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.

Martha Stewart Living is not a growth stock

Since I recommended buying puts on Martha Stewart Living (NYSE: MSO) last month, shares have tumbled more than 5% as the broader market has rallied. Yet despite this minor correction, the market is still pricing MSO as if it were an exciting growth stock, not the dying brand milking its core followers for every last penny that it really is. Recent developments reinforce the fact that this stock does not deserve its current 22 forward multiple or 2.7 P/S.

First, there was the apparently upbeat announcement that The Martha Stewart Show would be picked up by NBC/Universal for a fourth season in syndication. You had to actually read the entire press release to see the bad news that the show would now only be syndicated in 60% of the country versus the current 95% for season 3. The surprise here is that the show was actually renewed given its dismal ratings: during November sweeps, the show garnered just a 1.1 rating, a 20% drop from last year. This put it behind Jerry Springer (1.4) and just ahead of Judge David Young (0.9). Archrival Rachael Ray scored a 2.1.

Then came word that the company would shutter its Blueprint magazine. According to the company, the magazine was “Geared to women ages 25-45, Blueprint targets a different demographic than our core consumer…thereby broadening our advertising reach.” Like nearly every other effort MSO has made to expand its reach (The Apprentice, KB Homes, K-Mart), Blueprint was a disappointment. The company is placing new bets on recent deals with Macy’s and Costco, but the success of these new partnerships remains to be seen. MSO’s revenue from K-Mart will drop by over $40M in 2009, so it will have a lot of ground to make up.

I give Martha Stewart credit for finding a successful niche. She is a hero to my mom and millions like her. Yet there is only so much Martha that this core market can consume, and I believe it has nearly reached its saturation point. Every attempt to expand her brand to other demographics has flopped, and she has been replaced as the “it” homemaker by Rachael Ray. I have no doubt that MSO can profitably milk its loyalists for steady revenue during the next few years before its 66-year-old namesake decides to retire to the tropics. But there is absolutely no reason for this company to be priced as a growth story.

Disclosure: SmartGuyAB owns MSO puts

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.

Arbitraging Activision

• Sold ATVI calls at 9.60

I just want to let everyone know that I sold my ATVI calls this week when ATVI was trading at $27. I have since bought and sold some more calls as an arbitrage play when the broad market sold off strongly and dragged ATVI down. Although SGS is closing our ATVI position, we will watch post-merger to see whether this excellent company deserves another investment.

Building the bear case against BBW

• Sell BBW short around 15.17

Imagine you own a chain of retail stores selling expensive discretionary goods. When you first started out with your novel retail concept, you were wildly successful and the darling of the business world. However, now that you have been in business for a number of years, the buzz has started to wear off. Your same-store sales have been declining at an accelerated rate for the each of the last three years. And to top it off, the general economy is facing a housing crisis that nearly every expert agrees will negatively affect consumer discretionary spending.

What do you do?Most prudent business managers would get their house in order, rework their brand, and ensure that their company was on solid footing to survive an economic downturn. Well if you are Build-A-Bear Workshop (NYSE: BBW), the operator of specialty toy stores that allow kids to create custom stuffed animals, you take a different tack. Your solution is to:

1) Deny that your store’s popularity is waning. Instead, blame it on “macroeconomic conditions affecting consumers.” This is the primary explanation BBW has for the same-store sales drops it has been experiencing since 2005. Nothing they could do, just a bad economy. Tell this to luxury retailers like Coach and Tiffany, which posted record years in 2005 and 2006. Apparently, with all the money consumers were spending on $2,000 purses and jewelery, there just simply wasn’t enough left to afford $35 teddy bears.

2) Use all your cash flow to build more stores, especially in foreign countries where your store has no brand and is unproven. Through the first nine months of the year, BBW had burned through nearly $37M in cash building out new stores across the US and entering into France. But new stores only seem to be temporarily stopping the bleeding- BBW reported that third quarter revenue grew 8% and earnings 10% over 2006, despite having 71 (35%) more stores open at the beginning of the period! That’s not the kind of return on new stores that any retailer likes to see, but it’s what you get when you deliver a same-store sales decline of 10.1% in 2007, on top of a drop of 5.8% in 2006. And the worst part is, the newest stores appear to be the most unsuccessful. In 2006, sales at stores that were open for less than 3 years declined more than 50% more than older stores.

3) If all else fails, hire an investment banker to “explore strategic alternatives.” BBW hired Lehman Brothers to do just this last summer, but not surprisingly, there have been no takers to this point. And with its dismal same-store sales, it’s not likely that BBW is a mouth-watering PE takeout target in the current credit market. The bottom line is, management realizes that their fad has passed and is trying to cash out while the business still has some value. Unfortunately, they’re unlikely to get bailed out in today’s market.This holiday season, kids, like their parents, want the latest modern electronics like Nintendo’s Wii or Fisher Price’s digital camera. And ask any young girl (BBW’s target customer) whether they’d rather have a teddy bear or a much edgier Bratz doll. Build-A-Bear is a nice novelty concept, but that’s all. After a customer has had the experience once, the novelty has worn off.

In the interest of disclosing all risks, BBW does have one hidden thing going for it. By early 2008, the company expects to own a 34% minority stake in RidemakerZ, a new mall concept that allows young boys to build custom toy cars. While I’m skeptical that today’s stimulus-seeking boy would rather spend three hours putting wheels on a plastic Mustang than playing Wii, reports say that the store is off to a promising start. This is a potential promising asset that could deliver value for Build-A-Bear down the line.

But RidemakerZ is still an unproven concept that won’t deliver any tangible value to BBW for at least the next 12 months. In the interim, I think we can expect to see more sales declines and destroyed value for BBW shareholders. Analysts are expecting earnings to drop nearly 15% in the fourth quarter. The company certainly isn’t giving investors any confidence, having ceased activity under its $25M buyback plan. This despite buying back $4M worth of shares earlier this year north of $26/share. And just last month, BBW announced that it was restating its comprehensive income numbers for the first half of the year due to accounting problems.

I see no other near-term catalyst for BBW other than a miraculous buyout by some masochistic PE firm. Unless that happens, I expect the “bear” reality against BBW to take this stock down to the low teens.

Disclosure: SmartGuyAB is short BBW

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.