Planning for a 2008 Recession

March 7, 2008, Financial "Engineering", Investing Assumptions — Tags: , , — @ 5:54 am

The media talks about individuals defaulting on subprime and Alt-A (e.g. liar loans) loans, but this is clearly a freezing of the overall credit market. There has not been a new CLO created since May of last year; almost a year ago. I don’t see how this lack of credit liquidity could not cause a recession as businesses and municipalities are unable to finance new projects.

Understanding that the credit market is a leading indicator of the stock market is the stock market priced for a recession? I don’t think so. In one of John Maldin’s recent letters the S&P 500 earnings are discussed. Let me summarize; all numbers are for one share of the S&P 500. In January 2007, S&P estimated that the earnings would be $89.10 (FP/E = 16) for 2007. They were actually $71.56, down 20% from the estimate at the beginning of the year and down 12% from the actual 2006 earnings. The 2008 estimate has gone from $92.30 (in March 2007) to $83.90 (in December 2007, a FP/E = 17.5) to a current estimate of $71.20 (FP/E = 19.2). The scary part of S&P’s estimates is that it expects earnings will grow 20% in both the Q3 and Q4 of 2008; very doubtful if we are in a recession.

The S&P is currently at 1,304.34 assuming earnings fall 20% from their highs which appears very reasonable from 2006’s historical peak in margins to a recession in 2008, then earnings will be roughly $65 in 2008. That would give the S&P 500 a price/earnings over 20. Expecting at least a bear market drop to a P/E below 15 seems reasonable. So, I don’t think the market has yet to price in a recession.

My approach to the current market is one third cash, one third stocks (mostly tech), and one third short derivatives (options and inverse ETFs) and gold. Since the fall last year gold has been my biggest position and has cushioned most of the drop in my stocks. If gold keeps going up at the rate it has lately you wonder if it moves into bubble territory.

I think as other central banks start cutting rates late in 2008 the old greenback will rally some. Honestly, I’d rather have less money in straight cash, but my 401K has horrible options…only one bond fund (Who designed that!?!) and I do not have the option to go self-directed, so I’m working with what I can in that account.

 

Note: The UltraShort Real Estate ProShares (Symbol SRS) was up almost 10% today so that was a nice gain. I’m still waiting to increase my stock holdings, but prices keep getting more appealing. F5 (FFIV) dropped below 20 today giving the company a valuation around ten times cash flow. Not sure how much cheaper I can expect F5 to get. Especially considering that their much panned acquisition of Acopia Networks might actually pay off.

Shorting Financials (while waiting for tech to rebound)

March 5, 2008, Financial "Engineering", Tech Investing — Tags: , , , , , — @ 3:00 pm

While I focus on technology investments, because ultimately that is what I know, all the money I’ve made the past year is on shorting financial companies and ETF’s like XHB or buying inverse ETFs like SRS, SKF, and TWM. I made some great calls shorting MBIA when it was trading in the fifties and shorting PMI when it was trading with a forty handle. Unfortunately, these gains have done nothing more than balance declines in other areas of my portfolio.

Considering my gains the past 9 – 12 months have come shorting financials (or being long gold) I’m pondering when to unwind these positions. Based on the write downs and continued freezing of the credit markets I don’t think financials have bottomed.

One metric I follow is the US banks non-borrowed reserves published by the fed, every two weeks, which are now negative and have been for three weeks.  I’m sure this played are part into why the fed lowered the fed funds rate an unprecedented 1.25% over 8 days. US banks non-borrowed reserves have fallen to a NEGATIVE $15 billion (last row on page 2, in the column nonborrowed).  I’m not implying the banking system is bankrupt; I’m implying several major banks are technically insolvent.  And yes, I realize that has happened before and many of the insolvent banks (including Citibank) recovered.

So far this year I’ve sold my puts on XHB, MBI, and PMI, but I think the financial sector will hit a new bottom. The bond market is usually a good leading indicator for the stock market and right now the pendulum in bond market has swung from greed to fear. I look forward to a bottoming in the financial market so the economy can get back to growing and I can get back to focusing on investing in the technology industry.