Toro's Running of the Bulls Market Blog

Why Argentina is an Economic Basket Case, Reason #2,562,976

I'm taking a break from taking a break posting to put up this article from the Wall Street Journal. 

Some countries just cannot resist loading all the chambers and putting a gun to its head just to see what happens.  One of those countries is Argentina, a country that has done just about everything wrong economically over the past, oh, century or so. 

Argentina has an inflation problem.  But the government doesn't want people to know that there is an inflation problem.  Never mind that people see an inflation problem when they go to the stores, these giants of economic competence think that as long as economists aren't talking about inflation, no one will notice.

Argentina's government has filed criminal charges against the managers of an economic consulting firm, escalating its persecution of independent economists.

A federal court official said Friday that a judge is evaluating the charges but has yet to decide if it is appropriate to begin investigating them.

The government is charging MyS Consultores with "publishing false information about inflation data" to benefit themselves and their clients. The criminal complaint alleges that MyS's data also lead to speculative behavior in Argentina's bond market.

MyS Managing Partner Rodolfo Santangelo described the charges as "ridiculous" and said the firm's inflation data do not affect financial markets.

Consumer prices rose 9.7% in May from a year ago, according to the national statistics agency, Indec. But virtually all economists say annual inflation surpasses 20%—one of the world's highest rates—angering government officials who dismiss inflation as a problem.

The criminal complaint, initiated by the Commerce Secretariat, is the harshest in a series of legal measures against economists. The credibility of Indec's data has been questioned ever since former President Nestor Kirchner replaced longtime civil servants with political appointees in early 2007.

So far this year, the Secretariat has fined at least nine economic research firms 500,000 pesos ($122,000) each. This week, the Secretariat also slapped a second fine on Orlando J Ferreres & Asociados. ...

Mr. Ferreres said the legal actions are part of a strategy to prevent independent economists from publishing potentially negative information during an election year.

Outstanding.

On Semi-Permanent Hiatus

First, my apologies.  I made this decision months ago.  It took me two months to fully accept that I had to do this.  Once I made the decision, it was two months of sloth before I found the energy to write this post.  Then, it was a few more months before I actually posted it.  I should have posted this article at the beginning of November but I was overcome by a lack of motivation, which isn’t fair to those who have read this blog over the past four years.  And to you, I apologize.  It was unprofessional of me.

Running of the Bulls is on official semi-permanent hiatus.  I am no longer regularly blogging, which should be blatantly obvious.  I may occasionally post an item on economics, I intend to keep up with my book log – which is on the right – and I may do the occasional “myth-busting” and clarifying misperceptions like they do over on snopes.com. But apart from one or two items in the hopper, I will no longer be commenting on markets and investments.  I may revive Running of the Bulls in the future, but for now, I am in hibernation.

I regret halting publication.  I have enjoyed blogging.  And though this blog never garnered a vast readership (it was the best readership – ed.), it was fun adding my voice to cacophony of financial commentary.

So why am I stopping?  Simply put, I believe it is in the best interest of my employer.  Given my current duties, I believe it is the correct decision for all involved in my professional life.  This is a decision I have reached on my own with no input from anyone else.

Running of the Bulls has primarily been a forum for my own opinions.  I have gone out of my way to avoid giving specific investment advice. An investment program should be constructed around each individual’s unique risk/reward parameters, and my risk/reward parameters are most certainly different than most others.

However, I am going to deviate from this a bit.  I have written an article below giving advice on how to navigate the market.  Read it at your own peril. 

I have also written an article about how I see the future, which I will post soon.  I give zero credence to prognostications.  I suggest you do so too.

Finally, I would like to thank readers and active participants of Running of the Bulls.  It is a cliché but it is true – it is you who made this worthwhile.

I am going to turn off the comments section in the coming days.  I thoroughly enjoy comments from the readers, but this blog will get spammed to death if I do not.  And spammers annoy the hell out of me.

I want to restart Running of the Bulls when circumstances permit.  And I would like to stop blogging anonymously when I do.  I am no one special, but I think putting a name adds more credibility to the words.

Until that time, take care and Godspeed.  I wish you all the best in life and investing.  I hope you make a fortune.

T.

What I Have Learned

An investment program or a trading system must be specifically tailored to each and every individual.  Risk tolerances, return targets and cash flow needs are critical in structuring a program of capital allocation for investors. All programs and systems are unique based upon our own biases and requirements.

I do believe, however, that there are broad-based investing maxims that can assist individuals in navigating the financial markets.  These are the investment maxims I follow.

Human nature never changes. 

My favourite investment quote is from Jesse Livermore who said

Wall Street never changes.  The pockets change, the suckers change, the stocks change but Wall Street never changes because human nature never changes.

Knowing human behavior is a critical to successful investing.  It does not matter if one is trading short-term or investing long-term, any trade or investment is an explicit or implicit bet on human behavior. 

Understand history. 

