Jubak: The New Financial Bubble is Here

According to Jim Jubak, the next asset bubble is here and it’s called the US Treasury market. If one believes in his thesis, then one of the best ways to capitalize on the bubble popping would be purchasing TBT, the Proshares Ultrashort Lehman 20+ Year Treasury (it moves 2x the inverse of the 20+ year Treasury market):

What we’re seeing in the Treasury market is a bubble that has inflated government bond prices. But unlike the technology stock bubble or the real-estate bubble or the mortgage-backed-securities bubble, this one isn’t caused by greed. This is a bubble based on fear: Investors are buying Treasurys to protect themselves against the risk of government default, the risk of sinking nondollar currencies, the risk of market collapse, the risk of rising corporate defaults.



The question now is: How much longer will the fear last? For how much longer will investors be willing to take these low yields on U.S. government paper, knowing all they know about the state of U.S. finances, before they decide that 1) U.S. government debt isn’t as safe as it now seems to be versus the alternatives and that 2) the higher yields of corporate debt justify the risk?



My estimate is that the tipping point will occur later this year — but not all that much later. Moody’s (MCO, news, msgs) and Standard & Poor’s are forecasting that the default rate will peak near the end of 2009. At the same time, Credit Suisse (CS, news, msgs) projects that the yield on 10-year Treasurys will climb 4% by the end of the year, causing the prices of already issued Treasurys to fall. A Bloomberg News survey of the primary Treasury dealers who do business with the Federal Reserve projects a 3.1% decline in the price of the 10-year note in 2009.



That may not seem like much, but with the 10-year note yielding just 2.52%, a drop like that is enough to produce a negative total return from holding a 10-year Treasury.

The combination of the two — the prospect that the default rate on corporate bonds is near a peak and that the prices of Treasurys are about to fall — would send money from Treasurys into corporate bonds. That would, of course, accelerate the fall in Treasury prices and the climb in corporate bond prices. Investors who have been through the past two bubbles should recognize this kind of negative feedback as “lower prices produce still-lower prices.”

Jon Markman: Why the Bank Bailouts are Doomed

Hope you’ve taken your prozac today, Jon Markman is a pretty smart guy and he’s using some simple math to tell us that the bank bailouts are doomed. This of course means we’ve wasted around $500 billion and are on the brink of wasting several hundred more billion.

He’s reasoning? There simply are too many liabilities still left in the banking system:

The math is not complicated. Bank losses from the write-offs of bad loans and busted derivatives tally up to $1.5 trillion so far. In addition, $5 trillion to $10 trillion worth of off-balance-sheet businesses such as structured investment vehicles — leveraged lending vehicles used by big banks to fatten their profits in boom times — are being forced back to banks’ balance sheets by regulators. Rules require banks to keep a base of real shareholder capital amounting to 10% of those funds. So banks need to find up to $1 trillion within the next year to meet that objective.
Add the $1.5 trillion in losses to $1 trillion in needed new reserves, and you can see that banks need as much as $2.5 trillion in new capital to remain solvent under current rules. I know that we throw around words like “trillion” like they’re nothing, but that is a lot of money. Consider that the entire world banking system had only $2 trillion in shareholder capital in 2007, before everything blew up.

Markman is resigned to the fact that we are ultimately going to nationalize our largest banks:

You can’t very well have a bankrupt banking system, however, so the market has spent the first three weeks of the new year pricing in the inevitable next step: nationalization of most large banks. The reason is simple: If your owner can print money, you don’t need to keep any reserves. Problem solved.

Is he happy or optimistic about this solution? No:

You can pretty much count on the government knocking the financial system back to the Stone Age, or at least the 1950s — a situation in which banks accepted passbook savings accounts from Mr. and Mrs. Smith and then made plain-vanilla loans to Mr. and Mrs. Jones.

What should we have done? Dig into the bank’s books from day 1 and close the bad ones:

The best course of action, which would have been the most painful in the short term but beneficial in the long term, would have been to force banks to open all their books to regulators and investors, allowing us to see which were solvent and which were not. Then the Federal Deposit Insurance Corp., which is sort of a mini-nationalizer, could have closed the bad banks and merged their assets into strong banks, and we would be halfway through the crisis by now.
Instead, the previous Treasury secretary, Henry Paulson, decided on this disastrous course of putting insolvent banks on life support at public expense, which has only led to a massive waste of money and time.

What does the future hold? Close your eyes, this is going to hurt:

Now time is running out, because the next phase of the credit crisis is at the door: the part where we see a normal rise of loan defaults during a recession, further crushing banks’ earnings. At the moment, defaults are running at 2.5%, but history shows they will hit 10%-plus over the next year or two as commercial real estate and business loans sour. This is why fixing the banking system will not end the recession; it will help only to smooth the path of a turbulent descent.
Get out your parachutes — it’s going to be a rough landing.

