The Obama Bounce Trade: Here Today, Gone Tomorrow

The end of a presidential election cycle typically leads to a quick upturn in the market, regardless of the winner. But this time itchy traders jumped the gun and bid the market up on election, sold it off the day after and the bounce is officially over.
We are now back to waiting on the only thing that really counts — economic data and the window it provides into the economy.

Right now, that window bears a strong resemblance to one in a jail cell. The economy — and eventually the market — is locked into behavior driven by three things: the housing crash, the credit crisis, and the evaporating consumer.
The Housing Crash
Every week or two, a new data point comes out and the pundits try to spin it — “home sales ONLY fell 11%” or “average home prices fell only 16.6 % year-over-year” or some such nonsense.
I don’t hate homebuilders, I have no axe to grind, but I passed third-grade math and eight-grade English, and here is what I see by reading financial and other documents:

• Defaults of subprime and Alt-A (near-subprime) mortgage holders will peak in December, which means foreclosures from these mortgages peak in December. And just as this is happening …
  
• Defaults from option adjustable-rate mortgages (ARMs) — the funkiest of all funky mortgages — will accelerate. Wachovia (WB), now in the snug if increasingly shaky arms of Wells Fargo (WFC), already predicts 22% defaults — it will be far more due to the severity of the recession.
  
• The recession will cause its normal share of mortgage defaults and foreclosures. So, pile up all these new homes on the market — in addition to the historically high inventory — and you see home prices falling.

Will buyers swoop in at this time and save the day to become the Marines ! of the m ortgage meltdown marketplace? Nope — 40% of all buyers in 2006 were subprime and ALT-A and they will be eligible for mortgages about the same time Obama leaves Washington after his second term.
Credit standards are tightening, mortgage interest rates are quite high compared to the past five years, and we have a dearth of real buyers. Inventory plus weak demand equals a continuing slide in home prices.
Instead of 2009 (when Wall Street is fantasizing about stability) or 2010 (when Fannie Mae (FNM) and Freddie Mac (FRE), those two paragons of analytical excellence), start thinking the second half of 2011 for stability and mid-2012 for a rise in prices.
The Credit Crisis
Resolved, you say? LIBOR coming down means it’s over? The Fed backstopping commercial paper markets will do the trick, you say? Don’t believe this nonsense. Here’s what I and a few others know and understand, unlike most members of the press and Congress.

• When Bear Stearns (BS) took its curtain call, for every dollar in core capital or equity it had assets (loans and debt) of about $33-$35. Historically a bank — not an investment bank, a real bank with rude tellers — loans out about 11 to 12-to-1.
  
• We have since discovered many banks were actually much more leveraged than 11-12 to one by using “off balance sheet” entities called structured investment vehicles (SIVs) and variable interest entities (VIEs). We have also discovered the Europeans, especially the Germans, levered up as much as 50-to-1. Do I exaggerate? In a very short document filed with the SEC earlier this year, Citigroup (C) revealed it had something like $350 billion in derivatives in VIEs. Yes, billion with a “B.”
  
• We are now going back to leverage of 12 to 15-to-1. That means the amount of credit available would contract at least 50% even if there were no write downs of capital. Speaking of write downs …
  
• Banks have! written down around $700 billion, not all of it replaced by fresh capital. Jim Paulson (no relation to TARP man and Treasury Secretary Hank Paulson) made a few billion last year shorting subprime mortgages. Last week he made a speech and said he expects another $1.4 billion, which is $200 billion more than my own estimate. he Street is gong to be surprised as bank write downs continue apace and continuing problems in mortgages well past 20009 will make these surprises uglier and uglier.

Translation: Bank capital is shrinking just as bank leverage ratios are and the combination means credit available to businesses and consumers will not reach levels seen in 2006 for at least seven to 10 years. There we go with that second Obama term — maybe that is why he said in his acceptance speech he would not get everything done in his first term.
Am I too bearish? Let me throw in some human behavior — I know, most people think payers in financial markets are prone to inhuman behavior, but bear with me (pardon the pun). The word credit comes from the Latin cred and credit, words meaning confidence and trust. You think we might have a bit if a shortage of trust and confidence right now? And maybe next year?
And let me throw in new government regulations that uber-analyst Meredith Whitney thinks cold reduce consumer credit card lines by 2 trillion bucks. You add it all up and what you get is a very impaired credit market — for consumers, businesses and even many nations — and credit is the lifeblood of everyone’s economy.
The Consumer
ChangeWave Research and third-party surveys show the consumer has gone on vacation in a used car badly in need if repairs. Spending has hit a wall and since our GDP is about 70% consumer, this is worse news than simply saying there may be a few less shops to peruse at the mall. I just looked at some MasterCard (MA) data for October and electronics were down 19%, home furnishings 21% and sales of anything more than $1,000! bucks d isappeared. And this will only get worse.

