CWS Market Review – May 18, 2012

Wall Street’s spring slide got even uglier this past week. The S&P 500 has now dropped for five days in a row and for ten of the last 12. On Thursday, the index closed at its lowest level since January. Measuring from the recent peak on May 1st, the S&P 500 is down 7.18%. Bespoke Investment notes that in the last two months, more than $4 trillion has been erased from global markets.

I know it’s scary, but let me assure you—there’s no need to panic. In this week’s CWS Market Review, I want to focus on the two events that have rattled Wall Street’s nerves: the massive trading losses at JPMorgan and the growing possibility that Greece will exit the euro. The really interesting angle is that these two events are partially connected. I’ll have more on that in a bit.

I’ll also talk about how we can protect our portfolios during times of trouble: by focusing on high-quality stocks with generous dividends. Right now, six of our Buy List stocks yield more than 3.4% which is double the going rate for a 10-year Treasury bond. Reynolds American ($RAI), for example, yields a hefty 5.8%. There aren’t many top-notch stocks that can say that. But first, let’s talk about the god-awful mess at JPMorgan.

How JPMorgan Chase Lost $2 Billion Without Trying

Last week, JPMorgan Chase ($JPM) stunned Wall Street by announcing an unexpected trading loss of $2 billion. This was especially disappointing because JPM had been one of the best-run banks around. Despite the massive loss, JPM is still on a solid financial footing. Mostly, this is a huge embarrassment for the firm and their loudmouth outspoken CEO Jamie Dimon.

I honestly don’t know how much longer Dimon can last at JPM. He shouldn’t be on the New York Fed Board, either. In my opinion, bank CEOs shouldn’t draw attention to themselves. Ideally, they should be very dull and very competent. Dimon is half that equation and I fear he’s become a liability for shareholders.

So what the heck happened? I’ll try to explain this in an easy-to-understand way. First, we have to talk about “hedging.” When an investor wants to hedge a bet, this means they want to take positions that offset each other in order to get rid of some aspect of risk.

Let’s say you’re a bookie. You don’t care who wins the game; you only want to make sure that you’ve taken in the same amount of money from both sides. Now let’s say that your “clients” have bet $1,000 on the Lions and $900 on the Bears. Oops, you’re caught with some risk. No worries, you can place a $100 bet on the Bears with another bookie and presto, you’re back to even (minus some vig costs of course).

Now back to JPM. Last year the bank wanted to hedge their overall credit risk. The problem is that this isn’t so easy when you’re the size of JPM, so they shorted credit indexes. Or more specifically, they mimicked doing that by buying credit protection on baskets of credit. Now for the other side of the trade, JPM sold protection on an index of credit default swaps called CDX.NA.IG.9. I know that sounds like a George Lucas film, but trust me, it really exists.

With me so far? The problem with this hedge is that JPM had to sell a lot more protection on the CDS index than they bought on the credit baskets. For a while this worked fine. But late last year, the European Central Bank flooded the credit markets with tons of liquidity. The two sides of the hedge started to move together, not separately. In effect, the Lions and Bears were both winning and JPM had bet against both. Once again, the financial modelers had accurately predicted the past, but they weren’t so hot at predicting the future.

The bank dug the hole deeper for itself by ratcheting up on the CDS index side of the hedge. Soon hedge funds started to notice the prices getting seriously out of whack. What really struck them was that whoever was on the other side of this trade seemed to have limitless funds. This dude never gave in. They jokingly called him “the London Whale,” and it didn’t take long for people to suspect he was at JPM. Eventually the news broke that it was a French trader in JPM’s London office named Bruno Iksil.

Now the story gets a little murky. Last week, Jamie Dimon announced the trading losses on a special conference call. To Dimon’s credit, he said it was a massive mistake by the bank. On the call, Dimon said that the bank could incur another $1 billion in losses over the next few quarters as the trade is gradually unwound. It seems that the hedge funds smelled blood, figured out the specifics of the hedge and attacked. Hard. So instead of taking another $1 billion in losses over a few quarters, that got squeezed down to four days. There could be more losses to come.

What to Do With JPMorgan?

Shares of JPMorgan are down from over $45 in early April to just $33.93 based on Thursday’s close. As frustrating as the past week has been, I’m sticking with the bank. I’m furious with JPM’s management and their careless risk management. But with investing, we need to shut off our emotions and stick with the facts.

Let’s run through some numbers: Last year, JPM made $4.48 per share. For the first quarter, they made $1.31 per share which was 13 cents better than estimates. Those are impressive results. If the bank loses a total of $3 billion in this fiasco, that will come to about 80 cents per share. In other words, this is a punch in the face but it’s not a dagger to the heart.

