Stock Gurus: Doug Kass on Calculating the Bottom

Doug Kass appeared on Fast Money on 10/28/09 and discussed how he calculated the bottom this last March.

- Looked over 7 decades of S&P data. Market is valued at about 15x usually, 11.5x at the bottom.

- Book value of the S&P = $560 at the time. The average industrial earns 12%, or $67.

- $67 x 11.5 = 770, or about 800 on the S&P

- On March 9, 2009, S&P was at 685, way below. 685 is 9.7x (actually, 10.2x if you do the math)

- PE was also very low, especially in a time of quantitative easing.

And thus he called bottom in March.

Stock Gurus: Meredith Whitney

Meredith Whitney appeared on CNBC on Monday, 11/16, on CNBC's Closing Bell after Bernanke’s speech. I don’t always agree with Meredith, but she’s always insightful and her opinions are backed up by solid analysis. The only caveat is that timing may be an issue for her. For me, her comments make sense, question of when things will happen, and perhaps if they will be as severe (which is related to timing. Timing more spread out, less severe). Here’s the highlights of her comments:

- Mortgage Backed Securities. Bernanke didn’t say much. She wanted him to talk about the agency mortgage-backed purchase program, and he didn’t. The Fed has been buying Fannie, Freddie agency mortgage paper, and it’s 1/3 of their balance sheet, was zero at the beginning of the year. Fed is probably buying more than 100% of what’s available. Through these programs, rates are low, 20% of the banks’ capital has been created (estimated), allowed bank asset values to rise. Program almost done. When Fed exit, interest rates go up dramatically (probably more than 10%), affordability goes down, credit losses spike again, another leg down in the housing market. “I haven’t been this bearish in a year.”

Other programs have wound down, except for agency MBS. Extend program, Fed becomes one of the largest buyers of junky debt. Deed for lease program. If you can’t afford modification, then gov will rent house. So does gov become direct owner of US real estate?

- Consumer. Doesn’t Understand Why Stocks Are Up. Particularly in the consumer space. No fundamental reason. Plus contraction in consumer credit. Never been so much consumer credit contraction, even in Great Depression. In 1990-91, contraction, but securitization provided liquidity to consumers, consumer actually had more liquidity during that time. $1.5 trillion of credit lines pulled from the system. Is now re-accelerating. Not a good Christmas coming. “There’s nowhere to hide at this point”.

Retailers have reduced inventories, so that may be better. But so many credit lines cut, the middle class is getting squeezed the hardest. Worry about that most. Also getting kicked out of banks.

- Banks. To pay back TARP, banks will have to raise capital again. Adequate capitalized today? No way. Trade has been short regionals, long capital markets banks. Works because government behind capital markets. “If the lifeguard is on duty, people will jump into the pool”. Lifeguard will go off duty, just don’t know when. Capital markets volumes will be down. Equity volumes down, fixed income volumes are down, so big banks are converging closer to the regional banks. Reducing weightings on big banks.

But still, their stocks are rallying, doesn’t make sense. No root in fundamentals. Money on sidelines – never underestimate, usually goes to smarkt places. But now money not going to agency MBS. No substitute buyer. Money going to hard assets, businesses, gold. No one is buying mortgage backs.

Dip like last year? Don’t think so because before had mark-to-market accounting, makes big difference. Don’t think BAC will go back to $3. But thinks banks will go back to tangible book value. Have said this for 2.5 years now. Only trade above when there are core earnings. But increasingly clear, core earnings will not be what they claim. Likely will be ½ to ¾ of that, some fraction. Implying estimates will go down. Therefore, sell the banks.

- States. States need money. 44-48 states underfunded, and will be progressively more underfunded.

- Real Estate. Surprised Bernanke talked about real estate. Still residential real estate, many people have glossed over the fact that there will be another leg down in commercial real estate. Home ownership stands at 67.8%, will normalize at 65%. “Still the great sucking sound of liquidity coming out from the market.” Mortgage modifications – only 1% of trial modifications have gone to permanent modification status. Just waiting, 1^st quarter, when numbers show up, mortgage rates spike and fewer people qualify for mortgages, another leg down. Residential still much bigger threat than commercial. Banks assume real estate doesn’t go down further, 10% unemployment – already there. And states are still firing people.

- Where Put Money? Sit on cash for a little bit because you have to wait for leg down, S&P expensive across the board. Estimates have to come down, look opportunistically. Banks that are asset-sensitive to consumer credits are not where you want to be. Some core business that benefit from transaction services will benefit. Everything’s expensive now.

- Double Dip? Not as severe on second part of dip.

- What does it take to become more positive? Valuation, all about price.

Stockwatch: Goldman, Sachs & Co.

So early today, Goldman announced Q3 earnings, and again, it blew away the numbers. Still, the market has gotten used to Goldman outperforming and had high expectations, especially after JP Morgan’s great numbers the day before.

