Tuesday, November 25, 2008

Who Doesn't Enjoy A Good Spending Spree?

Like good little Keynesians, countries around the world are whipping out their nearly maxed-out credit cards in an effort to boost economic growth. It's easy to understand why. You can't expect much of a boost from consumption, housing, business investment, or exports. The only lever left to pull is government spending. And since governments aren't capable of just getting out of the way and letting excesses correct themselves (as they should), we're sure to see unprecedented growth in budget deficits and government debt in the next couple of years.

The U.K., for example, has recently announced its fiscal stimulus plans. Their budget deficit is projected to double next year and then increase another 50% in 2010, leading to a projected budget deficit that is greater than 8% of GDP - a personal best for the U.K.

Just as in the U.S., this eventually has to be repaid in the form of higher taxes and/or lower spending. This has been the enduring failure of Keynesian economics. Everyone loves a good spending spree. No one ever wants to take away the punch bowl.

Disclosure: The Rubbernecker is long gold and short the dollar and the plundering of our children's financial security.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Monday, November 24, 2008

Citigroup Bailout: Payback For Wachovia?

If you can't beat 'em...

I'm having some mixed feelings this morning. I've repeatedly expressed my frustration with the serial bailouts by the government and the Fed, and this morning we wake to learn that Citigroup will be added to our Bailout Wall of Shame. On the one hand, it pains me to see more taxpayer money being wasted.

On the other hand, I bought shares of Citigroup late last week for our more aggressive clients. This was my first foray into financials on the long side in quite a while, and I can't say that the purchase (a modest position) was made with an extreme amount of confidence. I viewed the purchase of the common more like a call option with (hopefully) no expiration.

It was clear to all that Citi was too big too fail. It was also clear later last week that the company was likely to need some government assistance, if for no other reason than to shore up confidence. The questions were how extensive the support would be and how much dilution would occur to the existing shareholders.

Now it's time for a little conspiracy theory. My sense was that Citigroup had a "get out of jail free" card to play. Recall, Citi had reached a deal to buy Wachovia with a government backstop not too dissimilar from what they are now receiving. That Wachovia deal was eventually scuttled when Wells Fargo came in with a counter offer. Citi then filed but soon dropped a $60 billion lawsuit to block the Wells deal. Why concede Wachovia so quickly, and why drop the suit? I can't help but think that Citi was assured of some preferential treatment in the future for quietly stepping aside in the Wachovia fight.

Whether or not there was any backroom agreement, Citi is certainly getting some good terms with this bailout.

  • Citi is getting another $20 billion in cash from the Treasury.
  • Citi will also get governement guarantees on a $306 billion pool of garbage assets. Citi will eat the first $29 billion of losses on this pool, and the government will cover 90% of additional losses. The guarantees are for 10 years on residential assets and five years for nonresidential assets.
  • The government receives $27 billion of preferred shares yielding 8%. This is a higher yield than the Treasury is receiving from its first round of preferred share issuance under the TARP plan, but it's less than Warren Buffet is receiving from his GE and Goldman deals (10%).
  • The government also receives warrants to buy 254 million common shares of Citigroup at $10.61.
  • Citi essentially has to eliminate its dividend, which is something it should have done anyway.
  • There will be some controls placed on executive compensation.
  • No management changes at Citi are required.
This strikes me as a great deal for Citigroup considering the market value of the company was only $20 billion heading into the weekend. This deal certainly doesn't guarantee that Citi will now prosper. They have a huge balance sheet beyond the $306 billion pool that will be covered by this agreement, and with the economy flailing, the company is sure to experience continued difficulties in the near-term.

This agreement does, however, buy Citi more time to address its balance sheet. The pressure will continue for the company to shed some of its assets. Buyers will be hard to come by, but just today we're hearing of potential interest from HSBC in some of Citi's foreign assets. Any asset sale would probably be greeted warmly by the market.

As for what to do now with this position given today's news, I plan to sit tight. I still view it as a call option - hopefully now a LEAP. It's nice that it's in-the-money (at least for the moment), and if it had an expiration (bankruptcy) date, that date has now been extended into the future. The government has explicitly signaled today that Citigroup is clearly too big too fail, and importantly, the government wasn't interested in wiping out the shareholders. Perhaps they feared that wiping out Citi's common shareholders would only make it harder for other banks to raise new equity capital.

Disclosure: The Rubbernecker is actually long a financial but still short the poor U.S. taxpayer.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Friday, November 21, 2008

Stock Options: Here We Go Again

A recent Wall Street Journal article has my knickers in a knot again. The article, "Technology Options Sink", deals with the fact that many of the stock options issued by technology firms in recent years are now worthless.

