Thursday, May 13, 2010

Kabaam: How to Short the Next Market Collapse (and then Go Long) - Alpha

Fundamentals are weak
Corporate earnings are at record highs, but still below 2007 peaks. S&P's forecast for net earnings in 2011 (not the bogus operating measure), are at a fair $65 to $72 (the operating earnings est. is in the $90 range), which makes the current PE ratio around 17x (but dividend yields are still very low). Clearly the equity bulls have paid more attention to the price rally, where low interest rates have made the maddening herd push toward any risk asset, and diverted investors from economic fundamentals and weaknesses in revenues, free cash flows, and dividends (numbers harder to fudge).

The "smart money" managers that I talk to (whom I can't name but are large HF managers), are bearish on any security that isn't super-senior (mortgages with large cushions, DIP loans, etc.) and on cyclical industries. Ordinary people can't buy these easily. Also, economic fundamentals are very weak in Europe, as the PIIGs' GDP will contract this year and next, unemployment will go to protest levels, and greater socialist policies (wealth transfers, taxes, regulations) will pick up.

The next 5 years - from the second collapse to "reflation part deux"
The best smart money macro view (from paranoid HF managers who made money in 2008 and 2009):

1) Second Collapse: In the short run, the enormous piles of global debt (government, household, and corporate) will naturally push towards a second collapse, which will rhyme with the Sept.-Dec. 2008 collapse (remember, history doesn't repeat itself, it just rhymes). You can trade into shorts, discussed below, for this. But governments will stop the collapse, as they've shown in 2008 and last weekend, by throwing everything and the kitchen sink at it (fiscal and monetary stimulus, i.e., printing cash when selling bonds doesn't work), damn the consequences. Politicians will not (and perhaps cannot) be responsible enough to encourage policies of saving, long run budget surpluses (not just reduced deficits), or boring (and safe) utility banking. And the key, remaining structural problem is all the debt. There is only one way to reduce debt if paying it back through austerity or defaulting aren't allowed. Inflation. Or politely put, "reflation" of asset values (and prices).

2) Reflation Part Deux:
So in the long run, governments and central banks (esp. the Fed and ECB) will be forced to print money to bail out banks again and to keep confidence levels up (as both the ECB and Fed showed last weekend). That will "reflate" assets and lead to high inflation (above 4% certainly, but a high chance of above 5%). Hence the optimal trading strategy: Short risk assets for the short run (next 12 months), through aggressive trading, and then go buy-and-hold long on inflation-assets (gold, metals ETFs, well-capitalized REITs, energy stocks, other stocks of companies with pricing power, etc.) after the governments lift up the floodgates again. Shorting long-duration bonds like zeros would work too, but that's hard for small speculators.

A 400-point trading day is bad news

Monday showed that the collapse is closer than we think. The ECB said that default would never happen, as it was commited to buying unlimited amount of government bonds to stave off a collapse. Hence any sort of inflation is better than market austerity for profligate borrowers and dumb lenders (Greek consumers and German/French banks, respectively). Or as the investment strategist David Rosenberg, who called the 2008 crash in 2006, put it this week:

"We said last week, and again earlier this week, that the behaviour of the VIX index has recently been consistent with either the tail end of a bull market in equities or the onset of a new bear phase. Indeed, a cursory glance of the market internals — divergences, put-to-call ratio, investor sentiment, the new high-low list — strongly suggest that the first move above 1,200 on the S&P 500 in January resembled the break above 1,500 in July 2007, and the next blowoff move through 1,200, again in late April, looked like the double peak in October 2007.

The obvious question is: how can the bull market possibly be over considering that we enjoyed that amazing 405-point rally on the Dow just three days ago (Monday, May 10)? Wasn’t that an exclamation mark that the bull is alive and well? Far from it. There have been no fewer than 16 such rallies of 400 points or more in the past, and 12 of them occurred during the brutal burst of the credit bubble and the other four took place around the tech wreck a decade ago. In other words, the most valuable information contained in last week’s intense volatility, underscored by the 400-plus point bounce in the Dow, is that it’s time to take chips off the table and brace for the breakdown."

Step 1: Securities to Trade the Second Collapse

Generally, I think the best short vehicles are European bank stocks and in Ultra-short ETFs (which are very bad investments, but are good, albeit very risky, short-term trading vehicles). Again, one should be very trading oriented when shorting (since psychology matters as much as fundamental valuation or the prediction of the reflation trigger).

My favorite bank shorts are Euro bank ADRs: STD (Santander), BBVA, DB (Deutsche Bank), BCS (Barclays), RBS, etc. All their balance sheets are horrible (to the extent the assets are measurable), and realistically, creditors will have to face losses after the equity is eaten through (more likely, governments will bail out creditors but let equity-holders take a beating).

My favorite ultra-risky Ultra short ETFs: EEV (Ultrashort Emerging Markets), EPV (Ultrashort MSCI Europe), and FXP (Ultrashort China).

Again, shorting is speculative. You need to dart around, trading, and market timing is essential, along with risk limits. This isn't for the faint of heart. The ETFs tend to be choppy and illiquid, among other risks. Vega thinks the double-short ETFs are highly inefficient vehicles to express a thesis due to their poor trade execution on the swap, and I agree (so I never hold them for more than two weeks, usu. two days to a week is my holding period). Using futures and options is better, but few people have those accounts set up (I can't set them up for certain reasons). If you just want to avoid playing with fire (double short etfs) and avoid getting hammered, hold cash and gold, then follow step 2.

Step 2: Securities for the "Buy-and-Hold" Reflation/Inflation Period

This is a tougher call. I would suggest three layers to think about.

First, you want to short Euros, and to a lesser extent dollars. All countries are debasing their currencies, and the US isn't as bad as Europe. The best currency short (of USD, EUR, JPY, etc.) is to go long by holding gold, the only "fixed currency": GLD (SPDR Gold Trust), GDX (MarketVectors Gold), UGL (Ultra Gold). I truly believe the second phase of the gold boom has started, and this too will eventually end in a bust years down the road (the first phase started in 2001). See a previous piece on gold here: MERITS OF GOLD

Also, you should cut your bank cash account in half and put that half into gold (with some physical gold nearby, just in case).

Second, you want exposure to hard assets like metals, energy, and REITs, such as: DBP (Powershares Precious Metals), VGPMX (Vanguard Precious Metals and Mining), VDE and VGENX (Vanguard Energy ETF and index), VNQ and VGSIX (Vanguard REIT ETF and Index), and so on. Most paper assets, esp. bonds, will tend to show their worthlessness in an inflationary world.

Third, take on as much (fixed-rate) debt as you can afford, if you can comfortably meet the interest payments load. Go buy a second house, if you can get a 5-6% fixed-rate 30-year mortgage, or put the money in natural resource stocks or gold. Consolidate your student loans and make only the minimum payment. As government policies will favor debtors (the more irresponsible the better), you have been incented to lever up, so you might as well get some benefit from the Great Reflation/Inflation that will come to stave off the Second Collapse.

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