History is a guide.  It is a road-map to the future.  It does not predict what is going to happen exactly because structural shifts occur, but the forces of economic history shift slowly over time.  I first read Reminiscences of a Stock Operator in 1998, and I was amazed at how accurately Livermore (through Edwin Lefevre) was describing our time.  In the same way that officers are taught military history to understand the mistakes of past battles and the evolution of strategy, investors should understand financial history to understand the mistakes and context of financial markets.  Mark Twain said history doesn’t repeat itself, but it rhymes.  Karl Marx said history repeats itself, first as tragedy than as farce.  Twain and Marx could have been talking about financial markets.

Hubris kills. 

The words I cringe the most upon hearing are "can't" and "won't."   When people say something "can't" or "won't" happen as it pertains to investments, I become very wary.  In investing, anything can happen.  Do not think in certainties.  Think in probabilities.  Banish the words "can't" and "won't happen" from your investing vocabulary.  People with a high degree of certainty about the future are the ones most likely to get wiped out.  Confidence is good.  Hubris is not.

Most people cannot invest successfully.  You are probably one of them. 

You are hardwired to fail at investing.  Literally.  Your brain and neurological system are wired in such a way to separate you from your money.  It is why your feel euphoric when your stocks are rising and why you feel revulsion when your stocks are falling. It is why you feel you have to buy something when it appears to be running away from you, and why you feel fearful when stocks are falling.  Learning to deal with your natural instincts may be the single most important aspect to investing success.  Fortunately, there have been significant advances in understanding behavioral finance and neuroeconomics over the past decade.  I have listed books on the subject in my book log.  Read those books ASAP.

This is not a part-time job.

It is difficult to do well investing and trading over the long-run without being dedicated to it.  It is difficult to invest profitably by dedicating a half hour of study in the evening.  Investing and trading is not a hobby.  Investing is a profession, a craft, a systematic pursuit.  If you are not willing to put the time and resources needed to be successful, you should not do this yourself.  Pay someone else who does this for a living to invest for you.  Or give the professional most of your money and invest in small amount yourself.

Protect your capital.

You cannot play the game if you have nothing to play with.  For an investor, that means buying a stock with a significant margin of safety.  For a trader, that means cutting your losses quickly.  An investor can average down if they have purchased a stock with a significant margin of safety, a trader cannot.  A trader must cut his losses.  An investor must be certain there is a margin of safety in his investment. Otherwise, capital could become permanently impaired.

Be patient.  You do not always have to be involved.

I am an impatient person.  I do not like waiting for a minute.  I get bored easily and want to do something.  Plus, I am greedy and feel that if I am not doing something, I am not accomplishing anything.  But this works against me.  Patience is a virtue when investing.  I have found that I have done really well being patient, and I do much less well being impatient.  You do not always have to be involved. Sometimes it is best to just step aside and not buy or sell anything.

Do not invest or trade something you do not understand.

Is this not obvious?  You do not need to know Microsoft’s code to invest in Microsoft, but you should know what Microsoft does.  If you are trading symbols, know your process cold.

Have a process and keep an open mind.

All great investors and traders have a process.  Some great investors are great visionaries with nerves of steel.  Some great traders flit in and out of markets successfully.  However, all have a process.  Different processes are often a function of differing emotional temperament and intellectual curiosity.  Everyone is different and different processes will appeal to different people.  But the important thing is to have a process.  Your process will evolve over time.  You will not do things perfectly.  Thus, keep an open mind on what works for you and what does not.  If there is a weakness in your process, be willing to change it.

Process and strategy are a function of time.

Whether a trade or investment is right or wrong is often a function of time.  I both trade and invest.  When I trade, I look out a few months.  When I invest, I look out a few years.  How each strategy plays out is dependent upon time.  In the short-term, what matters most is momentum.  In the long-term, what matters most is economics.  In the short-term, news flow, sentiment and emotion are all the matters.  In the long-term, what you pay for a stock relative to the long-term prospects for a stock is all that matters.  If you are an investor, the crowd is usually wrong in the long-run.  If you are a trader, the crowd is usually right in the short-run. 

Time frames matter.

Wall Street tells its retail clientele that stocks are for the long-run.  This is true, over generations.  If you start methodically and systemically investing in stocks when you are 20 or 25 years of age, you can weather the volatility of the market and buy at almost any valuation and end up with a nice nest egg when you retire.  But this is not necessarily true for most people.  Most people do not start saving significantly until their mid-40s or later.  If someone starts a saving plan at 45 with the goal of retiring at 65, plowing money into the stock market expecting to earn the historical return to equities of 10%, the results can be devastating if stocks bought at the wrong valuation.  A 10% annual return over 10 years equates to a 159% gain compounded.  But the US stock market has declined since the beginning of 2000.  For the 55 year-old who started investing in stocks a decade ago, this is a huge hole in his retirement account compared to what he expected. 

Do not base your actions on the opinions of others.

There are a lot of smart people doing stupid things in the world.  Simply because someone sounds smart does not mean they are necessarily correct.  I can remember just starting out as a portfolio manager, reading an extensive industry analysis by a well-respected Wall Street analyst, thinking “That doesn’t make sense.”  I liked the thesis but could not get around this aspect regarding inventory that kept nagging me which the analyst had brushed off.  I thought “Well, he knows more than I do,” and invested despite my reservation because everything else sounded good.  Turns out, I was dead right, and I lost money because I trusted someone else's argument rather than my own instincts. 

