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T Report: A Plausible Bear Path

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DOWNSIDE RISK
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I’m bearish, but I’m not expecting or looking for a big move down. It is more that I think there is a greater chance of asset prices declining from recent levels, than going up, and some small chance the decline cascades as bullish sentiment has grown.

The Bear Path
I see the potential for a series of small events to line up in a way that drives stock prices lower. No single event is critical, and certainly a range of outcomes exist, it just seems to me that the following path lower is the most likely outcome.
  • Rajoy doesn’t embrace the ECB plan. This already occurred. At least part of yesterday’s late sell-off was a function of Rajoy speaking. I don’t see him embracing the plan by the end of the week, nor do I see him being so brazen again, so I think this card has played. He is a character to watch just because his mood seems to swing with the Spanish bond market and that isn’t good for getting a deal done with yields near their lows. In the end he will agree to a deal so can’t get extremely bearish on his comments.
  • Germany’s Federal Constitutional Court requires some changes for ESM. I do not expect a full ruling against the ESM. What I’m hearing is the most likely outcome is a ruling in favor with warnings against stretching the rules from here and possibly one or two small requests for change that are inconsequential. A ruling against would hurt markets as they have relied so much on Draghi’s ability to use a variety of funds to stem the crisis. No warning about being near the edge would be positive as most people see ESM as really near the limit of what can be allowed. Requesting even small changes would hurt the market too. The ECB can proceed with EFSF, so the problem isn’t immediate it is that it leaves the uncertainty on timing. Germany would have to request changes, which would take time. More importantly, other countries may question the legality themselves. This could open up the floodgates to countries questioning the existing ESM. If that happens, the markets would react negatively. Again, I would expect this to be relatively minor and temporary, but think the court decision is more likely to chip away at market confidence than helping it.
  • Apple. The iPhone 5 has been expected for awhile. As has i-TV or whatever it will be called. The apple is “cheap” argument seems old, especially as many of these things were known when Apple was at 575 on July 26th. Virtually every time AAPL hit some analyst’s price target, the price target was raised rather than the recommendation changed. The raise to out-Blodget Blodget on price targets has been somewhere between surreal and comical. I first shorted AAPL the Monday after the Samsung verdict. While I don’t think the iPhone launch will be bad, or other announcements might be nice, I think a lot is priced in. There are also, I believe, some underperforming hedge funds that covered shorts in Europe and banks last week under extreme duress who have clung to their Apple longs. My theory that Apple became a macro asset class rather than a stock remains intact and I expect as next part of the re-coupling continued underperformance of AAPL. This will drag down U.S. stock indices.
  • The Fed. While the Fed is likely to be ultra dovish and even launch some new program, I think the market will be underwhelmed. I don’t expect a full scale balance sheet expansion QE. Without a balance sheet expansion QE, many investors will doubt the ability to force stock prices higher than they already are. Then, unless they do something interesting and new, the chorus of analysts questioning the usefulness of the program will be loud, and correct. So much is priced in, and this Fed has telegraphed so much, that getting a real, believable, positive surprise is hard to envision.
The Bull Dream
The best case for the bulls seems to be:
  • Rajoy strikes a reasonable deal this week.
  • China ratchets up its stimulus effort.
  • German courts give the all-clear sign and hint that banking license would be okay.
  • Apple blows away expectations on new products and the iPhone launch.
  • Fed embarks on biggest balance sheet expansion to date including more assets than before.
I don’t expect any of the above to happen, let alone all of them, but these are possible outcomes, so have to be fully aware of them.

Credit Markets, More Pro than Average Joe
The retail love affair with corporate credit seems to be ending. There is nothing wrong with corporate bonds or high yield, it is just that over the past year, investors have become pretty fully allocated to the sector. They had pretty good timing. HY indices that I look at are up just over 10% in 2012. The volatility has generally been lower as well.

There are a few specific problems facing the market. Investment Grade bonds are often sold on the premise that “spreads are cheap”. And yes, spreads look okay and in fact, I still think the trend for CDS in particular is much tighter than here. The problem is, most retail investors own investment grade bonds on a yield basis. Calling July 26th the most recent big bottom for many assets shows just how much investment grade bonds have struggled on a yield basis. LQD, as the big IG ETF, is basically flat since then, including dividends (“coupon”). It was down last week. If we see any pullback in Treasuries, investors will lose money here. The next wave will be even worse as spreads, and financial spreads in particular (which make up around 30% of LQD) have less room for improvement on the next “risk on” leg. The Fed will do what they can to keep rates down, but the danger of so many people being invested for “spread” reasons, in a “yield” product may have some repercussions.

High Yield has some similar issues. I started to look at the portfolios of the two largest HY ETF’s (JNK and HYG) to highlight some of these issues, and was quite frankly disappointed with the level of detail available on their sites. One didn’t let you dig very deep so I can’t tell how accurate it is, the other had flaws in calculating various yields and duration, critical to any investor taking risk in these. As the “easy” beta is pushed out of high yield, and much will depend on specific bond selection and access to new issue, I look at these to underperform, but will provide more details as we scrub the portfolios.

In the meantime, it seems to me that hedge funds have piled into credit again. Probably the right decision, but too many mistake “lots of tight prices” for liquidity and risk being trapped in the same longs everyone else has in an environment where any mark to market losses causes selling. So I remain cautious the class as a whole, but think individual bonds and CDS can still offer good value.

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POSITION:  No positions in stocks mentioned.

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