Let me jump right to the punchline. Employee stock options are a form of incentive compensation. In today's environment, management and employees should just be grateful to have a job. The fear of being called into a human resources meeting and then having security walk you out of the building as you carry a cardboard box filled with a picture of your kids, your "Employee of the Month" plaque, your cactus, and a pamphlet on COBRA benefits should be more than enough incentive.

Let's look at a few passages from the story.

At chip maker Advanced Micro Devices Inc., the situation has gotten so extreme the company is planning a shareholder meeting to ask permission to reprice 99% of its outstanding options. AMD, whose stock price had fallen about 76% over the past 52 weeks to $3.16 a share at Friday's close, said this is necessary to prevent key employees from leaving.
Leaving? To go where? Yahoo may be looking for a new CEO, but who else is hiring these days? They're going to quit their jobs and do what? Unless they have an in with the Obama administration or would be happy repossessing iPods for a debt collection agency, they'd be better off keeping their heads down and mouths shut. Most firms are letting people go these days, and these firms would be happy to take volunteers who are unhappy with their compensation. I say let 'em go. It's never been easier to replace any employee, even a "key" employee.
More than 80% of Silicon Valley's 150 largest publicly traded companies had some employees holding options that had fallen below the strike price as of Oct. 24, according to Equilar, an executive-compensation research firm. Equilar said about 90% of chief executives at those companies had underwater stock options.
Ah ha. 90% of these chief executives have underwater options. The clouds have parted and all is clear. The major beneficiaries of stock options are the senior managers of companies. And where does the call for repricing these options come from? Senior management. They dress it up and pitch it in terms of helping to keep their key employees from leaving, but they're really just trying to cut themselves a better deal. "Sure, my 1,000,000 options would also be repriced, but this is really about helping the engineers with their 100 options."
Some companies are trying to pre-empt shareholder opposition, designing "value-neutral" plans that allow employees to exchange existing options for a smaller number of new ones at lower exercise prices. That will help protect part of an employee's grant but avoid large-scale dilution or additional accounting charges, said compensation specialists.
Value-neutral? You gotta love consultants. If by value-neutral you mean exchanging a lot of essentially worthless options for a smaller number of valuable options then, sure, let's call it "value-neutral." Isn't that the kind of math that led to CDOs?
RiskMetrics' Mr. McGurn said investors will be much more sympathetic to plans that don't include executives and directors, many of whom are seen as overpaid. Shareholders also may want to see vesting schedules, the length of time employees have to work at a company before getting their grants, extended in order to entice employees to stay longer.
This almost sounds reasonable. No argument with the part about leaving out executives and directors, but I doubt it would work so smoothly. If the executives needed to be excluded to get approval for the rank-and-file, I wouldn't be surprised to see the issue dropped altogether. Or I imagine we'd see an even larger "catch-up" award for the execs the next time options were issued.

The idea of extending vesting schedules is fine, but that can be done on a going-forward basis with new option awards. There is no good reason to retroactively change the terms of stock option awards. Everyone knew the potential risk and reward when the options were granted.
"I would probably lean toward [repricing] if it would help keep employees," said Ryan Jacob, chief investment officer at Jacob Asset Management, which holds shares in many major technology companies, including Google, Apple and Yahoo.
Ryan Jacob? They're interviewing Ryan Jacob. This is the kid who managed to parlay some incredibly dumb luck during the internet bubble ("investing" in companies with no business plan, no cash flow, and insane valuation) into opening his own "investment" firm. He then proceeded to lose 90% of his investor's money over the ensuing three years. That would have been bad relative performance even during the Great Depression. Does anyone really give a flying stock option what Ryan Jacob thinks about this? How is he even still in business?
The situation is similar at Google. A third of Google's 20,000 employees hold underwater options, according to an estimate by Sandeep Aggarwal, an analyst at Collins Stewart. If Google doesn't deal with the problem, it could lose key staff, he said.
So, even the mighty Google has employees with underwater options. This is supposed to be the place where everyone wants to go and work, but the stock option game is struggling here as well. Where exactly are Googlers going to go if they're already at the best place to work? Ikea? Right now, Googlers should be thrilled that they work at a growing firm with an impeccable balance sheet. For any employee that leaves Google, management will probably have 1000 resumes to pour over.

I would encourage everyone to vote against any repricing of stock options for any reason. The risk and potential reward of these options grants and the trade-off between cash salary and incentive compensation were accepted by all parties when granted. Options are not a form of guaranteed deferred income. They are "option"al.

Management is simply looking to dilute existing shareholders to its own benefit. Don't fall for the "key" employee excuse. There are thousands of "key" employees on the market and many more to come. Furthermore, these "key" employees are often equally likely to be value-enhancing or value-destroying. The senior executives of every failed company and business venture in history were once considered "key" employees.

