Credit Bubble Stocks

Is High Yield Cheap?

2012-02-12T00:39:00.000-07:00

"[T]here is a nominal yield for high yield bonds which reflects the risk. It doesn’t matter where Treasury yields are, high yield bonds don’t care. As a result, when people in the media, or writing blogs those argue that high yield is cheap because yield spreads are wide, it is time to disregard then when Treasury yields are artificially low"

How Accurate Was the Clint Eastwood Superbowl Chrysler/Obama Ad?

2012-02-11T21:26:00.000-07:00

I am officially tired of Clint Eastwood. Here is a parody of the propaganda piece I refer to:

The automaker bailouts are another example of the broken window fallacy. What did we know about the automakers, ca 2009? That they consistently manufactured goods which were worth less than they cost. So, why keep those firms, and those managers, making automobiles? Why not let new firms bid for the defunct automakers' assets, and hopefully use them in a new way, making products that are worth more to consumers than they cost.

Meanwhile, despite what Clint said, Detroit does not seem to be doing so well.

The people of Detroit are taking no prisoners. Justifiable homicide in the city shot up 79 percent in 2011 from the previous year, as citizens in the long-suffering city armed themselves and took matters into their own hands.

Actually, that is the most bullish Detroit news story I have heard in a long time.

Anscombe's Quartet

2012-02-11T15:03:00.000-07:00

"Anscombe's quartet comprises four datasets that have identical simple statistical properties, yet appear very different when graphed. Each dataset consists of eleven (x,y) points. They were constructed in 1973 by the statistician Francis Anscombe to demonstrate both the importance of graphing data before analysing it and the effect of outliers on statistical properties."

Links

2012-02-10T23:22:00.000-07:00

What is happening to gasoline demand? And distillate demand (scroll to bottom - well below last year's demand)?
From Illusion of Prosperity: monetary policy is intended to create wage inflation, but mostly pumps up commodity and energy prices.
"Financial advisors have turned decidedly more optimistic about the market’s prospects for 2012..."
John Robb: "security is scaling slower than data, bandwidth, node, and user growth. It is falling behind and will continue to fall behind as the global system grows."
Goofy Warren Buffett giving a tour of his office to Charlie Rose. I wouldn't have expected him to have sports memorabilia. Does he actually watch college football? I don't know any intelligent people who do that.
Gary North, on entrepreneurship: "A handful of people have fire in the belly. They can put it out only by breaking ranks, breaking free, and devoting their time maniacally to some unique cause that no one else sees with equal clarity. These people change the world. But there are more who follow this path and fail than succeed."
Important paper: "Do Some Business Models Perform Better than Others? [pdf]"

Conrad Industries ($CNRD) Hits New High Again Today

2012-02-10T21:12:00.000-07:00

Up another 5% today; now 16.05x16.25! When we first mentioned it, it was trading at $10.

"Iron Giant: One of America’s great machines comes back to life."

2012-02-10T21:09:00.000-07:00

Approaching Alcoa’s 50,000-ton forging press feels a bit like approaching an alp: it starts out incomprehensibly huge and keeps getting incomprehensibly huger. From a distance, the thing dominates the horizon of the hangar-like Cleveland Works facility; as you get nearer, catching glimpses through forests of girders and around cliffs of firebrick, it begins to dominate the air above. But even as you stand at its foot, being told that the eight steel bolts anchoring it are 40 inches thick, calculating in your head that that makes them 10 feet around—even then it’s still a bit out of reach.

A Worthless Stock Buyer, Observed in the Wild!

2012-02-10T20:34:00.000-07:00

This is from an article on "thestreet.com" called "5 Stocks Under $10 Set to Soar". Before we start, raise your hand if you think that the stocks are expected to soar for fundamental reasons. If you said yes, go back to square one.

"Traders savvy enough to follow the low-priced names and trade them with discipline and sound risk management are banking ridiculous coin on a regular basis. [...] I definitely love to trade stocks that are priced below $10. I like to view them as a trading vehicle with lots of volatility and lots of upside when the trade is timed right."

Note that his emphasis was on "trade" - and on not getting caught holding the bag. He mentions three solar stocks (!), including Energy Conversion Devices.

Anyway, his comment about volatility is funny, because it is precisely the hypothesized reason for the worthless stock inefficiency. As Kumar (who calls them "lottery-type stocks") wrote,

"high idiosyncratic volatility is important in the sense that it may lead investors to amplify their perception about skewness. This would be especially true if they adopt an asymmetric weighting scheme and assign a larger weight to upside volatility and ignore or assign lower weight to downside volatility."

So... the "set to soar" article is another data point in support of our worthless stock theory.

Conrad Industries ($CNRD) Hits New 52 Week High

2012-02-09T13:50:00.000-07:00

Credit Bubble Stocks micro cap favorite Conrad Industries has hit a new 52 week high today. The market is currently 4000 shares bid 15.31.

No news, but a long writeup was posted on the VIC with some consulting from the good offices of Credit Bubble Stocks.

STR Holdings Comments on Fourth Quarter 2011 Results

2012-02-09T00:33:00.000-07:00

From the press release:

STR Holdings announced that revenue is projected to approximate $36.5 million for the fourth quarter of 2011... below the Company’s guidance of $44 to $48 million.

“Although the solar industry appears to have temporarily benefitted from strong German installations in December, we believe that most of this demand was satisfied from existing module inventory,” said Barry A. Morris, Executive Vice President and Chief Financial Officer.

Bearish.

Milton Romney

2012-02-08T23:54:00.000-07:00

Two New Energy Credits

2012-02-08T19:06:00.000-07:00

These popped up on my radar: the Stone Energy (SGY) bonds due 2017 yielding ~8 percent and the Comstock Resources (CRK) bonds due 2017 yielding ~10 percent. Interestingly, Comstock owns about ten percent of Stone Energy.

SGY has a market cap of $1.5 billion and net debt of $500 million, consisting of the 2014 sub notes ($200mm) and the 2017 senior notes ($375mm). Their ttm EBITDA is $574 million.

Various facts from the Jan 23 guidance and update: Estimated proved reserves as of December 31, 2011 increased to 100 million Boe or 602 Bcfe, representing an annual increase of 27% and a production replacement of 264%. The present value of the estimated future net cash flows from estimated proved reserves before income taxes at December 31, 2011 was $2.1 billion. The proved reserve base is 20% deepwater GOM, 30% Marcellus shale, and 50% GOM shelf.

CRK has a market cap of $600 million and net debt of ~$1.1 billion (more levered than SGY). Also, there is a bank loan, so owning CRK notes is less favorable than owning the SGY senior notes. Almost twenty percent of the float was short as of January 2012. Their ttm EBITDA is $270 million.

Links

2012-02-08T19:04:00.000-07:00

Have we seen the bottom in natural gas spot prices?
Deleveraging is history?
WSJ: "Oil and Gas Boom Lifts U.S. Economy"
"Allied Irish Banks Significantly Overvalued Versus Bank Of Ireland"
Looking at the swaption market: "Investors too complacent with the Fed’s pledge?"
MR: Lottery players "who win large amounts are just as likely to end up bankrupt as people who win small amounts. People who win a large amount, $50,000 to $150,000, have a lower bankruptcy rate immediately after winning but a higher bankruptcy rate a few years later so the 5-year bankruptcy rate for the big winners is no lower than for the small winners."

Low Recoveries in Green Energy Liquidations

2012-02-07T22:31:00.000-07:00

There was an article today about power storage company Beacon Power, which agreed to sell its only plant to Rockland Capital for $30.5 million, which will allow a roughly 70 cent recovery on the federal government's loan guarantee.

The recovery on Solyndra is going to be much worse: Obama's energy secretary won't even estimate the recovery, except to say that he is "anticipating that not very much".

One particular reason that recoveries are so low, besides the generalized statement that the assets are really specialized, is that the rate of technological advance is so rapid that the old manufacturing equipment quickly becomes obsolete and useless.

Efficiency in photovoltaic solar keeps increasing: "performance records are occurring across the board in every photovoltaic materials system, from CdTe (Abound) to CIGS (MiaSolé) to GaAs (Alta Devices) to triple-junction CPV cells (Solar Junction and Semprius) to crystalline silicon (SunPower)." (GTM)

So.. if you have plant and equipment that is locked in to early generation PV, it is basically worthless. Especially given the huge overhang of excess capacity in PV solar right now.

How We Will Remember Afghanistan

2012-02-07T19:28:00.000-07:00

What a sad waste of resources.

Another Sentiment Indicator

2012-02-06T23:14:00.000-07:00

Dynamic Hedge "Extreme Optimism is the Sentiment as of Now" shows a chart of the spread between the "dumb money confidence" and the "smart money confidence".

Conclusion: sentiment is stretched, but it could easily become more stretched.

USG Corporation (USG) Reports 2011 Fourth Quarter and Full Year Results

2012-02-06T19:28:00.000-07:00

Yet Another Quarterly Loss:

The corporation’s adjusted operating loss was $37 million in the fourth quarter of 2011, which compares to an adjusted operating loss of $39 million in the fourth quarter of 2010.

No position.

I think the wallboard industry is a joke, but the housing bulls have convinced themselves that the market is recovering (same as every year since 2007), and I do not want to stand in their way.

Links

2012-02-06T19:23:00.000-07:00

Solar Earnings Roundup

2012-02-06T15:18:00.001-07:00

DuPont's quarterly revenue missed Wall Street expectations as its customers bought fewer solar-panel materials and digital television parts, offsetting strong demand for chemicals used in agriculture. (Jan 24)
The glut of photovoltaic panels that wiped $30 billion from solar stocks last year is likely to expand in 2012, forcing manufacturers out of the industry... (Feb 1)
SMA Solar, Germany's biggest solar company, said it was unable to give an outlook for the ongoing financial year, blaming regulatory changes in key markets and the euro zone debt crisis. (Jan 13)
STR Holdings announced that revenue is projected to approximate $36.5 million for the fourth quarter of 2011... below the Company’s guidance of $44 to $48 million. (Feb 3)
Due to uncertainty on feed-in-tariffs and other legislation, as well as the global macroeconomic uncertainty affecting end market demand in both SBUs, Power-One is not providing full-year guidance for 2012. (Feb 2)
Prices for solar panels dropped 47 percent last year to $0.94 a watt after the 10 largest makers including China’s Suntech Power Holdings, the biggest, and No. 2-ranked LDK Solar, together doubled production capacity in 2010... The companies forecast a decline in shipments for the fourth quarter of last year. (Jan 5)

"Q-Cells bondholders agree to debt restructuring"

2012-02-06T15:18:00.000-07:00

"Ailing solar company Q-Cells said it agreed a deal in principle with major bondholders to restructure its three convertible bonds... 'Following this equitization, the 2012, 2014 and 2015 bondholders shall collectively hold at least 95 percent of the issued share capital of Q-Cells SE,' the company said..."

