American markets and the economy are in the midst of an additional setback. With every day that goes by, the case to short U.S. equities becomes lower-risk, higher-certainty and somewhat higher-reward. The Russell 2000 Growth index (ETF: IWO) is still overvalued and significantly above its 52-week low. Why short small caps? Small caps are more pure-play on the U.S. economy because they have less global presence and have recently rebounded more than the S&P 500. Why growth? Growth companies directly/indirectly benefit from a disproportionate amount of non-priority government grants/programs. Given the developments with the budget deficit (all over this week’s news), nonessential government help could easily recede.

 [  PS: I don’t like the idea of submitting a macro thesis - even though others have done it before me - but we’re living in special times and I believe in this idea  ]

 

 

 

Few will argue that the earnings of this index are only going downhill for now. Also, analyst estimates are only going down from here because it wasn’t too long ago that the market expected a second half recovery. Furthermore, while debate exists about the eventual depth of this recession, there is broad consensus that recovery will be long and L-shaped. Therefore, IWO’s market valuation will ‘stick’ to the earnings estimates of 2008 and 2009, with no attention paid to long-term normalized earning power (if it is large enough in the first place). Add in pessimism to this recipe. This is how Mr. Market works. So I fully expect IWO to drop to its 52-week low and lower, but how low?

 

Historically, a normal P/S range is 0.6 - 0.8 but these are growth stocks so perhaps they deserve a ratio of 1.00. There’s no way they deserve the current ratio of 1.25 and so IWO has a downside of at least 20% ($60 a share) with additional downside if Mr. Market applies the technical selling pressure that he always has. Now, since this is a macro short thesis, the rest of my write-up discusses the more complex issue: the catalysts.

 

 

 

We are in an environment where political and economic realities are short-changing equities. No one cares about shareholders as can be evidenced by the situation of near-bankrupt financials. I doubt anyone even cares about TPG’s investment in Wamu. The only distressed asset classes that get attention are real estate and debt, not equities. Furthermore, until a year ago we had a bubble in equity buybacks/recaps. We are seeing this bubble in reverse. Some companies have borrowings which may be uneconomic to refi, which implies debt-to-equity conversions. Also, with naked shorting still legal (though we don’t know for how much longer) there appears to be a way for shorts to drive down prices, which, coupled with publication of truths/rumors about the issuer’s situation, forces the issuer to raise capital at very low prices and dilute per-share value.

 

 

Corporate bankruptcies will continue to surge. In August, chapter 11 filings rose 38% MONTH-OVER MONTH from July. Spreads on both IG and Junk debt may widen further and equities should decline in tandem. Write-offs are not over by any means (no matter who’s estimates you take) and banks also have to refi some $200-300 Billion of debt in the next year. This will remove a bid from existing paper. Banks will also need to patch up capital ratios. One way to do that is curtail lending to consumers & corporations.

All indications are that credit card delinquencies are about to ramp up very significantly and lenders are cutting borrowing limits. The existing home inventory, getting to a peak of 12 months, is filled with desperate sellers who need to sell their homes for liquidity. Also, unemployment is rising. As such, I expect the American public to liquidate mutual fund holdings in large amounts and this should put selling pressure on equities. And even people who CAN afford to hold mutual funds might get scared of the market and switch to money funds. If they do, switching back to equities is going to take time.

 

Many management companies are managing hedge funds that are net long U.S. equities. Funds of funds are also closing. Trouble in the funds or with the management companies themselves will cause liquidations and increase selling pressure. Over the past month, away from the main headlines, the hedge fund industry has accelerated toward the predictions of Buffett and Munger. Examples:

 

September 8 – Bloomberg (Oshrat Carmiel):  “Camulos Capital LP, a $2.5 billion hedge fund specializing in corporate-credit investments, offered to cut its management fees if investors agree to keep their money with the firm for another year, the Wall Street Journal reported…

 

September 9 – Wall Street Journal (Donna Kardos):  “A survey of the largest U.S. hedge-fund firms showed that 35% of them lost assets in the first half of the year, putting the growth rate at 4.3%, the lowest in six years.

 

September 10 – Bloomberg (William Mauldin):  “Russian stocks may continue to decline after falling the most in two years yesterday because investment fund redemptions and margin calls are ‘dictating the market,’ JPMorgan Chase & Co. said.