Take more risk when you are younger.  Take less risk as you get older. 

When you are younger, you rely primarily on income from your job.  When you are older, you rely primarily on income from savings.  Thus, you can take more risk with your savings when you are younger and less risk when you are older.  When you are older, a sustained dip in the value of your savings can significantly alter your lifestyle.  Thus, your primary goal should be to avoid losses.  Conversely, a mistake many young people make is not taking enough risk.  The corollary in investing is that, over time, higher risk means higher returns.  Since younger people have more time before needing to draw on retirement savings, they should take more risk, and vice-versa.

Risk is however you define it.

Risk is usually defined in two ways – volatility and loss of capital.  Academics, quantitative investors and consultants tend to define risk solely as volatility.  Investors, usually value investors, tend to define risk solely as the loss of capital, particularly the permanent loss of capital.  In truth, the answer depends upon your own circumstances.  Some people do not want to see their capital fall, ever.  To them, they do not care if an investment they purchased is worth 60 cents on the dollar that falls to 30 cents on the dollar.  They care that it fell, period.  To someone living off savings, volatility can be devastating, given that a fall in savings means relatively more capital is drawn down when savings are being tapped.  This same affect occurs with an endowment or a pension fund that is required to disburse funds at periodic intervals, whereby volatility in itself can result in the permanent loss of capital to the fund.  However, if one does not need to draw on capital for an extended period of time, and one has the fortitude to withstand the ups and downs in the market, volatility is irrelevant, and the only thing that matters is the permanent loss of capital.

The only thing that matters is how much money you make.  Or, the only thing that matters is how much risk you take. 

We do not trade nor invest to test dogmatic philosophies.  We trade and invest to make money.  In the end, what matters is the size of your account.  Having the most logical or most elegant system means nothing if you cannot make money from it.  Making money, however, is a matter of taking risk.  Over time, the more risk you take, the more money you will make.  At times, you want to take lots of risk, at other times, you want to take no risk at all.  Understanding your risk profile and managing risk is perhaps the most important aspect of all in money management.

The only (other) thing that matters is price.

You invest and trade to make money.  You should not invest or trade for any other reason.  For example, you do not invest or trade a stock because it is a great company.  I do not know how many times I have heard an investor say that they were investing in a stock because it was a great company.  Cisco was a great company in 2000 when it was trading at 118x earnings.  It was a great company when it was trading at 7x earnings.  Investors who bought at 118x earnings lost 90% of their money top to bottom.  A great company can make you great losses if you buy at the wrong price.  For traders, if the price is working against you, get out!  Get out now!  If the price action is poor, the market is telling you are wrong.  In the short-term, arguing against the market is a losing proposition.  Do not do it.

Focus on what is going to happen, not what has happened.

This may sound trite but investors are often focused on what has already happened, not what is going to happen.  People want to focus on what has made them money in the past.  Nobody cared about homebuilders before the housing bubble, but you still see a disproportionate amount of commentary on homebuilders today, even though they have been crushed.  After the tech bubble collapsed, investors focused on tech stocks for years and ignored, at least initially, basic materials and industrial stocks.  And when the bull market inevitably ends in commodities, investors will focus on commodities for years afterwards.

Do not ignore the macro environment.

One does not have to be a macro trader to understand that the macro environment matters.  Self-avowed stock pickers often brush aside macro issues, stating that no one can forecast the economy so you should not pay attention to the macro economy but instead focus on valuation and quality of the company.  However, if one looked at the banks in 2006, one would have seen many great companies with stocks that appeared reasonably valued.  But the edifice upon which the banks had built their businesses was dependent upon housing prices.  Having a view on the banks meant having a view on housing prices.  If one was bearish on the banks, one was bearish on housing prices and the concurrent collapse of the financial system, which was a macro call.  The KBW Bank Index (the BKX) fell 86% peak to trough, which was greater than the Nasdaq’s decline of 78% after the collapse of the Tech Bubble.  High quality banks like Wells Fargo and US Bancorp fell 75% or more.  Yes, they have recovered, due in large part to government largesse - a political call even more disconnected from individual company fundamentals - but the volatility has been enormous, and most bank stocks have returned nothing over the past seven years.

It is much easier to make money in a bull market than a bear market.

It should be obvious that it is much easier to make money in a market that goes up 200% over a decade than one that is flat during that same time.  For example, you would have been much better investing in commodities over the past decade than stocks, just like you would have been much better investing in stocks rather than almost everything else over the prior two decades. 

Things can go on for longer than seems reasonable.

I remember thinking that technology was getting nutty in 1996. I thought housing was getting stupid in 2003.  Boy, was I wrong.  Both were just beginning.  Trends tend to last a long time.  Do not underestimate the strength of a trend.

Eventually, all bull markets and all bear markets end.

