bizzXceleration: Performance, Value and Profit

Strategic Outlook

El-Erian on Investment Outlook If you don't have secular anchors, you get sucked into bad trades. Today's economic and financial disruptions are part of a much larger phenomenon that is yet to be fully embraced by markets and policymakers. The global system is attempting to accommodate the breakout phase in the growth and wealth dynamics of a number of countries. The system is also trying to absorb the financial innovation inherent in the proliferation of structured products. Too many participants in the global system embarked on this journey with blunt instruments, inadequate monitoring, and risk management systems as well as a backward-looking mindset. We're seeing a much-needed recapitalization. Over the past decade you've seen the balance sheet of the emerging markets get recapitalized. Then it was the turn of the U.S. corporate and industrial sector on the back of Enron and WorldCom. Today we're seeing the recapitalization of the U.S. financial system. This not the time to go out and buy any credit risk. We're saying something different. To use a sports analogy, rather than just play defense or offense, you also need to play special teams. We're focusing on senior parts of the capital structure with very high-quality bonds, including the financial sector as it goes through this healthy recapitalization.

Massive risk looms, but bulls have reason to hope Last week, we offered fresh thoughts on why it might make sense to sell in May and go away. Today, consistent with our never-ending chase to see both sides of every trade, I wanted to offer five things the bulls are banking on. I share these vibes with the understanding that I expect more downside but respect the upside. Treasury Secretary HankPaulson and Federal Reserve Chief Ben Bernanke have a clear mandate. They're willing to mortgage our future with hopes that a legitimate economic recovery takes root. We've seen this movie before (on the back of the tech bubble) but memories are short given our immediate gratification societal mindset. In a reactive tape, technical analysis assumes a greater importance in the collective metric mix. The quantifiable nature of that approach allows traders to define risk and there's comfort in that, particularly in an unsure world. The reaction to news is more important than the news itself. Between American International Group, FannieMae, FedEx, crude, geopolitical unrest, housing malaise, derivative exposure, technical resistance and complacent ranks, the market has (had) every reason to melt like snow cone on a summer day. It hasn't -- yet -- and that might be offering a valuable clue in the near-term. If the S&P, NDX, and Russell can put aforementioned resistance underfoot, the potential for upside exacerbation exists. That could pave the way for a trading rally through Friday as front-month protection expires and the path of maximum frustration manifests. As I edge through the financial media landscape, I continue to be struck by those looking to be told what to do rather than understand how to do it. There are no easy answers, my friends, as the global equation continues to shift.

Positive Thinking vs Skepticism in the Markets The trusting and the skeptical have been doing battle all year, and the stark contrast offered by the market action on Friday and today are only the latest examples. That AIG has sprung a second and massive leak of red ink in as many quarters (which prompted its former Chairman to claim the company is "in crisis" -- see below) was the news that sat so poorly with Mr. Market on Friday. Today looked like it would fare little better when Fed Ex announced yet another shortfall over the weekend and MBIA served up another loss this morning (also below). Market participants would have none of it, and after an opening dip, they powered stocks higher almost all day. Not even a prediction from one of their heroes, Jamie Dimon, that the "recession is just starting" could deter the optimists, nor could a pronouncement from the Carlyle Group that "enormous bank losses" still have yet to be recognized (see below). The rally came, saw, and conquered because of the final quartet of news items you see posted below. HSBC reported lower write-downs than had been feared, Apple announced it was running out of I-Phones, and it was revealed that HPQ has an amorous interest in EDS. It also helped that some retailers posted better than expected results, causing many to think a recession won't visit these shores (see these charts). 

`Short-Sellers' Have Widest Choice of Candidates Since 1990, SocGen Says ``Short-sellers,'' or people who make money when shares fall, have the widest choice of stocks since at least 1990, as corporate finances deteriorate and profit growth slows, according to a Societe Generale SA strategist. About 100 European stocks currently fulfill the triple criteria needed to be a ``short'' candidate, the brokerage wrote in a report to investors dated yesterday. The requirements include an expensive share price, worsening company accounts, and lack of ``capital discipline'' on behalf of management. On average, the ``short'' list has had 20 stocks, Societe Generale wrote. In the U.S., the number has surged to 174 from 30. ``The opportunities are on the short, not the long side,'' the bank's London-based strategist James Montier wrote. ``Perhaps it is time to join the dark side.''

