Crunch Time

Thus far into the credit crunch, we have generally been able to cope with each crisis through a combination of two methods: existing plans [IndyMac and Subprime Lenders] and negotiated solutions [Bear Stearns and Countrywide]. We have now come to the climax of the story – Fannie and Freddie.

The world is scared of Fannie Mae and Freddie Mac – and for good reason. These Government Sponsored Enterprises (GSEs) have significant problems. They are financial guarantee companies, and like the other financial guarantee companies [the monolines ABK, MBI and the mortgage insurers MTG, PMI, RDN, TGIC], they are being thought of as likely to default. The GSEs have negative book value if their portfolios were marked to market – in other words in a timely liquidation scenario there would currently be a loss for debtholders. This is significant in that FNM and FRE have been considered “backed” by the federal government, which is why they have been assigned AAA credit ratings, even though they would not be worthy of such ratings on their own.

It is common thought that Fannie and Freddie really are “too big to fail” – and not just for the United States. Many foreign central banks hold much of their dollar denominated reserves in Fannie and Freddie paper. Unfortunately neither existing plans [bankruptcy] nor a negotiated solution [sale of the companies] would be a viable solution, as the GSEs are too large for a sale and too important for bankruptcy.

There are really only two options if we recognize them as being too big to fail (and therefore rule out bankruptcy) and also assume that they will need assistance:

1) The US government explicitly backs the GSEs debt
2) The US government injects additional capital into FNM and FRE

The first option cannot happen because this would likely cause the national debt to double, and the country would probably lose its AAA credit rating [per Moody’s early 2008]. Therefore the second option is the only logical outcome [also Secretary Paulson has in the past indicated that the government will not back Fannie or Freddie debt].

The capital injection could be completed in a number of different manners – junior (subordinated) debt, preferred stock, or common stock. The public feeling amongst our financial system big wigs is that, to avoid moral hazard, the common shareholders of Fannie and Freddie should pay the consequences of having invested in a GSE and lose the majority of their investment. A common stock capital injection would put the government’s claim at the same level as existing shareholders – moral hazard. Subordinated debt probably would have the effect of propping up the stock price. On the other hand a convertible preferred issue with highly dilutive terms would punish the common shareholders and provide the capital that FNM and FRE are thought to so desperately need.

There are models in past governmental bailouts of what works, and what doesn’t:

Penn Central Railroad 1970 – Penn Central was a failing conglomerate making ill-advised purchases of money losing non-railroad companies in a scheme to borrow ever more money for real estate investments. Eventually the corporation approached the government for $300 million in aid. Nixon approved the package ($750 million for railroads, of which $300 was for Penn Central) but congress did not approve the aid. Penn Central declared bankruptcy in June of 1970 leading to the creation of Conrail and Amtrak.

Lockheed 1971 - $250 million in federal loan guarantees.

New York City 1975 – Billions lent by federal government to the city at a rate of the one year treasury plus 1% on a term of 1 year with annual renewals.

Chrysler 1979 – 1.5 billion in federal loan guarantees, and creditors forced to renegotiate debt at 30 cents on the dollar. Deal allowed Treasury to participate in upside in the stock, and eventually the government made money. Recommended reading: http://www.time.com/time/magazine/article/0,9171,947356,00.html
http://www.heritage.org/research/EnergyandEnvironment/bg276.cfm
http://www.cato.org/pubs/pas/PA00Aes.html

Savings and Loan Intuitions 1980 to 1989 – The rules were changed for Savings and Loans such that insolvent institutions were not identified and shut down quickly by regulators, but rather hidden and allowed to remain open. Capital requirements were lowered, and fake capital (called “capital certificates”) were issued to troubled savings and loans.
http://en.wikipedia.org/wiki/Savings_and_Loan_crisis
http://www.fdic.gov/bank/historical/s&l/

Airline bailout 2001 – Playing the “terrorism killed our industry” card, the airlines received $10 billion in loan guarantees and $5 billion in cash from Congress.

