When Spanish Stocks Rally, They Rally Hard

Question: How do you know ahead of time when a garden-variety correction is about to turn into a bear market rout?

Answer:  You don’t.

I would love to tell you that there is a tried and true way to make that distinction ahead of time, but there isn’t.  At best, you can look at past scenarios that were similar and handicap the odds to the best of your ability.

With that said, look at the recent performance of the iShares MSCI Spain ETF (NYSE:$EWP). The Spain ETF is down nearly 10% from its January highs and is in negative territory for the year.  Given the bad press coming out of Spain these days (a corruption scandal is threatening to tank to government that implemented the reforms that appeased the bond market last year), it is understandable if you fear that Spanish stocks are in the early stages of another bear market tumble.

iShares MSCI Spain (NYSE:EWP)
iShares MSCI Spain (NYSE:EWP)

But if this is the case, then the six-month rally in EWP would be one of the shortest on record.  When the Spanish market rallies, it rallies hard.

More importantly, Spanish stocks are cheap at barely 11 times earnings, and sentiment towards them remains horrid.  With European Central Bank President Mario Draghi suggesting this week that the euro is priced too high (implying that further monetary easing may be in the cards), my bet is that Spanish stocks are simply taking a short break before taking the next leg up.

Action to take: Buy EWP at market.  Use a 10% stop loss.

Disclosures: Sizemore Capital is long EWP. This post first appeared on TraderPlanet.

SUBSCRIBE to Sizemore Insights via e-mail today.

Europe Reaching the Boiling Point: How to Invest

For a year that started with one of the best first quarters in history, the second quarter has proven to be something of a disappointment.

On the first trading day of June, the U.S. averages had their worst performance of 2012, pushing the Dow Industrials into negative territory for the year. The S&P 500 is still positive for the year…albeit barely.

Interestingly, Spanish stocks—which have been at the center of the European financial crisis that has been roiling the markets—finished the day roughly flat. Sizemore Capital continues to allocate funds to select Spanish stocks, and the relative calm in the Spanish market gives us hope that much of the selling there has already been done. Spain is home to some of the world’s finest multi-national companies, and the state of crisis has created absolute steals that we may not see again in our lifetimes.

The Sizemore Investment Letter Portfolio holds positions in Telefonica (NYSE:$TEF) and Banco Santander (NYSE:$STD) and has additionally sold out-of-the-money puts on both. (See “How to Keep Your Cool While Investing in Europe” for more details on our put strategy.) Additionally, the Tactical ETF Portfolio holds a position in the iShares MSCI Spain Index ETF (NYSE:$EWP).

More than even bad news, markets hate uncertainty. And the uncertainly about the Eurozone’s future has wreaked absolute havoc on Spanish and European shares.

Spain’s effective nationalization of the ailing Bankia—the country’s third largest bank by deposits—had precisely the opposite effect of what you might have expected. Rather than cheer the fact that the Spanish government is taking the crisis seriously, it simply raised new questions about the Spanish state’s ability to afford the bailout of its banking sector.

The way forward is becoming increasingly obvious. As The Economist wrote this week, “Spain’s problem is one of misdiagnosis.”

The focus of the Spanish government and of the broader European Union (and particularly Germany) has been austerity. The thinking is that budget deficits must be slashed in order to restore investor confidence. The case of the United States—where both debts and deficits are higher than in many of the EU’s problem states—proves that this is not entirely true. After all, the yield on the 10-year Treasury note recently hit levels not seen since World War II.

As The Economist continues,

“This fiscal focus gets things exactly backwards. Spain’s poor public finances, unlike those of Greece, are a symptom rather than the cause of the country’s economic woes. Before the crisis Spain was well within the euro zone’s fiscal rules. Even now its government debt, at around 70% of GDP, is lower than Germany’s.”

In Spain, it is all about the banks. Outside of Santandar and Banco Bilbao Vizcaya Argentaria (NYSE:$BBVA), Spain’s banks are by and large insolvent and in need of recapitalization.

Again, using The Economist’s figures, a recapitalization of €100 billion would be roughly 10% of Spain’s GDP. Borrowing this amount would still leave Spain safely below the debt-to-GDP levels of the United States, but the country would have to pay punishingly high rates of interest given current market conditions.

On a side note, the Financial Times estimates the cost of a banking bailout to be much smaller. The FT points out that roughly 11% of Spanish bank loans are non-performing, which is less than half the level of Ireland, the country whose predicament most closely matches that of Spain. At 350% of GDP, Spain’s banking assets are large by world standards, but again, less than half the levels of Ireland.