This is the natural thing for a distressed solar company to do. The bondholders take ownership.

Hussman

2012-02-06T02:09:00.000-07:00

I'm sometimes characterized as a "perma-bear." This is because the period since 2000 has been generally characterized by unusually rich valuations, which is duly reflected in the abysmal 0.80% average annual return, including dividends, that the S&P 500 has achieved from the 2000 peak through last week's close. That is not an accident, but instead matches the total return that we projected more than a decade ago, based on our standard valuation methodology. Given that, it should be clear that my generally defensive stance during this period is not some fixed aspect of my personality or temperament, but instead owes far more to the repeatedly and predictably disastrous overvaluation of the stock market since the late 1990's.

Small/Heavily Shorted/High Beta Stocks Up the Most

2012-02-03T23:38:00.000-07:00

The Russell 2000 is up almost 13 percent year to date, and close to a third since the beginning of October.

"Dow Chemical considers locking in low gas prices"

2012-02-03T14:38:00.000-07:00

"Companies are looking at these prices and locking in. Whenever you get near $2 (per million BTUs) you are going to have people locking in for the long term," said Phil Flynn... "I would imagine that we will see a lot of hedging at these prices."

"The survival prospects of democracy"

2012-02-02T19:39:00.000-07:00

"Until the American Republic demonstrated impressive longevity, the conventional wisdom was that democracy was inherently short lived. As soon as the masses discovered they could vote themselves rich, it would implode. Today, we observe that if it does not fall apart immediately, the elite import cheaper votes, and then it falls apart."

Journey to the Ants, E.O. Wilson

2012-02-01T11:57:00.000-07:00

"The foreign policy of ants can be summed up as follows: restless aggression, territorial conquest, and genocidal annihilation of neighboring colonies, wherever possible. If ants had nuclear weapons, they would probably end the world in a week."

Limits to Arbitrgage: The Dual Chesapeake Preferreds

2012-01-31T19:54:00.001-07:00

Here is a market inefficiency for you. Chesapeake Energy has two different publicly traded preferred stocks, both with a face value of $100, and both cumulative and convertible.

The 4.5% coupon, which is listed on the NYSE, has a conversion price of $43.91.
The 5% coupon trades on the pink sheets and has a conversion price of $38.81.

The second preferred has a higher coupon and a lower conversion price. You'd expect it to trade at a higher price than the first one, right?

Wrong. The lower-yielding, NYSE-listed preferred trades at roughly $90, which is a yield of 5 percent and a conversion parity of $39.52. The second preferred trades at around $80, which is a yield of 6.25% and a much lower conversion parity of $31.

There should be a total layup arbitrage here: buying the second one at a yield of 625 and shorting the first one at a yield of 500, and pocketing a 125bp yield spread plus a huge conversion premium. Except I cannot locate the NYSE listed one to short: a limit to arbitrage.

By definition, anyone who owns the first one is totally asleep at the switch. They could buy an equivalent security that yields more and has a much more attractive conversion feature.

[Note: Assuming the NYSE-listed pref is trading at the correct price and yield, the pink sheet pref should be trading at par, not 80!]

The "Skills Gap"

2012-01-31T18:04:00.000-07:00

Currently we have a yawning gap between people that can actually do things and people that work in highly specialized bureaucratic roles. That’s a big problem for those of us trying to build resilient communities...

Two Charts

2012-01-30T22:18:00.000-07:00

New high in Portugese ten year bond yield. A yield spread that high over Bunds means they are basically worthless. Look back at when Greece passed the point of no return.

New low in Baltic Dry Index. This is spooky. It's true that the glut of ships that were laid down during the credit bubble have made it so that the BDI probably will probably never reach the highs set in 2007.

However, on a short term (e.g. monthly) basis, the supply of ships is static. There are not new ships leaving shipyards every hour! So, that means that the BDI is currently telling us something about a change in demand.

Cool Video of Volkswagon Factory

2012-01-30T14:39:00.000-07:00

Hussman's Fascinating Hypothesis Regarding The Economic Data Uptick

2012-01-29T21:00:00.000-07:00

the extraordinarily weak economic data in late 2008 and early 2009 may have produced an upward bump in a wide variety of seasonal adjustment factors for data around the turn of the year, adding to the short-term noise we're already observing in various economic series

Distressed Names

2012-01-29T00:27:00.000-07:00

Taking a look at the distressed public universe. Some names and bond pricing contexts.

2012s
AMR ~25
FTWR ~15

2013s
GMXR ~60
STP ~65
LDK ~60
CSUN ~45
ENER ~38
EK ~28

2014s
USU ~60

2015s
YRCW ~43
ATPG ~70

2016s
AONE ~50 - this is another ENERish looking one with cash

Guess what? There are a ton of distressed PV solar names!

Another Paper on Worthless Stocks: "Maxing Out: Stocks as Lotteries and the Cross-Section of Expected Returns"

2012-01-28T21:22:00.002-07:00

The paper is called "Maxing Out: Stocks as Lotteries and the Cross-Section of Expected Returns", and is in the same vein as our previous research [1,2,3,4] on the worthless stock inefficiency.

This paper looked at the role of extreme positive returns in the cross-sectional pricing of stocks. They sorted stocks by their maximum daily return during the previous month and examined the monthly returns on the resulting portfolios (over the period from 1962 to 2005).

The relationship between maximum daily return and subsequent returns is negative, consistent with the other research we have seen about "lottery ticket" (worthless) stocks. These authors also believe that (retail) investors overpay for stocks that exhibit extreme positive returns, and that these stocks consequently exhibit lower returns in the future.

Their results were robust to sorting stocks not only on the single maximum daily return during the month, but also the average of the two, three, four or five highest daily returns within the month. That makes sense: what counts is whether a worthless stock experiences a squeeze. Once the squeeze dissipates, the subsequent returns are negative.

Their cognitive bias explanation for this inefficiency is that "errors in the probability weighting of investors cause them to over-value stocks that have a small probability of a large positive return."

Saturday

2012-01-28T20:01:00.000-07:00

Barron's: the cash held by its top ten firms equals close to ten percent of the market capitalization of the Nasdaq 100.
Also in Barron's: Hovnanian is still a total dog; "there has been no information from Hovnanian to support the price rise".
Tyler Cowen on the elderly: "The real question about our fiscal future is not Republicans vs. Democrats but rather whether any coalition can limit benefits to older people."
Atlantic on MBAs: "[E]ven 20 years later, the average salary of a class that graduated into a bear market was still lower than those of classes that had graduated into an equity boom..."

Energy Conversion Devices ($ENER) - What Are the Notes Worth?

2012-01-26T19:38:00.000-07:00

It is sort of absurd that we are going to talk about the recovery value of Energy Conversion devices debt on a day that the common stock was up thirty percent. In a sane world, that increase would imply some sort of good news or rational basis for optimism.

However, this is the world of capital structure arbitrage. Our research into the worthless stock inefficiency shows that a group of mostly retail investors buys these stocks because they behave like lottery tickets. From the time we have been paying attention to ENER, it looks like institutional investors have continued to sell out, and are now down to around a quarter instead of a third.

Anyway, back to the liquidation analysis. The most recent balance sheet we have is for September 30, 2001 from this 8-K filing. The first part of the analysis is to look at the assets. [Note that the company has not announced any plans to liquidate - I am just considering where bondholders and stockholders would likely turn out if that was the case. There is a wide margin of error because the numbers we have are now four months old.]

I'm assuming that the company burned $5 million cash during the fourth quarter of 2011. We really don't know, but we are certainly assuming that the quarter did not go well, given that the company suspended operations and laid off 70 percent of their workforce on November 8.

I'm assuming that accounts receivable would take a 20 percent haircut and inventory a 25 percent haircut - both seemingly reasonable given the lack of detail about these items. Other assets (e.g. prepaid expenses) I assume are worthless. I actually assume that the Ovonics subsidiary is worth ten million dollars more than the carrying value.

In the long-term asset category, I assume a 75 percent loss on property, plant and equipment. I assume 20 percent haircuts on the restricted cash and lease receivables. And a total haircut on the other long-term assets.

	As of 09/30/2011	Haircut	Value
Cash & Short Term Investments	119,876	-5,000	114,876
Accounts Receivable	21,621	20%	17,297
Inventory	68,012	25%	51,009
Other	13,957	100%	0
Ovonics	4,253	10,000	14,253
Total Current Assets	227,719		197,435
PP&E	59,064	75%	14,766
Restricted Cash	10,365	20%	8,292
Lease Receivable	11,428	20%	9,142
Other	9,857	100%	0
Total Assets	318,433		229,635

That results in a liquidation value of the assets of $229.6 million versus the current carrying value of $318 million.

Meanwhile, I value all of the liabilities at the amounts on the balance sheet, and I assume that the notes would share equally with the other unsecured creditors in the recovery value of the company.

	As of 09/30/2011	Haircut	Value
A/P	31,200	0%	31,200
Warranty – current	14,284	0%	14,284
Other	11,082	0%	11,082
Senior Notes	235,781	0%	235,781
Lease Obligations	21,134	0%	21,134
Other	16,916	0%	16,916
Total Liabilities	330,397		330,397

The result is $330 million in total liabilities, which exceed the liquidation value given above by $100 million! If my analysis is correct, buyers of the common stock are paying $60 million for a claim that is out of the money by $100 million.

Anyway, if all of the corporate liabilities share equally in our estimated liquidation value, that means that the unsecured claims are worth 70 cents (~70=230/330). Interestingly, this is 77 percent higher than the current trading value of the notes. So, given this initial set of assumptions, the common stock is worthless in a liquidation, but the notes are worth nearly twice as much.

I've put together a stress test analysis below, which uses the assumptions made above but shows the unsecured recovery percentage given different assumptions regarding what the property, plant, and equipment is worth, and also how much more cash (in thousands) the company burns before it liquidates.

		Continued Cash Burn
		-15000	-25000	-35000	-45000	-55000
Writedown of PP&E	100.00%	0.60	0.57	0.54	0.51	0.48
	80.00%	0.64	0.61	0.58	0.55	0.52
	60.00%	0.68	0.65	0.62	0.59	0.56
	40.00%	0.71	0.68	0.65	0.62	0.59
	20.00%	0.75	0.72	0.69	0.66	0.63
	0.00%	0.78	0.75	0.72	0.69	0.66

It is interesting that for all these assumptions, the notes are still worth more than the current trading price of around 40. Yet, under none of the assumptions does the equity come close to being in the money. [Note that the assumptions where PP&E are worth the balance sheet carrying value are presented for completeness and are not necessarily realistic. It would be basically unheard of for a liquidating manufacturer to be able to sell its plant without taking a loss.]

This painted an awfully optimistic recovery scenario for the notes. Let's do it again with a slightly different set of assumptions for the other balance sheet items.

