Wednesday, January 23, 2008


The way the market determines the value of anything it discounts the future stream of income at an interest rate. We know that US citizens hold assets valued at around 73 Trillion Dollars. Yesterday, the FOMC cut the discount rate by .75% from 4.25% to 3.5%. One can use a bond calculator to estimate the change in value that has resulted from this decline in interest rates. The value of a $1,000 30 year bond that carries a 4.25% coupon rate would jump by 14% if the 30 year interest rate fell to 3.5%! In other words, the cut in the cost of money by .75% is a huge cut. When the FOMC was in its tightening mode from June of 2004 until 2006, the FOMC carefully raised rates .25% 17 times to take the rates from 1% to 5.25%. The fall from 5.25% to 3.5% has been much more swift but even so not swift enough. The financial futures markets, where big money is bet on the future level of rates, have bet heavily that rates will be cut again on January 31 by .5% more. Again, using a bond calculator as a discount mechanism we find that the cut from 4.25 to 3% in just a weeks time would be the equivalent to increasing the economic value of 73 Trillion Dollars in assets by 24% or 17 Trillion Dollars.

Did you see the love fest between Harry Reid and George Bush today? Once Bush said that he would go along with a fiscal stimulus package, the politicians are all ready to come together in a great show of non-partisan tax relief for the little people. The big tax break will be a one time payment that totals about 1% of the annual GDP. To put this in perspective, imagine going home to your wife with the great news that your boss has agreed to give you a one time bonus check equal to one percent of your average pay. Then tell her that to be fair to the little people, the boss decided to give more to those who make less so your share will really only be one half of 1%. The point is not to gripe about fairness but to say that a one time payment of one half of one percent of your pay would be no reason for great joy.

To put it another way, which would be more valuable to you a one time check for one half of 1% of your pay or the opportunity to refinance all your debts, fee free, at a rate reduced by 1.25%. The comparison might be on the order of a 1 time check for $600 or a stream of savings equal to over 1 Million Dollars! For example, the payment on a $400,000 mortgage at 6.25% is $2,462 per month for 30 years. The payment at 5% is $2,147. Invest the difference of $315 per month each month for 30 years, earn 12% on this money and the result would be $1,101,158 (minus taxes owed).

You can see why the politicians are trying to pass a stimulus law quickly. They want the American people to give them credit for the coming good market and economy. These silly stimulus packages have been tried before. The great economist, Milton Friedman, wrote that a one time bonus paid to the sophisticated investor would result in extra spending of about 5%. The sophisticated consumer would understand that the bonus was indeed a one time thing so it would not make sense for this consumer to take on additional debt to buy a big ticket item with the cash. Few would want to blow the cash on short term merriment. Politicians use the knowledge gained from Friedman to suggest the money should be dolled out to the poor (after all if you are buying votes make sure you pay off the unsophisticated voter). Based on data from prior stimulus packages, from 30 to 40% of the bonus payments are spent during the 3 months after the checks are mailed. Another 20% or so is spent within 6 months. Many of the least sophisticated consumers will use the bonus to pay down on credit card debt which will only be run back up the following Christmas time.


Again, the first cut in rates from 5.25% occurred in August. The normal pattern has been for the market to be up by about 20% within a year following the first rate cut. Of course if the broad market is up 20% following a turn where prior winners do poorly, then there are normally many stocks that are up 100% or more within the first year. The pattern was broken during the last down turn. The rate cuts were gradual and were delayed while the politicians passed tax cuts in 2001. Once the FOMC finally cranked down on rates hard, a huge Bull Market started on October 10, 2002. The market came back a ways as a test in April of 2003 but by then the FOMC had rates down to 1% and the market was off and running.


Based on easily retractable known reserves, the world has enough oil to last 40 years. This does not count trillions of barrels of oil that is known to exist but that is not as easy to extract. In like manner, natural gas reserves easily extracted will last 70 years and coal reserves will last 170 years. The current situation is that natural gas is even more plentiful than oil in the short run. Supplies in storage are larger than usual and the US is having success cracking the shale oil encased natural gas deposits. As a result, natural gas keeps selling for less than 50% of the price of heating oil on a BTU basis. Of course, the worst of winter has not hit but every situation where consumers have the choice of buying natural gas or heating oil, they are buying the natural gas. As a result, oil refineries are running below capacity in almost every corner of the world. A check on the "sector melt downs yesterday" showed that energy stocks were down 3.42% while transportation stocks were down only .7%. CAL was down 13 cents on this meltdown day.

