Trade

Bought TSO (Tesoro) yesterday at $15.79. This is a play on lower oil. The oil refiners have gotten squeezed lately by rising prices. However, gasoline inventories are falling and I believe that the refiners may get some pricing power back by the end of the year. In that scenario, I look for TSO to trade up to $25.

I am still looking at a deflationary play. I want to short a Crack-Up-Boom favorite. POT? CLF? Maybe I'll go long DUG (ultrashort oil).

Trading Opportunity

Here's what I will be working on over the weekend.




The employment report comes out next Friday, August 1. Mish says that the BLS adjusts for errors in their birth/death model biennially, in Jan. and July. The August 1 report is for July. This data from BLS seems to confirm huge negative subtractions in employment last Jan. and July. That's the setup.



The result is a chance for a huge drop in employment. This is huge deflationary news.




Put this together with the Baltic Dry Index dropping below 200-day moving average while hitting a 3-month low during a seasonally strong time of year.

Chart comes from CapitalLinkShipping.

So, how do I play this? Short CUB (crack-up-boom) plays. Some ideas... Mosaic, Potash, Cleveland-Cliffs, copper miners, coal miners, dry bulk shippers, etc. I will try to make a list of CUB playas with large p/e ratios. Maybe I'll ask Russ what he thinks.

Downey and Out

The FDIC better get ready. Downy Financial is next! They announced earnings today, and their stock dropped 29% to $1.97. I have cut and pasted the following AP article in order to comment better:

For the April to June period, the bank reported a loss of $218.9 million, or $7.86 per share, compared with a profit of $32.7 million, or $1.17 per share, in the year-ago period.

Downey has now lost $21.49/share over the last year.

Analysts polled by Thomson Financial, on average, were expecting a loss of $4.60 per share.

The analysts are still way behind the curve.

Results were weighed down by a $258.9 million provision for credit losses, up from $9.5 million a year ago.

Non-performing assets increased to $1.96 billion during the quarter, representing 15.5 percent of total assets, compared with 1.53 percent a year ago.

Obviously, $260 mil in additional loss reserves doesn't help when non-performing assets are increasing at a rate of $1.77 billion per year. I don't know what Downey's total loss reserves are, but they're not enough. Their stock is too low to raise money, their npl's are getting worse, and the collateral backing those loans is dropping daily.

Net interest income, or income generated from loans and deposits, fell 26 percent to $82.9 million, reflecting a decline in average interest-earning assets and the effective interest rate spread. The decline in interest rate spread is primarily due to a higher proportion of non-performing assets.

Their interest income is dropping even faster than non-performing loans.

***************************************************************************

The short squeeze is over. The banks are all dropping again, like rocks down a cliff. I'm glad I stuck with my homebuilder shorts. RYL, until now an overperformer in the homebuilder world, posted humongous losses. Ford posted the biggest quarterly loss ever, $8.7 billion. The only thing up today is AMZN, which doubled profit in yesterday's after-market report. I'm going to have to get out of this one, as it seems that more and more people are learning that shipping is more efficient than a road trip to the mall. And I'm kicking myself on this one: Chipotle (CMG). Their profit jumped 23% and missed by a penny. The stocks been hammered, down $14.79 (17.65%). This is what happens to a growth stock that's growing at 23% when the P/E's over 30 in a recessionary environment. I was thinking about shorting this at the beginning of this year at $120+. DOH!

Cover Your Fannie!

Here's the next great hedge fund pair trade: Buy Fannie bonds and sell Treasuries. If the Treasury is backing Fannie bonds then Fannie bonds are just as safe as Treasuries, right? Duuuh. This one's a no brainer, IMHO. But I don't hedge.... so I only like half of this trade: short Treasuries. I'm using TBT. I think I'll add more with today's strength in Treasuries.

Let's Do the Math

Bloomber reports that Fannie and Freddie have $5 billion in REO's.

Together, Fannie Mae and Freddie Mac, the two biggest U.S. mortgage finance companies, owned a record $6.9 billion of foreclosed homes on March 31, compared with $8.56 billion held by all 8,500 U.S. commercial banks and savings and loans. Foreclosed houses sell at an average discount of about 20 percent, according to economists Ethan Harris and Michelle Meyer at New York-based Lehman Brothers Holdings Inc. At that rate, the two mortgage companies stand to lose $1.39 billion on the foreclosed houses they currently own.

The authors of this drivel are in the stone age. Instead of assuming that foreclosure sales recoup 80%, they could have used their own article for research. Then again, maybe the $1.39 billion number came from Lehman Brothers.

