Tuesday, November 13, 2007


I know that I sound like the "Boy Who Cried Wolf". The peak in housing in 2005 was 20 years after the peak in housing in 1985. In this instance, the "perfect" 18.3 year real estate cycle took 20 years to complete. Since the mid cycle turn was made around November of 1986, it sure seems that it should have happened by now. After the turn in November of 2006, the stock market stampeded. The broad averages went up 40% lickity split but then the second test of the mid cycle turn developed and on October 19, 1987 the DJIA dropped 23% in one day. I was lucky enough to have sold almost all of my stocks during September and October of 1987. I planned to buy bonds with the money but bonds appreciated 15% on the day stocks dropped 23%. Under the circumstances, I bought my stocks back at a deep discount (people could not believe I was buying stocks during November and December of 1987 but many joined me over the next couple of years).

Over the past 10 days or so, the market has given us a test that is reminiscent of the one in 1987. Gary Shilling should be given credit for suggesting that the bond market rally would be big. Bonds have appreciated to extreme levels over the past 5 months. Now is not the time to buy bonds, it is time to buy stocks. Who knows if we are at the exact bottom? Over the next couple of years, this dip will almost disappear on a long term chart.

Years ago, there was a Yogi the Bear cartoon in which Yogi sat down on a slatted park bench that had just been painted white. He corrected the problem by finding a slated park bench that had just been painted brown. Right now, those who missed the bond market rally, including myself, cannot make up the difference by buying bonds now. The dip in stocks has given us our opportunity to make up the difference by holding on to our stocks and buying more if we possibly can.


Take a look at the price of EXXON and you can see the turn in action. One of the things that the financial "news" reporters get wrong time and again is the relationship between price and profits. They would have you believe that when the price of oil is high, a company like EXXON is guaranteed to see a profit increase. Exxon has made record profits over the past several years but the current high price of oil is hurting its refining margins. The demand for finished product is slowing even as the price of the raw inputs increase.

I am thankful that Larry Kudlow has started giving his Econ 101 mini classes. He calls the series Kudlow 101. Those who remember the first couple of chapters from Econ 101 know that when prices go up because demand is very high, profits tend to be very high. Businesses love it when they can sell more product at a higher price. This is the sweet double whammy situation. A company that enjoys unusual demand growth can overcome lots of other problems. It may seem greedy for a business to take advantage of a "demand shock" by raising prices but all businesses must take the good with the bad in order to survive and prosper. As we all know, if profits stay extra high long enough, there will eventually be a supply shock.

In the oil business, one can see the supply shock coming. Monster oil fields are being developed from Brazil to Canada and from South Africa to Siberia and lots of other places in between. Oil refineries, around the globe, are being expanded. New construction has started in numerous locations. It is hard to know when oil supplies will catch up with demand but recent indications are that supply will have a lot of help from demand destruction. The IEA estimates for oil demand next year were just lowered by 300,000 barrels per day. Economies are slowing and ways are being found to use less oil. Again, one can see the demand destruction by looking at the price action in refinery stock prices. The market price of the major oil companies suggest that the fair price for oil is at least $20 per barrel below the current price. After the expiration of the December futures contracts today, I believe we might begin to see the full picture a little better.


A new but regular reader says that he very much appreciates what he has learned from me in regard to oil and airlines. He recently sold a number of mutual funds that had heavy allocations to oil company stocks. He used some of the money to buy airline stocks. He would like more ideas.

I continue to be reluctant to fill these pages with stock ideas for two reasons. Reason one is because I generally believe it is best for investors to not "go it alone". I do not necessarily recommend full service brokers but a sounding board to help with discipline is always worthwhile. It is too easy to jump off a stock market bucking horse that should be ridden. The second reason is that the international airline business currently enjoys the wonderful situation where demand is very high but new supply is very restricted.

Yesterday, Dubai, ordered something like 43 Billion Dollars worth of new airplanes. These planes will not be delivered until 2014. International demand in this business is growing by leaps and bounds but almost all the new planes to be built this year will go to emerging markets. Even after Boeing and AirBus ramp up to full production, it will take years for new supply to catch up with demand. Sure, one can buy Boeing and make money but the big profit will be made by carriers that continue to fill all seats at higher and higher prices. The leverage involved is tremendous. A small increase on the price of each ticket is an increase that can flow directly to the bottom line.

