Posted December 24, 2010

As we finish out 2010, we would like to take some time to consider the year we just had, and consider what may lie ahead. 2010 has been an extraordinary year for our clients, with our average account up approximately 43% for the year as of December 1st. December has also been a great month for clients, and we are eager to finalize our 2010 numbers for publication (http://lakshmi-capital.com/performance/) .

Looking Back – S&P 500 Earning Yield vs. 10 Year Treasury Yield Differential

We were able to profit greatly from the timely implementation of these positions, but as conditions have changed, the question of whether our logic is still relevant bears merit.

Much of our outperformance this year stemmed from our view that the summer pullback was little more than a correction during an ongoing bull market in risk assets (stocks, commodities, etc.). Our research regarding the differential between the earnings yield on the S&P 500 and the yield on the 10 year US Treasury note gave us great conviction in adding to all of our long stock and commodity positions, as well as establishing new positions to short volatility. Our original research can be found here. We were able to profit greatly from the timely implementation of these positions, but as conditions have changed, the question of whether our logic is still relevant bears merit.

Short Term Correction Likely

While conditions may favor a near-term correction, we believe that stocks and risk assets remain in a long-term bull market. Since we originally published our article, the S&P 500 has rallied 19% and the VIX has dropped 42%. While we are still bullish on stocks as a group, there are many reasons to be wary of a pullback in the near future.

The VIX Index has dropped ~42% since our recommendation to purchase stocks, and its current reading of 16.47 indicates relative complacency among investors. By comparison, the 100-day moving average of the VIX is around 21. While a level in the 20s is historically rare, such a high VIX is a very bullish indicator for stocks going forward, as it indicates a preponderance of skeptics and worriers.  As the skeptics are turned to believers, the market rallies and the VIX comes down.  The coming weeks or months will most likely see a short-term spike in volatility as stocks consolidate their recent gains.

Adding to the view that complacency may currently be too prevalent is the American Association of Individual Investors’ (AAII) Survey. This weekly survey asks the respondents if they are bullish, bearish, or neutral about the stock market over the next 6 months. Historically, the survey has proven to be a good contrarian indicator, as individuals are usually their most bearish when stocks are about to rally, and vice versa. While the indicator is more accurate in predicting a stock market rally, it is still useful to gauge investor sentiment.

The current ratio of bulls to bears stands at 3.86. This means that bulls outnumber bears by almost a 4 to 1 margin. Historically, this is a rare scenario, with the current reading being the most bullish since 2005. When the 2005 reading of 4.12 occurred, stocks began a 5% pullback shortly thereafter before continuing the bull market.

Long Term S&P 500 vs. 10 Yr Treasury Spread Opportunity Remains

Despite the probability of a near-term correction, we remain bullish on stocks.  As we discussed in our previous post, the basic premise underlying the earnings yield concept is that equity investors should expect the earnings yield on stocks to be at a level somewhat higher than the 10 year note in order to justify the additional risk taken by investing in equities versus government bonds. This is because the 10 year note is considered the risk-free benchmark, so investors must be paid a certain “risk premium” on top of this yield in order to be enticed to take on risk. Earnings yield is the yield an investor would receive if he or she theoretically owned the entire company that shares are being bought in.

equities still look underpriced on a long-term basis.

The peaks and valleys of this spread have been extraordinarily good leading indicators of rallies and drops in the stock market. The stock market began the summer rally after the spread peaked at 4.77% on August 31. Since then, the spread between the earnings yield on the S&P 500 and the 10 year US Treasury has decreased to 2.96%. The current reading is in the 92nd percentile of readings over the last 48 years (the longest that data is available). While the premium is not nearly as attractive as it was during the summer pullback, equities still look underpriced on a long-term basis.

With the yield on the 10 year note advancing quickly, this situation could change quickly, but we still view the current scenario as bullish for stocks in the long-term. While the 10 year note yield has increased from 2.35% to 3.39% in the last 2 months, we do not see 10 year note yields rising unimpeded. Mr. Bernanke and the Fed have indicated an extreme willingness to use any and all available means to keep government bond yields low. While bond bears will rightly claim that QE2 has been largely ineffective, we believe this is more of a “buy the rumor, sell the news” event than the beginning of a steep rise in yields. While we would agree that bonds are most likely entering a secular bear market, we believe the uptrend in yields will prove to be much more gradual than the last couple months’ experience. If government bonds are not able to stabilize on their own, look for the Fed to take even more aggressive measures to keep borrowing costs low.