Let's look at some numbers from Fannie and Freddie further in the article:

The typical price Fannie Mae received for foreclosed homes sold in the first
quarter fell to 74 percent of the unpaid mortgage principal from 93 percent in 2005

100% minus 74% = 26%. That's a bigger than 20% loss right there. (Running total = 26% losses.)

But wait, there are more gems:

It costs creditors such as Fannie Mae 2 percent of the value of the property every month in taxes, insurance, utilities, lost revenue, maintenance, management and cleanup after vandalism

And how long does it take Fannie to sell a house?

Freddie Mac-owned properties spend an average of 152 days on the
market and typically sell for 92 percent of the listed price, usually about 30
percent less than the peak prices of 2006

It appears that Freddie loses even more money than Fannie, but let's be charitable and not quibble over the difference between 26% and "about 30 percent". 152 days is five months. Take another 10% off that recovery. (Running total = 36% losses.)

Let's plug in the REO total for Fannie and Freddie: $6.9 billion.

36% losses = $2.48 billion.

Trades

I made some big moves today.

Bought TBT at 71.39. This reverses my holding of bonds, with a huge supply of Treasuries coming online, government borrowing headed through the roof, and the soon end of China/OPEC printing for Treasury.

Short GGP at 29.77. General Growth Properties is a commercial real estate REIT that is overloaded with shopping malls. When Starbucks pulls out of your mall, you know retail space is in trouble.

Short more COF at 42.05. Should've covered at $32, last week. Be that as it may, this is a no-brainer. Credit card write-offs are going to the moon. Houston, we have lift-off!

Short ANF at 60.29. Abercrombie & Fitch is going to get slammed at back-to-school sales and Christmas this year. They directly appeal to the shop-til-you-drop buy-stuff-just-to-be-cool young adult crowd. At half the market cap value as Gap, ANF is also too big for its britches.

Oil dropped a few bucks again today. I'm waiting for a bounceback for that move.

Keeping my Eye on

Homebuilders. Is it time to short more? Bloomberg reports that analysts are predicting Freddie Mac will purchase fewer mortgages from banks as they shore up capital.

The government-sponsored company is also considering selling securities and reducing its dividend while it prepares to issue $5.5 billion of stock, McLean, Virginia-based Freddie Mac said in a July 18 filing with the U.S.
Securities and Exchange Commission.

The Fed has agreed to accept Fannie and Freddie debt at the discount window - meaning that Fannie and Freddie can write more IOU's to the Fed any time they want.
In the meantime, the trade the hedge funds will play is to sell Treasuries and buy agency paper. Why? If the Treasury is backing Fannie and Freddie paper, then it's just as good as Treasuries, right? But I only like half of this trade. So, in keeping with my Rule #3 of Investing I am going to buy TBT, the Proshares Ultrashort Lehman 20+ year Treasury ETF.

By the way, here are my Rules of Investing, as I have formulated them so far. I will probably add more later.

Rule #1: Prices are Always Wrong. What this rules means is that I look for the prices that are the most wrong.

Rule #2: Markets first Overreact, then Underreact. What this rule means is that I don't try to time the pop of a bubble or a bounce off the bottom. For example, if something is undervalued, a suitable catalyst comes along, the price should take a nice jump as the market anticipates future developments. The market soon gets ahead of itself and retraces most of this bounce. If the catalyst is still affecting the fundamentals positively, then this is the time to buy, as the market will now be behind the curve on the fundamentals.

Rule #3: Don't Hedge. This rule means that if I see a trade I like, I do it. I don't try to play one thing off another, or capture a "spread." Most hedging trades require leverage, which destroys the supposed safety of having the hedge in the first place. The corollary to this rule is to always make the trade most specific to what you want to do. If you think oil will rise, then buy oil, or as close as you can get to it, such as an oil ETF or futures. Don't buy oil stocks, unless you have an additional reason for choosing the stock, such as buying, say, a company that supplies expensive services to exploration company in order to leverage a long term oil price uptrend that will place a premium on exploration services.

Time to Look for Bargains

One of George Sosos' rules of investing is that companies that survive tough times will reward investors with huge gains.

My pick: ALD. The shares are trading at 30% under book value. The dividend yield is almost 22%. Is this company going to survive?

Yes. There are two reasons for that. The dividend for the rest of the year has already been declared on a carryover from last years' earnings. Also, they recently raised almost $200 million in unsecured debt. Most of this was at 7.82%. The is not a bad price. In fact, it's confidence inspiring. If ALD can raise money in this environment, they will be able to pick up huge bargains themselves.

