Saturday, 29 March 2014

Credit - Too Big To Fall

"Risk comes from not knowing what you're doing." - Warren Buffett

Watching with interest the ever compressing credit space with the Europe High Yield CDS risk gauge Itraxx Crossover tighter by 30 bps to 290 bps since the new series launched on the 20th of March, we are indeed feeling the same nervousness around the rapidity of the spread compression we experienced firsthand in 2007. We also reminded ourselves lately of the epitome of the financial crisis namely the expression  "Too Big To Fail" which led to the definition of systemic importance for some banks. We decided this time around to play along this famous or infamous expression (whichever you prefer) in our chosen title given the abandon and frenzy with which investors seems to be seeking whatever is on offer in the credit space with a decent coupon, regardless of the risk (or covenant protection in some instances), but more importantly disregarding the growing "liquidity" risk we have often warned about, leading us to our chosen title, as we believe credit markets are indeed becoming "Too Big To Fall" given the shrinking balance sheet of  banks has led to paltry dealers book to accommodate any major selling pressure should it materialise in the near future.

On the subject of liquidity and credit markets, we could not agree more with Axa's recent take on the subject as reported on the 21st of March by Roxana Zega in Bloomberg:
"Regulatory change imposed on banks to make them safer may ironically end up sparking systemic risk, with current spreads failing to compensate for greater illiquidity, Mark Benstead, global head of SmartBeta Credit at Axa IM says in 2014 outlook.
 -Regulation has stopped market makers from being either willing or able to supply former levels of market depth for corporate credit
 -Central bank liquidity has engineered falsely low default rates
 -Axa says there’s a mismatch between size of credit market and the ability to trade it
 -Carry will be the main source of return for credit as capital appreciation is unlikely this year, with yields barely expected to budge
 -“Credit events” could dent returns, so careful selection is needed to dodge isolated risks
 -Expects central bank policy to be more divergent in 2014 than at any other time in past 5 years
 -Axa IM managed ~EU547b as of end 2013
 -Note: BNP said March 13 that low liquidity is main risk to credit" - source Bloomberg

A good illustration we think of risks coming from "not knowing what you are doing", from a credit perspective, can be ascertained from the growth of convertibles under ETF format in the US in assets under management (AUM), particularly when one looks at the growth of CWB US, the US convertibles ETF (SPDR State Street) which includes convertibles and preferred, leading it to be highly "equity" sensitive. Please keep in mind that when it comes to convertibles issuance, the US market has seen a strong pick-up in issuance from the technology and biotechnology sectors.

The surge in AUM has indeed been staggering - graph source Bloomberg - ETF Market Capitalisation:
- graph source Bloomberg

Of course the surge in the AUM has been closely following the surge in the price of the aforementioned ETF:
- graph source Bloomberg.

As we indicated recently there is a great article in Forbes by Bill Feingold on the high price being paid on some convertibles:
"A wise trader once said, “There are no bad bonds, only bad prices.”

If you’ve been following this space, you know that I’ve been trying to encourage companies to take advantage of a historic opportunity to issue convertible bonds on favorable terms.  The opportunity has come about for the same reason most things get more expensive:  increasing demand and limited supply.

Here’s a statistic that should get your attention. I mentioned it the other day but once was not enough. The only significant exchange-traded fund dedicated to U.S. convertible bonds, CWB, has seen its assets explode over the past 12 months. Barely over $1 billion a year ago, the fund now has nearly $2.5 billion under management.  It’s a passively managed fund designed to track Barclays BCS +0.45%’ index of large U.S. convertible bonds (each component must be over $500 million, or about twice the size of an average convertible).

That growth should tell you all you need to know about how demand for convertible bonds has been expanding. It’s understandable—investors and their advisors are worried about rising interest rates but want to stay with an asset class that, unlike stocks, promises principal repayment.

However, companies haven’t been issuing convertibles nearly enough. New issuance in the U.S. bottomed at $20 billion in 2012, compared with around $100 billion annually in the years leading up to the financial crisis. 2013 was a lot better, with almost $50 billion, but that was barely enough to replace maturing deals.  Current issuance is simply nowhere near enough to keep up with demand.

