Nouriel Roubini is a legitimate economic superstar who travels around the globe offering his view of the financial world to eager audiences.  The Harvard-educated iconoclast is never shy about making bold predictions, and perhaps his most notable one was to predict the global credit collapse that began in 2007 and can still be felt all around us.  His words carry a lot of weight in the financial markets and are often reported through various media outlets, and from time to time we discuss his statements on this blog.  That being said, “Dr. Doom” may be losing some of his punch as we have observed his prognostications have become more docile as time has gone on.

The pressure to live up to a name like Dr. Doom may have weighed heavily on him since he was proven correct about the onset of credit crisis.  Let’s take a look back at some of the more notable statements he has made recently to see if he has actually becoming a moderating influence on the market.

November 2008 - Roubini warns that the financial crisis may be just beginning as there is a real potential for “Stag-deflation”, which would entail a stagnant economy and deflation.  Clearly, that would be even worse that the Stagflation that the U.S. experienced during the 1970s.  Further losses in the equity market would likely be unavoidable in such a scenario.

January 2009 - Roubini and his team at RGE Monitor estimated there could be $1.6 trillion worth of loan losses and another $2 trillion in mark-to-market losses of securitized assets, totaling in $3.6 trillion worth of damage to the capital markets thanks to the credit bubble’s burst.  Banks and Broker Dealers would incur about half of those losses, which led him to conclude that the banking system was borderline insolvent.  He argued financial institutions would need $1-$1.4 trillion of public or private investment to be adequately capitalized.

March 2009 - As the U.S stock market finally began to rebound, Roubini argued there could be at least another 20% of downside risk in the equity markets.

June 2009 - Roubini warns that the U.S. dollar is at risk of losing its status as the world’s reserve currency.  He reasserted his belief that, “Recovery will be weak, anemic, subpar,” and advanced economies will grow at a slow rate after the recession.

July 2009 - The market rallies largely on Roubini’s comments from a speech in Istanbul, Turkey which were interpreted as bullish.  He quickly refuted that analysis, and said his remarks were taken out of context.  He reiterated his warning that the recovery will likely look W-shaped rather than V-shaped.

October 2009- Roubini remarked there may be a light at the end of the tunnel, and government efforts around the world have likely allowed a “bottoming-out”.  That being said, politicians have little margin for error in monetary and fiscal policies matters to reverse course at the appropriate time.  In addition to these comments, he still warned of the remaining possibility of the double dip.

Fast forward to today, Roubini spoke to a crowd in Hong Kong and although his comments could not be construed as bullish, there has clearly been a softening in language.  According to Bloomberg, Roubini believes the ongoing rally in equities will likely see a correction in the second half of the year due to the threat of slower global growth and deflation fears.

A global rally in stocks may end in the second half of the year amid a muted recovery in the world’s largest economies and as deflationary pressures limit gains in corporate earnings, Nouriel Roubini said.

Failure to restrain asset-price bubbles in emerging markets, fueled by loose monetary policies in the U.S. and around the world, may also cause an “unraveling and a significant correction of asset prices which will be damaging to global and regional economic growth,” Roubini, the Harvard- schooled New York University professor who in 2006 foresaw the financial crisis, said in Hong Kong today. — Bloomberg.com 1/21/2010

In general, he thinks asset prices have advanced too far, too fast and are not supported by the fundamentals.  That is not all that iconoclastic of an opinion, and shows just how far Roubini has come from predicting nothing short of global financial meltdown a year ago.  Dr. Doom will probably never be a cheerleader for stocks or claim we are living in a goldilocks economy, but this is a substantial, if gradual, shift in his outlook.

Once thought inconceivable, an interesting trend was uncovered in the October 29th The Wall Street Journal, there are a number of debt issuing firms foregoing the traditional credit rating process.  In an article titled Credit Rating Now Optional, Firms Find, the Journal points out some globally prominent firms and governments have decided not to have their bonds and debt backed securities to be offered rated by any of the major credit rating agencies.  Instead, these issuers are insisting that their investors do their own analysis of the cash flows and risks involved in each security.

