Earnings, Outlooks and China

With almost 80% of companies thus far reporting positive earnings surprises and more that two thirds reporting upside to revenue estimates investors should not be disappointed. But it is clear to even a casual observer that the investors are selling regardless of beat and raise results. The indiscriminate selling is generally something that I pay a lot of attention to and look for opportunities to go against the crowd. Clearly, there are a lot of concerns related to political and economic uncertainty, but much of it might either prove to be temporary noise or a knee jerk reaction and nervous responses to volatile economic monthly data. Case in point, last week investors fretted about potential non Bernanke non confirmation. I am not a political analyst, nor am I a huge fan of helicopter Ben, but from a practical standpoint, I felt the probability of him being nominated outweighed the risk. He is still the best man for the job at the moment.

Back to earnings. What bothers me, however, is the impact of outlook announcements. Despite strong results, management will be reluctant to provide upbeat guidance, quickly rewriting their (already pre-written)press releases and being more conservative in their guidance. The uncertainty of Chinese policies may potentially impact just about every commodity and industrial company, basically the whole cyclical sector. Given this 'dark cloud', I expect that companies with any direct or indirect exposure to China will guide mostly in line with consensus or slightly above, even if they internally expect to have a much stronger year. Think about it. No one will believe them if they guide strongly anyway. Why stick your neck out if the market is not rewarding you for it?

Clearly, this is the reason why cyclicals already had a much steeper correction than the general market. The rebound in $$$ is not helping either. Unfortunately, my portfolio also took a decent hit, being overweight in cyclicals.

The disconnect is important. Despite the fact that investors perceive the potential slow down in China to be real, the truth is, their economy will still grow in high single digits or potentially low double digits. On paper, the ability to quickly make changes to the economic policy is one of the virtues of the centrally controlled economy. But in reality, they can't put the Ginnie in the bottle. More than anything, the Chinese government is concerned about social harmony and stable society. I can't really blame Chinese for being prudent and trying to prevent inflation and asset bubbles by putting some breaks on. From my standpoint it should be looked at as a POSITIVE, not negative.
At the end of the day, I think the fears of Chinese economic growth coming to a standstill and subtracting from the global growth are overdone. The growth will continue, even if the pace will be a bit slower. I am a buyer of oversold, quality cyclicals on these concerns.

During the last few days I have been committing some of my idle cash to buy some of these companies as well as selling puts. We are bouncing today, and if we continue to bounce I may sell some into the strength to be prudent, but overall, I remain constructive on US cyclical, broadly on Brazil's infrastructure and commodities, and select Chinese US traded names. The risk here is that perception will overwhelm the reality and the stampeding herd will abandon the sector. So if you plan to follow my strategy, buy only those stocks that you don't mind to hold for a long time. This is a tough market to trade, unless you have a very very short term timeframe, but then, you may miss a real move.

Certain Uncertainties and the Market Multiple

Despite a very somber tone in the markets and a temptation to yield to panic and hide under the table, I am trying to maintain a healthy perspective. There are clearly plenty of concerns, negatives, and uncertainties in the market right now.

The market, being a continuous discounting mechanism, is making adjustments to account for new or elevated uncertainty. This is especially true of the extended and nervous markets, in which we seem to be now.

The past five trading sessions were brutal, but the lack of stampede tells me that my gut is right and we are in a corrective phase, rather than a new leg of a bear market. I am sticking to a technical definition of a bear market, i.e. a decline of 20%+. I just don’t think it is in the cards right now. Many investors have been expecting some type of correction in the first quarter, although personally, I thought it may come a few weeks later, at the end February. Well, we are getting it now and I am fine with it, although it’s never a lot of fun if you are net long.

There are clearly a lot of uncertainties in the market now and a lot of noise that will go away. We need to really understand what the market is adjusting for now, what has ALREADY been adjusted for and what is still to come.

I am not very bullish right now, more like neutral, trying to swim with the current, not against it. I am also not ready to come ashore. Basically, I am just trying not to panic and respond emotionally to Obama's lashing out politics. My take is that we are clearly marking US equities down to adjust for additional political risk. That’s right folks, a discount usually reserved for emerging markets with unstable governments, is now being attached to the US equities. I expect that we may correct roughly 8-10%, possibly a touch more on the SPX before we stabilize. My worst case scenario is 975.

Let’s take a quick look to see what are the key things investors are fretting about at the moment:

1) Political risk of Obama's anti-business policies - Obamacare, Volcker Rule, Cap and Trade, etc. Who will he go after next?
2) Potential China slowdown due to credit crunch and changes in lending guidelines, etc. Will it impact the US and European commodities producers and industrial exporters? How much will it subtract from the global growth?
3) Possibility of Bernake/Geithner resignations - funny that we even have to worry about it, but as the saying goes "The devil you know...".
4) Expectations of higher interest rates down the road (either because the Fed raises rates or due to higher yields demanded by the bondholders).
5) Negative Macro - fiscal irresponsibility of our government, unstoppable printing of $$$, widening record deficit, struggling housing, double digit unemployment, weak consumer spending, etc, etc.
6) Struggling US dollar - If it strengthens will it kill commodities and cause massive unwinding of a carry trade, negate the favorable currency winds we had for over a year for US multinationals and diminish their competitive cost advantage? If it stays weak will the Fed raise rates to provide some support to the falling currency?
7) What happens when the fiscal stimulus and other initiatives are pulled?
8) Geopolitical concerns - too many to name..Iran, Iraq, Afghanistan, Pakistan...you all read newspapers.

