Wednesday, November 07, 2007


A regular reader writes:

"The airlines seem to be hurting an otherwise beautiful portfolio. Gas prices continue to rise. What do you think? Do you still think airlines will go up soon?"

The first week of October, my wife and I made our annual trek to Blowing Rock, NC. We enjoy visiting the mountains this week because "Art in the Park" is held in Blowing Rock and because the mirror image of the maple trees around Bass Lake is as pretty a picture as you will see. This year, the leaves had not turned. Our walk around Bass Lake was still one of the highlights of the year but the leaves were mostly green.

The following week, I could hardly wait to go camping at Table Rock. If you have not been to Table Rock, you have missed one of the prettiest views in NC. The peak at Table Rock is only 1 mile from the state operated parking lot and picnic area, but the views of the NC highlands extend in all directions, including a full view all the way up Linville Gorge. Once again, I had a great trip and the views were gorgeous but the leaves were still mostly green.

We are now into the first week of November and the leaves are turning fast. Earlier this morning, the temperature hit 32 degrees. You can bet your boots that the green oak trees in our area are finally about to change colors. Yes, I do believe the leaves will turn and I believe they will fall off the trees.


This fall, the price of oil has been more stubborn than the leaves. Will the price turn? The timing is certainly less certain but yes, the price will turn.

The reason investors who have short term outlooks do not do well is that they switch out of winning positions to avoid short term pain. The temptation is simply too great to follow the crowd, even when common sense says the crowd is wrong. No one likes to feel like they are the only ones losing money. Studies show time and again that there is an inverse relationship between the frequency of trading and investment returns. Successful investors tend to identify trends early and they tend to sell too early. Successful investors do not try to catch every trend. It only takes a few 10 baggers to accumulate great wealth.


Many things in life that must ultimately follow the laws of math even though the math seems to be broken in the short run. The typical mathematical formula does not include a function for the emotion factor. Two of my favorite quotes from one of the greatest economist of all time, John Maynard Keynes, are: "The market can stay irrational longer than you can stay solvent", and "In economics, the majority is always wrong." The oil market currently fits both quotations. The greed factor is in full force in the oil market at the same time the fear factor is killing the dollar. The combination has pushed oil and the dollar to extreme levels.

Lets look at an economic formula to see if math is working in our favor.

Income = Consumption + Investment + Government Spending + Exports - Imports

The USA just reported GNP growth (income growth) of almost 4% for two quarters in a row. How can the US economy grow so rapidly in the middle of a housing slump that has knocked 1% off the growth rate? The answer is that all of the above components of income are contributing.

Consumption, by Shays Law, feeds on itself. The 3.8% real growth in GNP last quarter means that the average American experienced growth in income equal to 3.8% after accounting for inflation! In America, one thing you can count on is that if Americans experience a rise in income, they will spend more. The reason we call Americans "consumers" is because that is what they do.

In regard to investment, US assets have gotten very cheap relative to assets in the rest of the world. In particular, Europeans can now build a factory in the US for 35% less than the cost a few years ago. As a result, the drop off in residential construction has been almost totally offset by growth in business construction and the purchase of business equipment has held up well even in the face of a credit crunch.

In regard to government, the obvious statement is that we do not have to worry about a drop off in spending. It even appears that Congress will cut the AMT tax without raising other taxes as much.

Finally, we get to the big change that has occurred over the last year or so, export growth is exploding upward while import growth has collapsed. While anything can happen in the future, those who claim the US economy is currently in a recession are simply wrong. It is impossible for the income side of the equation to go down if all of the right hand side elements are going up.

Why is export growth exploding? Foreigners, who hold more US dollars than at any other time in history are experience the equivalent of the Jimmy Carter days. Back in the late 1970's, it made no sense to save ones money for future consumption. By the time one saved $1,000 to buy a refrigerator including compounded interest, the price of the refrigerator had gone to $1,500. Today, the citizens of the world, including US citizens are enjoying low inflation rates. However, the dollar has fallen relative to other currencies. Foreigners who hold dollars are missing the boat if they continue to hold the dollars instead of buying US goods or assets with those dollars.


Yes, the big turn has already hit US trade but the US dollar has continued to fall. Those who buy the dollar now are similar to those who bought oil stocks in 1999. Oil stocks did not go up immediately but they looked better and better as we moved to the other end of the fear and greed rope. This is where psychology trumps math in the short run. The reserves of US dollars held by foreigners has never been a higher number and these holders are sick and tired of losing money. The "old money Europeans" who hold at least a portion of their wealth in US dollars have seen the value of those dollars fall by better than 35%. What would you do if your bank sent you a statement month after month that showed your savings account had earned 4% interest but the principle value had fallen by 5%? If your savings are losing value, you might as well buy something with them.