The abundance of Natural Gas is likely to increase in the years ahead. A professor at a Pennsylvania university who has studied the Northern Appalachian oil and gas fields for the last 30 years says that trillions of cubic feet of natural gas in the Marcellus Black Shale Formation can be moved to the reserve category. His basis is that the eastern half of the nation has not adopted the more expensive recovery strategies that have been used so successfully in the western shale fields. It cost $600,000 to drill the typical vertical gas well and about $3,000,000 to drill horizontally. However, the current price of natural gas makes $3,000,000 peanuts relative to the amount of gas in the Marcellus Formation. It is estimated that the recoverable gas is somewhere between 168 and 516 Trillion Cubic Feet! In the mean time, Raytheon, the big defense contractor that got its mojo in the business of microwave ovens, has sold big natural gas producers a microwave heating system for shale oil fields. Like they say, price cures price, and at current prices all kinds of innovations will be found to extract more of the worlds energy resources.

The list of innovations is never ending. There are literally hundreds of discoveries daily. One recent innovation was that a method has been found to store more than adequate amounts of methane to make automobile fuel cell engines practical. The Department of Energy standard had never been met before but the latest innovation actually exceeds the standard by 28%!


It is simply hard for people to understand the relative scale of the world. For example, one of the big concerns Americans have expressed in recent years is the fear that all the land is about to be covered over by highways and parking lots. The fact is that 90% of America has nothing built upon it. Another fact is that half of the land that is not developed is covered in trees. The story is going around that investors should buy raw land suitable for fast growing trees and switch grass. While it is true that the US government has just mandated the future consumption of 36 Billion Barrels of bio-fuel annually, it is not true that the price of land will be driven up by these new "farming enterprise". The value of land goes up dramatically as it approaches development potential. Farm land is certainly worth more than raw land but one of the rationals for growing switch grass and popular trees for ethanol production is that the best of farm land is not used.


Energy stocks were down 3.4% yesterday and not far behind were basic material stocks, down 2.9%. The demand for certain basic materials has fallen rapidly. The drop in home building has reduced demand for a lot of materials but there are other longer term phenomenon at play. For example, tiny copper wires in circuit boards are quickly going the way of the horse and buggy. Of course, optical wires have been around for big traffic applications for a long time but even tiny wires are now being replaced with optical connections. Investors should remember that commodities follow the law of bad money. The cheap money will always drive out the good and the cheap commodity will ultimately be substituted for the dear commodity. Thus we have plastic water pipes in houses and sand based wiring delivering phone calls and data.


Markets can always get worse but when they are dramatically over sold they are likely to get better. In 2001 the US market was equal to 51.4% of the world market cap. In 2007, the US market had fallen to 32.8% of the world market cap. Sure the rest of the world grew faster but not by nearly so much. The US share of the world GDP went from 31.2% to 29.7% during the same time frame. Now one can certainly argue that the reason is that foreign markets are over bought and the recent action in world markets would suggest that to be the case, however, it is often true that the truth lies somewhere between extremes. Put another way, reversion to the mean is a fundamental law of nature.

A long list of indicators say that the US market is very cheap. For example, the bulls to bears ratio is at very extreme levels, more extreme than on October 10, 2002. Other indicators that are at extremes include insider buying, several put call ratios and the Arms index.

At the same time, there are reasons to believe the US economy is ready to spring forward. As we all know, residential construction has taken a bite out of GDP growth. However, export growth has more than made up the difference. In 2005, residential construction totaled around 790 Billion Dollars and in 2007 it had fallen to about 700 Billion Dollars. The drop of 90 Billion Dollars seems large, almost as big as the 150 Billion Dollar stimulus package, however, exports grew from 1.2 Trillion Dollars in 2005 to 1.6 Trillion Dollars in 2007, an increase of 400 Billion Dollars. Recessions simply do not occur unless there is a steep decline in industrial production. But innovation is causing massive new production to take place. A good example is RFID readers. In Europe, about 2,500 RFID readers were in use in 2007. It is estimated that 450,000 readers will be in use in 15 years. The number of RFID tags to be purchased is expected to soar from 144 million in Europe in 2007 to 86.7 Billion in 15 years. As you know, substituting a computer read inventory chip for the physical action required of a person to tally an inventory is another one of those high powered substitutions. The dramatically lower cost of inventory management will show up in lower unit labor costs, higher productivity and lower inflation.


No matter is you like Hillary or not, you will probably admit that she is a polarizing figure. While we do not know how long the cat fight will last between the black brother and the feminist ex first lady, we can expect a big turnout in November. I expect the vote to be large but for a significant number of people to vote for Hillary for president while voting for a republican for congress. We have all become well aware of the dangers of having one party in control of the congress and the executive branch. Unless Rudy or Mike can pull a rabbit out of their hats, it appears that McCain or Romney will be the Republican nominee. Chances are Hillary will beat either one. One can never say for sure because 9 months is an eternity in the world of politics, but the Clinton's are playing Obama like a cat plays with a mouse and it is unlikely that the conservative base of the republican party will ever be excited by a Romney, McCain or Giuliani nominee. The best hope for the country is a republican congress to balance a democratic president. As both parties have shown, ridiculous wasteful spending occurs whenever one party holds the congress and the presidency.