 

A list can be found at http://hf-implode.com/

  

 

Vietnam, India and now Korea are witnessing a spooking reversal in investment flows. The same thing could happen to many other countries. Dubai CDS doubled from 110 to 220 in the past quarter. The cash that flowed in and propped Asian currencies is now flowing away; some central banks now have to defend their currencies from declining, rather than from rising. If central banks were to use their reserves to prop up local economies, some bid would be taken away from American securities including treasuries. Also, U.S. exports may not hold up as well as some expect if these troubles continue. Furthermore, global equity markets have declined sharply while U.S. equities have been more stable. Since the global economy will suffer more, global equities are likely decline further, eventually becoming relatively so cheap that they steal some bid from under U.S. equities. Certainly, some people are starting to glance at Asian index valuations.

 

I’m not sure how many people - at this point – still believe that there is no recession. The 3% GDP growth number was a joke but mainstream people such as presidential candidates do use the ‘R’ word. In any event, when the NBER comes out with the recession declaration, a few people will be shocked and sell equities. I also don’t know what portion of the rest of us recognizes that it will be protracted. This recession doesn’t look deep for now but it may deepen and the recovery is sure to be slow. Sovereign wealth funds are less likely to participate in equity offerings of financial co’s after experiencing losses of 20-60% on the likes of UBS and MER. If they balk, this will further hurt the financial system and therefore the credit-based economy.

 

 

The depth of this recession depends on a few pillar variables, one of which is oil prices. Also, the amount of defaulted debt will depend on profit margin damage caused by oil prices. Although I’m not an expert by any means, here are some political issues to consider:

 

A country’s currency ought to be somehow correlated with its major export. For example, for Saudi Arabia and other gulf states, it should be oil. This way, when oil is expensive it brings in more money for eventual imports and when oil is cheap, the oil industry downturn is offset by a booming export sector. It’s a simple hedging mechanism. Saudi Arabia’s USD peg makes its economy more vulnerable to inflationary shocks when oil rises and to deflationary shocks when oil falls. It appears, therefore, that they may have just dodged an inflationary shock. However we’re quickly deflating now and world oil demand might decline all the way to ‘necessary usage’ levels. After all, at least half of the world economy is flirting with - or already in - a recession. If that were to happen, the Saudis may start believing (rightly or wrongly) that demand elasticity has disappeared. As such, they might decide to de-peg from the then-strong dollar so as to charge up their export sector. This would be a double whammy for the American economy: less exports and more expensive imports.

 

If there is war with Iran, especially a mini-cold-war vs. an Iran/Russia front, it is logical that oil prices would catch an incremental bid.

 

Iraq may or may not improve its oil production but it looks like Maliki is in more firm control after his rapprochement with certain Shia elements. Bush seems to have submitted himself to this reality, Obama surely would as well, and McCain probably would not be able to change this. As result, there is less likelihood that the benefit of Iraqi oil will flow to the American consumer.

 

 

There is ongoing and increasing risk of a CDS disaster. We have seen structured finance crisis, nonexisting/overvalued asset crisis, monoline crisis and counterparty fear crisis. However, we have not yet seen a pure credit derivatives crisis. As Bill Gross said, it’s not necessarily a matter of mark-to-market losses or credit losses (because honest people may have offsetting gains and losses). Rather, it’s a matter of certain people gaining and the other side losing in such large sums that money “swooshes from side to side” and rocks the boat. AIG’s CDS troubles are well known. If it turns out that the market is gripped with fear that anyone who bought CDS from AIG is in fact not really insured, the consequences could be far graver than those of the monoline crisis. A CDS crisis would cause liquidations of various asset classes including equities.

 

 

In sum, I believe we are reaching the moment where the various individual consequences of the year-old credit crisis are intersecting and combining into “mega-consequences”. After the Lehman situation this weekend, people will be wondering “who will bail me out if I fail” and “who will bail my counterparty out if *they* fail”? JPM needs to digest Bear and probably Wamu. Bank of America needs to digest CFC. Goldman wants to stay pure. Sovereign wealth funds are probably less keen on helping than they used to be. Hedge funds and PE shops might help but many of them got burned by identifying an early bottom. In other words, the next few blowups will test the system. Every non-bailed-out blowup will cause the type of reverberations that were avoided with the rescues of Bear, the GSEs and CFC. And as these blowups occur and credit card portfolios get uglier, and ALT-A keeps shocking people, it will be more difficult to fix the problems. And to the extent problems will be fixed, nearly every case will involve some form of debt-to-equity conversion.

 

The stock market is the equity tranche of this big capital structure called America. It is leveraged to debt at all levels, leveraged to the consumer, leveraged to sovereign wealth capital allocation, leveraged to unexpected disasters, leveraged to the wisdom of regulators, leveraged to the fears of corporate CEOs and portfolio managers. The only thing holding up equities now is hope and short covering. When both fade, there will be additional downside. It may not be huge, but it is likely. And more importantly, the likelihood of permanent stock market upside is near-zero.