Energy, Gold and BRICs

Here is more fodder for consideration:

Energy, as a percentage of the S&P500, peaked at over 20% in 1980. It then declined to near 6% in 2000. Now it is back at 10%. So, the price of energy stocks could double versus the rest of the market before they were historically overvalued / near a top.

Gold is a similar story. Gold relative to oil also peaked in 1980 at $800 versus oil at $40 per barrel. Normalized for inflation the past 20 years, the comparable price of oil would be $100, which means the comparable price of peak gold would be $2000. If the dollar continues to decline, then dollar inflation relative to 1980 (as a baseline) will increase this equation and $150 oil and $3000 gold at the next peak. If the pattern from the 70s repeats and we are at about 1972 right now (using the Bretton Woods II thesis), then we would see this scenario play out by 2015.

The above scenario is given a fixed world market for oil and gold. But it can be argued that the global supply of both gold and oil is tighter in 2007 and the demand is greater with the development of the BRIC economies (Brazil, Russia, India and China). So, lots of upside.

Bretton Woods 2: Wither American currency?

I had to share this article with you. It is a reminder that relative global interest rates and their effects on currency exchange rates are what really matter in investing. All the rest is just noise.

China and the ROW have been financing America for a long time, at least since 9/11, by buying up our Treasuries in exchange for the dollars they get from exporting to our consumers. This has allowed our interest rates to remain artificially low and has encouraged consumption and spending, including the housing bubble. It has kept our financial markets (and financial stocks like banks and brokers) strong and supported full employment (by financing production of consumer products and services).

So what happens when this trend reverses? Interest rates go up, financial assets including housing prices go down and inflation erupts. Eventually, unemployment increases and we get a recession. Through all of this, the only safe place to be, relatively, is in hard assets like oil and gold. The real value of hard assets remains constant through time, which means they increase in value relative to a declining currency like the dollar. Here is the article by economist Randall Forsyth in today's Barrons:


Bretton Woods II: About to Follow the Original?
IS BRETTON WOODS II heading for the same fate as its predecessor?

Bretton Woods is shorthand for the postwar international monetary system, named for the New Hampshire resort town where its blueprints were laid out by the Allies in the latter days of World War II. The rules called for currencies' exchange rates to be fixed against the dollar, whose value in gold was set at $35 an ounce.

In reality, however, foreign central banks would buy dollars to keep their currencies from rising in violation of the Bretton Woods rules. That would require the central banks to expand the supply of deutschemarks, yen or francs, to purchase the excess dollars, which was inflationary. Finally, when they started demanding gold for their dollars, then-President Richard Nixon closed the gold window on Aug. 15, 1971. About a year and a half later, the dollar would float along with the currencies of the other major industrialized nations.

The improvised, more-or-less floating exchange-rate system has prevailed since 1973, about as long as the designated-hitter rule in baseball, and equally unsatisfactory to purists.

Bretton Woods II arose not from some formal treaty but as an ad hoc response to the Asian financial crisis that began 10 years ago next month. Then, the currencies of most of East Asia were informally pegged to the dollar. The Thai baht came under attack, and the pegs of much of the rest of the region's currencies were threatened in turn.

The domino theory, so feared in the Vietnam era, came to fruition in the financial markets as hot money fled the region even faster than it entered. The culmination came a year later, following the Russian ruble collapse, which triggered the Long-Term Capital Management near-meltdown.

That's prologue to the present situation. In contrast to a decade ago, emerging economies around the globe, from Asia to Latin America to Europe, generally run substantial trade surpluses and are accumulating vast foreign-exchange reserves. The main reason: to forestall a rise in their own currency's exchange rate, which would harm their economies' export competitiveness.

As under the original Bretton Woods system, the signal aspect of Bretton Woods II is the willingness on the part of foreigners to hold U.S. dollars. In the current regime, that's meant recycling their mounting surpluses mainly into U.S. Treasury and agency securities, providing cheap financing for the budget deficit, American homeowners and the capital markets.

But, as in the early 1970s, the rest of the world is balking at continuing to accumulate dollars at the same pace as before. Bridgewater Associates' Bob Prince and Jason Rotenberg write in the money manager's Daily Observations letter that private-sector accumulation of dollars abroad overseas has been essentially nil.

Central banks have been forced to step into the breach, buying the dollars needed to fund the U.S. current-account deficit, which is equal to about 7% of gross domestic product. In other words, America spends $1.07 for every dollar it earns. Foreign central banks lend us the difference, a form of vendor financing for all those goods produced abroad, especially oil.

In the process, China has accumulated $1.2 trillion of foreign-exchange reserves. Rather than keep piling up Treasuries ad infinitum, China will invest $3 billion of that in Blackstone, which sounds like a lot but equals 0.25% of its reserves.

Less well-publicized is that central banks are just saying "No" to piling up greenbacks. Not selling, mind you, as the disaster-movie scenario envisions; just accumulating at a slower rate.

There are signs that's beginning to happen, as the Bridgewater duo detail. In just the latest, this week Syria became the second Middle Eastern nation to abandon its currency's peg to the dollar, which followed a similar move by Kuwait last month. Meanwhile, a parade of countries has directed an increasing portion of their reserves away from dollars and euros. Among them, the United Arab Emirates, Switzerland, plus America's good friends, Venezuela and Russia. And China announced this week said it, too, will increase the euro's share of its currency cache -- not reducing dollars, but not adding to them as much.

Syria? United Arab Emirates? When the dollar was being attacked in the early 'Seventies, the dollar was losing value against the Italian lira, long considered a joke among currencies. Informed of this, Nixon was famously captured on the Watergate tapes as saying, "I don't give a f--- about the lira." Later, the dollar would plunge, sending the price of everything, notably oil, soaring. (Question: which was more traumatic back then, Watergate or gas lines and soaring unemployment?)

Conversely, in recent years, if there's ever been a free lunch, the dollar has come closest for America. Because the rest of the world wants greenbacks for transactions or as a store of wealth, the U.S. can print dollars to cover the gap between what the nation spends and what it earns.

