Time of Greed

"It's Too Expensive to Be Defensive" is the headline in today's Breakout on Yahoo Finance.

Insurance is a wonderful thing — especially when you need it. But it's definitely not free. In fact, the cost of protecting your assets in the stock market has become really expensive, which is why some investment pros are of the mind that the cost of protection just isn't worth it anymore.

The cost of insurance for stocks is put options. With volatility low, that cost remains quite reasonable. However, the author is of course referring to the opportunity cost of not investing, instead of the costing of insuring the downside of an invested portfolio. That cost had certainly been very high for the past few months.

"It's too expensive to be defensive." But too expensive for whom?

Does it mean not investing or under investing will be costly in terms of clients' portfolios? Or does it mean the asset manager will lose his job because he is under-performing? Here lies the conundrum for professional fund managers. Not investing is simply not an option.

I am certain that most investors have heard the famous quote from Warren Buffett, "Be greedy when others are fearful. Be fearful when others are greedy." It seems we have once again entered the time of greed. It proves once again how hard it is to actually implement the wisdom of the the most famous investor. Judging by the speeches of his recently concluded annual meeting, the doctor is also having a tough time heeding his own advice.

Apple Issues Debt

Apple was in the market yesterday to sell a record amount of bonds in 6 different tranches, including floating rate notes of 3 and 5 years and fixed rate papers of 3,5, 10 and 30 years in duration. For a company with $145 billion in cash on the balance sheet, why would it even consider issuing bonds? The reason is of course most of Apple's cash is sitting overseas and can't be easily repatriated without adverse tax consequences. So to return money to shareholder, Apple has to resort to the bond market.

NEW YORK (AP) -- Apple Inc. sold $17 billion in bonds Tuesday in a record deal spurred by the company's plan to placate its frustrated shareholders.

The Cupertino, Calif., company sold the bonds in its first debt issue since the 1990s to raise money to pass along to shareholders through dividend payments and stock buybacks. The payments are part of an effort to reverse a 37 percent drop in Apple's stock price during the past seven months amid intensifying concerns about the company's shrinking profit margins as it faces more competition in a mobile computing market that Apple revolutionized with its iPhone and iPad lines.

Apple has $145 billion in cash, more than enough for the $100 billion cash return program it announced last week. However, most of its money sits in overseas accounts, and the company doesn't plan to bring it to the U.S. unless the federal corporate tax rate is lowered.

With interest rates so low, it makes sense for Apple to borrow a large sum of money rather than pay a big tax bill.

Apple bonds are well received by the market place. All the papers are currently trading at a slight premium to the issue price. For example, Apple's 10 year 2.4% bond is trading at 100.4 to produce a yield to maturity of  2.36%. While Apple is AA+ rated by S&P, its bond is actually trading at comparable yield to the AAA rated Microsoft. For those who are chiefly concerned with principle risk, I think the AA- rated IBM bond presents a slightly more attractive option. Its 7% 2025 bond trades at 142 and has a yield to maturity of 2.93%. On balance sheet strength and leverage ratio, IBM certainly looks weaker than Apple or Microsoft. However, one may very well argue that even though the short and intermediate term security of Apple is very high, its long term prospect carries greater uncertainty than IBM. Apple's products carry short refresh cycle and must rely on constant innovation just to stay relevant. With a few missteps, Apple is not far from becoming RIM or Nokia.

However, for those who are not only concerned with principle risk, but also the risk of diminishing purchasing power, it seems the stocks of IBM and Apple offer much more compelling risk and reward than their fixed income counterparts. In fact, even after a significant rally, blue chip stocks in general offer dividend streams comparable to highly rated corporate bonds. The deciding factor that favors stocks over bonds is due to the fact that dividend streams grow over time.

It is Real Money

IBM is the owner of one of the most resilient business models in information technology. Over the past few decades, it has gradually transformed from a hardware company to a software and service focused company. It is also the business model the likes of HP and Dell aspire to. No wonder it has become one of the few tech companies found in Warren Buffett's portfolio.

On Friday, the stock of IBM was down over 8% after a less than stellar earnings report. The disappoints came mainly due to the effect of a weaker yen and delayed software sales. CNBC published an article detailing the amount of loss at Berkshire due to IBM.

It's been a tough week for Warren Buffett's big investment in IBM (IBM).

Big Blue's stock plunged 8.3 percent Friday to $190 per share after the company reported disappointing first quarter revenues.

According to its most recent portfolio filing , Buffett's Berkshire Hathaway (BRK-A) owned 68.1 million IBM shares as of the end of December.

Assuming Berkshire's stake is still around that size, Friday's slide cut the value of those shares by $1.168 billion to $12.94 billion.

That's on paper, of course. Berkshire won't actually lose any real money until it sells the shares, and given Buffett's buy-and-hold track record that won't happen until years from now, if it happens at all.

When the price of a stock one owns trades down, that is often called "paper loss." When a stock is sold at a loss, that is called "realized loss." However, both forms are losses of real money, as real as if your bank accounts had been hacked and as real as if Warren Buffett had lost his wallet containing $1.2 billion. In Behavioral Fiance, the term anchoring refers to making decisions based on irrelevant information. It is precisely a commitment of anchoring when investors allow the purchasing price to effect one's sell decision. Long term investing involves the assessment of a company's intrinsic value. When the intrinsic value is above the current price of a stock, the long term investor would sell. Short term investing involves the study of a company trading momentum and technical factors. The purchasing price is relevant in neither process.

So Much Expected So Little Delivered

Amid the more headline grabbing data of weak retail sales and consumer sentiment, the US Labor Department released March Producer Price Index. Here is a report from Reuters.

The Labor Department said its seasonally adjusted producer price index fell 0.6 percent last month, the largest drop since May, after increasing 0.7 percent in February.

Economists polled by Reuters had expected prices received by the nation's farms, factories and refineries to fall only 0.2 percent. 

In the 12 months through March, wholesale prices were up 1.1 percent, the smallest rise since July. Prices had increased 1.7 percent in February.

Underlying inflation pressures also were muted, with wholesale prices excluding volatile food and energy costs rising 0.2 percent for a third straight month.

With central bankers around the world working overtime in the quest of greater currency production, it has been widely predicted for a very long time that inflation will eventually pick up. However, eventuality does have a habit of toiling with her pursuers and is never in a hurry to arrive. The liquidity that has been created with extreme low interest rate has flown mostly into supporting asset price instead of increasing consumption. In turn, the elevation of asset price is justified by the sustainability of low interest rate. By policy, the US Federal Reserve controls in short end of the interest rate curve and now quantitative easing, it also exerts the greatest influence on the long end. The Feds have stated very clearly that the ending of QE depends on two variables, inflation and unemployment rate. With unemployment rates still high and inflation under control, the foundation of the bull market remains intact.

Debate Within Fed

The March FOMC meeting minutes were released early today which showed active debate among Fed officials on the fate of $85 billion monthly bond purchasing program. Here is a report from the Wall Street Journal.

The minutes, which were released early Wednesday rather than in the afternoon as usual, showed that "all but a few" Fed officials agreed at the central bank's last policy meeting that they wanted to keep the program going "at least through midyear." But after that, officials had a wide range of views about how they might proceed.

Some at the March meeting felt the Fed would be able to begin tapering the program down around midyear. Others saw the Fed continuing through September before tapering down, and a few wanted to keep the program going at its current pace through 2013 and into 2014. Some also held out the possibility of increasing the program if the economic outlook deteriorates.

As the meeting was held on March 19 and 20, data released after the meeting have generally showed that economic conditions have mostly softened. Thus, strengthening the argument for those who want to extend and even expand the quantitative easing program. That is of course why the stock market is once again reaching new heights and the Fed minutes were all but ignored.

Onto the Fed wagon, stocks have hitched a ride. In Fed we trust that where ever the wagon goes, there shall be no roads that the Fed can't not navigate. Amen!

 

 

Measure of Greatness

In his typical well thought out piece posted on Pimco's website last week, Bill Gross pondered the age old relationship between epoch and her heroes. For those who enjoy a bit intellectual self reflection, the entire article is well worth reading, so here I quote at length.

So time and longevity must be a critical consideration in any objective confirmation of “greatness” in this business. 10 years, 20 years, 30 years? How many coins do you have to flip before a string of heads begins to suggest that it must be a two-headed coin, loaded with some philosophical/commonsensical bias that places the long-term odds clearly in a firm’s or an individual’s favor? I must tell you, after 40 rather successful years, I still don’t know if I or PIMCO qualifies. I don’t know if anyone, including investing’s most esteemed “oracle” Warren Buffett, does, and here’s why.

