SmartGuyStocks Interview with Master of the Debt Universe

At the beginning of 2007, savvy investors were watching the credit markets with candles and penlights. As the credit markets expressed signs of a bubble, flashlights replaced our trusty wicks and pocket tools. Since August the savviest investors have turned on their dusty floodlights (which have been in storage since exposing issues with tech stocks in 2000). Although 2008 should see the credit industry come under lights as powerful as Fenway Park’s, SGS tapped our trusted contacts in the credit market to help our readers and community get ahead of the curve and make winning trades. (Due to firm restrictions, our Master of the Debt Universe must remain anonymous.)

1) Tell us a bit about your hedge fund and job.

I am a corporate credit analyst and trader at a relative value and special situations hedge fund.

2) What does it look like on your turf in the trenches of the debt world?

Things are still pretty ugly. Liquidity is extremely poor and credit spreads are near all-time wides. With spreads where they are, issuing debt is very expensive for companies. Many financial corporations were able to fund themselves by paying as low as 50 basis points above Treasuries for issuing 10-year paper. These same companies are now forced to pay 3-5 times as much. For example, in mid 2006 Wachovia (WB) was able to issue 10-year senior bonds at Treasuries plus 70 bps. Now they would have to pay Treasuries plus 170 bps or more depending on where credit protection (CDS) is trading. And Wachovia is one of the better names. Bear Stearns (BSC), Merrill Lynch (MER) and Countrywide (CFC) — just to name a few — have to issue much much wider [i.e., more expensive debt].

Basically, it comes down to where CDS is trading on the Street. Companies must issue their debt at a similar spread to this credit protection, otherwise many funds would just choose to sell protection rather than buy the debt.

3) How will the current conditions in the debt markets affect the broader economy? Some traders in the debt markets believe we are heading toward a recession. Do you agree?

The current situations in the fixed income world lead me to believe we are heading into recession. Too much money was lent to too many people who do not possess the ability to pay it back. Significant losses are pouring through Wall Street. Due to the securitization and leverage of all these bad loans, the losses keep multiplying. There have already been huge job cuts throughout the Street and it is starting to hit the rest of the country. Many people will lose their homes and those that are able to refinance will most likely lose wealth.

4) A lot of doom and gloomers are coming out of the woodwork to prophesize payment to the piper in the form of a rough recession/depression. Do you agree with this thinking or will the recession be short lived?

This is a tough question and I never try to time anything. There are many guys also coming out now saying we can fight off the recession, but I am still not a believer. I think that a recession will last until we find some sort of new equilibrium between supply and demand in housing. There are many factors involved here, but I know that wages will have to rise at some point to keep up and exceed the devaluation of our currency. The easing of rates has already begun to combat these issues as well, so we will see what happens. There are too many unknown factors out there now to determine how long or how severe the hit will be, but I wouldn’t think more than a few years at most. We dug ourselves a nice big hole and now it’s up to us to find a safe way out.

5) Can the Fed save us from ourselves?

As far as the Fed bailing everyone out, these actions have large ramifications. The more money the Fed dumps into the system, the less each individual dollar is worth and, in essence, the bubbles get re-inflated.

In order for the housing market to correct itself, prices will have to fall and rent will have to increase in the areas that have been affected most (Florida, California, Nevada, etc.). Renting is way too cheap right now, and a significant number of homeowners cannot afford to pay their mortgages. [A few days after this interview, the Wall Street Journal wrote an article supporting this exact thesis: “Home Prices Must Fall Far To Be In Sync With Rents.”] I think the losses will start to seep into the broader economy and credit cards may be the next to take a hit as people max out their cards.

6) What key events should investors look for to know things are improving?

I think everything comes down to housing. Once more people start buying homes again and the foreclosures start to decrease, everything should get better. Right now prices are being redefined across the map. So, once they seem to reach some sort of stability or floor, hopefully buyers will come out of the closet. Right now there is simply much more supply than demand.

7) What would signal things are getting worse?

If credit markets continue to deteriorate and spreads continue to widen, liquidity will get even worse than it is now and you will witness extreme turmoil and volatility in the capital markets. Should this happen, I am quite sure you will see some defaults among some of the bigger players such as mortgage insurers, monolines, possibly even some smaller banks and lenders. Take a look at how the credit crunch is affecting MBIA (MBI), Ambac Financial Group (ABK), Financial Guarantee Insurance Corp (FGIC), Financial Security Assurance (FSA), XL Capital Ltd (XL), and Assured Guarantee Ltd (AGO).

8 ) Do you think the credit crunch is spreading? If so, which industries do you believe will be next to slow or blow up?