First, the numbers. Goldman earned $3.19 billion, or $5.25 per share, compared to the average analyst estimate of $4.24 per share. Revenue was $12.37 billion, again, far in excess of analyst estimates of $11.02 billion. The firm’s return on equity was 21.4%, despite high capital levels that would drag down the return on equity.

Next, the more interesting part: the business model and its sustainability. This is the part of the analysis that they never talk about post earnings. A quick look at the income statement tells you the following:

- Increased Fixed Income Share. The key was trading and principal investments, and in particular, fixed income. But in addition to skill, Goldman’s revenues in this area were driven by the disappearance of its competitors Lehman (a bond house), Bear Stearns and to a certain extent, Merrill Lynch. As Goldman’s CFO Dave Viniar said on the conference call, “we’re getting a bigger piece of a smaller pie.” Consider the Trading and Principal Investments line for the last three quarters: $5.7 billion in Q1; $9.3 billion in Q2; and $8.8 billion in Q3.

- Cost Cutting. The media coverage never talks about this, but cost cutting made a significant contribution to the bottom line. Again, look at the operating expense line: $6.8 billion in Q1; $8.7 billion in Q2; and $7.6 billion in Q3.

- Investment Banking Declined. Investment banking fell from $1.4 billion in Q2 to $899 million in Q3 , mostly due to a decline in leveraged loans. While a negative, investment banking is traditionally lowest in the 3^rd quarter because of slow IPO and merger activity during the summer, and because of vacations.

All this speaks to the trend in earnings: $3.49 per share in Q1; $4.93 per share in Q2; and $5.25 per share in Q3. Today, the stock closed at $188.63. And look at the profit margin by quarter: 17.6% in Q1; 19.8% in Q2; and 24.5% in Q3.

Today, the stock closed at $188.63. Based on 2009 estimated earnings of $17.74, that’s 10.6x PE. Based on 2010 estimated earnings of $18.05, that would be 10.5x forward earnings (these are today’s numbers, so these are pre-Q3 earnings estimates).

Now we get to the big question – what does Goldman look like in the long term? Are these numbers sustainable? It’s very possible.

- Investment Banking. Next year, in 2010, IPOs and mergers and acquisitions activity should pick up as the big fish with cash buy out the small fish that are still struggling upstream.

- FICC (Fixed Income, Currency and Commodities). You would think that a compression in the yield curve would hurt revenues here, but Meredith Whitney asked this exact question on the earnings call: “When the government stops buying assets (Such as mortgage securities. The government’s buying keeps prices high, yields low, expanding the yield curve), who will be the substitute buyers and how will that reduced buying affect Goldman’s business?” Dave Viniar’s answer: “There’s plenty of other buyers with lots of cash to spend. It won’t affect us because our profits are not based on positioning, but on velocity.” Meaning volume, and the commission earned on the turnover, is what is generating profits. If we are to take him at his word, this means that the fall of Lehman and Bear brought them business which can be expected to continue into the future. Time will tell, but for the moment I think we can take him at his word.

- Principal Investments. This is always a tricky line, because the company can manage this number, and what drives this number changes. This quarter, $344 million came from the sale of Goldman’s stake in ICBC (share in the Chinese bank) plus $911 from “Other corporate and real estates gains and losses.” Chances are, these are sales and mark-ups on assets. Whether this level will be maintained is hard to say. One fact that bodes well for this area is Goldman’s high level of capital. When the credit crisis recedes further, Goldman is likely to deploy the capital that it is holding in reserve. So no certainty here, but Goldman can probably find ways to sustain this number if necessary.

All in all, there’s no reason to think that Goldman couldn’t maintain $5 per share in earnings per quarter through 2010 (given $5.25 this quarter and $4.93 in the previous quarter). That would mean $20 per year in earnings, and with a 10x – 11x PE, that’s $200-210 on the conservative side.

Here’s one other way to calculate future share price. Book value per common share increased 4% to $110.75 this quarter. Based on today’s $188 close, the stock trades at 1.7x book. If we were to assume that book value could be increased at 4% per quarter, that gives us a $220 stock. And if Goldman increases its ROE, then of course, we get a bigger number.

If Goldman hits $220 within the next year, based on today’s $188 price, that would be a 17% gain. I’m currently long Goldman and would buy at this level. It may still trade down a bit as the stock rests, but that’s just another buying opportunity.

Monthly Investing Article

My October investing article is up at www.asiancemagazine.com:

http://asiancemagazine.com/2009/10/12/investing--the-forces-at-work

Thanks for reading,

Ming

Stockwatch: Proctor & Gamble - September 19, 2009

Recently, Proctor & Gamble stock has been on the move, reaching $57.32 this last Friday (up $1.79 that day). For most of the last year, P&G has been a disappointment. Since late April, P&G had been stuck in the $50-56 range. While the market has rallied nearly 60% off the March lows, P&G has only risen 27%. In early August, P&G reported 4^th quarter earnings of 80 cents a share, beating expectations of 79 cents a share by a penny but down from last year’s 92 cents a share. In addition, P&G forecast first organic sales growth of 0 to -3%. The stock immediately dropped from about $55.46 to $51.46 a couple days later.

