As I wrote last month, I have tried to remain defensively positioned as the economic tone has continued to worsen.  In September, I made very few new investments and maintained the large cash position that I mentioned in previous letters.  While this has not been enough to generate positive returns, the strategy has helped to diminish some of the pain of the falling market.  I also believe this continues to position us well to capitalize on a further pullback. 

Unfortunately, this positive decision has been offset by some negative ones, which hampered returns.  In particular the European financial disorder sparked a strong dollar rally against foreign currencies.  This affected our investments because I have had a bias toward a weak dollar and higher interest rates.  Each client’s portfolio reflects this view to some degree, and as a result most portfolios felt a drag from this positioning.  I don’t believe that the situation yet warrants a change in strategy, but of course I continue to monitor closely and am constantly challenging my assumptions.  Thinking with a long-term perspective though, I strongly believe that interest rates remain well below the rate of inflation, which should continue to pressure the US dollar and support commodity prices.

Net-net, the positives and negatives balanced each other during the month.  While we continue to outperform our peers for the quarter, I don’t think there’s much cause for celebration given the negative returns.  Going forward, my goal is to sit tight until mid-October when there will hopefully be more clarity and reinvest some then.  Companies will report earnings over the coming weeks, and should provide insight on whether recession fears are valid.  Beyond October, I remain optimistic that markets will end the year higher than today’s levels.  Let’s hope I am proven right.

Scott Krisiloff, CFA

Opinions voiced in the letter should not be viewed as a recommendation of any specific investment.  Past performance is not a guarantee or reliable indicator of future results.  Investing is subject to risk including loss of principal.  Investors should consider the suitability of any investment strategy within the context of their personal portfolio.

Bank Price to Book Multiples

Banks are cheap.  Extremely cheap.  Below are the price to book multiples of the largest banks in the world and the US ranked by total assets.  If the world doesn't go into a coordinated depression, surely there is tremendous value in this sector over the long term.

How do You Spell C-A-P-I-T-U-L-A-T-I-O-N?

Roar.

ISM Continues to Highlight Inventory Issues

Although the headline number on ISM was very strong today, the inventory lines still show some cause for concern.  As I pointed out last month, supply managers are reporting increasing inventories and higher levels of customer inventories.  Inventory accumulation tends to be the first sign of a recession because inventory liquidation can be a significant negative contributor to GDP.

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Sitting on the 200 mma

Watching the tide roll away...

Not only did we end the day sitting at 1100 on the S&P, which is an important psychological level if nothing else, we're also sitting here on the 200 month moving average, which is a trend-line that held in 2010 and is important support in its own right.

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S&P's Longest Losing Streaks

The end of September marked the 5th straight monthly loss for the S&P 500.  And if today was any indication, it looks like the streak could extend into October.

Before we get too negative though, this is only the 7th time that the S&P 500 has declined for 5+ straight months since 1957.  Of those 6 other times, there are only two in which the streak extended beyond 5 months, and this is already the 2nd largest percentage decline caused by any individual streak.

The data certainly seems to suggest that we may be due for a reprieve.  The good news is that immediately following the streak tends to be a nice sized rally.  The average gain in the first month following a 5+ month losing streak is 6.77%

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What are Property Casualty Insurers Worth?

Last week, Harleysville insurance agreed to be acquired by Nationwide for $60 per share, which works out to $1.6B or about 2x book value.  Prior to the news, HGIC was trading at about half that level.

P/C insurers have been beaten up with the rest of the financial sector and trade near historically low valuations.  Below is a list of the 25 largest insurers and their P/B multiples.  If 2x book is the right price to pay for a regional P/C business, then there could be some low hanging fruit here.