The credit crunch has spread through much of the investment grade names. It is much more costly for companies to issue debt, and risk is being repriced across the board. This is strictly speculative, but as I mentioned earlier, I believe credit cards may be the next to take big hits.

9) In general, what indicators do you use to assess the economy and markets?

We use many indicators. We look at all the economic data that comes out each morning (everything from GDP to Housing Starts). We also follow corporate and asset back fixed income markets very closely.

10) The web has increased access to analysts who are very skeptical of government economic data. Are you skeptical? If so, which data sets do you think need to be changed, and in what ways?

I am skeptical of government data and think much of it is skewed and biased. After all, it’s the government. Not only do they have a vested interest in making things look better than they are, but there is just way too much information needed to accurately compute this data. They take whatever they deem necessary and spit out the numbers. They also throw out a lot of stuff. For instance when measuring inflation, they take a basket of goods and services not including food and energy. However, those are the first two things I look at when trying to measure inflation.

Master of the Debt Universe, thank you for your time and insights. We wish you the best with your trading in 2008 and look forward to asking you some more questions as the credit markets move into a new identifiable phase.

Banking Crisis: No End in Sight

A few weeks ago I watched the documentary No End in Sight. The film analyzed the current war in Iraq. While watching I realized I had never seen much footage of Iraq. Like others in the U.S., I have seen the 10 second video clips and narrow lens snapshots, but I don’t know Baghdad or Fallujah as detailed as New York City, San Francisco, Miami, or the suburban and rural landscape of the States.

Given my ignorance of Iraq, I have failed to appreciate the complexity of warring there. Like other US citizens, when President Bush declared victory in May 2003, I believed the war in Iraq was over; however, the worst was yet to come. Similarly, although bulls on Wall Street are declaring that the credit crisis will be defeated in early 2008, the objective data continues to indicate the worst is yet to come.

Like my ignorance of the Iraqi landscape, most U.S. residents appear to be completely ignorant of the banking landscape. Most of my friends (including doctors, lawyers, PhDs, other professionals, and even some in finance) are what I call “financially retarded”: they spend more than they make, or save less than needed for retirement; they are ignorant of the Federal Reserve, how money is created, and exactly how a bank makes profits; and, they have no clue how many variables affect money and the economy. Consequently, we are still far from accurately pricing banking and financial stocks because many people still have no idea how bad things may become.

At the moment, banking and financial stocks seem to reflect issues caused by the housing market. However, do they reflect the full decrease in revenue from the credit crunch? Have shares been discounted to account for the possibility that commercial real estate may stage a similar performance? Are dividends safe at these tempting levels? What about the increasing defaults on credit card debt? How about issues with small business loans and accounts if a recession arises? And what if a recession causes paycheck deposits to decline when unemployment rises? Basically, since we price stocks based on future performance, do you believe banking and financial stocks are priced to reflect all these future risks?

Like the war in Iraq, initial positive press releases about the banking crisis are overly bullish. For example, last Friday an Associated Press headline stated “CEO: Wachovia Well Positioned for ‘08.” I immediately laughed out loud because I was just reading over a chart of CMBS loans that showed Wachovia (WB) as a leader in exposure to issues in the rapidly deflating commercial real estate market, and at the foot of my shredder was a Wachovia credit card solicitation. (See “Unpaid credit cards bedevil Americans: Americans’ see their debt woes expand as unpaid credit card bills are on rise.”)

Adding to the folly was the article in which CEO Ken Thompson stated:

I’m expecting a slower growth year than we’ve experienced anytime over the last five or six years … We’re still in the midst of a housing correction, which is impacting the real economy, but I do not expect a recession.

If Ken expects the slowest growth since our last recession, why doesn’t he expect a recession? That logic doesn’t pass the laugh test.

He goes on to note:

I think lenders made loans to people who should have not received loans.

Since Wachovia is one of those lenders, Ken was in charge of a company that loaned money to people who could never afford to pay back the loans. This is the CEO of the fourth largest bank in the U.S. and he allowed his employees to issue loans that could not be repaid! But he wants us to remain confident in his company’s stock?? Ken, give me one reason why I should own a bank whose CEO lends money to people who cannot service the loan? All CEO spin aside, such action is called a “gift” and savvy investors don’t invest in companies that give billions of dollars in gifts.