Stock Markets – Which Way José?: Poll Results The following observations are gleaned from the results: 1) The normal distribution of the June results assigns a smaller probability to the outlying index values (i.e. tails). This indicates that most participants are sticking to index values not deviating substantially from the current index level over the next two months. The distribution of the December results assigns a bigger probability to the tails. This points to a larger number of participants expecting the stock market to deviate significantly from current levels by December 31. 2) 84.6% of the participants were neutral (19.7%) or negative (64.9%) regarding the outlook for June 30. The figure decreased somewhat to 74.8% (made up of 11.8% neutral and 63.0% negative) for the December 31 period. 3) The weighted average index level is 12,338 for June 30 and 12,083 for December 31. These figures represent declines from the current index level of 12,970 of 4.9% and 6.8% respectively for the two measurement periods. (This compares with a Citigroup institutional client survey expecting gains of 3% to 5% for the S&P 500 Index by year end.) The results seem to lie in the same direction as one of my [3] previous polls (April 20, 2008) regarding the stock/bond ratio where 70.3% of the participants did not see stocks outperforming bonds over a six-month period. However, a recent [4] Barron’s poll among US professional money managers showed a different result, with 88% of the participants in the “bullish/very bullish” (50%) and “neutral” (38%) categories. Furthermore, 90% of the managers considered the US stock market to be “fairly valued” (35%) or “undervalued” (55%). 

Analysts Again Are Too Optimistic Investors are used to seeing big daily drops in individual stocks, often along with red-faced explanations by executives, when companies' quarterly earnings miss analysts' expectations. With less fanfare, however, the entire market is on an unprecedented streak of disappointment, driven by the financial sector. Most of the Standard & Poor's 500-stock index's first-quarter earnings are in hand and the aggregate profit of the broad measure's components has missed expectations by 2.4%, led by a 36% disappointment in the financials, according to the research firm Thomson Reuters. The S&P 500's quarterly "miss" is its third straight. Before the recent streak, there had been no "misses" for the index as a whole in the nearly 15 years for which Thomson has kept data. That's largely due to the successful massaging of expectations by companies. In fact, in the past decade-and-a-half, the S&P 500's earnings beat expectations by 3.2% on average, because executives generally try to jawbone analysts with cautionary guidance before their companies' earnings releases. The last three quarters of negative surprises point toward a few disturbing conclusions: First, financial firms don't just remain saddled with credit bets gone sour. They're also still having trouble accurately valuing those bets, or else executives would have an easier time playing the cat-and-mouse expectations game.Second, the woes of the financial sector, which represents a fifth of the S&P's market capitalization, are still capable of overshadowing the rest of the market. After all, positive first-quarter earnings surprises in other S&P categories like energy, which has beaten expectations by 26% for the first quarter, haven't been enough to keep the overall S&P's "surprise factor" in positive territory as usual. (Readings (Earnings): The Real Earnings Realities that Ain't...YET)

 Credit Crisis to Credit Crunch

Credit crisis over? Not likely Das' point was driven home last week by Citigroup's announcement of the sale of an additional $4.5 billion worth of shares -- its fifth attempt to raise capital in the past five months, each of which management hinted would be the last. The troubled bank has now raised $40 billion in the most expensive possible way -- diluting current shareholders -- while contending that everything's fine. Analysts at Goldman Sachs said they were surprised at the paltry amount raised in this round, suggesting it was the best the bank could do for now given its worsening prospects. To believe the worst is over, Das notes, you would have to believe that bank managers have obtained a firm grip on their credit-related losses and have written down at least half of the ultimate total, and that declining home values won't create more losses. He thinks this is impossible because the banks own many of the same losing securities yet have variously written off anywhere from 30% to 80% of their face values. Das figures that since few banks likely overestimated their losses, the variance in the write-offs means most banks continue to underestimate their losses. Thus he calculates that the $200 billion raised from outside sources so far is just a down payment and that banks have up to $700 billion more to go -- an amount far in excess of their total earnings over the past half-decade. And it's not just losses on current holdings that are the problem. Das wishes to remind investors of the $1 trillion to $3 trillion that's still in the process of moving onto the banks' balance sheets from related entities where they were hidden. It appears that a real secular, or structural, change has occurred that makes our past understanding of how banks perform outdated. So Das suggests you enjoy occasional two- to three-month advances as the speculative opportunities that they are, but don't be surprised if permanent improvement is much more elusive as financial stocks remain under pressure for at least an additional year or two, and possibly longer.

