Dancing With the Bear

This note was originally published at 8am on May 31, 2012. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“Theory helps us to bear out ignorance of facts.”

-George Santayana

I have a good friend whose dad is legendary for giving his sister’s suitors a difficult time.  As it’s been told to me, this young lady will bring guys she is dating home and her father will take them for a little walk outside and basically warn these young lads that they don’t want to dance with the bear – the bear being him.  Since he is a small town burly Canadian fire chief, the daughter’s suitors are pretty clear on the message.

As it relates to being stock market operators, I don’t think any of us enjoy dancing with bear markets.  A good friend of mine, and former colleague, is one of the head traders at a major mutual fund complex.  Every day I get his morning internal news summary which leads off with the ACWI etf, which is a proxy for global large cap equities.  On April 2ndhis note had the ACWI up +11.9% and on May 29thhe had the ACWI up +0.76%.  In effect, any investor who has a long only mandate has had to dance with the bears over the past couple of months and likely, just due to the inflexibility of their mandate, had to endure giving back performance.

But even as many of us have had to dance with U.S. and global equity bears, the Japanese have perhaps had it the worst.  The most populous bear in Japan is the Asian black bear, also called the moon or white chested bear, which is medium sized and, luckily enough, largely a herbivore.  While the Asian Black Bear is mostly focused on eating plants, the Japanese stock market has been focused on eating investors whole. Specifically, overnight the Nikkei close -1.1% and finished the month down -10.3%.

Our bearish thesis on Japan is, hopefully, at this point relatively well known.  In late February we hosted a conference call with a 100 page presentation (email us at sales@hedgeye.com if you aren’t a subscriber of our macro product and would like to trial and view the presentation) that outlined our view that Japan is facing a debt, deficit and demographic reckoning.  It seems Japanese equities are agreeing with us.  

One of the key catalysts we highlighted back then was the potential for a sovereign debt downgrade.  Early last week this catalyst came to fruition as Fitch downgraded Japan’s long-term local-currency sovereign debt rating one notch to A+; additionally, the agency reduced the country’s long-term foreign currency debt rating two notches to the same level.  As the other rating agencies follow suit and the ratings continue to tumble downwards, the larger risk is that the Japanese banking system has to do a massive capital raise in the future to keep their Tier 1 capital ratio at appropriate levels.  This is an increasingly realistic risk that you may want to bear in mind.

By the time you get this missive, the U.S. will have reported GDP and jobless claims this morning.  Both our predictive tracking algorithms and the stock market have been telling us that GDP is slowing and we would expect the data this morning to reflect the same.  On some level, of course, slowing growth is starting to be priced into the market.  Currently, in the Virtual Portfolio we are leaning slightly net long and have 8 longs and 7 shorts. 

The three most recent positions that we have added to the Virtual Portfolio on the long side are as follows:

1.   Apple (APPL) – As oil and commodities deflate, from a macro perspective the outlook for the iEconomy improves.  Additionally, and not that I have any edge of course, Apple is cheap at 10x forward earnings but also growing the top line, based on the last quarter, at north of 30%.  The simple fact is that many investors still don’t get that Apple is not a hardware company; it is a software company with long term sustainably high margins (think moat and barriers to entry).

2.   Amazon (AMZN) – Amazon, much like Apple, is a play on consumption which we believe continues to improve as oil, and energy input costs generally, continue to break down.  As my colleague Brian McGough wrote about Amazon yesterday:

“Let's not forget that it is the Haley’s Comet of retail. It's a retailer with $48bn in revenue growing at 40% with 2% EBIT margins that's investing on its balance sheet and p&l at a rate to make a third of retailers alive today extinct in 5+ years.”

3.   Utilities (XLU) – On our quantitative model, utilities are the only sector that is bullish on both TRADE and TREND durations.  This is in part due to the predictability of the cash flow streams in utilities and thus relatively safety, but also a compelling dividend yield of right around 4% which, when compared to the government bond market, is downright juicy.

So, even in the doldrums of dancing with the bear market, we’ve been able to find some compelling long ideas.  Time and price will tell whether they are rentals or names that, like Starbucks, we will hold for multiple years.  But the bottom line is this: if you are going to dance with the bear, be prepared to keep your hands, feet, and portfolio moving.

In fact as Wikihow instructs us, the top three tips for avoiding bear attacks are as follows:

  1. Avoid close encounters;
  2. Keep your distance; and
  3. Stand tall, even if the bear charges you.

For stock market operators, the last point is probably the most instructive and translates into buying high quality names when the bear market is charging away and providing a compelling entry point.

Our immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar, EUR/USD, and the SP500 are now $1546-1571, $103.27-106.97, $81.99-83.24, $1.23-1.26, and 1295-1334, respectively.

Keep your head up and stick on the ice,

Daryl G. Jones

Director of Research

Dancing With the Bear - Chart of the Day

Dancing With the Bear - Virtual Portfolio