Reiterated on June 1st: Sell China.

Investech's Jim Stack had a terrific call last month, reiterated on June 1st: Sell China.

“We DO want to issue a formal warning about the Chinese stock market and Shanghai Index. This market has entered a speculative frenzy, with more new Chinese trading accounts opened on Tuesday of this week than in an entire month last year! The government is clamping down on the speculation, and has raised interest rates for the 2nd time in barely two months. We suspect the pinhole will go into the Shanghai market’s parabolic rise in the very near future. If you own Chinese stocks through ADR’s or China-dominated mutual funds, we urge you to take profits now.”
-InvesTech Hotline Report – May 18, 2007

I agree with what Jim calls "Bubble Dynamics:" Once created, bubbles do not deflate gradually – they pop with quite the mess for those investors who have been participating. Fortunately, China's stock markets are not nearly as integrated into their society as ours, so a correction in their markets are much less likely to impact consumer spending and sentiment.

Housing Inventory Build Worsens

Ritholtz

Inv_housing_20070605 Last week, we noted that the Housing Freefall Continues Unabated. Conversations with Real Estate Agents prior to the NYT story anticipated that column's thesis that this has been one of the worst Springs -- the peak real estate selling season -- in decades.

The net result of this is that the inventory of unsold homes continues to build, taking the housing mess further away from its final resolution.

Today's WSJ has the details:

"Growing inventories of unsold homes continue to weigh on the U.S. housing market, portending more downward pressure on prices, the latest data show.

The number of homes listed for sale in 18 major U.S. metropolitan areas at the end of May was up 5.1% from April, according to figures compiled by ZipRealty Inc., a national real-estate brokerage firm based in Emeryville, Calif. The data cover all listings of single-family homes, condos and town houses on local multiple-listing services in those areas.

The sizable increase is notable because, on a national basis, inventories of listed homes have typically been little changed in May during the past two decades, according to Credit Suisse Group. May is one of the peak home-selling months because families with children often aim to move during the summer vacation.

Some of the biggest inventory increases last month came in the metro areas of Seattle, up 12% from April; San Francisco, 11%; Los Angeles, 10%; and Washington, D.C., 9%.

Inventories also are up sharply from a year earlier. For the 15 cities for which year-earlier comparisons were available, combined inventory was up 29% from May 2006."

As inventory continues to build, the effect on prices is inevitable. Even in the face of steady demand, economics 101 is that prices will fall. However, we seem to have diminishing demand, even as inventory ramps higher. That's a formula for prices that will fall more than just modestly.

As we noted way back in 2005, a 20 - 30% drop from the peak is hardly unthinkable.

Home_sale_price_reductions


The impact of this is already showing up in various consumer sectors.

And yet, some fools continue to insist that the housing slowdown is having zero impact on the broader economy. The best response to that silliness comes from Raymond James' chief strategist, Jeff Saut:

"Now for those pundits that insist that real estate is not spilling over into the real economy, we ask the question, “Why has the Association of Home Appliance Manufacturers’ Index posted a roughly 10% decline in shipments?”

Or, “Why is Circuit City laying off 3,400 of its best sales personnel and attempting to hire maladroit sales people at a much reduced compensation package?”

Similarly, “Why is Citigroup cutting 15,000 financial-related jobs?” And, “Why is GMAC stating that its Residential Capital subsidiary is going to hurt profits?”

Inquiring minds want to know such things.

Moreover, if the problems in sub-prime mortgages are NOT spreading, why are sub-prime mortgage companies dropping like flies, why are companies like ACC Capital closing their “call centers,” and why are delinquencies rising not only in the Alt-A complex, but in prime portfolios as well?” (emphasis added)

The answers to these queries are rather obvious: Housing is impacting the rest of the economy in a significant AND ongoing manner.

Further, its no coincidence that 1) housing prices are falling; 2) Mortgage Equity Withdrawals (MEW) are contracting; 3) Retail sales have softened notably.

Indeed, the broader risk to the economy is the impact of the real estate price declines on consumer sentiment. MEW has already declined from over $844 billion to well under $400 billion over the past 2 1/2 years. We still have the upcoming adjustable mortgages resets -- and at considerably higher interest rates.

The final chapter in the impact of Real Estate on the broader economy has yet to be written . . .

What Three Months Can Do

David Merkel
Three months ago, the global financial markets were at their short-term nadir, but few knew it at the time. Long term bond yields bottomed then as well, which should be no surprise in hindsight. Since that time, the average 10-year swap rate (what a AA-rated bank can borrow at) for the 10 nations that I track (USA, Germany, Japan, Britain, Switzerland, Canada, Australia, New Zealand, Norway, and Sweden) have risen 53 basis points (0.53%). Equity markets have rallied, and implied volatilities and corporate bond spreads have fallen.

The correlated change in the global bond markets is significant, and if it runs another one percent or so, could derail the equity markets. Bond yields would then be fair relative to equity yields, assuming that the current high operating profitability continues, which is not guaranteed, though I think it will persist long enough to embarrass those who say it must mean-revert imminently.