I expect that the final solution to the bailout of Fannie and Freddie will have multiple prongs: 1) The US Government will inject over half of the needed capital through the use of convertible preferreds 2) The US Government will lean on other central banks to inject most of the remaining needed capital, probably through the use of subordinated debt 3) The Fed will ensure liquidity for the GSEs in the event they cannot roll their debt by providing access to the discount window [already known to be the case] 4) Fannie and Freddie will raise additional capital through the issuance of debt and preferred stock in the public markets. Through the provision of additional capital and liquidity Fannie and Freddie will be allowed to remain open for quite some time, and if the housing market turns in 2009, as I expect, the government will again ultimately make money on their bailout.

The Bear Takes Hold

Sometimes it's not fun to be right. The market has been terrible. Unfortunately two of my picks in my last update has also done terrible [PG should do well in the long run, but WNR was a mistake - only buy it if you think oil has peaked which is difficult to predict]. The good news is that financials are near the bottom [SKF, the double short Financial ETF did terrific since my last post, and should do terrible as Financials recover some of the ground they lost]. My view is that house prices probably will bottom around the end of Q1 2009. Traditionally this would mean that the bottom for banks and builders would be around the end of Q3 2008, or September/October/November. However banks have fallen so far (as have homebuilders, just not as recently) that it's likely that the bad news is priced in at this point.

Overall the market [S&P 500] has fallen 6.64% since my prior post, but had rallied in the period in between. I still believe that the S&P will probably fall about 15% from the level of my prior post which would be 1,164 [8.9% from here]. Overall the odds are that the S&P 500 should fall somewhere in the 5% to 15% range from here.

What has happened since Q3 of 2007 is that corporate earnings have been dropping, and financials have been pulling down the market. If history rhymes then what should happen next is that financials will bottom out, yet the S&P will continue to fall, accelerating and eventually dragging financials back towards their lows again.

There are a good number of regional banks today that are very cheap on a price to book basis. If their problems don't multiply and accelerate, long term investors will do very well to buy them here.

Overall the economy is either in a recession or on the brink of one. I'm a believer that looking back we'll say that Q2 2008 was the start of the recession and that it ended in Q1 2009 [plus or minus a quarter]. Typically the market bottoms 6 months before the recession ends which should put the bottom sometime in August to November, probably around September.

When we do have a bottom in the S&P it should be a terrific buying opportunity as the problems that are here are not going to be here forever.


My prior recommendations [SKF (+49.27%), JNJ (-1.91%), PG (-13.67%), BUD (+29.41%), FMX (+3.94%), WNR (-14.44%), DNA (-8.44%)] averaged a gain of 6.31%, which outperformed the S&P 500 by a whopping 12.95%. I recommend at this time EWBC, MMM, UNH, JNJ, UYG, XHB, DNA.

Overall record since I began posting recommendations on this blog on 7/31/07 has been -0.93%, compared to the S&P 500's -12.18%.

Recession On

While stocks are currently cheap, the unfortunate fact is that housing is going to get much worse, and the effects are going to be felt over a long period of time. I believe the stock market will fall for the next 4 to 12 months (let’s call it 6 months) and that we are in a bear market. If that’s all true the market should fall about 15% more from here. Stay away from financials/mortgages/real estate.

My prior recommendations [BAC (+1.18%), C (-6.52%), WB (-18.12%), BBY (-9.22%), JOSB (-6.95%), BWLD (+15.47%)] averaged a loss of 4.03%, which underperformed the S&P 500 by a whopping 6.32%. I recommend at this time SKF, JNJ, PG, BUD, FMX, WNR, DNA.

Overall record since I began posting recommendations on this blog on 7/31/07 has been -6.81%, compared to the S&P 500's -5.93%.

Recession Called Off?