Similarly, in this week’s Barron’s Rich Pzena of Pzena Investment Management (PZN) went on record recommending banks and financials. When Pzena was asked why investors should snap up battered shares of bellwether Citigroup (C), he offered what I consider tremendously weak reasoning:

Citigroup is everywhere. It is a massive global franchise that will grow in line with global financial growth … There is some short-term downside risk. Looking out three years-plus, you have a really spectacular risk/reward trade. The odds that Citigroup sells for less than 30 in three years are very low, and the odds of it selling for substantially above that are very high.

Three years ago, what were the odds C would be trading below 30 in 2007? And if Pzena sees short-term downside risk, why recommend shares here? I’ll give you a clue: Pzena’s fund didn’t beat the market this year (it lost money) and he made huge bets on C and Fannie Mae (FNM). Sounds like someone wants to help keep shares propped up – so I would take these recommendations with the Dead Sea’s supply of salt. Further, the last time I heard fund managers asking investors to “look out three years-plus” was when the dotcom bubble was busting. If you followed that advice and bought bellwethers such as EMC (EMC), Cisco (CSCO), or Yahoo (YHOO), your investments still may be underwater. Thus, when Pzena says to “look out three years-plus,” I simply say look out.

On Saturday, a more accurate article about the banking crisis appeared in The Telegraph (a UK newspaper). Below are some highlights:

The Bank of England knows the risk [of a worsening bank crisis]. Markets director Paul Tucker says the crisis has moved beyond the collapse of mortgage securities, and is now eating into the bedrock of banking capital. “We must try to avoid the vicious circle in which tighter liquidity conditions, lower asset values, impaired capital resources, reduced credit supply, and slower aggregate demand feed back on each other,” he says.

New York’s Federal Reserve chief Tim Geithner echoed the words, warning of an “adverse self-reinforcing dynamic”, banker-speak for a downward spiral. The Fed has broken decades of practice by inviting all US depositary banks to its lending window, bringing dodgy mortgage securities as collateral.

Glance at the more or less healthy stock markets in New York, London, and Frankfurt, and you might never know that this debate is raging. Hopes that Middle Eastern and Asian wealth funds will plug every hole lifts spirits.

Glance at the debt markets and you hear a different tale. Not a single junk bond has been issued in Europe since August. Every attempt failed.

Europe’s corporate bond issuance fell 66pc in the third quarter to $396bn (BIS data). Emerging market bonds plummeted 75pc.

“The kind of upheaval observed in the international money markets over the past few months has never been witnessed in history,” says Thomas Jordan, a Swiss central bank governor.

“The sub-prime mortgage crisis hit a vital nerve of the international financial system,” he says.

Despite all the optimistic crystal ball predictions for 2008, those doing battle in the financial trenches are telling a much more ominous story. So long as the full platoon of risks is not fully appreciated, stay bearish on banking and financial stocks. As savvy investors, don’t get suckered into buying calls or shares while the negative data shows no end in sight.

Cutback on Dining Dollars Signals a Slowing Economy

Dual income families have had two important effects on our economy: increased inflation to adjust for higher household budgets, and increased outsourcing of what I call basic functions of existence (e.g., preparing meals, parenting from 8-6, cleaning clothes, cleaning one’s home, etc.). Of all the outsourced basic functions of existence, preparing meals seems to be the most widespread. Even single income families spend a significant portion of their food budget on packaged prepared meals, meals prepared by grocers, and meals prepared by restaurants.

Evidence of explosive demand for outsourced meal preparation is ubiquitous. Grocers’ shelves and freezers are overflowing with prepackaged meals, grocers have dedicated an increasing number of resources to preparing and selling meals onsite, and restaurants seem to outnumber all other businesses in every city and town across the US. Moreover, recently I have noticed specialty meal preparation businesses (i.e., niche businesses dedicated to selling clients a set of meals for a week or month) advertising more frequently and becoming more popular with the upper middle class dual income family.

Although you can outsource your meal preparation many ways, dining at restaurants seems to be the ultimate barometer for how wealthy a person or family feels. When times are good, most people I know eat out. When I get a bonus, my wife and I say, “Let’s go out for dinner.” Thus, when I see the casual dining sector warn about weak customer traffic, I know consumers do not feel wealthy (relatively speaking) and spending must be significantly slowing.

Last week Darden Restaurants (DRI), Ruby Tuesday (RT), Ruth’s Chris Steak House (RUTH), and McCormick & Schmick’s Seafood Restaurants (MSSR) all announced weaker guidance based on slower traffic and declining sales. In addition, shares of Brinker International (EAT) and Cheesecake Factory (CAKE) have also been under intense pressure since the summer. Although low-end eateries owned by Yum! Brands (YUM) and McDonald’s (MCD) have done well, growth has been fueled internationally while domestic sales have been tepid.