There is a change going on here, and as for my balanced mandates, I think it means that I toss out my long bonds [TLT] for a small loss, and keep my duration short. As for my equities, no action for now, aside from ordinary rebalancing activity. Don’t panic, but be vigilant, and use your ordinary risk control methods.

How Do You Value an Insurance Business?

David Merkel

As Paul mentioned in the comments on the last post, I answered a question at Stockpickr.com today. James Altucher, the bright guy who founded the site, asked me if I would answer the question, and so I did. Here is a reformatted version of my answer, complete with links that work:


Q: Any thoughts on how to value an insurance business? What are the best metrics to use? In particular I’m looking at small cap insurers (P&C) as potential acquisition targets. Does that change the methodology?A: That’s not an easy question, partly because there are many different types of insurance companies, and each type (or subsector) gets valued differently due to the degree of growth and/or pricing power for the subsector as a whole.

Now, typically what I do as a first pass is graph Price/Book versus return on equity for the subsector as a whole, and fit a regression line through the points. Cheap companies trade below the line, or, are in the southeast corner of the graph.

But then I have to make subjective adjustments for reserve adequacy, excess/noncore assets, management quality, pricing power on the specific lines of business that write as compared to their peers, and any other factors that make the company different than its peers. When the industry is in a slump, I would have to analyze leverage and ability of the company to upstream cash from its operating subsidiaries up to the parent company.

Insurance is tough because we don’t know the cost of goods sold at the time of sale, which requires a host of arcane accounting rules. That’s what makes valuation so tough, because the actuarial assumptions are often not comparable even across two similar companies, and there is no simple way to adjust them to be comparable, unless one has nonpublic data.

My “simple” P/B-ROE method above works pretty well, but the ad hoc adjustments take a while to learn. One key point, focus on management quality. Do they deliver a lot of negative surprises? Avoid them, even if they are cheap. Do they deliver constant small earnings surprises? Avoid them too… insurance earnings should not be that predictable. If they become that predictable, someone is tinkering with the reserves.

Good insurance managements teams shoot straight, have occasional misses, and over time deliver high ROEs. Here are three links to help you. One is a summary article on how I view insurance companies. The second is my insurance portfolio at Stockpickr. The last is my major article list from RealMoney. Look at the section entitled, “Insurance & Financial Companies.”

Now, as for the small P&C company, it doesn’t change the answer much. The smaller the insurance firm, the more it is subject to the “Law of Small Numbers,” i.e., a tiny number of claims can make a big difference to the bottom line result. Analysis of management, and reserving (to the extent that you can get your arms around it) are crucial.

As for takeover targets, because insurers are regulated entities, they are difficult to LBO. Insurance brokers, nonstandard auto writers, and ancillary individual health coverage writers have been taken private, but not many other insurance entities. State insurance commissioners would block the takeover of a company if it felt that the lesser solvency of the holding company threatened the stability of the regulated operating companies. The regulators like strong parent companies; it lets them sleep at night.

One more note: insurance acquisitions get talked about more than done, because acquiring companies don’t always trust the reserves of target companies. Merger integration with insurance companies has a long history of integration failures, so many executives are wary of being too aggressive with purchases. That said, occasionally takeover waves hit the insurance industry, which often sets up the next round of underperformance, particularly of the acquirers.

How to Sell a Securitization

David Merkel

In securitizations, a series of assets, typically ones with well defined payoffs, such as fixed income (bonds and loans) and derivatives of fixed income get placed in a trust, and then the trust gets divided up into participations of varying riskiness. The risks can be ones of cash flow timing (convexity) and/or credit. Regardless of what the main risk is, the challenge for those issuing the securitization is who will buy the riskiest participations.

When the market is hot, and there are many players gunning for high income, regardless of the risk level, selling the risky pieces is easy, and that is what conditions are like today, with the exception of securitizations containing subprime loans. When the market is cold, though, selling the risky pieces is hard, to say the least. If market conditions have gotten cold since the deal began to be assembled, it is quite possible that the will not get done, or at least, get done at a much smaller profit, or even a significant loss.

In that situation, hard choices have to be made. Here are some options:

1. If there is balance sheet capacity, keep the risky parts of the deal, and sell the safer portions. Then if the market turns around later, sell off the risky pieces.
2. If there is a lot of balance sheet capacity, hold all of the loans/bonds and wait for the day when the market turns around to do your securitization.
3. Sell all of the loans/bonds off to an entity with a stronger balance sheet, and realize a loss on the deal.
4. Reprice the risky parts of the deal to make the sale, and realize a loss.

The proper choice will depend on the degree of balance sheet capacity that the securitizer has. Balance sheet flexibility, far from being a waste, is a benefit during a crisis. As an example, in 1994, when the residential mortgage bond market blew up, Marty Whitman, The St. Paul, and other conservative investors bought up the toxic waste when no one else would touch it. Their balance sheets allowed them to buy and hold. They knew that at minimum, they would earn 6%/year over the long haul, but as it was, they earned their full returns over three years, not thirty — a home run investment. The same thing happened when LTCM blew up. Stronger hands reaped the gains that the overly levered LTCM could not.