Investing and the success at it are predominately viewed on a cyclical or even a secular basis, yet even that longer term time frame may be too short. Whether a tops-down or bottoms-up investor in bonds, stocks, or private equity, the standard analysis tends to judge an investor or his firm on the basis of how the bullish or bearish aspects of the cycle were managed. Go to cash at the right time? Buy growth stocks at the bottom? Extend duration when yields were peaking? Buy value stocks at the right price? Whatever. If the numbers exhibit rather consistent alpha with lower than average risk and attractive information ratios then the Investing Hall of Fame may be just around the corner. Clearly the ability of the investor to adapt to the market’s “four seasons” should be proof enough that there was something more than luck involved? And if those four seasons span a number of bull/ bear cycles or even several decades, then a confirmation or coronation should take place shortly thereafter! First a market maven, then a wizard, and finally a King. Oh, to be a King.

But let me admit something. There is not a Bond King or a Stock King or an Investor Sovereign alive that can claim title to a throne. All of us, even the old guys like Buffett, Soros, Fuss, yeah – me too, have cut our teeth during perhaps a most advantageous period of time, the most attractive epoch, that an investor could experience. Since the early 1970s when the dollar was released from gold and credit began its incredible, liquefying, total return journey to the present day, an investor that took marginal risk, levered it wisely and was conveniently sheltered from periodic bouts of deleveraging or asset withdrawals could, and in some cases, was rewarded with the crown of “greatness.” Perhaps, however, it was the epoch that made the man as opposed to the man that made the epoch.

Suppose we gather the population of the world and engage in a single elimination coin tossing contest. Those who keep throwing heads may continue and those who throw a single tail are eliminated. We shall crown the eventual winner or winners who have perhaps tossed 35 or so heads in a row, as the coin tossing king. Perhaps a whole industry will develop around the coin tossing techniques of those winners. The initial velocity of the toss, the angle of ascend and spin rate will all be analyzed to ensure the desired outcome. The advanced coin tosser may even consider subtle adjustments after studying ambient temperature or air moisture content.

Are what we consider to be great investors in fact great at finding investment winners? Alternatively, are they merely great because of the chance meeting with lady luck like our coin tossing champions?

As investment professionals, our craft is by nature a statistical endeavor. As a result, investment greatness can only be reasonable suspected over a long period of time and may never be assured even over a lifetime of accomplishments. Even within the epoch of credit expansion and general economic growth, many have over-levered themselves and thus failed to survive episodic credit crunch and general panic. Some become so tethered to a thematic outcome and failed to consider the very basic nature of supply and demand and competition. And most still toil in mediocrity and prefer the safety of the herd. Mr. Gross with his investment tenure and record has certainly distinguished himself and I personally believe his image is firmly established within the pantheon of great investors. Consistent and sizable out-performances over long time frame even within a single epoch are accomplishments claimed by very few. 

Stockton Syndrome

Yahoo Finance's Daily Ticker show spoke of the latest ruling by a federal judge allowing the city of Stockton to proceed under bankruptcy protection.

A federal judge earlier this week gave the green light to Stockton, Calif. to restructure under bankruptcy protection despite protests from creditors. The Wall Street Journal reports the judge signaled that Stockton may have to cut payments to its pension fund, which could set a precedent for other cities. The fight also has pitted California’s pension system, CalPERs, against other bondholders and the Wall Street firms that insure them.

“This really hasn’t happened before,” Matt Fabian, managing director of the Massachusetts-based Municipal Market Advisors, tells The Daily Ticker. “We are further along the road toward some potential haircut for bondholders. In all the bankruptcies that have happened in modern history, there haven’t been any haircuts for regular government bondholders – in general people have always gotten their principal back.”

In muni investing, sounds like one should be shifting to essential service revenue bonds from general obligation bonds. Personally, I have always had a bias against government or quasi-government type of bonds whether it is issued by a country, a city or an Indian reservation. The analysis of such bonds invariably involves accessing the will to pay in times of distress by the leaders of such entities as it is impossible to repossess a city or a country. In contrast, mortgage bonds or corporate bonds are much more dependent on underlying asset value. I find it much easier to access asset value than will power.  

Miss at F5 Networks

Among networking companies, F5 Networks has been a great performer delivering superior revenue growth and consistent margin. With its proprietary traffic management approach, it has competed successfully with the likes of Cisco in the application delivery controller market. However, last night it uncharacteristically pre-announced a large revenue and earnings shortfall.

NEW YORK (AP) -- Shares of F5 Networks Inc. tumbled before Friday's opening bell after the company cut its outlook for the January-March quarter, citing disappointing results from its North American business.

Seattle-based F5, which sells information technology and networking equipment and services, said telecommunications contract bookings dropped compared with the October-December quarter and the same period in 2012. Revenue from business with the federal government also fell.

The main culprit of the shortfall appears to be the company's North America business. The launching of multiple new products certainly lengthened the sales cycle and contributing to the miss. Not to be overlooked, the federal government business was also extremely weak. The market had essentially declared the sequester as a non-factor; however, as earnings season commences in earnest, we will find out if it is so. I will be very weary of companies with large exposure to the government vertical. 

 

Jobs Friday

News release from the Bureau of Labor Statistics showed US payrolls rose by only 88,000 in March and jobless rate declined slightly to 7.6%, compared to economists forecast of 200,000 additional payrolls and 7.7% unemployment rate. The ADP report on Wednesday had already foreshadowed a slowdown in the labor market; however, the magnitude of the this miss is still noteworthy even given the volatility of initial release of nonform payroll figures. Understandably, stock futures are trading off.

One interesting tidbits in the news release has to do with labor force participation.

The civilian labor force declined by 496,000 over the month, and the labor force participation rate decreased by 0.2 percentage point to 63.3 percent. The employment-population ratio, at 58.5 percent, changed little.

Hypothetically speaking, if labor force continues to decline, even with the subdued job creation, we may get to the magical 6.5% unemployment rate that Fed promised that they would cease the quantitative easing program. That may present an interesting dilemma for the Fed.

Waiting For Friday

At the beginning of each month, investors dutifully pay homage at the temple of ADP and Bureau of Labor Statistics. The fact that the Federal Reserve picked unemployment rate as one of  the conditions for ceasing its quantitative easing operation marks the importance of jobs report. Today, the just released ADP report as reported by CNBC showed job creation below expectation.

Private-sector job creation was considerably less than expected in March, indicating that the labor market's improvements could begin stalling.

A joint report Wednesday from ADP and Moody's Analytics showed 158,000 new positions, well below economist expectations of 200,000.   

The report serves as a precursor to Friday's nonfarm payrolls report, so the miss could cause economists to lower their projections.

"I'm very optimistic about the economy but I think the next six months are going to be pretty tricky and we're going to see that in the job market," Moody's economist Mark Zandi told CNBC. "So I think we actually will see weaker jobs numbers in the next few months."

Stocks are selling off modestly after the report. For the past few years, economic activities have followed a notable pattern of strength at the beginning of each year and only to taper off in the summer months. The performance of stock markets have also generally showed greater upward vigor at the ends of each year compared to the middle. The relatively weak showing of March employment figure as measured by ADP certainly invites speculation that such patterns are still holding. However, this modest pace of economic activities in fact have served stocks well as the timeline for Federal Reserve's easy money policies may yet be extended again.

Now, let's see what the official jobs report from the Bureau of Labor Statistics will bring this Friday.

The Value of Gold

A child of Zeus, neither moth, or rust devoureth it, but the mind of man is devoured by this supreme possession.
                                Pindar, 5th century BC Greek poet, describing gold.
 

After two decades of nearly continuous appreciation, the price of gold topped in August of 2011 at 1889.7 an ounce and have since retreated to the 1600 per ounce level. However, interest in the shining yellow remain high. Tuesday, on CNBC's "Future Now" program, RBC precious metal strategist spoke of the misconceptions of gold.

Gold is one of the most widely held financial assets - but that doesn't mean everyone understands the catalysts that drive gold higher or lower. On Tuesday's "Futures Now," RBC Precious Metals Strategist George Gero set out to clear two of the biggest misconceptions people have about gold.

Misconception One: If Gold Falls for a While, That Gives You a Good Chance to Buy It

This one sounds pretty obvious. Gold is worth a given amount, so if people keep selling it, than it will fall to a level at which it's a good value - right?