Traditionally, P&G has been considered a solid defensive stock, one to buy in times such as the last year. However this time, P&G has been hit by two distinct problems. First, high commodity prices significantly increased costs, leading P&G to raise prices and to shrink its packaging. This led to the second problem: customers started to trade down – and have stayed there. As a result, P&G has been losing market share.

Now P&G is starting to sing a new tune. Here’s the new news:

- The new CEO, Robert McDonald, took over from A.G. Lafley, the man who drove P&G’s acquisition of Gillette as well as the push toward faster growing, higher margin businesses. For Mr. McDonald, who took over on July 1^st, the fourth quarter (P&G reported 4^th quarter results the first week in office) was just at the beginning of his term.

- For 1^st quarter 2010, P&G still estimates $0.95 - $1.00 in earnings and the Street is at $0.97. Organic growth is still expected to be 0% to -3%. However, for the second quarter, Mr. McDonald anticipates 1-4% organic sales growth. Second quarter will begin in October, 1^st quarter reports should be in the beginning of November.

- P&G sold its drug business to Warner Chilcott fror $3.1 billion on August 24. This is a good sign, meaning P&G is focusing on it’s core businesses.

- P&G has long feared cutting prices on its premium products, but in recent weeks, the company has announced its willingness to cut prices and to reposition its brands. This reflects – finally – a recognition that the landscape has changed, and that price cuts will be necessary to bring back volume and growth.

- The company reaffirmed 2010 earnings of $3.99-$4.12 for 2010. This includes a one time $0.44 benefit and a $0.10 – 0.12 dilution from the sale of its pharmaceutical business. Before, analysts were expecting $3.65 - $3.80.

With the stock trading at $57.12, this places P&G’s current valuation at about 14x 2010 earnings (excluding the benefit from the Warner Chilcott sale and using $3.80, P&G would trade at 15x 2010 earnings). Compare this to the current S&P index, which stands at 1068 and has projected earnings of $72.96 for a 14.6x PE. Debates about S&P projections aside, P&G still trades at a slight discount to the S&P today.

How far can P&G stock go? In the short term, assuming P&G keeps pace with the general market, a 15x multiple on $4.05 2010 earnings would place the stock at $60.75. If we use Colgate Palmolive’s 16x PE ($76.10 / $4.77 = 16x), then P&G would trade at $64.80.

In the longer term, if P&G can return to the days of 6-9% growth and a premium PE of 22x (22x from 2004-2007; as high as 40x from 1999-2001), then we’re talking a stock that would be $80-90 (a conservative $3.80 x 22 PE = $83.60).

Still, that would be some time away. Right now, we’re looking at the likelihood that P&G has seen the trough in sales and the expectation that it can regain growth and stabilize share. Proof, via performance in Q1, would go a long way toward rebuilding confidence and creating upward momentum.

Ming is long PG.

A TBT Trade

I’ve long advocated a trade in the TBT. The thesis has been straightforward: over the long-term, money will have to come out of Treasuries. In times of fear, investors buy Treasuries because it’s the safest security, even though interest payments are very, very low. At some point, risk appetite will come back, and those investors will sell their Treasuries. The TBT is short Treasuries.

This is a long-term trade. The issue is, of course, that in the short term, this trade has a lot of variability. So let me be upfront, this trade is not for the beginner or the part-time player. This is really for someone that takes the time to understand what’s going on in Treasuries.

In the short term, the TBT should see a lot of variability. Given the market’s tremendous run since March, there has been growing fear of a correction. If that occurs, then the appetite for risk will recede and investors will go back into Treasuries. This has already occurred a somewhat, and the TBT, which was as high as the high $50s, is now trading at $46. A run up into the end of the year will cause the TBT to rise, a fall in markets will cause the TBT to decline.

Given that, the TBT can also become a trading vehicle. Again, this is not for novice players, be advised.

If you watch the TBT, it has, in recent months, fallen immediately after the sale of the 4-week Treasury. Then it has risen until the 30 year is sold, and has immediately retreated as soon as the results of the 30-year Treasury auction has been announced. That’s because people expect demand for short term Treasuries to remain high. So the short has performed well, and the TBT retreats after the 4-week Treasury sells well. Then the possibility that longer term Treasuries will not sell well infects the markets, and the TBT rises. In recent weeks, this fear has been unfounded. Fear of a correction has actually caused the longer term Treasuries to sell well. As a result, the TBT retreats after positive 30-year results have been announced.

So here’s the short-term trade hypothesis: buy the TBT after the 4-week auction, and sell just before the 30-year auction. Again, this is for active traders who understand the risk, not for novices. As always, put a stop loss in somewhere around your acquisition price to prevent pain from sudden downward moves.

I am currently long the TBT.