So far, a huge amount of the "extra income" of the airlines has gone to cover the "extra costs" of high fuel prices. Even so, high demand and restricted supply means that the seat prices will be raised more than enough. After buying the new planes, Dubai representatives were asked where they plan to add flights. Several were to the USA including to Huston and to New York. The immediate response by some investors was "oh shucks, more competition for Continental at its Huston and NJ/NY hubs". Once again, what is perceived as bad news is actually good news. US trade airline trade agreements are typically tit for tat. If Dubai wants to fly one route to the US, they must accept one US flight from the US. Since the high growth in traffic is coming from outside the US, the tit for tat system allows US carriers to catch half of this high growth.

Besides, the "lock Continental has on its NJ/NY - Liberty Hub" also gives it a lock on lots of domestic flights from and to this international hub. Dubai planes bringing more passengers to CAL's Huston Hub will allow CAL to fill planes for domestic follow through flights.

Next year will be the 30 year anniversary of one of the biggest industry supply shocks of all time, airline deregulation. Airlines went from the status of a highly regulated and protected industry to a highly competitive free market industry. As a result, the biggest of the surviving airlines, including AMR and UAUA, fly many planes that are 35 years old. All the while, the congress of the USA continues to subsidize their "friends" on private jets while making passengers on commercial flights pay an excessive share of the costs to operate airports. The big airlines have said, "no more". Discipline has been acquired. US carriers now refuse to lose money just so the fat cats can get a cheap landing spot. The bottom line is that profits are no longer being sacrificed by expansion of capacity, the old planes will be flown until profits are sufficient to justify expansion. The supply of small planes that feed the hubs has increased but the supply of seats on long haul international flights has not kept up with demand.

I am 95% sure that the share price of CAL will appreciate substantially over the next three years. On the other hand, other businesses seem to have great potential for supply shocks. Apple has been a great performing stock for me but we all know that there are dozens of companies working on competitive products. Apple has done a great job but I remain nervous about the share price. INTC is a great company, it just announced a new high speed chip that will blow your socks off but the number of chips being spit out nowadays is mind boggling. Wal-Mart is currently selling a $199 computer. When will computers become as cheap and plentiful as calculators? US toy companies have gotten a great boost because China is being bashed in the news media. Certainly the problems with the Chinese toys are real but how long will it be before safe low priced imports take away the "extra profits caused by fear"?

Believe it or not, I have great confidence in Ford Motor as an investment. I believe it is about to make a major turn. The stock has fallen from somewhere up around $40 to $8 and it has since dramatically reduced its total compensation costs. Furthermore, it is time for a lot of folks to git rid of gas guzzling trucks and Ford now offers alternatives. There are many good stocks to own.


As I have written many times before, 90% of success in the market comes from market allocation. Offer me the blessing of allocation skill or stock picking skill and I will take allocation skill every time. The down draft that I see coming in basic industry stocks will not help those who own the best of this group of "bad stocks".

As regular readers know, 85% of all investors achieve below average results. If you are among the "below average" crowd, you might want to change strategies. Average performance is easy to achieve. No investor should over weight a particular area unless he has very strong reasons. My reasons to over weight airlines are sound. My reasons to over weight US Growth stocks are sound. If not, I would buy "average" and still beat 85% of all investors!


Did you know that the price of lumber appears to have made a bottom? I will not buy housing stocks because I believe the next big run is years away but those who enjoy the "play for singles and doubles" might see a bounce in this area.


One can easily find buy signals today because they are many. Web sites such as the sentimenttrader, decision point, stockcharts, and many others have their favorite indicators. I look at a lot of "stuff" but am thankful to the Don Hayes group for posting a summary of the best of the signals. Of course, signals are often read two ways, beautiful fall leaves will cause some to "see God" and others to see a harsh winter on the way, both view points can be right depending on ones time frame.

