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  • U.S. Stock Market Appears Expensive, Caution for Equity Investors: Focus on Sentiment & Risks
     In our previous posts, we (1) reviewed the valuation of the Market based on CAPE and forward operating earning estimates for the S&P 500, which are two indicators that provide a general estimate that the Market appears expensive; (2) we noted that our anecdotal evidence indicates that there are fewer undervalued companies in the current environment, and in some cases free cash flow is not keeping pace with earnings; and (3) we analyzed investors’ sentiment and how investors are focused more on returns than risk.

    Sentiment Continued: Banks Market Forecasts Bullish

    Although we previously wrote and covered current market sentiment as being bullish, some of the banks since our last writing have posted their 2011 target levels for the S&P 500 and we’ve decided it was appropriate to cover these in this piece.  These 2011 S&P 500 target levels are as follows: (1) 1,450 from Goldman Sachs, approximately a 20% return from current levels; (2) 1,400 from Merrill Lynch; and (3) 1,325 from UBS.  As one can already guess, we believe these targets to be extremely optimistic, especially considering the topics discussed earlier.  In general, these forecasts dictate that the markets will rise on real gross domestic product growth (“GDP”).

    Assuming their forecasts for GDP are correct, there is no guarantee that the Market will react positively to GDP growth.  Often lost in these forecasts is the fact that there is a weak – at best – positive correlation between GDP growth and long-term stock market returns.  There are many explanations for this, one being that GDP resembles a total sales number and does not represent corporate income.  Stock prices are usually linked to earnings and earnings expectations.  Historically, due to various operating and financial leverage corporate profits tend to fluctuate much more than GDP, making GDP a poor link for corporate profitability.  Furthermore, once reported GDP is a historical number, while stock prices are based on future expectations of performance.  For those who wish to read more into this topic, we recommend the following external source from Virtus.

    When we focus on macroeconomic issues, our focus is more on the impact these issues will have on corporate profitability, confidence, and other psychological forces within the market.  During a bullish period, bad economic and stock news can be ignored or forgotten the next day.  Yet, if the news is of such magnitude that people suddenly realize their expectations for the future were too great, then panic or fear can take hold and trigger downward pricing pressure.  As we’ve told many people, understanding finance and valuation is important, but – more so – is the ability to hone into those situations where psychological market forces present clearly undervalued opportunities.

    These targets are just another example of the current bullish sentiment in the market that focuses on returns and not the risks.  To be fair, these banks did state that there were some risks that could cause the Market to significantly underperform their targets; however, they did not quantify that risk or adequately present it to the investor.  All the investor, or the public, sees is the bullish price target.  If the banks felt strongly about these risks, they would have showed up in the price target.  Considering that the price target tends to be calculated as an expected number from various scenarios, these risks were probably already quantified in the reported target.  If that is indeed the case, then just imagine how bullish their best case scenarios are: probably ranging from 1,500 to 1,700?  That would be one large rally.  In such a rally earnings would most likely have to continue to beat what are looking to be increasingly hopeful estimates.

    As a point of preference, we prefer to eschew the use a single price target level.  Instead, we will always use a range of value, since value is never confined to a single price point when considering the uncertainty that always accompanies the future.  Furthermore, the range will allow our readers to see exactly what our thoughts are of upside and downside potential of an investment.

    Potential Risks to the Current Market

    Despite our case that the Market is expensive and its participants tend to be very bullish, we do not believe that the Market is just going to drop one day.  There usually needs to be a trigger, or a catalyst, that causes people to question their current method of investing and induces emotions opposite of greed.

    Over the course of the last few weeks we have built a list of such items that could potentially trigger a downturn if they are to materialize.  These issues should not be unfamiliar to many of you as they tend to take turns having their 15 minutes of fame, yet some have been ignored for quite a while.   Due to the fact that some of the systemic risks to worldwide markets that existed in 2007 and 2008 remain unresolved, a large portion of these items are linked to each other.  We are not putting a timeline on these risks, but believe that some of them could materialize within the next year or two. As expectations for corporate performance continue to rise, we believe that the magnitude of the shock required to cause a downturn in Market prices from any of the risks below becomes less.  The list of our items, which is not an inclusive list, is as follows:

    (1)     Municipal bonds. Many state and local governments are in bad shape from a fiscal perspective and as time passes they may struggle to properly service their outstanding obligations.

    (2)     Premature fiscal consolidation. Historically, austerity measures and a reduction of fiscal stimulus before the economic recovery can stand on its own, results in downturns in both stocks and the economy.