Disclosure: The Rubbernecker is short Ryan Jacob, "key" employees, and self-serving executives.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Wednesday, November 19, 2008

The Money Hole II

I'm sure I can be forgiven for thinking the following Spiegel Online article was related to global equity markets. Isn't it bad enough that 2008 is the Chinese Year of the Rat?

World Toilet Day


Wednesday, Nov. 19 is "World Toilet Day" and Berlin marked the occasion by placing 50 toilets outside its Central Station. The United Nations declared 2008 the "International Year of Sanitation" in order to draw attention to public health issues around the world. The average person in the West goes to the toilet between six and eight times a day, but around the world 2.5 billion people live without adequate sanitation, according to figures from the World Health Organization.

Disclosure: The Rubbernecker is short modern art.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

The Alaska And Minnesota Senate Races

It's a crazy world. After election day passed, we were left with a few too-close-to-call Senate seats still up for grabs. One of them, Alaska, was just decided. Senator Stevens just barely lost his re-election bid by a mere 3,724 votes despite being convicted on felony charges. Alaskans almost elected a convicted felon! What do you have to do up there to lose an election by a wide margin -- kill Bambi? Oh yeah, that gets you the Vice Presidential nomination.

Another close Senate race is still underway in Minnesota between comedian Al Franken and Republican incumbent Norm Coleman. I have no dog in this fight (aside from not wanting any party to achieve a filibuster-proof 60-seat majority). I just find these tight contests fascinating. Franken currently trails by about 200 votes heading into a recount. A recent Sam Stein article for The Huffington Post discussed an analysis of voting patterns in Minnesota by Dartmouth professor, Michael C. Herron. Professor Herron believes that Franken will ultimately win the seat, but what I found more interesting was the following:

According to Herron's analysis, of the 2.9 million people who went to the polls in Minnesota, there were approximately 34,000 residual voters in the Senate race. In other words, there were 34,000 more ballots cast than total number of recorded votes for all the Senate candidates.

Why the difference? A good portion of voters, Herron concludes, voted in the presidential election but deliberately did not vote for a Senate candidate. These people won't matter when it comes to a recount.

There is, however, a portion of the 34,000 who intended to vote for one of the Senate candidates but messed up. Voters were supposed to fill in the circle next to the name of the candidate they supported. Some, however, marked X's. Others circled the name itself or crossed out the names of candidates they didn't like.

This group is key to determining the Minnesota Senate victor.

Basically, the Senate seat will be decided by the subset of the Minnesota population that was too ignorant, lazy, confused, or illiterate to follow directions. I'm not sure I'd want to win that race.

Disclosure: The Rubbernecker is long incredulity and short lazy gophers.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Sunday, November 16, 2008

The Money Hole

At least it might provide some support to gasoline prices...

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Wednesday, November 12, 2008

Intel Lowering Guidance - A Good Thing

What a difference a month makes. One month after releasing its third quarter earnings report, Intel has issued a press release guiding down revenue and margins for the fourth quarter. As recently as October 14th, the company was expecting Q4 revenue to come in between $10.1 and $10.9 billion with gross margin at or near 59%. The company is now looking for revenue of $9 billion with gross margin in the vicinity of 55%. In just under one month, Intel's business has deteriorated by 14%. This is a huge miss.

There will be plenty of negative commentary over the next day about this miss, but I actually think this may perversely turn out to be positive for the market in the near-term. Despite the earnings misses and the cautious guidance from virtually every company this earnings season, Q4 and 2009 earnings expectations still remain too high. Now that bellwethers Intel and Cisco have both put a serious ding in expectations, it's hard to imagine that investors and analysts will be able to ignore the poor near-term earnings reality that nearly all companies face.

I suspect this will soon lead to yet another near-term bottom (though not necessarily THE bottom) in the market, as investors (particularly the pros) start to think that a more realistically poor earnings outlook is finally being discounted.

As I wrote in my
November 6th post:

As we stand now, I plan to continue fading strong moves in the market. I'll be looking to cover the current shorts and rebuild the long side should we head back to recent lows. If we turn around and start heading back up, I anticipate adding short exposure in the S&P 500 and the Russell 2000 as well as in the consumer, alternative energy, and financial spaces.
With the market now down about 15% from its most recent peak on November 4th, my bias has again shifted to the long side. Today I covered 2 of my outstanding (alternative energy) shorts, leaving one financial short. I've also begun to add some long exposure (Russell 2000 and QQQQ). I plan to keep building the long portion of the portfolio at lower levels and will be a bit more aggressive if we see a sharp Intel-inspired sell-off tomorrow morning.

