2/15/11…stock in trade

…you sure can’t call the stock market ‘investing,’ especially the puny new highs being eked out each day on pitiful volume (although the Dow Transports did stage a 158 point gain Friday but were shy of a new high and slipped yesterday), so ‘stocks in trade’ is the more appropriate comment and not trading much, yet we are told this is an incredible time to buy and naysayers like TB and some others he respects scoff at the idea they represent value.

Yesterday’s NYSE Volume was a scant 817 million shares, well below the 12 month average of 1.13B shares which is only that low due to the lack of trading since the end of the third quarter. That 817 million shares is a new low year to date and brings the average volume to just 1.04B shares! There are two things to be said of this low a volume:

1. It represents an absence of sellers not a plethora of buyers, and
2. Only a fool shorts a thin market

When was the last time we had sellers? January 28th when the Dow plunged 162 points, its biggest move in either direction since 12/16/10! People this is valuable information and tells us that it is being held where it is by nothing but speculative buying and even they are tiring of it.

The S&P 500 p/e is hovering at 15.9x which is expensive by any means unless you subscribe to the belief that earnings are not only growing at $75 a share but will continue to do so – as far as the eye can see.

The question of course is risk and there are many ways of measuring it.

Stock professionals use the risk premium, or return above the riskless rate in each country (don’t laugh but that is U.S. treasury bonds for us, and Gilts in the U.K.). The riskless rate is not a constant of course as we have seen and the normal comparison is to the ten year maturity.

The risk premium demanded by investors was less than 3% just before the market tanked and then rose to well over 8% in late 2008 and is not back to around 4%. Pretty meager or at least indicative of a ’fully-priced’ market.

But since, as pointed out last week, over the past 30 years, the average holding period for stocks has shrunk from five years to just five MONTHS, what is the appropriate benchmark? If you are a buy-and-hold investor it should be the ten year note but what about for the only people who are really playing and thus really matter? Hedge funds, flash traders and their ilk. If they use the 3-month t-bill 0.15% is fine, and even if using 1 month LIBOR it is a mere 0.25%. Using the 10 year treasury however requires something above 3.625% now…up from 2.385% back in early October, when Big Ben Bernanke announced his new quantitative easing program (QE2) which was to keep short term rates low and at the same time buy up long U.S. treasuries to keep yields from rising. Since then the 10 year yield has jumped by 124 basis points (1.24%) taking the 30 year mortgage rate with it to 5.05% at a time when we need that rate to stay low. TB has not been able to see where the Fed has bought ANY mortgages or mortgage-backed securities over this time!

When announcing QE2, he disingenuously failed to disclose a third objective which he later did in an Op-Ed to the Washington Post: drive stock prices higher. Why? This is NOT a mandate of the Fed and the last person who allowed this to happen was Alan Greenspan who never met a bubble he didn’t like and did nothing about them. We are now in a mini-bubble but given the lack of credit availability it could burst in gargantuan proportions, and soon, since the buyers have been ”hot money” …and when hot money bails people get hurt…like yelling ’fire’ in a crowded theater.

Shifting back to the current state of the economy, last Friday the University of Michigan Consumer Sentiment February preliminary report was released and all you heard was the headline number: up 0.9%…splendid…rally stocks, right? Well, there are TWO components to that number: present conditions and expectations…the nice thing about this is that unlike Retail Sales (which we just got for January and were up just 0.3% with auto sales flat vs. consensus call for +0.5%), they are  not impacted by weather.

While the overall number and current conditions are improving, expectations plunged 1.7 and are 1.2 BELOW where they were a year ago! But the huge 5 point surge in current conditions made the report look strong…never mind that for investors and business the one that is far and away the most important is expectations as that is what drives hiring and growth in the economy.

This also raises the question of where the additional demand is to come from? Have we just seen the consumer do a last hurrah after being tired of their ennui?…only to replaced by guilt and fear when the get the bills? Something has to give and it isn’t going to be the banks.

You have all heard the salvos on municipal bonds that begin with Meredith Whitney’s appearance on 60 Minutes wherein she predicted disaster for that asset class similar to her correct call for the banks in 2008 (for which she was mocked but ultimately proven correct). Her gloom and doom scenario for municipalities however showed a total lack of understanding of the municipal bond market and struck fear into the hearts of small investors who dumped their bonds driving yields to ridiculously wide spreads to treasuries even as that asset class was upended as shown earlier in this column.

Immediately, bond professionals, most notably David Kotak, came to the fore saying this represents an ideal buying time for muni’s due to the spreads…not so for TB, who has seen this before in his 39 year career…you don’t jump in front of a speeding train…it wasn’t and isn’t over yet. To TB, Meredith Whitney is just another Elaine Garzarelli, who while at Lehmnan correctly called the 1987 crash, parlayed that into a successful career, and never provided much of value again. Meredith: corporates yes, muicipals…read a book!

But over the past week two others have emerged on the scene. First, credit professional, James Grant who panned muni’s NOT because of default risk because at the yields seen in the short and medium term end of the curve provide no value – other than relief from taxation…which also could expand to helping through providing capital losses. In the long end, he sees sovereign credits like U.S. treasuries and U.K. Gilts as in serious trouble, thus if their yields rise, investors will demand even higher yields from municipal bonds.

Then, yesterday, Pimco’s Bill Gross jumped into the fray saying that he has reduced his exposure to U.S. treasuries to the lowest level since 2009 (note he was wrong then), but again he sees more liklihood of rates rising and sees better value in emerging markets.

The point is that investors are afraid of risk even when they are rewarded for it in real and relatative yields. No one understood this better than Michael Milken, the junk bond king, who despite his artificially controlling the market to his advantage probably had the best understanding of risk than any other bond investor.

When yields are at or near double digit, the risk is manageable, and even if there is a default, if the interest is reinvested over five or more years the return can still beat treasuries…even with a default!

Grant, later in the same Bloomberg interview also said that mortgage REITS yielding from 10% to high double digit and run by well managed funds are his pick (as they have been for TB as they have not been thrashed even as treasury and muni yields have surged).

So think about risk and stop doing the same things that have consistently cost you money.

Have a great day!



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