Natural Gas Gets A Bump

Last week, natural gas got a bit of a bump. Much has been said lately about the massive oversupply of natural gas and how natural gas has tracked the cost of oil rather than reflecting fundamentals. In short, recent natural gas discoveries have led to an overabundance of the fuel in the last few years. Surprisingly, the price of natural gas has fallen, but not as much as expected given the oversupply. Instead, natural gas has followed the cost of oil. Analysts believe that if the price of gas falls far enough, producers will eventually be forced to stop production. The market estimates that natural gas will be in the $6-7 range next year, compared to the $2-3 range of recent weeks. If the market is right, then natural gas stocks should be a buy. A small decline in inventories last week created the bump in natural gas last week.

It makes sense that natural gas should bottom as storage reaches maximum capacity. Exactly when that will happen is unclear, and I won’t claim to know. As for investing in natural gas, I am, for the moment, just watching to see if how supply and demand actually works the way we think it does.

I am long XTO (a trade, as opposed to an investment).

Morgan Stanley’s New CEO

I’ve written about and recommended Morgan Stanley through much of this year. Over the last several months, Goldman Sachs has led, taking risk in trading and reaping profits. On the other hand, Morgan Stanley was more conservative, and ironically, suffered as a result. I was encouraged to hear a month or so ago that the firm was beefing up its trading operations and hiring more traders.

This week, the firm announced that John Mack would be stepping down as CEO, and that James Gorman, the head of Morgan Stanley’s brokerage unit, would take over. The problem here: Gorman was a former McKinsey & Co. consultant and currently manages the retail sales side of the house. He has no investment banking experience. This seems to indicate that the board wants to stay conservative and stay away from the risk that is yielding profits for Goldman Sachs. While selling stocks and bonds to retail investors can be profitable, it’s not as profitable as trading.

Of course, we can’t really know until Mr. Gorman has a little time in his job. Still, this wait and see situation changes my position on Morgan Stanley. I’m long, and it’s not a sell, but with any new money, I think it makes much more sense to toss it toward Goldman Sachs. They’ve proven that they can manage risk and profit in this environment. Mr. Gorman may yet try to follow Goldman’s lead, but if the firm remains conservative, it’s likely to lag the market. So why invest in a maybe when you can invest in the proven performer?

I’m long both Goldman Sachs and Morgan Stanley.

September 14, 2009: The Coming Week

After a bit of a run up, it would be reasonable to expect a bit of selling pressure this week. There’s not much expected in terms of market-moving news, just small indicators of trends. We have some tech news with Oracle reporting, and some consumer indicators with Best Buy and Kroger reporting. On the macro side, market watchers will be looking toward retail sales numbers and housing starts. Unless these numbers are significantly out of line, there seems to be little reason to anticipate significant market moves.

September Investing Article

My latest investing article is up at www.asiancemagazine.com. I'd post it here, but it's several pages. Here's a quick overview:

The Next Few Weeks. Over the next few weeks, I don’t expect significant movements in the market. We’re capped by skepticism above and a floor created by recent buyers unwilling to sell. Still, many in the market are positioned for a correction.

A Vulnerable Q3. A quick scan of sectors shows that we’re likely to have mixed earnings, but there’s no convincing case for a bad quarter. Still, we have to account for the possibility of a negative earnings surprises and given the nervousness of markets, we need to be ready for this possibility.

Managing A Position. A look at managing a position in the TBT (short Treasuries) and Apple. Trading with stops is can be a good thing.

Looking Ahead: Financials

I like looking at financials for two reasons. First, they are very indicative of the economy. Their exposure to residential and commercial real estate, credit and capital markets are all mirrors of our economy. Second, the financials will move with the markets, and the long-term thesis remains: over the next 3-5 years, I believe that the financials will offer substantial returns for investors.

The real question is how to handle the short-term. Over the next couple weeks, a correction, probably in the 10-20% range, is likely. Of course, such a correction needs to be confirmed by follow-through (several consecutive down days) and can depend greatly on data, such as unemployment reports (the next is Friday, September 3, 2009). Still, if it occurs, such a correction would actually be a good thing: it allows financial stocks to regroup and continue moving forward.

Personally, I plan to buy into the correction. To be clear, I’m not saying that it’s all clear in the financials, not by any means. As investors, we have to watch out for events or news that could turn stocks in one direction or another.

So here are the things I’m looking at. First, let’s take a look at the capital markets operations – the investment banking side of the equation. This applies to the pure plays – Goldman Sachs and Morgan Stanley, as well as the banks with substantial investment banking operations: Bank of America, Wells Fargo, JP Morgan and even Citigroup.

Over the next couple quarters, investment banking operations should continue to bring profits. In part, the investment banks should do well just because there are now fewer of them. With the fall of Lehman and Bear Stearns and to a certain extent, Wachovia, investment banking business falls to the few remaining players. Meanwhile, trading in government securities, corporate bonds and high yield debt remains very strong. Equity underwriting remains slow, and those that have retail brokerage operations and asset management divisions will see some weakness there. Still, propects remain good here. And, the government continues to support profits in this sector. This all bodes well for Goldman Sachs, Morgan Stanley (to a lesser extent, because it is less aggressive than Goldman), and the investment banking divisions of the banks.

