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How Do You Get Your Shirts So Clean?

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Last Year’s Dirty Shirts Did Pretty Well

Personally I don’t like the dirty shirt analogy, but it seems to have gained almost as much usage as “risk on/risk off” and “BTD or buy the dip” so I will run with it.

Somehow it is always the U.S. that is the cleanest shirt or least dirty shirt or most wearable shirt or something.  Pundit after pundit goes on and talks about the U.S. as being the least dirty shirt, basically saying we aren’t great but other countries are worse.  I have not seen anyone (other than us) say that the U.S. isn’t the least dirty shirt.  But let’s look at the facts:

For all the confidence people had in re-iterating that the U.S. was the best place to invest, many other markets outperformed.
Many of the markets most mentioned as markets to avoid, if not being outright despised did very well.  PIIGS debt blew away the S&P 500, and in many cases had reasonably low volatility on top of it.

The Nikkei, suddenly on everyone’s radar screen had a very good year.  Even the Euro Stoxx 50 almost beat the S&P 500 and adjusted for currency, it did.
Then I added in high yield bonds.  I don’t think they return so much this year, but for all the people lamenting a “bond bubble” the returns in the high space were very good, and on a risk adjusted basis, even better.
I didn’t put in U.S. banks which were great, but spent most of the year, and certainly the start of the year on everyone’s do not touch list.

So Where Do We look for Returns Now?

There seem to be a few themes out there right now.  Many still subscribe to the cleanest dirty shirt argument.  I think they are horribly wrong.  I think the U.S. is now the dirtiest shirt, and I can’t help but think of that old Calgon commercial and think about “Ancient Chinese Secret”.

Chinese Stocks Look Like a Decent Starting Point

Chinese stocks have struggled.  That is no secret.  While it seemed obvious to be a bubble in 2007, it is becoming at least a little surprising they haven’t been able to bounce.  There are stories of ghost cities. There are stories of former ghost cities getting filled.  There is concern about a change in leadership.  There is excitement that a change in leadership will spark new growth.  There are class struggles in China.  There is hope that a domestic economy can develop.

One of the things I find most confusing is the excitement that Apple (NASDAQ:AAPL) is selling iPhones in China doesn’t seem consistent with a stock market in the doldrums.

I have to admit that things like low Baltic Dry index are not encouraging, and of all the investment areas, I have spent the least amount of time digging into details about China, in no small part because the details are dubious in many cases, but I can’t help but be intrigued about it.  I find it hard to see a world economy growing and U.S. stocks doing well from here without a serious rebound in China.
As a good contrarian, I started to get interested in China in the fall when suddenly everyone was on board with the “hard landing” scenario.  Many, long in denial that China could have a hard landing, were suddenly happy when PMI was coming in low.  Expectations were ratcheting down.  That seemed to be a good time to get involved.

Spanish and Italian Stocks

Last year, the bonds of these countries performed well. Italian 10 year bonds made the list of top performers.  Spanish bonds didn’t make it, mostly because they started the year in better shape than Italy.  Hard to remember that one year ago the markets were more concerned about Italy than Spain.  Spanish bonds did do great though since their July bottom.

This just won’t be the year of the bond there.  They can do well, and I expect them to.  Bonds that investors wouldn’t touch at 6% yields as too risky are now tempting at lower yields.  Investors are so underweight these bonds in many cases that the run could be big.  PIMCO was on the other day talking about adding Italy here, and explaining how even 5 years looked good with the roll.

While I still harbor some doubts that OMT will ever be launched by the ECB, I think that for now the crisis is under control.  It may return, but the next phase will be for some “green shoots” or “brotes verdes” to appear.  Whether real or just a dead cat bounce remains to be seen, but I think we can see some tiny bit of progress.  Some signs that the austerity has actually helped – yes, I wrote that, austerity actually helped!  There is punitive austerity that hurts the economy, but in many cases something was necessary to take out excessive benefits and spur real growth, not artificial government funded largess.

I wrote a longer piece about how I see improvement and a chance for Greece to be the turnaround story of the year.  I am not yet there on Spain or Italy, but could see the potential.