It is difficult to know exactly when bull and bear markets begin and end.  However, they eventually do.  You might be late in making that determination but understand that the end is an eventual certainty.  Structural bull markets tend to last 10 to 20 years, so you have time in determining whether or not a bull market has begun or ended. 

Book Updates

It has been awhile since I reviewed any books.  Here are five that I have recently read and recommend.

Title - Bust: Greece, the Euro and the Sovereign Debt Crisis

Overview - Bust is written by Matthew Lynn, a reporter for Bloomberg.  Lynn traces the history of the euro, Greece's entrance into the eurozone, the outcomes to date, and what Lynn believes will happen in the future.  Lynn is not optimistic about the future of the euro, arguing that fixes thus far have been cosmetic and do not deal with the underlying problems in the eurozone.  I agree.  This is the first of what I expect to be several good books written about the euro, a narrative that has yet to fully play out.

Rating - 3.5/5 and is annointed a (*) as being highly recommended.

 

Title - Diary of a Very Bad Year

  

Overview - Diary of a Very Bad Year is a serious of interviews with an anonymous hedge fund manager by an anonymous interviewer.  The interviews take place over the course of The Financial Crisis, beginning in September 2007 and ending in August 2009.  It is an interesting portrait of the mind of a hedge fund manager as the financial world around him collapses.  Written as a series of essays for a magazine, it easy for non-professionals to understand, and etches into memory the mindset of the time, one that seems to be fading from view.

Rating - 3.5/5 and is annointed a (*) as being highly recommended, especially for non-financial individuals.

 

Title - The Death of Capital

 

Overview - The Death of Capital is written by Michael Lewitt, the author of the outstanding HCM Market Letter, of which I am a dedicated reader.  I was a little disappointed with this book, perhaps because Lewitt raised the bar so high with his HCM Market Letter.  The first 100 pages discuss philosophy, particularly Marx, Keynes, Adam Smith and Hyman Minsky.  It felt a little disjointed, but what do I know?  I'm not a philosopher.  The rest of the book deals with the Financial Crisis.  Lewitt'sprescriptions are somewhat vague but I believe he is on the right track.  Lewitt is a good writer and I enjoyed this book.

Rating - 3.5/5

 

Title - The Myth of the Rational Market

Overview - The Myth of the Rational Market by Justin Fox traces the history of rationality and the Efficient Market Hypothesis (EMH) as the bedrock of modern economic thought.  One awaiting for an intellectual demolition of the EMH might be a little disappointed but the book is an enjoyable read on the rise and fall of the EMH.  In truth, the EMH has not fallen far since nothing has yet replaced it.  The EMH has all sorts of intellectual problems, not least are the continuing financial crises that have permeated the financial markets over the past 30 years, but it plods on by default as the economic foundation for modern economic thought.

Rating - 4/5 and is annointed a (*) as being highly recommended.

 

Title - Wall Street Revalued

 

Overview - If you are not an investment strategist, portfolio manager, academic, economist or central banker, do not buy this book.  It will put you to sleep.  However, if you are an investment strategist, portfolio manager, academic, economist or central banker, you will probably find this book useful, if for anything as a reference. Written by Andrew Smithers, an economist with his own firm, Smithers & Co., Smithers writes as an economist, dissecting financial market and economic falacies with lots of numbers and graphs.  This book increased my knowledge but was somewhat dense, making it a useful but not always an enjoyable read. 

Rating - 3/5

 

Companies Do Not Trust European Stress Tests

Should you? 

From the FT

Leading UK and continental European companies are increasingly shunning banks from Spain, Italy and even Germany because they do not believe the Europe-wide stress testing of banks gave a true picture of their financial health.

Corporate treasurers from groups with revenues of more than $240bn told the Financial Times they were conducting their own tests to gauge for themselves banks’ robustness.

“What we are increasingly concerned about is credit risk,” said the treasurer of one of Germany’s largest industrial companies. “Even after the stress tests, we have to ask ourselves: are the banks healthy? The tests have opened up more questions than they have answered, especially here in Germany.”

Stuart Siddall, chief executive of the Association of Corporate Treasurers, said companies were taking a more proactive approach to assessing how financially strong banks are: “Everybody is spending a lot more time today on counterparty risk than they did before.”

Counterparty risk – the risk that a bank will default and be unable to meet its obligations – shot up the list of concerns of companies after the Lehman Brothers collapse two years ago.

Those worries had again intensified around the time of the official European bank stress tests in July, several treasurers said.

“There is an element of whether the emperor has any clothes on and what to do if he doesn’t. The stress tests were a joke,” said the treasurer of a large European media company. ...

A treasurer at a FTSE 100 company in the UK said: “We have no business with Spanish banks and a couple of Italian and German banks. If US banks are refusing to deal with these guys, then why should we?”

I doubt this is over.

Seventh Best September in 82 Years on Weak Economic Data

If September were to end today, September 2010 would go down as the seventh best September for the S&P 500 since 1928.  A mere three days into the month, the S&P 500 has risen 5.26%.  On only six other occasions – 1939 (start of World War II) +14.4%; 1950 (price/earnings ratio of 6.9x) +5.6%; 1954 +8.3%; 1996 +5.4%; 1997 (near resolution of the Asian Contagion) +5.32%; and 1998 (bailout of Long-Term Capital Management) +6.2% – has the market done better in September.