A major fact is that airlines are making money. One of the common half truths expressed by the financial media is to imply that if costs go up then profits must go down. A similar half truth is the notion that if a producers selling price goes down he will suffer profit declines. This kind of thinking would suggest that the huge profit growth experienced by Dell Computer in the 1990's was impossible. The fact is that as the price of computers fell, Dell sold more while maintaining or even increasing its profit margins. In the case of airlines, the industry lost a lot of money in 2003, 2004, 2005 and 2006 but it made a lot of money in 2007. The compounded fuel cost increase was very substantial but the profits did not start rolling in until after the price of fuel was very high.

One of many facts in favor of airline stocks is that airlines are a lot like buses with wings, the higher the price of fuel, the more economical it is to ride the bus. The fuel expended per mile per passenger is higher in a car than it is in a buss or a plane.

The real key to profits is the elasticity of demand versus the elasticity of supply. JAL airlines told the "elasticity story" in its most recent report. It seems that there is so much demand from Japanese business travelers that consumers are getting priced out of the market. JAL is still waiting for delivery of its huge order of new planes. When demand is great and supply is restricted, what can a business do? Around the world, the price of airline tickets are going up. JAL just joined the party with its announcement of a huge jump in profits.

The following are other interesting facts.

1) The world wide order backlog for new planes has never been any where near current levels.
2) Both Boeing and Airbus have experienced delays in bringing new planes to market.
3) China, India, and other developing nations have dibs on the great majority of planes to be delivered over the next couple of years.
4) US airlines are flying many planes that are 35 years of age with no hope of replacing these planes for 5 years.
5) These planes are gradually being retired, reducing the capacity of the carriers.
6) Many 50 to 100 seat planes are being added to the US system but these are being used primarily to feed traffic to international hubs.
7) For three years running, US carriers have set new records for full seats.
8) Another word for elasticity is flexibility and airlines have no flexibility in regard to adding enough seats to fill demand.
9) The only area of flexibility left is in setting seat prices.
10) After making 30 or so price increases of $5 per ticket over the past three years, the most recent increase was a $10 per ticket increase. Fuel prices are being passed along.


Next Tuesday, December oil contracts expire. By Tuesday, those speculators who put on short positions some months ago must deliver the oil. Now that the oil futures market has returned to backwardization, there is no incentive for big oil companies to store extra oil. They can simply wait to buy real liquid oil for substantially less than the price offered by futures contracts. As a result, excess inventories have been bled off. Over the past couple of years, world wide excess capacity has grown from a very tight 1 million barrels per day to 3 million barrels per day, which is admittedly still tight relative to daily consumption of 82 million barrels per day.


Major development projects will be completed in just a few months with even bigger projects to be completed the next year and the next. If excess capacity were up to 4 million barrels per day would the risk premium fall?

The fear of conflict in Iran will ultimately go away, one way or another. When it does, oil could fall as much as $30 per barrel in a hurry. One of the ways that the risk premium could go away is already in the works. A year ago, big oil companies stored all the oil they could because they were being paid well to do so and the fear of supply disruptions was high. Today, when oil is available on the market for less than the price of a futures contract and the excess supply of three million barrels is enough to offset a significant disruption. The incentive to store oil is fading quickly. More and more stored oil is going to be released. More and more strategic oil reserves around the world are going to be capped off. As far as I know, France is the only country so far to actually use strategic reserves but other reserves are full or close to being full.

Warren Buffet has said that in the short run the market works like a voting booth and in the long run it operates like a weighing machine. Right now the speculators are voting for $100 oil but the weight of the supply and demand evidence is that oil should fall to $60 or less.

Airlines are selling at very low prices relative to projected earnings. Analyst have consistently under estimated airline earnings for at least 8 quarters. Each future increase in earnings will likely be met with increases in the price of the stocks.

I predict a "major positive event" will occur within three months. This event could be anything from intervention in the currency markets by the US government to agreement in the middle east to a Palestinian state. The good news will be a surprise. Chances are good that airline stocks will appreciate in value before the news is public.


This is once again a Ken Fisher moment. The market is trying to buck you off the best horse. Hold on for a great ride!