We will assume that in Q4 2011, the company lost ten million in cash instead of five. We will assume an accounts receivable write down of 25% instead of 20%, and an inventory writedown of 33% instead of 25%. We keep the value of Ovonics the same, but assume that all the restricted cash is burned.

		Continued Cash Burn
		-15000	-25000	-35000	-45000	-55000
Writedown of PP&E	100.00%	0.54	0.51	0.48	0.45	0.42
	80.00%	0.58	0.55	0.52	0.49	0.46
	60.00%	0.62	0.59	0.56	0.53	0.50
	40.00%	0.65	0.62	0.59	0.56	0.53
	20.00%	0.69	0.66	0.63	0.60	0.57
	0.00%	0.72	0.69	0.66	0.63	0.60

I end up thinking that the notes are worth about 50, which would be a fair return for the opportunity cost and risk in owning them. I also do not see any reason to be enthusiastic about the stock.

FT: "Conoco to cut North American gas output"

2012-01-26T17:48:00.002-07:00

Improving supply fundamentals.

Why We Give Buffett A Hard Time on Credit Bubble Stocks

2012-01-25T17:26:00.000-07:00

Consider the following 2x2 matrix of possibilities:

Buffett is either right or wrong about an investment, and we either agree or disagree with him (and act accordingly). Note that "Buffett" can be a shorthand or placeholder for conventional wisdom in general.

	Buffett is right	Buffett is wrong
We agree	Make no money	Lose money
We disagree	Lose money	Make money!!

If Buffett is right and we agree, we make "no money" in the economic sense, i.e. no abnormal returns, because it is conventional wisdom and therefore priced in to the market.

If we agree with a wrong idea, or disagree with a correct idea, we will obviously lose money in those cases.

Our only way to make (significant, abnormal) money is to focus on areas where we are right and Buffett is wrong. That is, we need the Buffetts of the world - conventional wisdom - to create opportunities for us, either through indifference or actively making a mistake.

So, no wonder I focus my thoughts and research on areas where the market exhibits groupthink that I think is incorrect! That is the quadrant of opportunity!

[Afterthought: you could have a "fifth quadrant," with cases where Buffett is indifferent and we are right, which would also be profitable.]

Tuesday Links. 2011 Was "Just Buy The Dip." 2012 is "Buy the Rumor, Buy the News."

2012-01-25T14:46:00.000-07:00

The 24 hour economy. Nearly 40 percent of McDonalds stores are open 24 hours. Great news for drunks.
Niederhoffer: "The Blow-Up Artist" and "On Being Wrong".
Hmm. Mohegan Tribal Gaming Authority is asking bondholders to refinance.
There is an enormous bubble in U.S. farmland. I can't wait to bail out all these idiot farmers in five years.
Typical Wall Street attitude: "Baruch is not an American and the decline of the middle class there is not his uppermost concern; in fact he cares as much about the Chinese factory workers toiling away at Foxconn."
Manufacturing in the U.S. "The combination of skilled labor and complex machines gives American factories a big advantage in manufacturing not only precision products, but also those that are made in small batches..."
The economics of domain names.
Bullish thesis on manufacturing in the U.S.: "it takes about 25 years for the latest 'super-cheap-let’s-go-build-it-there' emerging industrial economy to lose its effective labor cost advantage over the U.S."

German Solar Firm Q-Cells to Restructure ($QCEG)

2012-01-24T20:37:00.000-07:00

From a press release by Q-Cells today:

Q-Cells SE plans a restructuring of its financial liabilities in two steps. After intensive negotiations with different creditor groups, the Company initially aims to come to an agreement with the holders of the convertible bond due at the end of February 2012. This agreement will provide among others for a partial repayment of the outstanding bond volume in tranches over a period of time. In a second step, and in due course, the convertible bonds due in 2014 and 2015 shall be restructured via a debt-to-equity swap.

"Partial repayment in tranches" would mean that those bondholders are getting a haircut, and getting paid in new debt with later maturities. And it sounds like the 2014 and 2015 bonds are getting only shares. The company has yet to publicly announce the details, but you would expect the shareholders to be basically wiped out in this restructuring.

In the same press release, the company mentions that it does not expect to achieve operating profit until 2014. In my experience, when someone projects that something will happen more than six months away, it either means never or "I don't know".

They will apparently be cutting manufacturing operations in Germany by 50% (more excess capacity in PV solar!).

Anyway, this is all good news for the short solar trade. Tons of excess capacity, and other firms that will emerge more competitive after restructuring.

Undifferentiated Trading in Solar Stocks

2012-01-24T15:15:00.000-07:00

This is a chart of Evergreen Solar common and Energy Conversion common over the past month.

Notice the very high correlation. Basically, every highly shorted stock spiked sharply last week (which of course meant the solar stocks did too).

It's funny because there is very little uncertainty about the value of ESLR stock: the company is in bankruptcy, the secured debt is taking a big haircut, the unsecured debt is getting virtually nothing (trading at less than a cent). Clearly, there is no good news or reason to buy the ESLR shares.

That allows us to test the hypothesis that there was no information content in the rally; just undifferentiated buying of highly shorted stocks.

What we see in the ESLR/ENER chart is consistent with that hypothesis.

Review of The Rise and Decline of Nations by Mancur Olson

2012-01-23T18:45:00.002-07:00

In his book “The Rise and Decline of Nations,” Mancur Olson suggests a theory for why the Great Depression was so long lasting. (And why the current depression has been, too.)

He thinks of the economy as having "fixed price" and "flexprice" sectors. The fixed price sector has monopoly or oligopoly prices set by either government, union, or collusive/cartel combinations. Fixed price also applies to raw materials with prices set by world markets. As with any collusive scheme, the cartel members in the fixed price sector benefit from abnormal profit while society suffers from below-equilibrium output. The flexprice sector is where prices are set by the free market, i.e. industries and sectors that are not just a racket being perpetrated.

Macroeconomic discussions usually posit a free market with prices that adjust dynamically according to demand. But during deflationary episodes, the fixed prices in collusive sectors do not adjust downward and consequently become absurdly high, resulting in falling demand and then falling production.

This explains why we see a clamor for inflation, because it brings the market price closer to the fixed price in the collusive sectors.

The health care sector is a cartel. The financial services sector uses taxpayer money to maintain their bonuses when they embarrass themselves. Most importantly: the amount of capital that is being raked off by these interest groups is going to end up leaving less for investing in productive enterprise.

4/5

Why Isn't Central Bank Reflation Working This Time?

2012-01-23T18:36:00.000-07:00

Although I have given Paulson quite a hard time, there was a plausible argument that 2008 would be followed by a normal cyclical recovery to new highs, i.e. the post-WWII experience. The Federal Reserve facilitated these recoveries by turning a blind eye to insolvent banks, lowering short term interest rates, and allowing the insolvent banks to borrow freely at low rates; then lending at a higher rate, and using the interest margin to earn their way back to solvency. This has never failed to work during the lifetimes of investors alive today.

The inability to lever up and rally to new highs should remind us of Japan. Why has their stock market been falling for decades? Don't central banks have the ability to target whatever nominal price they desire for a stock market index?

Could it be the aging population of Japan? By aging population, we mean a falling worker/retiree ratio. Among other outcomes, more people consuming and fewer people working means less investment and therefore slower growth. Because falling populations have not happened in recent history, almost no one sees the economic and social threat that this poses.

The aging populations are a result of falling fertility in wealthy nations. It is unclear what causes this, because the strongest correlation is simply with prosperity itself, as measured by GDP/capita. There is something about success that leads to demographic collapse. It could be that the social security safety nets in rich countries allow individuals to selfishly consume instead of reproducing. Or perhaps rich societies suffer from Geoffrey Miller's theory regarding Fermi's Paradox.

Whatever the ultimate explanation for aging populations, this trend is already in place and nothing can be done about it because everyone involved has already been born. Yet, strangely, U.S. investors continue in blissful ignorance of this underlying demographic reality.

Falling populations will of course decrease the demand for capital goods like new houses and cars. The housing market in particular faces three threats: aging population, excess supply and supply of the wrong type, and U.S. wage convergence with emerging market countries.

One structural problem with the U.S. economy is how leveraged it is to growth: the financial services sector needs positive first and even second derivatives of economic activity in order to prosper. Without a long term trend of rising population as a tailwind, investors will be less sheltered from malinvestments and problems of excess capacity.

These problems are obvious yet ignored because the consequences are grim and also because they involve concerns that are many years away. The phrase "I'll be gone, you'll be gone" applies here.

Energy Conversion Devices ($ENER) - What Are the Notes Worth?

2012-01-23T18:06:00.000-07:00

The real questions with ENER from a bondholder perspective are: at what rate do they continue to burn cash, how long will they continue doing so, and what are the plant & equipment worth?

They are burning cash more slowly now that they have halted production. Unfortunately, they are investing money in new equipment to keep the dream alive. As a bondholder I do not view that as a good investment.

Still, the bonds trade at less than my estimate of the current liquidation value. However, I cannot see any possible (p>.05) scenario where the bonds receive par upon maturity next year. This implies that the stock is overpriced.

"Chesapeake Energy Corporation Updates Its 2012 Operating Plan in Response to Low Natural Gas Prices"

2012-01-23T12:10:00.000-07:00

Highlights from the press release this morning:

plans to further reduce its operated dry gas drilling activity by 50% to approximately 24 rigs by the 2012 second quarter
operated dry gas drilling capital expenditures in 2012, net of drilling carries, are expected to decrease to $0.9 billion, a decrease of approximately 70% from similar expenditures of $3.1 billion in 2011.
plans to immediately curtail approximately 0.5 billion cubic feet (bcf) per day, or 8%, of its current operated gross gas production of 6.3 bcf per day, which is about 9% of the nation’s natural gas production. If conditions warrant, the company is prepared to double this production curtailment to as much as 1.0 bcf per day.

CHK common and the pref are up on the news. Meanwhile, a correspondent writes in about the Apache takeover of Cordillera Energy Partners.

"CHK has 2.4 million acres in the Anadarko Basin (Mississippian, Cleveland/Tonkawa, and Granite Wash). Of this, 1.4 million acres is Mississippian, leaving 1 million acres that is analogous to the deal below. This is just about four times the size of the below deal, suggesting a value for CHK of $11 billion for this portion of the Anadarko Basin. CHK's (soon to be JV'd) Mississippian acreage is probably worth $4 billion based on the recent SD/Repsol deal. This puts a total value of $15 billion on CHK's mid-continent position. This is slightly more than their market cap today."

Good stuff...

Nanolaw

2012-01-22T20:14:00.002-07:00

This is a funny short story about "mass speculative litigation".

Sunday

2012-01-22T18:24:00.000-07:00

Greentech Solar on the Solar Bust

2012-01-21T23:06:00.000-07:00

From a Greentech Solar post:

"A source has indicated that MiaSolé is for sale. But every solar company is for sale these days -- except perhaps for First Solar and the leading Chinese crystalline silicon firms."

