Monday, February 20, 2012

Post Greek Bailout Melt-Up or Meltdown?

Finally! CTV reports that eurozone ministers have agreed to a second bailout deal for Greece worth 130 billion euros that will cut the country's debt to 120.5 per cent of GDP by 2020, after nearly 13 hours of negotiations. Now what? How will markets react to the news?

Many traders are selling the news. Tim Knight of Slope of Hope and other bears are hoping for a massive rally tomorrow so they can start shorting this market. The hopeless bears at Zero Hedge still can't get over the spike in the euro after the announcement was made. Poor schmucks, they've been posting one doom & gloom article after another and yet this market keeps grinding higher.

I remain long risk assets and will keep buying any dip that comes our way. Why? Because I see a massive melt-up as the biggest tail risk of all right now. In fact, Reuters reports that bullish hedge funds are hiking their bets in 2012 rally:

Hedge funds are cranking up their bets in equities and credit in 2012's buoyant markets in the belief that the euro zone, U.S. and Chinese economies will fare better than many were fearing last year.

Many funds think the European Central Bank's long-term refinancing operations (LTRO), which flooded markets with 489 billion euros (409 billion pounds) of cheap cash in December and provide more this month, are a turning point in propping up the region's battered banks.

They are also betting that China, which is facing a fifth successive quarter of slowing economic growth, will experience a so-called 'soft landing', while the U.S., which saw its fastest growth in one-and-a-half years in the fourth quarter, is firmly on the recovery path.

The average hedge fund rose 2.6 percent in January but this was behind the S&P's 4.5 percent gain, according to Hedge Fund Research, and some funds missed out on the rally after taking a cautious stance towards the end of a turbulent 2011.

Many managers are now hiking borrowing to make their favourite bets punchier, or shifting the balance between their long and shorts to help them profit from market gains.

"What we're hearing from a number of managers is that the appetite for risk has risen," said Frank Frecentese, global head of hedge fund investments at Citi Private Bank.

"Their view on Europe is that the possibility of an extreme left-tail event has lessened, the U.S. is doing moderately better than expected and the risk of China ... heading for a hard landing has lessened."

The FTSEurofirst 300 of top European shares is up 8.3 percent so far this year.

One London-based hedge fund manager told Reuters he had cut his gross long equity position to around 80 percent by the end of last year.

However, in early January he raised this to 120 percent and plans to take it up to a long-term average of 130 percent in the next few weeks.

"POSITIVE CASE"

Managers, who lost 5.2 percent on average last year after many mistimed their bets, are now using a range of means to increase their bets.

Some funds are snapping up derivatives, which have fallen in price as volatility has slumped this year, as a cheap way of hedging their portfolios.

"Tail hedges have gotten a lot cheaper, so some managers are willing to increase exposure to their best ideas and they can buy protection at a reasonable price in case things go wrong," said Citi Private Bank's Frecentese.

London-based hedge fund firm LNG Capital is upbeat on banks because of the LTRO and has increased its fund's net position from between 25 and minus 25 percent in the second half of last year to between 50 and 60 percent net long.

Partner and senior portfolio manager Steven Mitra told Reuters he has been looking at the subordinated part of the capital structure for non-peripheral banks and lower tier two callable bonds, where there has been or will be a tender at a premium to the current price.

"We've seen the ECB flood the banks with cheap capital, so the whole (threat) of the financial system collapsing has been negated for the time being or pushed back," said Mitra.

"We like the banks sector and continue to believe, in the absence of a disorderly default and contagion due to Greece, that there is a very positive case for this sector."

He added that, thanks to the extra liquidity, any further haircuts the banks have to take on peripheral European bonds would "hurt" but the sector would not collapse.

"PROCESS OF HEALING"

However, even those less positive on the banking sector or the euro zone's debt difficulties still see reason to take punchier bets.

Sal Naro, founder of Coherence Capital Partners, which trades credit, is using relative value trades to express his view of a "sustained, moderate recovery" in the U.S., while Europe is in "a very, very difficult period".

"I do think now is the time to increase risk. I wouldn't have said that in '08 or early '09. Overall we're in a process of healing," he said.

"Our view is more skewed to longs on U.S. companies and shorts on European ones ... There's some good upside relative value momentum (in sectors we like) and some downside momentum (in sectors we don't like)."

He favours sectors such as autos and commodities, and is negative on financials and pharmaceuticals.

"(Car) inventories need to be replaced, the average age of cars has risen to approximately 10 years and advantageous funding is available," he said. "We're negative on financials, which still have a way to go in cleaning themselves up.