In this era of substituting debt for equity, maintaining balance sheet flexibility is a quaint luxury to most. There will come a time in the next five years where it goes from being a luxury to a necessity. Companies that must securitize will have a hard time then. Those that can self-finance the assets they originate will come through fine, to prosper on the other side of the risk cycle. Be aware of this factor in the financial companies that you own, and be conservative; it will pay off, eventually.

Listen to Cody on Risk Control

David Merkel

Cody has an point that everyone should listen to in his post, Cody on Your World with Neil Cavuto. I still regard myself as a moderate bull here, but it is altogether wise to take something off the table here. My methods have me forever leaning against the wind. As an example, near the close yesterday I trimmed some Anadarko Petroleum as a rebalancing trade. I still like Anadarko, but at a higher valuation, it pays to take something off the table. Why? Because we don’t know the future, and something could happen out of the blue that transforms the risk profile of the market in an instant.


So, what does this mean for me? I’m up to 12% cash in my broad market portfolio, which is higher than the 5-10% that I like it to be, but not up to the 20% (or down to zero) where I have to take action. My balanced mandates are taking on cash to a lesser extent. A 5.25% yield is pretty nice.


Now, here’s where I am different (not better, but different) than Cody. Cody advocated taking 20% off the table (in his Fox interview), whereas I am forever taking little bits off the table as the market runs. My robotic incrementalism takes the emotion out of the selling and buying processes. That said, I may leave something on the table versus someone making bigger macro adjustments.


Whatever you do, it has to be comfortable for you in order to be effective. The market may go up further from here; on average, I expect it will do so, but I can imagine scenarios where it will not do so. That’s why I take a little off the table each time my stocks hit upper rebalance points; my baseline scenario may not happen, and rebalancing to target weights protects against what is unexpected. It is a modest strategy that guards against overconfidence, and will always allow you to stay in the game, no matter how bad the market gets.


I don’t have to be a raving bull or raving bear. I just have to control my risks, and over the long run, I will do pretty well. Cody will do well too; he just does it differently.

Going Through the Research Stack

David Merkel

Once every two months or so, I go through my “research stack” and look at the broad themes that have been affecting the markets. Here is what I found over vacation:
Inflation

1. Commodity prices are still hot, as are Baltic freight rates, though they have come off a bit recently. Lumber is declining in the US due to housing, but metals are still hot due to global demand. Agriculture prices are rising as well, partly due to increased demand, and partly due to the diversion of some of the corn supply into ethanol.
2. While the ISM seemingly does better, a great deal of the increase comes from price increases. On another note, the Implicit Price Deflator from the GDP report continues to rise slowly.
3. Interest rates are low everywhere, at a time when goods price inflation is rising. Is it possible that we are getting close to a global demographic tipping point where excess cash finally moves from savings/investment to consumption?
4. At present, broad money is outpacing narrow money globally. The difference between the two is credit (loosely speaking), and that credit is at present heading into the asset markets. Three risks: first, if the credit ignites more inflation in the goods markets which may be happening in developing markets now, and second, a credit crisis, where lenders have to pull back to protect themselves. Third, we have a large number of novice central banks with a lot of influence, like China. What errors might they make?
5. The increase in Owners Equivalent Rent seems to have topped out.

International

1. Global economy strong, US is not shrinking , but is muddling along. US should do better in the second half of the year.
2. The US is diminishing in importance in the global economy. The emerging markets are now 29% of the global economy, while the US is only 25%.
3. Every dollar reserve held by foreigners is a debt of the US in our own currency. Wait till they learn the meaning of sovereign risk.
4. Europe has many of the problems that the US does, but its debts are self-funded.
5. The Japanese recovery is still problematic, and the carry trade continues.
6. Few central banks are loosening at present. Most are tightening or holding.
7. There is pressure on many Asian currencies to appreciate against the dollar rather than buy more dollar denominated debt, which expands their monetary bases, and helps fuel inflation. India, Thailand, and China are examples here.

Economic Strength/Weakness

1. We have not reached the end of mortgage equity withdrawal yet, but the force is diminishing.
2. State tax receipts are still rising; borrowing at the states is down for now, but defined benefit pension promises may come back to bite on that issue.
3. Autos and housing are providing no help at present.

Speculation, Etc.

1. When are we going to get some big IPOs to sop up some of this liquidity?
2. Private bond issuers are rated one notch lower in 2007 vs 2000. Private borrowers in 2007 are rated two notches lower than public borrowers, on average. Second lien debt is making up a larger portion of the borrowing base.
3. Because of the LBOs and buybacks, we remain in a value market for now.
4. Volatility remains low – haven’t had a 2% gain in the DJIA in two years.
5. Hedge funds are running at high gross and net exposures at present.
6. Slowing earnings growth often leads to P/E multiple expansion, because bond rates offer less competition.
7. Sell-side analysts are more bearish now in terms of average rating than the ever have been.
8. There are many “securities” in the structured securities markets that are mispriced and mis-rated. There are not enough transactions to truly validate the proper price levels for many mezzanine and subordinate securities.