Trade Recommendation

Since the readings of the VIX and AAII indicators are only short-term contrarian indicators, the market may continue to rise before pulling back. However, investors would be well-advised to utilize the next pullback to add to long equity positions, and, if there is a sharp rise in volatility, sell put options on stock indices.

We continue to own many income-producing stocks as well as many technology stocks, and will utilize any pullback to add to existing positions.

ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Posted on December 20, 2010

As we have discussed many times recently, we expect a renewed rally in silver to coincide with Managed Money reestablishing long positions. In the week ending December 14, Managed Money net long positions were down to 24,623 contracts from 26,799 on December 7. The five-year high for Managed Money net longs was 48,532 contracts, set on September 28. We expect that as Managed Money starts to reimpose the 24,000 contracts it would take to get back to the high, silver will begin a new rally that will take it significantly higher than its current level.

To illustrate why we are so confident in this outlook, we have prepared the following chart:

The top panel of the chart shows Managed Money net long positions. The bottom panel shows the price of silver.

Each time the Managed Money net long position appears to bottom out, silver starts a new bull run. It appears that silver’s rally is being powered by the Managed Money position. The line starting in October 2008 shows the upward trend in Managed Money net longs coinciding with the bull market in silver prices.

Each time the Managed Money net longs pull back and start to rally again, silver prices rally as well.

Even with silver at such a high level, around 29 $/oz currently, the Managed Money net long position appears to have bottomed out for the near term. This would seem to indicate that silver has much further to rally as Managed Money longs return to the market. The longer silver spends at this elevated level, the more confidence Managed Money will have in reimplementing the long positions they previously held.

The Producer short position decreased to 46,155 contracts from 47,945. The concentration of the short position decreased to 42.2% from 43.8%. It appears that Producers are covering their short silver exposure slowly, but they still have plenty left to buy. Look for the Producer short position to continue to decrease as silver prices increase.

As the fundamentals of the precious metals markets remain strong, we remain long silver and gold in the expectation that the bull market will continue for the foreseeable future.

ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Posted on December 17, 2010

[This post is reposted from a comment made on Whitney Tilson's Seeking Alpha article discussing his hedge fund, T2 Partners', rationale for continuing their short position on NFLX stock. The original article can be seen here: link]

As an industry professional who respects Mr. Tilson’s hedge fund, we at Lakshmi would like to thank him for such an in-depth look into his reasoning. It is truly rare for a professional of his magnitude to share analysis, and we wish the rest of our industry was as transparent.

While we do not disagree with Mr. Tilson’s premise, we believe his reasoning is fatally flawed at its core. Quite simply, valuation shorts should NEVER be entered. We 100% agree that NFLX is overvalued at the current 69.3x earnings it currently trades at. But, if one was to short this company, why not short WYNN at 82.49x earnings, LVS at 129.29x earnings, or better yet, Amazon (a company you mentioned as competition) at 72x earnings?

Every time an investor speaks about a valuation short, they talk about the one “misstep” it will take as a catalyst for the stock to start tanking. The problem is, there is no ceiling to how high an overvalued company can go in the meantime. We know from experience shorting the casino stocks at the then-ridiculous multiples of around 65-70x, that there is not much difference between a stock trading at 60x or 80x. There are no investors worth their weight in tin that think a stock is cheap at 69.3x, but then why is NFLX still trading there?

The largest holders of Netflix (Fidelity, Technology Crossover Management, Morgan Stanley, Renaissance Technologies, and Vanguard) are not fools. They know that a stock trading at almost 70x earnings is overvalued and they are still holding their shares.

The reason why? They do not care about NFLX’s valuation.

They know that the company will become more overvalued as skeptics turn to believers and buy the stock, whether the skeptics are short sellers being forced to cover or new long position holders. For this reason, Mr. Tilson can argue until he is blue in the face about NFLX’s prospects, but the problem is none of those reasons matter at all to the people holding NFLX’s stock. His only hope is that he convinces more short sellers to jump on NFLX in order to drive the price down.