    (3)     Continued growth of the fiscal debt. While we recognize the importance of fiscal stimulus, the growing debt of the U.S. has been a concern to some since 1990.  A nation developed nation has proven that it can hold a large debt burden for some time, but are we to believe that the U.S. can endlessly issue debt without any consequences.

    (4)     Defaults of junk bonds. Such an event could cause both equity and debt investors to rethink the presence of risk in their investments.  Especially if a number of the companies that default are publically held companies.

    (5)     Commercial real estate weakness lingers. With the commercial real estate market still weak and facing continued weakness, there are approximately 350 banks between the sizes of $1 billion and $10 billion with unhealthy exposure to commercial real estate.  In all, there are approximately 2,950 banks with significant exposure to commercial real estate.  Many write downs have been withheld, but that cannot continue indefinitely and many defaults and write downs are likely. For more information, see COP report.

    (6)     Consumer is still deleveraging and unemployment remains high. Remember the U.S. consumer isn’t just a target market for U.S. companies but also for many of the exporting countries.  Reduction in credit and spending does not occur overnight.  We must remember this is acts as a constraint on future sales growth for companies across the world.  Especially if, other countries’ consumers fail to replace the potential slack of the U.S. consumer.  The only way a society remains highly levered is if it is able to maintain a great rate of growth, the U.S. has not demonstrated that ability yet.

    (7)     Trade imbalances remain unresolved. Trade effects the direction of cash flows and the growth of many economies.  The persistence of these imbalances or a sudden reversal in them could potentially have negative effects on the profit maximizing behavior of many companies.

    (8)     Overheating of emerging markets. If emerging markets fail to continue to grow or all remain too dependent on the export model for growth, cash flows may leave their countries and trigger sell offs in their markets and currencies, thus destroying a portion of the wealth they created in the last couple of years.

    (9)     Rising commodity prices. The price of raw materials and commodities continues to increase – in general – and is beginning to hit manufacturers located in Asia and China.  Some believe that these increased costs will soon be passed on to retailers who have struggled to pass on prices to the consumer.  These increases could significantly hurt margins and reported earnings.

    (10) Continued housing market weakness. This weakness affects consumers spending behavior as well as could continue to negatively impact banks, especially with the foreclosure issues that have recently come to light.  Continued weakness may be enough to slow down the economic recovery.

    (11)  Long-term decline in oil production. Recently, the International Energy Agency reported that production at current fields is in decline and that by 2035 today’s active fields that are producing 70 million barrels per day will produce less than 20 million barrels a day.  While this problem is in the future, any recovery that leads to the pick-up in oil demand could be constrained by oil and other energy prices.

    (12) China. China, like the other emerging markets, is overheating.  Well, one could argue it has been overheating for years.  The fact that this economy has not faced a major decline yet is not a reason to assume that it won’t in the future.

    (13) European union and fiscal debt issues. As the economies of nations continue to be more interdependent, the more at risk the U.S. is to shocks across the world.  Europe is embarking on fiscal austerity measures, while facing challenging times for the euro, these problems do not look good for aggregate demand and the countries that export to Europe.

    (14) Currencies and fiat currencies. The currencies we use are based primarily on confidence.  If at any time that confidence begins to erode, then companies will have significant problems to address, not to mention the crisis that would likely be sparked in the markets.

    (15) Credit default swaps. This market still lacks proper regulation and – due to its size- could multiply the negative effects of any of the above issues.

    (16) Unintended or intended consequences of quantitative easing. While there is much misinformation and uncertainty regarding, its actions have consequences which include the rising of commodity prices and a large amount of reserves sitting at the banks.  These consequences could potentially threaten the profitability of companies and the confidence of the consumer.

    (17) Below expected earnings. This is a real threat to the market especially as expectations rise as headwinds still persist.


    Going forward in the next few weeks and months we will spend some time analyzing and researching these topics with much more depth as we try to better understand the impact they can have on investors’ returns.

    Actions Going Forward

    At this time, we believe that the Market will most likely behave as it has during past major downturns, which means it will enter into a period of range-bound cyclicality.  Unless companies manage to grow earnings at a record pace for the next five years, we do not expect the Market to march continuously higher as it did during the 1990s.