Unfortunately, this means that in many cases, investors who are just now putting their money into a generally terrific asset class may be getting on the wrong side of value. In some cases, this can be rather severe."  - source Forbes, Bill Feingold.

We think there are growing risks of seeing liquidity vortexes where the lack of bid will make prices gap down violently, hence our chosen title. New Basel regulations have pushed banks to re-assess their balance sheets and are less in a position to absorb secondary offerings when markets turn South. Like others, such as Matt King from Citi, we have been warning about the fact that spreads reflect less and less "liquidity" risk in the current environment, convertibles being no exception, as clearly indicated by Bill Feingold in his Forbes article. 

As posited more recently by Matt King from Citi, liquidity is indeed a growing concern because it is extremely fat-tailed:
Citi Matt King - Investing in fake markets - March 2014 - How is the distribution in markets?
- source CITI - Matt King - March 2014 - Investing in fake markets.

Highly leveraged funds in the case of a sell-off will be particularly hit hard in that case. The issue of course would be to hold a higher proportion of cash to mitigate the redemption risk, unfortunately, cash buffers have been going down in many cases. Negative convexity risk in callable bonds for instance can be as well mitigated by increasingly playing credit via the CDS market. Recent hybrid calls at 101 for Telecom Italia and Arcelor Mittal are stark reminder of the need of pricing "optionality". Another advantage of the CDS market is the added liquidity on the credit exposure you want to add to your portfolio. Of course you are somewhat switching liquidity risk for counterparty risk. It is never a zero sum game but we ramble again. For illustrative purposes, the graph below from Matt King from Citi, illustrates further the liquidity issue, volatility and risk you run between cash bonds and CDS:
 "The vol you see is not the risk you're running"
- source CITI - Matt King - March 2014 - Investing in fake markets.

When we talk about investors getting outside their comfort zone and adding risk they might not perceive, the Junk-Loan ETF space is growing at a very rapid space in an environment which is becoming more and more reminiscent of 2007 as indicated by Sridhar Natarajan in his Bloomberg article from the 26th of March entitled "Junk-Loan ETF Asset Surge Heralds Higher Rates":
"Investors just can’t get enough of exchange-traded funds that buy junk-rated loans.
After more than tripling their assets in 2013, the loan funds are now growing four times as fast as the rest of the $262 billion market for fixed-income ETFs, according to data compiled by Bloomberg. The biggest leveraged-loan ETF, Invesco Ltd.’s $7.4 billion PowerShares Senior Loan Portfolio, has already amassed almost a billion dollars in new money this year.
The popularity of speculative-grade loans, which have rates that rise with benchmarks, has soared with debt investors seeking shelter from higher borrowing costs as the Federal Reserve moves up its rate-increase projections. While the demand has been a boon for ETFs that invest in loans to the neediest companies, it’s also prompted regulators to warn that excesses which contributed to the credit crisis may be creeping back." - source Bloomberg

As Warren Buffet quote goes, risk does indeed comes from not knowing what you are doing given that single-B rated loans now make up the largest portion of the junk-loan market compared with 2007, when double-B rated loans were the most popular. As a reminder, during the credit crisis, loans were the worst performers among the major credit asset classes, losing 23 percent in the last quarter of 2008.

Loan ETFs are yet to be tested, by our "liquidity" fat-tail concerns but they are sure becoming "Too Big To Fall", and if indeed selling pressure does materialise, they will probably sell-off fare more than the index because they might not be in position to redeem the assets at the pace of the money being pulled out. Caveat investor...

In a world of increasing "positive correlations" where convertibles ETFs as well are getting even more sensitive to "equities", last year's sell-off in the credit ETF space for High Yield (ETF HYG) and Investment Grade (ETF LQD) illustrate, we think the "redemption" risk - graph source Bloomberg:

Another illustration of the "Cantillon Effects" at play and outside the credit space has been the London real estate market courtesy of Central Banks' generosity as indicated by Bank of America Merrill Lynch in their Thundering Word note from the 27th of March entitled "Hey Crude, don't make it bad":
"London...the last great EM “speculative fervor”
Prime London real estate is up 2X since 2006, 3X since 2000 and 4X since 1998.
And yet UK rates are the lowest they have been in 300 years. In our view, London property is a classic outcome of the Max Liquidity-Min Growth backdrop of the past seven years. We believe the risk of "speculative fervor" remains high. The UK could prove a useful early warning system.