My rationale for liking Spanish and Italian stocks is simple
  • Spain is finally recapitalizing banks and reducing (though not eliminating) the zombie bank effect that has hampered any attempt to get some growth
  • Spanish banks are stuffed to the gills with Spanish bonds, loads of them, but all in non mark-to-market accounts, and suddenly getting a lot of carry and feeling comfortable that portion of their portfolio might actually be “money good” and certainly is no longer the “black hole” looking to sink the entire banking system
  • Pent up demand, just like in 2009, the U.S. had a pleasant “growth shock” from pent up demand, Spain and Italy seem to have that potential as well.  You can only go so long without buying basic goods.  You can delay certain purchases for so long before you have to make them.
  • Sentiment towards these markets is still horrible.  Again, yesterday, I read a report talking about what a certainty it is that U.S. housing has bottomed and is going to rally, while seeing other reports, equally certain that Spanish housing has 30% more to drop.  Maybe.  I can’t completely disagree, but that level of certainty and the dynamic of “what is priced in” seems in favor of relative outperformance of Spain.
  • Then on a more basic, and overly simplistic level, Spanish stocks are down 5% this year and down about 10% from their 2012 peak.  A 10% rally in Spanish stocks would get them back to just 2012’s peak.  So many other markets are up on the year and are at or close to their annual highs that this sticks out.  Even Italy is up on the year and getting back towards their March highs.  The MIB index is at 16,270 and it was at 23,000 in 2011, and was above 35,000 in 2008.  IBEX at 8,150 was 10.500 in 2011, and 14,000 in 2008.  In comparison, the S&P 500 at 1,400 is higher than it was at any point in 2011 and is kicking around its 2008 highs.  A lot of “least dirty shirt” is priced in.
So these are areas of growth to me.

U.S. Banks and Homebuilders

I already think too much good is priced in for the U.S. market for it to meaningfully outperform, but these sectors in particular strike me as having priced in a lot, if not too much.

DR Horton (DHI) is at $20 a share.  I know P/E isn’t a great way to look at an individual stock, but at 25 current and 21 estimated, that seems on the aggressive side.  Its 2007 peak was 31 and I will admit it got to 40 in 2005, but I don’t see any way we return to those levels.  We still have excess inventory.  In many cities, there are still houses in poor locations that need to be cleared and the homebuilders only have access to even worse locations for new homes.  Sure some areas are coming back, some growth is occurring in areas that homebuilders can exploit, but I see this industry struggling to maintain current valuations let alone returning to once in a lifetime valuations.

I’m mildly positive on the housing market.  I think the economy is doing well enough to support price stability and maybe even some price increases.  The Fed is doing all it can to push on rates to keep them low and banks are being forced to lend more aggressively to make money, so that should help more people get mortgages.  Those are all constructive for the housing market, but it doesn’t mean that I have to like homebuilding stocks here.

Banks are a similar, yet different story.  I expect U.S. banks to have some great loan loss reserve releases.  The stability in housing is great for their balance sheets.  The problem I see for banks is where to make money going forward:
  • Net Interest Margins are low as spreads decline and the yield curve remains fairly flat
  • The improvement in the housing and mortgage space is good for their existing positions, but turnover is too low for big fee generation.
  • While the banks ignored direct lending, many types of businesses have stepped in at the margin and are providing middle market lending, and other types of financing that banks once made a lot of money in, but may find it difficult to reclaim.
  • A couple of the U.S. banks seemed to be on the, umm, how do you say, aggressive side of LIBOR quotations, and that may yet throw a monkey wrench in their valuations.
  • The capital markets and investment banking areas are under pressure as Dodd-Frank does change the playing field and alternative trading areas are developing at a furious pace.  While banks will be involved, particularly in clearing, the profits won’t be what they once were.
  • U.S. banks in particular have reduced their exposure to Europe and won’t participate as much in the recovery there, and look for Europeans to shun U.S. banks as much as possible on high margin business going forward, in retaliation for pulling out during the crisis.
If anything, I see more stable earnings, but at potentially long run lower levels.  There will be continued pressure to divest businesses and shrink.  The Fed has not pushed them hard in this respect as the system has remained too fragile, but as the economy stabilizes, and housing stabilizes, look at the Fed to push banks to become less too big to fail.