Unfortunately, the reason why Netflix, and all valuation shorts with high short interests for that matter, stay so high is short sellers like Mr. Tilson. The current short interest on NFLX is over 11 million shares, or 23% of the entire float of NFLX. As long as there are this many short sellers still short NFLX, it cannot fall. There are very few sellers left and an incredible amount of buyers (over 11 million shares’ worth, courtesy of short sellers buying to cover once they’ve reached their pain threshold). 23% of the float of NFLX is ~$2.2 billion worth of NFLX shares, an enormous amount of money that would cause the stock to skyrocket even from here. Adding to Mr. Tilson’s woes are that the more short sellers join him, the higher the interest rate he will have to pay in order to continue borrowing NFLX stock. He is truly caught between a rock and a hard place.

To put the pain of being short based on valuation in perspective, in March 2009, there were over 18 million shares short. NFLX’s price then? $39.37 per share. The stock has rallied 358% since then. I pray for Mr. Tilson’s LPs that he has not been short this entire time. At some point it is better to take your ball and go home.

Many Seeking Alpha comments have implied that Nasdaq in the tech bubble was an obvious valuation short which could have been capitalized upon profitably.

From our research, we will show that while shorting Nasdaq in hindsight seemed like a no-brainer, in practice it was nearly impossible to profit from it. Compared to the number of short sellers who lost huge shorting Nasdaq, there were very few who profited from Nasdaq’s collapse, and the ones who did owe it mostly to lucky timing than any astute observation on their part. The chart below shows short interest as a percentage of shares outstanding on the Nasdaq 100 Index from November 1997 to December 2002. The Nasdaq 100 is composed of roughly the 100 largest companies on Nasdaq.

As can be seen, short interest dropped steadily as the Nasdaq 100 began its historic run. This suggests that the run was powered, at least in part, by short sellers giving up and buying to cover their short positions. Once Nasdaq went parabolic around the beginning of the year 2000, short interest spiked dramatically as short sellers took a stand and sold into extreme valuations. However, short interest fell just as quickly as it rose when Nasdaq began its last huge rally from 3,570 to the peak of 4,397 (~23%) in the span of just 3 months. Short sellers were forced to cover their large bearish bets as Nasdaq went from ridiculously overvalued to mind-blowingly overvalued. The Price to Earnings Ratio on the Nasdaq Composite went from 151 to 175 during this last surge.

The majority of the collapse of Nasdaq occurred from March 2000 to March 2001; in this span, Nasdaq dropped 68%. Interestingly, this coincides exactly with short interest bottoming out in March 2000. By the time short interest started rising again in March 2001, most of the decline in Nasdaq had already been witnessed.

From the data presented, we can see that short interest is actually a contrarian indicator. The trend of overvalued companies and even entire indices will continue until short sellers largely give up. When short interest is high, it indicates a preponderance of disbelievers in the rally, which means there are plenty of new buyers left to come in (those skeptics being turned into believers). The trend will only reverse once the skeptics have been converted and there are no buyers left.

To illustrate the value of this point even further, Nasdaq hit its bear market bottom in August 2002…as short interest hit a new peak.

To parallel NFLX’s current overvaluation with Nasdaq, short sellers like Mr. Tilson and T2 Partners are still disbelievers in NFLX’s bull run, even though it has advanced enormously and cost them untold millions. NFLX will not stop its advance until its short interest falls drastically to a much healthier level. Just as short sellers took a stand when Nasdaq was obviously overvalued at 151x earnings, but were burned when it advanced to 175x, what is to stop NFLX from going from the current 69.3x to 80x, 90x, or even 100x? Given the $2.2 billion short position still left in NFLX, I see no end to the short sellers’ pain. There are simply no sellers left.

On to problems with Mr. Tilson’s analysis itself:

The most troubling part of his reasoning is his reliance on the expertise and savvy of media companies and their corporate leadership. History has shown that these companies are extremely stubborn, and are always the last ones to the new technology party. Having personally worked at Time Warner and Universal, I have a very different view of the quality of corporate leadership at Hollywood studios. These same studios are the ones who spent millions in court opposing the VCR, DVR, and then streaming music to the point where they completely lost out on the internet music business by selling off their music divisions at rock-bottom valuations before Apple revolutionized the industry by taking it online and giving consumers what they wanted (sound familiar?).

When it comes to application of new and disruptive technology, media companies are aimless dinosaurs who are hyper-protective of their content. Their historic inability to adapt to the future will ultimately cause their inevitable collapse. There is no more accurate truism to describe media companies’ quandary than this: innovation and technology ALWAYS win.