Prime London real estate has doubled since 2006, tripled since the 2000 and quadrupled since the last great Asia/EM crisis of 1998 (Chart 3). 
And yet the Bank of England's policy rate is at its lowest level in 300 years (Chart 2)."
- source Bank of America Merrill Lynch - The Thundering Word - 27th of March 2014

As per our conversation "Cantillon Effects", we too, have an our own useful warning system, being the art market in general and Sotheby's stock price versus world PMIs since 2007 - graph source Bloomberg:
We have argued previously that the performance of Sotheby’s, the world’s biggest publicly traded auction house was indeed a good leading indicator and has led many global market crises by three-to-six months.

As a reminder, why did we choose art as a reference market in describing "Cantillon Effects" and asset bubbles you might rightly ask?

Well, as posited by a very interesting study by Cameron Weber, a PhD Student in Economics and Historical Studies at the New School for Social Research, NY, in his presentation entitled "Cantillon effects in the market for art":
"The use of fine art might be an effective means to measure Cantillon Effects as art is removed from the capital structure of the economy, so we might be able to measure “pure” Cantillon Effects.

In other words, the “Q” value in the classical equation of exchange is missing all together for the causal chain, thus an increase in the money supply might be seen to directly affect the price of art.

Economic theory is that as money supply increases, the “time-preferences” of art investors decreases (art becomes cheaper relative to consumption goods) and/or inflationary expectations mean that art investors see price signals (“easy money”) encouraging investment in art." - Cameron Weber, PHD Student.

Nota bene: Classical equation of exchange, MV = PQ, also known as the quantity theory of money. Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.
-Endogenous money, PQ => MV (Hume, Wicksell, Marx)
-Exogenous money, MV => PQ (Keynes, Monetarist)

In our Cantillon Effects, we get:
Δ M  => Δ Asset Prices

Sales of art and antiques increased 8 percent from a year earlier to 47.4 billion euros ($65.9 billion), according to a report compiled by Arts Economics and published on the 12th of March as reported by Bloomberg by Katya Kazakina on the 12th of March in her article "Art Market Nearing Record as Global Sales Reach $66 Billion":  
"The results fell just short of the record 48 billion euros in 2007. The value of postwar and contemporary art transactions increased by 11 percent from 2012, reaching its highest-ever auction sales total of 4.9 billion euros as records were established for artists such as Francis Bacon, Roy Lichtenstein and Andy Warhol." - source Bloomberg.

Yet another example of "illiquid asset" such as London real estate to monitor closely in the near future and another illustration of our 2007 feelings we think.

On a final note and relating to our deflationary monitoring stance, we have been tracking with interest the shipping space as you know and looking at the recent Asia to Europe container shipping rates, it continues to fall and has indeed fallen to a 21 week low:
"Shipping rates for 40-foot containers fell 5.1% to $1,684 for the week ended March 27, marking the ninth-straight weekly decline and the lowest price since mid-December ($1,660), according to World Container Index data. None of the major trade lanes increased. Rates from Shanghai to Rotterdam (11.9% lower) and to Genoa (down 5.7%) declined the most for the fourth consecutive week, as rates for both lanes dipped to the lowest levels since October." - source Bloomberg.

The latest reading from the Drewry Hong-Kong/Los Angeles container rate benchmark tells a similar story - graph source Bloomberg:
"The Drewry Hong Kong-Los Angeles container rate benchmark fell 5% to $1,886 for the week ended March 26, reversing last week's gain and the eighth week in 2014 below the $2,000 mark. Slack capacity continues to pressure prices, with rates 13.4% lower yoy and 25.1% below the July 2012 peak of $2,519. Carriers are expected to implement a $300 general rate increase per 40-foot container from Asia to the U.S., effective April 15." - source Bloomberg.

What is of course of interest is the additional rate increases to counter the deflationary forces at play still wreaking havoc on the shipping industry as a whole. As a reminder, Containership lines have announced 13 rate increases, totaling $5,450, on Asia-U.S. routes since the beginning of 2012.