• Fed Chairman Bernanke Federal Reserve Chairman Ben Bernanke speaks about liquidity.
• Bernanke Highlights Feedback on the speeck, with CNBCs Steve Liesman
• Rubenstein Says `Enormous' Bank Losses Unrecognized
• Roach Says Credit Crisis `Repercussions' Just Starting May 15 (Bloomberg) -- Stephen Roach, chairman of Morgan Stanley's Asia division, talks with Bloomberg's Naga Munchetty in Brussels about turmoil in the credit markets, the prospects for growth in Asia, Europe and the U.S., and the competence of central banks to handle global economic challenges.
• Scholes Says Credit Rout May `Rival the Worst' Crisis May 15 (Bloomberg) -- Myron Scholes, chairman of Platinum Grove Asset Management LP and 1997 winner of the Nobel Prize in economics, talks with Bloomberg's Tom Keene in New York about the outlook for the credit crisis, economic modeling and the need for a new system of accounting.

Is Debt Thaw on Borrowed Time? Slowly but surely, the grease that lubricates Wall Street's deal machine is flowing again. A significant improvement in the credit markets since late March is emboldening more companies to undertake acquisitions and share buybacks that will be financed largely with debt. At the same time, banks and Wall Street securities firms, which have freed up space on their balance sheets to lend again, are encouraging corporate borrowers to take advantage of lower interest rates and hospitable market conditions while they can. Banks and debt investors are treading carefully. While they are more open to financing deals where one corporation buys another, many are still somewhat reluctant to fund leveraged buyouts by private-equity firms. Companies acquired in leveraged buyouts are often loaded up with a lot more debt relative to their cash flow, increasing their risk of default. Although debt issuance is picking up, the activity is so far largely limited to bigger companies or those with relatively strong balance sheets. The average size of new junk-bond offerings is half of what it was a year ago, and bankers don't think the market can yet stomach multibillion-dollar debt sales. There are some encouraging signs regarding the leveraged-buyout overhang. The pipeline of unsold leveraged loans and bonds has shrunk to roughly $100 billion from more than $300 billion last summer, alleviating some strains on the market. Meanwhile, the additional interest that most junk bonds pay over Treasury bonds has fallen by nearly two percentage points since mid-March to around 6.8 percentage points, according to Merrill Lynch data.

A Fear of Big Demand for Corporate Loans Banks have promised scores of companies money for a rainy day. Now that day is here — and the banks, hard pressed themselves, are worried they will have to keep their promises. With the economy struggling, some corporations are starting to tap so-called revolving lines of credit and other forms of backstop financing. If others rush to do the same, the banks might have to lend hundreds of billions of dollars at a time their own finances are stretched, forcing them to raise money to cover the loans. It is unlikely companies will reach for the emergency loans en masse, since such financing typically is used only as a last resort. Still, the worry is that the demand for cash might be greater than banks expect. The potential exposure is enormous. Collectively, banks have pledged to lend companies more than $1 trillion. And because most of those loans have not been made yet, and many perhaps never will be, the banks have not accounted for them on their balance sheets. In recent years, when banks were flush, many lenders promised to extend credit to companies on easy terms in the future if the companies hired them to underwrite securities, advise on mergers or arrange other loans. And as they did for homeowners with weak credit, banks sometimes waived their usual lending rules for the corporate credit lines, making it harder for the banks to wiggle out of them. GRAHPIC of Corporate Loan exposures.