After the new year SGS will probably recommend a bearish play on one of the casual dining restaurants above. (We are waiting for the unpredictable tax selling and low volume holiday season to pass.) However, YUM and MCD will most likely benefit as people look for cheaper restaurant eats and international sales continue to grow like the guest list for a Platinum Wedding.

Grocers may be another primary beneficiary of less dining out. Grocers should see sales rise as more casual dining is crossed off the family budget, yet eating is not foregone completely (for a new Wii, $3 gas, or the highest household energy bill in history).

If less casual dining signals a slowdown, then be on the lookout for frequent casual diners who are suddenly learning how to do more in the kitchen than press numbers on the microwave or warm up dinner in the oven … at that point we will be in a full recession.

Let the Games Begin: Bear Sterns first of many Lawsuits

Barclays PLC (BCS) has sent the first shot heard ’round the litigation world. The British bank has, among more detailed claims, asserted Bear Sterns (BSC) committed fraud by concealing requested performance updates on the now defunct highly leveraged BSC hedge funds, promising savvy risk management tactics for said funds, and failing to keep a promised line of open communication. Now that guns have been brandished, battalions of additional law firms should soon be contracted to surge against the wrong-doers.

These lawsuits possess three important “I”’s:

Indemnity: A party may now be forced to pay for errors. However, I would love to see Bear turn around and blame the rating agencies so we can truly see how fraud masquerades as legitimacy (e.g., “Hey, we said this was risky. Moody’s said it was AAA …”).

Irony: Although institutions perpetrated the housing bubble and financial engineering scams, individuals such as Alan Greenspan and the individual fund managers will get pinned with the donkey’s tail. This has been the strategy since time immemorial. Most recently, for example, Bush had a bunch of his advisers resign so his administration could later pin the ex’s with whatever blame necessary (a derivative of Malcolm X’s strategy). Like other institutions, corporations never want to sacrifice their individual interests for the betterment of our tribe (e.g., environment, health, family), however they ask their employees to sacrifice themselves for the betterment of the corporation as a whole — irony on a Shakespearean level.

Insight: Once the lawyers send their 160K/yr associates to sift through warehouses of documents, we should get some real insight as to how this whole fraud worked. If we are really lucky, it will force some of the banks to put their cards on the table so we can see how much toxic debt is in their hand.

Don’t hold your breath: we may not get any answers for a couple years (lawyers like their billable hours) … and by that time we will already know how the housing debacle will unfold in the real world and whether a recession is upon us. But one thing is sure to happen in the immediate future: more lawsuits and headline risk for the financial sector. China’s Summer Olympics now has competition for most interesting spectator sport of ‘08.

Crying “Excessive Bearishness” Near All-Time Highs is Excessive Bullishness

Contrarian indicators work. When investors become overly fearful, stocks become undervalued. When investors become overly greedy, stocks become overvalued. However, recently I noticed a little game that permabulls play: like the boy who cried wolf, they start screaming “too many bears!” when the market is less than 10% below all-time highs. This tactic is supposed to make the average investor believe we’ve hit bottom and it’s time to start bargain hunting. Consequently, the market stages lower volume mini rallies where smart money continues to sell to the naive and we witness the bearish phenomenon of lower highs and lower lows. When these declarations of excessive bearishness are not confirmed by a bear market or stocks trading far below historical valuations, then these false cries signal continuing excessive bullishness.

During the past couple months I have heard about excessive bearishness on CNBC, Kudlow & Co., in Barron’s, and from notable permabulls Jeremy Siegel and game show host turned analyst Ben Stein. With the exception of Barron’s, these information sources have dished out plenty of recommendations to buy homebuilders and banks as both sectors have tumbled like a four year old at the Little Gym. For both builders and banks, since the beginning of each downfall these bullish sources have continued to cry “excessive bearishness” as the reason to start buying. Evidently, they have been very wrong.

However, the permabulls have failed to note that true excessive bearishness is not a mere 10% pullback from all-time highs amidst a five-year bull market. True excessive bearishness is the kind touted by every “How to Invest like Warren Buffett” book (i.e., half the investing books at your local bookstore). True excessive bearishness is what bear markets are made of. We will know when bearishness becomes excessive because you will find the best companies selling at excessive discounts to value – and I do not mean a couple points below the long term average for price to earnings, or a great home builder with 24 months of supply on the books.

I agree that after the housing market decline and credit crunch we have heard more bearish voices percolate to center stage. Although we are seeing more bears now relative to bears in the past five years, we are far from seeing the bull-bear ratio reach levels where the market has massively undervalued stocks and pushed permabulls into hibernation.