"Copper and oil... (are) sectors to be reckoned with as the world moves towards global growth and will start to perform again. We're nervous on healthcare, particularly with U.S. elections, which could be a significant drag. You need to do your homework there."

I'll tell you, after going through the 13-F filings of top funds, I'm still long Chinese solars and got my eye on some tech shares and other industries that have yet to take off. One of those is the coal industry where shares of Alpha Natural Resources (ANR), James River Coal Company (JRCC) and Patriot Coal (PCX) are trading near 5-year lows after getting clobbered in Q3.

One of the top holders of James River Coal Company, SouthernSun Asset Management, posted their views on-line. Michael Cook provided his comments on the company in their Q3 2011 conference call:

As you're looking at slide seven in front of you, I think it is an appropriate time for me to maybe say a brief word because we have had several questions about James River Coal. It is noticeable on this slide and I think also is related to Rebecca's comment. It is worth noting that several other of our energy or energy related businesses made the list this past quarter, and I think would be one of the areas that I would highlight as we think about James River.

In looking at James River, I would want to point out really two broad issues that have negatively impacted not only the fundamentals of their industry in general in recent months but also impact other related industries. First of all, back to my original comments this morning, there are probably very few industries in the United States that have felt the depth and breadth of the regulatory environment any more than the coal industry in the United States.

We have clearly seen a trajectory over the last few years of increasing regulation, but I would also make a real strong statement, as strong as I can make it, as we think about that regulatory trajectory, I think it is important also to refer back to my comments about the issues that the public sector vis-à-vis issues regarding the lack of engineers and high quality industry people, it presents some really unique challenges for the coal industry as rules and regulations are passed down.

Anytime you talk about regulations in the coal industry in particular, it is always associated with cost. I don't think there's any question in our mind that the Massey Coal issue, the disaster there, brought a number of issues to the fore. I think that once again it is important to recognize that our propensity in these arenas is to have major overreaction that actually doesn't solve the problem that they're trying to solve in the first place. So I think that we have to think about it on a longer term basis. Clearly, environmental issues have risen to the forefront in the past several years, and in particular that's having an impact on the letting of particular mining permits, and that's not just true for James River, it is true across the industry.

The second real challenge I think that's worth noting is that the downturn in really the last three or four months has been very broad across the energy spectrum, and that's where I would also point to the other two names that are energy related that were on this list.

And so I don't think that it was reasonable to presume that James River was going to be completely unimpacted by a broader sell off that was based on whether or not European countries were going to default on their debt, whether Europe was going into some sort of deep recession, whether the U.S. is going into this recession, so all sorts of issues that plague people I think and were those headline events that things moved the markets on a daily basis. James River certainly was not immune from that.

On the flipside of that, I will say that clearly it is our view at this juncture that James River's balance sheet, versus where it stood even at the downturn in 2008, is, we think, much more de-risked, that there certainly is less risk in the balance sheet than there was at that point in time. That is an encouraging factor I think as we look at their ability to execute their business plan going forward.

The second is, and I think it got lost unfortunately in so many of the massive headlines, was, as you may recall, that James River made an acquisition and picked up really some metallurgical coal assets that we think have the potential to be valuable to the company and clearly helped balance their cash flow stream as we go out in time. As is true with any sort of acquisition, but I think maybe more so when you're talking about energy assets, it does take time to rationalize those assets and really begin to fully benefit from the additive quality that, particularly in James River's case, comes from the metallurgical coal versus the thermal coal that they've traditionally had.

As I stated in my last comment on the placebo effect of large hedge funds, there are always undiscovered gems in the stock market, and undiscovered gems in the hedge fund world. Are out-of-favor coal stocks like Alpha Natural Resources (ANR), James River Coal Company (JRCC) and and Patriot Coal (PCX) such hidden gems in a market that has already rallied sharply? Don't know but these stocks are on my radar, along with many, many others.

Would I start shorting stocks tomorrow? No, but if you gambled on the Greek stock market in the the last three months, you're up big. Probably a good time to take profits as traders will likely sell the news. We'll see how the market reacts to the news but I remain convinced that the biggest risk right now remains a melt-up and institutions that are too conservatively positioned will end up chasing risk assets at much higher levels in the second half of the year. Perma-bears beware, she could easily go parabolic here!

Below, Euro-area finance ministers reached agreement on a second bailout package for Greece that is vital to staving off a default next month, a European Union official said. David Tweed reports on Bloomberg Television "Asia Edge" with John Dawson.