Random Thoughts on a Tough Two Weeks

• We run a concentrated small cap fund and had well above average cash balances going into the month of August.  By that account, we should have been conservatively positioned to weather this kind of storm.  Nevertheless, it was still a very difficult two weeks.  I feel like I’ve been beaten with a lead pipe.

• As of yesterday, we put a lot of cash to work adding to existing positions and buyibg several new stocks that hit our buy targets.  Like meagain stated on the comments of the last post, there are finally some bargains out there.  But it wasn’t really until Monday and Thursday of this week that a lot of small cap stock valuations started to look ridiculously cheap.  That doesn’t mean they won’t go lower, but for long term holders, bargains are starting to appear.   

• If you assume we are still in a long term bull market, now is the time to buy.  Dick Bove said that at some point the Fed would step in and restore liquidity to the market and it clearly did that on Friday.  That could be a great buy signal.  Another buy signal is that the Russell 2000 hit the bottom end of its long term trend line last week and bounced.  In addition, the RSI on the Russell sank below 40, which has been a buy signal since 2003.  I’m going to guess we’re close to a bottom but you never know what’s out there.  The true character of this market will show itself in the quality of the next rally.  If it’s accompanied by weak breadth like the one earlier in the week, then we’ll roll over again.  However, if both large and small stocks advance, especially the financials, the markets should be fine. 

 

Chart courtesy Bloomberg

• The real problem for the equity market is that this epidemic could affect the overall economy.  If for some reason, you still beleive this panic is just a subprime debt issue, you should read John Rubino’s article in this month’s CFA Magazine.  He’s written a whole book on the subject, and although he was way too early in his declaration of the end of the housing bubble, what he predicted is now currently occurring in vivid detail. 

The subprime pandemic has spread to the banking sector and hedge funds and it will soon start affecting the real economy.  It’s pretty clear that Florida, California, Arizona and Nevada could fall into a housing-induced recession, if they’re not already in one.  New York and Connecticut could fall into a hedge-fund/Wall Street induced recession. Those states would join a lot of the Upper Mid-West that still in the throws of a manufacturing-induced recession.  In a couple of months, we might find out that the only growth in the economy is in corn-growing states.  If the equity market rolls over again and breaks the uptrend lines, it will be because it’s beginning to discount a recession.   

• The debt market is still in the middle an honest-to-God panic, but unless you actually trade debt securities, it’s not apparent. Most equity traders and investors don’t look at the bids on mortgage or debt securities.  That’s because a lot of the paper doesn’t trade very often.  For instance, the Bloomberg/Bear Sterns Asset Backed Aggregate Index only records a monthly average value.  You can see some of the panic starting in that index on July 31, but it’s gotten a lot worse in the past 10 days.  This is a classic crisis of confidence because no one knew what this paper was really worth – it hardly ever traded before this week.

Chart courtesy Bloomberg

• The subprime debt market problems have clearly moved from homebuilders to high yield securities to banking.  You can get some sense of the panic from the high yield (junk) bond index from Bloomberg.  Since last month, the average high yield security has lost a quick 8%.  That would just about wipe out the dividend you were expecting to get from that paper. 

   

Chart courtesy Bloomberg

Of course, it’s far from an outright disaster.  Since 2003, the high yield index has experienced several of these panics.  As bad as its gotten, it certainly could get a lot worse.  Investors fell in love with this high yield paper over the past three years and it will take a while to clear out the system if the panic gets worse.  Likewise, if the overall economy slows, then high quality bonds will be marked down as well. 

Chart courtesy Bloomberg

• The Fed woke up on Thursday and Friday.  It realized something was wrong (after Jim Cramer yelled at them) and began pretty massive open market operations.  The Fed desk made tons of repurchase agreements using mortgage backed securities as collateral to inject money into the banking system.  You can see from the chart below that this was a big operation and involved a lot of mortgage-backed paper (blue line). 

Chart courtesy www.bullandbearwise.com

Big operations that take place within a couple weeks time have sometimes marked bottoms in the equity indexes but its difficult to draw any hard conclusions.  I’ve marked the top 20 largest open market operations on the chart below. It’s not definite that liquidity injections lead directly to higher prices.  The Fed has already been relatively active this year.  Six of the top 20 temporary open market operations have come in the past 9 months (that’s almost half of the big operations if you exclude those after September 11th.)  Obviously, the Fed has been aware of the subprime problem and has been supporting the banking system with reserves. The crisis hit a new level this past week and the Fed stepped up operations even more.  I don’t know if that means we’re closer to the end or the beginning of this problem. 