This is a noteworthy trend as ratings from the major rating firms like Moody’s (MCO) and Standard & Poor’s (MHP) in some cases were seen as a rubber stamp authenticating debt and its associated risks.  However, these agencies have come under scrutiny during the credit crisis as many of their ratings have been proven unreliable.  Some would argue that the credit crisis exposed risks in highly rated debt issues that seemed to catch the agencies asleep at the wheel.  The emergence of non-rated debt does suggest a lack of confidence or at least lack of necessity of these established guidelines.  As the CEO of Italy’s Gruppo Campari was quoted as saying, “Our reputation is good….I don’t think a rating would have mattered that much.”

The lost credibility is clearly not the only contributing factor to the rise of unrated debt securities.  Possibly more influential in these unrated issues is the speed at which the financing can be gained without a credit rating.  Credit rating firms can take months to issue a rating on debt, and not to mention this is not a cheap undertaking.  If a company needs capital more quickly, they can simply raise the rate slightly to attract more interest from institutional lenders who will be conducting their own due diligence with or without a rating anyway.  For the issuer, it is obviously a tradeoff between cost of capital and speed of the deal. 

For now, it appears there are enough lenders ready and willing to undertake their own review in order to attain a higher return.  With many institutional managers and hedge funds still smarting from the credit crisis, an extra return can easily compensate for doing more of their own research.  In some cases the extra interest earned over the course of the loan can be substantial, as the article points to this specific instance from Dubai.

“The Persian Gulf emirate’s economy has been hard hit by downturns in real estate and the financial markets, but its unrated bonds attracted risk-taking investors looking for yield.  The Dubai government sold the debt for a yield over 6%, compared with 3.85% yields on comparable debt of neighbor Abu Dhabi, which has a strong credit rating of double-A and recently provided Dubai with financial support.” — Credit Ratings Now Optional, Firms Find

The point of this post is not to pass judgment on the major ratings firms, as we all know plenty has been written and said about their short comings.  Rather, the point is to highlight an intriguing trend in debt instruments; a trend that has been used by firms such as Highland Capital Management, Heineken NV, Gruppo Campari and Credit Suisse (CS).  The credit rating firms provide a service that many investors cannot do without, and the evolution of unrated bonds should motivate them to improve and not repeat mistakes that have harmed their credibility.  However, the emergence of independent research and due diligence is what is more interesting to us at Ockham. 

At Ockham, we try to make a point of telling clients that no investors should rely on one source of information for an investment decision.  We think of our research as a baseline for understanding and an aggregator of information, but it cannot supplant additional due diligence.  Investments should be rooted in a true understanding of where you are putting your money, and risks should always be weighed.  The ultimate responsibility for an investment lay with the investor who has taken on the risk.

Goldman Sachs (GS) reported a wider-than-expected fiscal fourth quarter loss as virtually no segment of its business was unscathed by the credit crisis. The company reported a quarterly loss of $2.12 billion or $4.97 per share, the first quarterly loss in the company’s history as a public corporation and the first loss overall since 1929. Analysts had expected Goldman to lose in the neighborhood of $3.73 per share. Revenue dropped 37% in underwriting, 48% in investment  banking and 54% in financial advisory services. It comes as no surprise that there is simply less opportunity for Goldman Sachs in this environment yet, as Chief Executive Lloyd Blankfein noted: “While our quarterly performance obviously didn’t meet our expectations, Goldman Sachs remained profitable during one of the most challenging years in our industry’s history.”

Well, much to its benefit, Goldman was able to release the bad quarterly results on a day in which the Fed dropped rates to the historic low range of 0% to .25% at the FOMC meeting. Today, the Fed’s interest rate news seems to be getting more attention from stock investors than Goldman’s worse-than-expected quarterly results for the shares are actually up 11% in early afternoon trading. We fear that Morgan Stanley (MS), who reports tomorrow, may not be so lucky. Morgan Stanley is participating in today’s broad rally in financials and is actually up more than eight percent.  However, tomorrow is a new day and it is likely that MS will announce painfully weak results to a much less receptive market.