What is the most likely solution? The budding consensus would seem to be using EU rescue funds to inject capital into the banks directly, which Spain is now advocating.

Currently, this is not legal under EU rules. But as the last year and half of on-again / off-again crisis has proven, EU rules are a bit of a work in process.

In any event, the next week promises to be anything if not interesting. Mariano Rajoy, Spain’s prime minister, publicly announced support for EU oversight of national budgets, apparently in an attempt to sweet talk German chancellor Angela Merkel. Separately, the European Central Bank indicated over the weekend that it was “prepared” to intervene with bond purchases or additional bank assistance if needed. And encouragingly, late last week, the EU announced that it would be lenient in allowing Spain another year to get its budget deficits under control.

What does all of this mean to us as investors? In investing, as in many of life’s endeavors, it is always darkest just before the light. And it would appear that we’re starting to see a sunrise in Europe. Sizemore Capital will look for opportunities in the weeks ahead to profit from the resolution of Europe’s crisis.

 This article was originally published as Sizemore Capital’s monthly market commentary for Covestor.

Telefonica: Latin American Growth, Crisis Prices

“Buy low and sell high” is the standard advice of any value investor. It can also be remarkably hard to put into practice.

You see, we humans are herd animals, and we tend to think and act as groups, particularly during times of stress. Call it the primal human instinct to seek strength in numbers.

Unfortunately, while this instinct may ensure our survival during times of war or natural disaster, it handicaps us as investors. When we see others panicking we too sell in fear or stand paralyzed in indecision at exactly the time we should be buying with both fists.

All of this is a lengthy introduction to the subject of this article, Spanish telecom giant Telefonica (NYSE:TEF).

Telefonica has had a rough year. The price of its U.S.-listed ADR are down nearly 70% from their pre-2008 highs. The domestically-traded shares have fared slightly better do to the lack of currency movements, but results have been dismal nonetheless.

Spain’s crisis has become Telefonica’s crisis. As the most liquid stock in the Spanish stock market, Telefonica has become a proverbial punching bag and an outlet for traders wanting to short the embattled Eurozone country.

This article was published on GuruFocus.  To read the full article, please see The Case for Telefonica.

Eurobonds: What Are They and Why Do They Matter?

By the time you read this article, Greece may or may not still be in the Eurozone.  But whether Greece is in or out, the European sovereign debt crisis will almost certainly still be raging on.  The focus of investor worry has, in any event, moved westward to Spain.  The Spanish 10-year bond yield hit 6.5% on Monday, and the spread between Spanish and German yields hit a euro-era record.

While there are no quick fixes, one of the options on the table is the issuance of Eurobonds.  The precise mechanics of how an issuance would work remain unresolved, but the basics are simple: the 17 member states of the Eurozone would issue bonds collectively and accept joint liability for the outstanding debt.

Before you draw the wrong conclusions, this is not at all similar to the United States federal government issuing Treasury securities.  In that case, the U.S. federal government raises funds for its own operations, not the operations of the 50 U.S. states.  Imagine instead the 50 U.S. states borrowing collectively and distributing the funds amongst themselves, and you can quickly see why the proposal is controversial.  Texas, a low-tax, small-government state would not be particularly fond of effectively guaranteeing the debts of, say, big-spending, high-safety-net California.  Likewise, German or Dutch citizens would resent lending their own country’s credit rating to less-disciplined problem countries like Spain or Italy.  And in the case of Germany specifically, such a move would likely be unconstitutional.

Suffice it to say, the issuance of Eurobonds would be one of the more difficult solutions to implement, but the idea is not without its merits.

For smaller, non-crisis countries, such as Austria or Luxembourg, the increased liquidity of a Eurobond relative to their current, relatively illiquid domestic markets would mean lower yields and borrowing costs.

And for crisis-wrecked countries like Spain or Italy, their bonds would effectively enjoy Germany’s rating, and yields would be more than halved overnight.  Such a move would make their debts payable and take away the immediate threat of meltdown.

Unfortunately, there is that pesky little critter known as “moral hazard” that presents a challenge.  Germany wants to keep the pressure on the Eurozone’s problem children in the hopes that the fear of meltdown will force them to implement needed economic reforms.  And they rightly fear that bailing out the periphery countries too soon will breed complacency and that the reforms will simply never happen.  Essentially, they want to avoid creating another Greece.

For these reasons, a Eurobond scheme would have to have some kind of enforcement mechanism to ensure that the problem states kept their budgets under control.  But this would also mean some kind of new treaty, because nothing in the European Union’s assorted arrangements or institutions allows for anything strict enough to make the plan workable.