Solar can't compete with natural gas. The Spiegel has an article "Re-Evaluating Germany's Blind Faith in the Sun". German PV solar has been an enormous boondoggle because... Germany is not sunny. If Arizona doesn't use PV solar, how could it possibly make sense in Germany?

Meanwhile, the price of polysilicon (primary input for PV cells) has fallen drastically. This is good for the cost competitiveness of PV solar generally.

However, the primary advantage of thin film solar technologies - like Evergreen - was that they used less silicon. That provided a meaningful cost advantage when silicon was expensive.

Saturday

2012-01-21T19:37:00.000-07:00

College majors: "Job or no job?"

This is not bear market behavior. The market is trying to speak to you ever so softly through price action. This is exactly what sentiment felt like in late 2009 and mid 2010. There were a million ways to spin the decline of modern civilization, but the market kept going up. Well, this is the same market that no one believes in.

Paper: No need for conspiracy: Self-organized cartel formation in a modified trust game: "It is often discussed if the observed fluctuations are a result of collusion among the gas companies, who attempt to increase the gas prices in unison [12]. Although this is certainly a possibility, our model shows that an explicit coordinated behavior among sellers is not an indispensable requirement for a cartel behavior."

NYT: "How U.S. Lost Out on iPhone Work"

Friday

2012-01-20T23:38:00.000-07:00

Asking The Right Question About Mitt Romney, Bain And Capitalism

Thinking about collapse: Big pieces of the current system (finance, insurance, real estate, consumer spending, new business development, farming), where access to easy credit underpins nearly every single financial transaction or decision that occurs in the U.S., is “brittle.” By “brittle” I mean that things work very well and very efficiently as long as individuals and firms have access to easy credit to finance operations.

The SOPA protest: "Wikipedia has now revealed that an astounding eight million people used its tool to look up their elected officials' contact info. ...] We heard from multiple Senate staffers that the phones – both in DC and back home in the district offices – were ringing non-stop with complaints about the bill."

Gary North on the lessons learned from the SOPA protest.

Natural gas and unseasonably warm weather.

Read Tim Knight's "Who Do I Think I Am?" post.

Barron's: "Solar: ‘Junk Rally’ Ignores China Pitfall, Says Jefferies"

2012-01-20T08:06:00.000-07:00

In Barron's:

"Jefferies & Co. renewable energy analyst Jesse Pichel today opines that a recent bout of short covering that has lifted shares of solar energy technology companies is destined to come to an end. The "solar junk rally," as Pichel refers to it, is failing to price in some looming risks..."

Look at the comments! His article brought irate retail investors out of the woodwork.

The 10,000 Year Clock

2012-01-19T19:23:00.000-07:00

Jeff Bezos is paying to have a 10,000 year clock built in the wilderness. Watch this video of a 12.5' dia, 500 foot deep vertical shaft being drilled using "raise boring", a fascinating drilling technique.

The clock is an awesome engineering challenge that represents the greatness of Western Civilization. And it is privately funded!

Time to Put the Energy Conversion Devices ($ENER) Capital Structure Trade Back On

2012-01-19T08:09:00.000-07:00

You may recall that we previously had a capital structure arbitrage trade on in Energy Conversion Devices, which we closed out last year when the stock collapsed to a de minimis value. I think I am going to put the capital structure trade back on. That is actually the best trade idea I have right now.

The reason is that an incredible short squeeze has taken place in the ENER stock, catapulting it from 20 cents to a high of 1.50 today. Meanwhile, the bonds have hardly traded, and are yielding nearly 80 percent. The prices of the company's bonds and common stock are inconsistent and imply wildly different valuations for the company.

Solar Short Squeeze
ENER manufacturers photovoltaic solar materials. The first two weeks of January have seen incredible short squeezes, in almost inverse proportion to the underlying strength of the business, for example in Evergreen Solar which has demonstrably worthless stock.

The other argument for the ENER rally is a recovery in the photovoltaic solar industry. Yeah, right. You can get a good sense of that possibility by reading this paragraph from a recent First Solar filing:

"In connection with a continuing objective of balancing production capabilities with market demand, [First Solar] is evaluating various means to reduce 2012 annual manufacturing production by more than 400MW. The Company expects to produce approximately 2GW of modules in 2012, reflecting an approximately 80% manufacturing capacity utilization rate, compared to an expected manufacturing capacity of approximately 2.5GW by the end of 2012. The Company expects to strategically idle some manufacturing capacity in 2012 in order to implement upgraded process technologies across existing manufacturing lines as part of its accelerated conversion efficiency improvement initiatives, and to better align production with expected market demand. The Company also expects to qualify its Mesa, Arizona manufacturing plant in 2012, but does not expect to start commercial production at this facility until 2013."

If FSLR is idling capacity, there is not going to be profitable business to be had by the smaller marginal solar producers. Marginal firms only do well when there is so much demand that the big firms in an industry are turning down orders. Here is more color on the PV solar market, from a Credit Suisse report:

“We caution that policy news tends to be very volatile day to day, and there will be occasions when a piece of news is interpreted as positive. However we think there is risk now that Germany will act in a way that reins in the pace of installations, adding to the oversupply in 2012, just like Italy did last year, and Spain in 2008. Last week’s solar rally is vulnerable to news flow on policy risk.”

Actually, the last we heard from ENER, they were completely idling their manufacturing to save money. This was from a filing on November 8:

"On November 8, 2011, Energy Conversion Devices, Inc. (“ECD” or the “Company”) publicly announced the temporary suspension of all manufacturing operations as an inventory control measure. ECD will continue to serve its customers through its direct sales force and its global network of solar integrators and building materials suppliers. The company expects to resume production in its manufacturing facilities as soon as possible once the existing inventory has been sold and market conditions warrant.

As a result of the suspension, 368 manufacturing associates have been laid off, while another 400 have been temporarily furloughed. The affected associates are located across the company’s Michigan, Mexico and Ontario manufacturing facilities. In addition, the company will lay off 132 associates from its corporate overhead worldwide. The estimated annualized cash savings from these actions is approximately $12.7 million.

In connection with the implementation of this plan, ECD will incur restructuring and other related charges in the second and third quarters of fiscal year 2012 totaling approximately $1.6 million."

According to Yahoo Finance, the company only has 1300 employees - so 70 percent of them have been idled. They are in complete free fall! That is why the stock was at 20 cents! Yet, it got swept up with the early January short squeeze and the misguided enthusiasm for solar stocks. I haven't heard an announcement from ENER about how sales are going, or whether they are any closer to restarting operations.

To me, the PV solar market represents a bet on three things: (1) rational demand based on unsubsidized IRR; (2) irrational demand from European subsidies; (3) irrational demand from Chinese subsidies. The rational demand has completely evaporated with the decline in natural gas prices over the past quarter.

Europeans can no longer afford alternative energy boondoggles, which was the big reason for the PV solar crash last year. That has not changed. The total German PV installation surprised to the upside for 2011, but the bad news is that the German PV subsidy will be cut by 24 percent as a result of this.

China has said that it will install 3 GW of PV solar in 2012. Remember from above that First Solar has idled 0.5 GW of their capacity in 2012. Anyway, China favors Chinese firms for solar projects.

For a given PV solar firm, their ability to sell depends on (1)cost and (2) bankability. Cost is a function of scale and technology, both of which favor the larger firms like First Solar. Bankability, meaning whether banks that finance projects believe that you will honor your warranty, is a function of balance sheet strength. Obviously, there are concerns with ENER in this regard.

ENER Capital Structure
Energy Conversion Devices has one series of debt, the three percent convertible notes due June 2013. There is $260 million face value of outstanding notes, which trade at 37.5 percent of par, for a market value of $100 million.

However, the company has $120 million in cash and short-term investments as of September 30, 2011. If the company could buy back its debt at a discount in the market without affecting the price, it could theoretically retire all the debt and have cash left over.

The fact that the market value of the bonds is less than the amount of the company's cash and short term investments means that the bond market ascribes a negative value to the company's business and investments in alternative energy: the “enterprise”. This is probably correct, because it implies that the company will continue to burn cash before eventually being forced into restructuring.

Were this simply a case of bonds trading at under forty cents on the dollar when the company has perhaps fifty or sixty cents worth of liquidation value, it might be interesting but still troublesome because that liquidation value would continue to fall as the company lost money in its operations.

The exciting part is that the company's market capitalization – the market value of its common shares – is $70 million. In order for the common shares to be worth anything, the enterprise must be worth as much as the face value of the debt ($260 million) minus the cash and short term investments ($120 million), which is $140 million. And a market capitalization for the stock of $70 million implies that the enterprise is worth $210 million. What does it mean if the stock market implies a valuation of $210 million for the same enterprise that the credit markets give a negative value?

Clearly, the valuations are mutually exclusive, and so only one of them can be correct. Ultimately, it does not really matter whether the bond market or stock market is right, because we can bet that the inconsistency will converge. By buying the bonds and shorting the stock, we can simultaneously “create” the enterprise at a negative valuation and sell it at a positive one. In fact, this situation is the first one I have found where the interval of enterprise valuations implied by different securities includes both negative and positive valuations.

Part of my investment process is to form a plausible hypothesis for why a market inefficiency or opportunity might exist. In this case, I can think of two possible explanations. First, an arbitrage opportunity involving a market capitalization less than $100 million is so small that many sophisticated arbitrageurs will not even look at the situation. Second, close to three-quarters of the Energy Conversion Devices stock is held by retail investors. These types of investors are generally oblivious or indifferent to the company's bond price, yet they are the marginal buyers setting the price of the stock. If they were paying more attention, they would consider selling their stock in a company with bonds that yield 80% to maturity, and buying the bonds instead.

Actually, it would appear that many of the marginal buyers that have pushed the price up this week don't actually have an opinion about the value of the company - they just want to "rent" a stock that is going up. A great way to check this is the Yahoo "Market Pulse" for the stock, which aggregates tweets and whatnot. The retail crowd got excited because the stock went up.

Recent Developments
The other major disclosure recently, besides the fact that they idled all of their capacity, was that they have started down the restructuring path:

"We expect to continue to refine these restructuring efforts and align our resources as conditions warrant to better execute on the revised technology roadmap and Open Solar business model. Although we are not currently experiencing significant liquidity constraints, we believe that a successful repositioning of our United Solar Ovonic business will require additional investment and refinancing or restructuring of our outstanding Convertible Senior Notes (“Notes”). We intend to invest the proceeds of any sale of OBC in our United Solar Ovonic business to support funding of our technology roadmap and Open Solar™ initiatives. We are considering a range of strategies to attract additional needed investment and we have retained the financial advisory firm of AlixPartners to assist us in evaluating our strategies. These strategies may include additional asset sales, technology license agreements, joint venture arrangements, renegotiating existing obligations or other transactions.