Since my last update the S&P 500 is down 8.92%. As of yesterday (1/22/2008), the S&P 500 was at its lowest P/E ratio in 10 years, lowest P/Book ratio in 10 years, and highest dividend yield in 10 years. Clearly if we aren’t headed for economic disaster this is a time to increase your equity allocations. Also, as a side note, with the 2 year treasury yielding 2.09%, 5 year at 2.64% and 10 year at 3.51% you probably want to be getting out of bonds (put the “non-stock” portion of your portfolio into a money market, the yield of which will go down along with these Fed rate cuts, but you won’t risk losing money if inflation takes off and interest rates rise). In general I expect companies with (long-term) growing earnings that are trading at a discount to the market should be the best companies to invest in, although this is the style I prefer in all markets.

Unfortunately for my returns several of the last recommendations made here turned out very badly (Alcoa and Boeing particularly), and my methodology for tracking returns in this blog do not take into account any sort of equity weighting (in other words I’m assuming that stocks are always 100% of this portfolio).

At this juncture, I expect the dollar to remain volatile but not continue the drop it experienced over the past several years, meaning that international should be trimmed back to 10% of your portfolio or so. Also, I believe that the selloff in financials and consumer discretionary companies have been overdone, and they seem to be regaining their footing since the Fed’s surprise ¾% Tuesday morning. The true value today lies in these unloved companies that cater to the American consumer (plus if everyone gets an $800 tax rebate check, and low interest rates combined with the thawing of credit markets allows prime credit borrowers to refinance their home, some of that money should flow to these sectors).

My prior recommendations [WMT (+6.0%), JNJ (-6.1%), BCS (-15.4%), BA (-17.9%), DIS (-12.1%), AA (-20.1%), AIB (+1.5%)] averaged a loss of 9.16%, which underperformed the S&P 500 by 0.24%. I recommend at this time BAC, C, WB, BBY, JOSB, BWLD. Note that this portfolio is only financials and consumer discretionary companies which may be too concentrated or risky for many investors.

Many Happy Returns, Mark Hanna.

Recession Looming?

We've got cratering consumer confidence, slowing corporate earnings growth, a huge rally in bonds, banks disinclined to lend, and a generally bad set of circumstances for financials and retailers. The dollar has hit new lows against most major currencies (causing possible commodities increases and therefore inflation). Many of these issues are already priced in to stocks. The biggest risk could be investors seeing that their balances dropped more than 5% and selling, which would continue the drop in the market that started a month ago (although we are well off our lows).

I recommend stock investors consider sticking with 20-30% international and the remainder in large cap US multinationals. My prior recommendations [WMT (+9.5%), JNJ (+12.4%), BUD (+8.2%), AIG (-11.8%), PEP (+14.0%)] averaged a return of 6.46%, which outperformed the S&P 500 (2.61%) by 3.85%. I recommend at this time WMT, JNJ, BCS, BA, DIS, AA, AIB.

Overall record since I began posting recommendations on this blog on 7/31/07 has been +6.89%, compared to the S&P 500's +0.97%. For long positions in stocks I try to average outperformance of 1.5% per quarter, so I am happy with this return over 4 months.

Send me an email if you’d like at Mark.Hanna79@gmail.com. Many happy returns.

Bear's Woods

Per my previous post (a month ago) we have been in a bear market. As an interesting note on consumer confidence, it came in today at 105 (down from 111.9), and anything over 100 is positive (not to mention that the street's expectation was 104, which was exceeded). I believe that we are not out of the bear's woods yet, however I will be bold and call the bottom (in hindsight) as the intraday low on August 16th of (S&P 500) 1,370.60. At that point the market had sold off a little more than 10% from its high on July 16th. Overall I recommend the philosophy at this point of "when everyone is fearful, it is time to be greedy".

My prior recommendations [WMT (-5%), JNJ (+1.9%), BAC (+4.3%)] averaged a return of plus 0.4%, which beat the S&P 500 (-1.6%) by about 2%. So what? Well if the market averages [insert whatever long run average market return you believe in, most people use 10% to 12%], that average includes these types of markets. Beating by 2% in a month is a huge advantage for low-risk investors.

