Sunday, August 12, 2007

The Trader: Is It Safe To Come Out Yet?

By Kopin Tan

What scares the market so? It isn't good news, which is in short supply these days. It isn't even bad news, which at least is a known woe.

What has traders quaking in their Bruno Maglis is the bewildering uncertainty pervading the stock market, as the financial world grapples with the unknown -- and so far unknowable -- damage suffered in the market for home-loan securities.

As losses pop up in unexpected places, worries increase that a chastened debt marketwill clam up -- denying credit to everyone from corporations to consumers, and thwarting the already-fragile economic expansion in the U.S. "There are now some indications that the subprime mess is leading to an indiscrimate rationing of credit," says Strategas Research's Jason Trennert.

Last week, the U.S. Federal Reserve and the central banks in Europe and Japan injected billions into the financial system. While that helped calm frayed nerves, it also fanned fears that the looming credit crunch may be worse than imagined.

Repeated reminders from the bulls -- of today's stronger balance sheets, moderate valuations and an earnings yield still greater than that from 10-year Treasuries -- spurred buying jags. But those were met with selling from hedge funds looking to de-leverage and shore up liquidity to meet any redemption calls. Since the July 19 market peak, a basket of 20 stocks with the greatest hedge-fund ownership has lagged the market by 628 basis points, notes Goldman Sachs.

The push-pull produced one of the stock market's most violent spells in years, with the Dow Jones Industrial Average swinging through triple-digit gains or losses in 11 of the past 16 sessions.

The week kicked off with a three-day rally that was the Dow's best since March 2003. But the biggest gains came from financials, materials and energy -- sectors that had fallen the hardest since July 19. This raised the specter of a "dead-cat" bounce, an impression confirmed Thursday when stocks suffered the year's second-worst one-day drop after BNP Paribas barred withdrawals from three of its asset-backed security funds. The selling was fierce and broad, with nine of 10 Standard & Poor's 500 sectors falling more than 2.5% in a day.

Trouble surfacing as far away as Europe suggests to the bulls that mortgage-market risk is spread wide -- and shallow. But the worry remains that such diffuse contagion could make it harder for regulators trying to limit any systemic risk. Not surprisingly, Friday's promise by the Fed to do all it can "to facilitate the orderly functioning of the financial markets" was met with more wild swings and had traders reaching for Dramamine.

The Dow fell as much as 213 points Friday before paring its loss to 31 points; it ended the week up 58, or 0.4%, to 13,240. Were it not for Friday afternoon's bounce, the Dow might have suffered its fastest 1,000-point decline since it skidded that much in the five days after the Sept. 11, 2001 attacks. The S&P 500 ended the week up 21, or 1.4%, to 1,454. The Nasdaq Composite Index gained 34, or 1.3%, to 2,545, while the Russell 2000 index rose 33, or 4.4%, to 789.

Consider this a sign of the times: Just a month ago, traders whiled away downtime picking potential takeover targets. Today, the chatter centers on which hedge fund or brokerage firm might be the next to suffer, and when the Fed may be forced to cut rates. Eddie Lampert's ESL Investments, for instance, has concentrated holdings in retail and bank stocks, and his positions in Sears (ticker: SHLD), Autozone (AZO), AutoNation (AN) and Citigroup (C) would have lost nearly $3 billion on paper since July 1.

What lies ahead? The pillar that is the job market thankfully is still standing, and global growth continues to lift profits at U.S. multinational companies. But hundreds of billions in adjustable-rate loans will reset to higher rates over the next year or so, and the impact on consumer spending remains to be seen.

Conventional wisdom holds that corporations, with their strong balance sheets, can withstand any credit crunch. But consumers stretched by rising mortgage payments and high gas prices might not hold up as well -- and they have been the drivers of this mature bull market.

In the shorter term, financial stocks that drive nearly 30% of S&P 500 profits may have to increase their loan-loss reserves. That may mean that profit forecasts for the third quarter will have to be adjusted down.

The market's worst fear is summed up by James Melcher, who runs Balestra Capital. "The equity market is just a sideshow to the main event, which is the bursting of the credit-market bubble," he says.