• The continuing decline in home prices — yes, there is a connection — makes people fell less wealthy, more nervous and more frugal.
  
• The recent sharp declines in the stock market — and the upcoming declines (I am giving away my ending, this is called foreshadowing) will also make people feel less wealthy and for many consumers, reduce their income.
  
• Speaking of reduced income — the recession is already going that and is going to hit much, much harder in the coming months. And as it hits, and spending contracts, the recession begins feeds itself.

Don’t despair — there is plenty of money to be made. Just don’t listen to Cramer or those long-only money managers on CNBC who think the term “shorts” refers to either evil men or something they put on every day.
Playing the Un-Bounce
I like fundamentals — yeah, “momentum” trading is “sexy,” telling someone at a party you “read charts” is really cool — but fundamentals will always bring you victory and profits when combined with patience. And the way to play this lack of an Obama bounce is by playing (or should I say shorting?) the fundamentals.
Shorting? Yes, shorting.
When people ask me if I am comfortable with shorting stocks — I am … if it is done with put options. I think of a favorite quote from Winston Churchill. “We sleep soundly in our beds because rough men stand ready in the night to visit violence on those who would do us harm.”
To my mind, short sellers are those at the ready; touts of stocks, long-only money mangers and pundits with no stake in the game like Cramer are those doing harm to our portfolios.
Which side do you want to be on?
You want to be on the short side — with the purchase of put options and ETFs, not the actual shorting of stocks. A! nd here is what you should consider right now:

• The banks are broke and getting broker, held aloft by Uncle Sam’s greenbacks and the promise of more to come. Check out the UltraShort Financials ProShares (SKF) — the SKF is an exchange traded fund that goes up 2% every time the Dow Jones Financial Index goes down 1%. It trades like a stock, is very liquid, and if you postpone that trip to Las Vegas, you could gamble and take that poker money and look at calls on the SKF. A 2% drop in the financials can lead to a 4% pop in the ETF and a 50% pop in the calls. While you are having a cup of coffee.
• The homebuilders are already hiring lobbyists to get Obama to spend some dough and help people buy new homes. That is funny — with foreclosures accelerating as they are, and all sorts of other problems, bailing out homebuilders with funky new programs for home buyers is a laughable thought. His probable answer? “Ask not what your country can do for you, it is dead broke.”Here is the dirty little secret — the homebuilders are getting cash rebates from the IRS based on losses they declare in 2008. Well, that well will soon go dry and once this source of cash dries up, getting new credit lines is going to be harder and eventually one builder will blow up, go bankrupt and the entire sector will be cut in half. Among the dozen or so publicly held homebuilders, look for ones with weak balance sheets, big debts coming due in 2009 and exposure to sunbelt markets.
• Also look at the cousins of homebuilders — material suppliers such as Masco (MAS) and Louisiana Pacific (LPX).
  
• And, of course, the consumer. Joe the material boy and Jane the material girl are now going frugal. There are a myriad number of choices, but stick with the most discretionary of spending — restaurants, travel, leisure goods. The Las Vegas casinos have been whacked but may also be ripe for another leg down.

How to do research? Restaurants are easy — go eat out and take a tax deduction. I do it all the time — and have put on 20 pounds since restaurants began to crater. For travel? Check prices for flights and hotels daily on Expedia (EXPE). Speaking of which, online travel sites are also a good place to find short opportunities.

So, don’t play momentum or charts or whatever — the post-election bounce is over. Now it is time for data — hard data — and a harder reality.
Want to see my take on playing Obama’s first year in office? Check out my story, 7 Trades to Make After Election Day by clicking here.