In connection with the foregoing, we have begun discussions with representatives of an informal group of noteholders regarding our repositioning efforts and to explore the group’s interest in restructuring our obligations under the Notes. Our discussions are at a preliminary stage. If we are unable to reach an accord with the noteholders or execute sufficiently on one or more of the strategies that we are considering to attract required investment, we may choose to seek reorganization under the U.S. Bankruptcy Code."

They are planning to sell the non-solar research subsidiary, which does about a modest amount annually through royalty revenue. That might be good for a bit of recovery of bonds. It is telling, though, that they are going to sell it and "reinvest" the money in the money-losing solar business.

Here is an interesting fact that tells you about the company's debt levels: in the most recent quarter, interest expense was 26 percent of revenue. Earlier this week, the company made its "previously deferred semi-annual interest payment" on the notes. They had taken advantage of a 30 day grace period not to pay. Apparently, that is wildly bullish!

Potential Catalysts
If I were in their shoes, I would offer the noteholders a combination of cash, new notes, and stock. I could see a coercive offer that gave the notes, currently trading at ~35, perhaps 10 cents in cash, 50 cents in new senior secured notes, and a majority equity stake in the company.

The noteholders should hold out for a lot of stock, preferably a controlling interest in the company, maybe even all of it, depending on what else they are offered. In these situations, you will often see management given a big chunk of the company (5-10%) to turn the keys over to the bondholders.

P.S. Someone else apparently agrees with me. Someone shorted "about 3,800 January 1 calls for $0.50 to $0.69. Volume is more than 4 times open interest in the strike." Selling calls is attractive compared to shorting the stock.

Another Short Squeeze - Evergreen Solar

2012-01-18T21:45:00.000-07:00

Look at what happened with Evergreen Solar over the past week. From a couple cents to a high of 23 cents yesterday! Over 10x!

Recall that Evergreen is in bankruptcy. Its nearest maturing unsecured debt is trading at a tenth of a cent! Only the secured creditors are getting anything.

For there to be a posted bid at all for ESLR shares is deeply irrational, and an example of the worthless stock inefficiency. And this thing traded almost 10 million shares this week! That means someone threw away close to a million dollars.

The Real Economy

2012-01-17T20:31:00.000-07:00

"Supervalu’s 1,280-store Save-A-Lot chain opens some supermarkets at midnight, when government benefits are loaded onto food stamp cards, and promotes higher priced bulk items early in the month. The chain switches to smaller sizes later as money dwindles..."

Monday Night

2012-01-16T22:12:00.000-07:00

The Telegraph has a very interesting article today, "When, oh when, will Europe face the truth?". It seems like the conversation in Europe is moving in the direction of reverting to national currencies. That seems like the British view and the S&P ratings view, at least. The money quote, "If this were just an issue of insufficient liquidity, then it surely would have been solved by now, given the expansion of central bank balance sheets which has already taken place"
That was the British perspective. For the German perspective, here is a random CEO of a German industrial firm, who correctly points out that "the willingness of crisis countries to reform themselves is abating if, in the end, the European Central Bank steps in." The Germans have started doing the math and realizing that having weaker countries leave the Euro, resulting in a stronger Euro, results in a net benefit even according to their fuzzy mercantilist math.
In the U.S., one of the Fed mouthpieces is talking about tightening monetary policy! This is a far cry from QE3! Notice, one of Prechter's predictions (and arguments for deflation) was that, even though central banks could theoretically monetize all of this debt, political constraints would prevent them from doing so.
ZH (clumsily) points out an unintended consequence of the ECB purchases of sovereign debt that are intended to prop up those markets. The ECB refuses to share in any "haircuts" that are negotiated between lenders and insolvent countries, because the ECB is so highly leveraged that they cannot afford haircuts. The result is that a bond is effectively senior if owned by the ECB and subordinated if it is not. And that means that for every bond that the ECB buys to prop up the market, the remaining bonds should be paradoxically worth less, because there is less recovery remaining for them to share.
Enough about central banks (ugh). Did you know that your probability of dying during a given year doubles every 8 years or so? Which means that your mortality rate is increasing exponentially? Which means that the probability of surviving to a particular age is falling super-exponentially! [This is a cool blog, by the way.]
A great paper from the same author: The problem of shot selection in basketball. He creates a very interesting model for deciding whether a player should take a shot or wait for a better opportunity, depending on how much time is remaining. He notices a discrepancy between the observed and the theoretically optimal shooting behavior of NBA players, in that they seem to be unwilling to settle for moderately high-quality shot opportunities early in the shot clock, believing that even better opportunities will arise later. One explanation for this is overconfidence.
Overconfidence is an interesting subject. If someone is overconfident, it means that their confidence intervals are miscalibrated: they overestimate the precision of their own forecasts. I have previously posted about managerial miscalibration and about the potentially adaptive advantages of overconfidence.
Latest Hussman column is out: "the investment implications are very asymmetric. A slow but steady stream of modestly good economic news is largely priced in by investors, but a recession and the accompanying earnings disappointments would destroy some critical pillars of hope that investors are relying on to support already rich valuations. We're always open to shifting our investment stance and outlook in response to new evidence, but the "optimistic" evidence that many observers are using to discard recession concerns is generally based on coincident or lagging data."

Fascinating Indicator - Realized Volatility Premium

2012-01-15T20:02:00.002-07:00

Macrofugue posted a chart of an interesting indicator: the realized volatility premium on the S&P 500. (The realized volatility premium is the implied volatility (VIX) minus realized volatility.)

As they put it, "when [the realized volatility premium is] positive, it has presaged increases in implied volatility -- as options writers may have under-priced volatility relative to what has been realised."

If options sellers aren't charging enough - which is what a negative volatility premium means - that is a sign of complacency. It makes sense that these complacent periods are major market tops that precede breathtaking declines.

Best Day Ever

2012-01-14T00:01:00.003-07:00

A 10 point bid/ask spread on the S&P 500!

End of Week

2012-01-13T21:28:00.001-07:00

In case we hear any nonsense about retail sales numbers as an economic indicator: retail sales did not turn negative year over year until Q3 2008! By which point, the S&P 500 had already fallen 20% from peak. And the XLF was down by a third.

This afternoon, S&P removed the triple-A ratings of France and Austria and downgraded seven others, including Spain, Italy and Portugal. (Italy is now only two notches above junk! What is an Italian consumer loan book worth now??) Next week, it would logically follow for S&P to downgrade the banks and other government-related issuers in the downgraded countries.

Should be exciting! And sentiment is high and shorts have covered already!

Dollar Hits New 52 Week High

2012-01-13T08:44:00.000-07:00

New 52 week low for EURUSD.

Also the Baltic Dry Index tumbles again.

Other Important Indicators

2012-01-12T15:35:00.001-07:00

As I suspected, this rally seems to have been fueled by short covering. Short interest as of Dec 30 had plummeted to the lowest level since Spring 2011, which was a significant market top. The short interest in the $28 billion NASDAQ ETF (QQQ), normally an important hedging tool, has fallen to an 11 year low as of the end of year. The massive $100 billion S&P 500 ETF (SPY) saw a 33% drop in short interest during the last two weeks of the year.

Shorts have been squeezed out of their positions as sentiment has become wildly positive. This week, AAII sentiment increased slightly to the highest level since February 2011. After that instance of exuberant sentiment, the market was never able to rise by more than 20 points.

This is happening in the face of deteriorating leading indicators. (Even though lagging indicators are still improving.) For example, the Baltic Dry Index (BDI), a measure of shipping costs for dry bulk cargoes, has broken through its August low. The BDI was a great leading indicator when it peaked in October 2007 (at a level that it has never regained, because of a glut of ships.) Also, Rosenberg points out that the strength in Treasury bond prices is another non-confirmation of economic strength, as the yield on the 10-year note is once again below two percent.

Worth Reading

2012-01-12T15:07:00.000-07:00

The Cult of Amazon Prime
Review of Thinking: Fast and Slow
Kaempferol [a compound in green tea] "induces apoptosis in glioblastoma cells through oxidative stress".
More on the CIT/Sears situation.

Today's Market

2012-01-11T22:54:00.000-07:00

Looking over the names that were up today, the rally this week has focused exclusively on high beta and high short interest names - similar to the monstrous October rally. Neither big cap growth nor any type of value is doing well; again, similar to the October rally. Remember that at the end of October when optimism had prevailed, the market then proceeded to drop 5% in two days.

Earlier this week, Prechter called for maximum short exposure. He is not infallible, but he is worlds better than whoever (or whatever) was buying solar stocks today, and I would weight his advice about 20 percent in a decision function.

The latest AAII survey will be out soon and should be instructive. I would imagine that retail is embracing the rally and is even more bullish than last week. That would be another high quality decision input.

I feel inundated by commentary of people who are looking at lagging indicators, like growth in consumer credit. This is a data series that peaked in summer 2008, close to nine months after that recession began. Read Hussman's column about this data interpretation problem. Similarly, in past recessions neither the level of job growth nor its short-term trend had any predictive power regarding the subsequent direction of the economy.

Reflecting further on the mania or upward panic today: it may be explained by managers who were down in 2011 and cannot stomach any further losses. That would explain why they are so skittish. It would cause short squeezes in the dogs and dumps of value stocks, just as we saw today. I do not think it probable that managers who have lost heart will be able to make money.

8 And the officers shall speak further unto the people, and they shall say, What man is there that is fearful and fainthearted? let him go and return unto his house, lest his brethren's heart faint as well as his heart.

A trading process that attempts to avoid any drawdowns by violently and immediately covering shorts and selling longs at the first sign of difficulty is unlikely to work. If it was possible to invest without drawdowns, then no one would need any capital to invest; you could leverage infinitely on margin. Whoever trades according to that process is going to systematically buy high and sell low.

Energy Conversion Devices (ENER)

2012-01-11T19:39:00.000-07:00

We closed this capital structure arbitrage trade last year, but it is a perfect example of the insanity that took place today. The stock was up forty percent while the bonds traded an oddlot at 33, which was actually down slightly from yesterday.

This is another one with massive short interest. (And it looks like 70%+ retail ownership.)

Nonsensical

2012-01-11T17:59:00.000-07:00

I'll follow up more on how bizarre trading has been this week, but just a quick note that the small cap solar firms (that are going extinct) were up massively today while natural gas and NG producers were down.

Solar cannot compete with electricity from natural gas at these prices. Falling electricity cost (which is set at the margin by natural gas prices) is ultra bearish for PV solar demand.

The only logical explanation is that there is very large short interest in the solar companies because they are rightly perceived as failures. And today was a gigantic short squeeze.

Followup on Chile

2012-01-09T17:58:00.000-07:00

There is a reason I posted about Chile earlier. Because their economy is so dependent on copper, it will absolutely crater if (when) the China bubble pops. That could set up buying opportunities.

