S&P’s defense in the government’s anti-fraud lawsuit

the lawsuit

According to the Wall Street Journal, both S&P and its parent, McGraw-Hill, have filed responses in federal court in Los Angeles to the Justice Department’s recent civil lawsuit against S&P.  The suit accuses S&P of fraud by giving too-high ratings to mortgage-backed securities that later imploded during the financial crisis.  Among the victims cited are Citibank and Bank of America, who created some of the securities and paid S&P to rate them.

the defenses

McGraw-Hill has two points:

–it can’t have defrauded Citibank and BofA, who were in the kitchen making the toxic messes and knew what they were doing much more intimately than any outsider ever could, and

–other ratings agencies, like Moodys and Fitch, issued identical opinions bu aren’t being charged (of course they didn’t reduce their AAA rating of Treasury bonds, the way S&P did).

S&P has a more humorous defense:

–it points to two prior court rulings that the company’s claims for its ratings–that they are independent and objective–are just subjective opinions that no reasonable person would take seriously.  That casts the claims as sort of like the Kia commercials that have sock puppets or giant rodents piloting company cars through time and space.   Not very flattering–particularly to anyone who claims to have taken the ratings as either independent or objective.

my take

1.  We all know as a matter of principle that there’s no free lunch–anywhere.  Yet, every few years salesmen of financial products tout some new “miracle” of financial engineering that subtracts the risk from risky investments, leaving only super-high returns.  Bernie Madoff is an extreme example.  But junk bonds were originally marketed as having all the rewards of stocks but with the safety of bonds.  In the early 1990s, short-term European bond funds were sold as being “just like” domestic money market funds, but with 3x the yield.

When these products implode, as they invariably do, the most common reaction is not to blame one’s own bad judgment, but to point a finger at the seller of the product.   Or in this case, to the seller’s front man.

2.  In the case of professional investors, it’s inconceivable to me that any buyer relied on S&P ratings as the sole, or even one of several, important reasons for purchasing a security.  At best, the rating is a gross screening factor (bad rating = don’t buy).  Everyone is aware that S&P is paid by the issuer of the securities it rates, and that it only gets paid if the rating is high enough to let the offering take place.

Every buy-side credit analyst knows he’s a lot better than anyone at S&P.  And the buy side knows that, unlike S&P, it has to live with the consequences of its buy decisions.  While it’s easy to blame S&P when an investment goes wrong, the real fault lies with the independent credit analysis done by the buyer.

3.   Why choose a bit player like S&P to sue?   …why not the banks who issued the toxic securities?

Other than the army, I’ve never worked for the government, so I have no special insight into the Justice Department’s mindset.

My guess is that S&P is the easiest for someone who has no practical experience in financial markets to understand.  The case itself is modest in scope.   It may not raise the thorny issues of how regulators could have been so deeply asleep at the switch, or why laws were changed in the 1990s to permit banks to brew their toxic concoctions.  And of possible targets, S&P likely has the fewest political and financial resources to defend itself with.

If the WSJ is correct, though, part of S&P’s defense is that the government has already lost this case once before.  Odd.

what do gold and AAPL have in common?

common factors

–they’re both large positive bets (large holdings) of hedge funds–and of many retail investors

–both have delivered weak performance over the past year, after extended periods of substantial gains.  And the losses have occurred during a time of generally stable conditions for the world economy, with ample liquidity and strong inflows of money into financial products

–recent trading in both seems to me to be giving signs of forced or distressed selling

are these factors connected?  

It’s hard to know, since global hedge fund disclosure is incomplete–and there’s ample evidence that what disclosure there is can’t be relied on.  However, I think it’s reasonable to assume they are.

if so, what does this imply?

In my experience, a professional investor goes through a three-step process as he realizes he’s made a mistake–or that his previously good idea is no longer working.  He:

–stops adding to the position when new money comes in, effectively shrinking its relative size,

–begins to sell, to further lessen the negative effect of the position on performance, and

–accelerates the selling when the position is small enough the extra visibility and extra downward pressure on price make little difference.

A professional investor can go through these states in the blink of an eye, or it can take a long period of time. A lot depends on style, self-awareness and how ugly the underperformance is.  Anyone who operates on margin may also get additional feedback from his lenders.