I also agree that financials, homebuilders, consumer discretionaries, and other related industries have been hit hard. However, the major indices have held up very well. Thus, we have not seen the quintessential excessive bearishness that spreads to all industries and sectors regardless of underlying fundamentals. True excessive bearishness is not simply when hedge funds use puts or shorts as insurance. True excessive bearishness is when everyone sells everything based on intensifying fear. Although some people act as though the last recession was 100 years ago, I have tapped into my long-term memory to access files of excellent companies falling far below intrinsic value in 2001. That was true excessive bearishness.

Given that there are tons of bulls keeping the market close to all-time highs, we have not experienced true excessive bearishness — no matter what the pundits say. Until you see stocks getting excessively punished and the indices reflecting excessive fear, there is still no wolf from which we must be saved.

Disclosure: SmartGuyDH wishes the free market would let equity valuations readjust so we could start going long again.

US Energy Bill: Where the Sun Don’t Shine

Last week, US lawmakers destroyed US chances for energy independence by renewing tax subsidies for oil companies at the expense of supporting a strong domestic industry for clean energy. As noted in Friday’s Wall Street Journal, “Overall, the big winner in the endgame that produced final passage of the bill … was major oil companies.” This haphazard move should have the Middle East and Venezuela cheering because it will drastically weaken US competitors who are seeking to become global super powers of solar, wind, biomass, and other forms of renewable energy.

At the moment, most clean energy technologies are in early adopter stages. As a result, products are relatively expensive when compared to mature energy inputs such as oil, coal, and natural gas. Although these fossil fuels have been heavily subsidized by tax payer dollars (i.e., receiving welfare) since WWII, the oil lobby has done an excellent job filling the mainstream media with barrels of spin to make the average citizen believe ethanol and solar are the big welfare enemies. The lobbying and PR worked because the oil industry has emerged with tax subsidies that common sense would have redirected toward the renewable energy credits. Apparently, the oil industry is more important than preventing terrorism and creating strong domestic industries.

Politics and safety aside, the new US Energy Bill leaves high-flying solar stocks in a very precarious position. Renewable energy credits are a critical component to the business models of solar companies. Without such credits, all of these companies will see margins shrink, and some of these companies will not be able to make their products cost competitive. Thus, I am placing the solar industry on the SGS watch list for opportunities to short stocks and play put options.

I was completely bewildered on Friday when solar stocks failed to react like Barry Cinnamon, president of Akeena Solar Inc. (AKNS), who said U.S. companies trying to compete internationally in solar “won’t continue to grow as quickly as they could have.” Cinnamon and other executives are announcing to the world that their growth will suffer, yet Piper Jaffrey suspiciously upgraded the sector on Friday and had ignorant speculators pushing solar stocks much higher. Given the industry is trading as irrationally as tech stocks during the dotcom bubble, I recommend waiting for reality to set in before attempting any bearish plays.

In recent years a ton of socially responsible investment (SRI) funds have burst on the scene to capitalize on the green movement. Thus a ton of hot money is chasing a relatively small universe of stocks. As these funds have put money to work to take advantage of the media frenzy surrounding climate change, sexy solar stocks have soared like Icarus (and we all know what happened to him). Moreover, newbie fund managers who are trying to capitalize like their predecessors during the tech bubble may continue to buy sell-side analyst calls because these inexperienced managers are not skilled enough to do otherwise. Consequently, we may see more irrational highs before these stocks revalue to account for the new US Energy Bill.

In addition to AKNS, JA Solar (JASO), Yingli Green Energy (YGE), Suntech Power (STP), Solarfun Power (SOLF), Sunpower Corp (SPWR), First Solar (FSLR), Evergreen Solar (ESLR), LDK Solar (LDK), Canadian Solar (CSIQ), MEMC (WFR), and Applied Materials (AMAT) will all feel the heat. Those with higher domestic exposure will get burned worst. On November 12, all of these stocks sold off on reports that the renewable energy credits would be left out of the bill, but for some reason people were less concerned now that this negative rumor has become harsh reality.

Skeptics will say we have another year to renew the renewable energy credits, but realists don’t bet on Washington getting anything done in an election year. Further, the renewable energy credits were left to expire last time before being renewed retroactively. If we have a repeat performance in 2009 or 2010, as Cinnamon noted in the WSJ, this lack of visibility will still stall investment in solar.

The stage is now set for a possible bursting of the solar bubble … but we need to wait until the bag holders realize they are fully exposed to the high noon sun.

