FedEx Corp and the Billion Dollar Report

FedEx Corporation stock is down over 4% today after a downgrade by a tier one firm.  Today’s decline is on top of the transport losses of the last few days, partly based upon the UPS news.  The analyst covering the stock is experienced, has won multiple awards and holds a law degree.

Most market participants will never know the reasoning behind this move.  Those summarizing it on TV cite it as further evidence of a weak economy.

What does the report say?

First, it says there is no risk to near-term earnings.  Next, it says that the stock is trading at a significant discount to historical one, three, and five-year average valuations.

In short, the market is already anticipating bad news.  And these values were before the analyst report took the stock down another 4%.

So what is the basis for the downgrade?

The analyst thinks that economic conditions will deteriorate so he is making a "macro call."  This is exactly the point I have been making about current street research.  Analysts do not stick to what they do well — covering the company and it’s business.  They instead become economic forecasters, calling the top of the economic cycle.  They are not experts at this and have a poor record trying to do it, but the post-2000 era encourages them to find downgrades.

The second basis for the downgrade is that FDX supposedly experiences multiple compression in the time after a Fed tightening cycle ends.  The analyst provides a table showing that PE multiples are about 10-20% lower a few months after the cycle.  (Coincidentally (??), this is about the size of the current discount.

The research report provides a table to verify this.  It shows two things:

  1. The research finding about multiples after a Fed tightening was based upon two casesThat’s right — count ’em:  One, two.  I could hardly believe it.  I guess the law school did not discuss anything about statistical inference.
  2. Even in these two cases the stock went up at an annualized rate of about 10% for the two periods combined.

So there you have it — the basis for a billion-dollar haircut in the Fed Ex market cap.  This is the reverse of the 2000 bubble era where analysts found reasons to take stocks to unprecedented valuation levels.

[I own calls in my fund.  I’ll buy some more.]

Current Market Risk Analysis

Who are the real contrarians?  Bearish market analysts point to indicators related to those who are actually trading right now — AAII surveys, the option volatility (VIX), put-call ratios, and the like.

Doug Kass looks at the short ratio of hedge funds, an interesting approach.  The problem with all of these measures is twofold:

  • They ignore those who have left the market — individual investors who have plunged into real estate and mutual fund managers who have significant foreign market exposure–chasing recent performance.  The market veterans who look at fundamentals have been "all-in" for some time, and they are not getting fresh money.  This is a manifestation of the backward thinking of individual investors.
  • The hedge fund measure does not reflect the vast increase in money managed by hedge funds.  There is much more money in the hands of managers who short aggressively, looking for the next market tick.

The hedge fund money will shift rapidly with the market.  The individuals, sadly, will come late to the  party.

Here is an idea about how to see the overall risk.  Let’s look at the growth in S&P earnings since 1960.  Even in the very worst recessions, the earnings decline was about 15%.  Take a look at the data, showing a decline of about 15% in 2000-2001, a similar amount in 1981-83, and a bit more in 1974-75.

Here is the lesson.  First, there were very few declines in a 45-year history.  Second they were all brief, with a brisk rebound.  If you want to play for this, you had better be agile, or else think this is the worst market in fifty years.

Remember that bearish analysts are predicting a slowing in the rate of earnings growth, not an absolute decline.  Remember also that they are ignoring that the analysts themselves are already projecting a weakening economy.  Nevertheless, let’s assume the worst case in the 45-year market history.

Let’s assume a 15% decline in earnings from the current forward projection (Thomson First Call) of aobut 88.40.  Even with that decline the forward PE of the S&P is about 16.5.  This is over 6% earnings yield.

The market can ignore earnings, as it has for the last two years.  It is already a very unusual phenomenon — a reverse bubble.  What happens when companies get great earnings and improve their balance sheets?  Let me quote from the excellent commentary by James Altucher, once again from a paid service on  (If you are trading yourself, you should subcribe, or check out the views of those who do).  This is a great explanation.

"S&P 500 companies are sitting with a ratio of cash over market
cap that is higher than it’s ever been before. They aren’t going to
just put that cash in a checking account while their stocks go down.
Here is what they will do:

  • Buy other companies;
  • Buy back stock;
  • Pay a dividend;
  • Make investments in R&D and infrastructure.
  • All of
    those items boost stock prices and boost the economy. We haven’t even
    really seen the effects yet of the massive cash that’s sitting on the
    sidelines right now in corporate America."