But as foreign central banks have become less ardent accumulators of dollars of late, U.S. Treasury security yields have been marching higher. Sure, the bond market has gotten over the notion that the Federal Reserve will cut rates any time soon. More particularly, as bonds have retreated, the dollar's recent recovery has stalled. Could there be a connection?

Bretton Woods II essentially translates into foreigners' absorbing a nearly infinite supply of dollars, which they recycle into the credit markets, funding everything from subprime mortgages to private-equity LBOs to the budget deficit.

They'll do that as long as it serves their purpose, mainly to keep their currencies in check to keep their exports strong. Once it no longer suits them, they'll withdraw from Bretton Woods II just as they did with the original. And U.S. bonds and stocks won't like it.

Redflex picks up Albany OR contract

Don’t run any red lights in Albany.

You may recall that about 18 months ago I invested in an Australian company called Redflex. This company makes automated traffic control systems, and sends you a ticket in the mail if you get caught running a red light. Sue got caught by one of their systems in Minneapolis about 2 years ago. I was so impressed with the technology, I began researching it and really liked the business model. Redflex splits the fines with the city in return for installing and running the system (so the city pays nothing for enforcement). It was just getting started in America, so I got in early. This business model is the ultimate monopoly since the business is protected by a city contract, and people will continue to break laws, right?

Now, you get the benefits (as long as you don’t run a red light) of this technology. Safer streets and more police time to chase bad guys rather than monitoring intersections (or speeders, when you get the Redflex speed enforcement system down the road).

I see that Salem also just entered a contract with Redflex. Corvallis has not done so yet. California and Washington have many systems, as does Arizona. Redflex USA is based in Scottsdale.

If you want to buy the stock, you can buy on the Australian exchange, ASX, as RDF for about $3.19 per share. In the USA, you can buy OTC as a pink sheet stock: RFLXY for about $20 (there are 8 ASX shares to one OTC share, times the exchange rate difference of 1.30 to 1). The price is now just about where it was when I bought in, so you haven’t missed anything. It is a small / speculative stock, so I wouldn’t buy too much. But it will be fun to see their systems around town as a stock owner.

Here is the announcement and the website.

http://www.redflex.com.au/ASX_announcements/PDF/432390.pdf

Market Strategy - May 2007 Checkpoint

I am still sticking with my original forecast for 2007, though the timing has changed a little. I always disclaim any timing calls because there is no way even the most educated, smart people get this right every year. There are just too many variables, especially now that we are in a world economy. But my general thesis is based on history repeating in some ways. Value is value, so that remains constant and is the basis for all other decisions. I had suggested that the first half of the year (through the summer) would see declines, followed by a rally at the end of the year into 2008 leading up to the elections. The year before presidential elections is almost always good for the stock market.

When the market corrected by 6% on Feb. 27, I thought I had this call nailed. But then the market came roaring back to new alltime highs on the Dow 30 the past month. I still think this summer will be weak and the decline could start any day. However there is a big BUT and that is global liquidity (many years of good profits in raw materials) and the China expansion prior to the Beijing Olympics. Our economy is now global and what worked in the past for American markets, is now influenced by global markets. So, maybe the Melt-Up continues. Here are the arguments for both directions, up and down:

1. The market is neither cheap nor expensive at around a P/E of 16 for the Dow and around 20 for the S&P (which has smaller cap companies). This makes direction difficult to choose. It is why my own portfolio is somewhere in the middle with about 67% equity and 33% cash and almost no bonds, since it is possible interest rates will go up from here as the dollar devalues (to attract money back to the dollar, the Fed can raise interest rates). Of the equity portion of the portfolio, most is in "value" or low P/E stocks like Health Care/Pharma (now historically cheap), Energy or Basic Materials. You know I am heavily in the CanRoy oil trusts both for their value and their large dividends. The big dividends provide the income and diversity that bonds would otherwise provide. Dividends provide a cushion against a potential market downturn.

While attractive from a fundamental, world growth, point of view, materials stocks like FCX and BHP have become more expensive on an absolute historical basis. But, their profits are growing almost as fast as their stock price, keeping relative value almost constant. The potential demand from China and Asia for infrastructure development has the potential to dwarf anything the world has ever seen. Materials companies with operations in that part of the world (both FCX and BHP have big operations in Australia and/or Indonesia) will benefit for years to come. That is unless the China economy were suddenly to come to a halt or collapse. This is possible over the next 12 months as the big push for the 2008 Olympics in Beijing comes to a close. There is a lot of risk in the China economy right now as it is growing at historically unsustainable rates (for a national economy) of over 10% a year for the past 5 years. It makes sense that once the artificial, government led push for the Olympics is done, that the Chinese market will cool off, and maybe cool off the entire world economy.

2. Other than the Olympics thesis, it is not possible to know for sure what might change the current global synchronized economic expansion. Various war scenarios are speculative, they may but probably won't happen. There really is no precedence for this global economy. There was a 20 year period before World War 1 that saw global peace and prosperity with lots of free trade. And again in the 1950s, during the reconstruction after World War 2, there was a 20 year period of the same (Korea in the 50s notwithstanding). But during those periods, there was no internet or global communications. It was also before the era of global air freight and the fast movement of goods and people around the world. So, the expansionary period since the last big recession from 1990-1992 is exceptional. The current environment that favors industrial goods and basic materials is also without precedent (the construction of industrial infrastructure in the USA took 100 years and America is only 20% the size of China by population). High demand and short supply for raw goods could continue for another decade or more, until global infrastructure development slows, or materials production facilities dramatically increase supply.

3. We are now officially in a bull market from the lows in 2003. We did not know this for sure until earlier this year when the Dow went past 11,700 surpassing the previous high from 2000 (the S&P500 has not yet confirmed with a new all-time high, but is only about 2% away at 1510). Bull markets tend to have 5 distinct segments: up for several months to a year, then a 10-15% correction; up for another several months, then another 10-15% correction, and then a final up move which can have a big "melt-up" at the end before it collapses from its own prosperity and exuberance. This was the pattern from 1992 into 2000.

