by Jeffrey Miller, Partner, Eight Bridges Capital Management

April 18th, 2016

It’s the most wonderful time of the year
It’s the hap-happiest season of all
With those holiday greetings and gay happy meetings
When friends come to call
It’s the hap- happiest season of all

CS earnings offshore

No, it’s not Christmas time. It’s earnings season, the most wonderful season of all. When we get most of the major companies reporting earnings all within a few weeks of each other. Conference calls, investor meetings, and the annual meetings are on the agenda for the next few weeks.  What makes the first quarter the most wonderful time of the year is that it’s when management teams are full of hope and optimism for the upcoming year. Budgets are still attainable, goals can still be made, and by golly, this year will be the year that the company really hits its stride. (This is in stark contrast to the third quarter’s earnings season, which is when these same companies will finally admit that there is no way they’re are going to hit their goals, and start cutting guidance.)  But for now, hope springs eternal that good things are on the way.

This is also a good time to be investing, especially in certain sectors where expectations had gotten overly bearish. Large cap banks have reacted very well to their earnings reports so far, as the stocks had sold off into the reports – so when they release just “ok” numbers, the stocks go up anyway, since poor reports were expected. That’s why this time of year is great for stock pickers – if you were patient enough to wait for the stocks to come down, and then chose wisely, you did very well.

Conversely, there is a whole cohort of stocks out there that are priced for perfection. These companies have sky-high expectations built into their stock prices, and any shortfalls will be punished. These stocks can be tricky for fund managers – while they are currently performing well, and not owning them makes you look stupid in the short-run versus your less discerning brethren, they are not a good investment long-term, as their stocks reflect not only expectations for strong earnings and dividends in the future, but the expectation that their price-to-earnings multiples will continue to expand over time. If either expectation proves to be too ambitious, the stocks will fall precipitously. We prefer to be early on the improvement in earnings for banks than to own stocks “too late,” like consumer staples and utilities, as the losses in these companies could be significant when they ultimately come back to earth.

This notion of being early is often construed with being wrong, as the two are closely correlated. If you buy a stock and it goes down, by definition you have gotten either the story wrong or the timing wrong. But, unless you bottom-tick perfectly every stock you buy, you will, inevitably, be losing money on most of your positions at some point after you buy them. So are you wrong or early? That’s the million dollar question. It’s hard to know which ahead of time. You can think you are right, but until you close the position out, either in a few months or a few years, depending on your time horizon, it is hard to really know.

The Big Short movie captured this conundrum really well (I highly recommend the movie as a hedge fund manager myself). A few smart investors did the work and figured out that the synthetic CDOs and CDO2s created from subprime loans were ticking time bombs. But between the time they put on their shorts and the time they paid off, they had to go through a very painful period in which their shorts went against them and the cost of carrying the shorts was high. Were they wrong during the year it took for their positions to pay off? Or just early?  Many of their investors thought they were wrong, and tried to pull their money. Others were unable to really tell the difference, but put enormous pressure on the funds to perform “now.” Making the argument for patience doubly tough was the fact that other managers at the time were doing really well, making the relative disparity look even worse. Until, finally, reality took hold and the fundamentals were finally reflected in the market in a dramatic fashion

Fast forward to today: bank stocks have had a very tough start to the year. As a fund that has a significant portion of its assets in financials, this has been painful, especially in January and February. The KBW Bank Index (BKX) touched a low on February 11th, down 23.4% for the year at that point.  That is a greater than 23% drop in 6 weeks.  That’ll leave a mark. Even after the recent rebound from those levels, as of the close of trading on April 18th, the BKX was still down over 8% for the year. When you wonder why your fund manager is having a tough time keeping up with the overall market, look at the banks for part of your answer.

For the rest of your answer, look at the insanity that is happening with “safe” dividend paying stocks. Normally, I’m a fan of “safe” and “dividends,” but the past few years of ZIRP and NIRP (zero interest rate policy and negative interest rate policy) have made people do things they otherwise wouldn’t do. Such as paying well over 20 times forward earnings for slow-growth consumer staples companies like Clorox, Campbell’s Soup, Coca-Cola, and Hormel. (Full disclosure: my fund is long puts on Campbell’s soup and the consumer staples ETF, XLP.)  Why are they clearly overpaying for these companies? Because the alternatives are worse if you are “risk-averse.”  Now, while it may seem riskier to buy Goldman Sachs or Morgan Stanley than Coca-Cola or Clorox, because the former are in the news all the time, and not for good reasons, as some politicians with bad hair who are running for president berate them constantly in their campaign speeches, while the latter evoke memories of the good old days of strong American brands, the stock market isn’t a popularity contest in the long run – it is a capital allocator. And if the investors who are hiding in consumer staples and, to a lesser extent, utilities, decide one day that the prospect of losing a little money isn’t attractive relative to the ability to lose no money at all by holding cash, I think we’ll see a massive wave of selling in these companies stocks.

There’ll be parties for hosting
Marshmallows for toasting
And caroling out in the snow
There’ll be scary ghost stories
And tales of the glories of
Christmases long, long ago

So we are in the most wonderful time of the year (for earnings). But keep in mind the coming shifts in the marketplace that can quickly change this happy tune into “scary ghost stories and tales of the glories of (prices) long, long ago.”

So where do we go from here?  As I said in my last Musings, “I think the S&P 500 is range-bound for now between 1950 and 2100, with a tighter range between 2000 and 2050. As we approach the end the quarter, we could see stocks drift down into earnings, as investors take a wait and see attitude towards new investments. Bond replacement stocks (staples, utilities) are incredibly expensive, while stocks with some issues (energy, financials, international stocks) look attractive.” Not a lot has changed, except the banks have rallied nicely and the S&P 500 is sitting just under 2100. As a result, we’re lightening up just a little, keeping ourselves very well hedged, and putting out some shorts in consumer staples and durables stocks.
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This week’s Trading Rules:

  • There is a fine line between being early and being wrong. Learn to tell the difference.
  • Unless you perfectly time every buy, you’ll be losing money at some point after buying. Learn to accept this as the price of admission to owning value stocks.

Markets in the U.S. have moved on the prospects for higher oil, a weaker dollar, and a trade into the higher end of the trading range. Nothing has really changed. Right-size positions and get ready to play a little defense if needed.

SPY Trading Levels: The market is still coloring within the lines. The SPY has stopped right at the 209/210 resistance we mentioned last time as being a tough level to get through. Moving a lot higher will be tough, but if we do, expect a sharp spike as shorts rush to cover and cautious investors play catch-up.

Support: 206/207, 205, 201/202, 195
Resistance: A lot right here at 209/210, 213, then not much.

Positions: Long and short U.S. stocks, ETFs and options. Short XLP, XLU, long CPB puts.