Thinking About Chile

2012-01-09T08:53:00.000-07:00

Chile has the highest GDP per capita of the South American countries. At $15,000, it is slightly higher than Argentina, Venezuela, and Urugay, and is about fifty percent more than Brazil's $10,000 figure. The other seven countries do not crack the five-figure threshold. Chilean GDP is $200 billion and government expenses are $40 billion; this is 20% of GDP versus U.S. federal government spending of 25% of GDP.

Chile also has a set of budget rules that essentially require a fiscal surplus over time. In 2011, the government's budget was expected to be in surplus by roughly one percent. Also according to EconoMonitor, the gross Chilean government debt was 8.8 percent of GDP, "which is less than the government’s holdings of financial assets, meaning that net debt is negative. On top of all that, it has a current account surplus approaching 2 percent of GDP."

The pillars of the Chilean economy are mining (one-third of the world's copper output), forestry (pulpwood), salmon (40% of worldwide sales), and agriculture. The country is heavily dependent on copper prices in much the same way that Russia is dependent on petroleum prices.

Interestingly, Chile exports high-value agricultural products even though a miniscule proportion of the country is arable land. Chilean agricultural output comes from its Central Valley, between the Coastal Range and the Andes. This area runs N-S across roughly ten degrees of latitude, creating a variety of climate regions and allowing staggered, extended harvesting seasons. Also, it has agricultural seasons that are the inverse of the consumer countries in the northern hemisphere.

I found a paper (from 2004) called Doing Business in Chile, which is a handy reference.Simon black from SovereignMan has been writing extensively about Chile.

"Leading Indicators and the Risk of a Blindside Recession"

2012-01-08T18:47:00.000-07:00

The weekly Hussman is up.

He and I agree that the potential market outcomes are asymmetrically bearish, because the market has essentially been tricked by invalid indicators into excessive bullishness.

Demographic Collapse: "America's One-Child Policy"

2012-01-08T11:31:00.001-07:00

"China and America have yet to witness the effects of falling fertility because of demographic momentum. Populations increase even as fertility rates collapse, until the last above-replacement generation dies, after which the population begins contracting. The rate of contraction speeds up as each generation passes. No society has ever experienced prosperity in the wake of contracting population."

No Such Thing As Coincidence

2012-01-07T07:38:00.002-07:00

The creak of a stair that had not creaked before; the rustle of a shutter when no wind was blowing; the car with a different number plate but the same scratch on the offside wing; the face on the underground that you know you have seen somewhere before: for years at a time these were signs he had lived by; any one of them was reason enough to move, change towns, identities. For in that profession there is no such thing as coincidence.

Sell Side Research and Chesapeake Energy ($CHK)

2012-01-06T06:48:00.001-07:00

From a Credit Bubble Stocks correspondent:

"[Investment Bank X] values the company based on a multiple of cashflow and as compared to its 'large cap peers.' This means they are valuing it the way you would value a no-growth company like Exxon. Because CHK is the largest shale company they have bumped it up into the large cap universe.' The smaller shale companies (mid-cap E&P companies) trade for double CHK’s valuation on an earnings and cashflow basis.

"Much more importantly, this valuation ignores the value of their assets. [They] admit as much, and the analyst writes under 'valuation' that their price target is '0.48x NAV' – or that they think the company is worth 48% of Net Asset Value. This is the reason I call these reports idiotic... the analyst himself says the company is worth more than $50 per share (the Net Asset Value). This could also be looked at as a break-up value for the company."

Sum of the parts is clearly the best way to value CHK, not multiples. It is not very difficult, because CHK frequently sells meaningful fractions of its natural gas plays. That creates a very usable implied valuation for each play, which you can sum together with the drilling and gathering assets.

January Effect

2012-01-05T22:33:00.000-07:00

Even though you can hardly tell that it's January in the Rockies, you can see the effect in the stock market where all the dogs are bouncing. Once again, this has totally suckered in retail.

The tell is the divergences that are popping up, e.g. the one between the Chinese and U.S. stock markets. There was a divergence between Chinese and U.S. markets that started in the spring of 2008 and resolved to the downside when the U.S. market collapsed in the fall of 2008.

The other notable divergences which I mentioned - the dollar rally, gold and silver collapses, etc. - are still in effect.

"Why Best Buy is Going Out of Business Gradually"

2012-01-05T20:02:00.002-07:00

"[ Amazon]simply does what consumers want. Best Buy does what would be most convenient for the company for consumers to want but don’t, then crosses its fingers and prays."

Excellent Essay: "Banks - Expensive at Every Price"

2012-01-05T20:00:00.000-07:00

"We're not in the habit of making heretical statements, but we believe banks are not an appropriate investment at any price for the thoughtful value investor." [pdf]

- Value Investment Institute, March 2011

Chesapeake Energy's Bullish Case for Natural Gas ($CHK)

2012-01-05T01:26:00.060-07:00

In their November 2011 investor presentation, Chesapeake Energy offered "many reasons to be bullish on intermediate and long-term natural gas prices." (p13)

"U.S. natural gas producers are rapidly moving to an oilier production base." Natural gas production in the U.S. increased about 28 percent over the past decade. Nearly half of this growth came from CHK alone. However, CHK continues to reduce drilling of natural gas wells, except where required to hold leases or use drilling carries. In 2012 and 2013, CHK plans to spend ~75 percent of capital expenditures drilling in liquid-rich plays.
CHK argues that the shift to liquid-rich wells will occur industry wide, as producers convert to drilling wells that produce $10-17/mcfe, and finish drilling enough wells to hold their shale gas shale leases. Once that conversion happens, it may take much more than "4,5,6, or 7" dollars per mcf to incentivise the industry to drill gas wells again. And the shale gas output has steep decline curves!
"Conversion of U.S. liquefaction import facilities to LNG export facilities." For example, the Sabine Pass LNG terminal, owned by Cheniere in Lousiana.
"Growing industrial demand: U.S. natural gas prices are lowest in the industrialized world and well below oil-based naphtha prices."
"Shift from coal to natural gas for U.S. electrical generation." Right now, lots of utilities are making decisions about whether to replace obsolete coal plants with more coal or natural gas. Low prices are encouraging the use of natural gas.
Construction of gas-to-liquid (GTL) plants. This is very cool - you can make a barrel of gasoline with natural gas feedstock, and at the current crude oil:natural gas ratio, it is incredibly profitable. Buffett should be buying CHK and building GTL plaints. South African company Sasol is building a plant in Louisiana.
CNG and LNG vehicles. CHK has made a small investment in LNG fueling infrastructure for trucks along interstate highways. Focusing on trucking is a very clever way of bootstrapping to solve the chicken-egg problem in fueling infrastructure. According to CHK, the "8 million American heavy duty trucks consume ~3 million barrels of diesel every day, that’s equivalent to >6 tcf of incremental natural gas demand per year." If fully converted to natural gas, that would be 16 bcf/d of incremental demand, compared to only 10 bcf/d of incremental natural gas supply in the U.S. between 2000 and 2011!

This is a pretty good supply/demand situation. Things look grim and the price is low, but there are imminent catalysts that will decrease supply and increase demand. By buying the convertible preferred stocks, we get paid to wait.

Why would you buy a noncumulative preferred stock in a European bank when you could buy a convertible preferred stock with safety and a free call option on natural gas? It takes all kinds...

Astonishing Jump in AAII Bullish Sentiment

2012-01-05T00:41:00.000-07:00

See here and here.

Cable Companies, Netflix, and "The Poverty Problem."

2012-01-04T10:30:00.006-07:00

Last year, while we were short Netflix, I started paying more attention to cable companies. They have all been bleeding subscribers - hundreds of thousands of cancellations each quarter.

I found that there was one Wall Street analyst who was actually paying attention to the impoverished consumer: Craig Moffett, an analyst at Bernstein, who wrote a report called "The Poverty Problem.":

The often-quoted average family has annual income of $62,000 a year. But the median ... is only $42,000 a year. There's 40% of America that has no discretionary income... [T]he mean for each quintile was, in ascending order, $9,956, $27,275, $45,199, $71,241 and $149,951. The big take-away from this de-averaging exercise is that the top quintile now has 15 times the after-tax income as the lowest quintile. Forty years ago, this ratio was less than 8 to 1. [...] After the necessities of food, shelter, transportation and healthcare each month, the bottom 40% of U.S. households have already exhausted all of their disposable income. There is nothing left for clothing… for debt service… for cable… or for phone.

His argument was that this income distribution is uniquely bad for subscription TV providers. Close to 90 percent of U.S. households have cable TV. Hardly any other sectors are that exposed to the bottom of the U.S. income distribution; a group that is hanging by a thread.

Of course, big U.S. multinationals don't care about this (yet) because they think that they can sell Harley Davidsons to the Chinese. But owners of fixed assets like real estate, cable TV systems, and celular phone networks certainly need to care about the effects of global wage arbitrage.

Who Are the Suckers in the Market?

2012-01-03T20:41:00.000-07:00

Stableboy wrote a post called "Who's the Sucker in the Markets Today" and asked whether there are "enough of them to feed the hedge funds?" I have some ideas about who the suckers are:

Index investors (i.e. efficient market adherents). This is a free ridership problem. The philosophy of index investing is, "other people will make good decisions for me, for free." I also call it, "buying stocks at random." An enormous amount of capital is allocated this way. There is one trillion dollars just in index mutual funds, not counting ETFs or closet index funds. Notice, most of our good shorts have been owned by index funds and not active investors. I rarely find myself on the opposite side of a group of hedge funds; more likely to be retail investors and index funds.
Dip buyers. This is a type of behavior that evolved during the 1982-2000 bull market. The prime example is Bill Miller - have you heard his saying "lowest average cost wins"? People still use this technique even though it is a spectacular failure.
Obviously, people who buy worthless stocks. (My concept of the worthless stock inefficiency.)
Baby boomers, as a class, are suckers, with a free ridership problem just like the index fund investors. As William Bernstein put it, "it is simply not mathematically possible, let alone politically feasible, to expect each worker to support 0.67 retirees, no matter how many coconuts, dollar bills, stock certificates, or Krugerrands they save up in the meantime." Thus, we have the aging population and therefore falling demand for what will be a great part of my lifetime. Which brings me to my next point:

Remember my concept of investor genotypes in an investing ecosystem? During the bull market (1982-2000) within a bull market (1932-2000), any style that stopped to consider the possibility of a bear market would have been maladaptive. If you think about it in terms of expected value, for any value of caution regarding a bear market, such a framework would only have lowered expected value and could only have been maladaptive. As a result, the "cautious genotype" has largely been purged from investing.

Stableboy quotes an author named Steven Crist, who was the publisher of the Daily Racing Form. I ordered two of his books: The Horse Traders and Betting on Myself: Adventures of a Horseplayer and Publisher.