Well, not exactly. As Gero explains, "Asset managers look for performance - and performance has not been with gold." This explains why the major stock market rally has presented a serious headwind for gold. As stocks have seriously outperformed bullion, managers moved their money out of bullion and into what was working.  

That's why trends in the gold market can be far more important than any sense of inherent value - meaning that, paradoxically, falling gold prices are bad news for people who are looking to buy in.

Whatever merits or lack there of are in what the "expert" had to say, is not the object of this post. However, the assertion that professional asset managers who try to profit from changes in the value of gold had nothing better to go on other than the price of gold itself speaks loudly to the nature of the value of gold. Financial assets derive their value from actual and potential cash flow. Holding gold generates none. In this sense, gold doesn't even qualify as a financial asset. Gold is a good, much like food and shelter which derive their value from utilities. Gold serves primarily two functions, one as adornment and the other as media of exchange or money.

Gold is used as jewelry. The reasons are of course self evident. However, gold also serves its other purpose better than any material in the world. Gold is found on every continent, yet rare enough and hard enough to dislodge from the rocks that surround it to be valuable. Gold is inert, malleable and infinitely divisible. Other materials have been used as money throughout history, but none more universally recognized and successful as gold. So in gold, not only lies the perfect attributes of money, but also the brand equity of universal acknowledgement.

On this earth, there are two universal currencies, gold and the US dollar. Gold priced in US dollar has been stalled because the US dollar has been strengthening against other major earthly currencies such as the Euro and the Japanese Yen.

Who is Jeroen Dijsselbloem

Jeroen Dijsselbloem, a name investor better get used to, made news yesterday by saying the Cyprus bank recapitalization plan serves as a template for future Eurozone bank rescue plans.

(Reuters) - A rescue programme agreed for Cyprus on Monday represents a new template for resolving euro zone banking problems and other countries may have to restructure their banking sectors, the head of the region's finance ministers said.

"What we've done last night is what I call pushing back the risks," Dutch Finance Minister Jeroen Dijsselbloem, who heads the Eurogroup of euro zone finance ministers, told Reuters and the Financial Times hours after the Cyprus deal was struck.

 

"If there is a risk in a bank, our first question should be 'Okay, what are you in the bank going to do about that? What can you do to recapitalise yourself?'. If the bank can't do it, then we'll talk to the shareholders and the bondholders, we'll ask them to contribute in recapitalising the bank, and if necessary the uninsured deposit holders," he said.

Later on, Mr. Dijsselbloem attempted to retract his statement by tweeting that Cyprus was merely a "specific case." One can only guess if his recantation was made after seeing markets trade off after his comment or because the template idea was only his own thought, not the consensus among European finance minsters. Arguable, Mr. Dijsselbloem's slip was much less damaging than his predecessor, Jean-Claude Juncker, who famously quipped,"when the going gets tough, you have to lie." However, Mr. Dijsselbloem must quickly learn that the markets hates surprises. If Cyprus were to serve as the template, then by all means let the market know and be prepared. If it is indeed a "specific case," those in charge must be adamant even if you are not so sure you can really guarantee such outcome.

Meanwhile, in the US, home prices are up and durable goods orders were robust. As the world burns, will the power of US consumers extinguish the flames abroad or will the US economy fall victim to world contagion? Many have offered guesses, but only time can tell.

Experts on Cyprus

Upon hearing the last minute deal for the re-capitalization plan for the two troubled Cyprus banks, a Reuters article optimistically declared,"Cyprus deal to bring US stock rally, experts say."

The last-ditch effort to save the banking system in Cyprus should bring a rally when U.S. stock markets open on Monday, according to several investment managers.  

Cyprus secured a 10 billion euro ($13 billion) package of rescue loans in tense, last-ditch negotiations early Monday, In return for the bailout, Cyprus' second-biggest bank, Laiki, will be restructured, and holders of deposits exceeding 100,000 euros will have to take losses.

It was unclear just how big of a hit big depositors will have to take, but the tax on deposits was expected to net several billion euros.

U.S. investors won't care too much about who takes losses in Cyprus, as long as there's a bailout that stops the run on banks in the Mediterranean island nation and keeps the eurozone stable, said Karyn Cavanaugh, market strategist at ING Investment Management in New York.

"If this works out, regardless of the terms, this is going to be good for the market," she said Sunday night.

Around 10:40 AM east coast time, as the market turned negative, another Reuters article delivered the not so optimistic news, "Stocks cut gains, Dow turns negative."

NEW YORK (Reuters) - Stocks cut their gains on Monday, with the Dow turning negative as initial optimism over a deal to keep Cyprus afloat faded.

What has been called a rescue package were in fact a recapitalization package. The aid from EU to Cyprus were to be used for fiscal control, not bank rescue. The banks were recapitalized with money seized from uninsured depositors. The new capitalization plan merely shifted the source of seizure from both insured and uninsured depositors to uninsured depositors alone. The new plan achieved the goal of protecting small depositors, but will not succeed in the objectives of maintaining Cyprus's business model of international destination for attractive Euro deposit and the capital flight from Cyprus banks for those depositors who are not forcibly tethered by capital control. The idea that depositors including insured depositors can be seized has been released. It can not be put back into the bottle again. Should the financial condition of another European peripheral nation take a turn for the worse, bank depositors will remember that speed means safety.

  

 

 

The Cyprus Breach

Stocks around the world reacted negatively to the proposal by Cyprus government to impose losses on depositor in order to bail out the two most troubled banks. Here is just one report from the Wall Street Journal:

U.S. stocks followed overseas markets lower as a Cyprus bank-deposit tax sparked renewed fears about Europe's debt crisis.

The Dow Jones Industrial Average was down 38 points, or 0.3%, to 14376 in midmorning trading. The Standard & Poor's 500-stock index dropped eight points, or 0.5%, to 1553 and the Nasdaq Composite Index shed 16 points, or 0.5%, to 3233.

The euro tumbled versus the dollar. The price of the 10-year U.S. Treasury note surged as investors sought haven assets, pushing the yield down to 1.949%. 

So far the US investors have acted more nonchalantly than their Asian counterparts where Nikkei closed down 2.7% and Shanghai was off by 1.7%.  We may casually dismiss the importance of Cypress as an economy, but the coherence of the world today owes more to ideas than machinery. When the government of Cypress acquiesced to the German demand that depositors pay part of the bail out, it breached an idea that the governments around the world have instilled within the financial world since the days of great depression. idea is bank deposits are absolutely safe.

The widespread adoption of fractional banking system has provided ample fuel for the modern economy. The strength of such system lies with its ability to increase money supply and provide additional capital for your hungry entrepreneurs. As the Greeks had noted long time ago, the strength of most things also tended to be their inherent flaw. In a fractional banking system, no bank can meet the demand of redemption if sufficient depositors demanded them simultaneously. This flaw proved fatal for a large number of banks during the great depression. Even since then, government deposit insurances have propped up in various forms to protect depositors during time of distress. After 75 years, the disease of run on the bank has virtually been wiped out. So we thought.

The Cyprus Breach has once again raised the specter of bank run. If the Cyprus levy was indeed implemented, what is to prevent the depositors from taking their money out after the pilferage on the vary rational thought that this may not be a one time deal? What is to prevent depositors from yanking their money out of Spanish or Italian banks on the possibility that such practice may eventually be applied to them as well?

The Euro is now at a crossroad. The German's desire to punish the irresponsible is certainly understandable. However, the choices before them is either to shoulder the entire responsibility of bailing out their less assiduous brethren or time to declare failure on the Euro experiment.

The Cyprus decision will be a big deal.

Perfect 10

Stocks, of course, continue their hot streak. With gains today, the Dow Jones Industrial Average has now been up 10 days in a row. The titled "Dow Winning Streak Captivates Traders, Tests Statisticians" appeared on Yahoo Finance's Breakout segment.

By now you've surely heard that the nine-day winning streak on the Dow Jones Industrial Average (^DJI) is its longest since 1996. If it succeeds today in extending its run for a tenth day, it would be the 25th time it has achieved this feat in the past 70 years.

 

To gain the all-time longest streak title, the Dow Industrials will have to topple a 14-day streak set back on June 14, 1897, according to Rebecca Patterson of S&P Dow Jones Indices. The longest modern day streak was 13 days in January 1987.

Even though I am not a statistician, I would like to take a crack at the statistical problem of market streak. We know that on any given day, there is about a 2/3 probability of stocks being up and 1/3 probability of stocks being down.  We may ask given such probabilities, what are the odds of a 10 day up streak in a given year.