Some pundits have compared the current economy to the 1990-91 economy. While there are similarities, the severity of the "crisis" is not even close. During the S&L debacle of those days, the write downs exceeded 2.5% of the GDP. During this cycle, the write downs have been dramatically exaggerated by the fact that the bad is difficult to separate from the good but even so the total write downs are only .7% of the GDP. Here again, even smaller than the puny stimulus package proposed by Bush.


The list of innovations that are rolling out are absolutely incredible. Some are mundane energy savers and others are life savers. LG Electronics has added a steam cycle to its dish and close washers. These appliances use less water and less energy per load and the loads are larger than average. One of the new life savers is an electronic stethoscope that records and analysis the beat of the heart. Of course, the progress in cell biology is all the more powerful and remarkable. Life expectancies are ready to soar to 135 years and beyond! Good news for the old and infirm is the advent of robot care takers. After talking about cars and phones that hear and understand voice communications for decades, practical applications are jumping to the forefront. Tellme Networks is offering voice accessible yellow pages while VoiceBox Tech is offering Voice Recognition for cars, computers and phones. In laboratories, robots are following instructions and completing scores of mundane tasks. Aqua Sciences is snatching clean drinking water out of the air and Novartis has found a neat new drug that helps those with hypertension.


I have not been a fan of bank stocks in a long time but the yields available keep catching my attention. Wachovia says its dividend is secure and it currently yields 7.9%! Like I have said, exaggerated write downs should show up as steady profits when home loan after home loan proves to be money good. If we were truly headed into a major recession, I would say STAY AWAY FROM BANKS, but I still do not see the recession. Merrill Lynch stated today that it sees home value declines of 30% but the "big boys" always are extra negative at the turns. Such calls by Merrill or Goldman in particular make me believe the worst is over. NO! I am not saying that the bottom was made today! Like Don Hays says, there is reason to have a love-hate relationship with super strong market indicators, because there is as much as a 7 week window after even the strongest of market indicators. Seven weeks of slightly lower stock prices would seem like an eternity to the nervous or fearful investor.

The point is that if you buy WB and earn 7.9% while you wait for the "big bounce" you will not have done badly even if the banks are slow to recover.


Thompson got many of his votes from the uplands of South Carolina which was Huckabee country. Had Thompson not been in the race, Huckabee would have probably won in South Carolina and the race in Florida would be very different. As it is, Huck will spend his resources in Georgia and other southern states. While Thompson took votes from Huck, now that he is out, some of the "old republican money" has started to flow to McCain. As we all know, the big money wants to back the winner in order to be in the position to ask for favors latter. No reasonable person denies that politics is largely about winning the power of the government purse. The naive want to believe that politicians are more pure than they seem but people are easily fooled into believing what they want to believe. For example, when Judas left the upper room to betray Jesus, other disciples believed that he must be going to buy food for the festival and to give money to the poor. The bible says that Judas was a thief and our best guess is that money for the poor was sometimes diverted from the community purse to the Judas purse.

If McCain or Romney wins in Florida, they will be the odds on republican nominee. If Rudy barely wins, then he too may be the slight favorite. The only chance left for Huck is that a close three way battle is fought to a close finish. After such a battle, where there is no clear winner, Huck could win enough southern states on February 5 to remain a viable candidate. Congressman John Linder wrote a good article explaining how Reagan was the outsider against insiders during the early days. Huck is certainly not the establishment candidate and it is painful to see his relatively excellent record as governor twisted into that of a corrupt, liberal loser. The problem is that the establishment does not want to do away with the income tax. Many a republican investment manager, accountant, lawyer, broker, foundation manager, and lobbyist would rather endure 8 years of Hillary than to give up the earnings offered to them by the income tax.


The US did not get all the new sanctions it wanted against Iran but Russia and China did go along with a tightening of the screws. A feud has broken out within the government of Iran. The supreme ruler has boxed the ears of the President. The sanctions are taken a toll. In the meantime, an American General in Iraq says that al Qaeda is on the run. Conditions are ripe for a deal with Iran. Iraq is about to let bids on development of an elephant oil field. A little good news could cause a quick $20 drop in the price of oil. Such a drop would send the market off to the races and give the McCain a great shot at winning the presidency.

17 Trillion Dollars of Economic New Value. These assets can be bought for much less. How long will it take the public to catch on? BUY, BUY, BUY all the stock you possibly can!