Greater questions emerge in the last quarter of 2009 and going into 2010. Eventually, government support will have to be withdrawn, and if substantial profits are reported through year-end (already, there’s talk that 2009 might be a very strong year for bonuses at Goldman Sachs), withdrawal of support becomes more likely. A tightening of interest rate spreads may also make it harder for these companies to finance their operations. And if the second half of the double dip occurs, trading, debt and government securities operations may very well slow. Remember that in 2009, the investment banks will benefit from companies re-capitalizing their balance sheets and credit markets returning. Much of that may fall away in 2010.

For the more traditional banks, the picture is more serious and I believe that the possibility of a double dip is fairly strong. 2009 has been an usual year because of the need to stabilize the banks. As we go into 2010, the Fed will feel the need to start withdrawing support from the system. Truth be told, the Fed probably wants to support the banks for a long as possible, but I suspect that there will not be the political will to do so because everyone believes the crisis has past. And Washington does not work well without a crisis.

On the economic side, all indications are that foreclosures are now affecting the prime and jumbo market, and these are mortgages that can’t be worked out because these homeowners are having trouble paying their mortgages (due to job losses, etc.). Reports this week say that the number of homes in foreclosure are increasing, not decreasing. Commercial real estate is also beginning to hit the point where they have to be dealt with, and so that will be another hit to the banks. In 2009, banks have delayed recognizing losses by trying to work them out, providing extensions and so forth. We will soon reach the point where delaying tactics won’t work anymore; it will be time to face the music.

Other macro factors will test banks. Eventually, the Fed will have to start exiting the quantitative easing strategy. That means interest rates may start to rise and banks will not benefit from the fat spreads that they’ve seen in the last year. Foreign banks may very well slow their purchases of US debt, and inflation may also start to rear it’s head.

All in all, there are several reasons to be concerned about the banking sector going forward. So what would be the game plan? I still like Goldman Sachs and Morgan Stanley to a lesser extent, especially if their prices dip because of a correction. For the banks, I plan to buy the next pullback, but with two qualifications: much depends on the individual bank, and these banks have to be owned with a careful eye to the obstacles mentioned above. JP Morgan remains the strongest; Wells Fargo has great earnings power but needs to figure out how to pay back TARP; US Bancorp is solid, well managed bank, but has lending exposure; Bank of America and Citi are interesting but risky because their balance sheets are weaker. All can are subject to the headwinds mentioned above, so if things start to turn the wrong way and we get the second half of a double dip, it may mean stepping out and then stepping back in later.

For those that don’t want to trade in and out, I still think that dollar cost averaging, or buying on pullbacks, remains the best strategy. For example, if you are conservative and don’t want to spend too much time watching the markets, you could buy JP Morgan on dips, and dollar cost average if we enter the second half of the “W” recovery. This will give you a lower cost, and JP Morgan will probably emerge as a very strong bank in 3-5 years with most of its troubled assets off its books. This is a conservative, long-term strategy that has a strong probability of working.

For the regional and smaller banks, these are more-lending based, and so they are exposed to all the headwinds mentioned above without the benefit of diversification into the capital markets. Most analysts expect as much as 500 more banks to fail by the time this is all over. For me, this is a steer clear area, or a lot of work to make sure a smaller bank is a good investment.

All in all, the entire banking sector still faces challenges ahead. But for the patient investor, that could very well mean opportunity.

I am long Goldman Sachs, Morgan Stanley, JP Morgan, US Bancorp, Bank of America and Citigroup. I have no position in Wells Fargo at the current time.

Trading AIG: Playing the Walking Zombies

If you’ve been watching the markets at all, you will undoubtedly have heard that AIG has had a massive run. It was not long ago that the stock was trading for a little more than a dollar. So the company engineered a 20-for-1 reverse stock split, meaning that if you at 20 shares valued at $1.00 each, you now had 1 share valued at $20.00.

On June 30^th, the company proceeded with the reverse stock split and the new shares started trading at $23.20 – the equivalent of $1.16 before the split. Within days, the stock plummeted and stockholders cried foul. By July 10, AIG had fallen to $11.74. The press had a field day, and the chorus of “who thought that one up?” was loud and persistent.

But then something curious happened. After drifting in the $11.00 -$13.00 range for almost a month, the stock took off, hitting $22.00 on August 5, 2009. No big deal, many said. After all, $22.00 was equal to $$1.10 on a split-adjusted basis. But the stock kept going up, hitting $28.70 within days. A few days later, it had drifted down to $23.42. And then, the stunner – the stock took off, hitting $50.23 today. Some are saying that AIG could hit $100 soon.

