Wednesday, November 14, 2007


Bear Sterns has stated that the worst of the sub prime crisis is over. A number of stocks impacted by this "mess" have bounced. Some say that firms such as Country Wide, Northern Rock and E-Trade will never recover. "They" may be right; these three companies and others may be taken over. My take is that those who keep looking for a major disaster can find "reasons to believe". The global warming crowd is a case in point. The science is not nearly as clear as the doom crowd would have us believe but those who believe in big government programs have financial incentive to believe. This is the same kind of phenomenon we get with Goldman stock recommendations, the recommendations are almost always wrong but, time after time, the company makes money on its trading activities. The company clearly does not follow its public advice. One of the reasons it is clearly time to buy airline stocks is that Goldman went from buy to neutral last week (just before the turn).


My 20 month old grand daughter, Jules, has a stock portfolio. We call it her ABC mutual fund because we intend to buy A through Z before starting over. The fund is all about education. We want this young lady to be a patriotic citizen, one who understands that people help other people when they make good products and sell them for reasonable prices. We want her to learn to have a long term view, to pay as little as possible in fees and we want her to get tons of company literature in the mail. Her first 6 stocks were AAPL, BIIB, CAL, DAL, ETFC, and GOOG. Her returns to date are 83%, 58%, -24%, -9%, -68% and plus 39%. Her average return is 13.1%. If we had skipped the E-Trade, her average return would have been 29.4%.

The management at E-Trade has strongly stated that the firm is well capitalized. Over the past two days, it appears that the "vultures" have started covering their shorts. In a few months, it is going to be clear to the world that the sub prime mess was not nearly as big a deal as it was perceived to be.

There are several indications that the worst of the housing related problems are over.

1) Reported pending home sales were higher than expected.
2) Lumber prices, after dropping for more than a year, have turned up.
3) The maximum write downs reported by the big holders of "sub prime slime" is less than half of one quarters banking profits.
4) The winners made what the losers lost. Companies such as Goldman Sachs made money on the short side of leveraged transactions.

A well know fact is worth repeating here; recessions do not occur during times of strong wage and job growth. Of course, near the end of a strong boom, when wage and job growth have been strong for an extended period, central banks find it necessary to raise interest rates to kill off inflation. The US Central bank has recently lowered interest rates twice, even while wage growth has boomed. The reason our central bank can lower rates during a time of rising employment and rising wages is because other factors are holding down the inflation rate. The naive focus on the price of gas while those in the know realize that the cost of a text message substituted for a trip represents a huge drop in inflation. The change in core PPI reported this morning was ZERO!


The following are a few of the key "hours on the economic cycle clock".

Down turn in commodity prices -- 5 O'clock.
Bonds rise stocks rotate -- 7.
Mid-cycle stock bottom -- 8.
Technology stocks peak -- 9.
Transportation stocks peak -- 10:30.
Market peak -- 2.

In this cycle 5 O'clock matches up to April of 2007, which was the date of the peak in industrial metals used in manufacturing.
Bonds have risen and the rotation in stocks has been taking two steps forward and one backward for many months.
Contrary to what the "inflationistas" predicted, bonds have risen to extreme highs. Seven o'clock has come and gone.
The market made a bottom and then came back and tested the bottom. Bottoms can only be called in hindsight but it appears that the "worst is over". Companies such as Bear Sterns have bounced off their lows. Unlike a regular clock, the economic clock can go backwards for a little while. It sure looks like we have passed 8 o'clock.
Technology stocks enjoyed a great run, got whacked and then took off again. AT least part of the crowd is playing in the after 8 o'clock cycle.

By the way, the peak in momentum will not mean the tech sector dies at 9 o'clock. The market boom, which will last until about 2 PM, will include lots of stocks and lots of sectors. Some sectors will do much better than others but many will participate.

Every economic cycle is different. This one has been distorted by the incredible growth in China, India and other emerging markets. This fantastic growth has not repealed the business cycle. Oil and gold have held up long after the turn in industrial metals. "Oil Inflation" was pushed into agricultural commodities when food stocks were inadvisedly used to produce fuel. The Chinese recognized the mistake some time ago and cut back on the production of ethanol. The Chinese are adding coal fired power plants at the rate of one per week so that corn can be used to feed hungry people. The turn appears to have come to agricultural commodities. It is too early to say for sure as the latest move down could be just a dip. The congress of the US just passed a farm bill that to expand payments to farmers even while farmers enjoy record revenues and profits. High prices have lead to increased production. As soon as a few more countries stop wasting food crops on fuel, the price of agricultural commodities will fall.

The potential for a big move is here. Declining demand for oil is being met with jerky growth in new supplies. A long list of "elephant oil fields" are under development. US demand for oil fell .6% in 2006. While US demand was growing during the first half of 2007, it has declined in recent weeks. The price of oil is destructing demand. It appears that the US will end the second year in a row with slightly less demand. Again, the flow direction of pipelines between the mid west and the gulf coast have been reversed. The increase in production from Canada has replaced imports from other countries. China has once again raised bank reserve requirements. Moderately slower growth in China could be the catalyst for billions of barrels of hoarded oil to flow back on the market. As noted in previous emails, now that the futures market is in backwardization, the incentive to store oil has been reduced and US inventories have been drawn down a touch. Still, the world wide total of oil in storage is still near all time record levels. Peace, which appears to be breaking out in the middle east, will take away about $20 to $30 per barrel in risk premium.


The Jules fund is basically a buy and hold fund. It is what is commonly known as a coffee can portfolio, large fortunes have been made using the "coffee can technique". She pays zero annual fees, zero hidden fees and virtually no brokerage fees. She has taken a hit on her ETFC shares but 20 plus years ago her mother took a bad hit on a stock that was later bought by UNH and that has grown to more than 130 times her original investment.

I believe ETFC will survive. If it does not, it will probably be purchased by a big bank. Wachovia recently added AG Edwards to its brood of brokerage companies. I disagree strongly with the fellow who recently said with great emotion that the business uses a flawed model. There is big money to be made in the Internet brokerage business. The irony here is that ETFC has suffered because it attempted to diversify away its risks. It is the lending business, not the brokerage business that hurt ETFC.

Like I said earlier, I believe the worst is over. Aggressive investors with extra money available should buy ETFC. It will likely take great patience to make big money. If a take over occurs, the price may be well below the old high but probably at least double the current price.