At $34, JPM is clearly a bargain. When it will recover is still a mystery, but time is on the side of patient investors. Due to the recent events, I’m going to lower my buy price on JPM from $50 to $38. At the current price, the stock yields 3.54%. Make no mistake: This is a cautious buy, but the price is very good.

Euro So Beautiful

The other issue that’s got Wall Street worried is Greece. The politicians there haven’t been able to form a governing coalition, so they’re going to have elections again next month. The only issue that unites voters is anger at the bailouts. My guess is that some left-wing anti-austerity coalition will eventually prevail.

On Thursday, Fitch downgraded Greece’s debt to junk. Actually, it was already junk, but now it’s even junkier junk. For a long time, I didn’t think it was possible for Greece to leave the euro. Now it seems like a real possibility, but it will be a costly one. Greek savers have already been pulling their money out of banks because they want to hold on to euros. Their fear is that if Greece changes over to drachmas, the new currency will be worth a lot less and I can hardly blame them.

The standard line in Europe is that no one wants Greece to leave the euro, but also no one seems willing to do what’s needed to keep them in. The Greek economy isn’t strong enough to pay back their debt because the debt is so heavy that it’s weighing down the economy (Mr. Circle meet Mr. Vicious). There’s simply not much time left. Greece’s deputy prime minister said the country will run out of money in a few weeks. If Greece ditches the euro, Ireland and Spain might be right behind. In fact, foreigners are even pulling their money out of Italian banks. This is getting worse by the day.

How exactly would Greece leave the euro? Eh…that’s a good question and I really don’t know. But if Greece were to leave the euro, a lot of eurozone banks would take a major hit. I don’t think the damage would necessarily be as bad as feared, assuming the banks were recapitalized. If enough people want this done, it can be done.

The standard line is that this is what Argentina did several years ago. The difference is that the global economy was much stronger then. I think the best path for countries like Greece, Portugal, Ireland and Italy is to go full Iceland: to depreciate their currencies. It’s painful in the short-run, but it’s a much sounder strategy. Interestingly, Iceland has actually been doing rather well lately.

So with Europe already in recession and China slowing down, what’s the impact for investors? One impact is that the euro has been plunging against the dollar. The currency is down five cents this month to $1.27. I think it will head even lower.

Another impact is that U.S. Treasuries are surging as investors head for cover. On Thursday, the yield on the 10-year Treasury closed at 1.69% which is at least a 59-year low. The Fed’s data only goes back to 1953. The intra-day low from last September was slightly lower. The bond rally has lured money away from stocks, but that may soon end.

A further impact is that the stock sell-off has been felt most heavily among cyclical stocks. Over the last two months, the Morgan Stanley Cyclical Index (^CYC) is down nearly 15%. The Morgan Stanley Consumer Index (^CMR), however, is down less than 3% over the same time span. That’s a big spread. You can see the impact of this trend by looking at Buy List stocks such as Ford ($F) and Moog ($MOG-A).

Protect Yourself by Focusing on Yield

The market’s recent drop has given us several good bargains on our Buy List. AFLAC ($AFL), for example, is now below $40. It was only three weeks ago that the company beat earnings by nine cents per share. Here’s a shocking stat: The tech sector has dropped for 12 days in a row. Oracle ($ORCL) is now going for less than 10 times next year’s earnings. That would have been unthinkable during the Tech Bubble.

This week, I want to highlight some of our higher-yielding stocks on the Buy List. I always urge investors to look out for stocks that pay good dividends. Their shares are more stable, and they hold up much better whenever the market gets jittery.

For example, look at CA Technologies ($CA). This was another company with a solid earnings report and the stock now yields 3.90%. Nicholas Financial’s ($NICK) yield is up 3.21%. I think NICK can easily raise its dividend by 30% to 50% this year.

I already mentioned JPM’s yield, but check out another bank: Hudson City ($HCBK) which yields 5.23%. Last month, Johnson & Johnson ($JNJ) raised its dividend for the 50th year in a row. JNJ now yields 3.84%.

Sysco ($SYY), which also beat earnings, now yields 3.89%. Harris ($HRS) raised its dividend by 18% earlier this year. The shares yield 3.39%. Our highest-yielder is Reynolds American ($RAI). Just two weeks ago, the tobacco stock bumped up its quarterly dividend by three cents per share. RAI currently yields a sturdy 5.80%. These are all excellent buys and they’ll work to protect your portfolio during downdrafts while having enough growth to prosper during a rally.

That’s all for now. I’m looking for a relief rally next week as traders get ready for Memorial Day. On Monday, Medtronic ($MDT) is due to report earnings. They’ve already told us to expect earnings between 97 cents and $1 per share. I also expect Medtronic to increase its dividend for the 35th year in a row very soon. Be sure to keep checking the blog for daily updates. I’ll have more market analysis for you in the next issue of CWS Market Review!

– Eddy

Posted by on May 18th, 2012 at 7:20 am

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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