So what is the new trick to offset deflationary forces, you might rightly ask? It is called "Container Liner Alliance" by the U.S. Federal Maritime Commission (FMC) when it should be called "Oligopoly" or more simply a cartel:
"The U.S. Federal Maritime Commission (FMC) approved the alliance of the three largest containerliners Maersk, Mediterranean Shipping and CMA CGM, dubbed P3, on March 20 to set sail in 2Q.
The alliance of 252 vessels (2.6 million 20-foot equivalent units) represents 42% of Asia to Europe, 24% of Trans-Pacific and 40% to 42% of Trans-Atlantic capacity, according to the FMC. P3 may help reduce costs and manage excess capacity, stabilizing rates." - source Bloomberg.

So in the competition of survival of the fittest, the set-up of a de facto "cartel" in the shipping space  with the benediction of US authorities has no doubt "boosted" the probability of survival of the big three. This latest "intervention" does indeed validate our January 2014 musing "Shipping and Deflation - Only the strong survive":
"In a Bear Case scenario, only the strong survive such as Maersk. The world's largest container shipping line with 15% of the world's market share, did report an 11% increase back in November in third-quarter profit after cutting costs by 13% in the quarter helped as well by its new line of triple-E ships being introduced which has been countering the deflationary trend in freight rates." - source Macronomics, 9th of January 2014

Looks like the containers industry is like the banking industry after all, it's "Too Big To Fail".

"If my survival caused another to perish, then death would be sweeter and more beloved." - Khalil Gibran, Lebanese poet

Stay tuned!

Friday, 21 March 2014

Guest Post - Equities: Frothy Sentiment

"The good news is, we're not bankrupt. The bad news is, we're close." - Richard J. Codey

Please find below a great guest post from our good friends at Rcube Global Asset Management. In this post our friends go through the frothy sentiment building up in the equities space:

The MSCI World (developed markets) briefly tested its 2007 all‐time highs last week.
The strength in US equities explains most of the rise since 2009, but more recently Europe also helped the advance. The remarkable thing about this is how quickly sentiment towards stocks has reached and in many indicators even surpassed previous peaks in euphoria.

The indicator that has really caught our attention lately is the % of US IPOs with negative earnings. Most observers would have guessed that the 80% level reached back in 2000, at the height of the tech bubble, would never be reached again, but we are almost there again. Bloomberg reports that currently about 75% of all IPOs are money‐losing companies. So on top of the fact that rising equity issuance is negative for stocks’ expected returns in aggregate, the poor health of companies issuing shares is another medium‐term warning.

This goes hand in hand with extreme retail optimism which can be also tracked by looking at the RYDEX bull bear ratio. This is more interesting than the classic bullish/bearish ratios because it is based on actual money invested and not on surveys. It tracks the ratio of AUM between bullish and bearish RYDEX funds. As the chart below shows, it is at all‐time highs.

The net debit margins at the NYSE has reached almost 300bln and penny stocks’ trading volume has soared.

We also notice that the US market "breadth" is poor. The S&P Small Cap Index (S&P 600) has been printing new historical highs for 12 consecutive months with fewer and fewer shares trading above their 50 days moving average. Indexes are lifted by a small number of shares; this kind of negative divergence is rarely a good sign.

Additionally, we are now amazed to witness that Short VIX ETFs are almost as popular as Long VIX products. For us, who have been consistently selling equity volatility on spikes from 2009 until early 2013, when both retail and investment professionals were pouring money over Long volatility instruments at the worst possible times (vol was mispriced and the vol term structure curve was steep), it is astonishing to see retail investors now doing the opposite with vols in the low teens and the term structure now flat or slightly inverted.

While most of these indicators are usually useless to time equity markets on a short-term basis, they are nonetheless very useful for longer term expected returns.

From a long term technical analysis perspective, the US market is in an expanding wedge pattern. Each high is higher than the previous one, while each low is lower than the preceding bottom. The pattern ends once the third top is in; the "technical" target is lower than the 2nd bottom (March 2009 in this case).

This is the same pattern as in the 1970s.