So before going on, let me state clearly why I’m even bothering to look at this. Let me say straight out, I’m not recommending this stock and if I were managing a client’s portfolio, I wouldn’t even mention it. But I think there’s a lot to be learned about the markets here, and I’m always interested in seeing what the logic might be behind the behavior. After all, someone, somewhere, is making these decisions. So mainly, it’s about seeing what we can learn. A secondary reason is that we will see similar situations come up again – Citi is looking at a reverse split, and that might be just around the corner.

Now a couple facts for context. There was a huge short interest in AIG. Even as of August 15, 24 million shares were sold short. As of today, the stock has a total market cap of $7.25 billion, even after the run to $50 a share. That’s far, far outweighed by the $180 billion of credit that the government has extended to the company. In late July, Catherine Siefert, an S&P equity analyst, estimated AIG’s common tangible common equity at negative $336.62. In Q2, reported early August, Siefert thought that tangible common equity had inched into the black, but that was due more to accounting than to any change in fundamental value. Still, the trading in AIG is rampant, and according to CNBC, it’s the retail investor at work: the average number of shares traded is 219.

So given all these negative facts, why the climb in AIG stock? Reasons are swirling, including talk of a debt-to-equity swap, a new CEO, promises by the new CEO to slow down asset sales. I find all these explanations unsatisfactory. What makes much more sense to me is that traders are taking advantage of short sellers squeezed into a corner.

Consider this. If you had a lot of money, you would buy shares of AIG and drive the price up. The short sellers would have to cover, driving the price up further. And you would buy the shares knowing that if the stock starts to move up quickly, other day-trading buyers would jump in, and the short sellers would have no choice in the matter. That would spark the move up. After that, the momentum guys would jump in. And more short sellers would cover. And more momentum guys would follow, too. And then, the retail guys would jump in. And then you would sell. If you had lots of money to play with, and were close enough to the markets to react quickly, this would be a pretty good formula for making some dough.

One precedent to support this theory: look at Citi before the conversion of government debt early this year. Everyone knew that Washington would convert their debt (actually, preferred shares) into common, flooding the market with shares and diluting existing shareholders. Short sellers piled in, so much so that it was pretty much impossible to find any more shares to short. The government’s conversion rate had been announced, and a little math would value Citi in the $2-3 range. Despite all the short interest, the stock climbed to the $4 range, squeezing the shorts. Months later, when the government converted its shares, Citi eventually drifted back to the $2-3 range in July. Somebody made a lot of money squeezing the shorts.

So does AIG go to $100? It’s within the realm of possibility. Keep in mind that $100 is only $5 pre-split. Still, it’s a risky game. AIG could go to $100, or it could go to $10. And at some point, the run has to end. Those that got in early will take profits, and that will put significant downward pressure on the stock. Also, many bought AIG when it was a $3-4 stock. So as AIG rises to the $60-80 range, a lot of those players will be looking to exit. I think AIG has some more to go, but somewhere in the $70 or greater range, it could swing the other way.

A lot of people wonder why you would buy a stock that is worth nothing when you do the math. Someday, the government will make a decision about what to do. But frankly, that day could be a long way off, and forcing a reconciliation of the books anytime in the near future would just put a huge loss on the government’s books. No one wants to do that.

So in the meantime, AIG is a big trading vehicle. And something else to notice: the move in AIG comes when other options have been exhausted. The good stocks have had their move and have stalled. Take Goldman Sachs, best in breed: it’s stalled in the $160-165 range for several weeks now. The market is not ready to take the “good” stocks such as Goldman any further, and so it’s picking through the trash.

If this interpretation of AIG is correct, then we should see similar action in Citi if it does a reverse stock split. We may also find similar action in other forsaken zombies, Fannie Mae and Freddie Mac. Perhaps the moral of the story is that even in trash, there’s some opportunity. Time will tell.

Ming is long Citi and Freddie Mac, and has no position in AIG or Fannie Mae.

August 26, 2009 - Caution Recommended

In the lazy days of August, it’s easy to not do much. The market, while still trending up, is fairly lethargic: volume is low, indices see little movement. People are on vacation, and it’s easy to let our attention drift.

Still, wisdom dictates that it’s the best time to look at the porfolio and plan for the coming year. The September to November period has historically been a tough time for the markets. I used to wonder why, but it makes sense: it’s only human nature to take this time and look at the prospects for the next year. Our New Year might be in January, but psychologically, we still carry the “school year” starting in September.

The markets have had an amazing run. So much so that the S&P is trading at a recent PE high of 19x (based on diluted earnings from continuing operations), according to research firm Bespoke Investments. To give you perspective, the S&P’s PE has been as low as the 10x range in the last year , and hasn’t been as high as 19x since the 2002-2004 period.

The recent run has also driven out the short sellers in the market. Bespoke also calculates that short interest as a percentage of float for stocks in the S&P is now at 6.9%. The last time short interest was this low was in February 2007, before the recent market turmoil. Back in early August 2008, short interest was nearly 12%.

In sum, the market hasn’t been this bullish in a long time, and that alone is enough to bring out the contrarians and the bears. Despite the year recent year highs of the indices and the failure of bears to drive the market down, calls of froth in the market abound. Many are saying that we are topping.