Many retail investors, in my experience, just panic–very close to the bottom.

Recent price action in gold and in AAPL strike me as Stage-Three end-game activity–some combination of panic, response to margin calls and/or dumping of the remainders of positions being sold over long periods.

is this an opportunity to buy?

gold: 

For me, the answer here is easy.  It’s “No.”  The key supply-demand issue is whether central banks in emerging markets will continue to buy gold in the aggressive way they have done over the past several years.  I have no idea.  So I’m clearly the “dumb money” in this arena–the strongest reason there is to stay away.

AAPL:

We’ll have more information tomorrow, after AAPL reports its latest quarterly earnings.

The stock is now trading at less than 9x historic earnings and yielding 2.7%.  The shares have underperformed the S&P 500 by more than 50 percentage points since last September.

The company has no debt and its cash holdings are approaching almost half the market cap.

If there’s anything “wrong” with the stock, it’s that its fall from grace has been so extreme.  That prompts the question, “What must sellers know that I don’t?”

How do you overcome aversion, based on an extended decline, to a stock that looks like a $100 bill lying on the street?  The first step, I think, is to look for signs that the waves of selling that have pummeled AAPL are over.   This means having AAPL announce bad news and have the stock go up, rather than sell of further.  That’s why tomorrow’s earnings report may be important.

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Intel’s 1Q13–another transition quarter

the report

Intel (INTC) reported 1Q13 earnings after the close on Tuesday.  Revenue came in at $12.6 billion, down 2.5% year-on-year.  EPS, however, were $.40, down 25% vs. 1Q12.  The latter figure was slightly below the Wall Street consensus of $.41.

INTC believes this is a low point for its business, expecting revenues to show slow but steady improvement as the year progresses.  It expects earnings to advance at a faster rate.  Brokerage house analysts as a group are a bit more cautious, projecting 2Q13 EPS of $.39.

Consensus earnings per share for the full year are $1.88, a number I have no quarrel with.  INTC’s dividend yield is just over 4%.

What I find most interesting is that INTC shares, one of the worst performers of 2012, have been rising since the company’s earnings report, in an overall shaky market.

How so?

I think it’s because INTC is now a qualitative “big picture” stock, not one that will be driven by near-term earnings.

details

First, some housekeeping stuff from the report.

Servers, which comprise about 20% of INTC’s business, were a strong point.  High-end and cloud models are growing at 30%+.  Generic corporate servers, purchases that rise and fall with GDP, are up a little.  Overall server revenues were up 7.5% yoy during 1Q13.

PC chip sales were down 6% yoy.  INTC’s customers have continued to work down their PC inventories from already lean levels, so end user demand is a bit better than INTC’s sales would indicate.  At some point, one would expect PC makers to rebuild inventories to more normal levels.

The transition away from old school heavy, clunky laptops–epitomized by DELL or HWP offerings–toward ultrabooks and other “post-PC” devices (think: Samsung or Asus) is going faster than INTC had expected.  This has several consequences for the company:

–older chip-making machinery is going out of service faster than anticipated, meaning extra depreciation charges,

–clients are asking for larger numbers of test models for INTC’s newest chips, where production isn’t still super-efficient, again meaning higher costs, and

–some older machinery can be reconfigured for use in cutting-edge chips, saving INTC $1 billion in capex this year.

The first and second items non-recurring.  Together, they’re the reason for the 1Q margin deterioration that led to the sharp decline in operating earnings on only a very small decrease in revenues.  As I mentioned earlier, INTC believes the worst on this front is behind it.

the big picture, according to INTC

INTC thinks that the chips it’s starting to ship this quarter will spark a quantum shift in the market for mobile computing devices.  By next year, we’ll have more powerful, touch-screen ultrabooks with better graphics and longer battery life selling for around $500.  Don’t need sleek or instant-on?   …then $400.

Tablets will see big power improvements and  maybe a $300 price for an iPad clone.

New form factors will emerge, too.

The disappearance of the huge price gulf between ultrabook and tablet will shift demand toward the former. That’s good for INTC.  Chips that use less power and generate less heat mean INTC has a chance to be a real presence in the tablet category for the first time.

can this happen?

Yes.  I think it will, and maybe even in time  for the holiday selling season this year.

