by Jeffrey Miller, Partner, Eight Bridges Capital Management
February 20th, 2016
‘Cause we’re young and we’re reckless
We’ll take this way too far
It’ll leave you breathless
Or with a nasty scar
Ben Graham Lecture Notes
I recently stumbled across two precious resources about the Godfather of value investing, Ben Graham. The first resource is a collection of notes from Benjamin Graham’s lectures when he was a professor at Columbia University. The notes were taken during lectures given in 1946, six years after the 1940 version of "Security Analysis" was published. Read More
- Blank Space by Taylor Swift
The selling has been relentless. Almost every day from January 1st through January 25th the XLF financial ETF went straight down. Pull up the chart. Why? Why did the largest financial stocks in the U.S. go on a forced march from over $34 to under $28 so fast? Oil and sovereign wealth funds (SWFs).
Oil dropped about 23% during the same time frame. As oil dropped, sovereign wealth funds of countries that are used to operating large social programs funded by oil revenues were tapped to meet cash needs. Saudi Arabia, Qatar, Norway, and others all went from swimming in cash to needing to tap their savings to pay their large bills. And what is, by far, the largest holding of SWFs? Financials. Financial stocks make up 46% of the holdings of sovereign wealth funds according to Piper Jaffray. In a distant second are consumer durables at 16%. So why are U.S. financials down? Coming recession? Fear of credit costs going up? Weak earnings? I say none of the above. It is liquidations by sellers who need cash.
Add to this list a few other potential sellers, like hedge funds (last week it was reported that Citadel was liquidating its large (the Wall Street Journal said $50 billion with leverage) Surveyor Capital division) along with a number of financially focused trading books due to poor performance. Anecdotally, the mood at last week’s KBW Financial Conference in Miami was notably dour. “Unbelievable”, “Makes no Sense”, and “This is Ridiculous” were phrases thrown around quite freely by bank fund managers. The nadir of negative sentiment was reached on February 11th, right in the middle of the conference, even though management teams presenting were quite sanguine about their own companies. We were decent-sized buyers for our fund that day, and are sitting on some nice short-term gains, but the bigger question is, where do we go from here? Will this move higher continue, or leave us with a nasty scar?
So it’s gonna be forever
Or it’s gonna go down in flames
You can tell me when it’s over
If the high was worth the pain
- Blank Space by Taylor Swift
U.S. banks are in pretty solid shape. Strong capital, but subpar returns due to low interest rates, fairly manageable oil and gas exposure, increasing M&A activity, and very reasonable valuations.
European banks are cooked. Italian banks are a mess, and four recently were seized. Big banks have more energy exposure than many thought, and the game of kick the can down the road hit the wall recently. Coco’s (contingent convertible bonds) are the issue du jour, with fears of those bonds being forced to convert to equity driving down large German banks in particular. Adding to the pain is the fact that European leveraged loans have recently traded down from 97% to 95.25% of par according to Bloomberg, or 1.8%. This isn’t good. Leveraged loans are held in CLOs and on large bank balance sheets. Let’s assume a conservative leverage ratio of 8 to 1 at a CLO and 10 to 1 at a big bank (I’m being generous). At 10 to 1 leverage, a 1.8% decline becomes 18% of your capital allocated to the portfolio. Surprised European banks are off nearly 30% from their highs? Me neither.
Chinese banks are even more cooked. How cooked? Burnt to a crisp, makes 2008 here look like sushi cooked. Kyle Bass, in his latest partner letter, details the problems facing China in detail. Instead of rehashing them here, I will just quote a small part of it. From Hayman Capital’s letter:
As the renminbi appreciated over the last decade, China undertook a massive infrastructure spending program in order to maintain politically-determined GDP growth targets in the face of these headwinds. This policy action created a system of distorted incentives (not to mention a dramatic misallocation of capital) whereby local officials were promoted to higher office by exceeding those targets without regard to the return on investment of the projects they supported. In 2005, exports and investment constituted 34% and 42% of China’s GDP, respectively. By 2014, exports had fallen to 23% and investment had grown to 46%. This growth in investment was funded by rapid credit expansion in China’s banking system, which grew from $3 trillion in 2006 to $34 trillion in 2015.
You read that right – assets in the Chinese banking system grew by 10x, or $31 trillion, in the past 10 years. Now, you don’t need to be a genius to figure out that not all of that is going to be paid back, especially when you consider that those loans were made in a country with poor corporate governance, managed centrally by a small committee of communist dictators, who have no experience running businesses or allocating capital. China is mixing a retail investor base with a gambling mindset towards capital markets with loss aversion at the senior government level and a state mythology of infallibility of its government leaders. But they are Young and Reckless when it comes to capital markets. They don’t deal with uncertainty well. (Last month, in The Emperor’s New Clothes, I wrote that “If I was able to, I’d short Mr. Xiao’s career at the top of the Securities Commission.” Well, Mr. Xiao Gang “resigned” from his post this week. I’m still betting on prison for him sometime in 2016.) The U.S. doesn’t like uncertainty either, but at least it has a higher hurdle for when it intervenes directly in markets. For that reason, we are expressing our views via shorting U.S. companies with high China exposure instead of its currency, like Bass at Hayman is, as we believe that China can easily change the rules of the game to suit their needs, and the short Yuan trade feels crowded.
The reverberations from China’s banking problems, even though China represents a fairly insignificant part of overall U.S. exports (kinda happy about those closed markets now, aren’t we?), will be felt in global markets not because of direct exposures, but because of de-risking by macro funds and other investors like SWFs that will sell what they can (U.S. stocks) to raise cash to backstop their own problems. So while bounces like we had this week are nice, and I do think U.S. banks in particular are attractive, it’s not quite time to tell you it’s over. When China goes down in flames, the high won’t have been worth the pain.
Screaming, crying, perfect storms
I can make all the tables turn
Rose garden filled with thorns
Keep you second guessing like
“Oh my God, who is she?”
- Blank Space by Taylor Swift
This week’s Trading Rules:
- When investors face uncertainty, they sell, creating losses and fear of further declines in others. Feedback loops and reflexivity kick in – selling begets more selling, as raising capital becomes more expensive. (Look at Deutsche’s Coco bonds for example.)
- Regret Theory and Loss Aversion drive average investors to make irrational choices. Price movements can extrapolate well beyond the fundamentals in both directions as a result. Mean reversion traders need to understand the psychology driving bull markets and bear liquidations before committing capital to a contrarian position.
Markets have bounced very nicely in the past week and a half. Will it continue? I think the S&P 500 could easily move up to 1950 or even 2000. After that, I expect it to bounce between 1850 and 1930 for a while, i.e., until China comes apart. Then it will be time to play defense and wait for the next down leg to occur. But in the meantime, I’m going to repeat what I said at the end of the last letter: what’s really interesting is what is happening beneath the surface. I think a wave of M&A is coming to community banks, and that companies that have been crushed on the back of oil’s decline and aren’t actual oil drillers are, for the most part, interesting investments down here. Leadership in the markets will shift from growth to value and large-cap to small.
SPY Trading Levels:
Support: 187/188, then 181/182, then a little at 175.
Resistance: 193/194, 200, 204.5/205, then it’s not going above 209/210 soon.
Positions: Long and short U.S. stocks and options.