Ron Paul

2012-01-03T17:16:00.000-07:00

From Tom Woods at Lew Rockwell:

A Ron Paul victory would mean that more Americans than we could have imagined even five years ago are prepared to tell the establishment to stick it. The more you smear, the more viciously you attack, the more obvious your venom for one particular man, the more we will rally to him. Since this is the only man who truly terrifies the crooks, the flip-floppers, the thought controllers, and the whole range of so-called respectable opinion, he is obviously the one to support.

What a message that would be.

No CNN reporter will be visibly deflated if Mitt Romney wins in Iowa. Or any of the others, for that matter. That’s your tip-off.

NYT: "The Joy of Quiet"

2012-01-02T18:29:00.000-07:00

"A series of tests in recent years has shown... that after spending time in quiet rural settings, subjects 'exhibit greater attentiveness, stronger memory and generally improved cognition. Their brains become both calmer and sharper.' More than that, empathy, as well as deep thought, depends (as neuroscientists like Antonio Damasio have found) on neural processes that are 'inherently slow.'"

December 1899 Market Crash

2011-12-30T23:13:00.000-07:00

An interesting story about a "Day of Panic and Financial Wrecks" from the New York Times archives.

"After yesterday's experience Wall Street men, recalling the troubles following President Cleveland's Venezuelan message in 1895, and the opening of the Bryan free silver campaign in 1896, were inclined to talk of those times as days of comparative quiet."

Noticing Divergences

2011-12-30T23:00:00.000-07:00

USD above October high.
EUR/USD below October low.
Commodities index in a clearly descending trend.
Gold below October low.
Silver below October low.
Silver/gold ratio has fallen below the October low.
Shanghai well below October low.

The only thing missing are U.S. equity indices! They need to catch up...

Forestry Mowers

2011-12-29T12:00:00.000-07:00

That is awesome.

Follow Up on Amrep

2011-12-28T21:26:00.000-07:00

One of the first Credit Bubble Stocks posts was about Amrep, the New Mexico land developer. At that time, we observed that the fundamentals were not looking good for land in Rio Rancho.

There was an incredible parabolic blow-off in the Amrep share price at the beginning of 2007. Just now, I was blown away by the collapse in the price since then. It has traced out a classic parabolic bubble and collapse.

Silver Crushed Again

2011-12-28T14:16:00.000-07:00

Down almost 6 percent today!

Short Volatility Idea: Sears Holdings ($SHLD)

2011-12-27T13:31:00.000-07:00

A correspondent writes in with the following short volatility trade idea to take advantage of the Sears Holdings obliteration today:

Sears stock is getting crushed after a lackluster holiday season. I think the thesis is intact (cashflow is positive). . .

You can sell $30 strike puts for Jan 2013 for $11 . . . this means you are only risking $19 (if put the stock, that would be your cost). Your return for 13 months if the stock stays above $30 per share is more than 50% of the $19 you have at risk.

At a stock price of $19 the equity value would be about $2 billion . . . . The company has been buying back $500MM-$1billion of stock per year, so either it never gets this low, or the public float rapidly disappears. Lampert, his hedge fund, Berkowitz & Tisch own 80% of the company already (Berkowitz owns 15% and could face redemptions though). Any way you slice it, the public float is only 20% of the shares or about $750 million worth at the current price ($35 per share). If it goes below, the public float could be bought in pretty easily. They have $3 billion undrawn on the revolver (only $500MM currently drawn). The company has only $1.5 billion of bonds outstanding and they don’t come due until 2018.

The real kicker is that 10% of the stock is sold short. This is half the public float! The company can easily buy back 10% of their stock at these prices (less than $400MM) and the shorts will need to cover a further 10% of the stock . . . this account for the entire 20% public float.

Even if Berkowitz’s fund was forced to cough up an additional 5% of the company, this looks very asymmetrical. The options trade is much more asymmetrical because the stock is hard to borrow (because heavily shorted) so the puts are artificially expensive – probably priced 50% higher than they would be otherwise.

Volatility is also bid up today due to the big price drop. I don’t see many ways to lose here (the stock would have to fall to below $19 despite huge buybacks which have been steady since the stock was triple here, and a huge short interest that is almost sure to get squeezed), and the (limited) upside is more than 50% for a year . . .

Sears is a total dog. But, this could work...

Ceres Global Ag

2011-12-26T15:28:00.000-07:00

A Credit Bubble Stocks correspondent wrote with thoughts about Ceres Global Ag, a holding company with investments primarily in grain storage and handling facilities. It trades on the TSX and also the pink sheets in the U.S. The company has a significant investment portfolio.

We only know what the value of the portfolio is at the end of every quarter. On September 30, 2011, there was $48.3 million of cash and portfolio investments--$3.22 per share. The only other asset is the 100% ownership stake in Riverland Ag, which owns 15 grain storage facilities. In the four quarters ended September 30, 2011, EBITDA was $18 million, or $1.18 per share and net income was 45 cents. So you pay $1.78 for assets generating earnings of 45 cents--about 4X earnings for the grain storage business.

Grain storage and handling is an odd business. One way you make money in storage is to buy grain, store it in your elevators, and sell it forward. In order to be profitable, that strategy requires the futures market to be in contango: future prices that are higher than the spot price. And in order for the market to be in contango, there needs to be a glut of the commodity. Basically, the grain storage facilities get paid the most when there is a lot of commodity to store, which makes sense.

I notice that corn and hard red spring wheat are both in backwardation right now, which must be hurting elevator operators. What is the likelihood that Ceres elevator markets will once again have a glut of grain to store? You are long that option.

The other way to make money with grain handling facilities is that there is usually a spread (basis) between the cash price that the operators pay the farmers and the futures price. I suppose that spread would be a function of how many competing elevators are serving the area: location, location, location. Lack of competitiveness was a bigger issue in the past, before it was possible to ship grain by truck to competing elevators. In fact, it was a political issue, and the prices paid were sometimes regulated, or else the elevators were purchased by the farmers themselves and run as cooperatives.

WSJ: "Shale-Gas Boom Spurs Race"

2011-12-26T14:53:00.000-07:00

For producers of nitrogen fertilizers, "the economics have changed radically," said Stephen R. Wilson, CEO of CF Industries Holdings Inc. of Deerfield, Ill. Natural gas is by far the biggest raw-material cost for making anhydrous ammonia, the base nitrogen fertilizer made by CF. The company, which has gone from a high-cost producer by world standards to a low-cost producer, plans to spend $1 billion to $1.5 billion over several years to boost capacity at some of its North American plants.

Merry Christmas from Credit Bubble Stocks

2011-12-24T15:56:00.000-07:00

"Trials and Errors: Why Science Is Failing Us"

2011-12-24T15:53:00.000-07:00

From the latest Wired,

"[C]auses are a strange kind of knowledge. This was first pointed out by David Hume, the 18th-century Scottish philosopher. Hume realized that, although people talk about causes as if they are real facts—tangible things that can be discovered—they’re actually not at all factual. Instead, Hume said, every cause is just a slippery story, a catchy conjecture, a “lively conception produced by habit.” When an apple falls from a tree, the cause is obvious: gravity. Hume’s skeptical insight was that we don’t see gravity—we see only an object tugged toward the earth. We look at X and then at Y, and invent a story about what happened in between. We can measure facts, but a cause is not a fact—it’s a fiction that helps us make sense of facts."

Fermi's Paradox, Caused by Computer Games Not Atomic Weapons?

2011-12-24T00:00:00.000-07:00

Read the whole thing:

I suggest a different, even darker solution to the Paradox. Basically, I think the aliens don’t blow themselves up; they just get addicted to computer games. They forget to send radio signals or colonize space because they’re too busy with runaway consumerism and virtual-reality narcissism.
[...]
Heritable variation in personality might allow some lineages to resist the Great Temptation and last longer. Some individuals and families may start with an “irrational” Luddite abhorrence of entertainment technology, and they may evolve ever more self-control, conscientiousness and pragmatism. They will evolve a horror of virtual entertainment, psychoactive drugs and contraception. They will stress the values of hard work, delayed gratification, child-rearing and environmental stewardship. They will combine the family values of the religious right with the sustainability values of the Greenpeace left.

Fantastic essay. And I read to the bottom and it's... Geoffrey Miller!

AAII Neutral Sentiment

2011-12-22T14:59:00.002-07:00

This week's AAII neutral sentiment was 38%, the highest since April 2005. Isn't that weird?

"Secrets of Professional Turf Betting"

2011-12-21T22:30:00.000-07:00

Interesting observation from Speculative Investor, in reference to the book Secrets of Professional Turf Betting, regarding the analogues between investing and betting on horses:

The principle of only putting money at risk in cases where there is an attractive overlay applies perfectly to stock market speculation. An "overlay" in the stock market would, for example, occur if the stock of a company is dramatically under-valued based on the cash that it is currently generating or is likely to generate in the future (the market value assigned by the public is low compared to the company's intrinsic value).

Well said, and the analogy seems apt. The turf betting book looks like it would be good although it seems to be out of print.

WSJ: "Whatever the Strategy, Hedge Funds End 2011 With A Whimper"

2011-12-20T12:17:00.000-07:00

All seven trading strategies tracked by the Dow Jones Credit Suisse "Core Hedge Fund Index" are showing losses as of Wednesday, Dec. 14, with the entire index dropping nearly 8%. Investors would have been better off in the Standard & Poor's 500-stock index, which dropped only 4% over the same period.

Silver Collapse

2011-12-19T17:16:00.000-07:00

What an ugly chart the silver collapse has made since April. And yet, the silver bulls have been fighting it every step of the way, even though silver is fundamentally overvalued and the technical picture is really ugly.

I'll probably start feeling excited at $10-$15, and I might load the boat if it ever gets back to $5.

Monday Morning Thoughts

2011-12-18T23:49:00.000-07:00

Both the EURUSD and the Chinese stock market have broken through their October lows. Meanwhile, the dollar index has broken out to a higher high than October. There is a divergence between these markets and the US equity market. I would expect the US equities to follow them, by declining.

Hussman has another great column out tonight:

"[T]here still remains some short-run ability of policymakers to distort market forces, to badly misallocate capital in the process, and to wreck the economy more thoroughly in the long-run. The hope for QE3 continues to mount, despite the lack of evidence that QE2 had any meaningful effect except to bring a some pent-up demand forward and create a speculative investment environment that constantly depends on new doses of sugar to prop it up."

Read what he says about economic "surprises." It's hard to believe how poorly Hussman's fund has done over the past ten years, given what a brilliant analyst he is. That may be due to the constraints associated with running a mutual fund.

Skill Imbalance in the Labor Market

2011-12-17T15:08:00.000-07:00

There’s a similar excess of many postgraduate skills. Take law, which flourished in a society that had easy access to credit. Now, with the economy tepid, law schools are churning out many more graduates than the market wants. Roughly 30 percent of those passing the bar exam aren’t even working in the profession, according to a survey by the National Association for Law Placement. Another EMSI study indicates that last year, in New York State alone, the difference between the number of students graduating from law school and the number of jobs waiting for them was a whopping 7,000.