Despite these very valid concerns (not an exhaustive list by any means, but I don't want to make this post any longer than it already is!) the earnings thus far are looking fine and at the end of the day, earnings and earnings growth are the key variables that influences stock prices over a long term. So with E ok, we are really taking a machete to the multiples...The US equities would need to correct to a more reasonable multiple to account for the uncertainties mentioned above. Some of them are temporary and some have already been discounted. At 1150, the SP was trading at ~15.3x 2010E. Currently we are down ~5.5% from 52 week high. At the next support ~1070, we will be roughly at 14.2x or a full 1x multiple adjustment. My worst case scenario assumes 975 on SP, a 15% move down from the high, resulting in a 13x multiple. I think a full 2x adjustment to the multiple, without corresponding erosion in earnings, should make this market valuation attractive again. Of course, if Obama has his way he will not only destroy the multiples, but the confidence of business leaders, and capital investment necessary to sustain this feeble economic recovery.

Back to the market action. We seemed to have bounced from the early morning selloff after the benign message from the FOMC and good news from Apple about the launch of Ipad. Looks like the buyers are dipping the toes back in the water, very slowly. But I would not be surprised if the declines continue tomorrow. Getting this correction out the way early and having it run its course, will also provide a necessary sentiment adjustment which could bring new money still sitting in the low yielding CD's, bank accounts, or overvalued bond funds.

So - don't panic, you will never make money trading emotionally and following the heard. If uncomfortable with this volatility, take some risk off by reducing portfolio beta, diversify into bluer chips, away from some of the spec stocks where you don’t have a lot of conviction, and wait it out. But my advice is - stay in the game. I am.

Quick Take On The Market Action

No sooner that I finally published my thoughts on 2010 investments, the market decided to roll over. Despite a rough ride over the past few days, I remain constructive. I am also not being complacent and still maintain a decent amount of of cash, although I am starting to deploy it in a few select areas, consistent with my outlook outlined in the previous post, First Post of 2010.

As far as technical levels are concerned, some short term damage was clearly done, but thus far it is contained. None of the major indices have broken their intermediate supp port levels. With market finally overbought, and irrationality once again prevailing, I smell fear and urine on the street. Well, the smell of urine in NYC streets is often there often, lol.
SPX - watching levels 1120, which was broken today, and more importantly 1070-1075. This one is clearly the level where are a lot eyes are watching.

In general, I feel that the smaller companies, Russell 2000/3000 are more likely to rebound, but as the entry levels on many stocks in my watch list are getting hit, I am slowly buying them.

I consider the reasons (excuses) for this pullback and profit taking to be pretty lame. Obama going after banks - come on, not gonna happen. Nothing but saber rattling, he lost his way, he is pissed off about the his pet healthcare project getting basically reduced to nothing, and he is lashing out. Bad, bad recipe to gain support for anything. Plain dumb.

China containing their lending - a lot of rhetoric. If anything, the growth will continue, and companies will use equity markets to finance its growth. With China number 2 goal being self sufficiency (#1 gaol is preserving social harmony and order), we will continue to see the the growth trajectory over the next few years, even if there will be bumps along the way. I would not sweat the impact on US and global commodity producers or energy companies.

But the trade I most excited about is adding more exposure to Brazil via BRF and EZW, and BZF (the last one is more a bet on real appreciating against the dollar). With two major global events coming up in the next 4-6 years, the World Cup in 2014 and Summer Olympic Games in 2016 will not only drive investments in infrastructure, but also force the government to continue its pro-business policies that they have been emphasizing thus far. As usual, expect the Brazil GDP to add at least 300-400 bps to account for all the economic activity associated with build outs to accommodate these two super public events. I would focus on infrastructure, such as steel, construction, and commodities industries, although someone will have to finance all this growth - so Brazilian banks will benefit as well. With tame inflation, stable economic and political climate and currency that will continue to appreciate as the foreign investment continues to flow in, Brazil is my top emerging market for 2010 and beyond. I would use this pullback opportunity to load up on Brazil.

In addition to Brazil, I am actively focusing on some of the energy plays, coal, tech and healtcare. I will publish on specific names soon, but you can also continue to monitor my trading, which is generally ahead of my posting.

The First Post of 2010.

I have been a bit neglectful about posting over the past few weeks, caught up in whirlwind of my own stuff to do; wrapping up the year, starting a new year, and a nice vacation in between. I also started a totally different blog, something that has absolutely nothing to do with the stock market. As far as the markets, I also didn’t have much new to say, since what has been going over the past few weeks (a solid end to the year and a strong start) is pretty much in line with my expectations and thinking. This post has been drafted a few weeks ago, but I just never got around to finishing and publishing it. Thanks to a few free hours during the MLK day off I finally did it.

