Friday, November 02, 2007


The see-saws are moving. When merger mania and hyper leveraged transactions ended, the big investment banks dropped. Regular banking activity is ready to boom. Business construction has largely taken the place of residential housing and the construction loans are being handled through "normal" banking transactions.

See-saws are all over the place. Exxon Mobile, at the king of the hill, has taken a hit. While the price of oil has moved from 82 to 95 the price of the stock moved from 92 to 95 and then back to 92. Believe it or not, the average price the consumer has paid for a gallon of gas this year is less than the average at the same time last year. The oil companies are having a more and more difficult time of passing through the higher prices of oil, demand destruction has occurred. Refining margins have collapsed. The traditional see-saw, oil on one end and high tech on the other is in evidence.

If you don't believe these two segments see and saw, take a look at the past blow off peaks. During 1999, when the tech bubble was fully extended, the price of a barrel of oil was $12. During the oil record setting days of 1980, technology stocks were at selling at decade low PE ratios, Business Week's front cover was about the death of tech. The current boom in tech is well underway, tech stocks are up an average of better than 30% year over year. Even Microsoft, which had been stagnate for years, is moving up sharply relative to oil stocks.

Yesterday, the US Dollar rose on the same day that interest rates were cut. The pundits suggest this was because the FOMC cut only a quarter when they could have cut a half. The fact is that the US economy is very strong and growing and there is reason to buy dollars. The GNP grew 3.85% the last quarter, this is the inflation adjusted rate of growth and it is well above the long term trend. Real disposable income growth was off the chart. The "see" has already "sawed" in regard to export and import growth, in the past year, US growth in manufactured exports was over 16% and imports of goods grew by less than 3%. The see-saw in export-imports will lead to the turn in the dollar (assuming Congress fails to override the Bush veto of the billion dollar tax increases offered by Congress).


In response to my piano story yesterday, I got feedback from a friend who just sold her baby grand. Her kids are almost grown and she needed the space for other things. She confirmed my story. The value of all but the very best of used pianos has fallen dramatically. Charities, churches and auction houses often refuse pianos. I feel compelled to reiterate this situation because it is the crux of the disinflation story and since writing the story I heard two more TV pundits talking about how the government inflation numbers are false. TV pundits, like "news" reporters, fall into the trap of telling half truths because only those who tell exciting stories get more air time. One pundit mentioned this morning that if you have children headed toward college then you understand that the inflation rate is still very high.

Sorry Charlie, the full price of college tuition is paid by only the very few. The great majority of students get very substantial discounts in one way or another. At my alma mater, UNC-CH, the top 10% of the students now get a totally free ride! By jacking up the price, the perceived benefit of the scholarships are greater. When a top student has the opportunity to accept the $100,000 scholarship from one school or the $80,000 scholarship from the other, he is inclined to take the free ride at the $100,000 school. Under such circumstances, the price at the $80,000 school is apt to rise quickly to the $100,000 price.

College tuition and the price of a hospital operation are just two of the misleading numbers people use to say that inflation rates posted by the government are false. Both are misleading because almost no one pays the full tuition cost and almost no one pays the posted hospital operation price. If the price of an operation soars from $20,000 to $40,000, was the inflation rate 100%? What if a number of new programs were offered to allow large discounts to those who have no insurance? What if the large insurance companies went from a 20% discount to a 50% discount? In other words, if the Medicaid reimbursement rate went from $7,000 to $9,000 and if the private pay persons best negotiated rate went from $15,000 to $22,000 and the insurance reimbursement rate went from $17,000 to $25,000 then the real inflation rate was a weighted average of the various payment rates. When the government agrees to pay x percent of the total price, there is strong incentive for the price to be raised.

The same phenomenon happens in private industry all the time. For example, airline seat pricing follows a similar pattern. One legacy airline might raise prices and wait to see who follows. Chances are, the price increases are rolled back on 70% of the routes due to competition from low cost carriers. Then many of the highest priced seats are offered "on sale." The net increase is often only a tiny fraction of initially announced price increase. There were something like 17 across-the-board ticket price increases in 2006 and 9 so far in 2007 but the average price of an airplane ticket per mile flown is still about 15% below the price available in the year 2000. The point is that one cannot look at the head line numbers to determine the rate of inflation.