"Banks resist European pressure to buy government debt"

2011-12-16T20:09:00.000-07:00

Banks are unlikely to come to the aid of debt-ridden eurozone countries, with many planning to ignore political pressure to use cheap money from the European Central Bank to fund purchases of sovereign bonds.

"Bernanke: No Fed Plans to Aid European Banks"

2011-12-14T15:54:00.000-07:00

Senator Bob Corker, a Republican from Tennessee, said Bernanke made it “very clear” in closed-door comments today the central bank doesn’t intend to rescue European financial institutions. [...] Bernanke told lawmakers that “he doesn’t have the intention or the authority” to bail out countries or banks.

The Waiting Was the Hardest Part

2011-12-14T10:20:00.000-07:00

Silver is getting crushed today, back below $30 an ounce. It has completely reversed the bubble gains from the spring of this year. Silver could actually be a good short from here since it has no "support" and is still trading far above fundamental value. The best part is that the bulls on Zero Hedge are saying "we are still in a bull market". Sure.

On the other hand, equities are currently lagging the drop implied by silver. Normally they are highly correlated. Also the U.S. equity market is lagging the decline in the Chinese stock market. Anecdotally, the bears seem scared to press their advantage here.

Why Wait to Reduce Your European Credit Exposures?

2011-12-13T21:29:00.000-07:00

Seriously - why wait?

The plans for "fixing" the inherent problems with the EU invariably consist of a scheme for Germans to bear the loss on bad loans to Mediterranean countries. Losses that have already been incurred but not recognized.

Since these losses are enormous even in relation to German GDP, the plans are invariably nonstarters. As Hussman very aptly put it, investors want someone to buy the bad debt "and willingly take a loss on it so the money doesn't ever actually have to be repaid." Thus, the market currently prices in a complacent scenario, when it is actually very hard to imagine a way for the Euro to survive intact, or for loans made to the PIGS countries to be repaid in real terms.

Meanwhile, investors are lending to the PIGS, to highly leveraged banks with tons of PIGS loan exposure, and to individuals and corporations in the PIGS countries - all at single digit rates of interest. (Well, not to Greece anymore.)

I've written in the past about the loans to individuals and corporations in the PIGS countries as an area of particular concern that is ignored by the market. The value of a mortgage loan is the present value, at an appropriate discount rate, of the periodic principal and interest payments over the life of the loan.

With a loan made in Greece or Italy and denominated in Euros, there is a very high probability that the cash flows will switch to a devalued currency sometime during the remaining life of the loan. Because of this risk, investors should be much more wary of financial institutions that have significant non-sovereign debt exposures in the PIGS countries.

The best way that I have found to play this is to short a structurally inferior security (the noncumulative preferreds or NCPs for short) of European financial firms that are massively leveraged and have exposures to PIGS debt that are multiples of their market capitalization.

Look at a NCP from the perspective of the bank that issues one. They have the option at any time to stop making coupon payments. They can suspend them indefinitely. The preferreds are perpetual, so the coupon payments are the only source of value.

The buyers of the NCPs are short this option!! And they have sold it for a yield premium of a mere one or two hundred basis points.

I have been thinking about this from a game theory perspective. The equilibrium is that no one is ever able to issue a NCP because there are no suckers dumb enough to buy one; certainly not at a yield that would make sense for the issuer. However for some reason, the market broke out of this equilibrium over the past decade and now these securities exist again. The new equilibrium is for the issuers to suspend the coupon payments, let the price of the NCPs crater, and then buy them back at a huge discount. It's like the fable of the scorpion and the frog.

Chesapeake Energy (CHK) and the Utica Shale

2011-12-13T13:22:00.000-07:00

Fixed some typos, replaces the earlier version from last night.

After building a huge position in the Utica shale over the last year (to the initial consternation of shareholders), Chesapeake finally announced a monetization deal in this Eastern Ohio play on November 3rd. Rather than selling 25-35% of their Utica position in the form of a joint venture - as Chesapeake had done in five previous shale plays and as the market was expecting - Chesapeake announced two smaller transactions. Chesapeake placed their "wet gas" Utica acreage (like the Eagle Ford shale, the Utica has a "dry gas", "wet gas" and oil window) into a non-recourse subsidiary called CHK Utica LLC. They sold $1.25 billion of 7% perpetual (callable at a 10% IRR to the buyer) preferred shares in this subsidiary, which also receive a 3% royalty on the first 1,500 wells drilled in this area. Chesapeake also signed a letter of intent to sell 25% of this same "wet gas" acreage for $2.14 billion in a traditional joint venture with an "undisclosed major international energy company". CHK shares traded up overnight on this announcement of a "$3.4 billion monetization", but traded off the next day on disappointment that only $500 million of the total $1.25 billion preferred issue had been sold and that the joint venture was only in the letter of intent stage.

Since then CHK Director Lou Simpson (of Geico fame) purchased 100,000 shares at $26.69, CHK closed the rest of the of the preferred issue, receiving an additional $750 million, and the stock has continued trading down to $23.72 per share. The stock is off 18% since the November 3rd announcement and is trading roughly where it was one year ago before the Utica was discovered, leased up and partially monetized. Clearly the market is disappointed in the size and structure of this transaction as well as the fact that the joint venture has not been closed and the partner not named. Chesapeake has never failed to close a deal or turn a letter of intent into a deal before, but the market is clearly concerned given CHK's large capex plans for 2012 which will exceed free cash flow. The company has publicly and privately said that they have not and will not consider abandoning their plans to reduce net debt in 2012 (as part of their 30/25 plan) and this has added to the uncertainty surrounding their 2012 funding.

There are two possible explanations here. That market has apparently decided that Chesapeake was unable to get a bigger deal done in the Utica (or one at all so far), may come up short in funding their huge discretionary capex plans in 2012, and is stubbornly refusing to give up on their debt reduction plans - all of which suggest a cash crunch. An interesting corollary of the market's view is that the rest of CHK's Utica shale is likely worthless. This is interesting for a number of reasons, not the least of which is that the majority of Chesapeake's other 725,000 Utica acres not included in the above deal (they have 1.375 million total acres in the play) are in the oil window to the West. Not only does CHK continue to lease and take out drilling permits in the oil window, but so does Exxon, Devon and Anadarko along with smaller companies.

A quick word on valuation: the already announced transactions only concern "CHK Utica LLC" which is in the wet gas window. Assuming the joint venture closes, the unnamed energy company: will have paid a discounted price of $1.95 billion (discounting the future drilling carries at 10%) for 25% of this portion of the play. This recoups Chesapeake’s entire cost in the play and implies a retained value of almost $6 billion dollars or about $9 per share. This ignores the non-recourse preferred shares and assumes the rest of the Utica is worthless. Considering the other companies involved and that activity is ramping up I think this is a baseline value.

There haven't been any well results out of the oil window yet and so it makes sense why CHK would be unable or unwilling to do a joint venture in that part of the play yet. CHK's junior partner in the Utica is Enervest and their publicly traded MLP EV Energy Partners (EVEP). Enervest/EVEP had a lot of land in Eastern Ohio prior to the discovery of the Utica so CHK partnered with them. As part of EVEP's deal with Chesapeake, the larger company shares all information with them. John Walker, EVEP's well respected CEO made some interesting comments at a Wells Fargo conference last week that I think have big implications for CHK:

"We are pleased to be a partner with CHK, I think you’ll find out more later this month about who the JV partner is and more about the terms of the deal. $15,000 an acre, I think, is a base price. We think the price is gonna get much better in the oil window."

This is significant because Walker has seen all of CHK's information from the oil window and is participating with Chesapeake in a number of wells being drilled there currently. His company, EVEP, is planning to open a data room on their oil window Utica acreage in Q2 of next year to either sell the acreage or do an asset swap. For this reason, I don't think he has any reason to be promotional - by the time his company does anything with their acreage everyone will know what the oil window is worth. Walker clearly is very confident from what he has seen and would rather wait for well results (which he is privy to), than sell into the current hype and already high prices.

The market is saying the oil window is worthless, that CHK has a 2012 funding problem, and that they are stubborn and reckless to hold onto their debt reduction plans. Might Chesapeake have an ace up their sleeve? From Walker's comments it sounds like acreage in the oil window could be worth more than the $13,700 per acre in present value that CHK and EVEP received for the acreage they sold in the wet gas window. This would mean another $9+ billion in value to CHK (~$15 per share) and potentially billions more in cash in the door in 2012 from a new Utica joint venture.

A quick note about the pending joint venture. The French oil major, Total, previously bought into Chesapeake's Barnett shale in Texas. Total publicly said that they want to buy into the Utica shale and both CHK and TOT will not deny (nor confirm) that Total is the joint venture partner. Interestingly, CHK did deny that Reliance was the joint venture partner. Also, in Chesapeake's latest 10Q it was disclosed that Total is accelerating next year's drilling carry payments to CHK (at a 10% discount) for the Barnett shale and allowing them to lower the amount of rigs they must keep active there. Basically, rather than pay for most of Chesapeake's drilling in the Barnett next year, Total handed them $500 million in cash in October and told them they didn't need to drill as much. This is good business on Total's part because gas prices are low, but it is also very helpful to CHK and puts less stress on the company to do a premature deal in the oil window of the Utica. If Total is not the joint venture partner in the wet gas window (and I think contemplating a deal in the oil window when there is more information on it) the company is sure making a lot of statements to suggest it is them for some unknown reason.

I think the logical conclusion from all of this is that not only will the "Utica joint venture" close, but that it will turn out to be the first Utica joint venture for CHK. Either way, just closing this first deal (expected by the end of December) will have created $9 per share of value for CHK. From where I'm standing, there is a lot of circumstantial evidence that there is another $15 per share in value to be had in the oil window.

MF Global Recoveries

2011-12-12T23:01:00.000-07:00

There is a dearth of information about what to expect regarding the balance of customer funds missing at MF Global. The best data point that I have seen is that the market is apparently treating the bonds as a bet on how much money will be left over after the customers are repaid, and the bonds are still trading in the low 30s. There is something like 2 billion in bond debt so that would suggest an extra 600-700 million, assuming that framework is correct.

I'm interested in reading about what is going on with the situation, but it is hard to take Zero Hedge seriously when they rant about it without addressing these types of details. With big banks and brokerage firms, they either get bailed out or the entire financial system collapses.

When you think about it, it's weird that people smoke or ride motorcycles AND worry about survivalism. But the cognitive bias research shows that the mind is shockingly bad at comparing rare events, even if the incidence is separated by many orders of magnitude. Partly the bias seems to be induced by skewed media attention. So, for example, people think that murders are as common as car accidents because they are talked about roughly equally on TV news.