Friday, November 25, 2011

We're Bottoming: Time To Accumulate

I've been bearish on risk for most of this year until the 9th of August, then I played the rebound and again went short on the 2nd of September. I changed my bias to net long Tuesday night.

The world sure is a risky place these days, but it is at times like these that things need to be put in perspective, and arguments from both sides carefully examined.

1. Sentiment

Sentiment is surely a fickle beast, but appears extremely bearish right now. One non-scientific measure is how often 2011 is compared to 2008 and how many analysts are expecting a Lehman-like event. Given the broad expectations of another calamity, its simple absence should generate a rally.

2. Europe

Yes, the situation is messy. But all evidence is pointing to the approval of the expanded (440bn) EFSF, which will ultimately obtain a bank license and have the buying power of ~2tn through leverage. Only a few more European parliaments have to vote on the expansion and prospects look good. Once that is in place, it will buy the continent time for institutional reforms and allow it to build firewalls to protect the rest from Greece - should it go down (not a scenario for this year in my opinion) - and evil speculators. It would also allow them to recapitalize banks. The longer-term outlook is only marginally better, but short-term disaster should be averted.

3. Recession risks

They have not substantially diminished, but neither have things gotten worse - at least in the US. Europe will in all probability experience a recession next year, but the US could avert it. It should be noted that the last series of PMIs came in better than expected in the US and Europe, and we're around 50 - not collapsing as we were in 2008.

click to enlarge

4. China

Recently, worries have emerged about a China hard-landing. (The definition of a hard-landing varies though: some say it's slow! ing to 2 -3% growth while others say it means sub-8% growth) The west is mostly out of monetary and fiscal bullets - not so China. They have the capacity to manage the slowdown. Inflation is slowing, and should allow the authorities to ease in the next 2-3 quarters. There may be a few corporate casualties (ie. in the real estate sector), but the economy will continue to operate at a decent pace.

The premium/discount on the A-Share ETF listed in China has been a good contrarian indicator. The recent retreat of capital suggests that Chinese equities should be higher in 6 months time.

5. Valuations

Valuations are for the most part attractive - especially in Europe, where the DAX and CAC trade on Case-Shiller P/E ratios not seen since the early 80s. I would argue that parts of EM equities (and credit!) are also very attractive. From a macro standpoint, countries which were overheating are buy candidates as a global slowdown will allow them to ease. In this category India comes first, China second, and maybe, maybe Argentina 3rd.

This chart shows MSCI Asia ex-Japan price-to-book and Book Value evolution

6. Technicals

I will just point to one - possibly arbitrary - measure. The reversal on the S&P Tuesday doesn't happen very often, and even if 1074.77 was not the bottom, we are in the process of bottoming. We made a new low and then closed 4% higher. Even if I am wrong and the cycle takes another leg down, it looks like a tradable bounce is building.

What to do?

Accumulate quality stocks that have sold off. There is a quick screen of stocks that have fallen by more than 10% in the last 3 months, yet generate substantial free cashflow, exhibit sales growth and have reasonable valuations (EV/EBIT<10).

My picks here would be Western Union in the US, Inmarsat in the UK and HTC in the tech space. I would take some profits on the long USD position but remain long against the EUR.! Also, i f you don't own it already, now is the opportunity to build a gold position.

At the very least, cut shorts and move to a more neutral risk positioning. Don't bet on a calamity now - too many people already are.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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