Since stocks go up 2/3 of the time on a given day, then the probability of stocks going up 10 days in a row should simply be (2/3)^(10), or 1.73% of the time. Let us also assume that there are 300 trading days in a year as a result, we have 291 separate 10 day periods. During the first 10 trading days, we know there is a 1.73% of chance stocks will all appreciate. However, if that fails to happen, it may then happen on the second 10 day period or from day 2 to day 11. The probability of that is the probability of streak failing on the first 10 days which equals to 1-1.73% or 98.27%, multiplied by the probability of 10 up days in a row or 1.73%. This yields 1.70%. Of course, if both of these scenarios don't work out, the streak could happen on the third 10 day period or from day 3 to day 12. The probability of that is the probability of first two scenarios both failing at 1-1.73%-1.70% or 96.57% multiplied by the probability of 10 up days in a row. So the odds of day 3 to 12 producing a streak after day 1-11 have failed is 1.67%. Thus, we can recursively compute the probability of all 291 10-day periods after all the proceeding periods have failed. By adding up all those possibilities, we can arrive at the probability of a 10 streak within a given year.

By my computation, the odds of a 10 day up streak for any random year is 99.38%.

Most readers are likely surprised by such high odds of streak. I recall reading a professor (sorry for the lack of source) who asked his students to toss a coin 10 times in a row and record their results. Those students who genuinely did the experiments were far more likely to record streaks of 3 or more in their data. Those who fudged their data most often did not contain such streaks. Rare events will occur given enough trials such as the same lottery number appearing consecutively. The fact that most people under-estimate such occurrences is the reason why this world in general and stock market in particular are full of myths and superstitions.

The Dow Jones Industrial Average only had 25 such 10 day streaks over the past 70 years, which works out to be a probability of only 35%. Furthermore, the longest streak is only 13 days. This to me indicates that stock returns are in fact serially correlated. What happened yesterday does have an impact on what happens today, which will impact what will happen tomorrow.

VIX and Stock Market Performance

As the stock market spiking to new heights, the volatility index, being inversely correlated with stock indices, has been descending to new lows. Today, it took an 8% tumble and fell to 11.56. It is the lowest close since February 26, 2007. As luck would have it, on the very next day, February 27, 2007, S&P 500 fell 3.5% on concern over slowing growth in China, which was then the growth engine of the world economy. Those who would like a refresher on that fateful day six years ago, can read this article from CNNMoney.

The fact that the VIX is at a six year low worries many market participants. We all know that volatility index is inversely correlated with stock indices. So as low volatility inevitably revert to the mean, there must be a subsequent drop in stock price. To assuage my own uneasiness, I downloaded the historical VIX data from Yahoo Finance and decided to find out what actually happened when VIX had fallen to such low levels.

There had been 5844 trading days since Jan 2, 1990. There were 372 days on which VIX closed between 11 and 12. VIX closed between 10 and 11 on 106 days and below 10 on only 9 occasions.
During those 22 plus years, in any given 90 days, there is a 33% chance that S&P 500 would record a negative price return. For 45 day periods, the odds of negative return for S&P 500 increased slightly to 36%. On the day that VIX closed between 11 and 12, there were a 31% chance of S&P 500 incurring a loss during the next 90 days and 28% chance of such events for the next 45 days. For VIX closing between 10 and 11, the odds of loss over the next 90 days was 17% and over the next 45 days was 31%. So the empirical results did indicate that on days VIX closed at a level between 10 and 12, the subsequent returns were in fact not worse off compared to any random days.

It was indeed very rare for VIX to close below 10. On the 9 occasions that it did over the past 22 years, the subsequent 90 day return were negative on 5 of them and positive on only 4, which meant the odds of adverse development is over 50%. For 45 day returns, there were 6 negative occurrences and only 3 positive ones. However, for the 90 day periods, the average of the negative returns was about 4% and non of the returns was worse than 5%. These were hardly calamitous. Furthermore, of the 9 days VIX closed below 10, there were really only two clusters. All the single digit VIX numbers were produced either during the end of 2006 and beginning of 2007 and the end of 1993 and the beginning of 1994. So we really only have two data points from which no statistically meaning conclusion can really be drawn.

When market is doing well and investors are calm, VIX is low; when market is in turmoil and investors are nervous, VIX is high. These are simply two different aspects of the market and even though VIX is inversely correlated with stock indices, history shows that one can not use VIX to predict market return. Just as rainy days and sunny days are two different types of weather conditions, the fact that sunny days inevitably follow rainy days, does not make rain a predictor of Sun since rain itself can not forecast the during of rain thus the subsequent ascent of the Sun. In the market, turmoils do always follow calm, but we can not use calm to predict turmoil as calm can last for a long time. So VIX as a market timing tool is simply not all that useful.

Retail Anecdotes

Of the retailers reporting same stores comparisons or quarterly earnings today, the results seem to be mostly negative. Ross Stores, a discount clothing retailer, reported tepid same store sales growth that missed wall street estimate.

NEW YORK (MarketWatch) -- Ross Stores Inc. said Thursday that its February same-store sales fell 1% after a 9% gain a year earlier. The most recent month's result missed the 1.1% increase analysts surveyed by Thomson Reuters were looking for. "We believe the slight decline in February same store sales was mainly due to the delay in income tax refunds," said Chief Executive Michael Balmuth.

In addition, Big Lot, another discount retailer reported a good quarter beating Wall Street estimates, but indicated that current quarter sales have been challenging. Shoe Carnival, a discount retailer of footwear, reported 4th quarter results and stated that sales suddenly fell during the last 2 weeks of January. PetSmart, which has appreciated 50% over the past 2 years on strong sales and earnings growth, also allowed forward sales guidance in its earnings announcement.

It seems that the effect of high payroll tax and the delayed tax refund due to government operating under continuing resolution are starting to wield its effect. Going forward, we will also have the additional headwind of the gradual implementation of the sequester to contend with. The profitable trade in stocks continues to be buying Bernanke and selling Washington.

Boundary Value Problems and Equity Valuation

One of my favorite classes in college was boundary value problems. It was essentially about solving differential equations under certain constraint. For example, if you stick one end of a steel rod into a giant bath of boiling water, the temperature of that end must adapt to equal the boiling point of water. That would be out fixed boundary. The heat from the water bath would gradually travel lengthwise to the rest of the rod and effect its temperature as well. Since the rest of the rod is exposed to the normal environment, an equilibrium is reached when the temperature is such that the heat supplied by the hot bath equals the heat dissipated to the normal environment.

As Dow has crossed its historical highs and S&P is nearing such a feat, there is a palpable nervousness among investors and pundits alike. Today, the entire financial market is immersed in the fixed boundary of zero interest rate. Slowly but surely, the asset value levitating effect is permeating to the rest of the investment world.

The business of private equity is essentially capital arbitrage. They take advantage of cost of capital differential between equities and bonds. When fixed financing is abundantly available at a cheap rate, private equity transactions will be most active. That equities, despite reaching new heights, are cheap compared to bonds is evident by the increasing PE activities. The large deals like Dell and Heinz of course catch most of the attention. But smaller deals is also happening. Today, teen retailer Hott Topic is being acquired by Sycamore Partners.

Normally, bond investors tend to be more conservative as bonds have limited upside and 100% downside, while stock investors are more sanguine as stocks have unlimited upside. Today, the opposite is true. Bond market is trading at the level it is at not because bond folks have lost their minds, it is because the boundary conditions imposed are so overwhelming. In mathematics, fixed boundary is assumed to lessen the complexity of the ensuing equation. In the real world, powerful forces tend to have powerful side effects. This is why equity investors are so nervous.

The Next Decade

Today, the headline on CNBC's website cheers "Dow Smashes Record: End of the 'Lost Decade'?"

Since the burst of the tech bubble in March 2000, stocks of course have shown investors the most stingy of returns. Hence, the past dozen of so years have been loosely dubbed the "lost decade." But the decade is only lost in the narrow sense of equity investments. In the world of bonds, commodities and real estate, it is anything but lost. Bonds of every kind, Treasury, high grade corporate, high yield and emerging market, all thrived. Oil, Copper and Gold have all enjoyed significant appreciation. Even Real Estate, despite the drubbing it received during the 2008 financial crisis, still sits on a much higher plateau than the start of 2000.

More aptly, the decade of 90's is the equity decade; the decade of 2000's is the bond decade; the decade yet to come will, I believe, be the lost decade.