The Bull’s But: Signs of a Market Downturn

Permabulls accept the end of a bull run at either two points: never or long after the market sours. However, these eternal optimists can help us spot a market downturn long before they accept reality because they offer a signal of fear. When a permabull asserts everything is excellent “but, the Fed needs to be more aggressive,” the permabull is truly saying, “I want you to believe everything is excellent, but excellence now depends on some good ole fashion welfare.” Or, as a normal person would say, “We need help because the economy’s growth is no longer sustainable.”  Thus, the bull’s “but” can help an insightful investor move to the sidelines or make bearish investments (e.g., puts, short selling) in uncertain times.

We all have two famous permabulls at our disposal: Larry Kudlow & Jim Cramer. Larry describes himself as a free market capitalist who thinks the US economy only grows. He has a poor record of accepting recessions, and caused a lot of people to lose money at the end of the dotcom bubble. Although Cramer (host of Mad Money and founder of TheStreet.com) does switch from bull to bear, I consider him a permabull because he is always overwhelmingly exposed to stocks and in bear markets he prefers defensive stocks (e.g., Proctor & Gamble, Pepsi, etc.) rather than raising huge cash positions. As a result, Cramer is almost always praying for the market to rise. When either of these two CNBC personalities show you their “but,” it’s time to think about getting out of the market.

For example, Thursday night I was on the treadmill digging my runner’s high when during Kudlow & Co. Larry was glossing the economy like a high school senior in the National Cheerleading Championships. As usual, he only discussed bullish evidence and annoyingly talked over the guests who attempted to mention the credit crisis, inflation, the housing debacle, or waning consumer spending. However, suffering through Larry’s entire show was worth it because he showed me his “but”! When a self-declared king of free market capitalism hypocritically begs for an outside entity (e.g., the Fed) to lay its hands all over the economy, we have ourselves a genuine bull’s “but” signal that the market is in trouble.

Larry’s former partner Cramer has also spent the last week opining that the Fed needs to be more aggressive despite Cramer’s unwillingness to call a recession. SmartGuyDMoney also noticed that on days when the market is down, Mad Money places a red down arrow in the corner of the screen. However, no green up arrow is used on days when the market rises. Is Cramer preparing our little home gaming minds for his switch from permabull to bear?

A bull’s “but” is not a pure sell signal. However, when combined with other signals such as the one’s discussed in my previous article about a sucker’s rally, we can begin to build confidence that cash, puts, and short selling weak companies is best while analysts and permabulls beg you to buy or hold so they will have someone to whom they can pass their bag of what comes out of a real bull’s butt.

Disclosure: SmartGuyDH likes Jim Cramer and appeared on the first Mad Money episode with a live audience in 2005.

Sucker’s Rally?

Despite mounting data that the economy is quickly weakening relative to the past few years, the stock market continues to price itself near all time highs and bulls continue to control perception. The stock market says the economy is strong, while creditors, retailers, homebuilders, and CFO’s say the economy is weakening. Which data should investors follow? If the market rallies, should we jump aboard? Or, is this a classic sucker’s rally?

The most worrisome indicator for investors should be the increasing divergence between stock market action and economic action. As we all learned when we studied market history, the stock market and underlying economy do not always move in perfect tandem. However, given that the stock market is a derivative of economic activity, investors should pay very close attention when the value of their pieces of paper do not reflect the true underlying value of the business(es). When stock certificates are worth less than the underlying business, a buying opportunity exists. When stock certificates are worth more than the underlying business, a selling opportunity exists.

At the moment, stock market valuations remain near all time highs, yet banks are writing off years of profits, core credit markets are crunched, rating-agency confidence has been suspended, homebuilders are in a crisis, the housing market is in free fall, and bellwether retailers (e.g., Target, Wal-Mart) have been issuing ominous warnings about traffic and sales. Banks are now undergoing a second wave of write downs because, as UBS AG (UBS) declared yesterday, the “ultimate value of our subprime holdings … remains unknowable.” As housing market prices continue falling, banks must readjust the inputs for their valuation models and ultimately write down more losses. This will only end when the housing market finds a bottom or all toxic loans have been completely purged. Unless either of these scenarios occur in the immediate future, we have a lot more adjusting to do – and, despite mini rallies in bank shares, banks will be worth less.

Moreover, credit issues are beginning to spread. This week student lender First Marblehead Corp. (FMD) announced that rising defaults and decreasing federal subsidies are hurting their business. On a related note, as consumers watch their huge home equity and refinancing loans dry up (you didn’t think they were investing, did you?), we will watch their spending slow and their credit card debts come under pressure.