Whatever Europe’s leaders decide to do, they had better do it quickly.  Their indecision has consequences.

Virtually everyone practicing the investment management profession today was taught in business school that markets efficiently process information and reflect that information in market prices. Prices reflect the underlying reality.    Therefore, rising bond yields reflect investor fears about the creditworthiness of the borrowers in question.

The problem, as George Soros explained in his Theory of Reflexivity, is that the tail also wags the dog.  Prices not only reflect the underlying reality; they affect it as well.  Rising yields have a way of creating a self-fulfilling prophecy; investors, by pushing yields to unsustainable levels, effectively create the event that they feared most by pushing the borrower into default.

At time of writing, I do not believe that Spain or Italy is at risk of default, and in fact I have several open positions in Spanish stocks (see “Bargain Hunting in Spain“).  But part of my bullishness is predicated on my belief that the European Central Bank will act aggressively to force down yields to more sustainable levels. I also expect Germany to take a more relaxed stance when presented with the truly awful alternative of a Eurozone meltdown.

We shall see.  But until something close to an agreement is made, expect the volatility of recent months to continue.

Christmas May Come Early This Year

It’s a little early for Christmas in July, but now is the time for investors to be putting together their “Christmas lists” of sorts.

Recently, I wrote a piece that described an old investment strategy of Sir John Templeton (see “An Anniversary We’d Prefer to Forget”).  Sir John would make a list of companies he’d love to own “if only” they fell to a more attractive price.  He would then place limit orders to buy those companies at prices substantially below the current market price.  In the event of a sharp selloff, the limit ordered would be executed, and Sir John would have his shares at the prices he always wanted.

His rationale for the strategy was simple enough: we humans are instinctively herd animals, and we tend to panic when we see others around us panicking.  We lose our independent judgment and we freeze in fear at exactly the moment we should be buying aggressively.  Templeton’s move was designed to take his own emotions out of the equation; Sir John understood his own human shortcomings, and essentially gamed himself.

Today, with Europe teetering on the edge of a potential meltdown,  I’m going to recommend that investors take a similar approach, though mine has the added bonus of adding a little extra income.

I recommend that you make a list of strong multinational companies based in Europe that you are confident can survive Armageddon with their businesses intact.  Ideally, these companies would have significant percentages of their revenues coming from outside of the Eurozone.

Once you have your list of stocks, consider selling deep out-of-the-money puts on them.  If prices remain relatively stable or rise, the options expire worthless and you pocket the premium.  And if the share prices take a nosedive, the options will be exercised and you will be obligated to buy the shares at the prevailing market price—which was your objective all along.  And you still get to pocket the premium.

Here a little explanation is needed.   When you buy an option, whether it be a call or put, your risk is limited to the price you paid for the options.  You are buying the right to buy or sell shares at a given price, not the obligation.

Selling, however, is a much trickier business.  Your upside is limited to the premium at the time you sell the option.  But your downside is much, much bigger.  In fact, when selling a naked call option, your risk is theoretically infinite.  For example, if you sell the right to buy Facebook (Nasdaq:$FB) at $38 to another investor and the stock rises to $100 the next day, you’re on the hook to buy at the prevailing market rate of $100 and sell at $38.  Not an appealing prospect.

Likewise, when you sell a put, you are giving an investor the right to sell you shares at a price that might be far higher than the prevailing market price.  So, when selling put options on your list of European stocks you’d like to own, make sure that you have the cash on hand to handle the trade if it is exercised.  Don’t get greedy and sell contracts for more shares than you can afford to buy or that you would ideally like to own.

I’m not going to recommend specific put option contracts for you to sell because the entire point of this article was for you to create a list of stocks you like at prices you want to pay.  I also want the advice in this article to be general and something that you can use months or years from now; recommending a specific contract would make this article too short-term for my liking.

I will, however, toss out a few company names for you to consider.  Last week, I recommended Spanish bluechips Telefonica (NYSE: $TEF), Iberdrola (Pink:$IBDRY)and Banco Santander (NYSE:$STD) (see “Bargain Hunting in Spain”).

I continue to like all three, and to this list I would add French oil major Total (NYSE:$TOT) and British telecom giant Vodafone (NYSE:$VOD).  While Vodafone is not a Eurozone stock, it has significant operations in the Eurozone and I would expect its share price to take a tumble in a general market rout.

If you’re not comfortable with options, that’s ok.  You can accomplish essentially the same thing by placing limit orders like Templeton.

Disclosures: Sizemore Capital has positions in TEF.

This article first appeared on MarketWatch.

Related Articles
[related_posts limit=”3″]