    In our opinion, at present, the Market has much less upside than downside.  Thus we believe an investor should: (1) hold a significant cash position; (2) implement a selective investment process; and (3) be patient.  These three steps should adequately help prepare one for any outcome that occurs in the Market.  We think that it is wise to be cautious and begin augmenting one’s cash balance by liquidating a portion of his equity allocations.  Despite our view, we have not, personally, gone into all cash – there is always the possibility that our current Market view is wrong.  Yet, as discussed earlier, cash provides one with options and can be an effective hedge against a downturn.  Yes, the cash may not be earning a return for you while it’s in the form of cash, but you will be protecting it from investment losses, which is more important.  Remember multiple years of stock returns can be wiped out in a rather short period

    As always, we are being very selective of our investments.  We will not overpay for a company, or pay for a company that does not offer significant protection against market shocks in the long run.  Consequently, many of the companies that we review are quickly removed from consideration.  Yet, there are still a few opportunities and we will continue to search for these.  Even in a bullish environment, market forces can turn against good investment opportunities.  We will wait patiently for such opportunities.  We are not going to force investments for the sake of keeping up with the short-term returns our peers are posting. Due to our selective approach, we feel comfortable maintaining our equity allocation.  If the Market continues to climb higher, then we may farther liquidate our equity holdings.

    Patience is essential to successful investment from a value-oriented style.  The key to investing during this period is to not force anything.  If we are correct about this Market entering a period of range-bound cyclicality, then one may not have to wait much longer to deploy their cash into good undervalued opportunities.

    Over the next few weeks and months, we will continue to flesh out our view of the macroeconomic risks that exist, while also searching through many companies for truly cheap investment opportunities.  We look forward to continuing to post our research and opinions for your consideration.  If you’ve enjoyed our work please feel free to pass on to friends and family.

    Best regards,

    Chain Bridge Investing

    Disclosure: No Positions
    Dec 03 9:43 AM | Link | Comment!
  • U.S. Stock Market Appears Expensive, Caution for Equity Investors: Focus on Sentiment (Part 3)
     In our previous posts, we (1) reviewed the valuation of the Market based on CAPE and forward operating earning estimates for the S&P 500, which are two indicators that provide a general estimate that the Market appears expensive; and (2) we noted that our anecdotal evidence is indicating that there appears to be fewer undervalued companies in the current environment and in some cases free cash flow is not keeping pace with earnings. In the following, we will take a brief look at general investor sentiment.


    Sentiment: The Search for Yield


    Market participants and the main stream media seem to be very bullish and this worries us. With such sentiment, investment decisions tend to ignore risk and are primarily motivated by high return possibilities. At present, one frequently heard cliché is “the search for yield.” A phrase that emphasizes only returns. While most of our opinion has been focused on the equity market, a great example of this return-only sentiment comes from James Murren, the chief executive officer of MGM Resorts International, when in an October interview he said, “The bond market will get better. People are going to start to have a more positive outlook toward 2011. They’re going to be searching for yield and they’re going to go down the rating scale and that’s going to benefit companies like us.”

    The current environment benefits non-investment grade companies like MGM Resorts International that need to issue more debt and can due to investors need for yield. Yet, Murren fails to mention that MGM’s junk bonds come with large risk of default and that is why they are trading at a high yield. To illustrate this general risk of default, here are a few statistics from the U.S. Municipal Bond Fairness Act of 2008 on cumulative historic default rates:

    (1) For all non-investment grade corporate bonds the default rate is 31.37% for those bonds evaluated by Moody’s and 42.35% for those bonds evaluated by S&P.

    (2) For corporate bonds rated in the Caa-C/CCC-C ranges the default rate is 69.18% for those bonds evaluated by Moody’s and 69.19% for those bonds evaluated by S&P.

    The reader should note that MGM just issued $500 million of bonds rated CCC+ on October 25, 2010. Given MGM’s credit ratings and the fact that the economy is still extremely fragile, MGM and other non-investment grade companies should be having trouble finding investors, but they are not. Non-investment grade corporate debt has been issued at historically high levels during 2010. Investors are so desperate for a return that they are risking their hard earned money on an opportunity that has approximately 69% probability of failure. To be clear, while the risk/reward of these investments are unappealing to us, it’s the ease and the magnitude at which companies are able to issue their junk debt that makes us uneasy. We believe it is easy to see our concern.


    Sentiment: Institutional and Individual Investors Bullish

    While the above was an example of the sentiment in the debt markets, sentiment in the equity markets is very similar. The general sentiment at both the institutional and the individual investor level remains very bullish.

    At the institutional level, according to the Investment Company Institute, mutual funds as of October 2010 were holding approximately 3.6% of their assets as cash, which is near historical lows (please look at this chart from ZeroHedge). Such a low percentage of cash holdings is a sign that the mutual funds are very bullish and nearly fully invested.

