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Hedge Fund Stars Gundlach and Einhorn Have a Sixth Sense --They See Dead Countries


Date: Friday, May 18, 2012
Author: Susan Kalla, Forbes

At the Ira Sohn conference Wednesday, rock star investors gave their best picks to a well-dressed group of 2000 attendees from hedge funds and mutual funds around the world.  At the 17th Annual Conference, where proceeds go to fund pediatric cancer research, portfolio managers hung on every word of the billionaire speakers. No wonder trades are highly correlated. The conference highlighted red flags from the bearish speakers. 

China Will Crumble

The Chinese have funded many of their major infrastructure projects with dollar-denominated debt, and the funding source (the US) has dried up. Unfortunately, the Chinese government may need more cash to complete the infrastructure projects. The projects don’t generate adequate cash flow and are non-self-sustaining. With the increased credit risk, spreads could widen making new loans more expensive.

David Einhorn of Greenlight Capital pointed out that the Chinese face overexpansion and indebtedness that could slow the GDP for the country.  As reported in  Market Folly, Einhorn said, “there is big trouble in China, where overbuilding outside of main cities [may force a day of reckoning], since the projects don’t pay off the debt service. Now that US dollar-denominated loans have dried up, the gig is up. Chinese banks are in trouble along with the infrastructure projects. And, Chinese elites [sensing the oncoming train wreck] are taking money out of the country.”

Latin America is Loan Averse

Credit problems are also growing in Latin American, where the currency crisis has heaped on more stress. Jeffrey Gundlach of DoubleLine Capital pointed out how dramatically Latin American currencies have fallen relative to the dollar. So, Latin American borrowers see their revenue and cash flow depreciating while their interest obligations are appreciating. With the local currency and the dollar moving in opposite directions, the borrowers are losing traction in their ability to pay down and service the dollar-denominated debt.  So, as the local currency depreciates, so does the cash flow. Already, Argentina has stepped in to nationalize indebted companies in trouble, which transfers the problem to the public balance sheet.

Air Coming Out of Growth Balloon

The worsening credit problems will depress GDPs in emerging economies.  Likewise, in the US, the third leg of the stool for global economic growth, the consumer credit problems will stymie GDP growth.

Indeed, many speakers at the conference jarringly noted the potential for credit calamities throughout the world. The underpinnings of the global financial system may be weaker than most investors realize due to the persistent credit problems. Macro issues, that is, problems in credit and currency can bring down the banking system, as we saw a few years ago in the US.  If the macro issues worsen, stocks could correlate more tightly and move down together with credits.

 In summary, the macro warning signals are:

  1. Einhorn said China faces a further slowdown in GDP growth because the influx of dollars has stopped.  Large borrowers can’t service their debt, and with the rising spreads, options are limited.
  2. Gundlach indicated in the US, consumer credit-card debt is a bubble, and a weakened consumer will pressure GDP growth. 
  3. Gundlach also said in Europe the unemployment picture hints to Germany’s intentions in the crisis. The unemployment per country ranges from 5% to 22%, with Germany at the low end and Spain at the high end.  Germany’s low unemployment relative to the others indicates it is not willing to bailout the weak countries. 

Tech is Tough

Some calls from the conference were polar opposites, but the differences could be explained by timeframe. For example, Einhorn recommended Apple as a buy, and Gundlach recommended it as a sell.   Apple may be volatile over the next year so there are plenty of chances to make money trading it either as a long or a short.

Einhorn’s bull case stems from his belief that Apple is a software company, not a hardware company.  As such, its operating platform is makes the products sticky.  (Note: our view is Apple is an ecosystem company. The business model is sustainable because it plays across hardware, software, retail and media.)  Einhorn is also long Microsoft (MSFT) and Marvell Technologies (MRVL).

On the other hand, Gundlach does not like Apple’s chart, a parabola.  And he does not like the fact that Apple correlates tightly with Google despite the differences in the two business models.    

Other managers were bullish on tech, media and retail.  Bill Ackman recommended JC Penny (which got a lot cheaper after the earnings call yesterday).  Meryl Witmer recommended media giant, Viacom.  And, Phillippe Laffont recommended Virgin Media as a broadband-Euro play. 

Gas is Good

As a final note, several managers mentioned natural gas as a timely investment. John Wilder from Bluescape Resources had a compelling presentation.

He is bullish on natural gas as he believes the oversupply situation is an anomaly. According to Market Folly, Wilder said, “There was a huge increase in supply in North America in 2011, the biggest yearly increase in history.  About 30% of the additional supply was due to technology breakthroughs. Gas rig activity doubled from 2002 to 2008, but only 40% of it was from the four main players: Marcellus, Fayatteville, Haynesville, Barnett.  

While supply grew steeply, demand stayed steady, so prices fell. The US is in the process of switching from coal to gas. Gas prices dropped from oil parity to coal parity. Now gas prices mirror the cash cost of production. The situation will not last.  Expect to go back up to coal substitute pricing, but not back to oil parity.”