To suppress interest rate is to raise asset value. To raise asset value without commensurate rise in cash flow beyond the rate of inflation is to suppress real future return. To buy a 10 year Treasury bond at 1.9% yield is to lock in a return of 1.9% over the next 10 years. That is the very definition of a lost decade. Equities do have a fighting chance as the possibility of technological advancement and productivity gains could propel corporate earnings growth speedy enough to justify current level of valuation or compensate for a somewhat lower level of asset value.

For the past 30 or so years, investments in general have enjoyed relatively healthy gains thanks in part to the tailwind of receding interest rate and upward leverage of both governments and consumers. For the decade to come, we will see at best flat interest rate and possibly a rising rate environment. Governments and consumers alike are now de-leveraging. As a result, the decade to come will prove to be difficult of assets of all classes.

Market Pullback Ahead?

Sam Stovall, the well respected chief strategist at S&P Capital IQ, was on Yahoo Finance's Breakout segment and pronounced that stock market will likely have a 5-10% modest pullback.

"You're better off watching for a tsunami than you are an earthquake because the lack of volatility usually indicates that it's a matter of when, not if, we're going to have a market decline of 5% or more," says Sam Stovall, the chief equity strategist at S&P Capital IQ, in the attached video. The good news, however, is that although we're overdue for a shakeup, he says "I don't think it's going to turn into a bear market."

He says, a check of economic, monetary, sentiment, earnings and more all suggest a shallower, more subtle pullback is in store, rather than something more sinister.

Thus, Mr. Stoval joins a chorus of pundits calling for a modest decline including Liz Ann Sonders of Charles Schwab, who stands out for her modesty and composure among the pantheon of market prognosticators who clamor for your attention. Here is what she wrote:

Headwinds have reemerged and investor concern is heightened yet again. We still believe stocks can run further, but a pullback is more likely in the near-term. 

My investment experience is perhaps modest compared to some of the strategists out there. It did however encompass 20 years, including both bull and bear markets. I have come to believe that a pullback of 5-10% can happen anytime in the stock market. Those of us in the market long enough knows how difficult it is to predict future movements. However clairvoyant we may be, we have all been wrong so often that we start to speak of Mr. Market in personified and reverential terms as if it is the embodiment of wisdom. However, even those who profess such respects for the market can not constrain their desires to know her evanescent whimsy. If the market is to have a pullback and only to reverse course in short order, who are then the suckers selling into such ephemeral doldrums? It is difficult enough to predict a downturn, but to predict a downturn and a reversal seem to me have crossed some kind of boundary of modesty.

  

Risky Business

Joel, you wanna know something? Every now and then say, "What the heck." "What the heck" gives you freedom. Freedom brings opportunity. Opportunity makes your future.

That is a dialog between Miles played by Curtis Armstrong and Joel Goodsen played by Tom Cruise in the 1983 movie "Risky Business." The original quote of course used certain other four letter word which has been changed for the purpose of good taste. This might as well be the utterance of Ben Bernanke to Mr. Market.

Today, Mr. Market pretty much said "what the heck" to the so called sequester. The dysfunction of our national government in its failure to reach a sensible solution to our mounting debt problem did not seem to perturb the market much. Stocks was down perhaps for two hours in the early trading hours and by a little more than a half a percent. Then it merrily went its upward ways. Investors now seem to heavily vested in the idea of a Bernanke put. Whatever happens, the Fed will be there to rescue the market. For Joel Goodsen in "Risky Business," he was able to regain control of a chaotic situation and obtain admission to the college of his choice, not to mention the girl of his desire.

Will the easy money policy of the Federal Reserve spin out of control and lead to unforeseen consequences? Will investors be agile enough to exit the party when the Fed eventually takes the punch bowl away? The plot thickens.

Penney for My Thought

What percentage of success is attributable to luck and what percentage by design?

Ron Johnson, the new CEO of J. C. Penney and the man credited with the success of Apple Stores, so far seems to have met neither on his new job. The latest earnings report from Penney was a disaster, at least in the eyes of Wall Street. Here is how Reuter reports it.

(Reuters) - Shares of J.C. Penney Co Inc (JCP.N) opened 19 percent lower on Thursday after the department store operator reported its sharpest drop in sales since announcing a transformation plan 13 months ago.
  The results prompted at least three brokerages to cut their price targets on the stock, which has lost 48 percent of its value in the past year.

"We were most surprised by the more than 1,000 basis points decline in gross margins in the quarter," Deborah Weinswig of Citigroup wrote in a note, cutting her price target on the stock to $22 from $25.

Mr. Ron Johnson of course insists that turning around a long time failure like Penney is a multi-year project and he needs more time to execute on his new strategy. I have no basis of doubting Mr. Johnson's sincerity. However, it has been my general observation that in the world of business, predictions are never wrong; they are merely premature. Strategies are never erroneous; they always need more time. Here is a thought. Perhaps the success of Apple Stores have something to do with those iphones and ipads and less to do with selling said items on tables instead of counters. 

Bernanke to the Rescue

After a modest sell off, albeit one accompanied by a sharp rise in volatility, Mr. Bernanke once again rode to the rescue. Appearing in his semi-annual Humphrey Hawkins testimony to Congress, the Fed chairman re-assured the market.

 In the current economic environment, the benefits of asset purchases, and of policy accommodation more generally, are clear: Monetary policy is providing important support to the recovery while keeping inflation close to the FOMC's 2 percent objective. Notably, keeping longer-term interest rates low has helped spark recovery in the housing market and led to increased sales and production of automobiles and other durable goods. By raising employment and household wealth--for example, through higher home prices--these developments have in turn supported consumer sentiment and spending.

There in fact has been talks among the jittery wall street types that the Fed chairman may address the possibility of ending asset purchase sooner.  However, the effectiveness of monetary policy depend just as much on credibility as it is on setting interest rates. Whatever private concerns Mr. Bernanke may have, he has to maintain his unwavering public stance. It is clear that the Fed is trying to raise asset price to foster stronger economic activities. It will continue to do so until the stipulated bonds of inflation and unemployment rate have been breached.

Advice for investors: don't fight the Fed.

The Italian Job

Even since the release of Federal Reserve's January meeting minutes showing a few members' concerns of the long term consequences of QE, the stock market had acquired a downward bias. However, none of the subsequent trading days have showed such panic as today's closing hour. For the day, S&P 500 was down 1.8% and the volatility index rose 34%. The reason for such panic was attributed to election results in Italy. Here is a Reuters report explaining it.

The center-left coalition led by Pier Luigi Bersani won the lower house by around 125,000 votes and claimed the most seats in the Senate but was short of the majority in the upper house that it would need to govern.

Neither Grillo, a comedian-turned-politician who previously ruled out any alliance with another party, nor Silvio Berlusconi's center-right bloc, which threatened to challenge the close tally, showed any immediate willingness to negotiate.

World financial markets reacted nervously to the prospect of a government stalemate in the euro zone's third-largest economy with memories still fresh of the financial crisis that took the 17-member currency bloc to the brink of collapse in 2011.

Grillo's surge in the final weeks of the campaign threw the race open, with hundreds of thousands turning up at his rallies to hear him lay into targets ranging from corrupt politicians and bankers to German Chancellor Angela Merkel.

In just three years, his 5-Star Movement, heavily backed by a frustrated generation of young Italians increasingly shut out from permanent full-time jobs, has grown from a marginal group to one of the most talked about political forces in Europe.

Berlusconi's campaign, mixing sweeping tax cut pledges with relentless attacks on Monti and Merkel, echoed many of the themes pushed by Grillo and underlined the increasingly angry mood of the Italian electorate.

It has always been a worry for the market that how long the citizens of Europe's peripheral nations will accept the yoke of austerity. Regardless of how Italian election finally shapes up, the expanding influence of this anti-austerity block can not be denied. Mr. Grillo, who is the leader of the anti-austerity movement, wants Italy to hold a referendum to decide whether it should stay in the Euro zone. Of course, we are a long way from Italy leaving the Euro zone. But the existence of such a possibility has given the market a strong reason for pause.  

Is TI the New Model for Mature Tech Companies?

Amid the hoopla of the Dell buyout and the ensuing shareholder push back, the stock price of another Texas tech giant reached a 52 week high. In a press release last Thursday and a subsequent conference call on Friday, Texas Instrument outlined its new capital allocation strategy.

DALLAS, Feb. 21, 2013 /PRNewswire/ -- Texas Instruments Incorporated (TI) (NASDAQ: TXN) today said it will increase its quarterly dividend by 33 percent, from $0.21 per share to $0.28, payable May 20, 2013, to shareholders of record on April 30, 2013. Annualized, the new dividend will be $1.12. Additionally, TI authorized the repurchase of an additional $5 billion of its common stock bringing the total outstanding authorization to $8.4 billion.