It could again be the pattern, with the correction last summer of 10%, now followed by the up leg which may be "melting up" right now. Note that the every day public investor like you or me is typically the last to get into a bull market (even though we all probably have mutual funds investing on our behalf all along the way). People who follow such data professionally say that the public is still on the sideline and never got back into the market after the 2001-2002 collapse. Until that money comes in, the market can't make a true bull market top. By definition, tops in stocks or in stock markets happen when everyone who ever will buy has already bought. Then, there is no one left to buy at a higher price, so all that can be done is to sell, driving the market lower (into a bear market).

The way we can know a major market turn as average people without access to industry data that shows this action conclusively, is to watch major magazines and newspapers. When the media headlines start talking about a New Era and featuring great riches earned (or lost), we know we have either a market top or bottom. You may have noticed a year ago that all the talk was about how EVERYONE was making money flipping real estate. That was the sign that the top had been reached in that market. Same thing was true in 2000 with all the talk of the Internet changing the world and creating a new era and people day-trading tech stocks that had no earnings.

So, if in the next few months, everyone gets in, then that will spell the top of the market. Since that time is hard to see until it has passed, it is probably good to have one foot in and one foot out of the pool. At this stage of the cycle, investments should be defensive (lower P/E and non-cyclical necessities of life) with a lot of dividends to provide a foundation for the stock should there be a correction.

4. The dollar continues to weaken against world currencies. Fewer nations are using the dollar as a benchmark. Japan still does, but says it may not in the future. China is gradually moving away from the dollar as its standard, slow enough not to hurt its export economy. As the world moves to other currency standards (or "baskets of currencies"), and the US goverment continues to run big deficits, the dollar MUST continue to devalue. This will move the price of all world raw goods, especially precious goods like gold and silver, higher in dollar terms, even if the prices stay constant in other currencies. Gold, then, is a good hedge against devaluation, as are energy plays like the Canroys or the other Materials stocks like BHP or FCX. In fact, the first quarter's supposed "earning surprises" to the upside were mostly a result of currency translation by the big multi-national companies issuing those earnings reports. When the dollar goes down against the Euro, then all profits from Europe earned in that currency will appreciate by the amount of the decrease in the dollar. The dollar decreased by about 8% in Q1. That was about the same as the "earnings increase" reported on average. So, on a weighted basis, profits in real dollar terms may have only increased by 2-3%, not the 8% reported. This will eventually catch up as year over year comparisons do not benefit from currency translations in the future (if the dollar stops sinking).

If you are looking for an idea, other than precious metals / gold (VGPMX) or the CanRoys I recommended in January that you bought, I am now buying and recommending BDJ and DHG. BDJ is a twist on "Dogs of the Dow" investing. It buys the highest dividend Dow 30 stocks and does so with borrowed money which leverages the return. It also uses a Covered Call options strategy to further enhance payouts. Covered Calls are a good defensive strategy and easier to execute on large cap Dow stocks when working with big money in a fund like this (options fees are high compared to the available returns on these big name stocks for average investors). The return is currently around 8.3% with a monthly payment. The payment has been steady for a couple years at a little over 10 cents a share per month. Share price is right around $15. If the Dow goes up, so will the price of BDJ, as its portfolio appreciates. But it is a closed-end fund, so underlying value (NAV) and the market price can be and usually are different. Make sure you don't buy at a premium to NAV. It is a small discount right now, so a good time to buy.

Another closed end that I have started buying is DHG with a dividend return around 7.8%. This is more of a commercial paper (short term loans to companies with high interest rates) and a high dividend fund specializing in deep value stocks (including some CanRoys). It is run by Dan Dreman's fund company. Dreman is a renowned value investor. This one is brand new and so has had a pretty spastic market price as a closed-end can, even though the NAV has hardly changed at all.

Both the above benefit from a lot of diversity. It is unlikely either will get hammered in a market selloff on NAV (market price MIGHT get hurt, but would quickly rebound. The payout probably won't change, so the yield would provide some drag on the selloff: as price goes lower, the dividend yield goes higher if payout is constant). As long as high yielding investments are in tax deferred accounts, there is no tax impact from the payments and they will continue to compound if reinvested in the CE funds.

www.etfconnect.com is a good place to research closed end funds and see the history of discount versus premiums

More defensive stock / naked put ideas

Besides ADM and ALL both defensive names with good financials and dividends, here are two more worth considering that will diversify the portfolio: FTD and KMB.

Both have dividends over 3%. FTD is a demographics play as the boomers get older and wealthier they should be sending more gifts and flowers to each other. Also, florists are a consolidating industry and FTD will be the consolidator. Kimberly-Clark is also in the out of favor paper products industry and is a consumer staples company with global presence, so has good long term prospects.

Contrarian View: Housing Slump WILL Affect Spending

Jeff, Just as we discussed today, here is something that showed up on Barrons that makes the point. Economists are almost always wrong, that is one thing I have learned. Notice how they acknowledge they were wrong in the short run, but still don’t concede they will also be wrong in the long run. This is the consensus, so the opposite is more likely to happen:


Housing Slump Won't Mow Down Spending

UBS Investment Research

WE CONTINUE TO EXPECT WEAKENING in housing to lead to a noticeable slowing in overall growth but not an economy-wide recession.

Our "soft landing" forecast counts on 100 basis points easing [of short-term interest rates] by the Federal Reserve in 2007, with the bond market likely to move ahead of the Fed. Ten-year Treasury yields have already dropped below 5%; we expect a 4.4% yield by the end of 2006.

Our forecast also reflects the expectation that the indirect effects of the weakening in housing, through slowing home prices and a decline in home-equity extraction, will be significant but not sizable enough to cause consumer-spending growth to weaken dramatically. The size and speed of such wealth effects are major sources of uncertainty, however.

Housing appears to be weakening even more than we expected and, on Aug. 18, we reduced our forecast for real Gross Domestic Product (GDP) growth in the second half of 2006 to a 2.0% annual rate, down from 2.5% (still no recession). We also trimmed our 2007 growth forecast to 2.4% down from 2.6% on a fourth-quarter-over-quarter basis (and to 2.2% down from 2.5% on a calendar-year average basis).