A decade of muted borrowing costs and lax credit have created a vast pool of liquidity that has inflated home prices and reduced sensitivity to risk. Liquidity has flooded so much of the financial system that mopping up its excesses will take time, "and we're not there yet," Melcher says.

Because money managers cannot accurately gauge the value of mortgage securities on their books, the losses suffered have yet to be fully quantified, and selling assets to meet redemption calls can play out for some time. That's one reason gold prices have slipped 3% even during the flight to safety over the past three weeks, and why energy bulls nonetheless are selling oil stocks -- because that's where they have profits.

Fearing fallout from the mortgage market's excesses, the global-macro hedge fund Melcher runs took a defensive stance as early as last year. That earned him some derision when stocks surged, but the fund is up 85% so far this year, after fees.

While waiting for the market tumult to run its course, Melcher says he is holding a lot of cash and Treasury bonds. He is also long the yen (he reckons the yen carry trade could unravel further), the euro and gold. He also holds credit-default swaps on select corporate and sovereign bonds.

Stocks he favors in this fracas include gold, oil services and large, non-durable consumer staples (think toothpaste makers). But he hasn't loaded up on these stocks yet because selling by index funds could still send prices lower -- with the buying opportunity still to come.

Anyone who needs an example of how capricious the markets can be need only look at the lost swagger of the merger crowd.

For each of the first seven months this year, the tally for U.S. mergers has exceeded $100 billion, even reaching a whopping $205 billion in July, according to Thomson Financial. But with the credit market balking, just $18 billion worth of mergers have been inked so far in August.

Since June 30, high-yield debt issuance totaled just $2.43 billion. The number of mergers topping $1 billion averaged 31 each month from January to July; so far in August, there have only been three.

Buyout firms also have retreated, and could remain in wait-and-see mode as they watch how the pipeline of debt offerings is met in the market. For much of the year, private-equity firms accounted for about 36% of all U.S. mergers. But since July 23, their part of the haul has fallen to 11%.

It isn't unusual to see deal-making slow slightly in the second half, says Richard Peterson, Thomson's director of capital markets. But such conspicuous retreat mirrors the market's growing concerns of dwindling credit -- and the still-unknown impact on economic growth.

Should you need another example of how cruel the market can be, consider the swift downfall of Dillard's (DDS).

Shares have skidded 35% since July 18. First, a constricting credit market quashed hopes that buyout firms might swoop in to buy the Little Rock department store, or that Dillard's could lever up to return value to shareholders. Then, Dillard's last week reported a 6% drop in same-store sales, the 12th sales decline in the past 14 months. With waning home prices and big gas bills, hopes for a resurgence in shopper traffic seem like wishful thinking.

A bout of bargain hunting lifted the stock 8% Friday, but Dillard's is hardly a bargain. At 24.25, it is trading at 14.4 times forward earnings, and profit projections risk falling if consumer spending wanes.

Billy Joel gets all the attention whenever he drives into a tree, but in fact, three million vehicles are totaled each year in the U.S. And that's all big business for Copart (CPRT).

The Fairfield, Calif., company has a leading 35% share of the domestic auto-salvage market, brokering the sale of totaled vehicles from insurance companies to buyers like rebuilders and scrap recyclers. The salvage business isn't exactly fast-growing, but Copart has improved profits steadily and kept gross margins near an enviable 50%.

It accomplishes this with live Internet-bidding technology that has transformed the once-sleepy business of salvage auctions. Internet auctions "improve the return on vehicles auctioned by attracting more bidders and reducing costs," notes Baird analyst Craig Kennison. Maximizing the price yield further helps Copart win vehicle-supply agreements from insurance companies and charge a premium for its service.

As domestic expansion starts to mature, Copart has set its sights overseas, and recent acquisitions in the U.K. will let Copart graft its technology to a global platform. "Given that profit levels and market value of the highly fragmented global market are far below those of Copart, we perceive a considerable opportunity for global value creation," says Rochdale Securities analyst Jaison Blair, who initiated coverage of the stock last week with a Buy rating.

With $100 million in annual sales, Universal Salvage, which Copart is buying, is the largest U.K. salvage company. Yet it is only marginally profitable -- compared with Copart's 24% net margin.

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