In other thoughts, I am not happy with a lot of my current positions. Most of the ones I really like, I've covered or sold with big profits.

Homebuilders: they have probably gone as low as they will for a while, now that the government backup of Fannie and Freddie has removed the fear of mortgage rate spikes. I'm thinking of closing these positions.

Forex: my CNY position hardly moves at all. Although I think it's a winner, the upside is probably minimal. Also, I bought this position for the same reason that I hold FXP, the Shanghai market index ultrashort ETF.
FXY also seems to be going nowhere. Since I've bought FXY, it spiked to 100 from 93. Since then, it's come back down to 95 and followed the dollar down with the weakness in the Japanese economy. There's no money to be made holding one weak currency against another.

Treasuries: I would have expected a flight to quality with the past month's whipping of the market. However, this has not materialized. If the current panic didn't cause a flight to quality, there's not much chance of it happening. On the contrary, the bailout will probably cause the Treasury to borrow more money. This will increase supply, at the same time that China is overheating. Sooner or later, China will have to stop printing money, and therefore Treasuries. If oil falls, as I am beginning to expect it will, OPEC will also not be a big buyer of Treasuries.

I am going to watch VLCCF spot tanker rates like a hawk. If they've shown or start to show any weakness, it may be time to short oil. Demand is weak. US oil inventories are rising, and I expect tanker rates to weaken soon.

I am thinking about moving to the following positions:

Long income-producing bargains: (MCGC, ALD, XGM, etc.) 30%
Short 30-yr. T's: 20%
Short oil: 10%, but wait for a bounce...

I started moving in that direction today by closing FNM at $8.15 It hit a low of $7.07, but if I had covered with the bailout news on Monday, it would have been at $9.73.

Who will bail out the Bailout?

The Fannie/Freddie Mae bailout won't work. Paulson is trying to get permission for the Treasury to shore up equity in Fannie and Freddie, while at the same time saying, "no bailout for shareholders." Excuse me, but if there's no bailout for shareholders, then what's to keep the stock from going to $0? How will Fannie and Freddie raise money to cover their losses and survive until the housing market gets better if the stock is at $0? How will they raise money in the bond market when their liabilities exceed their assets (i.e., they are technically insolvent, as former Fed governor Poole observed last week)? No one will lend bond money when there's no collateral.

While it could be argued that a bailout is necessary to break the vicious cycle in credit deflation and falling housing prices, the costs of a bailout are almost as great as the benefits. It's the same as literally trying to pull yourself out of quicksand by your bootstraps.

The government can force the taxpayers to bail out the housing market, but the problem is that there are almost as many homeowners as taxpayers. It's like trying to borrow from yourself to get out of debt.

However, from a trading standpoint, the bailout may improve investor perceptions, at least long enough to raise some money and put off the day of reckoning. This thought made me check the market today with the idea of closing Fannie and possibly the homebuilders on a steady rally, even if they were painfully higher then last week's close. Unfortunately, today the market was too indecisive to inspire me to make a decision. I'm going to wait for a day with a clear direction. Fannie could jump 50% and I'd still have a 50% gain. I don't think that will happen, though. They jumped nicely today, recovered into positive territory, and ended down again. The VIX doesn't show enough fear to buy for the sake of buying, yet. It would have to approach 35 for that. Also, my short position keeps getting smaller and smaller. It's about one-third of the size it was at the beginning of June, and having already taken huge profits prematurely in June, my risk in suffering a strong rebound day is not as great as the potential gain I see from further volatility in the market.

The market is not showing the fear that it should with the credit crunch coming back worse than ever, despite all the Fed's machinations. The market is finally showing that the banks won't be able to raise money. NCC, -17%, WaMu, -35%, Wachovia, -13%, BAC, -7%, etc., etc.

These banks will fail or stop providing credit very quickly, probably by the end of the year. NCC is ten times as big as IndyMac, which will cost the FDIC $4-$8 billion. The FDIC doesn't have $40 billion. The dollar has only suffered a small slide compared to the sinkholing it will suffer when NCC is seized and closed. I believe they are next because of the Fed's action last week of rewriting their equity raising contract. Either way, they won't be able to raise any new money.

I'm thinking of what to short in preparation for the bank failures. Retail, anyone? How 'bout Coca-Cola (KO) with a p/e of 19? How do they get a p/e of 19?

What do I buy in preparation for the dollar's next plunge? I was thinking about CLF or DUG or POT, but they're rebounding, not showing any deflationary fear. With the market only down 45 today, it's clear that traders are just shifting into new sectors.

Quickie

Fannie and Freddie dropped up to 50% before recovering later in the day.