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Michael Shulman is the editor of ChangeWave Shorts. To learn more about him, read his bio here.

The best stocks to invest in 2011

Despite the market’s recent resuscitation, many stocks are still trading at fire-sale prices-no surprise given the immense decline that preceded the advance. But which stocks to invest in 2011?
Between March 9 and May 4, Standard & Poor’s 500-stock index surged 34%. Beaten-down “value” stocks and stocks of smaller companies have been the best performers during the recovery. Examples of revived value stocks are Citigroup (symbol C), which tripled from an intra-day low of 99 cents on March 9 to $3.20 at the May 4 close, and Bank of America (BAC), which skyrocketed from $3 to $10.38. Meanwhile, Morningstar’s small-company-value index rose 22% in April, and its large-company-growth index gained just 8%.

I’m not jumping on the bandwagon. Given the fragility of the markets, the financial system and the economy, I don’t think stocks of small companies or companies with huge problems are the ones to buy. Instead, I think you should put most of your money into the highest-quality blue chips (companies with little or no debt and the ability to generate a lot of cash).
If you’re looking for ideas, Morningstar StockInvestor ($119 annually) is a great resource. According to the authoritative Hulbert Financial Digest, the newsletter’s stock picks returned an annualized 2.6% from the end of 1999 through last February, a period in which the broad-based Dow Jones Wilshire 5000 stock index lost an annualized 5.0%. What’s more, the Morningstar letter is less risky than the index and tends to do little trading; on average, the letter holds stocks for about three years.

Editor Paul Larson says he looks for companies with competitive advantages over their rivals: “My strategy is fairly simple. I focus on high-quality companies, and I buy them when they’re cheap.”
Morningstar’s 100-plus stock analysts estimate “intrinsic value” for every company they cover. They compare intrinsic value to a company’s share price to arrive at a star rating. Larson then draws up two lists — a “tortoise” portfolio and a “hare” portfolio-consisting of about 25 highly rated stocks each.
Larson’s favorite is Warren Buffett’s Berkshire Hathaway (BRK.B)(best stocks to invest in 2011). At $3,114.90 a share on May 4, the stock has shed more than one-third of its value in the past year. But Larson believes that Berkshire’s collection of more than 70 businesses, dominated by insurance, is dirt-cheap. Says Larson: “For a long time, people have been pricing Berkshire as though Buffett were no longer around. But he’s still alive and kicking-and adding value. And the balance sheet is still one of the strongest around, even though the company no longer carries a triple-A debt rating.”
The world’s largest and most diverse health-care company, best stocks to invest in 2011 -Johnson & Johnson (JNJ), is another favorite. Larson says that the company is largely insulated from economic downturns. “People need to take their medicines regardless of what the economy is doing,” he says. J&J is well-managed, has little debt and generates a staggering $1 billion in free cash flow per month (free cash flow is the money left after a company makes the capital expenditures needed to maintain the business). The stock closed at $53.76 on May 4.
Defense giant best stocks to invest in 2011- General Dynamics (GD) is another company that’s built to withstand recessions. It builds ships and armored vehicles, as well as information-technology systems for the military. “The government has a vested interest in maintaining the health of this company,” Larson says. “It came through the Defense Department budget cuts relatively unscathed.” The company boasts a rock-solid balance sheet. The stock closed at $54.00.
Wal-Mart Stores (WMT), the world’s largest retailer, has increased its market share during the economic slump. Its sales of consumer staples at discount prices have been increasing as other retailers have been going out of business. The company’s managers are focusing on cutting costs and satisfying customers. Wal-Mart, one of only two stocks in the Dow industrials to climb last year, closed at $50.84.
As employee benefits grow ever more complex, The best stocks to invest in 2011-Automatic Data Processing (ADP) benefits. It provides such services as payroll processing and benefits administration. Its large scale and respected brand, and the high cost of switching to another vendor, give it a big competitive advantage. The share price: $34.86.
When competitors were spending enormous sums to build up oil-and-gas reserves during last year’s bubble in oil prices, ExxonMobil (XOM) stayed focused on increasing profit margins. Because of that, Exxon can continue to buy back shares, raise its dividend and increase capital spending (at a price of $68.20, the stock yields 2.5%). It’s the world largest integrated oil-and-gas company, and participates in almost every facet of the business.