One of the best of the long term buy signals is the Gambill index as reported by Scott Gambill. This index shows the buy sell ratio of the insiders at 3,000 of the largest companies. One interesting point is that the index just made a "second spike". In other words, the index is not just strong, it has taken the recent market hit in stride and spiked for the second time in just a few months. The second spike has historically been the confirmation needed for a major turn. On average, insiders are buying stocks. How about you?

Another historically good indicator is the bull-bear ratio reported by various services, including the AAII index. This indicator is well below the strong buy line. It has certainly been stronger before but those who bought every time the index was at this level did not miss the bottom too badly.

Oversold indications have also reached the BUY, BUY, BUY levels.

Total Put Call Levels are also screaming BUY, BUY, BUY.

A regular reader points out that November is the start of "the season for stocks". The numbers are compelling, those who held the DJIA for only the time from May 1 to October 31 for the 45 years of 1950 to 2004 lost money, excluding dividends. Those who only owned the DJIA from November 1 to April 30 made an average return of 7.9% in addition to dividends.

Election Year Cycle. The average gain from the mid term low to the election year high is about 50%!

Yield Curve is screaming BUY, BUY, BUY. Historically when interest rates start to fall, the market heats up. Mark Dodson reports that over the last 30 years, one year after the first cut in interest rates, the DJIA average increase has been 18.8%. Through in about 4% yields and one gets healthy even in the big old dumb and ugly stocks.

The false story in the press is that the dollar will be hurt by lower interest rates. The press does not appreciate that it is the real, after inflation, interest rate that matters. The reason the FOMC is able to cut interest rates is because the trend in inflation rates has changed. The lower inflation goes, the higher the real interest rates go. Put another way, low interest rates encourage economic activity and you need dollars to complete transactions. Over the past 30 years, one year after a cut in the Fed Funds Rate, the dollar has appreciated 4.5% on average, gold has fallen 5.4% and the CRB index of commodity prices has fallen 6.2%.


Have you noticed the lull in the battle between Bush and the Congress? It is kind of a spooky quiet. There is no doubt that this huge multiple trillion dollar budget will not be passed without significant compromise. In the old days, this was the time for the smoke filled rooms. The smoke is gone but I suspect midnight oil is being burned in attempts to reach a "grand compromise". The scale of the compromise remains to be seen. Because expectations have gotten pushed to the bottom, the potential for surprise is great. For both sides to win, significant changes need to be enacted into law. Neither party can count on winning the presidency in 2008. The time for congress to act is now!


It would take a heck of a recession to reduce earnings enough to make stocks expensive. The average S&P earnings yield is up to 7.12% while the 10 year treasury bond is only paying 4.21%. Those who are too scared to own stocks right now will pay a hefty price when sentiment changes. The flight to the safety of bonds will end with a bang. Bonds will fall in value at the same time that stocks jump in value. Stocks are currently at a 40% discount to bonds!


Please respond if you understand that inflation is about both the price of goods and which goods are bought. If a fellow normally makes $1,000 and normally spends $999 a week suddenly finds he only needs to spend $998 per week, his cost of living has gone down. If the $1 savings was because he started buying a coke instead of a beer after work and if he enjoys the coke just as much as the beer, then his standard of living did not decline. The price of top cow hide buggy whips does not affect the inflation rate because almost zero buggy whips are purchased. Inflation is a weighted average of all the things actually bought. Sales growth naturally occurs in the things that go down the most in price. On a daily basis, billions of people around the world are "buying phone calls" as a replacement for making extra trips to the store. The cost of those calls has fallen to zero at the margin but the savings from trips avoided continues to climb. The person who saves a 15 minute, five mile trip to the grocery store and back, in exchange for a "free" phone call has seen a dramatic drop in his personal cost of living. Indeed, the standard measures missed the time savings which were more significant than the cost of the gasoline versus the cost of the phone call.


Don't let the "gloom and doom" crowd talk you into avoiding good investments as a way to avoid risks. The great investment irony is that the small sure risks accepted by many investors adds up to a much greater risk then the highly unlikely large risk that they seek to avoid.