Near-term trading is all about newsflow and expectations. The past week offers evidence of this maxim up in spades.

The market soared this week not because the economic news was good.  It was not.  It was mediocre at best.  The market soared because it was not as bad as thought.  Jamming shorts into an illiquid market pushed the indices into the upper end of their four-month trading range.

The market was exceedingly pessimistic going into the month, with all sorts of chatter about a double dip.  Four pieces of data mattered, three of which caused the market to take off like a scalded cat and one that was ignored.

On Wednesday, the August ISM Manufacturing index handily beat expectations.  Perma-bear David Rosenberg detailed concerns about the ISM print, but the market would have none of it as the S&P 500 rose 3% and the Russell 2000 4% on Wednesday.

On Thursday, pending home sales unexpectedly rose 5.2% in July whereas economists were expecting a decline.  Sales declined 2.8% in June and a whopping 29.9% in May after the expiration of the homebuyers’ tax credit.  Whether or not the increase in home sales is a dead cat bounce remains to be seen, but for the moment, the market interpreted the data as the consumer having a pulse.

Friday was the jobs report.  Nonfarm payrolls in August declined 54,000, half of expectations.  Private payrolls rose 67,000, beating expectations of +40,000.  Perhaps more importantly, there were substantial upward revisions, with July revised from -131,000 to -54,000, and June from -221,000 to -175,000.

Interestingly, manufacturing jobs declined by 27,000, even though the jobs component of the ISM survey increased.  Prior to the release, David Rosenberg questioned the jobs component of the ISM, noting inconsistencies in the data.

An increase of 67,000 was the eighth consecutive month of positive private job creation.  However, job creation is still weak.  The prior seven months were; July +107k, June +61k, May +51k, April +241k, March +158k, February +62k, and January +16k.  Private job creation has been positive but August was below the year's average of +99k.  Over the past four months, private sector job growth has average +72k.  Private job growth has decelerated.

This is consistent with the claims data.  Initial jobless claims last week were 475k, above the 2010 average of 465k. The average of initial claims for August was 486k, the highest monthly average this year.  

According to the ISM non-manufacturing index, employment may even be contracting.  The broad index came in lower than expected at 51.5, signaling continued but slowing expansion.  (A reading above 50 implies expansion. A reading below 50 implies contraction.)  However, it was the lowest reading since January.  Given that the market went ga-ga over the ISM manufacturing index and ignored the services index, it should be noted that services are a much bigger part of the economy than manufacturing.

What was more interesting were the components of the index.  Business activity, new orders and order backlog all declined, while employment and new export orders were in outright contraction.  The reading for employment was 48.2, indicating that employment is falling in the services sector of the economy.  Also, inventory sentiment rose, indicating that managers think their inventories are too high.

Net net, the news releases were better than expected but weak in the absolute.  However, in a market where expectations were clearly negative, incrementally positive news can jam the market higher, especially when everyone is at the beach (except of course the machines that run the market, which never go to the beach).

The question now is whether or not the market can break through the fast approaching resistance levels.  My guess is that Tuesday will be up day, as Mutual Fund Monday is deferred because of the long weekend, pushing the market towards the upper end of the trading range.  I think the real test will come later in the week and into the following week as volume comes back into the market.  If volume does not come back into the market, be concerned, even if the market goes up.

The market is a discounting mechanism.  Perhaps the market action of the last three days is signaling that the economy is going to get stronger.  But the economy is going to have to show strength soon.  The data thus far has been weak, consistent with an anemic economy and a market in a trading range. 

 

Dell, HP – Something You Won’t Hear Me Say Anytime Soon

“I want to buy Dell and HP stock.”

Apart from the breathless announcements from CNBC flashing on my screen regarding the bidding war between Dell and HP for 3Par – a company that makes data storage equipment – I have only tangentially been following this farce. 

Frankly, I will proclaim my ignorance.  This may be The Greatest Acquisition in the History of Mankind.  But I am skeptical.

The “winner” to buy 3Par – Hewlett-Packard – will have the privilege of purchasing a company whose stock flatlined around $10 a share over the past year for $33 a share, a full 242% above 3Par’s closing price on August 13 of $9.65 when the bidding frenzy began.

For those not paying attention – which is impossible if you have had CNBC on for more than 10 minutes – HP and Dell have been engaged in a spectacular bidding war for a company most people have never heard of.  On August 16, Dell offered to buy 3Par for $18 a share, nearly double the prior trading day’s closing price.  A week later on Monday August 23, Hewlett-Packard offered to buy 3Par for $24 a share.  On Thursday of that week, Dell upped its bid to $24.30 a share.  Like an antsy day trader who just can’t wait to buy, eight hours later, HP offered $27 per share for 3Par.  Dell then matched HP’s offer the following morning.  Determined to show Dell exactly who was the Baddest on the Block, HP offered $30 a share two-and-a-half hours after Dell's bid.  Both sides cooled their heels over the weekend, and with rumours of Dell readying to up its bid yet again, HP today jacked up its offer to $33 a share, effectively bidding against itself.