I'd like to use this first blog post of the year to encapsulate my thought process and anchor my 2010 investment strategy. The readers of this blog would likely remember some of these themes. I don't necessarily view them as predictions, just an outline of where I am at the beginning of the year. As facts change, my thought process and strategies will also change accordingly. While this post is just a brief summary, the next few entries will drill down more into the actual investment ideas.

1) We will end 2010 with high single digit or low double digit return. Most of this return will come in the first half of the year. This puts my year-end target on the SP at around 1215-1250’sh. January will remain a fairly strong month, but I think we will see a pullback (more than your typical profit taking selloff) sometime in late February or March. By then, most of the excitement and new money that comes with it will be invested, and a strong performance caused by these inflows will force many institutional investors to shift to a more market neutral stance from a net long bias at the start of the year.

2) The volatility will gobble up returns and many investors will end up losing money in 2010. Making money this year will be more difficult than in either 2008 or 2009. In both of these years one could've easily achieved decent returns by simply betting on any of the market tracking ETFs, or inverse ETFs as was the case in 2008. This year will require more discipline and understanding of what moves individual stocks and sectors. We will have to grind it out by fine tuning our timing models, focusing on the right themes and picking correct stocks.

3) Fundamentals will matter again. Over the past two years good ole' fundamental analysis was ineffective, given so many macro, technical, and sentiment overrides. Although it will still be very important to understand the impact of macro and TA on stocks, the relative importance of fundamentals will once again become invaluable. I always favored techno-fundamentals as the framework for finding ideas and entry/exit points , and this year will certainly be no different. Other analytical disciplines will remain important, but as the world comes back to some degree of normalcy, even if its the 'new' normalcy, fundamentals will matter again.

4) Inflation will rear its ugly head no matter when the FED decides to raise the rates again. I've been saying for some time that one should be prepared to protect portfolios from an inflationary impact. The prices are going up, quietly. Starbucks just raised the price of its coffee. My neighborhood sandwich place also raised the prices, gasoline is back near $3. Many other stealth price increases are already happening across the country, as the cost of raw materials is forcing companies to pass it along to the end consumers. Small businesses don't have much leverage to raise prices, but will have no choice, if they want to survive. Many people are focused on wage inflation metrics, which are still showing no signs of any inflationary bias. As the economy recovers, very very gradually, we will start seeing these metrics change. The market will eventually force the Fed’s hand. Watch the bond market which will move in advance of the Fed and look for small changes in the Fed speak to telegraph their inevitable intent. My guess is that you will start seeing them in March/April.

5) Emerging Markets will outperform, but stick with BI nor RC. I am focusing more in Brazil and India in my emerging market trade, and avoiding Russia, with small exposure in China. Brazil remains my favorite way to play several themes, including energy, infrastructure, strong economic growth and two major events – 2014 World Cup and 2016 Olympic games will create a strong investment opportunity for the next few years. Russia is mostly about oil and materials, an exposure that I can get from Brazil, Canada or Australia without taking the political risk. China is still a big favorite of mine, but I have seen some many unjustified moves , that it scares me that it is vulnerable to a major hiccup. I might as well wait, although will still buy a few select Chinese stocks here and there.

6) Geopolitics will trump economic concerns this year. It’s hard to believe it, but with Mideast turmoil finally spilling into the front lines, I hate to say it, but I think it is likely that our Nobel Prize winner President will get his will tested. Since we can’t change it, we might as well try to profit from this. Its tough to predict when political issues will flame up, only that it will likely happen sometime this year, whether its Iran, or Afghanistan, or Pakistan.

7) After correction in February/March, the market will likely make the necessary adjustment to account for the eventuality of higher rates, stronger US dollar, and potentially some sooner than expected inflation, the equities should rebound strongly and and continue attract capital flows from bonds, which by then will be publicly neutered as an investment choice. This will be a healthy and necessary pause and adjustment to the investor sentiment, but I don't think this will be a return of the Ursa Major.

8) In 2010 we will see the decoupling of the US dollar and equities, something I have pointed to in late 09, as each asset class will start trading on its own merits again. We are already beginning to see it. The US dollar will most likely rebound, but I am not a dollar bull and see only a slightly higher trading range for the buck. The fiscal irresponsibility of this administration has basically killed any chance of a sustained appreciation of our currency for a long time. Unless, of course I am right about the geopolitical concerns.

9) The regulations and initiatives undertaken over the past few years will finally make alternative energy plays more of an investment reality, but don’t expect to win with broad based ETF bets. Within the space there will be clear haves and have-nots.

10) Healthcare will end the year much stronger than many expect, as the overhang from the Healthcare reform will soon disappear. The changes will prove to be less onerous than investors feared, and as always the clarity beats uncertainty so investors can at least go back to analyzing these investments again albeit with a new set of rules. The discounts priced in many of the quality HC companies reflects this uncertainty and the multiples should soon go back to more historical levels.


As I said in the beginning of this post, over the next few weeks I will try to explore these ideas and drill down into specific investment and trading ideas. Stay tuned and happy trading in 2010!