I am not attempting to predict how bad things will get before they get better. I merely want to point out that things are not well, yet the stock market is humming along like a teenage varsity athlete. I wonder: has the five year bull run created an inertia that will keep the market near all time highs until we have no choice but to acknowledge that the economy is hurting? Or, like Pavlov’s dog, has 60 months of “buy the dips” caused us to go on autopilot despite the increasing turbulence?

I leave you with an image to ponder. During the most recent market pullback (a 10% correction) notice how selling volume was strong and strengthened with the sell off. Now, notice how during the recent rally buying volume has been weak and weakened with the recovery. This is a classic sign of a waning bull market. This activity indicates that less investors are willing to go long regardless of the market gain. In my opinion, this activity also indicates that the smartest money is done buying, and what you are looking at is the 85% of the institutional investors who will not beat the market and the countless uneducated individual investors who have yet to shift from greed to fear. These two latter groups are why the term “sucker’s rally” starts with the qualifier “suckers.”

Changing the direction of the economy is like turning the Titanic. No matter how much the Fed cuts and the President freezes ARMs, many issues must play out in order for the economy to strengthen. During these times, the music must stop so the DJ can change records, yet suckers keep dancing. However, SmartGuys and SmartGals raise cash and prepare to strike once the ship has turned and the new tune hits the speakers.

Activision Merger Brings Blizzard of Money

Last weekend, Activision (Nasdaq: ATVI) announced an exciting merger with Vivendi. The offspring, Activision Blizzard, will combine the two companies’ video game units and leave Vivendi with 68% of the outstanding shares. To initiate the deal, Vivendi will be tossing in $1.2 billion while Activision will make a cash tender offer for up to 146.5 million shares at $27.50.

SmartGuyStocks readers who bought the ATVI calls I recommended are getting an early holiday gift. The question now is whether to sell and take the gains, hold longer, or exercise the options closer to expiration.

If you scaled into your position and are sitting on gains of 100-300%, by all means, take some or all off the table. Otherwise, there is an arbitrage gap that will continue to approach $27.50 as we get closer to the merger date in mid 2008. The only way the stock will not ultimately reach $27.50 (and beyond) is if the deal falls apart. I think this is highly unlikely given the great benefits to both companies and the lack of antitrust issues. The only snag I envision would be shareholders demanding a higher price. However, given that the deal should close in approximately six months, it’s hard to prove ATVI would be trading higher in such a short period of time (especially given the recent run up).

If you are very bullish on the deal and expect Activision Blizzard to be the new guerrilla on the block, you may consider exercising your options (when your strike price reflects an underlying stock price as close to $27.50 as possible) and holding the new shares. The video game industry is growing faster than the S&P, so the shares should outperform. Moreover, Electronic Arts (Nasdaq: ERTS) may lose priority in fund managers’ portfolios, and rebalancing holdings in favor of ATVI may push Activision Blizzard higher. I will most likely call the shares to maximize the move to $27.50. But I will let you know closer to expiration.

No matter what you do with your ATVI calls, the windfall should make you hum the jingle bell rock on Christmas morning when your children or friends are jamming out to their new Guitar Hero III.

Disclosure: SmartGuyDH owns ATVI calls.

Living on a Prayer: Blockbuster is the New Tower Records

After mulling through the transcript from Blockbuster’s (BBI) conference call and listening to today’s analyst day, I cannot help but think of another business that stubbornly focused on physical sales in an increasingly digital and internet dominated world: Tower Records. In case you are unaware, Tower Records was a flagship store to music like Blockbuster is to movies. However, the company got too far behind the curve as consumers shifted purchasing habits online, and the business ultimately went bankrupt.

Although I am not foretelling Blockbuster’s bankruptcy, I think the current quarter held many ominous signs. First, management has decided to surrender to Netflix (NFLX) in the online rental battle. This is a mistake. More people will still shift to online rentals as they get comfortable conducting more of their lives online. It’s easier to pick a movie at the office and not worry about stopping anywhere on the way home. Habits are slow to change, but they are changing (as evidenced by the success of Amazon – AMZN).

These same people are more likely to move from in-store to online delivery before jumping all the way to downloads. If they weren’t ready to rent online, do you think they have top quality broadband for a two-hour stream? Do you think they want to watch on their PC screen? These people are probably not tech savvy enough to have the computer hooked into the entertainment center, otherwise, why was renting online such a challenge for them? Thus, Blockbuster has erred in giving NetFlix the next wave of online renters.