Disclosure: The Rubbernecker is getting longer again but is still short slothful, Panglossian, sell-side analysts.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Friday, November 7, 2008

A Quick Note On Employment

The headlines have covered the big picture. We lost another 240,000 jobs last month, and September's figure was revised lower by 125,000. These are terrible numbers but not surprising given the sharp fall in economic activity in recent weeks. Plenty of companies have been announcing layoffs (right-sizing), and the management commentary on the conference calls that I've heard makes it clear that more cuts are coming.

One of my favorite components of the employment report is the birth/death model. A review of this model is available here. Remember that this model is responsible for about 1/3 of the total nonfarm payroll figure. For September, the birth/death model continued to spit out some absurd figures. Despite a fall of 240,000 jobs in the headline number, the birth/death model assumes that a net 71,000 jobs were created.

This means that if the birth/death model had conservatively predicted that no jobs were created or lost, the headline figure would have been a loss of 311,000 jobs. If the birth/death model had actually calculated a net loss of jobs (which was almost certainly the case), then the headline number would have been even worse. This model is notorious for being way off at turning points. These figures will be revised in a big way at a later date.

It makes me wonder how many people we pay to sit at the Department of Labor and churn out this misleading random data.

Disclosure: The Rubbernecker is short useless models and 4 out of 5 statisticians.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Cramer Still Confused

A friend brought an article to my attention today written by Jim Cramer entitled, "Cramer: Four Reasons to be Skittish." Cramer starts off the article as follows:

People ask me why I am so often freaked out about what is happening daily in this market. Let me give you four reasons: Sheldon Adelson, Sumner Redstone, Howard Lester and Aubrey McClendon.

All four of these gentlemen got overextended and bought too much of their own stock or the stock of another company and got margined out.
These four gentlemen are the heads of Las Vegas Sands (LVS), CBS (CBS), Williams-Sonoma (WSM), and Chesapeake Energy (CHK), respectivley. These stocks have all been destroyed in recent months, and their chiefs have been forced to sell their stock near the lows to meet margin calls.

Cramer's punchline is simple. "Four men. Four seasoned players. Four guys who didn't see it coming. So how are we supposed to?"

I take a somewhat different view of this. We have some very smart and successful guys who've been forced to sell their shares in the companies they run because they believed so strongly in their companies that they borrowed huge amounts of money to "back the truck up." As a contrarian, this type of news strikes me as fairly constructive. Smart guys don't get forced out of their shares at market tops.

Maybe Jim is really "freaked out" because the value of his 3.9 million shares of TheStreet.com has fallen from $62 million earlier this year to $13.7 million today. And maybe he's freaked out that a prolonged bear market might not be good for his shock-jock style of investment "advice."

Either way, the fact that Cramer has turned more negative on the market long-term is probably another piece of bullish data.

Disclosure: The Rubbernecker is still short a "freaked out" Cramer.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

State and Local Feeling The Pain

The economic decline is starting to impact state and local budgets in a meaningful way. With almost every state having a balanced budget requirement (ex Vermont), any state budget shortfalls will have to come from tax increases or spending decreases. It should come as no surprise that I strongly favor expenditure cuts. The problem with tax hikes during a downturn is twofold. First, you're asking (telling) people to pay more at a time when they have less to pay. Second, these hikes are seldom if ever rolled back once the economy begins to grow again.

When times are good, government programs proliferate. And when times are bad, government programs still seem to proliferate. Perhaps when times are really bad, government may finally be forced to retrench. As much as I'd like to believe that any move to smaller government expenditures would be permanent, the wool just doesn't stretch that far over my eyes.

Below are a few of the headlines from just the last 24 hours. This list is by no means exhaustive.

Schwarzenegger asks for $4.4 billion tax hike" - USA Today
"Philadelphia Makes Big Cuts to Help Close a Budget Gap" - NY Times
"Bad Budget News in Kansas" - Kansas City Star
"Granholm's executive order will cut state budget" - Crain's Detroit Business
"Election hangover: State Democrats face $3 billion budget hole" - Milwaukee Journal Sentinel
"More trimming as NC budget expected to worsen" - Forbes
"Nickel a drink to save state budgets" - MarketWatch
"Big Apple starting to crumble" - Financial Post
"Arizona officials plan for special budget session" - Forbes
"Toledo council may rotate trash pickup over holiday weeks" - Toledo Blade
"$1.8M cut from Norwalk operating expenses" - The Advocate
"Elgin cutting jobs to save $5 million" - The Courier News
"State's flow of red ink deepens as it runs up $2B in new debt" - NJ Star-Ledger
"State Revenue Down in Declining Economy" - WMUR New Hampshire
"San Diego mayor proposes drastic budget cuts" - San Jose Mercury News

Disclosure: The Rubbernecker is short wool eye masks.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Thursday, November 6, 2008

Obama Rally and Market Strategy

Buy on the rumor, and sell on the news. The markets had a nice run-up of nearly 20% in the week prior to the election. This can't all be attributed to an expected Obama victory, but it was likely one of the factors.

