Bearish News

VIX is spiking. Rally might actually be done (yes, it’s been said before). I sold most of my remaining AAPL today, from a lucky grab @81.86 here. Also shorted WFC on Monday @28.59.

chart via ZH

Since January of ’09, Citron Research has been warning about the questionable business practices of Apollo Group (owner of University of Phoenix):

Count on the Obama administration to take a fresh, critical look — as the largest single recipient of Student loans in this country is a for-profit institution whose insiders have sold hundreds of millions of dollars of stock while collecting over 75% of their revenue from government guaranteed loan funds, while delivering an education of questionable value amid a history of unsavory business practices.

Well, after-hours today the WSJ reports that the SEC is investigating some of Apollo’s revenue-recognition practices. The result? APOL down 17% after hours.

Apollo Group Inc. said the Securities and Exchange Commission has launched an informal inquiry into its revenue-recognition practices.

Apollo, whose University of Phoenix is the country’s largest private college and has benefited from the economic downturn, reported fiscal fourth-quarter results Tuesday that beat Wall Street estimates. But news of the probe, its second this year, sent its shares tumbling in late trading.

Finance Chief Brian Swartz said in a conference call with investors Tuesday that the company believes “that our revenue recognition policies are appropriate and in accordance with GAAP.” He added that it didn’t have “any further insight” into the probe.

For-profit colleges have come under fire numerous times for their methods of recognizing revenue, most of which is derived from government loans. Apollo received a letter from the SEC’s Division of Corporate Finance related to its revenue recognition in February and said in its conference call that, “to our knowledge,” it answered all of that division’s questions. The current probe comes from the SEC’s Division of Enforcement.

Apollo said that it took an $80.5 million charge in its fourth fiscal quarter to cover the costs of a possible settlement of a whistleblower’s suit pending in U.S. District Court in Sacramento, Calif. The suit alleged that Apollo owed the government refunds on billions in financial aid funds because it allegedly paid recruiter incentives based on the number of students they enroll. Federal education law bars such incentive payments.

Disclosure: Short APOL

Homebuilders: Short or Steer Clear?

KB Homes missed big today, reporting an $.87 per share loss. Their outlook on the market wasn’t rosy either. They dropped 8.5%. Builders appear to be a good short candidate. But like most industries, one needs to consider government interventions before shorting.

Major HB names are still up more than 100% from their 52-week lows. Kinda makes the S&P 500′s rally look meek:

1. Meritage Homes (MTH) up 307%
2. M/I Homes (MHO) up 198%
3. KB Home (KBH) up 145%
4. Ryland (RYL) – up 111%
5. Toll Bros (TOLL) up 47%

Government Crutch

Since last Fall, when a depression seemed imminent, builders have clearly benefited from government-support. The big question is: How long can this last? The Fed claims to be planning their exit strategy. But they always add a disclaimer, “not too soon“. Meanwhile, the fundamental side has changed little.

Cheap mortgages are here to stay for an extended period. Bernanke and Geithner have made this clear. They will do all it takes to prevent (or postpone) a depression. Cheap rates will buoy builders, but enough? This is where the homebuyer-tax-credit comes in, acting as another gross distortion of markets. Think about those people who bought a day/week/month before the credit passed. “Oh, gosh. You bought your home yesterday? Too bad.”

$8,000 Credit: Double and Expand It, Please

The first-time home buyer credit is scheduled to expire in November. But lobbyists are fighting hard to get it renewed. Congress seems likely to bite, despite our huge deficits. These market-interventions will largely determine the direction of home-builder stocks over the next year plus.

Sen. Johnny Isakson of Georgia, an ex-realtor, has proposed not only extending the credit, but expanding it to a max of $15,000. And he thinks everyone should be eligible in 2010; not just first-time buyers (WaPo). Bailouts and moral hazards don’t show any sign of abating.

So while the administration is under (a little) pressure to shrink deficits, more bailouts will probably pass. Our economic leadership views these market-distorting actions as victimless. Everyone benefits from rising home prices, right? Wrong. What about the millions of renters who are going to face higher taxes, due to drops in tax revenue? And what about responsible savers who have been waiting for homes to drop into their price range? They get screwed.