These increases reflect the company's ability to generate cash and management's commitment to return it to shareholders. Over the past few years, TI has built a business model for growth and high margins with its focus on Analog and Embedded Processing semiconductors. As a result, TI believes it can consistently convert 20-25 percent of its revenue into free cash flow* and return 100 percent of that free cash flow (less debt repayment) to shareholders.

Much of mature tech giants today including Microsoft, Intel and Cisco are generating copious amount of free cash flow and seeing their cash holdings increase each quarter. Should these companies choose the lead of Texas instrument and pay out substantially all free cash flow, none will ever complain about an under-valued stock. Investors can only hope that TI is the new model.

Cisco and Heinz

Cisco reported earnings last night. Once upon a time, the market would move according to what Cisco reported or had to say on their earnings conference call. Today, it barely noticed. Instead, a much stodgier company grabbed the stage. Heinz was being acquired by Warren Buffett and Brazilian private equity firm 3G Capital for $72.50, about a 20% premium to previous day's close.

In late 2000, when I was a mutual fund manager canvassing around the country and ballyhooing the worthiness of my own special blend of stocks and bonds, I surveyed a roomful of financial advisers. If they could hold one stock, what would that company be? For their one and only Valentine, most advisers chose Cisco. Of course at the time, Cisco was trading in the high 60's and carried a PE multiple in the triple digits. Heinz, being a food company, of course was never showered with such affection during the growth crazed years of 1999 and 2000. In late 2000, it carried a price around $40 per share and a PE multiple of  16.

Fast forward 13 years ahead, Cisco had grown revenue from $18.93 billion in fiscal 2000 to $46.06 billion in fiscal 2012 for a compound annual growth rate of 7.1%. Earnings per share had grown from $0.39 to $1.50 during the same period for an annual growth rate of 10.9%. Heinz, on the other hand, had grown, revenue, also on a fiscal year basis, from $8.94 billion to $11.65 billion equating to 2.1% annual growth. EPS had grown from $2.51 to $2.87, a minuscule growth rate of 1% annually. Now for the number that  really matters to investors, at today's stock price of around $21, Cisco had lost more than 70% of its value and Heinz had gained more than 80% at the buyout price.

So for lesson #1, the stock market has a propensity to overvalue growth. Overpaying even a great company can have acutely negative consequences for your portfolio.

Even before today's $12 climb, Heinz at $60 was trading at 21 times it latest fiscal year end earnings while Cisco only sports a multiple of 14. Cisco is by no means an inferior business compared to the ketchup king. During the latest fiscal year, Cisco had a gross margin of 61% and return on asset of 8.8% while Heinz had a gross margin of 34.3% and return on asset of 7.7%. The natural questions is of course, why does Cisco which grows faster and has superior return characteristics, trade at a much lower multiple than Heinz. The answer is  Heinz will still be selling Ketchup 10 years from now while Cisco may very well be supplanted by an emerging technology or may have to re-invent an entirely new product line.

So here is lesson #2, the stock market has a propensity to overvalue innovation. In fact, companies with long and stable product lines always have the superior business models over companies that had to re-invent themselves.

At $72.50, Mr. Buffett is paying 19 times Heinz fiscal 2014 earnings estimate, which I believe is overly optimistic. I think given his extremely low cost of capital, Mr. Buffett is paying a fair price for an extremely slow growth company. I also tend to think that the market is also over-estimating the business risk of Cisco who occupies a dominant position in networking and is well entrenched in enterprises and governments alike.

For my money, I will bet on Cisco at $21 over Heinz at $72 for the next 10 years.

Currency War

Ever since the finance minister of Brazil announced in September of 2010 to a group of industrial leaders gathered in Sao Paulo that nations of the world were engaged in a currency war, there have been these unconvincing denials by money printing central bankers around the world that they were merely trying to resuscitate their respective moribund economies in an environment of shrinking demands. Never mind the results of money printing weakens one's currency and thus helps the nation in gaining an increasing share of limited demand. With the election of Shinzo Abe, Japan stripped away the veil by setting explicit exchange rate targets. Now the world is up in arms, thus during the gathering of G7 nations in London, they felt compeled to issue this statement:

The Group of Seven leading economies Tuesday attempted to head off a potentially destabilizing round of currency devaluations, issuing a statement that reaffirmed their commitment to let market forces determine exchange rates, and saying central bank policy will be focused solely on domestic objectives.

The question of currency devaluations is an awkward one for industrialized nations, many of which have embarked on monetary policies designed to boost their economies that have the side effect of lessening the value of their currencies. The U.S. Federal Reserve's bond-buying policy has previously sparked world-wide concern given its impact on the dollar.

In the statement, the G-7 made it clear that their central banks weren't attempting to weaken their respective currencies when they engaged in monetary stimulus, but simply were trying to support flagging domestic demand.

In international politics, the fact that nations pledge not to do it, is how we know they have been doing all along and will continue to do so.

 

Pimco's Currency ETF

Pimco is launching a currency ETF. Here is a summary of what it is all about:

PIMCO plans to launch an active currency ETF designed for investors who want to protect against a devalued U.S. dollar with the bond giant’s expertise in global markets.
The ETF will invest in foreign currencies and is expected to list on the NYSE Arca on Tuesday with the ticker FORX. The fund will charge a management fee of 0.65%, according to the prospectus.

It will be called PIMCO Foreign Currency Strategy ETF. PIMCO is putting the ETF together for investors who want to diversify with currencies if the U.S. dollar depreciates, said Don Suskind, head of global ETF product management, in a telephone interview Monday.

I must admit I am a huge fan of Bill Gross and Mohamed El-Erian. I read everything those pairs write. My image of Pimco had always been an intellectually vigorous firm who at least thought to offer products that serve the long term interest of investors. But a currency ETF seem to cater to the basest instinct of their customers. Currency trading is a zero sum game in a frictionless world. Subtracting the cost of procuring currency contracts, Pimco's management fees and the commission from your favorite discount brokers, investors are asked to play a negative sum game. With that in mind, may I so boldly predict that the overwhelming majority of FORX purchasers will end up losing money. And I don't think that is in the long term interest of investors.

In the world of fund management, ETF is where the money is. If Willie Sutton, a mere bank robber can see it, surely an intellectually vigorous firm like Pimco, can too.

Buyout Undervalues Dell, Says One Large Shareholder

Apparently, Southeastern Asset Management, the largest outside shareholder of Dell, agrees with us that the buyout price of $13.65 vastly undervalues Dell's true value. For our thesis on Dell, please see yesterday's post. While we considered Dell from a free cash flow and dividend paying potential point of view, Southeast looked at it from a hidden assets point of view. Over the years, Dell have made numerious acquisitions totaling $7.58 per share. Within Dell's vast corporate structure, their must be parts that are valued by the current market place and can readily be unlocked. I suspect that is part of Silver Lake's strategy. Dell has failed to become IBM. Thus it is time to unwind the empire. The parts are surely worth more than the sum. The letter Southeastern wrote to SEC is well thought out and worth quoting at length:

Southeastern believes that straightforward, modest valuations of Dell result in per share valuations vastly in excess of the $13.65 offer price. Net cash per share after deducting structured debt within Dell Financial Services (DFS) is $3.64. Dell Financial Services has a book value of $1.72 per share. In addition, since Michael Dell resumed his role as CEO in 2007, the Company has spent $13.7 billion or $7.58 per share on acquisitions intended to transform the Company into a sustainable IT business and lessen its reliance on the PC business. During Dell’s June 2012 analyst day, Dell Chief Financial Officer Brian Gladden said that in aggregate the acquisitions to that point had delivered a 15% internal rate of return. The Company has neither taken nor discussed the need to take any write downs of these acquisitions. We therefore conservatively believe the acquisitions are worth a minimum of their cost. Taken together, these items total $12.94 per share before we even look at the other businesses.

 

The current bid therefore places a value of less than $1.00 per share on the remainder of the Company. By any objective measure, that is woefully inadequate.

 

As highlighted in an example below, the Company could have paid shareholders a substantial special dividend (close to $12.00 per share in the example below) while still retaining the ability to generate anywhere from $1.14 to $1.34 per share of free cash flow per year (same as the Company’s measure of “non-GAAP” earnings). Using the midpoint of the free cash flow range of $1.24 based on the estimates below, the Company would produce over $2.2 billion in free cash flow annually. This level of cash flow generation provides interest coverage of 4:1 based on the numbers below.