OK SO WHAT DO YOU LIKE NOW? REITERATE: WMT and JNJ. BAC will do great over the next 60 months, but I am not confident they will outperform over the next month. I still like the same play book 1) Growth at a reasonable price 2) Large Cap 3) With a dividend (or at least some indication management is allocating capital wisely). Think WMT, JNJ, BUD, AIG, PEP.

8 Months

Well it has been 8 months since my last post (math check: 7+12-11=8 whee). The stock market has rallied 4.6% over those 8 months. Doesn't sound like much. In actuality it is not that much, as earnings have increased well over this 5% gain, so stocks are cheaper.

That said, we are now in a bear market. We've just finished two down months for the indices (June and July) and are seeing chicken littleitis regarding financials (who doesn't like BAC - Bank of America at 9.5 times earnings and a 5.4% dividend yield???). I watched a little CNBC (dangerous) tonight and EVERY show featured EVERY person stating to stay away from financials and "don't bottom fish here".

I've been occupying some of my time (outside of moving from West TN to Knoxville, the family, the job, and everything else I do) looking at stocks and, more recently, stock options. To back up my case on a bear market we see 1) Elevated Volatility 2) Huge run up in short sales of stocks on the NYSE and 3) very cheap call options with expensive put options (IE the volatility index's run up has to do with puts becoming more expensive as everyone is buying downside protection). "Sell in May and walk away" is it?

OK SO WHAT DO YOU LIKE? I like 1) Growth at a reasonable price (some call this value some call this growth some blend, bottom line is earnings growth at a good discount to underlying value) 2) Large Caps 3) Those that fit #1 and #2 and pay a nice growing dividend. Think WMT, JNJ, BAC as the most obvious names.

Take care. Drop me a line if you'd like at Mark.Hanna79@gmail.com

Frist Drops out of Presidential Race

It was reported today that Bill Frist has announced that he will not likely be seeking the presidency in 2008. He wants a "sabbatical from public life" and to spend some time on health-care again. It has been noted that this leaves the South without a Republican candidate that is considered centrist for this race.

Economic Indicators

The Wall Street Journal today reported that the number of existing homes sold in October increased 0.5% month over month (+6.4% in West, UNCH in Midwest, -1.2% South, and -2.9% Northeast). These results were higher than the market expected. The median price of an existing home showed no change month over month, at $221,000 but was down $8,000 (-3.5%) year over year, the largest ever annual drop and record third monthly consecutive decrease.

Consumer confidence was expected to slightly rise to 105.8 from October's 105.1 but instead it has dropped to 102.9. A number over 100 is considered good.

I expect that my prediction on 11/11 ("Money has been flowing in the market in anticipation of a Q4 rally, which has driven the market up double digits. I think that if this rally does not materialize we could easily see a disappointing reaction") is beginning to pan out. I'd predict at this point Q4 will be fairly close to unchanged overall (if that is correct, we have about 4% to give back from large caps and 7% from small caps), and Q1 07 will be a downer. As pretty much always, I am bullish on the long-term outlook for the market, but today I am fairly bearish on the near-term.

To those who don't know my feelings on it - stay invested. It never really works to try to jump in and out of the market. Just consider these things and think about positioning your portfolio in a more conservative manner -- Focus more on mega cap companies with strong fundamentals. Make sure you have some (but not too much) foreign exposure for diversification.

Dollar Drops

http://seekingalpha.com/article/21258

Well the dollar is starting to matter.
We talked about this back in August and it
has always cast a shadow on our trading as I've never been able to get all
gung-ho while ignoring this pressing issue.
While we were all out having
turkey, the rest of the world took a long, hard look at our balance sheets and
downgraded us.
As our debt is looking riskier to foreigners, the rumors
that the Fed will LOWER rates to boost a slowing economy make no
sense at all to buyers of international paper (or to anyone who actually
understands economics).
So let's be very, very careful out there as things
may LOOK good over here but to other countries we look a lot more like this:

More comments on this later