The auto sector also looks poised to be a near-term drag on GDP growth, although the drag appears to reflect more of a short-term inventory correction, with much less potential for sizable indirect effects, than the weakening in housing. We estimate that auto production will subtract about 0.5 point from annualized GDP growth in the second half of 2006.

We forecast a 100,000 rise in payrolls in the August report, consistent with some slowing in growth but no collapse. We expect the unemployment rate to reverse 0.1 point of last month's 0.2-point rise. In contrast to housing, growth in the manufacturing sector still looks solid; we expect the Institute for Supply Management index slipped to 54.0 from 54.8 in July. Core personal consumption expenditures (PCE) prices probably rose just 0.1% in July, keeping the change from a year ago at 2.4%.

We expect second-quarter real GDP growth to be revised up to a 3.0% pace from 2.5%, with much of the revision concentrated in inventories. The minutes to the Aug. 8 Federal Open Market Committee meeting will be released on Aug. 29.

By itself, that weakening in residential investment would not appear to suggest a significant risk of a broad recession. Historically, however, housing downturns have been associated with economy-wide recessions. Meanwhile, housing's indirect effects on growth appear to have been unusually large in the current cycle when housing was growing, raising the potential for more related weakness as housing contracts.

As with most issues in economics, there are plenty of points and counterpoints, and every cycle is different (This Time is Different, haven’t we heard that before!!??). The business sector looks strong financially, the broad stock market has shown resilience, inventories are reasonably lean, global growth looks healthy, the trend in core inflation is tame, and interest rates are not especially high.

The big question: to what extent will slowing in home prices cause consumer-spending growth to weaken? The sharp slowing in home prices raises the possibility that home-equity extraction (HEE) and the spending that has been financed by HEE will plunge in coming quarters. We estimate home-equity extraction totaled 7% of disposable income in the first quarter of this year.

We expect the slowing in HEE will be more gradual than the slowing in prices. We also believe the impact on household spending, which we define as consumer spending plus residential investment (which includes home-improvement construction) will be smaller than the decline in HEE.

Some of the surge in HEE has been used to pay off more-expensive credit-card debt or for investment in financial assets rather than for financing increased household spending. In round numbers, we expect housing's indirect effects on consumption, much of which is through HEE, to swing from adding about 0.5 percentage point to the rate of growth in spending to subtracting 0.5 point. This issue is a major source of uncertainty, however.

So far, consumer spending has shown no sign of dramatic weakening. Indeed, the latest retail-sales data were strong. Also, in the very near term at least, the drag on spending power from rising energy prices is likely to decline, thanks to the drop in gasoline prices in recent weeks. That said, we expect the weakening in housing to have enough of an impact on employment growth, as well home-equity extraction, to pull consumer-spending growth down to around a 2.5% trend from what was a 3.5%-4% trend until recently.

In gauging whether our forecast is on track, we will be especially focused on consumer- and labor-market data.

-- Maury N. Harris, chief U.S. economist
-- James O'Sullivan, senior U.S. economist
-- Samuel Coffin, U.S. economist

Contrarian View: Housing Slump WILL Affect Spending

Jeff, Just as we discussed today, here is something that showed up on Barrons that makes the point. Economists are almost always wrong, that is one thing I have learned. Notice how they acknowledge they were wrong in the short run, but still don’t concede they will also be wrong in the long run. This is the consensus, so the opposite is more likely to happen:

Housing Slump Won't Mow Down Spending

UBS Investment Research

WE CONTINUE TO EXPECT WEAKENING in housing to lead to a noticeable slowing in overall growth but not an economy-wide recession.

Our "soft landing" forecast counts on 100 basis points easing [of short-term interest rates] by the Federal Reserve in 2007, with the bond market likely to move ahead of the Fed. Ten-year Treasury yields have already dropped below 5%; we expect a 4.4% yield by the end of 2006.

Our forecast also reflects the expectation that the indirect effects of the weakening in housing, through slowing home prices and a decline in home-equity extraction, will be significant but not sizable enough to cause consumer-spending growth to weaken dramatically. The size and speed of such wealth effects are major sources of uncertainty, however.

Housing appears to be weakening even more than we expected and, on Aug. 18, we reduced our forecast for real Gross Domestic Product (GDP) growth in the second half of 2006 to a 2.0% annual rate, down from 2.5% (still no recession). We also trimmed our 2007 growth forecast to 2.4% down from 2.6% on a fourth-quarter-over-quarter basis (and to 2.2% down from 2.5% on a calendar-year average basis).

The auto sector also looks poised to be a near-term drag on GDP growth, although the drag appears to reflect more of a short-term inventory correction, with much less potential for sizable indirect effects, than the weakening in housing. We estimate that auto production will subtract about 0.5 point from annualized GDP growth in the second half of 2006.

We forecast a 100,000 rise in payrolls in the August report, consistent with some slowing in growth but no collapse. We expect the unemployment rate to reverse 0.1 point of last month's 0.2-point rise. In contrast to housing, growth in the manufacturing sector still looks solid; we expect the Institute for Supply Management index slipped to 54.0 from 54.8 in July. Core personal consumption expenditures (PCE) prices probably rose just 0.1% in July, keeping the change from a year ago at 2.4%.

We expect second-quarter real GDP growth to be revised up to a 3.0% pace from 2.5%, with much of the revision concentrated in inventories. The minutes to the Aug. 8 Federal Open Market Committee meeting will be released on Aug. 29.

By itself, that weakening in residential investment would not appear to suggest a significant risk of a broad recession. Historically, however, housing downturns have been associated with economy-wide recessions. Meanwhile, housing's indirect effects on growth appear to have been unusually large in the current cycle when housing was growing, raising the potential for more related weakness as housing contracts.

As with most issues in economics, there are plenty of points and counterpoints, and every cycle is different (This Time is Different, haven’t we heard that before!!??). The business sector looks strong financially, the broad stock market has shown resilience, inventories are reasonably lean, global growth looks healthy, the trend in core inflation is tame, and interest rates are not especially high.