Chart Courtesy www.stockcharts.com

• The problems with the huge inflows into hedge funds over the past couple of years is finally beginning to become apparent.  For instance, the "algorithm" hedge fund managers are making a mess of the small cap stock market.  I’m not going to disparage funds like Renaissance because they have outperformed me for years.  Renaissance Equity makes lots of small bets on lots of small stocks based on quantitative models.  This is a good strategy overall.  The problem comes when everyone on the Street starts employing similar strategies.  Renaissance has been so successful that every smart guy with a quant model has started a long/short fund.  Although Renaissance would disagree, it doesn’t take a PhD to figure out how they are allocating their capital.  They are all using derivatives of earnings growth, earnings momentum and estimate revision strategies with maybe a smattering of valuation formulas thrown in for good measure.  This of course, leads everyone to short and buy the same set of stocks. 

When a disruption like we are experiencing in the debt market hits, a lot of managers have to cover shorts or sell stocks to cover losses in other markets.  This has lead to a lot of interesting moves in stocks.  As a contrarian manager, I’m often on the other side of the trade from these quant funds so I have a front row view of a lot the goofiness going on in the market.  Tons of stocks that have no business going up because they reported lousy quarters are ramping.  Likewise, stocks that should be ramping higher are tanking.  Here’s a brief run down of some of the goofy moves I’ve seen over the past two weeks….

White Mountains (WTM) is a high-quality, mini-Berkshire Hathaway insurance company that most people have never heard of.  The company is generally conservative and doesn’t split their stock (priced at $540) because they don’t want the volatility associated with hitting or missing quarterly earnings expectations.  They manage the business on a multi-year timeframe and want the stock to behave in a similar manner.  Well, that hasn’t really worked for them in the past week.  The company had a mediocre quarter which weighed on the stock over the past month but in the past week the stock had a 10% swing up and down on no news.  The historical beta on WTM is about 0.5.  In the past week, it’s been about 4.  That’s quite a statistical aberration for a stock that no one really knows about.  I’m going to guess there was a short and a long squeeze all in the same week. 

Chart Courtesy www.stockcharts.com

Then there are volatile stocks that have become so crazy they’re almost untradable.  Luminex (LMNX) is one of my favorite speculative stocks.  It develops the underlying analytic technology that allows more rapid drug discovery and disease diagnosis.  The company doesn’t make money and trades at very high multiples causing it to be a favorite among short sellers.  The stock has a short ratio of 17 with over 10% of the stock’s float sold short.  The company reported an uninspiring quarter but the stock has gone on a wild upside ride nonetheless…

Chart Courtesy www.stockcharts.com

And then there are bunches and bunches of low-quality  stocks that embarked on major short squeezes on absolutely no news.  Carbo Ceramics (CRR) makes proppants to help extract natural gas from aging wells.  It’s had relatively mediocre results in the greatest energy bull market of all time.  Yet this week, it’s looked like the next Schlumberger (SLB). 

Chart Courtesy www.stockcharts.com

I could go on and on but you get the point.   Low-quality stocks are acting great and great stocks are acting like dogs.  I think this is directly the result of too many hedge funds using similar algorithmic strategies, piling into the same stocks.

• The benefits of owning stocks that don’t go anywhere becomes very apparent in a market like we had in the past two weeks.  My original Unlucky Seven Portfolio (great company’s with stocks that haven’t done anything in 7 years) is up a bit since I wrote the article vs. the S&P 500 which is down slightly more than 4%.  I’m not trying to highlight the performance (it was truly meant as a list of stocks to hold for 2-3 years) but I wrote the article for just such an occasion as we’re experiencing right now.  The companies I picked were unlikely to keep pace with a run-away market.  But over time, quality companies bought at the right price will outperform the averages.  Like Warren Buffet said, "You don’t know who’s naked until the tide goes out."   

As an addendum for the Unlucky Seven, I wanted to pen a piece a last week about Citigroup’s Charles Prince but didn’t get to it because of the market.  I thought that Wall Street didn’t like Prince because he wasn’t Sandy Weil.  But in mid July, Prince said "as long as the music is playing, you’ve got to get up and dance" in regards to making large loans for risky LBO deals.  He added, "When the music stocks, in terms of liquidity, things will be complicated." I was wrong and Wall Street was right.  Prince is incompetent.  A good CEO understands the environment he’s operating in and leads the company out of harms way.  Prince seems to be jumping off a cliff with all the other lemming bankers even though he knows what will happen.  I would normally suggest to sell the stock but I think it will only be a matter of time before Prince gets fired.   The stock will go up 10% that day.