The only real question is whether INTC can maintain its dominant market share in PC-like devices and displace ARMH offerings in some tablets (smartphones are only a possible INTC story in, say, 2016).  I like INTC. I hold the stock.  I think they have a very good shot at doing what they say.

as an investor…

…I think the rewards outweigh the risk that INTC finds itself the odd man out in an ARMH-dominated mobile world.

Why?  It’s valuation.

–arguably, INTC’s server business as a stand-alone is worth than the current market cap of the entire company.

— INTC has by far the best chip manufacturing operations in the world.  They’re certainly better than TSMC’s, the king of the third-party foundries.  Ignoring its intellectual property, were INTC valued solely for its manufacturing capabilities on the same basis as TSMC, INTC shares would be well over $30 (yes, gross margins would be lower, but so too would R&D and marketing expenses).  TSMC also has a much more cyclical earnings record).

So I’m content to wait.

commodities cycles

commodity rhythms

agricultural

The co-owner of one of the smaller investment companies I’ve worked for was a farmer.  He made me realize that there are no long cycles for most agricultural commodities.  If prices for a particular crop are high, farmers will plant more–usually a lot more–the following season.  That virtually guarantees that prices will either level out, or more likely fall.  The opposite happens–supply falls, and prices subsequently go up–if prices are currently low.

Considering that many crops have two or three growing seasons in a year, price adjustment comes swiftly.

metals

Metals mining, especially base metals mining, is just the opposite.  Mines tend to be gigantic projects, costing billions of dollars and designed to last 20 years or more.  Most of that money is spent up front:  for the mine itself, for all the drilling machines and other earth moving equipment, for the ore processing plants, for the roads or rails to tap into a country’s established transport infrastructure, and maybe even for new sources of electric power.

Because the optimal project size is “humongous,” mines tend to spew out very large amounts of output when they open.

Because–unless you’re very unlucky–the running costs are low relative to the initial investment, projects seldom shut down once they’re up and running.  They normally don’t even consider doing so unless the output price falls below out-of-pocket extraction costs.  And even then a mine may not shut down.  Miners always identify pockets of especially rich ore that they set aside for a rainy day.  So the first response to weak pricing it to turn to these high-grade areas in order to keep going–and spewing even more price-depressing output on the market.

In addition, some emerging countries run their mines to create employment and get foreign exchange.  Because whether they make money or not is a secondary concern, such mines almost never shut down.

The result of all this is a supply/demand dynamic somewhat like the farm one I sketched out above.  When times are good and metals prices are high, miners generally spend their cash developing new mines.  This creates periodic overcapacity when supply outstrips global industrial demand as all the new mines open at once.  But, unlike the case with soybeans or corn, excess capacity doesn’t disappear come winter.  Instead, it can stay for a decade.  What cures the oversupply is the eventual expansion of the world economy to the point where it can use all the raw materials being produced.

an example

I was a starting-out analyst when a supply-demand imbalance sent base metals prices skyrocketing in 1980.  I remember copper briefly hitting around $1.40 a pound and bringing previously loss-making capacity back onstream.  The price almost immediately fell back.  It took nine years for demand to expand to the point where it absorbed all available supply–and for the price to regain that 1980 high ground.

Another wave of new capacity pushed the price back down in the mid-1990s, where it stayed again until sharply climbing demand from China absorbed all the new output.  The price began to rise again in 2003.

For most metals, this pattern of feast and famine is common.  It’s not alone.  Chemicals and shipbuilding are the same way.  The common threads are:  commodity industry; long-lived assets with most of the capital in up front; capacity additions coming in large chunks.

Try to find a copper chart that goes back to the 1980s.  It isn’t that easy–suggesting to me that commodities traders aren’t as up on their history as they should be.

investment significance

I think that for base metals, and maybe for gold as well, we’re deep in the end-game transition from fat years to lean.  It has less to do with the state of demand in China than the state of supply among mining companies.  If I’m correct, time–and the accompanying gradual world economic expansion–is the only cure.

I’ve updated Current Market Tactics: price action this week has made me a bit more cautious

I’ve updated Current Market Tactics, based on recent price action of the S&P 500.  If you’re on the blog, you can click the tab at the top of the page.