The big question: to what extent will slowing in home prices cause consumer-spending growth to weaken? The sharp slowing in home prices raises the possibility that home-equity extraction (HEE) and the spending that has been financed by HEE will plunge in coming quarters. We estimate home-equity extraction totaled 7% of disposable income in the first quarter of this year.

We expect the slowing in HEE will be more gradual than the slowing in prices. We also believe the impact on household spending, which we define as consumer spending plus residential investment (which includes home-improvement construction) will be smaller than the decline in HEE.

Some of the surge in HEE has been used to pay off more-expensive credit-card debt or for investment in financial assets rather than for financing increased household spending. In round numbers, we expect housing's indirect effects on consumption, much of which is through HEE, to swing from adding about 0.5 percentage point to the rate of growth in spending to subtracting 0.5 point. This issue is a major source of uncertainty, however.

So far, consumer spending has shown no sign of dramatic weakening. Indeed, the latest retail-sales data were strong. Also, in the very near term at least, the drag on spending power from rising energy prices is likely to decline, thanks to the drop in gasoline prices in recent weeks. That said, we expect the weakening in housing to have enough of an impact on employment growth, as well home-equity extraction, to pull consumer-spending growth down to around a 2.5% trend from what was a 3.5%-4% trend until recently.

In gauging whether our forecast is on track, we will be especially focused on consumer- and labor-market data.

-- Maury N. Harris, chief U.S. economist
-- James O'Sullivan, senior U.S. economist
-- Samuel Coffin, U.S. economist

Finer Points on Writing Option Contracts

I am liking the idea of writing calls and puts closer to expiration. The time decay is uneven. The closer to expiration, the faster the decay. When selling, time decay is good, just as it is bad when buying. So, the best annualized returns usually occur on the shortest dated contracts. I haven’t found an exception to this rule. Also, short dated contracts minimize exposure to dividends and their effect on contract prices. Plus, short contracts are more likely to capture short swings in stock price. For example, Apple and Armor Holdings, which I have held for 30 days, are falling apart. One week ago, they were looking good. The longer you hold the underlying stock, the more likely something fundamental is going to change. Oil could break down in the next 90 days as natural gas has (though not likely), but you will be locked up if you write for September, although, if it moves away from you (down if you are writing a call), the cost of closing out gets cheaper. I closed out of my GM options and reloaded at a higher price to capture some more premium to help offset the loss on the underlying. BTW: you saw that Jim Cramer came out with a BUYBUYBUY on GM on Wednesday (AFTER the 30% move)? He is predicting $40 in 12 months. Sounds like a good reason to be short to me.

I would like to be able to capture the most gain from writing in the shortest period possible. Even 0.60 per contract looks good when over just 10 days, on an annualized basis. Do the numbers in my spreadsheet and you will see what I mean.

What about the precious metals? I am thinking of selling half my PCRDX and VGPMX. I will definitely pull that trigger if gold hits $800 and maybe sooner. Precious metals have become very speculative meaning that when they go down, they will go down fast. I would like to capture some gain before then, and buy back in after the correction.

Covering Shorts on GM

Well, I couldn’t stand the pain of being short GM any longer, so I took cover.

This morning, I put in orders to buy calls for GM to protect my hiny from any more abuse.

I bought (8) June 30 call contracts for 0.50 each and (10) September 30 call contracts for 1.10. If the worst happens, and GM goes to 30 in the next 30 days (could happen with as many people want to see GM work out, and also, the US market index funds must buy GM as more people buy into those index funds), I sell the June 30 for maybe 2.00 and the Sept 30 for maybe 3.00. This will give me around $3200 in coverage, which just about offsets my losses on the short positions from today, with GM at 25.80 (30-25.80 = 4.20 x 800 = $3360).

On the other hand, if the market gets its senses back and GM goes back down to $20, I will lose the call contracts that cost me $1500, but also be able to continue writing sell orders on my 800 GM shares at about $1000 per month. So, this won’t work out as well as I originally hoped, but at least I don’t lose my rear (and will be adding to profits after two months).

If GM does get to $30 and I sell out my positions, I will be buying naked put contracts against GM, that is for sure.

Next time I try one of these covered puts, I will buy my long dated call at the same time to stop losses at 15%. I would already be in the money if I had done that with stock at $20 in mid-April (a 50 cent Sept contract at 25 then would now be paying $2). It takes about 5 months to pay back a 15% loss (at 3% gain a month on writing the put), but I can live with that. This also points out the difficulty of any bet on the short side, which you already appreciate. The market is biased to the long side.

Brian

P.S. GM proudly made the big announcement this morning that they are raising prices on new cars because they are losing too much at current prices and having to dump unsold cars on the rental fleets. Good luck! This will shrink their market share even more, creating even more labor problems and closing more production that must be capitalized regardless. If they weren’t selling enough cars at the lower prices, how does raising the price help? They don’t have a variable cost structure so this can’t possibly work. They will sell even fewer and will find themselves with as many excess vehicles but with lower total revenue at fixed expense. STUPID!!

Recommending Redflex Holdings

I would like to recommend a new stock for your research and perhaps purchase. If you follow my occasional investment newsletters (and upcoming Financial Planning website), you know I don’t recommend new ideas lightly. They have to be original to me, not some pass along idea. The company I am recommending is Redflex Holdings. This is a company we discovered the hard way: by getting a traffic ticket.

Redflex Holdings is a technology company with Australian originations. It has moved its USA HQ to Scottsdale, AZ (who can blame them!). Redflex has its roots in military communications. It continues a Communications Division that has contracts with Lockheed and the US Navy. In Australia, Redflex developed a “traffic enforcement” technology, using cameras mounted at intersections and high speed digital photo analysis to determine drivers who violate red lights (hence the name of the company). The technology is very precise and accurate and the results are great for the municipalities that contract with Redflex: they get better traffic control enforcement, leaving police to higher duties like fighting crime, and cities do not have any capital expense, but share the fines with Redflex. Redflex also offers a “speed limit enforcement” system that is gradually being deployed around the world.