Now, it's the morning after (well, the afternoon of the morning after the morning after), and it seems both Democrats and Republicans are selling shares once again. I'm guessing that Obama's supporters are selling some shares to replenish their cash after funding his campaign to the tune of $600 million (an absolutely insane figure). Republicans are likely terrified of the Democratic victory and are selling some shares to stock up on ammo and to reserve their "Palin 2012" commemorative moosehide parkas.

To what degree did an expected Obama win help boost stock prices just prior to the election? Of course, we can't quantify it precisely, but it may be instructive to look at the following graph of TAN, a solar ETF. This basket of solar stocks rallied about 75% in the week leading up to election day.

Obama has made no secret of his support for alternative energy development. In an October 31st
interview with Wolf Blitzer of CNN, Obama listed energy independence as his number 2 priority for 2009 (the economy was number one). In that interview, Obama said, "We have to seize this moment, because it's not just an energy independence issue; it's also a national security issue, and it's a jobs issue. We can create 5 million new green energy jobs." The strong move in the alternative energy stocks leading up to the election hints of an expected Obama victory being one of the factors for the rally.

So, again we've had a rally, and again we're giving it back. There are plenty of potential explanations. Could be acceptance that analyst earnings estimates still have to come down. Perhaps the reality that our economic and financial problems transcend any President or government action is setting in. Maybe we're seeing profit-taking from the rally or more forced de-leveraging. Perhaps the Plunge Protection Team had to take a breather to reload the ink in its printing press.

Whatever the case, we should expect the dramatic volatility in the market over the past month to continue in the near-term. Fortunately, this volatility has provided some good trading opportunities. As I've stated, my intention has been to fade any strong moves in this market, and that's what I've been doing. Both times last month that the S&P 500 approached 850, I turned short-term bullish and added some long market exposure while covering my shorts. And both times the S&P 500 approached 1000, I sold those positions. The most recent assault on 1000 occurred on election day, during which I fortuitously unloaded the QLD, SSO, and GOOG exposure that had been added during the prior dip.

I was hoping to rebuild my short exposure gradually during the latest market rally. Unfortunately, I was only able to add a few short positions (a couple of alternative energy names and one financial) before the rally fizzled.

As we stand now, I plan to continue fading strong moves in the market. I'll be looking to cover the current shorts and rebuild the long side should we head back to recent lows. If we turn around and start heading back up, I anticipate adding short exposure in the S&P 500 and the Russell 2000 as well as in the consumer, alternative energy, and financial spaces.

I'm also keeping an eye on the currencies. I sold our Yen exposure back on the 24th when it spiked, leaving us with exposure to only the Chinese Renminbi. I should have rolled the Yen exposure into the Canadian dollar at the time, but I missed it. The long-term fundamentals of the U.S. do not support its recent strength. The strong move in the dollar has been largely due to short-term technical reasons as well as a knee-jerk flight-to-safety. I am very negative on the dollar (long-term) at these levels and will likely be buying the Canadian dollar if it weakens much further.

Disclosure: The Rubbernecker is long volatility and short whiplash.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Tuesday, November 4, 2008

Chesapeake - Never Boring

At the beginning of 2008, Chesapeake had a market value of $23 billion. Four months ago this company had a market value of $43 billion. A few weeks ago, that market value had fallen to $7 billion, and today it stands at $12.7 billion. I'm getting a bout of vertigo just typing these numbers.

I know what you're thinking. "What's the big deal? All of the banks are getting killed these days." That's fine, but this isn't a bank. This is the largest independent producer of natural gas in the United States. They have a strong exploration and production track record and hold some large and interesting acreage positions.

$43 billion to $7 billion in a few months. That's a decline of over 80%. That works out to over a 300% annualized loss (it's the new math). Immediately, one's thoughts wander to Enron. These guys must have been cooking the books. They must have overstated the amount of natural gas reserves they own, right? Wrong. So what's going on here?

For starters, we have to put that 80% decline in context. The market overall hasn't been exactly kind to anyone since the end of July. From the time of CHK's peak to its bottom earlier last month, the S&P 500 fell about 30%. It didn't help that natural gas prices fell 53% over this same time period in sympathy with oil prices (down 43%) as the global economy continued to sputter. XOP, the SPDR S&P Oil & Gas Exploration & Production ETF, was down 62% over this period. Still, CHK has outdone itself by falling further than any of these.

There is an added wrinkle to the CHK story. Chesapeake's CEO, Aubrey McClendon, owned about 32 million shares of CHK on October 8th. A couple of days later, most of those shares were gone. Loss of confidence in the company? Not exactly. McClendon was hit with a margin call. Amazingly, this billionaire thought it wise to keep adding to his already sizable CHK stake by buying on margin as the stock started falling this summer. You have to admire his belief in the company while questioning his money management strategy.