With regards to the argument that Netflix’s content is weak, why do they have 16.9 million customers and growing fast? Quite simply, if people didn’t like Netflix’s content, they would not sign up. See the “vote with your feet” economic theory of Charles Tiebout (wikipedia).

Furthermore, if Netflix’s content is so weak, then how exactly would their current suppliers be justified in increasing the price of their content by 1,000% as you suggest? Both arguments cannot be simultaneously correct. I fully agree that the price of their content will rise, but it is anyone’s guess as to how much, as negotiations are still underway.

As for the saturation and internet bandwidth these are little more than pie in the sky reasons to sell the stock. Saturation is not a problem, especially when taking a global market for NFLX’s product into account. NFLX being hurt by internet bandwidth price increases is laughable. That is the financial equivalent of grabbing for straws. The day internet companies see multiple contraction based on the rising price that consumers are paying for bandwidth is the day pigs fly.

The legal risk argument is also flawed. While attending UCLA School of Law I spent a great deal of time researching intellectual property law specifically as it related to “new media,” meaning digital distribution. Just as the courts struck down the studios’ challenge to VCR’s when they became popular, and again to Digital Video Recorders (i.e. Tivo), I highly doubt the courts will strike down the First Sale Doctrine. The reason for this is that courts are hyper-sensitive to stunting growth and innovation by allowing content creators to challenge new technology. If the studios sold Netflix the DVD’s while the First Sale Doctrine was in force, then they were on constructive notice that Netflix was free to do with them as they pleased. Just because the studios have run their businesses ineptly and Netflix has innovated profitably since does not mean that the courts will have sympathy for the studios. Throughout the history of audiovisual innovation, the studios have opposed almost all forms of progress through the courts.

In spite of huge legal fees paid, their result has almost unequivocally been unfavorable. Courts always rule on the side of innovation.

Finally, the most dangerous parts of Mr. Tilson’s reasoning are the assumptions he has not discussed. He is assuming that Netflix’s strategy and business model will remain largely static in the face of these strategic challenges. Given CEO Reed Hastings’ demonstrated ability to out-think the studios and innovate, I would not bet on this. Just as Amazon proved all doubters wrong, Netflix could as well.

For the record, we have no position in NFLX, or in any media company for that matter. However, after reading the reasoning regarding the continued short interest in NFLX, it makes us seriously consider a long position in the stock.

ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Posted on December 17, 2010

Because of silver’s recent run, much attention has been given to the rumored JP Morgan short silver story, which we have covered (link). However, the shortage of silver in COMEX inventories is potentially as conducive to the long silver story, and is also thoroughly verified.

As of December 10, the COMEX holds only 106mm ounces of silver, or roughly enough to cover 21,000 contracts (Go to: CME Group Link and click on “Silver Stocks”).  From the most recent Commitment of Traders report from the CFTC, there are more than 137,000 silver contracts outstanding.  That means if only 15% of silver long holders decide to take delivery of physical silver, a short squeeze unlike any other ever seen may result.

The reason the COMEX shortage could turn into such an explosive story is because of the lack of physical silver available to cover the existing futures obligations.

Courtesy of Eric Sprott and Sprott Asset Management, the above table shows the amount of silver being held by various silver ETFs, trusts and central banks.  As can be seen, 519mm ounces are being held by these entities, and with investment demand increasing, they are bound to hold even more as time goes on.
SLV, the US silver ETF, has become the most popular way for investors to gain exposure to physical silver.  From time to time, SLV purchases new lots of silver based on investor demand for SLV shares.  Since investment demand for silver increased 184% in 2009, SLV has been expanding their silver holdings rapidly.  With silver gaining even more popularity as an investment, 2010 figures to be another year in which silver investment demand skyrockets.

As SLV and the other entities hold more silver, there is less silver out there to be delivered.

Once these entities own the silver, it sits in a vault and is not expected to be resold except in very small portions to pay expenses and fees.  Shown above is a chart of worldwide silver demand, courtesy of the The Silver Institute.  As can be seen, investment actually comprises a very small amount of global silver demand, although that amount is skyrocketing (investment demand rose 184% in 2009).

In addition to the skyrocketing investment demand, much more silver is used for other purposes, and due to the miniscule amount used per unit, this silver will not reenter circulation.  Approximately 50% of silver demanded each year is consumed in industrial processes, with medical, photography, jewelry, and silverware usage comprising an additional large proportion.  The amount of silver used for these purposes is so small on a unit basis that there is no virtually no ability to economically salvage the silver used.