In the midst of all this, HP announced a buyback program to repurchase $10 billion of its shares.

Oh, did I mention that HP does not have a CEO?  Former Hewlett-Packard CEO Mark Hurd resigned on August 6 amidst sexual harassment allegations, though both he and the alleged accused denied the charges, which then morphed into accusations that Hurd abused his expense account. So HP has been engaged in a frenzied auction with nobody at the helm.

Surreal.

This frenzied bidding tells me that both companies are saying “We have no growth left so we are willing to crazily bid for a company that the market did not rate three weeks ago.”

HP closed at $39.69 on Thursday.  Dell closed at $12.36.  Ten years ago, HP traded at $62.50, Dell at $43.

Neither will be found in the Toro Portfolio anytime soon.

Market Action, September 2 2010 - Melt-Up

That is what the past few days have been.  Clearly, the market had gotten too pessimistic, including yours truly. 

The catalyst for the melt-up was Wednesday's ISM survey, coming in at a surprising 56.3, handily beating estimates of under 53.  This contradicted several of the regional surveys – Empire Manufacturing, Philly Fed, Chicago Fed – which were more bearish. 

This morning, Housing Sales were better than expected at +5.2%.  Economists were expecting a decline of 1%.  Retail sales have also come in better than expected.

Hence the melt-up.

(Before we get too carried away with housing sales, housing starts the past three months have been as follows; +5.2%, -2.8%, -29.9%, the latter due to the expiration of the homebuyer tax credit.  Thus, it is difficult to say that the housing market is healthy.)

Clearly, Friday’s jobs number is important, especially given the illiquidity in the market.  I said to a colleague this morning that I thought the payrolls data had the ability to move the market much higher.  My rationale was that with pessimism so high and expectations ratcheted down so much, there was a good chance for an upside surprise. 

Given the market action today, however, the bar has been raised for nonfarm payrolls to move the market higher.  The Russell 2000 is up 5% in two days and nearly 8% from its intra-day low last week.  The index is now trading in the middle of its recent trading range.  Likewise, the S&P 500 has clawed back half its losses from August.  The S&P 500 appears to be trading in a well-defined range between 1040 and 1130, and is right back in the middle at 1090.  If the jobs report disappoints, the market could snap back and reverse the gains of the last two days. 

Also bullish for the market has been the reversal of two week groups – banks and the semiconductors.  Unlike the broad indices, both broke down through support last month.  However, both rallied hard Wednesday and Thursday, with the BKX up over 7% from the lows on Tuesday the SOX up 6%.

I am short the semiconductors, which is an industry call, not a market call.  I have traded this group successfully over the past 15 years, and it has been my experience that the first piece of bad news is not usually the last.  It is likely more bad news is coming after Intel’s warning and Cisco’s cautious comments last month.

But will it matter?  Maybe not.  Right now, everything trades off macros.  Correlations are all converging to one.  If the risk trade is back on, industry fundamentals may be irrelevant.

Is Something Bad Coming?

Frankly, I do not know.  I do not make big, grand predictions.  I am loathe to make such prognostications.  But I have been wondering if something bad is soon coming in the market.

Everyone is biased by their own portfolio, including me. You must understand that my positioning may be affecting my state of mind.  Thus, this is my personal portfolio:

• Massively short semiconductors through put options on the SMH
• Long some small banks
• The banks are hedged out by a position in a financial services leveraged ETF
• Lots of cash

That’s it.

Here is what is bothering me.

The economy is decelerating.  There are anecdotes that the economy is doing okay – I am seeing more cars out on the road and fast food restaurants advertising for workers.  However, the data over the past month has not been good.  One proprietary indicator I look at, which called both the deep recession and the recovery, is now showing outright albeit mild contraction.

The politics are deflationary. On Intrade, the odds of the GOP winning back the House is 77%, the highest yet.  A Congress focused on deficit reduction and spending cuts may be good over the long-term, but it is deflationary in the short-term. And deflation is bad for stocks.

Central banks pulling back.  The market was disappointed with the Fed’s recent pronouncement on quantitative easing.  Stocks sold off in Japan today when the market concluded the Bank of Japan was not being aggressive enough lowering the yen.  The central banks may be unwilling, or unable, to support the economy and the market.

Horrendous market structure. The machines control the market.  The high frequency traders and algorithms supply, supposedly, liquidity.  If there is any hint of a breakdown, the liquidity will disappear fast.  I fear what might happen if the 1040 level on the S&P500 does not hold. The risk of another Flash Crash may be high.

Warnings from Cisco and Intel. I started shorting the chips after Cisco’s earnings conference call when CEO John Chambers said Cisco saw a slowdown in orders during the summer.  Intel’s pre-announcement and their purchase of McAfee and Infineon’s wireless business tells me that Intel has less confidence in the PC market.