From a behavioral finance point of view, the extreme levels of sentiment indicators we are watching make that catastrophic scenario a remote possibility that needs to be carefully examined. An energy price shock, similar to both 2000 and 2008 (fast rise in oil and gas prices) would seriously increase the odds of that happening. This is why, a move for Brent above 113 and followed by a sharp upside acceleration would send in our opinion a very negative signal for global stock markets around the world.

"You never want to have to give your child bad news of any kind."Jonathan Dee, American novelist

Stay tuned!

Saturday, 8 March 2014

Credit - The Thin Red Line

"If we take the generally accepted definition of bravery as a quality which knows no fear, I have never seen a brave man. All men are frightened. The more intelligent they are, the more they are frightened." - George S. Patton

Watching with interest the events in Crimea, after having spent some time wondering about the raft of "good" economic data (PMIs, nonfarm payrolls,...), and the recent geopolitical events we thought we ought to use a reference to a military action, given we quoted the maverick George S. Patton earlier on. 

This time around we decided to pick a military action by the red-coated Sutherland 93rd Regiment of Highlanders at the battle of Balaclava on the 25th of October 1854 during the Crimean War. In this event the 93rd backed back a small force of Royal Marines and some Turkish soldiers routed the Russian cavalry charge, earning the fiery Scots more Victoria Crosses than at any other time:
"The Times correspondent, William H. Russell, wrote that he could see nothing between the charging Russians and the British regiment's base of operations at Balaclava but the "thin red streak tipped with a line of steel" of the 93rd. Popularly condensed into "the thin red line", the phrase became a symbol of British sangfroid in battle." - source Wikipedia

The Thin Red Line became an English language figure of speech for any thinly spread military unit holding firm against attack. The phrase has also taken on the metaphorical meaning of the barrier which the relatively limited armed forces of a country present to potential attackers. 

You must therefore be already wondering where we are going with our chosen analogy. Colin Campbell, 1st Baron Clyde, the commanding officer of the "Thin Red Line" had such a low opinion of the Russian cavalry that he did not bother to form four lines but two lines, although military convention dictated that the line should be four deep. 

When ones look at the growing sense of "impunity", in both the equity space with the S&P breaking records after records and in the credit space with the Markit CDX North American Investment Grade Index touching the lowest intraday point of 61.6 basis point, the lowest level since the 1st of November 2007, we are left wondering in this replay of "Balaclava" if investors are not too "complacent" by not bothering to protect their portfolio, preferring, like Colin Campbell, to hold two lines of defense, rather than the conventional four (volatility being currently very cheap).

Credit wise, we reminded ourselves that dealers' books have shrunk from $256 billion in 2007 to $56 billion today. So, when and not if, the market turns, mind the gap because, as goes one of our favorite quote which we have used repeatedly:
"Liquidity is a backward-looking yardstick. If anything, its an indicator of potential risk, because in liquid markets traders forego trying to determine an assets underlying worth  - they trust, instead, on their supposed ability to exit." - Roger Lowenstein, author of When Genius Failed: The Rise and Fall of Long-Term Capital Management. - "Corzine Forgot Lessons of Long-Term Capital"

So dwindling dealers' books and rising bond offerings might make DCM bankers put on a huge smile but if the market turns, everybody will cry, much more than in 2008.

In this week's conversation, the metaphorical meaning in our title is that of the relative "limited" protection offered in terms of "liquidity" due to the relatively limited dealers book present to potential "redemptions" on the downside for credit investors. But we ramble again...

For us "The Thin Red Line" is how thinly liquid credit markets are today relative to 2007. Valuations wise in segments of the technology space are akin, we think to 1999, and credit markets looks more eerily familiar to 2007. We could indeed be looking at 1999+2007 for both equities and credit. 

In this week's conversation, we wanted to convey our thoughts and some of the "Red Flags" we have seen as of late, not justifying the on-going complacency when it comes to assessing the replay of "Balaclava". We are not too sure the "Scots" (USA and Europe) can hold the line this time around versus Russia but we digress slightly.

