Hey Fed!! Why??

Second Quarter Report 2013 So far so good. It has been a good year for your account, but there are reasons for caution

this quarter.

For the first time this year, the stock market is now in a correction. As of this writing, we are in the midst of a 7.5% decline in the S&P 500. We expect a messy quarter, until credit markets calm down. We don’t feel this correction will be the start of “the big one,” like it was in 2008. We think the correction will resemble numerous declines suffered since 2009, in the 10- to 20% range. Here is our opinion of what we see occurring in the market now, and explanations regarding changes we have made in your account.

The stock market topped out in the second week of May, and since then, has been in correction mode. At that time, we noticed storm clouds forming, when the credit markets began behaving badly. Whether it was a U.S. treasury bond, a junk bond, foreign bond, or AAA-rated corporate bond, all went down, and went down big. When this happens, it isn’t a good environment for stocks, which again proved to be true.

Why is this happening? Why the sudden back-up in interest rates worldwide since May? The official response on CNBC and in The Wall Street Journal is the markets are worried about the Federal Reserve tightening credit. We suppose when you go from printing $85 billion a month to less than $85 billion, it does slow down credit creation, but it’s hardly a cause for concern.

We think it’s a real stretch to accuse Ben Bernanke of being the second coming of Paul Volker. By the end of this year, the Fed’s balance sheet will have grown by at least 20%, year over year. Humongous from a historical perspective. But if the Fed isn’t causing the problem, then what is? Inflation? Nope. Investor panic? Yes, a little. Bank regulators and Dodd-Frank? Yes and yes.

The markets are trading as though a giant margin call is out there, where investors who borrowed money are forced to sell--whether they want to, or not. Our first candidates for blame are Chinese bank regulators who instituted tough policies this quarter to halt Chinese banks lending to real estate and bond investors in China.

This is a very messy subject, but here is the abridged version. In China, a bank can take $100,000 in warehoused copper/gold, and lend it to twenty or thirty different people. Suddenly, $100,000 dollars in physical assets is used as collateral for two- or three- million dollars in loans. Each entity thinks it owns the title to that gold or copper. In reality, it doesn’t.

The Chinese government rightly decided to end this practice in April. By June, a full- fledged panic overtook the banks in China. Chinese investors aren’t sure who owns what.

To monitor this situation, we created a Chinese bank index of the largest bank stocks in China. As of now, they are setting new lows for the year. There is genuine fear about how these banks will rectify this mess. Until last week, the Chinese government was not providing liquidity to these banks. In the last week of June, the Chinese Fed caved, began buying stock in their banks, and giving them money.

Long-time clients know we are bearish on China, and this mess won’t be cleaned up overnight. We think the margin call created by the new banking regulations caused problems worldwide. It is finally being dealt with, but it will take time to run its course.

The second candidate for forced selling is a new provision regulating swaps in the Dodd- Frank legislation our politicians voted for in 2010. A rule within the bill mandates all swaps (we wont explain swaps; just trust us on this) and derivative counter-parties must put up collateral for trades. In theory, this seems like a great idea. Trade with somebody else, and you ought to provide good faith collateral, in the event you were wrong and must pay off. We tend to agree, but like all good ideas, problems arise.

At least $50 trillion in swaps and derivatives are out there, where no collateral was put down when the bets were placed. When people go to roll these over, or establish new positions, they now must put up money to do it. We have seen estimates where the necessary collateral ranges between one- and five-trillion dollars. That’s one heck of a lot of money to find under a couch cushion, even if you’re Goldman Sachs.

These rules are finally coming into play. You can either put up more money to support your position, or sell your position, (which is what we think they are doing now) or urge your local politician to ask the Commodity and Futures Trading Commission to intervene and abolish the regulation. Currently, the latter option is underway. The next “margin” call is in mid-July, if the CFTC does not act. We can’t predict which way this will go, but markets could stop in their tracks, until they either sell, or put up the cash, or the rule is bounced.

