ETNs (exchange traded notes) are bonds.  They are not funds.  They are are subject to the general creditors of the issuer (typically a bank).  If the bank fails, your ETN assets will stand in line with other bond holders in the liquidation or bankruptcy process.

ETNs are an interesting product with important uses, in prudent doses, in good times.  In this difficult period, their are very high risk.

Don’t own ETNs for now.

Read our September 15 “ETN Caution” article for more information about the bank issuers of ETNs. The capital position of most and perhaps all of the issuing banks have most likely deteriorated since that article was written.

Richard Shaw
QVM Group LLC

Investors, not just mortgage lenders, whether owning bonds or stocks, need to pay more attention to credit worthiness now and in the future than they have in the past.

Investors have become used to thinking of risk as merely volatility (standard deviation of return), but there is also absolute risk — the risk of permanent loss of value.

Mortgage REITs and banks are examples from the past. Money market funds are “close call” examples of the present.  Tax exempt funds and exchange traded notes could be examples of the future.

Money Market Funds:

Bank of New York (BK) and Northern Trust (NTRS) have joined the list of sponsors contributing capital to bolster their money market funds to avoid “breaking a buck”.

Others including Wachovia (WB) and Legg Mason (LM) have done the same since the run on money funds began recently with the Primary Reserve Fund, the oldest money market fund and the first in 14 years to see its money market fund price drop below $1.00.

From Bloomberg today:

Investors pulled a record $120.5 billion from the funds in the week ended Sept. 23, according to the Money Fund Report, a newsletter based in Westborough, Massachusetts. …

“Even with withdrawals there is more than $3 trillion in money market mutual funds that has to find a home,” Credit Suisse’s Jersey said.

The problem is that general money market funds invest in assets that include commercial paper and CDs that now have questionable credit worthiness, and therefore low Bids, and therefore market-to-market hits to money fund NAV.  Treasury Bills have Bids and don’t have mark-to-market problems.

Today (Sep 29), the US Treasury opened a program to insure the value of all publicly offered money market funds for those funds that apply and pay a premium.  (see Treasury press release).

We have been advising clients during this difficult period (see prior articles) to use money market funds that invest only in US Treasury Bills.  We continue to make that recommendation, unless you are certain that your money fund is a participant in the US Treasury program that guarantees money fund value.

Tax Exempt Bond Funds:

We recommend investors with tax exempt muni funds be cautious about those funds relying on revenue bonds versus general obligation bonds.  The chance of default on revenue bonds is probably higher now.

Exchange Traded Notes (ETNs):

Similarly, we recommend limiting exposure to ETNs (single issuer bonds pegged in maturity value to some independent index), because ETN’s are subject to the risk of the credit worthiness of the issuer.

We wouldn’t stop using ETNs in areas where they provide unique exposure if the credit quality of the issuer is high, but we would be aware of the nature of the counter-party risk and keep exposures in reasonable proportion to the overall portfolio. (see article on specific ETN issuers).  The most significant ETN issuers include Deutsche Bank (DB) and Barclays’ Bank (BCS).

Summary:

Investors have been too focused on yield and earnings growth at the expense of credit worthiness.  That has contributed to the market dilemma we face today.

Investors, as well as mortgage lenders, whether owning bonds or stocks, need to pay more attention to credit worthiness now and in the future than they have in the past.

Richard Shaw
QVM Group LLC

[Securities named in this article: BK, NTRS, WB, LM, DB, BCS]

We make investment decisions fundamentally, but fundamentals seem to be out the window in the market right now.  The general dash to safety in the face of the credit market situation is crushing markets, punishing good and bad companies, whether fairly valued or not.

So let’s try to look at the technical crystal ball.

The image below shows the 16-year arithmetic chart for SPY which tracks the S&P 500 index.

What might that chart be saying?

Please note the following is intentionally limited to what is in the charts and does not take into consideration any fundamental information.  The fundamentals may paint a different picture, but this article is purely about a chart perspective.

We do not belief that charts are necessarily predictive, except to the extent that market participants make them predictive through their behavior by following the signals that charts are commonly understood to convey. There may be more to technical analysis than that we do admit, but at a minimum charts inform a material group of market players who act upon chart signals.

click image to enlarge

The red horizontal bars on the left are “volume at price”
The black vertical bars below are volume per period.

Most technical reviews involve periods much shorter than 10 years — often 10 minutes, 10 days, or a few months, maybe a year or two.  This chart looks at 16 years with 10 years in focus.