My interest in this company is based on several factors: a contractual monopoly, or as Warren Buffet calls it, a “toll business with a wide moat”, recurring revenues due to its business model of sharing fines with the municipalities contracted to it, a small business base with a very large potential market, significant penetration and demonstrated success, an established business (defense contractor) that feeds capital into the new growth business (this provides dependable cash flow to finance growth reducing risk of growing faster than liquidity permits), provides a service that is very beneficial to society and not a fashion or fad.

Here are some of the metrics which are attractive: low awareness by the investing community (I had never heard of this company until we received a ticket), reasonable price compared to growth rate (40% revenue growth and 50% earnings growth year over year vs. a P/E of around 30), Positive Operating Cash Flow ($15M in 2005 vs. $5M in 2004, price ratio of less than 6 times cash flow), Reasonable price to sales ratio (about 1.8, very good for a fast growing tech company), solid return on equity (15% as calculated by $9M earnings per share divided by $60M net equity per share). Here is the Annual Report: http://www.redflex.com.au/ASX_announcements/PDF/274690.pdf

Many times, the financial metrics for a small growth company are not nearly as attractive as this. Often a lot of faith is required to purchase a small cap growth stock. They frequently are expected to lose money for several years (Amazon STILL is losing money!) That makes this story even better.

What can go wrong? There could be a backlash against automated traffic enforcement. In the Annual Report is a warning that the Ohio state legislature has a bill that would require manual (police officer) enforcement. I think that while this is the emotional response (BIG BROTHER), that eventually people will get used to the idea and accept it. The accuracy is undeniable as the ticket received in the mail has photos of your car with a closeup of the intersection traffic signals and your license plate. You cannot deny the light is Red as you are in the intersection. You can see its color in the photo. The timing of the infraction is to the 1/10th of a second along with indication of speed traveled (which is the basis for the future implementation of speed control).

There may be patent or other intellectual property challenges. Redflex won such a suit earlier this year (actually, it was dismissed). So, like all investments, this has some risk. But I think the upside is worth the risk in this case. Redflex trades as RDF on the OTC BB as RFLXY (20.50 USD on Nov. 11). It trades as 1 share to 8 on the ASX (Australian) exchange. Today (Nov. 11), the RDF.ASX closed at 3.54 AUD on 293K shares (about 3 times normal daily volume). The exchange rate is 1.34 AUD to the USD. So there is no difference between the two markets on converted price. The stock has been going up all year on increasing contracts for the Traffic systems (several signed this week). This could be a very large winner over the next 5 years based on the available market and the minimal penetration to date.

The Power of 11

In this week’s Barrons (July 11, 2005) is a great article on the merits of investing at the market’s current valuation. Jeff Murphy and I joke about the Power of 11. This is our own spin on the common advice of saving / investing 10% of income for a comfortable retirement. Just to be different, we have updated this “saw” to 11% invested in the market for an 11% return (compounding will cause the amount invested to double every 6.5 years, growing in an exponential fashion).

Well, what should I find this week but some academic research that not only reinforces the number ‘11’, but also makes a very compelling case for the fact that the market is currently overvalued, and that the 11% market return is “baked into the cake” over the very long term. What was eye-opening for me was the way this number was derived: from backing out of “Return on Equity”. Of Course! The ROE is a ratio of the profits (Return) as a percent of equity (Book Value as calculated by Assets minus Liabilities). The results are inherently “normalized” because book value should be inflated or deflated by the value of the currency, maybe not in one year, but over a period of years, say twenty.

Not only does the market provide a consistent 11% ROE over long periods of time, but it also grows very dependably at a 5% rate: Very encouraging for the long run. However, in the short run, using the same metrics, it can be shown that the DOW is more than double its historical value based on this analysis. It should be 4500, not 10,500. How does it get back to its long run average? Does it collapse by 50% or more? Probably not. But this builds the case for sideways trading for another decade while the Return catches up with the Equity.

Why is this 11% number so constant? People (the market) determine the price of the assets that comprise the aggregated “Stock Market” through the bidding process. People have the same sense of valuation over long periods of time, all other things being equal, like currency. To make this point from a different perspective, human beings have essentially the same fundamental needs requiring satisfaction: air, water, food, shelter, etc. These survival needs are programmed into us by our basic genetic code. Most of us, statistically, must make decisions on what to buy, how much to pay, for those basic necessities of life: Adam Smith’s “Invisible Hand”. It can be reasoned that since we all have the same genetically wired perspective on how the essentials should be valued, in the aggregate we end up valuing all market assets in a similar way.

Competition amongst us dictates that we will bid the price of a basket of financial assets to a return of no more than 11.6% and no less than 10.5%, in the long run. If short term exuberance or discourage gets the best of us for a period of time, we will inherently wait until the return adjusts to our required comfort zone or norm.


Read On:



The 11% Solution

Forecasting broad market earnings creates new problems for investors

By ADAM BARTH

EVERY BUSINESS DAY, INVESTORS ARE BOMBARDED with new economic data, macro and micro, all of which supposedly affect the value of U.S. stocks. While some investors may dismiss macroeconomic information such as quarterly gross domestic product, initial jobless claims and factory orders as irrelevant in the making of portfolio decisions, few probably would file this year's and next year's earnings estimates for the Dow Industrials or Standard & Poor's 500 under a "More Useless Information" heading.

But that's what they ought to do: Insights about individual firms are valuable; fixation on broad measures of current or future earnings isn't. Not because predicting corporate earnings is an impossible task, but because future long-term macro-earnings can be predicted with almost complete precision.

Examine the Dow's annual return on equity for each 20-year period since 1920 (that is, 1920 through 1939, 1921 through 1940, and so on): Average earnings as a function of book value barely varies in the slightest, and has remained basically immune to inflation, wars, massive changes in the tax code or any other external factor.

For the 34 consecutive 20-year stretches between 1934-1953 and 1967-1986, the return fell in an incredibly narrow range of 10.5% to 11.6% -- or an average of around 11%. Furthermore, the Dow's book-value growth rate has remained near its 4.8% historical average from 1920 to 2003 for every 20-year period on record.