It boggles the mind that a billionaire would risk his fortune by buying stock on margin and not diversifying his holdings, but that's what McClendon did. This is a massive failure in Financial Planning 101. Amazingly, he wasn't alone. We've been learning of executives at other firms (see BSX, CPE, DNR, LTM, PROV, PHM, and WSM) also experiencing margin calls, although of a lesser magnitude.

McClendon was forced to unload 31.5 million shares between October 8th and 10th at an average price of just over $18/share. He sold 1.8 million of those shares as low as $12.64 on the 10th. Ouch. With the stock now back at $22, that forced sale has "cost" McClendon another $125 million. Ouch. It doesn't help that this margin call occurred as the market was gapping down to a new low on the 10th.

You can see in the chart below that from the peak on the 9th to the low on the 10th, CHK lost about 50% of its value. With about half of McClendon's shares hitting the market on the 10th, it's pretty safe to assume that the extra 15 million share of selling pressure somewhat exacerbated the stock's decline. Not surprisingly, with that selling pressure now abated and with the market a bit higher, CHK has rebounded a tremendous 83% from its intra-day low on the 10th.

This is all water under the bridge at this point. The more pertinent issue is what to do with the stock now. Is the stock attractive at this level, or is this a value trap? As I've shared in the past, if I can't figure out that a company is inexpensive on the back of an envelope then it isn't worth my time or money. And, as always, I encourage everyone to do their own work.

With that said I'd like to share a couple of comments from last Friday's quarterly earnings conference call (10/31/08) that caught my attention. Chesapeake CEO, Aubrey McClendon, started off the call with an interesting statement:

First, we open the third quarter with a bang, in announcing a very innovative sale of 20% of Chesapeake's Haynesville acreage position in the Plains for $3.3 billion in cash and drilling carry. This was a great transaction for both parties and established a $13 billion value for our remaining 80% in the Haynesville, a value that today ironically exceeds our entire market cap. That does seem very unusual to me.
What makes this even more intriguing is that the Haynesville play accounts for only 20% of the company's total proved and risked unproved reserves. We can argue all day and night about the pros and cons of shale gas production, but this is an actual deal with a knowledgable buyer, so it's hard to dismiss it. To be fair, however, this deal was struck back when natural gas prices were near their peak, so I don't believe for a minute that the company would fetch $13 billion for its remaining 80% today. In defense of management, however, their timing on that sale was impeccable, or impeccably lucky.

McClendon continued,
Second, in early August, we completed another innovative JV transaction, this time in the Fayetteville Shale with British Petroleum to whom we sold 25% of our Fayetteville assets for $1.9 billion, leaving our remaining 75% position in the Fayetteville worth about $6 billion or roughly $10 per share which is about one half of our stock price today. For the record, only about 4% of our proved reserves are booked to the Fayetteville yet this transaction alone established a remaining Fayetteville value equal to 50% of our stock price; again, very unusual.
Again, natural gas prices have fallen since that time. Still, these transactions provide a bit of support and some margin of safety. The company has more of these deals in the works. It will be interesting to see what type of value they receive and its implications for the entire company's valuation.

As I always stress, I don't pretend to know what any stock or market will do in the short-term, but this is the type of situation I like. We have a real company with real assets that is currently out of favor due to a recession of questionable length and severity. If you believe that the recent flood of bad economic and financial news around the world is a sign that the rapture is near, then you'll probably want to pass on this stock (and every stock). Of course, if you believe the rapture is near, why are you wasting your time reading this? If you believe that the economy will eventually recover and you have a long-term horizon, then the following points are worth considering:
  • As with many stocks, this sector is best bought when it's out of favor. Check.
  • Current natural gas prices aren't too far from average industry all-in cost levels. This may provide some price support.
  • Natural gas wells deplete fairly quickly, on average. This helps to balance supply when activity slows due to excess demand.
  • Most everyone is expecting the rig count to continue falling in the coming months, further reducing expected natural gas supply.
  • Natural gas is much cleaner than oil and much closer to home. Demand is likely to resume growing following this recession.
  • CHK's balance sheet looks fine. They have no large near-term debt maturities, they have a nice chunk of cash, and they should generate significant excess cash in coming years.
  • Valuation looks very attractive on a number of metrics.
  • McClendon has to be angry given how much money he recently lost. He probably has a nice-sized chip on his shoulder right now. I wouldn't bet against him.
Importantly, natural gas is a self-correcting market. Lower prices result in less drilling which leads to less supply which leads to higher prices. The only real question relates to the length of time it takes for this to occur, and that depends on how far and fast natural gas prices decline, how quickly firms pull back on their drilling, how quickly wells deplete or are shut-in, and how severe the fall off in demand is. But make no mistake, the stage is again being set for a period of tight supply, higher natural gas prices, and higher equity valuations for this sector.