Dell Going Private. Who are the Losers?

By now, it is old news that Dell have agreed to be taken private by private equity firm Silver Lake Partners and its founder Michael Dell. Here are some highlights from the press release.

Under the terms of the agreement, Dell stockholders will receive $13.65 in cash for each share of Dell common stock they hold, in a transaction valued at approximately $24.4 billion. The price represents a premium of 25 percent over Dell’s closing share price of $10.88 on Jan. 11, 2013, the last trading day before rumors of a possible going-private transaction were first published; a premium of approximately 35 percent over Dell’s enterprise value as of Jan. 11, 2013; and a premium of approximately 37 percent over the average closing share price during the previous 90 calendar days ending Jan. 11, 2013. The buyers will acquire for cash all of the outstanding shares of Dell not held by Mr. Dell and certain other members of management.

As of Jan 31, 2013, Dell has $14.82 billion worth of cash and short term investments and $9.25 billion of short term and long term debts. At the buyout price, dell sports an enterprise value of $18.83 billion and a EV/Ebidta valuation of only 3.5, substantially similar to the valuation of HP and less than half of well run companies like IBM.

It is a popular misconception that private equity companies are in the business of buying troubled businesses and fixing them. In the stock market hay days of 2007, both Harmon and Penn National Gaming were offered buyout deals at the peak of their then respective prices. Of course, neither companies needed any fixing. In the capital market, equity requires a higher return compared to fixed income securities. Private equity is all about arbitrage between those two types of asset classes. So its business model is not so different from your importer who buys shoes from Vietnam or your exporter who sells wines in China. So long as your business can earn a greater return than your borrowing cost, your equity value will be enhanced. Of course, if you can somehow improve the acquired business, that will just be gravy.

In the press conference, Michael Dell purportedly claimed that it would be easier for him to turn around Dell without the glare of public investors and the pressure of quarterly earnings target. Of course, the goals of both Dell and HP are to become IBM. To get there, Dell has been making acquisitions. Without the currency of the public float and a more leveraged balance sheet, it seems to me the task gets more difficult, not easier. The Dell privatization happened because of the confluence of an extremely undervalued stock and an enthusiastic credit market for the benefit of Silver Lake partners and Dell's management. To quote Jerry Seinfeld, "Not that there is anything wrong with that." This is capitalism afterall. As soon as Dell becomes a private company, substantial dividends will be paid to the new equity holders both out of existing cash on balance sheet and Dell's ample free cash flow. I am aware that Dell's cash holdings are substantially in foreign jurisdictions and can not be repatriated without tax consequences. I believe a way will be found around this issue.

The most obvious loser in Dell's privatization, yet hasn't be pointed out all that frequently, are Dell's public debt holders. For example, Dell's 6.5%38 notes were trading at 116 before story of its buyout broke. It now trades at 89. By agreeing to a leveraged buyout, Dell's credit rating will certainly fall to junk status. So the 6.5%38 note holders have just saw a 23% drop in asset value. But I believe the public stock holders were also losers. Dell is in a mature business and pretending to be a growth company. Had Dell been run primarily as a business with substantial free cash flow and paid a higher dividend, let's say $1 per share, I believe Dell's stock price would have been much higher that even the current buyout price of $13.65. Even at $1 dividend rate, Dell still would have ample cash flow to pursuit acquisition, not to mention a much higher stock as currency.

So once again, both public stock and debt holders were screwed. Ain't that always the case.

January Returns

January was a great month for stocks, but not so great if you were invested in bonds. Here is the tally:

• Treasury: -0.95%
• High Grade Corporate Bonds: -0.72%
• High Yield Corporate Bonds: 1.38%
• S&P 500: 5.18%.

So for the month, stocks significantly outperformed bonds. For the past few years, high yield bonds have closely matched the return of stocks, but so far this year, it has lagged.

The falling prices of Treasury and investment grade bonds have prompted a few strategist calling for the possibility of an unruly exit from bond land.

But an expected shift out of fixed income - particularly top-quality investment grade - and into stocks coupled with a commensurate rise in interest rates and a much more easily traded corporate debt market could send tremors through the space, Bank of America Merrill Lynch said.

"A disorderly rotation out of bonds - characterized by higher interest rates and wider credit spreads - is the biggest risk for investment grade corporate bond investors this year," Hans Mikkelsen, credit strategist at BofA, said in a note to clients. "However, history offers little guidance about how much of an increase in interest rates would prompt such disorderly scenario and how it would play out."

It is certainly possible that Treasury and high grade corporate bonds continue their incremental slide while stocks advance. However, if 10 year Treasury rates were to back up toward 2.5% or even 3% range, it is inconceivable that stocks could act as a shelter for bonds. Most likely, both asset classes would sell of severely. The policies of the Federal Reserve have certainly placed investors, particularly income investors between a rock and a hard place. The extended duration of low interest rates have elevated all asset prices which necessarily usurp future return for the service of our present balance sheet.

 

Is the Stock Market Cheap?

Doug Short of Advisor Perspective writes some of the most informative blogs on the web. His postings can be found at www.dshort.com. Today, Mr. Short shone the light on market valuation as the Dow Jones Industrial Average revisited the 14000 level for the first time since 2007.

The price to earnings ratio is of course one of the more common methods used to determine stocks and stock market valuations. However, since both prices and earnings can gyrate widely, the P/E ratio sometimes produces counter intuitive results. For example, during the market trough of 2009, the P/E ratio stood at triple digits, higher than the market peak of early 2000. Mr. Short's method of choice is the so called PE10, championed by Yale Professor Robert Shiller. Here is how he explains it:

Legendary economist and value investor Benjamin Graham noticed the same bizarre P/E behavior during the Roaring Twenties and subsequent market crash. Graham collaborated with David Dodd to devise a more accurate way to calculate the market's value, which they discussed in their 1934 classic book, Security Analysis. They attributed the illogical P/E ratios to temporary and sometimes extreme fluctuations in the business cycle. Their solution was to divide the price by a multi-year average of earnings and suggested 5, 7 or 10-years. In recent years, Yale professor Robert Shiller, the author of Irrational Exuberance, has reintroduced the concept to a wider audience of investors and has selected the 10-year average of "real" (inflation-adjusted) earnings as the denominator. As the accompanying chart illustrates, this ratio closely tracks the real (inflation-adjusted) price of the S&P Composite. The historic average is 16.4. Shiller refers to this ratio as the Cyclically Adjusted Price Earnings Ratio, abbreviated as CAPE, or the more precise P/E10, which is my preferred abbreviation.

According to Mr. Short, the current PE10 ratio falls within the top 20% group of the highest and is 34% above its historical mean of 16.5.

I started my career in the financial industry as a quantitative analyst. Our industry has an unrivaled ability to explain the past and an abysmal record at predicting the future. Ratios such as PE10 must necesarily move at such a slow pace to be basically useless for those with income to earn and moeny to invest. An individual investor simply can not sit on 0% return for years without losing patience and a professional one can not do so without jeopardizing his job.

On the question of market valuation, I happen to think the bulls and the bears are both right. Now before you start calling me names, let me explain.

As a financial asset of indefinite life, the value of a stock is determined by two things. First, its ability to earn a return now and forever into the future. Second, the prevailing interest rate now and forever into the future. Those who are pessimistic about stocks have assailed both of these front. Their arguments are based on what will happen in the future. They have argued that corporate profit margins are above historical average and are liable to fall to the mean. The prevailing interest rate is nothing but an anomaly manufactured by the brute force of the Federal Reserve. As sound as these arguments may be, it can not counter the mathematical reality of asset valuation. Stocks have been rising because corporate profits have been resillient and interest rates have stayed low. If T-bills will stay at 0% and 10 year Tresury will hold at 2% forever, then stocks are decided undervalued trading at a trailing PE ration of around 17. The fact is it makes a huge difference to the issue of stock market valuation whether the mean reversion envisioned by the bears arrives in 2 years or in 10 years. These days market participants have simply extended those said reversions toward a more distant future.

Is it more risky to sit on 0% return or to bet on your ability to foresee storms in the distant future?

Now that is a tough question.

January Employment Report

The US economy added 157,000 jobs in January according news release from the Bureau of Labor Statistics, roughly in line with Wall Street estimates. However, you have to scroll to the last paragraph to find the surprising news.

The change in total nonfarm payroll employment for November was revised from +161,000 to +247,000, and the change for December was revised from +155,000 to +196,000.