JP Morgan (JPM) at $44 isn’t quite back to levels it had gotten to in March of this year (pre whale) or had been at in 2010 or 2009.  So that would argue for some more upside.  On the other hand, the 2006 peak of just over $50 seems uncomfortably close given that was the heyday of structured credit, M&A, housing, CDS, etc.

Looking at it from a market value perspective tells a similar story.  The bank had to issue equity during the crisis and while starting to buy some back, means that the market cap of the company for any given stock price is higher than you might think.  So the company has a decent valuation.  Can it go higher?  Sure, but there are limitations and I liked the company much more during the heart of the Whale story when you could pick up shares below $37 and for a brief while below $35.

Bank of America (NYSE:BAC) and Citigroup (NYSE:C) seem to have some more upside having been beaten down for longer, but think they have bigger actual problems, and while we should see bigger one-time gains from reserve releases, they have been so distracted on dealing with the past, that their competitive situation going forward is worse than it should be.  Wells Fargo (NYSE:WFC) is at the other end of the spectrum, where it never felt the brunt of the crunch, but hard to see it getting a big pop.

So I don’t mind banks, but think much of the upside in stocks is gone.  On the fixed income side, particularly the CDS side, I think we could see continued tightening.  Lower risk earnings should help CDS more than the stock, yet so far, the inverse is largely true.  JPM CDS spent most of the period of 2000 to July 2007 trading 15 to 25 bps. It did spike to about 200 at the heart of the crisis (though people at Citi, Lehman, BAC, would only dream of a level as tight as 200 at the time).  It got back to 50 bps in 2009.  It widened to 150 at the height of the euro crisis when investors still believed U.S. banks had massive exposure, but has failed to fully recover.  I can’t help but look at JPM CDS at 89 and think cheap.  Yes, it could widen in a heartbeat, but I think CDS is too negative relative to stocks.  The reality that JPM is too big to fail isn’t being priced in.  The fact that over time clearing should reduce the need to hedge JPM exposure isn’t being priced in.  I think CDS is stuck in a mode that one day we wake up and everyone loves bank CDS and we see some great outperformance there.

I chose to look at JPM since it is the easiest story to spin, as Citi for example is near its post 2008 tights of 120, but even here, I find it hard to imagine scenarios where C gets in real trouble.  The Fed is helping.  For all the damage the Fed might be doing to longer term growth of the banks, it is certainly helping with legacy positions.  Slowly but surely Citi is stabilizing.  The stock is still a mess, but I think credit, particularly CDS offers some value.

High Yield Bonds – Off the Beaten Path

This is a weird and contrarian chart, even by a weird contrarian’s standards.

This looks at the relative performance of HYG versus HY18 since June 30th.  I picked that date since it is post Rescap (which had a Credit Event that settled in June).

What you can see here is that the CDS has actually outperformed since then, but I think it will continue to outperform.  I prefer HY19 to HY18, but since that wasn’t created until September, the chart is less meaningful.

So why would I like HY CDS better than HYG (or liquid high yield bonds in general)?
  • Fixed duration on each name, rather than duration that varies bond to bond, with the yield to call paper having virtually no upside.
  • No rate risk, while CDS won’t be impacted by a move higher in treasury yields, it is easy to see that the price of some BB bonds will struggle to go higher in a rising yield environment as rate risk is high relative to spread risk for many of those bonds.
  • Crowded long from retail versus a crowded short from funds and traditional money managers.  CDS is always a favorite home of shorts and that remains the case, and while many have taken off their IG shorts, many remain in HY shorts, particularly since the “decompression trade” was making its rounds post election.
For many of new, the arguments I’m making are nothing new.  We have looked at the make-up of the high yield bond indices and come away scratching our heads on how to make money.  While the HY CDS index is our most obvious choice, I think investors could do extremely well with.
  • Shorter maturity, off the run dated, single name CDS, where the CDS market doesn’t reflect the strength of the leveraged loan market, which really does play a key role in reducing default rates, as companies that might otherwise run out of cash, can find ways to roll debt.
  • Off the run, illiquid bonds, or sectors that have been deemed to risky, as more people realize they can’t hit their “bogey” with on the run, go-go bonds, more investors will come scrounging around for those hard to find bonds
  • Finally, looking at structured paper, whether lower rated tranches of CLO’s, or even old CDS tranches, should do well.  We are seeing correlation reduce – ie, individual bonds are getting valued more on individual credit prospects than the market as a whole, which is good for these tranches/structured products, and as investors continue to search for risk, the underlying markets as a whole will do well, making the higher beta of these tranches pay off.
While much of the above applies to investment grade CDS, I think we have already seen a lot of that move, and HY offers more opportunity, but I would position similarly in IG.
I regret cutting shorts on Thursday (now), but do think it is right and adding to longs here is the play.  The fiscal cliff, one way or another won’t last too long.  Nothing dramatic will remain on the books for long, and I think Obama may well be playing this in such a way that we no longer talk about the Bush Tax Cuts, but the Obama Tax Cuts.  Sad that is the state of the country, or at least the government, but it is the case.