More and more, investors are not getting compensated for the credit risk they expose themselves to in the High Yield space. For instance, a recent example of the complacency we think is illustrated by the new HeidelbergCement 2019 new issue in Euro, offering 2.40% of yield, for an annual coupon of 2.25%. It isn't much being paid out for a BB+ 5 year bond when you think that the Iboxx Euro Corporate All benchmark index commonly used in investment grade mutual funds is offering a yield of 2.12% for a modified duration of around 4.5 years.

This growing disconnect is clearly illustrated we think with the evolution of the Itraxx Crossover 5 year CDS index (European High Yield risk gauge based on 50 European entities) and Eurostoxx volatility (1 year 100% Moneyness Implied Volatility) - graph source Bloomberg:
"The greatest trick European politicians ever pulled was to convince the world that default risk didn't exist" - Macronomics.

The evolution of the US Vix index and its European counterpart the V2X tells as well a similar story of volatility being contained by the sea of liquidity. Evolution of VIX versus its European counterpart V2X since 18th of April 2011 - graph source Bloomberg:

As we already posited in our conversation "All that glitters ain't gold" in December 2013, 2014 is indeed the year of the "Carry Canary" in particular in the convertibles space given M&A and buyback activity are always a catalyst for issuance as illustrated by the below chart from Bank of America Merrill Lynch displaying the proportion of high yield issuance used for acquisitions:
Another point which indicates a "Thin Red Line" has been in the loan space with the significant rise in high loans without covenants as indicated by Caroline Salas Gage and Kristen Haunss in their Bloomberg article from the 6th of March entitled "Banks Enriched by Junk Resist U.S. Regulatos Standards for Loans":
"For the first time, more than half of the junk-rated loans made in the U.S. during the fourth quarter and so far this year lacked standard protections for lenders such as limits on debt relative to cash flow, Bloomberg data show. Such so-called covenant-light loans amounted to a record $84 billion in the fourth quarter. That was followed by another $57 billion since December.
The exclusion of “meaningful maintenance covenants” is a sign that “prudent underwriting practices have deteriorated,” the Fed, OCC and Federal Deposit Insurance Corp. said in a March 21 statement accompanying the release of their underwriting guidelines.
The advisory said debt levels of more than six times earnings before interest, taxes, depreciation and amortization, or Ebitda, “raises concerns.” Underwriting standards should also consider a borrower’s ability to repay and “delever to a sustainable level within a reasonable period,” the regulators said." - source Bloomberg

It reminds us of the buyout of TXU in 2007 for $48 billion which came at the peak of the private-equity boom which ended up in tears. Energy Future will probably end up  being the biggest failure of a private equity-backed company since Chrysler Group LLC in 2009.

Another "Thin Red Line" we have been looking at has been in the convertible space with the gigantic Tesla convertibles issue upsized from $1.6 billion to $2.3 billion has also made us revisit the hay days of 2007, given most the latest issues in the convertibles are offering a zero coupon with an "ambitious" premium, such as Akamai which in February announced a $500 million Senior Convertible Note with 0% coupon and 45% premium, giving you an interesting negative yield of -0.2% / -0.3% and 50% premium:
"Akamai intends to use the remaining net proceeds of the offering for working capital and general corporate purposes, including potential acquisitions and other strategic transactions. Repurchases of common stock from purchasers of notes in the offering, as well as any additional repurchases of common stock by Akamai, could increase, or prevent a decline in, the market price of Akamai's common stock or the notes." - source Akamai offering.

In relation to that 1999 feeling for equities, we noted the following as reported by Bloomberg by Leslie Picker and Ari Levy on the 6th of March from their article "IPO Dot-Com Bubble Echo Seen Muted as Older Companies Go Public":
"Last year, 208 companies went public, raising more than $56 billion in the U.S., the most since 2007, data compiled by Bloomberg show. Companies seeking more than $100 million in their U.S. IPOs surged an average of 21 percent on their first day of trading, the biggest annual increase since 2000.
People who argue that this time is different “have a vested interest to ensure the investing trend continues,” said Ian D’Souza, an adjunct professor of behavioral finance at New York University who co-founded a technology-focused equity fund." - source Bloomberg

When it comes to stretched "valuations" and echos from the 1999-2000 era, we have been monitoring a specific stock which appears to us strongly reminiscent of the 2000, namely, which displays many prior accounting similarities with Microstrategy.  had a Q4 EPS of $0.07 beat by $0.01. Q4 GAAP loss per share was ($0.19), yes GAAP (all that matter for us). Salesforce previously introduced in 2012 a new metric called “unbilled deferred revenue,” a "non-GAAP" measure of the value of contracts. For us, more than a "Thin Red Line", a "Big Red Flag". Unbilled deferred revenue rose 29% Y/Y to $4.5B after growing 40% in FQ3.