Jubak: 6 Stocks to Watch Now, Buy Later

A recent article from Jim Jubak detailing 6 stocks to keep an eye on and look to buy later. He gives us 4 potential characteristics to look for in a company during a recession, and while they are overly general, they can serve as good starting points:

But investors can see indications of which companies will come out of this recession stronger than they went in. The signs aren’t visible — yet — in quarterly earnings reports; the economy is still too weak for that. The evidence that a company is “wheat” and will come out of this recession a winner is to be found around the edges:

News of dividends increased.
Reports of hiring.
Capital spending maintained.
Acquisitions made.


Jubak gives us 6 stocks that fall into these categories, and in my opinion MON is the most promising for the first part of 2009:

Rising Dividends – Monsanto (MON)
Hiring – Teva Pharmaceuticals (TEVA)
Capital Spending Maintained – Intel (INTC), BNSF Railway (BNI)
Acquisitions – US Bancorp (USB)
The sixth stock is Ericsson (ERIC), and while it doesn’t meet any of the above qualifications (unless it acquires some of the pieces of Nortel), it appears to be one of the few telecom equipment makers who could be left standing after this depression, er, recession.

Disclosure: Long USB

GMO Quarterly Letter: Jeremy Grantham

From the quarterly letter of GMO, Jeremy Grantham gives us some worthwhile insights into our current crisis. Some excerpts:

Greed and reckless overconfidence on the part of almost everyone caused us to ignore risk to a degree that is probably unparalleled in breadth and depth in American history. Even more remarkable was the lack of insight and basic competence of our leadership, which led them to ignore this development, or worse, to encourage it. Ingenious new financial instruments certainly facilitated and exaggerated these weaknesses, but they were not the most potent ingredient in our toxic stew. That honor goes to the economic establishment for building over many decades a belief in rational expectations: reasonable, economically-induced behavior that would always guarantee approximately efficient markets. In their desire for mathematical order and elegant models, the economic establishment played down the inconveniently large role of bad behavior, career risk management, and flat-outbursts of irrationality. The dominant economic theorists so valued orderliness and rationality that they actually grew to believe it, and this false conviction became increasingly dangerous. It was why Greenspan and Bernanke were not sure that bubbles – outbursts of serious irrationality – could even exist….

Never underestimate the power of a dominant academic idea to choke off competing ideas, and never underestimate the unwillingness of academics to changetheir views in the face of evidence. They have decades of their research and their academic standing to defend. The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all. It left our economic and governmental establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives, and wickedly complicated instruments led to our current plight….And the absolutely worst aspect of this belief set was that it led to a chronic underestimation of the dangers of asset bubbles breaking….

It is obvious that the scale of write-downs that we have been reading about in recent months of $1 trillion to $2 trillion will not move our system anywhere near back to a healthy balance. To be successful, we really need to halve the level of private debt as a fraction of the underlying asset values. This implies that by hook or by crook, somewhere between $10 trillion and $15 trillion of debt will have to disappear….

Our path this time is likely to involve a hybrid approach:we will certainly take some painful debt liquidations; this crisis will almost certainly take far longer than normal to play out; and probably, before a new equilibrium is reached, we will see inflation rates that are well above normal…..

Current Recommendations
Slowly and carefully invest your cash reserves into global equities, preferring high quality U.S. blue chips and emerging market equities. Imputed 7-year returns are moderately above normal and much above the average of the last 15 years. But be prepared for a decline to new lows this year or next, for that would be the most likely historical pattern, as markets love to overcorrect on the downside after major bubbles. 600 or below on the S&P 500 would be a
more typical low than the 750 we reached for one day.

US Bank Quarterly Earnings and Jubak’s Take

Disclosure: I am long USB (yes, I own a financial…)

USB announced quarterly earnings last week, earning $.15/share, $.07 below estimates. The stock is trading at around a 12% yield, which tells us the market is anticipating a dividend cut. The company did not announce a cut, and anticipates earnings for 2009 will cover the dividend. However, if they expect at any point that earnings will not cover the dividend, then it will lead to a dividend cut. I like USB long term since it is one of the best capitalized banks and they have seen growth in deposits, loans, and interest income and should be one of a few large banks to emerge for the depths of our financial crisis. However, given the state of financials in general and the overall economy any purchase of USB would probably best be accompanied by purchasing an out of the money put and/or writing a covered call to limit one’s risk. Here is Jim Jubak’s take on USB:

Will US Bancorp (USB, news, msgs) follow the lead of so many of its peers in the banking industry and cut its dividend? The question isn’t academic to me: I had added this stock to Jubak’s Picks in April 2008 because it then paid better than 5%.