The Dreaded Spillover Effect

There would be a spillover effect on the broader economy if housing prices dropped. But do we really want to return to the days when houses were ATMs? Clearly that’s not sustainable. And despite falling prices, house valuation ratios remain out-of-whack. In a recent piece titled Falling House Prices Are The Solution, Not The Problem Patrick Killelea wrote:

It’s still much cheaper to rent than to own the same size and quality house, in the same school district. On the coasts, yearly rents are less than 3% of purchase price and mortgage rates are 6%, so it costs twice as much to borrow money to buy a house than it does to borrow (rent) the house itself. Worse, total owner costs including taxes, maintenance, and insurance come to about 9% of purchase price, which is three times the cost of renting. Buying a house is still a very bad deal for the buyer on the coasts, but it does make sense to buy in Michigan and some other places where prices have fallen into line with salaries and rents.

Shifting to a non-supported housing market too quickly would have negative effects. But we need to let housing prices fall much more than we have. It’s important to remember that we are fighting fundamental market forces here. Even the US government can’t really “win”. Something’s gotta give, someone has to lose. Let banks take the hit. They benefited from low interest for long-enough.

In short: For the immediate future, I won’t be shorting homebuilders. Too risky while all this cheap money is flowing. But I’ll be watching them, especially MHO, KBH, and MTH.

Disclosure: No positions in any companies mentioned
Disclaimer: None of this information should be treated as investment advice. Always consult a professional.

Do fundamentals matter?

David Tice doesn’t see this rally lasting more than six months. Part of me wants to agree with the legendary bear, who founded the Prudent Bear Fund (BEARX). He thinks equities are overvalued, and I couldn’t agree more. Bloomberg:

‘The economy is in really, really bad shape’ Tice said today in an interview with Bloomberg Television. The Federated Prudent Bear Fund that he founded returned 27 percent last year as the S&P 500 plunged 38 percent, the most since 1937. ‘So many people are trying to be optimistic. We’ve gone from oversold to overbought.’

But this irrational rally has legs, and could continue for a year, maybe even a few. Our current leadership seems determined to goose equity markets and sacrifice the dollar. Until the Fed starts contracting the monetary supply (if they ever do), I’m avoiding large short positions. Events over the last six months have caused me to rethink many aspects of US equities. In April I wrote:

Companies with horrific balance sheets are a dime-a-dozen these days. Fundamentals of the economy are bad and getting worse. Seems like a short-seller’s’ paradise, right? Not necessarily. Inflation and bailouts may be the factors that ultimately decide the battle between Bull and Bear.

Being in foreign assets, precious metals, and select equities may prove safer than shorts. The free-market side of me detests this, because US equities are incredibly overpriced. Being short makes a lot of sense, but as Keynes said “the market can stay irrational longer than you can stay solvent“. How ironic that current irrationality is due in part to his disciples.

It’s important to focus on what is likely to happen, taking into account political and economic realities, not what should happen. There’s too much manipulation, Fed-pumping, quant funds, and distortion to make bets based on logic and fundamentals. Not to mention suspicious short-squeezes.

Am I hedging my statements here? In a way. The direction of this market depends on the actions very small group of people. Gotta stay flexible, since we don’t exactly what they will do. What I’ll be watching most is interest rates. If the Fed tightens, that would be a very negative catalyst for US equities.

S&P 500′s Real P/E Ratio: 129

As I have noted multiple times, US equity valuations are ridiculously high. The real P/E of the S&P 500 is currently 129x. Don’t believe me? Check S&P’s site for yourself. Why is this different from P/E numbers you see, like the 20x number used in the Bloomberg piece on Tice? Two reasons:

1. Changes to accounting rules, allowing banks to sweep losses under the rug (FASB-157-4 in particular).
2. Increased use of “operating earnings” to hide losses. This is a relatively new phenomenon. See chart below and this post for a detailed rundown. The MSM and analysts use these “operating earnings” in their bull-cases, despite the fact that they don’t conform to Generally Accepted Accounting Principles (GAAP).

I don’t like this contrived rally any more than Mr. Tice. But I’m not nearly as confident in a major correction as he is. It’s certainly possible. If The Fed starts tightening, for example, it’ll be time to reevaluate. But the existing power structure will do everything possible to keep the party going.

Note: Prudent Bear is arguably the best long-short mutual fund out there. They maintain long positions in cheap stocks and gold miners to hedge against inflation, smoothing returns. Since January of 2000 (as far back as Google Finance goes) the fund has returned 49% compared to the S&P 500′s -25%.

Related:
Flaws in the Deflation Case (June 22nd 2009)
David Tice Interview with Bloomberg TV (Sept 22nd 2009)

Updated 9/23/09 for clarification

Disclosure: No position in any companies or funds mentioned. Nothing posted here should be considered investment advice. Always consult a professional when making investment decisions.