Mark to market relief bounce... coming up?
I want to talk mostly about mark to market accounting, but first I'd just like to say folks, this isn't the time to sell. I'm not afraid to sell when I'm down, even way down, on a stock. But right now I will not be putting any more money into cash. Whatever I sell goes back into something else. Because we're getting severely oversold and the hype about how stocks are still expensive (which is silly) is getting a bit long in the tooth. I was very long the market just 2 weeks ago (just slight cash reserves in my investment account), but then my biggest holding got sold out and that left me with a whole lot of cash... so on last teusdays bump I dumped alot of holdings I was well down on to offset some of the gains on the sellout... which left me alot of cash.
And i'm putting it back in now.
Because the market is crashing blindly even in the presence of some positive signs. Some of these signs are short term, some are long term, some relate to the economy, some relate to this. None are a prediction that the market is going up from here, that this is the bottom, or that the week will end up from here. Or even the month. I have absolutely no foggy clue about the short term. But
1. Spending was up in January. And thats good.
2. manufacturing wasn't down as much as people expected. And thats good.
3. the car industry (a big part of the manufacturing decline) is running well below the scrap rate. that means we're junk yarding more cars now than are being built, more going off the roads than coming out of factories. And while that IS NOT reason to believe sales will pick up by summer it is without a doubt setting the stage for a bit of a boom in car sales at some point down the road. And that will be good.
4. Q4 was so bad, so brutal, so greusome... it begs the question of "can Q1 really be worse?". If Q1 is even the same as Q4... the market may well treat that as good. Its the fear of how far things will fall that is scaring people more than how far they have fallen.
5. The level of shorts on the market is unbelievable. Many stocks have a short interest equivalent to more than a WEEKS WORTH of trading. And that was on Feb 10th, i've no doubt its higher now. this just adds upside to the market once it starts to move up, especially on really battered stocks like OSK and RCL.
6. And this is longish term. Could start to flatten out in Q1 reports, could turn positive as early as Q2, or could turn positive certainly by later htis year. And this, folks, will be a huge relief for entire broad sectors of stocks.
Mark to market accounting will stop hurting companies. The amazing horror's being wrought by mark to market accounting right now... will one day be partially reversed. For folks who don't know what mark to market accounting is, it kind of works like this:
Lets say that I have a business that profits $700k every year. And I draw a $100k salary, pay alot of taxes, and put away say $300k into an investment account in the companies name every year. And after say 10 years I have $5 million in the investment fund and I'm still plugging away making $700k/year with the business.
And then the value of those investments tumbles by 50%. Say they are bonds (Nova Chemicals bonds were trading for 50 cents on the dollar when I bought some Nova a while ago) or whatever. And say they keep paying interest just like normal so the amount of money coming into the funds isn't changing. And say I don't plan on doing anything but holding the bonds to maturity... It doesn' tmake any difference to me that the bonds are down today, and in the end it doesn't matter to me at all as long as one day the bonds are repaid at maturity.
So nothing changed for you unless one of the companies or cities who's bonds you hold goes bankrupt. Nothing has changed for you at all. But you would, if using mark to market accounting, lose 1.8 million dollars for the year when your investments dropped in current value. And then 3 years from now... the markets settle down the bonds are back to trading at face value and you're still making $700k every year. That year you'd make 3.2 million.
Every year you do exactly the same. But your income varies from -1.8 ml to +3.2 mil.
Now, absolutely positively in no way are all of the mark-to-market losses coming back. But a whole lot of them might, or dare I bullishly say, will. The spreads on debt and sale prices for private companies right now are absolutely amazing, historical, and WILL get better with time. WILL.
This mark to market situation is severely hurting several categories of companies including insurance companies, BDCs, some chemical (and presumably other) companies using FIFO mark-to-market accounting to account for value of inventories. Each of these are having earnings brutally battered, sometimes when they are actually still flowing cash and making money.
The following are not necessarily recommendations (although I'm very long XL at an average price of about $3.25) but are some stocks suffering badly from mark-to-market accounting (i.e., making -$1.8 million this year) that might get a bit of an earnings boom from a reversal of the severe negativity in debt spreads, etc., in coming quarters or years (i.e., making $3.2 million, or maybe at least $2.8). NONE OF THESE ARE LOW RISK STOCKS, but the upside could be glorious if they survive 2009 and come to see mark-to-market working for them.
-XL Capital. Insurer working hard to de-risk its portfolio, beat the street last quarter and trading at a tiny fraction of book value, with some potential to recover mark-to-market balance sheet value down the road.
-Many other insurance companies. They are all suffering from this same thing, but XL is the one that I've read enough about to feel comfortable talking about.
-BDCs. ACAS, ARCC, BX, ALD, HCGC. I am most familiar with the ACAS situation. ACAS paid down debt in 2008, had good cash flow, ample coverage of debt. Q4 was rough, and there are some questions about Q1 2009 (if there weren't the stock wouldn't be $1), but the real problem is that mark to market accounting has put them in violatoin of loan covenants. They aren't not paying, and they aren't close to not being able to pay. But their loans required that their net asset value be above X. With mark-to-mark dramatically marking their assets down (even for assets that are still paying) they wound up in violation. So they have to re-negotiate with their lenders. Can they re-negotiate? Can they survive until mark-to-market starts putting dollars back onto their balance sheet? Can they survive to pay another dividend?
that folks is the 50-bagger or bust question.
I don't know for certain, of course, about ACAS or XL or anybody else. But I feel strongly that in 5 years alot of the biggest returns in stocks will be from companies that followed this cycle
1. got killed in part by mark to market
3. lived long enough to see mark to market give some of what it took away back.
Think how an extra 2 or 3 billion would look on XLs income statement in 5 yeras? or over 5 years? Could happen. Or it might not.
But somewhere out there are a variety of mark-to-market reversal 10 baggers. And of that i'm certain.