Since the company’s Jan. 21 announcement on fourth-quarter earnings, a majority of investors on Wall Street have been thinking the dividend is headed for a cut. A stock-price drop of 12.5% on Jan. 22 left the yield on the shares at 12.1%. You don’t see that kind of a yield on a bank stock unless the market is convinced the company will cut its payout.

I can certainly see why investors think that. The bank didn’t exactly give a ringing defense of the dividend in its earnings conference call. Executives said the company believes it will be able to cover the dividend from earnings in 2009 but noted that it reviews the dividend every 90 days — which puts the next review in March — and that the bank has no intention of continuing the current dividend if earnings don’t cover the payout.

The real issue then, as the company said in its statement, is earnings for the rest of 2009. On Jan. 21, US Bancorp reported earnings of 15 cents a share. That’s a profit — unusual for a bank these days — but still 7 cents a share below what Wall Street had expected. The problems? There were $253 million in losses on securities and a $635 million increase in provision for credit losses. All in all, charges and losses chopped 34 cents a share out of earnings.

It’s also clear that the bank’s business, like that of all banks I know of, is still getting worse. Nonperforming assets climbed to 1.14% in December, and the bank said it anticipated that nonperforming assets — that is, loans that the bank can’t collect on in a timely fashion — will continue to climb in 2009. It’s cold comfort to investors that the bank’s performance continues to be so much better than other banks’. The increase in nonperforming assets to 1.14% in December is only a modest increase from the 0.88% in September. That indicates the bank’s lending standards continue to hold up to a very difficult economy.

The bank’s operating results, in fact, were quite impressive. Loans grew 17% (12.7% excluding acquisitions) and deposits 15.2% (9.6% excluding acquisitions) from the fourth quarter of 2007. (In November 2008, the company acquired Downey Savings and Loan and PFF Bank and Trust from the Federal Deposit Insurance Corp.) Net interest income grew 22.6%. Tier 1 capital remained at a strong 10.6%.

So will US Bancorp cut the dividend or not? Unfortunately, it’s a danger and, also unfortunately, uncertain. It depends on how long the economy struggles and how big the losses get on the bank’s portfolio of loans. I still think US Bancorp will be a winner in the current crisis, and this quarter’s results are evidence that the bank is picking up loan and deposit volume as customers opt for the bank’s relative safety.

I’d certainly be disappointed at a dividend cut, but I think the potential from here outweighs the damage that even a dividend cut would temporarily inflict. As of Jan. 23, I’m cutting my target price to $35 a share, from a prior $44 a share, and stretching out the schedule to March 2010 from December 2009. (Full disclosure: I own shares of US Bancorp in my personal account.)

Cumberland Advisors: 50% stock/50% bonds/no cash

From Cumberland Advisors courtesy of The Big Picture, their 2009 outlook is a little more rosy then some others. The are banking on the monetary and fiscal stimulus will have a positive impact on the economy and thus the stock market. Their current allocation they are recommending is 50% stocks and 50% bonds (investment grade). I am not as optimistic as them, but I would agree that 2009 won’t be an all out bloodbath for all assets outside of Treasuries (a la 2008). We should be able to find bargains and positive returns if we select our sectors and investment vehicles carefully. An excerpt:

We believe the economy will bottom in 2009 and the bottoming will be in the data during the second half of the year. We believe that the stimulus combination of massive fiscal and massive monetary will work. And we are applying that assumption in our portfolio management.

Clients who do not agree with us have asked us to take a more cautious view, and we do so for them. We are a manager of separate accounts. We are not a common fund. Our job is to meet the client’s objectives and not impose our will on the client. If the client asks, we offer what we think is our best guess of the future. If the client wants to be riskless and in US government credit only, we do it.

That said, we are recommending to our clients that they use an asset allocation of 50% stocks and 50% bonds. Cash is at zero. Remember that the classic efficient frontier is 70% stocks and 30% bonds. So we are 20 points under on the stocks side and 20 points over on the bond side. The reason is that bonds are soooooo cheap that they warrant overweight.

Both sides in this 50-50 stock-bond mix are fully invested. On the stock side we only use exchange-traded funds (ETF). We do this domestically in the US, and we do this abroad. And we do this in other asset classes like currencies and commodities and precious metals.

On the bond side we are emphasizing high-grade credits. The junk bond market is very cheap, but it requires a special set of skills and we do not apply them at Cumberland. Clients who use junk bond allocations are using other managers. We are in investment-grade bonds only, whether taxable or tax-free. On that note, our clients are also fully invested and favor longer duration.

As this financial turmoil period enters its third year in 2009, we expect the various sectors to heal and the spreads to narrow. This will occur piecemeal. We already see it in some areas. The results of the application of stimulus by the Fed will be seen sector by sector and will have its own accelerator. Investors who wait until the air has cleared are taking no risk, but they are also not going to get a reward.