 "Those who cannot remember the past are condemned to repeat it" - George Santayana

Fortunately for us, we do remember the past.

When it comes to the accounting similarities, the previous case of MicroStrategy Inc in 2000, was a case of Revenue Recognition Fraud or Error, as explained by Sudha Krishnan, assistant professor Loyola Marymount University:
"On March 20, 2000, MicroStrategy announced that it planned to restate its financial results for the fiscal years 1998 and 1999. MicroStrategy stock, which had achieved a high of $333 per share, dropped over 60% of its value in one day, dropping from $260 per share to close at $86 per share on March 20th. The stock price continued to decline in the following weeks. Soon after, MicroStrategy announced that it would also restate its fiscal 1997 financial results, and by April 13, 2000 the company’s stock closed at $33 per share." 

Basically, MicroStrategy stock tanked in 2000 because it had materially overstated its revenues and earnings contrary to GAAP not complying with SOP 97-2. So when we read that tells the SEC it cannot quantify the revenue impact between new customers and additional subscriptions as indicated by Michael Blair in Seeking Alpha, we do indeed chuckle. Particularly when we know that in 2012, Salesforce introduced a new metric called “unbilled deferred revenue,” a non-GAAP measure of the value of contracts not yet booked as sales.

So we really do feel sorry but, in our world, sales growth without profit is pointless. From an equity valuation point of view is overstretched. We do not know when this stock will crater in similar fashion MicroStrategy did, but eventually it will.

Another illustration of this 1999 feeling comes from the recent surge in China's Tencent Holdings Ltd, as displayed by Bloomberg's Chart of the Day:
"China’s Tencent Holdings Ltd., the best-performing major technology stock worldwide in the past five years, is mirroring gains by the biggest U.S. computer companies at the height of the dot-com bubble.
The CHART OF THE DAY compares Tencent’s 1,246 percent advance in Hong Kong trading since March 2009 against the rallies in Microsoft Corp., Cisco Systems Inc. and Intel Corp. before the stocks peaked about 14 years ago. The lower panel shows Tencent shares trade 10 percent higher than the average 12-month price target of 27 analysts tracked by Bloomberg.
Surging demand for Tencent’s online games, e-commerce platform and WeChat social-networking app in the world’s most-populous nation has helped the company boost earnings at a 48 percent annual rate since 2009 to become Asia’s largest Internet business. While ABCI Securities Co. says the advance is built on stronger profits than many U.S. stocks during the 1990s bubble, Shenyin & Wanguo Securities Co. says Tencent is becoming a riskier bet after its valuation reached an almost six-year high.
“A rally like this cannot go on forever,” said Gerry Alfonso, a trader at Shenyin & Wanguo in Shanghai. “There is upside on this stock, but it is clearly a more risky stock to buy than a few months ago.”
Shares of Microsoft, Cisco and Intel climbed between 1,078 percent and 3,432 percent in the five years through March 10, 2000 -- when the Nasdaq Composite Index peaked -- to become the world’s most valuable technology companies. The trio plunged between 55 percent and 81 percent over the next three years on concern valuations in the technology industry overshot the potential for earnings growth.
The gain in Tencent, the best performing technology company with a market value of at least $20 billion, left it trading at the biggest premium over analysts’ price targets among large-capitalization peers. The stock is valued at 60 times reported profits, the most among Asia’s top 100 companies. Cisco’s price-to-earnings ratio was 196 on March 10, 2000, versus 63 for Microsoft and 52 for Intel.
Jerry Huang, a director of investor relations at Tencent, declined to comment, citing restrictions before the company reports earnings on March 19." - source Bloomberg.