We don’t view it as a long-term problem, but it is a short-term one. We’re amazed nobody on CNBC is talking about it, nor is anyone writing about it. We think most selling will be in commodities and bonds, for the reasons outlined above. For the record, bonds and commodities had a horrible second quarter, so there is anecdotal evidence Dodd-Frank is causing a problem with those assets. We also think the stock market will overcome these issues by year’s-end.

There are changes to your account this quarter we need to explain. Because we don’t make a lot of changes in the stocks we own, this quarter was notable for turnover. In April, we sold Wal-Mart to buy Exxon. The primary reason is we view Exxon’s valuation to be twice as cheap as Wal-Marts valuation. We are also concerned Wal-Mart is slowing its international expansion, which affects its long-term earnings growth rate. We surmise Exxon is so cheap, because Wall Street anticipates a big drop in oil prices. We think fear is already priced into the stock value, and decided the switch made sense. We predict oil prices won’t increase by much this year, but it’s a good bet they’ll go higher in the future. 

We also bought Apple’s stock in your account, and cut back on Cintas and other holdings. Again, the primary reason for the switch is Apple is a very cheap stock, compared to what we sold. We give Apple a rating of 22, and rate Cintas at 7, (higher is better) so you can see there is quite a gap in valuation.

In our opinion, Apple is cheap, because competition in the handheld device business has caught up with Apple. There are concerns on Wall Street that Apple will be forced to reduce its phone’s pricing. We think it’s inevitable, but not the end of the world.

Apple charges AT&T $650 dollars per phone. A consumer pays $200 to AT&T for an iPhone. AT&T then charges a higher monthly fee, for a two-year period, to recoup the $450 AT&T paid to Apple. We think the iPhone’s price will fall, but the market has become too depressed about this company’s prospects.

The obvious winners in the cell-phone battles are Apple and Samsung. There is room for both to profit without blowing up each other’s business models. As cell-phone technology expands, the ability to earn additional fees through software sales will offset some pricing problems. We like Apple, and think it’s a good, long-term investment.

Our final transaction this quarter was selling half of your Rentrak position. To be honest, we’re just pissed off at this company right now. Our average cost in this stock is around $9, and we sold it for over $20. We have made money in this stock, but are having second thoughts about its new management team.

The more Rentrak grows revenue, the more its SG&A (Selling, General & Administrative Expense) increases. Rentrak is a software company, and as revenue grows, SG&A shouldn’t be going up like it is. We think it has a tremendous product. We know management wants to sell Rentrak in the next five years, at a higher stock price than it trades now. That said, we don’t intend to own a big position in a company that can’t, or won’t, control its costs.

In 2007, in Portland, I met with the company’s now-former management team. I met the new management in New York, in October. I just don’t have a good feel for these guys. I think they can ramp the business, but if the money doesn’t flow down to stockholders, we have made a mistake. We will continue to monitor these guys, and let you know how it goes.

A quick update on BGC partners: In April, it sold its electronic “on the run” Treasury bond business to Nasdaq. This business represents 7% of its revenue base. In return, it received $1.3 billion in cash and stock--equal to the total market value of BGC’s stock, on the day this was announced. BGC retained 93% of its revenue base, which is one heck of a deal, in our opinion. BGC now owns 10% of Nasdaq. This transaction in April is why the stock basically doubled last quarter. We continue to like this stock, and think its 8% dividend at these prices is secure. We think the stock should trade closer to seven bucks on this news (current price is $5.80). 

Our bad performers mentioned in our previous report, Level3, Maxwell, and American Public, were up 4%, 33% and 6%, respectively. Maxwell reported good interim results in April. We hope it completes its financial restatements by the end of July. At that point, we expect another move up in the stock. There is no news to report on Level3, or American Public, at this time.

Feel free to call us, if you have any questions about this report. We forecast the market going higher from here for the year, though in the short-term, it might get a little messy. Be prepared for some volatility, and have a good summer.


Mark Brueggemann IAR        Kelly Smith IAR       Brandon Robinson IAR