Dollar, Oil & Commodities 

Dollar's decline finally may have ended However, there is a good chance that the recent run-up in the dollar could be more than just a head fake. Indeed, this just might be the start of something big. To see why, let us start with the fundamental reason for the dollar's protracted decline -- the humongous trade deficit that the United States has been running with the rest of the world. That it narrowed by almost 6% in March is only the tip of the iceberg. For when you drill down, the numbers are even more striking. Imports fell by the most for any month since December 2001. What makes this decline even more significant is the fact that it occurred while oil prices were rising sharply. We paid 3% more for the oil we imported in March than we did in February, but actually brought in 3% fewer barrels of the black stuff. Our performance on the export side is also noteworthy. Over the past year, exports have jumped nearly 10% from their levels at this time in 2007 as U.S. goods have become cheaper to holders of rising currencies. These numbers suggest that the dollar may have reached a level that is low enough to start equalizing the terms of trade. Aside from this, there is the question of interest rates. Ever since the markets came to believe that the Federal Reserve would pause in its campaign to push rates lower, the dollar has stopped falling. Part of the dollar's earlier decline stemmed from investors switching to the euro and other currencies looking for higher rates of return. Then there's the open-mouth policy. Some monetary officials on both sides of the Pond have recently voiced concern over the shrinking dollar, while others have said that they think the U.S. economy will soon speed up while the euro zone will slow. The implication of these remarks is that the dollar should rise against the euro, and if the markets don't do this on their own, there just might be some sort of coordinated central bank intervention to push the buck higher that could occur at any time. This has caused currency traders to hedge their bets. In recent weeks there appears to have been a swing to a net long position on the dollar, from years of a net short posture. Indeed, the entire short dollar-long commodities trade seems to be unwinding. Witness the declines in prices of such key commodities as oil, gold and many foodstuffs as the dollar has firmed.

Beijing/Riyadh and the USD A plummeting US currency would also cause chaos globally, as central banks sought to protect the value of their reserves. And after the inevitable overshoot, the currency would snap back, sending financial markets into a tailspin, and threatening a fully-blown global slump.That danger has been averted for now, but could soon come back with a vengeance. And while policymakers in Washington will be content with the current situation, those elsewhere shouldn't be. It's instructive that the main reason for the dollar's "recovery" has little to do with the US economy. The greenback's relative strength is less about the robustness of America, than the weakness of the eurozone.But a slew of bad data has lately challenged such assumptions. Eurozone retail sales fell heavily in both February and March. Last month, the PMI Euro-manufacturing survey dropped to its lowest level since August 2005. New data shows the bellwether IFO index tumbling in April - contrary to market expectations. And in Germany, the eurozone's powerhouse, factory orders have just contracted for the fourth month in a row. But the situation is by no means stable. One reason is that the US has got by far the better end of the deal. The dollar seems to have stabilised, but at a level well below most estimates of its fundamental value. And, anyway, the biggest problem for the US isn't the eurozone: it's the rest of the world - in particular China, the other emerging giants and the Middle Eastern countries which peg their currencies to the dollar. The weak greenback is harming these countries as it forces them to import inflation. All the signs are that their patience is now wearing thin. And, at the same time, these countries now call the shots, accounting for 75 per cent of the world's foreign currency reserves.So my prediction is that the US will soon reluctantly start talking the dollar up even more. But it won't be Brussels forcing them. It will be the likes of Riyadh and Beijing.

The key to commodity profits If you want to be a successful investor in commodity stocks, start thinking like a CEO. Most investors in the sector are still making investment decisions based on the demand side. Will demand in the United States fall? Will demand from China hold up? They calculate their potential risk and profit based on the answers to such questions. The CEOs at commodity companies are much more focused on the supply side. At this point in the commodity cycle, they know that what's important to their companies is how quickly record prices will bring new capacity into production. In past commodity cycles, a surge in production has led the market to swing from scarcity to glut, destroying the economics of their companies. They know that's how commodity cycles end -- with a rapid growth in production that sends prices plunging. A supply-side glut, not a demand-side collapse, is how a commodity boom always comes to an end. These CEOs are watching very carefully for any signs of a glut. Every decision the industry's smartest veteran CEOs are making these days is about the supply side. Take a look at the oil market, for example. A slowing U.S. economy hasn't been the disaster investors feared. The Energy Information Agency of the Department of Energy now projects U.S. oil consumption will fall by 330,000 barrels a day in 2008, yet oil has still climbed to $120 a barrel. Whoops, better make that $125 a barrel. Growing demand from China, the Middle East, Russia, Brazil and India has more than made up the difference. Chinese demand alone is projected to climb 400,000 barrels a day in 2008. Outside the United States, strong economic growth, rising incomes, rising consumerism, government subsidies and price controls mean the oil market has so many sources of growing demand and so many consumers who don't care much about prices that the rising global thirst for oil for the next five to 10 years is as close to a certainty as anything ever gets in macroeconomics.