In his latest letter David Einhorn first of all proceeds to unload on the epic accounting gimmick that was GE's $16 billion charge, which to the Greenlight manager is confirmation of how the industrial conglomerate was cooking its books for years:
GE’s staggering $16 billion after-tax charge will drain another 5-7% from the S&P 500 quarterly earnings. Given that GE is exiting these portfolios after several years of economic and valuation recoveries and still has to take an enormous loss, the gigacharge adds clarity to the multi-decade debate about the integrity of GE’s reported results. That GE chose to exit and finally own up to its cumulative chicanery rather than face its first Fed-supervised stress test is one of the first real successes of Dodd-Frank.
... but more importantly notes that the time to lower exposure has arrived, and is precisely what he has done: "During the quarter, we reduced our net exposure from 30% to 14%. This move was driven both from the bottom-up and the top-down."
Why? Two reasons:
Bottom-up: Short candidates are easy to find, but as noted above, the opportunity set on the long side is quite constrained. Most of the investment theses we have reviewed over the past several months can at best be described as late-cycle opportunities, with valuations that often ignore historical economic sensitivity. The operating (and in some cases activist) execution needed to achieve target results has to be rated at Triple Lindy difficulty level.
Top-down: Valuations are on the high side and earnings are in a precarious spot. Last year’s snow slowed the entire economy, setting up the first quarter to be the easiest comparison quarter of the year. It nonetheless hasn’t turned out to be a good quarter (despite this year’s snow confining itself mostly to New England). At year-end, first quarter earnings were supposed to grow about 5%, but now, they are expected to decline by a similar amount, and this doesn’t even include GE’s large, anticipated first-quarter charge as it exits most of GE Capital.
The full year S&P earnings outlook is even worse, as the comparisons become more challenging.
As a result not only is Einhorn lowering his net exposure, he is also adding shorts:
At the bottom of the cycle, firms cut labor faster than output. The higher productivity led to improving margins, earnings and stock prices. Now labor is being added faster than output, and with large companies like McDonalds, Walmart and Target announcing pay increases, unit labor costs are likely to increase further. All told, there is a good chance earnings will actually shrink this year. We think the market is too high if earnings have, in fact, peaked for the cycle, and we have reduced our net exposure by adding more shorts.
The only good news for bulls is that according to Einhorn at least stocks are not all in a bubble, just a few.
The bull case is that equities haven’t yet reached bubble levels at a time when fixed income is behaving bubbly, and that the Fed will support the market. As to the former, it may prove true. We don’t like the proposition of betting on a bubble, though one may yet emerge (or, more clearly, a bubble might expand beyond the current small group of high flying stocks). As to the latter, despite all the attention paid to every utterance of any member of the FOMC, it is clear that the Fed isn’t going to add further accommodation unless conditions deteriorate substantially. How fast it tightens should be less important than the fact that it will tighten.
Finally, we echo Einhorn's question to Draghi and we hope that someone in the next ECB press conference will ask it, assuming of course Draghi doesn't have any more close encounter of the confetti kind:
Mario Draghi says he sees no sign of a bubble in the sovereign debt market, which raises the question: what does Mr. Draghi think a bubble in sovereign debt might look like that isn’t already evident?
Perhaps for the right answer Draghi needs to consult with the Fed's bubblebusters first, and specifically Stan Fischer committee on "avoiding asset bubbles" because clearly German 10Years at 0.07% and 53% of all global government debt trading below 1% is not it.