Disclosure: The Rubbernecker is long CHK and short the rapture.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Monday, November 3, 2008

American vs. Chinese Bankruptcy

Hat tip to my friends over at Calculated Risk for bringing the following LA Times article to my attention, "Some owners deserting factories in china."

First, Tao Shoulong burned his company's financial books. He then sold his private golf club memberships and disposed of his Mercedes S-600 sedan.

And then he was gone.

...As more factories in China shut down, stories of bosses running away have become familiar, multiplying the damage of China's worst manufacturing decline in at least a decade.
I don't want to condone disappearing bosses who run off with whatever cash remains and leave behind unpaid employees and suppliers, but there is a simple beauty and efficacy to this process. Capacity is immediately taken out of the market.

Entering this global downturn, it is clear that many industries are suffering from an excess of global production capacity given declining demand. One of the things needed for the global economy to find some support is for production capacity to adjust lower to meet the new lower demand. Basically, factories need to be shut down, and the sooner the better. The fact that Chinese capacity can disappear overnight is actually a good thing for rebalancing the global economy, especially since much of the excess capacity that was built in recent years was built in China.

When these Chinese bosses disappear and their factories are shut down, that production is gone. Contrast that with the typical U.S. corporate bankruptcy. In the U.S., a troubled company files for bankruptcy "protection" and continues to produce. Typically, the stockholders are wiped out, and the bondholders are given new equity in the company in exchange for their debt. Then, the company emerges from bankruptcy, often with a production footprint not terribly different from its pre-bankruptcy days.

So, not only is it likely that zero to modest capacity was taken out of the system, but now the remaining competitors in that industry are facing this "new" old competitor which has a clean balance sheet and can more aggressively compete on price. This puts added pressure on the "survivors" who may have been fairly conservative and done everything right, but nevertheless now face a stronger competitor that would have been liquidated in a true free market. There's probably no better example of this than the U.S. airline industry.

We can bad mouth the Chinese bosses who are leaving their employees and suppliers in a bind, but at least they've found a way to quickly address the excess capacity overhang.

Disclosure: The Rubbernecker is long disappearing Chinese bosses and short the U.S. bankruptcy code.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

So That's Why Gold Prices Are Up Today

Those who've followed me for some time know I've been a fan of gold for over 5 years now. So I folllow the news on gold, gold prices, gold mining, gold teeth, gold mining stocks, gold pine cones, gold demand, gold supply, and alchemy pretty closely. Those who've followed me for some time also know how ridiculous I think it is when the press attempts to explain away why a particular market or asset class rose or fell in a given day. MarketWatch has obliged both of these interests of mine today with an article entitled "Gold Rises 1% On Speculation Prices Have Bottomed."

The article begins,

Gold futures rose Monday for the first time in three sessions, adding 1% on speculation that the precious metal's prices, after suffering their biggest monthly loss in October, may have bottomed. Gold for December delivery gained $7.30 to stand at $725.50 an ounce on the Comex division of the New York Mercantile Exchange. The contract had surged to $739.50 earlier.
Now, I'm glad that gold is up, but this type of commentary is ridiculous. First of all, in this market a 1% move in just about anything is little more than noise. There haven't been many days in the past few months when gold hasn't moved at least 1%. We even had a gain in gold of 11% back on September 17th. A 1% move may have been significant in prior years, but a move of only 1% makes for a fairly quiet day of late.

It's even more ridiculous that MarketWatch believes it can attribute a minor 1% move in gold to any particular factor or set of factors. In this case, MarketWatch attributes the rise to speculation that gold has bottomed. How can they know this? If there were only one buyer and one seller who both happened to be cousins of Moming Zhou (the author of the piece), then fine. But this is a market with many buyers and sellers. Some are trading to speculate while others are trading to hedge. There is no way to net out the effect of all of these trades and boil it down to only one factor.

Claiming that a price rise is due to speculation that prices have bottomed is also about as weak an explanation as can ever be given. It's akin to saying that prices are rising because people expect prices to go higher. No kidding?

Unfortunately, this claim and rationale could have been proffered (and probably was) for any 1%+ move in gold over the past few months, yet gold is trading only 8% above its 52-week low. So, even if the author truly believes that "speculation of a bottom" was the reason for this massive 1% rise in gold prices, perhaps he/she could have pointed out that prior bottom-fishing speculations have proven to be a false dawn over the past few months. Also, the gain on the day is much smaller than the fall from the intraday high. Why no explanation for the fall in gold prices from the intraday high of $739.50 to $725.50? This $14 fall seems at least as interesting as a $7.30 rise. Actually, it seems almost twice as interesting.