    Introducing the Concept of Local Market Efficiency

    Anyone who has experience in the market learns respect.  Your account tells you daily the verdict of the market.  The Efficient Market Hypothesis, which is a central theme at "A Dash," holds that each piece of news gets accurately priced into every stock in a forward-looking fashion.

    I have maintained that markets can get very far from an accurate valuation.  One need look no farther than the recent "bubble era" where stocks reached incredible multiples of sales with miniscule earnings.  Despite this macro failure, the market operated "efficiently" on a day-to-day basis.

    The concept that I am introducing here — Local Efficiency — is an accurate description of how most market participants behave.  They accept yesterday’s values as valid and ask what the directional impact is of any piece of fresh news.

    Taking today as an example, there was news about increased MIddle East tension.  This was obviously a fresh negative for the market to the extent that this geopolitical risk was not already discounted in stock prices.  How did it play out?

    Let’s look to the comments of Doug Kass in his excellent commentary on StreetInsight, a paid service of  Kass is generally bearish, calling himself the anti-Cramer, but he makes frequent long-side trading calls and he had one going today when the news hit.  He quickly posted two things:

    1. Cancel all longs.
    2. The market was not adequately discounting geopolitical risk.

    The first of these statements identifies pretty typical market behavior — bids get pulled.  Everyone knows this is negative, but perhaps does not know the magnitude.  Step back and check it out.  The market declined by less than one percent from this point, with extra selling in anything related to a strong economy.

    Given that people were pulling bids, what does the selling tell us about the risk factor?  From the reaction, not much.  The Kass approach is typical of what many (most?) of the fast money traders follow and it has enormous influence.  My problem with this approach is that there is no fundamental anchor for where individual stocks or the market as a whole is valued.

    Local efficiency assumes that yesterday’s prices were right.  Those who are bearish (or reversing the analysis in 1999 were bullish) see each piece of negative (or positive in 1999) news as vindication of their thinking.  The same facts are repeatedly discounted without regard to underlying value.

    There is no way of knowing exactly how long this will persist.  Some of the smartest minds in the business got buried in 1999-2000 by shorting the market at ridiculous valuations.

    What is needed is some concept of the overall market risk, my next topic.

    Determining the Contrarian Position

    Continuing our analysis of the Contrarian Approach to investing, a concept we strongly endorse, we run headlong into the question:  Where is the crowd?  We want to be somewhere else!

    Much of the opinion about market sentiment is anecdotal.  Those with contacts in the hedge fund community claim to know which way positions are leaning.  Others look at forecasts or sentiment indicators.  You can look objectively at a number of quantitative indicators, as we see in this Barry Ritholtz analysis.

    Do these indicators capture the current situation?  A Cody Willard story yesterday explored several themes that match out own observations.

    • The Bears reign on Wall Street, according to the read of his networks.  It is anecdotal, but he is well-placed to know.  I might add that long-only managers are not getting inflows and that hedge funds use leverage, increasing their impact.
    • Sentiment indicators like AAII’s miss the mark — because….
    • The individual investor is out of the market.  This is the big one.  Cody’s conversations in his travels square completely with ours.  People lost money in 2000 and they have moved to the sidelines.  Many have turned to second and third homes and investment real estate.
    • The economic news has been given a bearish twist by people, even though their personal circumstances are fine.

    It is a nice article, but it would be even nicer to have some quantitative measures to back it up.  We will outline some indicators in our Contrarian Picks for ’06.

    Contrarian Investing Framework

    We’re going to come up with a better definition of a contrarian trade that gives us a framework for analysis.  In order to do that, it is helpful to look at the behavior of those accepted as charter members of the Contrarian Club.

    I nominate Doug Kass as a great example.  I enjoy reading Kass’s column "The Edge," on Street Insight.  Somehow he is able to run his hedge fund, finding the right trades to maintain his success, and still post a real-time log of what he is thinking.  He is also a frequent guest on various CNBC shows.  He takes pride in going against the crowd and finding the contrarian trade.  Right now, he calls himself the "Anti-Cramer."  Jim Cramer, long-time successful hedge fund manager, founder of, and now a TV Star on CNBC, is currently very bullish on the market.  Kass is very bearish.