A Simple Calculation

Finding the Dow's normalized earnings in any given year is as simple as multiplying 11% by the Dow's book value at the time. These earnings will grow at a little under 5% per year -- the Dow's steady and predictable 20-year book-value expansion rate.

Although almost all analysts focus on the current or following year's earnings forecast in valuing stock indexes such as the Dow, the approach is primitive and misleading. While earnings gyrate from year to year, the Dow's earnings over the coming 20 years or any 20 years is virtually preordained.

The popular notion that the long-term earnings growth rate is highly variable and affected by the daily news that speculators, economists and the media slavishly focus on is a great red herring.

The portfolio strategy of "relative value" is based on this red herring. The many purveyors of this strategy tout their "bargain" investments in companies trading at price-earnings ratios in excess of 20 and well above any asset conversion or private-market value.

Where is the margin of safety for these investments? According to these investment managers, it exists in how underpriced their investments are, relative to the market. While these managers claim to be "bottom-up" value investors, they actually have tied their fates to that of the broader market.

A major reason for these managers' decision to shadow an index is the belief that stocks' superior performance in the past proves that they have been mistakenly undervalued, and should now command a richer valuation. As a result, most money managers have rejected traditional equity-valuation standards as overly demanding, and have replaced them with newer measures.

A Peculiar Notion

The most popular and influential of these new approaches is the "Fed model," which holds that U.S. stocks' earnings yield should equal that of the federal government's 10-year bond.

This Fed model rests on the absurd proposition that corporations' equity -- their most junior and risky obligation -- should be equated with U.S. government debt. This approach is nonsensical, as it completely ignores companies' priority of obligations and posits that U.S. public corporations' equity cost of capital should be the same as the risk-free rate. The Fed model pretends that the cardinal risk-and-return principles of finance do not exist.

In the rush to create valuation models that justify current stock prices, investors and economists have missed the clear evidence that historical valuations are not only logical, but virtually necessary.

The 11% solution demonstrates why this is so. Of the Dow's 11% ROE, 5% has consistently been retained -- thus allowing the Dow's 5% earnings-growth rate. The remaining 6% has been free cash flow available for distribution to shareholders in the form of dividends and stock buybacks. As such, the Dow is a perpetuity that can be easily valued by dividing its current free cash flow (6% of current book value) by its expected rate of return minus its long-term growth rate (9% minus 5%).

With the Dow's current book value a little under 3000, its normalized free cash flow is roughly 180. Dividing 180 by an expected return of 9% minus free cash flow growth of 5% (.09 - .05) yields a valuation for the Dow of 4500, less than half of its current market valuation. To justify a Dow value of 10,500, one has to lower the future expected investment return for the Dow to 6.7%.

From 1920 to 2003, Moody's Aaa corporate-bond yield averaged 5.9%. Recently, Barron's Best Grade Index has shown a current yield of 5.24% for top-grade corporate bonds. Assuming a forward rate of return of 6.7% for the Dow would imply an equity-risk premium of just 0.8% to 1.5%.

The preceding analysis will probably shock most investors. Conventional wisdom is that the Dow's earnings are much higher, and that its P/E ratio is much lower. Conventional wisdom, however, is based on some bizarre assumptions and beliefs.

A normalized 20 P/E ratio for the Dow would imply a normalized 18% return on equity (5% earnings yield x 3.6 book value multiple = 18%). While the Dow averaged an 18% return on equity over the prior decade, assuming a lasting return on equity anywhere near this figure is absurd, given the historical record.

Although there have been many short periods in the past during which the Dow Industrials' return on equity significantly exceeded 11% (such as the 1920s, when it also averaged 18%), an elevated return on equity has always come at the expense of future profits, and ROE has always reverted near its 11% average over each 20-year period. While the causes (excess credit creation, faulty accounting) may be contested, the results are incontestable.

Putting history aside, basic logic alone dictates that a sustained 18% ROE is impossible. A return of this magnitude would mean that American business as a whole is capable of lasting, monopoly-type profits. The truth is the exact opposite: Big Business' profit growth has consistently trailed broad economic expansion, with nominal GDP growth increasing at a 7% rate and Dow profit growth lagging behind, at near 5%, for nearly every 20-year period on record.

Small Margin of Safety

Current stock-market valuation levels have made the search for equities that possess a margin of safety a generally difficult task, and the job of professionally managing money even more difficult, given the myriad pressures and incentives to remain fully invested.

In response to this challenge, many investors have turned to a relative, rather than absolute, value approach.

The problem is that these investment approaches are radically different, despite some seeming similarities. In choosing relative value, investors subject themselves to the value of the broad market.

This is not a prudent choice, given the current valuation of large-cap U.S. stocks and the limits to these companies' profitability and growth, as demonstrated by the 11% solution.

Bill Gross and the Coming of Stagflation

It is time to make a slight change in my past prognostication of “stagflation” in the USA economy and the resulting investment implications. I think the “stag” is here to stay for a while, but am changing my position on the “flation”. I derive quite a bit of my economic and interest rate insights from reading Bill Gross’s monthly commentaries. This month, Bill is making a change in his call on the future of inflation and interest rates, so I will too.

What does this call mean for a USA investor? Bill argues for a practical limit on real interest rates of 0% (real interest rate = inflation minus nominal short term interest rates). We are currently at 1% (as shown by TIPS), so he makes the case that there is very little room left for further real interest rate reduction by the Fed. The real interest rate in early 2003 was 4% (at the end of the last recession when real interest rates were typically high as the Fed stimulates the economy. This stimulation can also be seen in a steep Treasury yield curve). A declining real interest rate is reflationary or inflationary and signals monetary stimulation. Since there is little more room to stimulate, as given by the low real interest rate, there is little chance for a significant increase in inflation, so the argument goes.

From this line of reasoning comes Bill Gross’s and Pimco’s interest rate forecast for the next 5 years on the 10 year Treasury of 3% to 4.5%, nominal, with inflation at around 3%, as it is right now. This bodes well for Treasury bonds and other high quality debt instruments (municipals, high grade corporates). It is also modestly positive for stocks since low real interest rates make corporate cash flow yield (CF/price) relatively more attractive.