Therefore, silver used in industrial and other processes is essentially gone forever.

As the ETFs, trusts, central banks, industrial and other uses take silver out of circulation, the amount left for investment demand and, more interestingly, for delivery of COMEX short positions continues to dwindle. If 15% or more of the long silver futures holders decide to take delivery, our best guess is that the COMEX itself would be forced to purchase physical silver on the open market, driving up the cash price of silver greatly.

Due to the amount of silver constantly being taken out of global supply by the above mentioned factors, this could lead to an incredibly explosive short-squeeze that drives the price of silver up to and beyond the all-time high of 40 achieved in 1980.

In addition to the COMEX silver shortage, the fundamental thesis regarding purchasing silver is well intact and gaining momentum.  The dwindling supply of physical silver available globally coupled with COMEX’s woefully insufficient silver inventories are yet more kindling to power silver’s rally long-term.

We continue to be long silver in various forms for clients, as well as long SLW, GDX, and GDXJ.

ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Posted on December 13, 2010

This week’s Commitment of Traders report shows little change from last week’s – even with silver rising 5.5% for the week ending December 7.  Producer net short positions were reduced slightly to 47,945 contracts from 49,545 contracts the previous week, and Managed Money net long positions were actually slightly reduced to 26,799 contracts from 27,485 contracts.

The continued rise in silver prices even with Managed Money cutting their net long positions suggests that the silver rally has plenty of steam left.  For comparison, the high for the year in Managed Money net long positions was 48,532 contracts on September 28, 20,000 contracts more net long contracts than Managed Money currently holds.

If Managed Money approaches this level again, silver should experience another sharp move upwards.

The fact that Managed Money has been slow to reestablish their long positions even with silver back up near the decade-high shows that commodity funds and precious metals traders are fearful that the current rally in silver may stall.  The longer silver prices remain at an elevated level, the more confidence these managers will have in reentering the market.  We can see from the chart below  that consolidation of prices at a higher level has a bullish effect on confidence going forward.

After silver began its large move up, the rally stalled around the 23 to 25 $/oz level (denoted by the white box).  After consolidating for a few weeks, prices began to move higher, only to consolidate again between the 25-28 level.  The action in recent days suggests that we may see further consolidation between the 28-30 level.

This chart is useful in that it shows the willingness of investors to buy into silver once it has shown an ability to hold its elevated level.  In each case of consolidation, the price moved higher, and used the previous resistance as support, a very good sign that a security is in a bull market.

As silver continues to show resilience in holding its gains before breaking out to new highs and consolidating, more investors will gain confidence that 2010′s silver breakout is not a fluke but is in fact the beginnings of a new bull market in the metal.

Silver’s upward trajectory in the face of less than stellar Managed Money long exposure is a classic example of a security climbing a “wall of worry.”  In such a case, many doubters and skeptics are not willing to purchase the security, even though it is rising in price.  This phenomenon is classically indicative of a healthy bull market, in that many market participants have not yet entered on the long side.  As the skeptics are turned to believers, they are turned to buyers, and the price of the security continues its ascent.

In the chart above, the amber line shows the level of Managed Money net long contracts, whereas the yellow line shows the price of silver.  As can be seen, Managed Money cut long positions drastically during the run-up in silver prices.  However, the price of silver has continued to rise even with Managed Money long positions near their lowest levels in the last year.

If Managed Money long exposure was high relative to historical norms, this would be a sign of an imminent pullback, as there would be very few buyers left, and the current long holders may be inclined to liquidate quickly in the face of any correction.

However, with Managed Money net long positions at such a low level, there seems to be quite a bit of fuel left to power silver’s rally.

Additionally, the white line on the chart above shows the net short position of Producers.  As silver prices began their ascent, it appears that Producers began to cover their short positions, reducing them by approximately 15,000 contracts.  While the Producers (rumored to be the banks, which we covered in an earlier post: http://lakshmi-capital.com/2010/11/a-twist-on-the-silver-market-are-banks-short/) have covered a significant amount of their short position, there remains a very large number of contracts that the Producers will eventually have to cover.  This could provide yet another positive catalyst for silver prices going forward.

We remain long silver futures, silver futures calls, and miners.  If prices return to the 28 level, we will increase our long exposure significantly.

ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.