The Return of the Bear Market
It's beginning to look a lot like a bear market. I'm not that surprised given the negative headwinds of late. Ironically, this is actually proving much of the perma gloom-and-doomer crowd wrong, as most of them have been suggesting that the US is in the worst shape. Au contraire --- both China and the Eurozone face significantly greater problems right now. The US, relatively speaking, is the best of a bad bunch.
The Eurozone situation in particular frightens me --- but maybe for reasons different than those of most people.
Perhaps I am a bit of a contrarian right now in belieivng that the Euro will survive. It seems an overwhelming number of commentators are predicting its demise. It's a distinct possibility, but I believe it will be avoided. The Eurozone is sort of like the US in 1783 under the Articles of Confederation --- a work in progress. All the same, the Euro experiment is very beneficial to all of Europe and I think that there will be extreme relunctance to end it. Instead, we will see major reforms over the next decade. (But don't bet the bank of either outcome --- I give the Euro 65-35 odds of survival.)
Germany and France might be nudging the Eurozone members to adopt strict deficit spending requirements. This news is floating under the radar, but may be the biggest news of the past month. From a policy perspective, this sort of move might be essential. From an economic perspective, it probably means a ton of pain for the Eurozone over the next few years (if not longer). This move could create very strong deflationary pressures in Europe, which will exacerabate the economic problems there.
In fact, you could argue that Europe is now facing a similar set of circumstances that helped created the Long Depression (that resulted after the Panic of 1873). Will it fare as poorly as that depression? I hope not; but I'm not confident of that. In spite of all the hyperinflation talk, the bigger fear should be sustained deflation and a severe depression that could be in the cards.
Some of you might think I'm advocating the alternative to deficit-slashing --- but not so much. Keynes was right about monetary policy and credit contraction, but the dynamics right now are different than they were in the 1930s. Deficit spending is alright in limited quantities, but much of the world has been on a debt binge. It was unsustainable and there is no realistic alternative to major spending cuts, unfortunately.
But there are major strucutral differences between the US and the Eurozone and the Eurozone will be unable to bear this without significant changes to its structure.
The Great Wall of Fraud?
The other dynamic right now is that the Chinese markets appear to be crashing. Is this possibly a sign that the housing bubble has finally burst? Given the heavy hand of the Chinese government, it's very difficult to predict how this will play out. But I'm not here to talk about that --- instead I want to focus on something else.
At the most recent Value Investing Congress, Chinese's largest hedge fund manger, Lei Zhang, casually noted that about '200 of the 350 Chinese companies traded in the US are frauds or have significant problems.' This quotation really stuck in my head.
A week later, I noticed a lot of top CAPS players jump aboard on NIVS IntelliMedia (NIV). I started looking at it and saw why people were so excited. It looked very cheap by the numbers. Except, I noticed that they had used a relatively unknown auditor. This isn't that big of a deal, but I always like to look into auditors I know very little about. One of the first results I found in a Google search --- a PCAOB inspection report citing a number of non-conformities in the firm's inspection.
As I dug into NIV's financial statements more, I noticed that their operating cash flows seemed to routinely lag their earnings. This was almost entirely due to their rising Accounts Receivable balances, which were specifically cited as an area of concern in that PCAOB inspection.
I've not had time to dig into NIV very much and it may indeed be a great value, but I would have a great deal of skepticism towards it. After looking at a few other Chinese small caps traded on American exchanges, I see a lot of similar potentially negative signs. They might look cheap, but I'd be very afraid of some of these Chinese microcaps right now. I'm not saying there aren't great values out there --- but I'd be particularly diligent about doing due diligence first.
What Am I Buying?
Not much, to be honest. But I wouldn't go heavily short the market, either. Rather, I'm still mostly long, with only a few minor short positions (for hedging purposes more than anything). I have sold off some stuff to increase my cash position.
While many might say I'm crazy, I still believe REITs are undervalued. There are few deep value plays in the sector now, but they are still undervalued in the aggregate. I will also continue to hold onto a basket of small commercial banks.
Aside from that, the only sectors I like are energy and defensive stocks. I like big pharma stocks right now --- particularly PFE and LLY. As far as energy goes, I do believe BP has been beaten down further it probably should be. More importantly, I think nuclear and natural gas are the near-term future. I like natural gas, in particular, right now.
There is a Sunny Side
While down markets are bad, they also create opportunities. If indeed, we are seeing a renewed bear market, it will be painful for a while, but there will be great values to be had somewhere down the line.