There is still a case for hard asset inflation for those assets that are supply-limited with high demand in the developing world. Oil may be one such asset, grains another (with an improving diet among the billions in Asia who are seeing a rising standard of living). There is also a longer term case for precious metals. When the world comes off “Bretton Woods 2” (as Gross tags it, the use of the US dollar as the world’s reserve currency) and switches back to some type of gold standard, as is predicted, it will greatly increase demand for gold and related precious metals. China is likely to make a gradual move away from the dollar as a benchmark over the next five years. Since there is no other reasonable paper benchmark (the Euro, unlikely; the yen…No Way!), either gold, or an index of commodities is likely the future reserve for the Chinese currency.

But the outlook for financial assets, and real estate is more of a financial asset than hard asset in today’s highly mortgaged / leveraged world, is not so good. Financial assets rely on a contraction of real interest rates to increase their value, and as Gross points out, the Fed-orchestrated contraction has run its course.

Neither can a case be made for any type of manufacturing product, either the capital goods to conduct manufacturing or the consumer and industrial products made by manufacturing. This is a world marked by excess supply of manufactured goods, with low cost labor in developing economies, a flood of capital into those economies to build manufacturing plant and the remains of the manufacturing expansion of the late 90s. It is this excess supply of manufactured goods that keeps a cap on inflation, limits employment growth in the developed economies, an also limits the upside for the stock market, especially the capital equipment and technology sectors.

"Fool's Gold in Oil Patch" Makes Dorsey the Fool

TO: Patrick Dorsey, Morningstar Editor:

Patrick, I found your analysis of the oil sector in “Fool’s Gold in the Oil Patch” posted on the Morningstar.com website to be highly flawed in its assumptions. Although you try to support your arguments with data from Morningstar, the data does not at all confirm the points you are making. I found your chart on the price of gasoline versus demand in California to be particularly unimpressive. It makes the assumption that gas prices in the US respond to demand in California. I don’t think so. Gas prices respond to the cost of oil first, and the availability of refining capacity second. A maintenance shut-down at a large refinery has much more to do with short term price variations in gasoline than does demand. Demand for gasoline changes in the short term due to seasonal factors, not due to driving patterns.

To dissect your weak arguments, first examine your statement about the acceptable price of a barrel of oil to the makers of the market, namely OPEC and the Saudia Arabia princes. It is flawed from the outset. You make the point that they are implicitly targeting a mid-30s price for oil, yet on CNBC this morning, Prince Alaweed stated that Saudia Arabia has abandoned that target and are instead targeting $40-50 / barrel. He stated OPEC’s comfort with $50 per barrel oil based on the observation it was not causing significant global economic damage. So your argument about where the price of oil will settle is already in danger.

Next, you make the case for the long run price of oil per barrel to be around $20. This is incorrect. Please cite your sources when you make statements such as this. The long run price is closer to $40 per barrel. Someone “Infinitely” (your choice of words to describe where oil would have to go to make a good investment) more credentialed than you to make statements about the long price of oil is Ben Bernanke, one of the Federal Reserve Board members and the leading candidate to replace Allen Greenspan as chairman. In a speech / article he authored in October 2004 (http://www.federalreserve.gov/boarddocs/speeches/2004/20041021/default.htm) he makes the compelling case, backed up by serious research, that $39 is a minimum price based on industry data. He references that as of October last year, the futures market was implicitly pricing the long run value of oil between $38 and $60 per barrel (2/3 probability). Of course, the futures market has priced oil even higher recently (as of April 2005), but we will let that point go for now.

Your financial analysis of the market, using Morningstar “return on invested capital” data appears compelling and may “Fool” some of your readers. However, it does not take into account the backward looking nature of the data. 2004 industry returns were based on oil prices from 2003 and 2002, since most industry players hedge in the futures market to smooth their earnings. The industry profits do not respond instantly to changes in the sales price of oil. 2005 and 2006 oil prices will be much more informative about the effect on industry profits of price per barrel in 2004.

Also, your position is in opposition to (besides the Saudis), T. Boone Pickens and Tom Petrie (of Petrie-Parkman) all of whom know much more about the industry than do you. Check out their websites and do a little research.

What your thesis completely ignores is the significant changes in global demand and supply over the past 10 years. In the 80s and 90s, the Pacific Rim nations developed as suppliers of electronic and heavy industry goods to the USA. Their development did not require significant increases in oil-based energy. It did not drive demand higher at a time when global oil reserves were still sufficient for global demand. Now, however, nations with much larger land mass per capita are undergoing development (China, India, Brazil, and Eastern Europe and Russia to a lesser extent). These nations will be voracious consumers of oil-based energy to meet their public’s transportation needs. Alternatives to oil-based transportation are well off in the future. Fuel cell technology is more than a decade from commercial reality (check out the price of Ballard Energy stock). Even when it becomes a reality, the first versions of fuel cell vehicles are expected to run on natural gas. So your demand story based on replacement technologies is just plain wrong.

The supply story is equally wrong. In the past, there was always plenty of cheap oil to exploit when demand increased, allowing for supply to meet (or exceed) demand. This was the case in the 1970s when the Middle East oil infrastructure was not completely developed. Now, however, the easy oil is gone. There are no new discoveries where, like Jed Clampett, you can shoot your shotgun at the ground and have oil spurt out. All the world’s oil, even in Saudi Arabia, will require more expensive techniques for extraction, at the very least pumping and in many cases stimulation techniques involving insertion of chemicals and /or steam into the wells. This will raise the bar on the minimum economic cost of a barrel of oil. Producers do not produce for long below their break-even point which puts a floor under the price of oil. That floor is going from $20, where it was in the 80s, to $40, where it will be by 2010. This is the information you can glean from industry experts if you will take the time to research the industry, before spouting your wisdom.

The bottom line: I am glad there are people like you to scare investors out of the oil market. It leaves better investing opportunities for people like me.