Click here for the entire article, Markets Measure; They Don’t Forecast

Long Term Chart of the Dow: Trending to 4000?!

From Barry Ritholz at The Big Picture, the long term chart of the Dow from 1901-2009:

Since you are into posting long term charts, here is another one. You might want to take note of the years ending in 2. There is a ten yr cycle from 1932-1942, a 40 yr cycle from 1942 to 1982 and 50 yr cycle from 1932 to 1982. Projecting 10 yrs from 2002 we get 2012 which fits with the Mayan calendar dates. If you shoot out 40 and yrs from 1982, you get 2022 and 2032. Just fun with cycles.

The long-term 1932-1982 trendline is sloping into 4000 in 2009. It is a bet I am sure the Black Swan guru has a few nickels on.

Event-Driven Research for Risk Managers
John Bougearel
Director of Financial and Equity Research
Structural Logic, Inc.

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Articles for Thursday

I posted a new article/link under my Trading Strategies column on the right hand side. The article is from Tom Lydon and is a trend following system for long term investors using ETFs. A very useful article for those interested in relatively easy to follow trend systems. For those wondering how to capitalize on the early stages of a rebound but still following a trend system, he recommends putting 25% of your money in a fund after it breaks up through the 50 day moving average, and then adding 25% on each subsequent 5% move up. Also, for those wondering what to do if they didn’t sell when their funds/investments broke trend, here is his advice.

For those of you interested in low priced biotechs, an article from Today’s Financial News details four names. I can’t quite figure out that site – they are selling their own products/services but then also seem to have some tangible stock ideas for free. The names mentioned: ASTM, CERS, GERN, and CYTX.

Finally, an update on TBT, the ultrashort Lehman 20+ year treasury from Trader Mark. TBT has rebounded in recent days as treasuries have declined.

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Horowitz: 3 stocks to thrive in hard times

From Andrew Horowitz, we get 3 stocks he thinks could thrive in this economy. They are all educational stocks and the charts for APOL and ESI look great. Perhaps EDU is the next to pop? The article:

Layoffs are affecting millions. Stores are closing, municipalities are cutting hours from their paid work week and all around there are signs of concern about the economy. Yet, even with all of that, there are stock and even sectors that will do well. Take the education stocks as an example. Since there are too many people chasing too few jobs, many have decided to go back to school to enhance their marketable abilities.

Embedded in China’s economic stimulus package was money dedicated to educating the population. That is good news for companies like New Oriental Education (EDU) which is expected to report a profit of $0.06 cents per share for this quarter’s earnings. Although market conditions have been extremely tough, we are seeing a great opportunity for owning post-secondary and continuing education companies. Here’s why.

We have anticipating a surprise to the upside from EDU as we have seen a solid track record of stable earnings and sales growth. One piece of information that provided us with some valuable insight was gleaned from the January 8, 2009 earnings announcement from Apollo Group (APOL). That day, they surprised investors with a result that was 14% higher than expectations.

It looks as if New Oriental Education may be a prime candidate to receive a portion of China’s stimulus package as it provides private education programs for over 1.2 million Chinese residents at over 200 locations. Specifically, the company provides language training, test preparation as well as post secondary education for future career placement.

Along with being poised for a bounce due to the stimulus package, this company has had consistent earnings growth at over 40% for the past seven quarters. Estimates for 2009 earnings have been reduced due to the global economy’s woes but are still projected to grow at 18%, year over year. Although sales have ticked down slightly in the previous quarter, they are still growing at over 47%. This is astounding considering the market conditions we are currently facing. Management currently holds 22% of the shares outstanding which gives them a great deal of incentive to make sure the company is running smoothly.

Technical Indications
We are currently looking at strong resistance at around the $52-$53 level. If we were to break above the January 5, 2009 high of $57.50 we could see a significant move higher. If the earnings are to come out as a surprise to the high-side, then this price target would be reasonable, even in the midst of a global meltdown.

If there were to be a surprise to the downside, there should be buying support around the $48-$50 level. BUT, if we were to break through the January 8, 2009 low of $47 then it is possible we could re-test the late November 2008 lows of $39.

Monitor the earnings closely and look for a trading opportunity around these suggested levels. If you open a position, make sure to place appropriate sell-stops to protect the downside. While you are at it, take a look at ITT Education (ESI).

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S&P Regression to the Trend

An interesting and scary article from Barry Ritholtz showing the S&P regression to the trendline. We’re just reaching the long term, inflation adjusted trendline now after being above it for years, and there have been several sustained periods where we have stayed below the trend. The implication, of course, is that we could be headed down further in real terms.

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