Observations:

1. Far more more shares are held at a cost basis above the current price of $116.61 (line “C”) than below that price.  That may create overhead resistance as distressed owners seek to bail out as the share price rises to near their cost.
2. The 2007 high and the 2000 high (line “A”) look like a double top
3. The much heralded July 15 2008 “bottom” at $120.99 (line “B”) was pierced on September 15 and 17. If the price stays below $121 for a few more days, then $121 will become important resistance.
4. The July 15 “bottom” may have been called because it might have been seen as supported by the price consolidation areas on the way up in 2005 and 2006, as shown by the red circles at points on line “B”.
5. The next level of support comes at about $105 (line “D”) [about 10% below the current market price] which represents a 2/3 retracement of the rise from the 2002-2003 triple bottom (line “E”) to the 2007 high (line “A”) — that retracement level being a popular Fibonacci threshold of change between a test of support and a solid reversal
6. The Fibonacci 2/3 threshold support at $105 is confirmed by line “F” which connects today with the prior major bottom in 2002 and 2003 with a “beginning” point nearly 14 years ago
7. If the Fibonacci 2/3 threshold (line “D”) is pierced and remains pierced for a few days, then the only visually remaining support is the 2002-2003 triple bottom (line “E”) at about $80 [about 31% below the current market price and 48% below the 2007 high (line “A”).

That sounds pretty scary, but it can happen.  It did happen in the US from 2000 to 2002.

Given all the fear in the market and the wholesale exit from risk, testing the $105 level seems likely, and reaching the $80 seems possible.

Compound Rates of Return:

Various price levels today represent the following 15-year long-term growth rates for SPY (proxy for S&P 500) from the September 17 1993 starting point of $35.99:

• $155 = 11.2% return
• $121 = 9.2% return
• $105 = 8.2% return
• $ 80 = 6.0% return

A 6% return ($80 share price) would be deeply disappointing, but not impossible to conceive.  The often referenced 8% to10% long-term rate of return for US equities lines up with the $105 next support level and includes the current price.  A 10% return would put the index at about $133. If you stretch the long term growth possibilities to 12%, a price of $171 could be imagined — not too likely looking at the charts.

Combining the charts and the compound return calculations, we reach into our magic hat and pull out a rabbit that predicts a price range for SPY in the current time period in the range of $105 to $133.

What are we doing?

We are 50% or more cash in accounts we manage and have all cash in money market funds that invest only in Treasury Bills.  See our recent article calling for investors to switch to Treasury money markets during the current troubled situation.  We also encourage caution in allocating assets to ETNs which pose counter-party risk in this market with counter-parties going bust (see article).

At the same time, we do believe that the current situation is creating value in some cases that deserve investment consideration for careful accumulation.

In this market, though, beauty is definitely in the eye of the beholder.  The level of disagreement about what is a value and what is a trap, and when the pull the trigger is so high that we don’t wish to add to the noise with one more voice.

We are willing to stick out necks out and say that prudence would suggest dividend paying companies are a better choice than those that do not pay dividends — because you may have to live with your position for a while before it appreciates — plus we are somewhat biased toward equity-income with or without a crisis.

As a do-it-yourself investor, you should keep your head about you and begin to scan the investment horizon for value, then screw up the courage to accumulate positions when your research and opinion tells you good value is present.

Richard Shaw
QVM Group LLC

Last year, we advised investors to transfer all money market assets to money market funds that invest exclusively in US Treasuries Notes (Better Safe Than Sorry” Aug 21, 2007).

That was due to the then new credit crisis and the then recent insolvency of a money market fund and the risk of some funds “breaking a buck” (NAV falling below $1.00).

Today we reissue and redouble that advice, and take it one step further.

For all of your liquidity (”cash” and “near-cash”) in money markets or in banks:

• if it’s in a money market fund, transfer assets to a US Treasuries money market fund (which means no corporate debt or government sponsored enterprise debt)
• if it’s in a personal or business bank account, reduce the account to $100,000 (the FDIC insured amount) and place the balance in other banks with $100,000 limits per account, or with a solid US Treasuries money market fund.

With FannieMae (FNM) and FreddieMac (FRE), who hold about 1/2 of US mortgages, considered to be insolvent, and IndyMac (IMB) seized by the FDIC yesterday in the second largest bank failure in US history, and with the ripple effects that will result throughout the financial sector, you should not exposure yourself to the consequential risk of loss in your “cash” position.