Second, people who had horrible experiences with Blockbuster Total Access are surely not interested in trying out the BBI download service. Those dissatisfied customers are already moving over to NetFlix, which has its own download service that is already superior to Blockbuster’s. Please, go to blockbuster.com and tell me if you can figure out how to download a movie. You cannot because on analyst day CEO James Keyes said we shouldn’t expect the move until late Q1 ’08. That gives NFLX almost a year head start on downloads (and Redbox, Walmart (WMT), and Walgreens (WAG) already have a first-mover advantage with kiosks).

Third, Blockbuster has a new CEO James Keyes who did a brilliant job at 7-11, but his focus on in-store retail compliments is not new. Although in-store promotion may be more aggressive (and annoying), Blockbuster has been selling movies, candy, ice cream, and magazines for as long as I can recall. In fact, two weeks ago my local Blockbuster started selling movie posters. Sounds like a good idea if you don’t get out much. But if you noticed that they are $39.99 and you can buy the same posters on posters.com for $3.99, you know it’s a dumb move. The move is so bad that after 14 days, more than half the posters in my local store are already 50% off. Analysts were skeptical about retail since they too know BBI has offered these extras for a long time. Further, one of the worst signs for an investor is when companies shift focus from their core business to incremental revenue opportunities. Such a shift is occurring at BBI.

Bottom line: retail is not new and BBI is not the place to pick up soda and candy if you are not renting a movie. That’s what 7-11 is for. And with gas prices starting to rise again, I doubt people will pay extra at Blockbuster for what is cheaper at the quickie mart, Target (TGT), or posters.com. Shareholders want store closures, online rentals, kiosks, and downloads (basically, they want BBI to move with consumer behavior trends instead of grasping the dying past). Keyes is on the wrong track by focusing on bringing more customers into the store and selling them extras, and analysts are well aware. Like President Bush said, “Fool me once, shame on … shame on you … a fooled man can’t get fooled again.”

Keyes may have been great at 7-11, but he is not the messiah. Shareholders have been hearing this same hype for a couple years. On analyst day Keyes revealed very few details. He drastically overused the words “hope,” “potential,” and “brand value.” Analysts pointed out bad same store sales, customer base erosion, increasing competition from Walmart, Redbox, Walgreens, and NFLX. One analyst asked about domestic same store sales being down 9-10%, and Keyes responded that he wants to get more people back in the store. Genius. So does every CEO who loses customers. And when asked how, he again used the magic red flags “hope,” “potential,” and “our powerful brand.” That great brand hasn’t done anything for BBI to fend off competition and a dying business model. Why now? Keyes had no good reasons. But he is “excited” to be working at Blockbuster and has a lot of “hope” about the “limitless potential.” I could almost hear the soundtrack in the background playing Bon Jovi’s classic “Living on a Prayer.”

Fourth, Blockbuster announced a new advertising relationship with Facebook, but college students get their movies free. If you know anyone in college, you know they have all their illegally downloaded free movies on their hard drive or copied onto blank DVDs. This is the same anecdotal evidence that the music business ignored. I noted how Warner Music Group (WMG) has been pained by their missteps, and BBI seems to be following suit. BBI’s relationship with Facebook is nothing more than a set of elder executives trying to catch some of the white-hot buzz surrounding Facebook. Contrary to Blockbuster’s opinion, getting poked by Blockbuster is probably not very cool. And I have read numerous articles interviewing Facebook users who declare they have used the site since near inception and never clicked on an ad. WMG has been marketing on MySpace and Facebook since the sites were new, and look what that has done for their stock. Lastly, Netflix and movie critic sites are free to create their own Facebook widgets and profiles. The return on investment (ROI) for this marketing plan will be as stellar as BBI’s nonexistent revenue growth.

BBI is now trading with a forward multiple of 40. Such a multiple is warranted for a super-star turnaround that has been growing the top line. Unfortunately, revenues at BBI have been decreasing steadily year-over-year and the bricks-and-mortar rental business model is heading toward extinction. At best, I would pay 20 times earnings as a spec flyer that something extraordinary may happen. That would put the current price at $2.40 and close to book value.

On a technical basis, trading volume on the two recent up days has been below average. This is a clear indication that buying was simply shorts taking profits as we head back toward $4. I do not anticipate strong buying any time soon because the big players have already given BBI a ride and big money does not have big patience. Thus, most are selling and will move on to greener pastures.

I think CEO Keyes said it best at the end of analyst day when he nervously stated, “I assure you that all the moving parts will come together at some point.” Not exactly the beacon of confidence and clarity. As I wrote the other day after BBI’s earnings announcement, Blockbuster can play lots of MBA tricks for a while. However, shareholders and customers alike know when they see another Tower Records.

Disclosure: SmartGuyDH owns BBI puts