The senate passed a $400 billion housing bailout plan.

30-yr. T's sold off on this jumping almost 0.1% today.

IndyMac bank was seized by the FDIC. The FDIC expects $4-8 billion in losses.

Spain postponed a bond sale due to high costs.

Doh!

Let's cover the most important, although obscure news first: the Fed has re-written NationalCity's capital raising deal, according to the WSJ. The rumor is that the Fed rejected an imbedded put option in the deal that would refund Corsair Capital for additional shares sold by NCC under $5.00 in the future. Sounds like the Fed thinks that NCC will be needing to raise more money. I don't know if Corsair can back out now, but it sounds like the Fed just pulled a fast one on them.

When WaMu or Wachovia go back to the trough, there may not be any suckers left. The banks have raised almost unimaginable amounts of capital, but that capital is becoming harder and harder to raise. Soon the banks will be at the end of the rope. We will have a lot more IndyMac Banks before this is over.

With the Dow falling 236 today, I'm thinking that I shouldn't have cashed in my shorts so quickly! No matter, can't get greedy here. I'm still highly leveraged, but in much less volatile positions. Forex and bonds now account for about 100% of portfolio value. Leverage is still about 2x, but volatility should be down as I wait for some good opportunities. In the meantime, with so much short interest in the market, I'm thinking more and more about waiting for a decent bounce and a return to VIX <>

While we could have a little bear market bounce soon, the banking sector just looks worse and worse long term. Fannie Mae is a disaster, although their bonds have pared spreads from 1.45% over 30-yr T's to 1.30% over the past few days. They just paid the highest spread ever (0.74%) over 2-yr. T's for short term funding. This will absolutely cause mortgage rates to rise, possibly to 7+% by the end of the year.

Oh, No! But what if I want to buy a house? Does that mean I need to buy now, before rates go up? No. The housing market is so weak that any increase in mortgage payments due to higher interest will be more than made up for in additional price discounts. Wait. Especially if you are in California.

Close the Doors!

IndyMac bank has been shut down by regulators.

SAN FRANCISCO (MarketWatch) -- IndyMac Bancorp said late Monday that regulators have told the lender it isn't "well capitalized" after failing to raise new capital.

The company said it has agreed to a new business plan with regulators which includes halting new mortgages to shrink its balance sheet and
improve capital ratios. It will also cut 3,800 jobs, bringing staff levels to
roughly 3,400.

IndyMac is also barred from accepting new brokered deposits unless it gets a waiver from the Federal Deposit Insurance Corp., a bank regulator that insures deposits. But the company said it's not certain a waiver will be granted. Second-quarter losses may be larger than the first-quarter, the company also warned.

Translation: IndyMac bank is done. Charred to a crisp. Time to take this subprime turkey out of the oven. This article should be entitled "Regulators Order IndyMac to Close." But people aren't stupid. There might be a bank run anyway. On it's annual report through March 31, 2008, IndyMac listed $17.8 billion in deposits. How much will the FDIC have to cover?

Fannie, Freddie Insolvent

It seems that the Enron accounting on Fannie and Freddie has been reported on.

Bloomberg -
FAS 140
The new FAS 140 rule that seeks to stop companies keeping assets in off-balance sheet entities may force Fannie Mae and Freddie Mac to bring mortgages back onto their books, requiring them to put up capital, Lehman analysts led by Bruce Harting wrote in a note to clients today. Fannie Mae would need to add $46 billion of capital and Freddie Mac would need about $29 billion, the Lehman analysts wrote. The companies will probably get an exemption from the rule because it would be ``very difficult'' for them to raise that amount of capital, the analysts said.

Of course they probably will get an exemption. However, there remains the possibility that the regulators will crack down on Fannie/Freddie lending. In the meantime, the even bigger problem they face is the blowout in spreads from about a 1.00% spread over 30-yr Treasuries to 1.45%. This means that investors are shunning agency bonds. If Fannie and Freddie can't resell bonds to investors, the entire US housing market will become a black hole.

How many people can pay cash for a house?

Looking at Steel

Cleveland Cliffs continued its slide today, even with the market up 73 points.



The jobs report came out at -69,000, -114,000 if you include downward revisions to previous months.



The ECB raised rates a quarter point.



Here's a story about IndyMac. Looks like they might be the next big bank to fail. Regulators have ordered them to raise capital. Over the past year, their stock has fallen from $31.50 to $0.67 (98%).

Financial records indicate that they have $2.5 billion in loss reserves, and $17.8 billion in deposits.