Don't get me wrong. I hope gold has bottomed. At some point it will. If the press keeps attributing any slight hiccup in the price to "speculation that prices have bottomed," one day they'll be right. Even a blind squirrel finds an acorn sometimes.

By the way, gold is now up only $3. It's down $17 from its intraday high.

Disclosure: The Rubbernecker is long dentistry and golden plant organs and short the press.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Sunday, November 2, 2008

3Q08 Earnings Season and Valuation

What a week. We wrap up the worst month in the market since the 1987 crash by enjoying the best week in the market in 34 years. This neurotic bi-polar market continues to redefine everyone's view of volatility. It feels like we've had 3 years worth of action in just the past few weeks. The news flow has been incredible as well as the financial crisis continues to unfold at the same time as earnings season is in full swing.

Now that I've had a chance to catch my breath, there are a few thoughts about this earnings season that I thought I'd share as we enter the last heavy week of reporting. First of all, it isn't surprising that most of the news on the earnings front has been rather disappointing this quarter. It's looking like earnings for the quarter may end up falling 9-10%. Few firms in any industry are very upbeat about the near future although most firms claim to be very well-positioned for the long-term. This is just how things are done during a "slowdown." Mangements are typically of the optimistic sort, so when the near-term outlook is terrible, the conversation begins to focus more on the long-term, for which their enthusiasm knows no bounds. Of course, when the near-term starts to improve, we can expect the conversation to quickly shift back to their more typical, "long-term", three-month outlook.

Another point that I'd like to stress is that it gets a little more difficult during an economic downturn to assess the performance and prospects of a firm. Whatever the true reason for a slowdown in sales, a fall in margins, or a lower earnings forecast, virtually all companies will blame any shortfall on the economy. Thus, differentiating between company-specific and economy-specific reasons for a firm's poor performance gets a little tricky. No CEO really wants to say, "Hey. Not only does the economy stink, but we've been really making a mess of things around here ourselves." So, instead, blame gets shifted solely to the economy. For this reason, paying attention to a company's industry peers takes on even more importance during a recession (yes, this is a recession). If all of the companies in an industry are hurting fairly equally, it's probably the economy. The larger the differences in performance, the less likely it is that the economy is the only factor impacting the laggards.

Finally, let's take a look at earnings expectations for the fourth quarter and 2009. A report from Thomson Reuters Research came out in the middle of last week that showed that analysts were expecting earnings for the fourth quarter to increase by 32.2% and for 2009 to show growth of 15.7%. I suppose anything is possible, but these figures strike me as a touch absurd.

Let's look at earnings estimates a little closer, using Standard & Poor's data. For the fourth quarter of 2008, the estimate for S&P 500 earnings based on analyst projections (bottom-up) is calling for a 15.2% sequential increase over Q3 and a 36.8% increase year-over-year. These are operating earnings, which leave out all of the "one-time" items. Unfortunately, there isn't a comparable top-down operating number. The top-down estimates that we have come from strategists (as opposed to analysts) and are for reported earnings, which do include those "one-time" items.
It's interesting to note the difference in these figures. The bottom-up (analyst) operating estimate for the fourth quarter stands at $20.82 while the top down (strategist) reported figure comes in at $12.12, 42% lower. For 2009 those numbers are $94.25 and $48.52, respectively. That's a huge difference of 48.5%. By way of comparison, the difference between the reported and operating numbers for 2007 and 2006 were 19.8% and 7.1%, respectively. The difference for 2008 is forecast to be 25% currently.

What does this mean for valuation? The S&P 500 index closed last week at 968.75. Put a 15 multiple (arbitrary) on the $94.25 figure for 2009, and you get a level for the S&P 500 o
f 1413, implying that the market is undervalued by 45% currently. Put that 15 P/E on the $48.52 figure, however, and we find fair value at 727, implying the market is overvalued still by 25%.

There are two points to this analysis. First of all, the bottom-up estimates from the analysts are almost always too optimistic, particularly during a downturn. The analysts are being spoon-fed by optimistic managements and are therefore very slow to bring their numbers down to better reflect reality.

The other point is that we have to be very careful when trying to value the market using P/E analysis. There are a number of different earnings measures and time frames that can be used. The use of a particular P/E multiple is also highly subjective. Care must be taken not to mix a forward (2009) earnings estimate with a P/E based on historical trailing earnings. Forward P/Es must be applied to forward earnings, and trailing P/Es must be applied to trailing earnings. Better yet, these inputs should be normalized for the business cycle. Unfortunately, rather than approach valuation objectively, many people tend to use the combination of earnings and multiple that best helps them justify the bullish or bearish view they already hold. This is called data mining, and it's a dangerous substitute for objective analysis.

Disclosure: The Rubbernecker is long mining, but not data mining.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.