The bears may very well be right, but I prefer to look at things in several different ways and see if I can come up with the same answer. The one thing that favors the bear argument: the market needs good, hard economic news to drive it higher. In recent months, we’ve had a rally based on cost cutting, “less bad” news and money on the sidelines playing catch-up. All of these market drivers will eventually exhaust themselves, and we will need new catalysts to keep things moving upward.

And what would those catalysts be? Earnings and industrial production statistics in Q3 would have to be favorable. At this point, that would mean revenue increases, as opposed to cost cutting. That in turn means somebody has to be spending. And thus the problem – who would that be? I think the consumer will be in hibernation for years to come. For the consumer, it’s like gaining weight: very easy to put on several pounds quickly; it takes a long time to take the weight off (believe me, I know). Another way to think of it – consumers are headed to Target and Wal-mart before they go to Saks, Nordstrom’s or Bloomingdale’s.

And what about businesses? It’s not clear by any means that they’re spending. The decline in unemployment would say that businesses are cutting less aggressively, but the fact remains, unemployment is still high. Last quarter’s earnings reports still showed year-over-year revenue declines for companies selling to businesses, so there’s no clear catalyst there. The only thing we can be sure of at this point is that costs have been cut and inventories are being worked off.

And finally, what about emerging markets and the much talked about China? Here, I think the talk of China as an engine of growth is overblown. China remains export dependent, and despite its high rate of growth, is not yet a consumer economy on the scale of anything in the West. True, China has been buying commodities, but it hasn’t been just for production. China has been a trader and a speculator, buying and stockpiling commodities when prices are low. That means China will eventually stop, or at least slow down purchases, especially as prices rise. I think that relying on China for further growth would be too much.

In commodities, there is a dynamic that could eventually support prices, and that’s basically the depletion of inventories. As we work off supply, we will eventually have a situation where we will have demand but limited supply, and that would drive prices up. I don’t think that would happen immediately, but markets could react to the expectation of this kind of condition within the next 3-6 months.

So today, we have a situation with a big rally behind us and no clear catalyst for a continued rally ahead of us. In the short term, we also have no clear catalyst that would drive us down, and given the amount of buying in recent months, coupled with very low short interest, it would take significant bad news to bring us down as well, in my opinion. The bears haven’t had much success in recent weeks, and that situation could continue.

Still, with lots of space below, the situation calls for caution. That means placing stops under stocks, buying puts, and/or taking profits. For the moment, caution is highly recommended.

July 15, 2009 – An Interesting Week

So this is turning out to be an interesting week. Tomorrow, Thursday, we have some biggies reporting - JP Morgan Chase, who will give us a sense of how the commercial banking side will be doing; Google, a tech indicator; and IBM, another tech-ish indicator. Obviously, weakness in earnings or outlook will pressure stocks, strong earnings and outlook will give the market another lift.

On Friday, we have Bank of America, General Electric and Citigroup. On the whole, these are more likely to underwhelm and are unlikely to lift the markets unless they provide major surprises to the upside. Also on Friday we have options expiration, but with lots of shorts being covered today and probably tomorrow, there may not be that much activity on that front Friday.

Looking into next week, the companies of note are Halliburton, Coca-Cola, Apple, Altria, Boeing, Amazon, McDonald's and Schlumberger - all interesting, but none with the weight of the companies reporting this week. With the S&P at 933 today and facing upward resistance of 950, keeping the market moving up and through the 950 mark would seem challenging. I think we would need a sense that a recovery in the second half is definitely forthcoming to keep the market moving up past 950. I would think that next week will be mixed - Apple will do well; Amazon might; consumer-driven companies Coca-Cola, Altria and McDonald's will perform respectably but will be hit by currency issues; and for Schlumberger and Halliburton, I doubt that world industrials are on the verge of a recover. In sum, mixed.

As I said earlier this week, I favored the optimistic side going into earnings. If we have good reports tomorrow (Thursday), I would remain optimistic through Friday and then expect momentum to be challenged going into next week. For any positions that have had a bit of a run, I'd consider trimming over the next day or two.

July 14, 2009 – JNJ Earnings

The Results. Today, Johnson and Johnson reported the following:

- Revenue fell 7.4% to $15.24 billion from $16.45 billion last year. $1 billion of that decline was due to two drugs, Risperdal and Topamax, that came off patent. Sales of each of these drugs was down two-thirds or more. Excluding these drugs, sales would have been up $770 million, or 4.6%

- Earnings were $3.21 billion, or $1.15 per share, compared to $3.33 billion, or $1.17 per share a year ago

- The company confirmed its 2009 forecast of $4.45 to $4.55 per share, excluding items

Analysts expected $1.11 per share on revenue of $15 billion. As of 12pm today, the stock was up $0.28 to $58.