Breakdown of the semiconductor stocks. When I short, I want to see three things – overvaluation, deteriorating fundamentals and technical breakdown.  We are seeing awful technicals from the chips, not only in the near-term but over the long-term as well.  It appears that the group wants to go back and re-test the lows.  On Friday, Intel reversed and closed higher on the pre-announcement.  That is good.  Today, it gave almost all of it back and closed on the low.  That is bad.  The stock held Friday’s intra-day low, but barely.

Lousy market technicals. Similarly, the broad stock market closed Friday on the highs after selling off in the morning.  It appeared that the market had put in an intra-day reversal.  Friday may have been the bottom.  But to come in on a Mutual Fund Monday, the day before the end of the month, and close at the lows, as we did today, is awful.  We are holding support at 1040 on the SP 500, but if it breaks through, look out below.  The only caveat is that Monday’s volume on the NYSE Composite was a paltry 2.95 billion, lowest of the year.

Banks continue to fall. The action in the banks is just terrible.  Like the semis, the banks have already broken through support.  It is hard to imagine the broad stock market rising as the banks continue to fall.

The VIX wants to go higher. At least that is how I see it.  It appears that the VIX has put in a near-term bottom.  A rising VIX is not good for stocks.

Collapse of bond yields. Government bond yields have collapsed.  Some argue that this is because investors are chasing yield.  That may be correct.  Or, it may be that investors are getting worried and piling into Treasuries.

Strength of the dollar. Increased demand for government bonds means an increased demand for the dollar.  The dollar has been inversely correlated to the stock market over the past few years.  When the dollar has risen, stocks have usually fallen.

Gold at the brink. Gold appears to be at an important inflection point.  I do not know if it is going to go up or down.  I can make a case for gold going both higher or lower if stocks get hammered.  The bullish case is easy – fear drives gold higher.  The bearish case is that the dollar spikes, stocks fall as does gold.  Hedge funds with liquidity problems will sell stocks, and gold, to raise cash.  Deflation is bad for gold, as it is for stocks.  Gold is at resistance.  The chart is developing a pennant formation, which often means a big move.  I have no position in gold at the moment.  I am 50.1% confident that the next move is down.  I will happily change my mind if gold breaks to the upside.

There are bullish anecdotes as well – copper is rising, the market is over-sold, we are going down on light volume.  I do not know what is going to happen.  Maybe we are bottoming, I do not know.  I am just telling you how I am feeling and what I am thinking right now.  And I do not like the market.

Canadian Housing Bubble, er "Market" Update

In our never-ending quest to profit from the works of others, we here at Running of the Bulls present to you two papers on the Canadian housing market, which is a bubble, or kinda bubble-like, at least in some places.

First off is an update from Alexandre Pestov (HT ZeroHedge) who updated his original paper we highlighted a few months ago.  An abridged version follows.

Canadian home prices in May 2010 (Exhibit 1.1) were up 13.6 percent from a year earlier, according to the Teranet - National Bank National Composite House Price Index™. The 12-month gain was strongly influenced by Vancouver, up 17.1 percent, and Toronto, up 16.0 percent. In the other four markets surveyed, the 12-month rise ranged from 5.6 percent in Halifax to 11.4 percent in Ottawa. In Calgary it was 7.8 percent and in Montreal 8.5 percent.

During the 10-year span between May 2000 and May 2010, housing prices increased 96 percent nationwide, 118 percent in Calgary, 116 percent in Montreal, 69 percent in Toronto and 126 percent in Vancouver. Doubling of housing prices over the 10-year period coincided with the all-time highs in nominal terms in the three major cities except Calgary where prices remain 8.6 percent below their stratospheric highs set in August 2007. Year-over-year and from May to June 2010, nominal home prices edged higher in all key markets without any surprises.

Home prices should rise at the nominal rate of GDP, plus or minus variations in local markets.  Home prices are also affected by other factors, such as mortgage costs.  Doubling of home prices in 10 years implies a compound rate of 7% per year, above the long-term trend in nominal growth.

The significant decline in sales year-over-year was observed uniformly across Canada ... The new mortgage regulations and exhaustion of an adrenaline boost from the HST scare in British Columbia and Ontario inflated sales volumes in the months preceding June 2010, and led to very disappointing, albeit predictable, results in June.

In June, volume from a year ago fell 40% in Calgary, 19% in Montreal, 23% in Toronto and 30% in Vancouver.

It is an old adage in trading that a market rising on declining volume is a market not to be trusted.  It is a hallmark of a market top.  That does not mean that the Canadian housing market is topping, but it is a sign that it may be.  The exact same thing happened in America at the top of the US housing bubble when prices continued to rise even though volume fell off a cliff.

Commencing 2007, the new dwelling starts, completions and units under construction experienced a sizable correction. Despite these changes, the number of units set to be constructed in 2010 now exceeds the long-term average, indicating a continuous oversupply of homes. The sharp reduction in number of new starts and completions was softened by the 2000-2007 swelling of dwellings under construction. The number of units remaining in the pipeline will fuel additional supply of homes released into the market and in spite of the declining dwelling starts the overbuilding is expected to continue for into foreseeable future.