With IndyMac, National City, WaMu, and Wachovia all looking like they will fail, the FDIC's $50 billion looks paltry in comparison to insurance liability. In fact, with the Fed's asset holdings of only $473 billion, even they might have trouble covering everything that may fail.

Again, this is looking more and more deflationary. If there is any inflation in our future, it will be in dollar devaluation plays. In the meantime, I am thinking about what deflationary plays will coexist with a weak dollar. That way, my risk is minimized. Could oil be a great short here? Perhaps, but it could also jump on a weaker dollar. Let's move a little further up the production ladder. Steel? I'm thinking this is more like it. CLF looks like the one to short, with a P/E of 39. Even with today's 73 point rally, they continued to slide. Every analyst opinion over the last two years has a buy on the stock. Earnings estimates are expecting 111% growth. However, CLF has missed estimates three out of the last four quarters.

I'm going to think about this one some more....

Inflation vs. Deflation 2

Deflation reared it's ugly head today:

The US auto industry has collapsed as shown by this chart courtesy of the New York Times via Russ Winter's Winter Watch:

Here's the market reaction:

GM: -15%

US Steel: -13%

Cleveland Cliffs: -17%

Camphania Vale Rio Doce: -5%

Oil? It's up to $144.

Here's the calendar: Last year, we had a deflationary scare in August. Then everyone was focused on inflation in November and December. That was followed by suprise rates cuts and everyone turned around to ponder deflation from Janruary through March. After the March lows, the market again switched fears and has now been cowering from the inflation monster for the past three months. It's about time that deflation came back, at least in the mind of the market. Today confirms that this is the new trend for the next couple of months or so.

So, I bought more bonds. I doubled my duration to 10 years. I was thinking about how to calculate this as leverage on the portfolio. I'm thinking that for lack of any better ideas, I could take a duration of 30 as a 100% position, and therefore a 10-year duration would be 33%. With a five bip move required to move the total portfolio 1%, I think this is a reasonable calculation considering the volatility of Treasuries.

With GM down to $10.00 (a 54-year low), and Merrill Lynch warning of Bankrupcy (GM Bankruptcy `Not Impossible,' Merrill Analyst Says), I've been thinking. It's the value lover in me hearing a little voice saying, "companies that survive difficult times do very well." So, I'm remembering a recommendation to buy GM senior bonds that trade in low dollar denominations on the stock exchange. The symbols I'm looking at are HGM, XGM, and GMS. I need to call Schwab for more info on these. The crucial data will be: yield, yield to maturity, payment schedule, seniority of notes, any callability or convertibility, callability or convertibility dates and triggers, and date of maturity.

One thing is Certain (Almost)

One thing is certain, and that is that Starbucks cutting jobs makes it much less likely that Ben Bernanke will be raising rates. In my opinion, it's more likely that his next move is to cut further. Which in this twisted situation is more likely to cause more price inflation.

As far as definitions go, I have to go with Mish. But it's hard to argue with Russ when he calls our near 100% yoy rise in oil hyperinflation.

Deflationistas, Unite!

Lately, I have been eagerly following the Inflationista vs. Deflationista debate personified by Russ Winter and Mike "Mish" Shedlock. While each is right according to their own definition of inflation, I think their future predictions are vastly different.

I have found myself lately in the middle of the two camps. So far they have been both right: Russ with his predictions of "Mad Max" commodity price hyperinflation fed by a dollar collapse, and Mish with his predictions of a deflationary collapse in banks and the auto industry.

Into this situation comes the latest news from Starbucks: "Starbucks to cut up to 12,000 jobs, close 600 stores." Excuse me, but this is not inflationary. However, it's not good news for the dollar either. Will Mish be right in the near future? Will commodity prices collapse? If they do, will it even happen this year?

So, what is the story here? What's weaker, the world economy or the dollar? I think that the dollar is clearly weaker. Fund managers calling for a bounce in the dollar are premature.

However, we can see the weakness spreading slowly. New Zealand's economy contracted last month. Great Britain's housing market is plunging. So is Australia's. Europe is suffering from a slowing economy as well as high inflation.

Well, I couldn't resist a trade on this spread of the global housing implosion. I shorted FXA, the Australian Dollar ETF today, with the Aussie very near a 52-wk. high. I wanted to short Sterling as well, but the ETF is so oversold it's unshortable. Too bad. Maybe I'll look for a UK equity index to short instead.

In the meantime, I will continue to take my time and try to understand both the price inflation resulting from a weak dollar and the deflation resulting from the collapse of peak credit. There is no need to rush. These cycles will take months, if not years, to work themselves out.