TV pundits who like to obsess over the price of oil fail to consider the efficiency of the US economy. We use a tiny fraction of the oil we used 30 years ago to do any particular task. In the "old days" huge quantities of oil were used in "non-transportation" pursuits. Today, the problem to be addressed is to convert transportation away from the use of liquid fuels. That process will take time but the market will make the switch smoothly if the politicians will stay out of the way. As usual politicians shoot the smooth process in the foot by such things as silly regulations. They might enact CAFE standards to try to force the issue, but mandating high mileage cars takes away the incentive from the consumer to make the more fundamental changes needed. Why ride the buss or move closer to town if the price of fuel is held down through regulations? In other words, we need to let the see-saw in this area as it does daily in all other non restricted areas.


The science of constructing an investment portfolio is a complicated process. The good news is that one does not need to understand the science of the internal combustion engine to drive a car well and one does not need to understand all the give and take involved in portfolio construction in order to invest well. Indeed, the person who thinks he is the best is often the person who has the biggest wreck or the one who goes out too far out on a financial limb.

As we move toward the end of an economic cycle, it will become more and more important to buy big companies. However, there is no rush to go all "big" right now. As a general rule, buying "big" adds a defensive element to a portfolio. Indeed it is intuitive to think that buying growth rather than value adds an aggressive element to a portfolio. Such cross currents can easily confuse even the "experts". As I have often stated, about 90% of performance is a result of asset allocation. Stock picking can be fun, exciting, highly profitable and very humbling but not at all a necessary investment skill. Indeed, most people would be better off using the dart board approach to stock selection. THE REASON THIS IS TRUE IS THAT STOCKS ARE SOLD THROUGH THE NEWS MEDIA AND IF A STOCK IS IN THE NEWS IT IS NOT THE BEST ONE TO BUY!

It is easy to conform to the opinion of others, the good news is that the herd is typically right during the first couple of years of the prosperity phase. Right now, one does not have to go it alone to make serious money.

At the current time, if an investor wants to try the dart board approach now, I suggest that he limit his dart board to big cap US companies. I say this knowing that over the long haul, small stocks beat large stocks and international growth beats US growth. I doubt that my message is clear because it is time to be very aggressive in the defensive area of "big cap".

When one end of a see-saw goes up, the other end must go down. The difference between see-saw movement and stock market movement is in order of magnitude and in terms of relativity. If oil stocks go up 20% over the next 4 years while tech stocks go up 100%, then there was a see and saw. Big oil integrated oil is "big cap value", the QQQ index is big cap growth. My forecast is that the QQQ will outperform big oil considerably over the next few years.


Anyone with experience running a small business knows that the reason so many small businesses go out of business is because of inadequate cash. New business owners often incorrectly assume that profits are the key to success. Of course, in the very long run, a business needs to turn a profit. Having run a resort rental business, I can tell you that cash is king. Year after year, for decades we experienced tough cash flow and negative profits. The good news was that the value of the properties appreciated dramatically while all the rents and then some went to pay all the expenses.

Now that the economic mid cycle turn is here, the availability of financing is tighter. Starting a small business will be harder than it was over the past 5 years. Venture capital will be more and more dear. Funding will be available to profitable businesses but they will need solid balance sheets.

The reason to favor large caps in the current environment is that large caps tend to be "self funding." The current run up in Microsoft (most all of my friends own Microsoft through their ownership of the Q's) makes the point well. Microsoft has accumulated billions of dollars of cash and has all the more cash flowing-in. The coming build out of the mobile Internet (it will be an ongoing renovation over the next 50 years) will require huge amounts of money. Big companies which have the cash to move on opportunities have the advantage.

The smartest of the smart will continue to bring forth innovations. Facebook is an example of innovation capturing imagination and making the founder a multi-billionaire quickly. However, the only way for you to own a piece of Facebook right now is for you to own a piece of Microsoft. At the same time, Google is making big move after big move to compete directly with Facebook. It is my belief that churches, businesses and other organizations will soon adopt the Facebook "method of communication." Programs like Facebook and Myspace started as "virtual homes for teenagers" but are proving to be a valuable productivity tool for business. A number of businesses offer password protected communities of users. Email will eventually be relatively passe'.

The battle for dominance in all the the fast growth areas is ongoing. Millions of innovations fail to catch-on. Now is not the time to try to find the next Google, Yahoo, Myspace or Facebook. These companies have a head start on systems that have room to grow. As you all know by now, I believe Google's location specific mobile platform adds will be the most profitable of all time. Besides, by the time Facebook shares are available to you directly, they will cost an arm and a leg.


Since a number of my readers work for big pharmaceutical companies, I must mention that the good times are upon you. The see saw of healthcare is swinging back into your direction. The momentum will grow at a gradual pace during the early part of the prosperity phase but like a see saw the speed will increase right to the apogee of the move. Within a few years, the compounded returns will be better than most "expert" expectations.