    The stage is set.  I would like to use this to show the strengths and weaknesses of the Kass approach.  A couple of days ago, Kass cited the Business Week Story on forecasts for 2006.  His particular interest was in the economic forecasts, which he said showed evidence of positive bias.  He also cited the strategist forecasts in the same way.

    I submit that these two groups are very different.  You can be a successful contrarian with one, but not with the other.  To help show this, let’s open our minds by looking away from the investment world for a moment.

    Suppose that you are at Arlington Park, looking at The Racing Form for a big race.  Let us also suppose that there is a group of experts with excellent handicapping information about the race.  They have charted past races, analyzed the "trips charts," and developed their own speed ratings. They throw out certain horses knowing that they will not "be in the picture" at the finish.  The experts are not interested in the heavily-bet crowd favorites, since they have no edge.  They are looking for overlays, situations where the real chances are better than the quoted odds. They are the PhD’s of handicapping and they do their jobs well.

    Information about expert thinking has two important impacts.  First, their betting moves the odds.  Second, the information they produce may start to find its way into the crowd.  The odds adjust a bit.  A possible surprise winner might become 5-1 instead of 8-1.  The favorite might drop a little.  In short, expert information changes the price that are available to the bettors.

    But notice something important:  The opinions of the experts does not affect the outcome of the race!!  The horses do not know the odds and do not care.  The jockeys are not affected (unless there is a rare fix).

    Now let’s go back to Doug Kass.  When he takes a "contrarian" opinion on economics, he is not really finding any edge.  If he had to make his money betting against the consensus economic view that he cites, he would go broke.  Doug cannot change GDP, inflation, or corporate earnings by being contrarian, any more than a handicapping expert can change the outcome of the race.  Whe he takes a contrarian view, he is really saying that he knows more about economics than all of these experts in Business Week.  He has a theory that the consumer is "spent up, not pent up."  Does he not think that the list of economists in the survey think about consumer spending, savings, debt, inflation, business investment, etc.?

    This is the trap for the hedge fund manager or "chief global strategist."  You are supposed to think about a lot of things.  If you watch CNBC you will learn that a guy like Doug Kass seems to know economics better than the economists, monetary policy better than the Fed, how to run a company better than the CEO’s of assorted large enterprises in different market sectors.

    Doug does not mean it as arrogance, since his writing shows him to be a very nice, caring, thoughtful person.  Nonetheless, it is arrogant when one denigrates the expertise of professionals who spend their entire lives working on something that is a small part of your day.

    Doug’s skill comes not from doing economics better than economists, but from understanding how events will be interpreted through the prism of market perception.  At that, he is a true expert.

    Here at A Dash, we try to make optimal use of experts in every field.  If other hedge fund managers are not doing so, then we gain an advantage.  When it comes to the economy, we respect the economic consensus, even when we have some opinions of our own.

    To summarize:  Being "Contrarian" cannot change GDP or earnings.  Saying that you are "Contrarian" does not really make you smarter or more expert than all of the economists.

    You can win by being contrarian on how the market will react, but not on the events themselves.

    You, too, can be a Contrarian

    How many strategists and managers can be contrarian?  Why does everyone want to be one?

    As with many principles, the basic idea is easiest to understand by looking at extremes.  At market bottoms (or bottoms in specific stocks, commodities, etc.) no one wants to buy.  This is a terrific opportunity because the selling is over.  Ownership has moved into strong hands.  There is no one left to sell, so the stock is ready to rise.

    At tops it is the opposite.  Think of the famous story about Joe Kennedy and the shoeshine boy who offered him some stock advice.  Kennedy famously sold his holdings, avoiding the ’29 crash, since he realized that there was no one left to buy.  [I had a close eye on a hotel parking attendant in Denver a couple of weeks ago.  He headed for the business center, so I watched to see if he was planning a little online trading.  PHEW!  He was just checking his email.  Don’t laugh.  In 1999 I saw CNBC on in parking garages and assorted retail establishments with everyone checking quotes.]

    So every hedge fund manager or strategist wants to be a contrarian, since that shows there is a big opportunity.  You just have to find something where you can contend that everyone else is wrong and you have a lot of edge.

    There is a lot of interest in this topic right now, so I plan a series of posts looking at a framework for analysis, some examples of those who are taking contrary positions, a look at some of the indicators and why they are broken right now, and finally, my suggestion for the best contrarian trade.