Tuesday, March 11, 2008


The Russel Small Cap Index jumped forward yesterday, almost a 5% move in one day. It appears that my call to move 401-K money to the small cap value index was well timed. After waiting so long for other calls to work, it is nice to have such an immediate response. Of course, even a stopped clock gets the time right twice a day.


Market participants have been playing multiple games of IF. If there is a recession, airline traffic will suffer. If there is a war, the safe play is in gold and oil. If there is a democratic congress and president, taxes and inflation rates are going up and up some more. What are the answers to these questions?

There is always a recession somewhere. Recessions tend to roll through the world from one industry and one country to another. For a recession to be declared, there must be more than a few industries suffering. The pain in one area must spread to other areas before the average industry is in contraction. Because we live in an unusual time of excessive savings, the piles of money repeatedly has driven interest rates to very low levels. Low interest rates make assets, such as houses, easy to buy at higher prices. With the demographics just right for houses and with prices soaring, there was a very long term housing boom that peaked in 2005 and that has corrected very sharply since. However, we still have baby boomers and echo boomers at prime ages to buy homes and second homes and interest rates are once again down to very low levels. So, while there has been a serious recession in the housing business, conditions are ripe for a turn. All the while, the recession in housing has been accompanied by a world wide economic boom. Even the construction industry in the USA is not in much of a recession if you add commercial construction to housing construction. The commercial construction boom has largely offset the down fall in housing construction. Two more nuclear power plants were announced yesterday. These two, to be built for Progressive Energy in Florida, will cost about 14 Billion Dollars and are planned to be finished in 2016 and 2017. The cost of these two plants is the same as the cost of 100,000 $140,000 homes. Yes, this is future construction but the example is given to show the magnitude of construction that is underway. China just approved the construction of 6 more nuclear power plants. There is about one coal fired electric plant per day opening somewhere in the world right now. Coal fired plants cost less than a third of the price of nuclear plants so each day we have the equivalent of 16,000 single family homes being completed.

The world economy is so strong that US exports are soaring. The latest "disappointing" figures showed an increase of US exports of better than 16%! The actions of the FOMC and cooperating central bankers in Canada and Europe yesterday, will make all the more money available for lending. No, the numbers reported yesterday were not inaccurate, business and commercial loans have increased at the annual rate of 21% before these actions taken by the FOMC! Yes, there is always a recession in some industry somewhere but the world is currently enjoying an economic boom. A big IF was removed yesterday, the money has been made available to support the US housing industry.


There is always a war going on somewhere in the world. I have forgotten the current count but I believe the number of current wars is in the double digits. Believe it or not, the US has gone to extraordinary extremes to prevent a war with Iran while trying to end the age of government sponsored terrorism. Thirty or so years ago, the terrorist modus operandi was to hijack a plane and hold the passengers hostage until some leader or group of soldiers were released from captivity. Over time, the strategy morphed into a willingness to blow up innocent people in markets and on planes. One of the big events in this cycle was the blow up of a plane in the early 1980's. The terrorist in this case were traced back to Libya and the US eventually bombed Libya. The good news is that one country after another has stopped overtly supporting terrorist and by all accounts many have stopped all support of terrorist activity. Unfortunately, the strongest military power and most strategically located nation in the region, Iran, has not stopped financing and training terrorist. Coalition troops are engaged on all sides of Iran, in Afghanistan, Iraq and Pakistan, but, so far, coalition forces have not been willing to attack Iran.

Over the past 30 years, economic sanctions against Iran have been gradually tightened. Over an even longer time, the USA has applied economic pressure to Cuba to little effect. There is a big difference. In the case of Iran, Russian and China have joined the rest of the UN Security Council (Indonesia abstained) to sanction Iran. Iran is carrying the weight of the whole world on its shoulders.

The price of gold and oil says that there is a serious risk of war with Iran. Iran has expressed its desired to wipe Israel off the map and there is no way that Israel is going to sit still while Iran develops a nuclear bomb. The good news is that the higher the perceived probability of war, the higher the cooperation of the UN Security council. For that reason, those in power, such as Bush, have the incentive to talk tough in public while trying to get to the negotiating table in private. My opinion is that war with Iran can be avoided but I am a retired investor in NC who has no political experience: who will listen to me?

Still, as an observer, I can see the two steps forward and one back progress. The steep decline in violence in Iraq is a very good sign but, 42 civilians were killed yesterday and 4 US soldiers? The thing is that the market will "know" if a deal has been made before the deal is announced. Stocks will soar in value long before a deal is sighed.


Week after week, month after month and year after year the market has shown that international air traffic is growing rapidly. This growth has happened concurrently with the increase in the price of oil. Part of the reason the price of oil is up is because the demand for air travel is so high. What is particularly significant is that yields are increasing. It is one thing to say that traffic is up 6% but quite another to say that the average ticket price is up 5%. The combination of the two shows the market is very strong. If the business were selling shoes, it would be great to sell more shoes but even better to sell all the shoes at a higher price.

The US has been through two quarters of slow growth. Most recessions last from 6 to 9 months. Economically speaking we are in the 6th inning of a 9 inning game. Share prices lead the economy by 6 to 9 months. The market breathe turned negative back around June of 2007, 9 months ago. Yesterdays great response to the FOMC action shows how nervous the market is. There is a ton of money sitting on the sidelines and great fear of missing the next big "BULL". With public sentiment about as bad as you will ever see it, the "active players" are as jumpy as you will see them. The "active crowd" is trying to "catch the bottom". No one is good at "catching bottoms" but there are lots of people who continue to try. Once this crowd perceives that the bottom has already been made, there will be a stampede into stocks.


It has now been about two years since I wrote that health care was due for an internal turn. I wrote about how the labor intensive side was on one end of the health care see saw. I expected companies such as United Health Care, Humana and Well Point to suffer and for the big pharmaceutical companies to gradually start out performing. Yesterdays action confirmed that the turn is finally upon us. My proxies have been PFE and UHN. Just a few months ago, the relative performance since my first writing was still upside down from my call, UNH was up 5% over the prior 20 or so months while PFE was down 13% (not counting dividends which almost brought the total returns in line). After yesterdays moves, UNH is down 35% while PFE is down 18% over the prior two years. Through in a high dividend from PFE and you can see that the relative performance has now turned substantially in PFE's favor.

The new trend is here, big PHARMA should out perform "provider care" over the next several years. You can buy PFE now with great confidence that the returns will compound at higher than average rates for several years. Throw in the nice dividend and you will see substantial returns.

For at least 6 months after the turn, US SMALL CAPS will out perform most sectors. After a turn, you want to be in high beta stocks. Small banks are very heavily represented in the Russel Value Index. Small banks are now enjoying a positive yield curve after 19 months of fighting the FED. Earnings will surprise the market over the next several quarters.