The Wall Street Journal reported today that FDIC figures show 37% of the nation’s $7.07 trillion of bank deposits are above the government insured limits.  While nobody expects all the banks to fail, the total uninsured amount is $2.6 trillion.

The yield advantage of holding money market assets exposed to credit risk is not great enough to warrant the current elevated default risks in the market place.  Money market losses are unlikely, but do you want to take that risk in today’s environment versus the reasons you hold liquid reserves in the first place?  We don’t and we are not.

We issue this advice beyond investment portfolios.  We think your business bank accounts should be evaluated too.  If you can avoid holding amounts above the insured limits, then you should consider doing so.

Intentional risk in stocks and bonds is one thing, but unintended risk in what was thought to be safe portfolio cash reserves or business operating funds is something else altogether.

There is risk enough in your stock and bond allocations.  Your cash liquidity position needs to safe so you won’t be sorry,

Richard Shaw
QVM Group LLC

Conservative investors may wish to evaluate public stocks in terms of values as they might be viewed for a private acquisition.

That would minimize the risk of buying into a bubble and the “greater fool” approach to investing, which assumes that someone will pay you more for something you paid too much for in the first place.

Of course, conservative investing based on takeover value also greatly reduces the universe of eligible stocks, because by far most stocks are priced beyond private takeover value.

While one overvalued, high multiple public company can use its inflated stock as currency to buy another overvalued company sporting a lower multiple, a cash buyer or a leverage buyer must look at affordability and cash-on-cash return, or debt service capacity of the target.

One of the measures that private acquirers look at is Enterprise Value to Earnings Before Interest, Taxes, Depreciation and Amortization (EV / EBITDA).

Private buyers (those playing with their own money) prefer to buy at an EV / EBITDA of 4 or less, and may go to 6 (maybe 7). Those multiples are based substantially on the ability of the acquired company to generate cash to pay purchase debt or to provide an attractive cash return on debt-free cash used to make the purchase.

There are other issues to consider beyond EV / EBITDA, but it is a good starting place to begin to identify companies valued such that they could make sense if purchased for money instead of stock.

Definition:

EV is the market capitalization of the company plus its long-term debt. EBITDA is similar to “cash flow”. It is operating earnings before interest on and amortization of long-term debt, and before depreciation and taxes.

What We Did:

We did a screen of approximately 9,000 stocks (including ADRs) available in the US markets, to see what kind of EV / EBITDA opportunities are out there today. We used continuing earnings in our calculation of EBITDA.

We also excluded those companies priced below $5 and excluded those that did not have a positive EBITDA in the preceding 12 months. Those two criteria reduced the universe to 4,243 stocks (more than 1/2 of stocks were eliminated.

We did not require a minimum market-cap.  If we had put a $100 million market-cap minimum into the screen, we would have excluded another 636 stocks.

The table above shows the percentage of stocks in each EV / EBITDA range along with the cumulative percentage of stocks included as the EV / EBITDA increases.

The Screen Results:

The table shows that the great middle (aproximately the 80% middle) of stocks with positive EBITDA are currently priced at an EV / EBITDA between 8 and 21.  About 16% are priced at 7 or below and less than 3% are priced at 4 or less.

Looking at quartiles, the break point multiple between the 1st and 2nd quartile was 8.2.  The median multiple was 11.8.  The break point betwen the 3rd and 4th quartile was 18.3.

Example Stocks:

Not as recommendation, but simply as markers, two stocks at each of the quartile break points were:

• EV / EBITDA 8.2  — CNOOC (CEO) and Oppenheimer Holdings (OPY)
• EV / EBITDA 11.8 — Mattel (MAT) and Diamond Offshore Drilling (DO)
• EV / EBITDA 18.3 — Smith & Nephew (SNN) and Yingli Green Energy (YGE)

Other Factors:

Of course, you will want to examine why a company carries a low multiple.  Surely, it will tend to be that way due to low expectations or some perceived flaw.

Low expectations can be a good thing, because the probability of positive surprises may be greater than for companies priced to perfection.

Perceived flaws are OK, if you know what they are and believe they are curable.  Incurable flaws are potentially fatal, but curable flaws can lead to good long term value.

Remember that great companies are not always great investments (because they may be overpriced), and mediocre companies are not always bad investments (because they may be substantially underpriced).

Moral — do your homework.

Richard Shaw
QVM Group LLC