    One argument we’ve seen defending this statistic is that asset prices have increased while cash balances have remained stable, thus only on a percentage basis have cash balances declined. This argument is irrelevant, in most cases, relative levels are more important in portfolio management than absolute levels. Mutual funds participate in rebalancing activities all the time, to take some positions that have gone up in value and liquidate a portion to cash is not a hard act, nor is it unusual. We believe that this statistic indicates that mutual funds remain bullish as they continue to “search for yield,” and do so in a manner that is not protective of the capital being entrusted to them.

    In our opinion, very low cash levels indicate a mentality that ignores risk and searches for yield. Cash is a very valuable position in a portfolio and offers the portfolio manager the chance to buy assets at low prices if there is a dip, or rather a downturn in prices.

    For instance, assume we are observing a mutual fund that is long-only (which most are) and its portfolio manager is fully invested in an asset class. If prices for the asset class drop, then most of fund’s assets will drop in value and hurt his returns. With no cash he cannot buy into the asset class at these lower prices, without realizing some of his current losses. One should note that the asset class will likely experience increased prices in the future as markets tend to be cyclical, thus allowing the mutual fund to make up some of its losses. However, mathematically, the mutual fund’s initial positions have to increase in price at a greater rate than they declined in price to fully offset the losses, which can be a tall order as the Market is still not at its pre-crisis levels.

    Nevertheless, a larger relative cash position allows the fund to hold a position that did not decrease with its other investments. With the fund’s target asset class priced lower, the fund can use its cash balance to buy the asset class at reduced prices. When prices of the asset class increase, the new positions acquired with cash will mitigate the losses experienced during the downturn. In this way, we believe holding a cash balance of at least 5% of assets is imperative, especially for long-only funds which cannot short to hedge against losses. Holding a cash position is responsible and a policy that portfolio managers implement when focused on both returns and risk.

    Furthermore, one popular argument by a few institutional investors to justify the current bullish sentiment in the market is that the Federal Reserve (the “Fed”) will not allow the Market to drop substantially. Basically, do not fight the Fed. David Tepper, a very well respected and successful hedge fund manager, was on CNBC at the end of September expressing this view that the Fed will continue to increase liquidity in the various markets via quantitative easing in order to keep asset prices afloat even if the economy experiences a slow recovery or enters into another recession. Thus, the Fed’s intervention has put a floor on how far asset prices may drop in the future and provides investors with some protection.

    This argument depends on quantitative easing being an effective tool and that remains extremely debatable (and outside the scope of this piece). Moreover, this argument bears a very strong resemblance to the notion, which has repeatedly come up during the 20th century, that the U.S. has managed to overcome the downward fluctuations of the business cycle (a piece to consider on this topic). As we know, every time that claim has been made by someone, it has been proven incorrect. Besides having history on our side, we do not believe that the Fed is large enough to successfully implement a floor on Market prices during a period of panic and fear. Furthermore, the Fed’s balance sheet is already loaded with risk assets and its tools at this point in the game are rather limited. Through out the history of equity markets regulators have continued to implement rules and laws to prevent bubbles and downturns, yet we still experience them. As long as greed and fear exist as human emotions, market and business cycles will continue to persist.

    On the individual level, we have noticed the same bullish sentiment that has been seen at the institutional level. This bullishness of individual investors is illustrated in the chart below, which depicts the weekly results of the American Association of Individual Investors (“AAII”) individual investors’ sentiment survey. The period covered in the chart begins 1/6/2005 and ends 11/24/2010.

    Historically, there have been instances where very bullish sentiment preceded significant Market downturns. We believe the current bullishness is not justified by the current risks, which will be detailed on Friday, and the operating fundamentals of the companies. As seen above, market participants appear too focused on returns and not on the preservation of capital. Nevertheless, such optimism does not guarantee a downturn in the very near future, but it is another reason to be cautious, especially if the Market’s price continues to increase.


    To be continued on Friday with more analysis on risks and some basic steps one can take to protect himself.

    Disclosure: No Positions
    Dec 01 7:58 AM | Link | Comment!
  • U.S. Stock Market Appears Expensive, Caution for Equity Investors (Part 2)
     In our previous post, we reviewed the valuation of the Market based on CAPE and forward operating earning estimates for the S&P 500.  These two indicators provide the reader with a general estimate of valuation of the whole Market.  Consequently, after our brief analysis and review, they seem to indicate that the Market is currently expensive.