Other factors that impacted earnings included

- global recession

- unfavorable currency exchange rates, which cut total revenue by 6%

- Cuts in spending of 13% on sales, administration and research, and 6% in production costs

By product area, pharmaceuticals sales fell the most, by 13%; consumer products were up operationally, but down due to exchange rates, leading to a decline of 4.5%; and medical devices fell 3.1%. In consumer products, some sales were also affected by the switch to private label brands.

Recently, JNJ also made investments in Cougar Biotechnology for a prostate cancer drug and took a stake in Elan Corp for an Alzheimer’s drug. The FDA also recommended reducing dosage of Tylenol, a drug that brings in $1 billion a year for Johnson and Johnson. About half of the $1 billion is related to the extra-strength 500-milligram dose, the dosage that would be affected.

The Stock. Consensus estimates are $4.51 for December 2009 and $4.88 for December 2010. Based on today’s current price of $58.15, that would be 12.9x 2009 earnings and 11.9x 2010 earnings. Current estimates imply 8% growth year-over-year, and the current dividend is 3.4%.

Historically, the stock has traded in the 17-18x range in the last few years, and in the low to mid-20s before that. On a PE basis, JNJ is trading at historical lows.

There is no question that this is a quality company; its track record speaks for itself. Over the next year, we can expect the recession and currency issues to continue to affect earnings. Moreover, it may take some time for new drugs in the pipeline to boost sales. If JNJ hits its targets, we would have 8% growth plus a 3.4% dividend for a 11.4% return. To get a higher return, we’d have to see an expansion in the PE, something which may not occur this year, but is more likely to occur in later years as the economy rebounds and JNJ comes closer to harvesting its pipeline. So all in all, a respectable stock for a conservative portfolio, but don’t expect any fireworks soon.

The Coming Week - July 13, 2009: Earnings at the Doorstep

So earnings really starts in earnest tomorrow, Tuesday, as Goldman Sachs reports. Other key companies reporting are Intel, Dell and CSX tomorrow; Best Buy and Yum on Wednesday; and Bank of America and General Electric on Friday.

Goldman will set the tone for the week. I fully expect Goldman to beat, and this morning, Meredith Whitney’s positive call on Goldman set off a 185 point rally in the Dow and a 22-point rally on the S&P. The rally also helped the S&P bounce off a key technical resistance level of 874.

The rally in Goldman sets up a bump in the stock going into earnings, and depending on how much Goldman beats by, there could be either a little more after earnings, or a sell-off on the news. There is a fair segment of the market that will argue that Goldman’s performance will be a one-time event, and that keeping it up through the rest of the year will be hard to do. I remain a long-term bull on Goldman, and do expect the company to beat earnings for the year. So I would look at any dip or sell off as a buying opportunity. My thesis is two-fold: first, Goldman makes money any time money is raised. So as long as there is activity, Goldman will be a beneficiary, either as a facilitator of equity raises, debt financing or even principal investing. Second, Goldman, as one of the last investment banks standing, will benefit from the fall of Lehman and Bear, and the flight of high-paid bankers from the remaining competitors. I see Morgan Stanley in a similar vein, although not as much of a risk-taker as Goldman. As one pundit called it, Morgan Stanley is Goldman Sachs light.

As for the other major banks – JP Morgan, Wells Fargo and Bank of America – they will all benefit from mortgage refinancings and restructurings, as well as from government support. Accounting changes may also benefit these banks. The commercial side should be weak, but the investment banking side (Wells will probably benefit the least, but Wells is planning on beefing up that side) should do well. Finally, the sale of assets, such interests in China Construction Bank, could bump earnings as well. On the downside, the repayment of TARP and share dilution will counteract some of these pluses. All in all, there’s a lot of “stuff” in this quarter’s numbers. I personally think that overall, the banks, in the short term, will not be terrible, and may even give some strength to the market.

In other sectors, we’ve lost the oil trade for the time being, and I don’t expect any earnings reports to be catalysts for the commodities market. Gold is weakening, and many believe that gold is headed toward the 880 range. The consumer will remain weak, and I find it unlikely that industrials will see a recovery around the corner. So at least, barring a surprise, I don’t see any short-term, predictable catalysts for commodities.

Tech remains an area of interest. In certain parts of the market, we have product cycles driving sales – smartphones (Apple, RIMM) and computers (Windows, Intel, etc.). Today, Dell put a damper on that product cycle by saying that Q2 margins will be lower and that customers are delaying purchases. Not a good sign, but it’s not yet clear whether that will be indicative of the next couple quarters. In conclusion, I think, of the stocks mentioned, Apple has the strongest product cycle, driven by iPhones and iMacs. I do think the Windows product cycle will give some lift to these stocks, although how much remains to be seen.

Otherwise, the remainder of earnings season should be mixed. Once we get past Goldman’s numbers, we will get some positives (perhaps the banks), but some negatives, like Dell today. Which way the market will go remains indeterminate, in my opinion, but now market direction is less important than picking winning stocks.

I am long Apple, Intel, Dell, Goldman Sachs, Morgan Stanley and Bank of America.