Expect to see down revenues across the board from Morgan Stanley tomorrow, much the same as they were for Goldman. Because of the credit crisis, there is simply less business in every area for investment banks–particularly on the deal side. This has necessitated that both Goldman and Morgan thin their workforces in order to cut costs in these lean times. For a telling sign of the times, average compensation at Goldman Sachs is down 45% from last year, to only $363,654 (how do they make ends meet?). Morgan was one of the banks that had significant exposure to the subprime mortgage market when that meltdown started and the firm has made a huge effort to reduce its exposure to such risky debt. Analysts expect Morgan Stanley to lose $0.34 per share and, even more troubling, also expect it to post negative revenue for the quarter from losses in trading and other operations.

Only three months ago Goldman and Morgan were expected to earn $4.00 and $1.10 per share respectively. Needless to say, there have been countless revisions downward since that time. These firms were allowed to operate with up to 30x leverage for many years, which inflated profits in boom times but such times are long gone. At Ockham, we do not put out earnings estimates, but it is clear that the two remaining major independent brokerage houses are in one of the most challenging environments in history. The air of Goldman infallibility is little more than a memory as the company has lost two-thirds of its market value in the last year. Here’s to hoping that Morgan exceeds expectations but it would not be surprising to see the market punish Morgan tomorrow for any slip-up and short interest in its stock has been growing this week.  Both of these company’s are undervalued compared to historical valuations but, these days, financial stocks are only for the bravest of investors.  They are simply to risky and volatile to merit our recommendation at this time.

Harley-Davidson, Inc. (HOG) stock has been crushed over the last three months losing more than 60% of its value. The iconic motorcycle company is dealing with a challenging economic environment and consumers who are less willing to make major expenditures, especially on nonessential purchases. When evaluating HOG, it is easy to see that the stock is at very depressed levels compared to its historical norms; however, it may be some time before Harley-Davidson’s underlying fundamentals levitate undervalued HOG shares.

First of all, we rate HOG Undervalued because its price has fallen very rapidly. Even though the company’s fundamentals, such as sales and earnings, are showing weakness, they have not deteriorated so much as to warrant this big of a price drop. When looking at the stock from a long-term perspective, in this case 10 years, HOG is selling well below historically normal valuation ranges. For example, over the last ten years the stock has normally traded in a price-to-sales range of 1.95x to 3.2x but, as of the most recent sales results, the stock is trading at just 0.7x. Furthermore, the company has normally traded in the price-to-cash flow range of 9.8x to 16.4x yet its current price-to-cash flow is only 3.9x. Rarely do we find these metrics at such depressed levels compared to historical precedents, even in this market!

Harley-Davidson pays a substantial dividend (eight percent plus yield) and that dividend appears safe for now. Also, Harley-Davidson has recently reaffirmed its earnings estimate for the full fiscal year to come in at just above $3.00 per share. So, the company is trading at a P/E of just over five. It is easy to see why the company is buying back stock, HOG is extremely cheap! However, it is always to important to resist looking at valuations in a vacuum. After a little bit of digging, we found sufficient reason to be cautious in recommending this stock.

In addition to a weak consumer discretionary spending environment, the company’s financial services branch has significant exposure to so-called “subprime loans”. An industry report states that as many as one third of loans outstanding from Harley-Davidson financial services branch have gone to borrowers with suspect credit history. It seems that as the consumer spending environment started to slack, Harley-Davidson began offering loans with interest rates as low as 3% or sometimes without making the borrower put money down on purchases. These are not the sort of sales we were hoping to see factored into our ratings methodology. This sort of activity prompted Business Week to claim that Harley financial services operated, “in a pattern eerily similar to the housing bust.”

Now, we know that in the last quarter the company reported $6.3 million in write downs for loan defaults. We do not want to overreact to a few million dollars in loan losses because, in the grand scheme of things, this is relatively small amount.  However, if there is anything that we have learned from the misery of the last year, it is that credit crises of this sort take time to fully unwind. There are far too many good companies with solid fundamentals that truly warrant our Undervalued rating and that do not have this potential liability for us to recommend HOG.

When you combine the potential credit issues confronting HOG and the fact that consumer spending is expected to be weak for at least the next two quarters, we do not recommend buying HOG shares right now. Although the valuation of HOG looks quite appealing based on what the market has traditionally paid for the shares, we think that there is ample reason to be cautious. You may be able to buy these shares even lower in the coming quarters.