    Analysis of Individual Companies Supports Notion that Market Appears Expensive

    Nevertheless, our bottom-up analysis of individual companies initially indicated to us that the Market may be expensive and was the initial source of our concern as well as motivation for writing this letter to you.  Currently, few companies appear to be cheap when looking at future earnings and cash flow on a risk-adjusted basis.  Where we used to have nearly 150 companies on our list of potentially cheap companies that required evaluation, we now have approximately 30.  The reader should note that this list is updated daily.  Of those 30 companies, we will be content if three to four of them pass our evaluation process as strong potential investments.

    Furthermore, from the company screens and research that has been conducted in the past couple weeks we’ve noticed a trend of caution from our anecdotal evidence.  The trend is that companies that appear cheap on an earnings basis are usually expensive from a free cash flow basis.  For those that may be wondering, this problem has been revealed in both asset-light and asset-heavy companies.  In theory, cash flow and earnings should, over time, eventually move towards and not away from each other.  With this in mind, we worry about the quality of earnings that are being reported by companies.  If the quality of earnings is in decline, then one can expect future earnings and cash flow to be lower than those levels necessary to justify current Market prices.  One metric that may prove helpful is the “Excess Cash Margin,” which is explained in more detail here.  Investors who are currently evaluating their investments should be on guard for such differences and look into the reasons for these differences.

    Yes, we understand our evidence is not empirical.  Again, we remind the reader this is a very informal opinion that will continue to be fleshed out in future weeks.

    As stated in the prior post, expectations of future earnings and cash flows for these companies seem to be very high.  In other words, the Market and its companies appear to be priced for perfection with no room for error or risk.  In such a situation, if estimates are not met to the liking of analysts and the market, then the price of the Market or the company will decline significantly.

    For instance, on November 10th, Cisco announced that its growth rate estimate for its revenue for the next fiscal quarter was about half of the growth rate analysts had estimated.  As a result, the stock dropped approximately 16.3% in one day.  This is a rather large one day drop.  The problem is that in an expensive market with high expectations and bullish sentiment, any shock to high expectations can cause a stock to drop rather quickly, and in some cases cause a panic, as people realize their investment was on hope and not sound fundamentals.

    Since this drop, Cisco’s management and others have argued that the stock remains a buy and is cheap.    Cisco’s management has gone an extra step in announcing an additional $10 billion repurchase of its common stock.  Based on our models, the only way that Cisco can be justified as cheap based on fundamental operating data is if for the next five years it averages 10% sales growth per year and yields an earnings before interest and taxes (“EBIT”) margin of approximately 30%, both of which require the company to significantly outperform its last 10 years of operating performance.  Moreover, the company would have to obtain such growth as a much larger company than it was 10 years ago.  This revenue growth, if achieved, would have Cisco surpass the current revenue of Microsoft in 5 years.  With its growth estimates in mind, perhaps Cisco should save its cash for growth projects and not repurchase its shares.   Even if it does achieve such growth, Cisco still doesn’t present an investor with a large margin of safety.  Of course, this is a back-of-the-envelop evaluation that serves as a sanity check and does not include a qualitative perspective, which is required for a complete analysis.  Nevertheless, even though many value investors appear to like the stock, it would not go on CBI’s list of possible investments for more detailed evaluation at its current price, primarily due to our belief that it remains expensive with little margin for safety.

    More non-performance of operating fundamentals or future shocks have a strong likelihood of putting downward pressure on Cisco’s price and other stocks whose price is dependent on lofty expectations of future performance.  From our experience the more hope that a stock’s price is based upon, the more acute the decline in price, which means it may be hard for investors to close out of such a position before losing their gains.

    Furthermore, we are beginning to question the wisdom of the many companies that are announcing share repurchases as a good use for their cash.  Does an investment in their own shares represent the best return possibilities for companies and their cash?  A company that states it wants to execute a repurchase of its outstanding stock can have several motivations, but prices do not appear cheap enough, especially in Cisco’s situation, to make such a use of cash appear wise at the moment. This is worrisome especially for the asset-heavy firms that rely on capital expenditures to justify their future earnings and free cash flow forecasts.  At present, no one should blindly purchase shares due to a company announcing a repurchase of its shares.  Such an action should be evaluated in context of the whole company.

    Many companies before 2008’s collapse announced buybacks thinking their shares were cheap.  Yet, they probably wish they had waited a few months longer. This is a topic that we will definitely be following up on in more depth later this month.

    To be continued with more analysis on sentiment and some basic steps one can take to protect himself. 

    Disclosure: No Positions
    Nov 29 6:21 AM | Link | Comment!
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