Of course of the main culprit for the "meteoric" rise of some stocks in the technology space, has been the generosity of the Fed and its QE as displayed by the below graph from Bank of America Merrill Lynch form their 18th of February note entitled "Pig in the Python - the EM carry trade unwind":
"Could the party go on? Yes, if for some reason – a significant deterioration in the US labor market, or a deflationary shock from China, or any other surprise that could lead to a cessation of the US tapering could prolong this carry trade. This is not the house base case. We believe it is better to start preparing for a post-QE world. As one of our smartest clients told us: “the main theme in the past five years was QE. If that is coming to an end, investments and themes that worked in the past five years must therefore be questioned.” We agree."- source Bank of America Merrill Lynch.

When it comes to the deflationary forces at play, they should not be underestimated we think, no matter how "rosy" the latest data appears to be. From our point of view, we have a hard time believing the US economic recovery is genuine and that US has finally reached "escape velocity" when we look at the trend for shipping as our favorite deflationary indicator. Container shipping rates continue to fall, highlighting no doubt the fragile state of global growth as displayed in the following Bloomberg table:
"Shipping rates for 40-foot containers fell 7% to $1,843 for the week ended March 6, marking the sixth-straight weekly decline and the lowest rate since mid-December when prices dipped below $1,700, according to World Container Index data. All major trade lanes declined, except Rotterdam to Shanghai, which rose 3.4%. Rates from Shanghai to Rotterdam declined the most, falling 15% for the seventh-straight decrease, to $2,166, the lowest price in 11 weeks." - source Bloomberg

As we indicated on numerous occasions, any change in consumer spending trends is depending on a more pronounced housing market revival and will directly impact container traffic.

But, when it comes to the housing market revival, we would have to agree with Bloomberg, namely that the housing-market prospects in the US seems shaky:
"Housing may slow the pace of U.S. economic growth this year even though home prices and sales of new single-family dwellings would indicate otherwise, according to Pavilion Global Markets Ltd.
The CHART OF THE DAY displays one reason for the firm’s conclusion, presented in a report yesterday. As the top panel shows, the annual rate of home resales fell 15 percent for the six months ended in January, according to data compiled by the National Association of Realtors. The decline contrasted with a 25 percent increase in new-home sales during the same period, according to data from the Commerce Department.
There were 8.7 existing homes sold in January for every new dwelling, the fewest since August 2008, as illustrated in the chart’s bottom panel. Yet about 90 percent of transactions for the month were resales, based on a sales-rate comparison.
“Housing is on a shaky pillar, and perhaps more than recognized,” Pierre Lapointe, head of global strategy and research at Montreal-based Pavilion, and two colleagues wrote.
The market presents “one of the largest real economic risks to U.S. growth in 2014.”
Smaller gains in home prices are another reason for concern, the report said. The Standard & Poor’s/Case-Shiller price index for 20 U.S. cities rose 13.4 percent in December, down from 13.7 percent in November. The change in the growth rate, called the second derivative, slowed earlier last year. The potential for reduced investment buying of homes, the lingering effect of foreclosures, and a reluctance among many banks to provide mortgage loans may also weigh on the housing market, the report said." -source Bloomberg.

In similar fashion, container shipping rates fell another 5% recently as shown by the latest reading from the Drewry Hong-Kong/Los Angeles container rate benchmark - graph source Bloomberg:
"The Drewry Hong Kong-Los Angeles container rate benchmark fell 5% to $1,886 for the week ended March 5, declining to the lowest rate since early January and marking the fifth week below $2,000 in 2014. Slack capacity continues to pressure prices, with rates 17.9% lower yoy and 25.1% below the July 2012 peak of $2,519. Carriers are expected to implement a $300 general rate increase on containers from Asia to the U.S., effective March 15." - source Bloomberg

So investors might indeed think that "The Thin Red Line" is enough to keep the deflationary forces at bay, but, given volatility remains cheap, we think investors would be wise to follow military convention  which dictates that the line  of "defense" should be four deep.

"Courage is what it takes to stand up and speak; courage is also what it takes to sit down and listen." - Winston Churchill

Stay tuned!

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