Despite talks of fiscal cliff, the average jobs added in the last two months of the year came to 220k. This is fairly impressive by the standard of a slowly growing economy. During the turning points in labor market, the jobs report tends to underestimate the addition and subtraction to the jobs market. We could be at such a point and the labor market appears to be strengthening. 

The Purpose of Money Printing

The ever articulate Jim Grant, publisher of the most perspicacious newsletter, "Grant's Interest Rate Observer," came on Yahoo Finance's The Daily Ticker and pondered the weighty issue of Federal Reserve's bond purchasing program with conjured dollars. Here is what he said:

"I think the Fed's actions are counterproductive," he says. The Fed's intentions to jump start growth are actually working against the economy, Grant argues.

"If it were as easy as printing money or creating credit to levitate an economy or to reactivate business activity the world would have been richer many generations ago," he says.

Of course, money printing creates no wealth. However, in 2008 the financial market faced both a liquidity and a solvency problem. If all asset prices take a dramatic enough fall, no banks in the world can remain solvent. That's what happened in 2008. By suppressing interest rate and injecting trillions of dollars into the banking system, the Fed succeeded spactacularly in levitating the prices of stocks, bonds, real estate, commodities, gold and art works. Now most banks and home owners alike have more assets than liabilities. Furthermore, their liabilities are priced so cheaply that they can actually afford the interest payment. So problems solved, liquidity and solvency. The Fed does not create wealth, but it can certain plunder from those who save to rescue those who borrow.

As individual investors, we just need to make sure we are not on the wrong side of Fed's redistribution scheme. "Don't fight the Fed." Often times, the simplest works the best.  

Q4 GDP Decreases 0.1%

The expectation for fourth quarter GDP growth certainly was not high, but the 0.1% contraction was worse than expected. The full text of news release from US Commerce Department can be found here, which always comes in the most matter-of-fact intonation:

Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- decreased at an annual rate of 0.1 percent in the fourth quarter of 2012 (that is, from the third quarter to the fourth quarter), according to the "advance" estimate released by the Bureau of Economic Analysis.  In the third quarter, real GDP increased 3.1 percent.

Market reaction, however, is decided muted. Even though the headline numbers look horrific, the underlying thesis of a slowly recovering economy remain unchanged. The Q4 GDP numbers were adversely effected by the 22% decrease in defense spending and the less than expected inventory accumulation due to uncertain fiscal climate during the fourth quarter. Here are the good news in the report:

Real personal consumption expenditures increased 2.2 percent in the fourth quarter, compared with an increase of 1.6 percent in the third.  Durable goods increased 13.9 percent, compared with an increase of 8.9 percent.  Nondurable goods increased 0.4 percent, compared with an increase of 1.2 percent.  Services increased 0.9 percent, compared with an increase of 0.6 percent. 

Real nonresidential fixed investment increased 8.4 percent in the fourth quarter, in contrast to a decrease of 1.8 percent in the third.  Nonresidential structures decreased 1.1 percent; it was unchanged in the third quarter.  Equipment and software increased 12.4 percent in the fourth quarter, in contrast to a decrease of 2.6 percent in the third.  Real residential fixed investment increased 15.3 percent, compared with an increase of 13.5 percent.

With personal consumption, durable goods, investments, both residential and nonresidential structures increasing at a comfortable pace, no wonder the market wasn't too worried about the misleading headline.

Consumer confidence has been gloomy over the past several months, yet consumer spending has been expanding. Looking at the consumers' balance sheets, even though deleveraging is still occurring on the surface, those numbers are now entirely due to firmer asset values instead of actual increase in savings or paying down of debts. At such low interest rate, there is strong incentive to spend, not to save. That, I believe, is the most important reason for increased level of consumption. However, with the tax increase beginning this year, consumers are now actually drawing smaller paychecks. Will such robust spending continue? That remains to be seen.

Bipolar Caterpillar

Caterpillar is one of the bellwether stocks for gauging global economic condition. It reported earnings last night. The earnings conference call transcript can be found on seekingalpha.com. Here are some highlights:

In the United States we’re becoming increasingly optimistic. The feds interest rate policies and their plan that continue injecting liquidity are in our view positive for 2013 growth. We are expecting the U.S. economy to grow at least 2.5% in 2013.

Our outlook assumes that Chinese government will maintain pro-growth policies throughout 2013, and we’re expecting the economic growth in China to be near 8.5%, a more favorable environment for construction and higher commodity demand.

We’re expecting sales and revenues to be in a range of $60 billion to $68 billion reflecting both upside and downside potential from 2012. We’re increasingly optimistic that there may be potential for better growth ahead, but we remain cautious about how quickly that improvement in going to translate into higher sales for Cat.

After expressing a rather sanguine outlook for US and emerging market economies, Cat put forth a rather pedestrian and unusually wide revenue outlook of $60 to $68 billion. In addition, its EPS guidance was an even wider $7 to $9. At the bottom of the revenue range, sales would fall close to 10%; while top of the forecast represent a mere 3% increase. Perhaps Cat was being conservative as most companies making such forecast try to do. But it does seem that even a company like Caterpillar with tentacles reaching nearly every construction project around the globe has limited visibility a few months out into the future.

Alternative Investments

InvestmentNews, an online publication for investment advisers, reported that Vanguard, the champion of low cost investing, is looking for greater exposure to alternative investments. You may read the whole article here.

The Vanguard Group Inc., a longtime champion of low-cost, passive mutual funds, is weighing a more aggressive push into alternative investments.

The company's consideration of investments outside traditional stocks and bonds is being driven mainly by demand from financial advisers. Since the 2008-09 stock market downturn, advisers have been relying more heavily on alternative investments as a way to reduce risk and volatility in their clients' portfolios

Despite the popularity of nontraditional assets, Vanguard isn't looking to jump too deeply into the alternatives pool. Instead, it is considering products aimed more at reducing risk and volatility than boosting performance.

In a time when the VIX, a common measure of stock market volatility, is languishing near the low end of its historical range and  the year 2012 had been one of the least volatile in history, investors still clamor for even lower volatility. In a time when stocks have more than doubled in value from the lows of 2009, investors are still exiting stock funds and pouring into bond funds.

Of course, Vanguard already has alternative funds in its lineup. One of them is a market neutral offering. Here is what the same article had to say,

Vanguard has proved that it is capable of running fairly sophisticated strategies on the cheap. For example, the Vanguard Market Neutral Fund (VMNFX), which it launched in 1999, has an expense ratio of 0.25%, significantly less than the 1.75% charged by the average market-neutral fund.

 

The fund has stumbled, however, in terms of performance. The Vanguard Market Neutral Fund, which was subadvised by Axa Rosenberg Group LLC for more than a decade before being taken over by Vanguard in 2010, has five-year and 10-year annualized returns of -2.69% and 1.09%, respectively, putting it in the bottom-10th percentile of the market-neutral category.  

It always seems odd to me that someone would try to construct a stock portfolio to produce bond like return. Is that what bonds are for? The result predictably failed to beat neither stocks nor bonds.

The sheepish behavior of investors over the past few years is quite understandable. After all, we had two stupendous stock market crashes over the past 12 years and stocks have delivered the most meager return over this period. However, 12 years ago, stocks were adulated and worshiped. It was afforded such a sky high valuation that essentially robbed the abysmal 2000's to pay for the abundance of 1990's.

In the world of investing, chasing glamour is hazardous to your wealth, that includes the so called alternative investments.

S&P Above 1500

The financial media is abuzz with S&P 500 closing above 1500 for the first time in five years. Here is how Wall Street Journal put it:

 The S&P 500 closed above 1500 for the first time in five years on Friday, capping its longest streak of daily gains since 2004, amid better-than-expected earnings from Procter & Gamble, PG +4.02%Halliburton HAL +5.05%and others.

The Standard & Poor's 500-stock index tacked on 8.14 points, or 0.5%, to 1502.96, its highest close since Dec. 10, 2007. The index rose for an eighth session in a row, the longest such streak since a nine-day run ended in November 2004.

Investing is a journey without a finish line. However, considering men's psyche and need to celebrate milestones, we have come to embrace round numbers of indices. Such habits are indeed harmless fun by itself less they distract us from the most important aspect of investing. The most profitable decision arrives via finding good company selling at a reasonable price, not obsessing over the short term direction of markets at essentially meaningless milestones. Whether stocks are at a high plateau or a low valley, I find nothing soothes my nocturnal somnolence better than knowing I have good companies purchased at a good price.