Thursday, November 18, 2010

Morning Note...

**Please note there will be no Morning Note tomorrow**

Futures ~100bps higher this morning as markets rebound off their recent malaise on the back of an EU-led bailout for Ireland (which has the EURUSD up 80bps) and GM’s IPO price of $33/share for 478M shares.  Additionally, U.S. initial jobless claims for the week ending 11/18 were slightly lighter than expected, at 439k vs. 441k.  Continuing Claims were spot-on, at 4.295M, which was exactly the expectation.  Europe is up ~1.5% at writing, and Asia was also ~2% higher overnight as tightening concerns in China abate and commodities snap back from recent weak price action.  Oil +1.5%.  Gold +1.2%.  USD -70bps.  In corporate news, Sears (SHLD; -4.6%) is trading lower after reporting disappointing earnings.  Humana (HUM; -6%) lowered 2011 guidance.  NetApp (NTAP; +5%) is trading higher on a 72% jump in quarterly profit and after losing as much as 6% last night on an early earnings leak.  The Limited (LTD; +5%) is also trading higher on earnings.  Note that PC-maker DELL reports after the bell tonight.  Also, October Leading Economic Indicators data is due at 10am today, along with the Philly Fed survey results. 

Concerns over municipal default here in the U.S. have been much talked about (check the MUB chart), but the “other shoe” has yet to drop.  Here’s an interesting piece from CSFB on that topic:

Municipal Volatility: A technical correction or the start of something more?

There has been a fairly sizeable sell-off in municipal bond indices and ETFs during the last week. In credit we have had the muni situation on our radar for quite some time as a potential ‘next shoe to drop’ in the credit crisis and recent price action leads us to investigate whether this time has come. A quick glance at the chart below showing the iShares S&P California AMT-Free Bond Fund ETF (ticker:CMF) suggests that it has been a rocky week to say the least.

Source: Bloomberg

So, what is going on? Well, there has been a confluence of events that we believe has led to a sell-off which is more technical than fundamental in nature. The year-long focus on terrible state and city finances had set a nervous stage for investors. Come November we saw Republicans take control of Congress, the realisation the Build America Bond (BAB) program was expiring, a huge municipal bond pipeline incl. California attempting to sell $14bn in bonds and, the announcement of a possible Bush tax cut extension. This has resulted in a large imbalance between supply and demand leading to a profit-taking hastened sell-off. If we look at State of California CDS we see that, from a default risk perspective, things are still subdued, as levels sit well of the highs of earlier this year when mid-year budget issues spooked investors. As of last night Markit showed California CDS as trading around 270bps while back in summer it reached the mid 300s, much higher. Although we see trouble ahead for the municipal world we think that the current sell-off may be more a correction than something more serious.

PETM lower on earnings.  GME lower on earnings.  RIMM cut at STFL.  QCOM upgrade at CSFB.  CITI ups STP.  OPCO ups EL.  BERN cuts ABT.  WEFA cuts GMR.  ARUN beats by 1c.  ATI upgrade at JPM.  BKE beats by 4c.  CVC to spin-off Rainbow Media to shareholders.  DRYS beats by 13c.  HEAT offers 5M shares.  SPRD beats by 4c. 

S&P 500 PreMarket 8:30am (last/% change prior close/volume): 

Today’s Trivia:  Who does Rocky fight in Rocky III?  How about Rocky IV?
Yesterday’s Question: What does “sound navigation and ranging” describe?

Yesterday's Answer:  “Sound navigation and ranging” = SONAR. 

Best Quotes:  Interesting Bloomberg story about a junk bond guy who is bullish on stocks…

Fidelity's Junk-Bond King Notkin Adds Stocks as Debt Rally Dies
2010-11-18 05:01:00.7 GMT

By Charles Stein
     Nov. 18 (Bloomberg) -- Fidelity Investments' Mark Notkin, whose high-yield mutual fund beat all rivals over the past five years, said the rally in junk bonds is over and stocks are a better buy.
     The manager of the $12.8 billion Fidelity Capital & Income Fund is putting more money into equities and leveraged loans while cutting back on high-yield bonds, which have soared 80 percent since the start of 2009.
     "I don't see the value in the high-yield market," Notkin said in an interview at his Boston office. "You are not being paid to take risk."
     Corporate junk bonds climbed last year after the U.S.
recession ended and the default rate fell. Investors added $55.1 billion to U.S. junk-bond funds in 2009 and this year through September, according to Cambridge, Massachusetts-based research firm EPFR Global. Withdrawals from U.S. equity funds were $129.9 billion in the same period.
     It's time to shift gears because equities offer bigger gains, said Margaret Patel, who oversees about $1 billion for Wells Fargo & Co. in two mutual funds that invest in both asset classes. Notkin's fund, which can keep as much as 20 percent of assets in stocks, had 17 percent in equities at the end of September, according to Fidelity's website.
     "The pendulum has swung from high yield to equities,"
Patel said in a telephone interview from Boston.
     Patel said that as earnings rise for companies tied to the global economy over the next 12 months, stocks are likely to deliver more than the 6 percent to 7 percent gains she expects from junk bonds.

                           Low Yields

     Junk-bond yields that are low by historical standards and the prospect of increasing interest rates will limit gains, Patel said. Firms that issued high-yield securities in the past three to five years may buy back outstanding bonds because the debt can be refinanced at lower rates, she said.
     Speculative grade, or junk, bonds, are rated Ba1 or below by Moody's Investors Service and BB+ or below by Standard & Poor's.
     High-yield bonds could outperform stocks if the U.S.
economy slows, said Patel, because companies would still be able to pay their debts even as profits slump.
     Notkin, 46, joined Fidelity in 1994 as a high-yield analyst covering broadcasting, gaming and lodging. He earned a bachelor's degree from the University of Massachusetts and a master's of business administration from Boston University.

