The T Report: A Time to Think & 5 Key Issues

Time to Think    

Last week was a feeding frenzy for algos and a disaster for those who were poorly positioned. Crowded complacent trades were pummeled, including, or especially, investment grade CDS. But now we have had some time to think about what happened and the markets seem calmer. On this bond market holiday, let’s just take a look at 5 simple things. These will be the drivers for the market.

Apple

If there was ever a case of people lamenting now owning a stock, swearing they would buy more if it ever came down, then dumping en masse when it did come down, this is it. Apple is unique in that it isn’t just a huge component of the indices (which it is) but it has become such an indicator of sentiment, that guessing Apple correctly is very important, if not critical. I like AAPL here. Sadly I started liking it at $570 but added some Friday morning. The sell-off seems overdone, at least for now. All those worried about paying taxes on their “big” gains, now need to worry about the gains. While everyone else was “amazed” by the great Apple products, I went to stores and found the iPhone 5 available on launch date, and remain confused about why the iPad mini which is either a small iPad or a big iPhone with no voice capabilities was such a big deal. But that was at $650 and above. Here I like it and it is oversold by many measures, including my personal favorite – RSI. I am also encouraged how many people were talking about the 200 day moving average. Many were investors who normally would demand you wash your mouth out with soap for saying such a naughty word. Finally, if they finally do something big with their cash, the multiple should look very attractive.

I’m not saying this gets back to its highs, but I think $580 to $600 is a near term target. That would drag the market up, so bullish.

Greece

Will the Troika let Greece go? They might. There are far too many indications, for my comfort, that they are considering a Greek default. In the end I think they will delay it for two simple reasons:

• The Troika will finally understand that once there is a Grexit, the Troika no longer controls the purse strings, or more importantly, the amount and timing of official sector losses
• Spain and Italy are still on the cusp of another sell-off with no actual programs in place, and if Greece exits now and investors lose, particularly due to forced currency conversion, then Spain and Italy will have capital flight like we haven’t seen yet.

So, as much as the seemingly arrogant, stubborn, and occasionally clueless Troika might want to push Greece out in some show of strength and retaliation for some perceived slights, they will be told now is not the time. Greece actually voted for the measures, and the consequences remain high. As I said last year when people were talking about an imminent Greek exit, this will take time. It will eventually happen, but I think it will be a Q1 or Q2 event.

Spain and Italy Need Backstop Programs

It is always a bad sign from a credit perspective when a corporation draws down on its “revolver”. But most companies have revolving credit lines or loans in place with banks for precisely that reason. They ensure that they have a source of cash that they can access if the markets get shut down. They pay a small fee for this and hope like hell that they can draw down before they trip a covenant. Banks provide these on the hopes that they never had to lend, but with every intention of getting ancillary business in good times, and elevating themselves to senior creditor status in bad times, by tripping covenants and demanding collateral to extend loans or waive covenants.

Revolving credit is a well understood game that the ECB, Spain, and Italy need to understand. Actually it is just Spain and Italy that need to understand it, as the ECB fully gets it. The ECB’s LTRO demonstrated how well the ECB understood the need to be lender of last resort. While they have many ongoing programs to help individual banks, it is also pretty clear that they would launch more LTRO if the system as a whole needed a backstop lender again.

Spain and Italy need to sign up for a program. It doesn’t even have to be implemented, but it needs to be established. Until this happens, they will be hit hard by any Grexit, but even without that, will see pressure from the markets.

One of these days, Europe will take too long to react to a crisis and we risk going into an uncontrollable sell-off and global recession. The Lehman bankruptcy didn’t cause the market to tank and the economy to shrink by itself. It was the catalyst that triggered the great unwind of many bad trades, positions, and business plans. The risk is that Europe thinks they have the problem “contained” or that they can react in time, and don’t understand that it won’t be enough. That somehow their delays or bad plans will trigger a bigger risk aversion than we’ve seen yet.

I think Draghi sees this and is pushing for plans of all sorts. Even the IMF, which I don’t always agree with, seems to understand the need to have pre-emptive policies in place. I am not convinced Europe is going to do this. That remains a negative for me. A small negative at this point, but one that could become a greater concern if it looks like any plan down the road will be delayed, or that Greece gets pushed out.

Fiscal Cliff

For all the headlines this was attracting, it was as much a placeholder for an Obama sell-off as anything specific. I don’t like the tone of either the president or the opposition, but remain hopefully that after the election hangovers are over, whether celebratory or from a night of bitter rage, the politicians will realize they need to do something right this time. That both parties can actually benefit from compromise. That doing the right thing for the country and showing the middle range of voters that the politicians can do something right is important. Maybe they won’t, but for now I remain convinced they will. If the rhetoric gets worse this week I will have to re-evaluate my position, but I am looking for progress on the fiscal cliff and that the market will benefit from that.

The “tax” related selling was interesting, as stocks drove down high yield, in spite of the fact that bonds have done well, the earnings are good enough (so far) and that the tax disadvantage of owning high yield should diminish. Even in muni land, BABS did well, and they have no tax advantage. I think some of that selling was indicative as knee-jerk reaction, and in a calm market for stocks, we will see a rebound (ie., credit can outperform equities here in the short term).

China

New leadership here, unlike the U.S., is a big deal. They have a lot of control. They also still have huge amounts of reserves. They also seem to have data that seems to bend to the will of politicians. I cannot see any reason for China to show more weakness with the new leaders. In spite of the fact that any weakness would be blamed on the predecessor, we all know it doesn’t. In the short term Chinese leadership is likely to say and do things to encourage the market, and the data is likely to show that those programs or ideas are being successful.

I like China near term.

Overall

I continue to look for a bounce. S&P 1,400 to 1,425 only, so not a big bounce. China can outperform. I am neutral in Europe. I want to bet on Spain and Italy, but can’t pull the trigger yet. I do think that the risk/reward is one of those awkward phases. Maybe 80% likelihood of a small move upwards (2% to 5%) and a 20% chance of a bigger move down (%5 to 15%). So the “expected value” is about right but the skew is scary. If we do see a grind higher, and a reduction in VIX, I would look at some out of the money puts.