Psychological Analysis

Let Fear Be Your Friend in the Market

Our friends at Forbes published this article in Dec 2013 and it serves as a good example of how Fear is typically misunderstood on Wall Street. Instead of buying into downtrends (thesis of this article) we prefer to buy into uptrends on periods of temporary weakness. Or short strength in bear markets.

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Forbes: Let Fear Be Your Friend in the Market
Let us share an investing secret we live by, at your absolute pinnacle of fear, do the exact opposite of what you want to do.
We believe from a trading perspective that your return on an investment shall be in direct proportion as to how much you fear it.
The very best advice we can give any investor comes down to measuring one’s fear in entering any investment.  Fear is your friend, if you can learn to use it to your advantage.
Capitulation Can be Your Friend
Quarter end, in combination with year-end, often provide spectacular investment opportunities as capitulation mounts near peak levels and portfolio managers are forced to re-balance positions.
Risk managers and investment committees review portfolios and ask themselves, what do we want to own at year end?  Or more importantly, what do we want our investors to know we own when they look at our portfolio and year-end account statements?
Believe it or not, the end of 2013 is much like recent years as fear is mounting in some unpopular sectors.  Gold miners GDX are off more than 53%, rare earth metals are 30% below January levels, and coal names have been bludgeoned off 20%.  Even the once loved home builders are off 6% from their May highs with the S&P 500 up 7% even from the same point.
S&P 500 in 2013
Airlines +96%
Travel & Leisure +77%
Elect Equip +76%
Biotech +67%
Gold Miners -52%
Rare Earth Metals -30%
Coal -20%
REITs -4%
Yet those who bought fear at the end of 2012 were handsomely rewarded.  From mid-August 2012 to the end of December, shares of Best Buy were off some 43%, while First Solar FSLR shares were torched, off 33% from their March 2012 highs heading into year end.  The most pain was felt in Hewlett Packard HPQ, which collapsed over 60% from February 16th to December 26th2012, off 30% in the 4th quarter alone.   These 3 stocks were up on average 90% in the first half of 2013.  We say “buy fear.”
What about 2011?  The ugliest sector, no one wanted to own in the 4th quarter of 2011 was the financials.  The space was off nearly 25% in 2011, 17% in the 2nd half of the year.   Bank of America alone was off 32% from Sept 1st through year end.   Over the next 12 months, investors fell back in love with the financials, up 27% on the year, BAC surged 100%.
Tax Man Cometh
Many high income taxpayers now face tax rates in excess of 50%.  High net worth investors are staring down the barrel of a combination of federal tax increases for 2013: a top marginal rate of 39.6%, up from 35%; a 20% tax on long-term capital gains and dividends, up from 15%; and a new 3.8% on investment income.
After recent tax law changes, qualified dividends and long term capital gains can be taxed as high as 25% if you include limits on deductions and the new surtax.  In 2013, there are more reasons than ever to rebalance your portfolio at year end, take losses where they are, and get in the best position possible for this higher tax climate.  This is causing a fear induced rush to the exits in some sectors as investors sell their losers to offset gains in their winners.
So How do you spot a Turn Around?
We look for clues that indicate the part of a company’s capital structure is the cheapest.
At year end, a solid equity buy signal is when we see a company’s bonds outperforming.  Credit tends to lead equities.  In many cases 40% to 60% of a company’s capital structure lies in its bonds or debt, so why would you just focus on the stock price?  You’re only seeing half the playing field!
Credit Leads Equities
In many of the gold miners such as Newmont NEM, coal names such as Peabody Energy BTU and the home builder Hovnanian HOV; the credit is substantially outperforming the underlying equity.  Simply put, the company’s bonds are doing much better than the stocks.  This is a positive buy signal for the equity.
Every year in December we have a model that searches for these dislocations in value. We look at the 5 year credit default swaps of companies and compare their performance relative to the company’s stock price.  In many cases, exceptional investment opportunities arise when we spot the cheapest part of the company to own.
For example, Peabody’s 5 year credit default swaps CDS are 140bps tighter since their worst levels this summer but the stock price is 15% lower.  Translation; investors love the credit but hate the equity.  Someone is very wrong; it’s likely the equity is mispriced.
(Credit Default Swaps: CDS is a form of insurance against default of a company, the lower the bps spread the stronger the credit profile.)
A look at Hovnanian HOV equity and its 5 year credit default swaps CDS is even more telling.  This was a standout in our model.  Since the first week of September the CDS has moved from 630 bps to 468 bps, a substantial credit improvement.  But since mid-September HOV equity is off some 10.5%.  The company’s credit profile is improving while the equity is moving lower.  Sounds like tax loss selling divergence to me.   Why is this important?  The company has an enterprise value of $2.18 billion, $682 million equity market capitalization and $1.5 billion of debt.  If most Hovnanian’s value is in the bonds, again why just watch the stock?
Where’s the Value?
As the stock market has marched higher, the dividend yield on the S&P 500 is down to 1.85%, while coal stocks as represented by the KOL ETF now yield 2.12%, gold miners through the GDX ETF 2.25%.  With the Federal Reserve promising investors a 0.25% Fed Funds rate (low interest rates) well out to 2016, we must appreciate an income advantage where it’s found.   Dividends don’t provide a floor on stocks but in a low interest rate world they do provide relief as investors are searching high and low for yield.  Likewise, with the PE on the equity market nearing 17, the gold and coal names look cheap at 10 and 12 respectively.
With the S&P 500 up 28% this year vs. the Gold Miners GDX, off 55%, and Coal KOL names off 20%, one has to ask how long can the spectacular spread of outperformance continue.
With Uncle Sam in mind, one has to ask, after January 1st who will be left to sell the Gold and Coal stocks?  In the first quarter of 2014, we expect these underperformers to play some serious catch up.  With the average gold miner off some 65% from their 2011 highs, a lot of bad news is priced in at today’s levels.  Today’s losers will become tomorrow’s winners once again.

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