                          Third in Size

     He took over Fidelity Capital & Income in July 2003. It's the third-largest U.S. junk-bond fund after the $17.3 billion American High-Income Trust, run by Los Angeles-based Capital Group Cos., and the $13.1 billion Vanguard High-Yield Corporate Fund.
     Notkin's fund fell 32 percent in 2008, compared with the 26 percent drop in Bank of America Merrill Lynch's U.S. High Yield Master II Index, as the financial crisis prompted investors to dump risky assets.
     By the end of 2008, Notkin saw an "extraordinary opportunity," when the average yield on junk bonds rose above 20 percent.
     "At that point I thought it made sense to be pressing down on the gas pretty hard," he said.
     Notkin used the fund's cash stake, which he had built to about 20 percent of the portfolio, to buy the riskiest high- yield bonds.

                      Not for Fainthearted

     By Sept. 30, 2009, according to Chicago-based Morningstar Inc., the fund had 35 percent of its assets in bonds rated CCC and below, among the lowest credit ratings assigned by New York- based Standard & Poor's. The typical high-yield fund had 21 percent in bonds rated that low, according to data compiled by Morningstar.
     "This fund is not for the faint of heart," Miriam Sjoblom, an analyst with Morningstar, said in a telephone interview.
     Fidelity Capital & Income surged 72 percent in 2009, compared with a return of 58 percent for the Merrill Lynch index, Bloomberg data show. In the five years ended Nov. 16, Capital & Income averaged gains of 9.9 percent, the best among
422 high-yield funds tracked by Morningstar. This year the fund has risen about 14 percent.
     The default rate for junk-rated corporate debt is expected to drop to 2.4 percent in the year ending September 2011 from 11 percent at the end of 2009, Standard & Poor's said in October.

                          Reducing Risk

     Notkin said he has been "de-risking" the fund this year by substituting higher-quality bonds for those of lesser stability. As of Sept. 30, 21 percent of the fund was in bonds rated CCC and below, compared with the 17 percent allocation among his average peer, according to Morningstar.
     With prices on high-yield bonds near all-time peaks and yields near a record low, investors can expect gains over the next 12 months of about 7 percent, Notkin said.
     "The market is fairly valued, if not overvalued," he said. "Compared to high yield, equity is very cheap."
     Notkin expects interest rates to rise to historically normal levels over the next year or two, which could push up yields on U.S. Treasuries in the 5- to 10-year range more than 200 basis points, or 2 percentage points, he said. The yield on the 10-year Treasury note is about 2.88 percent. Bond prices fall when rates climb.
     "We aren't Japan," said Notkin, referring to a nation where rates have stayed near zero for more than a decade.
     Patel of Wells Fargo said gains in junk bonds will be further restricted as corporations buy back more of their high- yield debt.

                        Ceiling on Prices

     "That creates a ceiling on how far prices can advance,"
she said.
     In April 2009, Notkin's fund had 5 percent of assets in stocks, filings with the U.S. Securities and Exchange Commission show.
     "If I find opportunities, don't be surprised if it gets to 20 percent," he said.
     Notkin said stocks have underperformed high yield "dramatically" since he began running the fund. The high-yield index has gained more than twice as much as the S&P 500 over that stretch, Bloomberg data show.

 Stocks also look attractive using other measures, he said.
The earnings yield on the S&P 500, the index's total earnings divided by its price, was 6.86 percent in the second quarter, the highest it has been since at least 1993, data from Standard & Poor's show.
     Money managers often compare the yield on stocks and fixed income as a way to gauge the appeal of the two asset classes.

                      Stocks 'Attractive'

     "Stocks are attractive relative to any kind of bonds,"
said Michael Mullaney, a portfolio manager at Fiduciary Trust Co. in Boston, where he helps oversee $9.5 billion.
     More U.S. executives than ever are increasing earnings forecasts compared with those lowering them, based on data Bloomberg began tracking in 1999.
     Shares of Teck Resources Ltd., which Notkin acquired in the third quarter of 2009, have climbed 72 percent since Sept. 30 of that year, Bloomberg data show. Vancouver-based Teck, Canada's largest diversified mining company, was the fund's 10th-biggest holding as of July 31.
     TRW Automotive Holdings Corp., another top 10 position for Notkin, has almost tripled in value over the same period. The Livonia, Michigan-based company is the world's biggest supplier of vehicle-safety equipment.
     "We love the auto sector," said Notkin. The business will continue to grow globally, he said, and companies that sell safety and emissions gear will do especially well as governments around the world force carmakers to raise standards.

                        Tech, Materials

     Notkin favors industries such as technology and materials that will benefit from expanding economies in emerging countries. Businesses that depend more on the U.S., including retailing and homebuilding, are less appealing to him.
     "We don't see the domestic economy going gangbusters anytime soon," Notkin said.
     Leveraged loans are rated below investment grade and are repaid first in a bankruptcy or liquidation, which makes them a more defensive investment than high-yield bonds. Because the interest rates on the loans float, returns may rise if rates climb.
     Economists surveyed by Bloomberg expect the yield on the 10-year U.S. Treasury note to reach 3.3 percent by the fourth quarter of 2011. The S&P/LSTA U.S. Leveraged Loan 100 Index has returned 8.1 percent this year.
     Notkin said he is looking to add to his loan holdings, which represented 13 percent of the portfolio as of April 30, according to a filing with the U.S. Securities and Exchange Commission.
     "When rates rise, which will happen eventually, bank debt will look attractive and will outperform high yield at some point," he said.