The Nikkei – From Goat to Crowd Favorite in 60 Seconds

I’m not sure what else to say here.  I don’t mind the Nikkei.  I’m even willing to believe that it is a compelling story.  On the other hand, it seems amazing how quickly everyone has jumped onto the bandwagon.  Weak yen, more exports, higher stocks, Domo Arigato, Mr. Roboto.
It is up 17% this quarter, and 10% this month.  Year to date it is up 23% though only up 10% in dollar terms.  Just a quick pause for thought here: the € is STRONGER on the year, the ¥ is WEAKER on the year.  Even with the facts staring us in the face, neither the stories nor sentiment read that way to me.

So, for years, I’ve had a soft spot for Japan that somehow they would get it right.  It hasn’t been a focus recently.  Part of me is bitter that I didn’t catch it this time around, but I was focused elsewhere.  I do have to make sure I don’t let missing it early, stop me from missing it altogether, but I think this may have to take a breather before long and there will be better entry points.

Long the Long Bond and Munis

I spent a lot of time looking at who owns the Treasury market and I keep coming to the conclusion that with little free float, a Fed that is continuing to buy, and a high likelihood that the Fed neither creates much in the way of jobs (so they keep buying) nor do they create inflation (just not enough growth is achieved) so Treasuries will do okay.  I don’t love them, and they need to be traded, but so many are picking for a rotation out of treasuries that there is some sentiment on your side.  Plus you have the money printer, who doesn’t care about price on your side (and not going away any time soon).

With Treasuries doing well, and municipalities having done a decent amount of work in terms of cutbacks and trying to get their balance sheets in better shape, I think they can do well here too.  Maybe not a huge trade, and obviously certain issuers need to be avoided, but seems like there is some value here relative to other areas of the credit markets.  The sector doesn’t benefit from the institutional search for yield, but could well do if the rich see taxes higher while retaining the tax free nature of muni income.  In fact, right now is interesting, because depending on how you play it, coupons are higher than yields, so get the coupon tax free, and the price drop is tax deductable, making the after tax yield more interesting than it would seem otherwise.

Auf Wiedersehen Germany

Bunds: NEIN.  DAX: NEIN.  Okay, maybe the DAX has more room, but I cannot get comfortable with bunds here.  The flight to quality trade is nearing an end, but more importantly, the hopes of getting some new deutschemark bonds rather than bonds denominated in Euros is dissipating.  Germany has its own elections coming up, and while it might roil the markets as a whole, it could well have more impact on German assets than European ones.  This is particularly true if Europe is starting to see at least stability if not some signs of growth, giving Merkel evidence her policies have been working.  France is similar, though there I dislike the stock market more than the bond market, though I don’t find either particularly compelling, at least not from long side.

I would be remiss to mention that the DAX was just over 8,000 in 2007 and is now at 7,600.  The currency has devalued a lot since then, so the DAX has more room in dollar terms, and could well breach the old highs, just think that again, too much has been priced in and with the flight to quality/redenomination trade potentially over, I see less chance of strength.

Twitter: @TFMkts
POSITION:  No positions in stocks mentioned.