Supply is increasing whle demand is decreasing.

In one of my first Econ 101 classes, I learned about the elasticity of supply over the short and long run.  Elasticity of supply means how supply changes based on the change in pricing.  My professor used housing as an example.  In the short run, housing is very inelastic, i.e. small changes in demand for housing has a disproportionate affect on pricing since homes cannot be built in a day or two.  It takes a while to build a house.  Over the long-run, however, the supply of housing is very elastic. As home prices rise, builders respond by building more homes.  There is a lagged response but the supply gets built. This is what can make homes a bad investment.  Demand for housing can change dramatically while supply is being brought onto the market, exacerbating negative shifts in pricing.

Not only is home supply rising, so are vacancy rates.  Apartments add to the supply of housing.  When vacancies rise, supply has risen faster than demand.

Affordability has improved but it is still expensive to buy a house.

It is more affordable to buy a house now compared to the 1990s only because mortgage rates are so low.

Carrying costs continue to rise.

Any increase in interest rates will have a dramatic affect on the affordability of homes.

That is because incomes have not kept up with home prices.

On annual basis, Demographia compiles a report to cover price-to-income ratios in 270-plus markets in Australia, Canada, Ireland, New Zealand, the United Kingdom and the United States. The Demographia International Housing Affordability Survey employs median house price divided by gross annual median household income in each market to rate housing affordability values. Demographia uses the following scale to rate housing affordability:

• Severely Unaffordable 5.1 & Over
• Seriously Unaffordable 4.1 to 5.0
• Moderately Unaffordable 3.1 to 4.0
• Affordable 3.0 or Less

The scale calibration is derived from historical values observed over a period of time. According to Demographia, the Median Multiple has been remarkably similar among the nations surveyed, with median house prices being generally 3.0 or less times median household incomes. In late 2009, Calgary and Montreal were rated ―seriously unaffordable‖, scoring 4.6 and 4.9 respectively. Toronto made it to the ―severely unaffordable‖ hall of fame with a score of 5.2. Vancouver ranked the most unaffordable city amongst the 272 markets surveyed with a price-to-income ratio of 9.3 (Exhibit 4.1).

And the price of a home relative to rental income in Canada is amongst the highest in the developed world.  Not good.

Pestov compares Vancouver real estate to the Nasdaq

Though I think the two markets are not entirely analogous  - the Naz fell 80% top to bottom after the bubble collapsed, a decline that would shock me if it occurred in Vancouver real estate - I sympathize.  Some argue that such comparisons are facetious but I think they are a good representation of human psychology.

Pestov concludes that a crash in Canadian real estate is not necessarily pre-ordained, and I agree with that.  Prices can instead stagnate for many years.  However, the risks of a crash are high, particularly given the enormous problems and imbalances in the global economy, from which Canada is not immune.

Pestov does good work.  Take some time and read the whole paper.

A recent paper from the IMF differs somewhat.  The conclusions tend to be more sanguine.

Canadian house prices have increased significantly between 2003 and early 2008, with a marked downward trend since mid-2008, especially in the resource-rich western provinces. This paper estimates the evolution of equilibrium real home prices during this period in key provinces and finds that, following recent declines, home prices are now generally close to equilibrium throughout Canada. However, house prices in Alberta and British Columbia remain around 8 percent overvalued at the end of the sample (second quarter of 2009). Despite the limitations of econometric estimates of house-price dynamics, the measured small degree of overvaluation suggests that the Canadian housing market is essentially at equilibrium.

Frankly, I do not put stock in their conclusions.  The paper uses an equilibrium model.  Here are the assumpitons of the model.

The error-correction model postulates that the growth rate of real houses is explained by a combination of the following factors (depending on the province considered) ... :

• Past growth rates of real house prices. For most provinces, we find that the current growth rate is positively correlated with the past growth rate.
  
• Reversion to fundamentals implied by the long-run equation. We find that for most provinces (with the exception of Quebec and British Columbia, which is not statistically significant), the growth rate of house prices shows long-run reversion to the equilibrium prices derived from the model, implying that prices would tend to fall when they are out of line with fundamentals.
  
• Economic fundamentals. For all provinces (except Quebec which is statistically insignificant), we find that the growth rate of house prices is positively affected by (per capita) real income growth, which increases households’ purchasing power and borrowing capacity. The growth rate of house prices is positively affected by mortgage credit growth (higher rates indicate that households are less credit rationed) in the case of Alberta. Population growth (as a proxy for the growth rate of households) positively affects house prices only in Saskatchewan.

In other words, their model of current home prices is at least partly based on past home prices.

In 2006, Fed chairman Ben Bernanke testified in front of Congress that he didn't think housing prices were overpriced. He doubted that home prices would fall much since home prices had not fallen for 60 years.  As we now know, that reasoning was an enormous logical fallacy.

Given that home prices are nine times income in Vancouver, the highest in the English-speaking world, it is hard to believe that home prices in Vancouver are only 8% over-valued.  Investors should ignore this paper.