The fact that consumer spending has reached the all time high of 72% of GDP is being used by alarmist to suggest that a long down turn is underway. (see chart below) For various reasons, some people do not want to see the good and to be happy.
When government gets too big, economic growth slows. Here is the Rahn Curve, developed by Richard Rahn.
New home construction has increased for five months in a row. However, multifamily (apartment) home construction fell by 13.3% last month! The 1% decline in new starts masks a rebound in single family home construction.
Several readers have asked me about the recession talk in the news. They sometimes have mentioned the Dorfman article that suggest one of the worst recessions ever is on the way. My opinion is that a recession is unlikely.
My key reason is that total compensation will rise about $500 billion in 2007. Furthermore, the inflation that Ben Bernanke is worried over is the "wage-price spiral inflation" that can take over during the economic boom of the prosperity phase of an economy. Bernanke is holding the fed funds rate about 75 basis points above the t-bill rate because he is trying to keep wages from rising too fast!
Of course, Ben thinks he has the fed funds rate at the perfect level right now. He is prepared to lower rates more if there are more economic problems and he is ready to stand pat if it appears the turn has been made.
A number of signs suggest that the turn is here. It took only a hint that Merrill would hire a new CEO and the stock soared. I do not recommend investment banks as an investment right now but it would be amazing for Merrill and Citi to replace their CEO's while suffering such a short period of pain.
By the way, the big write downs were probably political moves. One almost has to express sympathy for Charlie, Nancy and Harry. Here they were ready to tax carried interest as the source of funding to eliminate another bad tax, the AMT tax, when the carried interest profits disappeared! Wow, I know I sound like the greatest cynic of all time but it is amazing how "bad" the economy has gotten just about the time the congress is ready to raise all sorts of taxes. Of course, this might simply be a chicken before the egg story. The quote about cynics that comes to mind is that "diplomats are honest, well respected people who are hired to go lie for the best interest of their country".
Believe it or not, Bush is playing a strong game of poker and he holds the winning hand. He has Iran backing away almost as fast as Mrs. Pelosi. Congress is going to go way past its deadlines without finding the way to push through much in the way of new taxes. When the congress packs up and goes home (probably after coming back after Thanksgiving) the market should see a relief rally. The decks are being cleared. 2008 is going to be a good year for investors. NO RECESSION IN SIGHT!
A regular reader writes:
"The airlines seem to be hurting an otherwise beautiful portfolio. Gas prices continue to rise. What do you think? Do you still think airlines will go up soon?"
The first week of October, my wife and I made our annual trek to Blowing Rock, NC. We enjoy visiting the mountains this week because "Art in the Park" is held in Blowing Rock and because the mirror image of the maple trees around Bass Lake is as pretty a picture as you will see. This year, the leaves had not turned. Our walk around Bass Lake was still one of the highlights of the year but the leaves were mostly green.
The following week, I could hardly wait to go camping at Table Rock. If you have not been to Table Rock, you have missed one of the prettiest views in NC. The peak at Table Rock is only 1 mile from the state operated parking lot and picnic area, but the views of the NC highlands extend in all directions, including a full view all the way up Linville Gorge. Once again, I had a great trip and the views were gorgeous but the leaves were still mostly green.
We are now into the first week of November and the leaves are turning fast. Earlier this morning, the temperature hit 32 degrees. You can bet your boots that the green oak trees in our area are finally about to change colors. Yes, I do believe the leaves will turn and I believe they will fall off the trees.
PRICE IS PREDICTABLE BUT NOT AS PREDICTABLE AS AUTUMN LEAVES
This fall, the price of oil has been more stubborn than the leaves. Will the price turn? The timing is certainly less certain but yes, the price will turn.
The reason investors who have short term outlooks do not do well is that they switch out of winning positions to avoid short term pain. The temptation is simply too great to follow the crowd, even when common sense says the crowd is wrong. No one likes to feel like they are the only ones losing money. Studies show time and again that there is an inverse relationship between the frequency of trading and investment returns. Successful investors tend to identify trends early and they tend to sell too early. Successful investors do not try to catch every trend. It only takes a few 10 baggers to accumulate great wealth.
STRAIGHT FORWARD MATH IS OFTEN A KEY TO SUCCESS
Many things in life that must ultimately follow the laws of math even though the math seems to be broken in the short run. The typical mathematical formula does not include a function for the emotion factor. Two of my favorite quotes from one of the greatest economist of all time, John Maynard Keynes, are: "The market can stay irrational longer than you can stay solvent", and "In economics, the majority is always wrong." The oil market currently fits both quotations. The greed factor is in full force in the oil market at the same time the fear factor is killing the dollar. The combination has pushed oil and the dollar to extreme levels.
Lets look at an economic formula to see if math is working in our favor.
Income = Consumption + Investment + Government Spending + Exports - Imports
The USA just reported GNP growth (income growth) of almost 4% for two quarters in a row. How can the US economy grow so rapidly in the middle of a housing slump that has knocked 1% off the growth rate? The answer is that all of the above components of income are contributing.
Consumption, by Shays Law, feeds on itself. The 3.8% real growth in GNP last quarter means that the average American experienced growth in income equal to 3.8% after accounting for inflation! In America, one thing you can count on is that if Americans experience a rise in income, they will spend more. The reason we call Americans "consumers" is because that is what they do.
In regard to investment, US assets have gotten very cheap relative to assets in the rest of the world. In particular, Europeans can now build a factory in the US for 35% less than the cost a few years ago. As a result, the drop off in residential construction has been almost totally offset by growth in business construction and the purchase of business equipment has held up well even in the face of a credit crunch.
In regard to government, the obvious statement is that we do not have to worry about a drop off in spending. It even appears that Congress will cut the AMT tax without raising other taxes as much.
Finally, we get to the big change that has occurred over the last year or so, export growth is exploding upward while import growth has collapsed. While anything can happen in the future, those who claim the US economy is currently in a recession are simply wrong. It is impossible for the income side of the equation to go down if all of the right hand side elements are going up.
Why is export growth exploding? Foreigners, who hold more US dollars than at any other time in history are experience the equivalent of the Jimmy Carter days. Back in the late 1970's, it made no sense to save ones money for future consumption. By the time one saved $1,000 to buy a refrigerator including compounded interest, the price of the refrigerator had gone to $1,500. Today, the citizens of the world, including US citizens are enjoying low inflation rates. However, the dollar has fallen relative to other currencies. Foreigners who hold dollars are missing the boat if they continue to hold the dollars instead of buying US goods or assets with those dollars.
THE BIG TURN
Yes, the big turn has already hit US trade but the US dollar has continued to fall. Those who buy the dollar now are similar to those who bought oil stocks in 1999. Oil stocks did not go up immediately but they looked better and better as we moved to the other end of the fear and greed rope. This is where psychology trumps math in the short run. The reserves of US dollars held by foreigners has never been a higher number and these holders are sick and tired of losing money. The "old money Europeans" who hold at least a portion of their wealth in US dollars have seen the value of those dollars fall by better than 35%. What would you do if your bank sent you a statement month after month that showed your savings account had earned 4% interest but the principle value had fallen by 5%? If your savings are losing value, you might as well buy something with them.
AIRLINES ARE MAKING MONEY
A major fact is that airlines are making money. One of the common half truths expressed by the financial media is to imply that if costs go up then profits must go down. A similar half truth is the notion that if a producers selling price goes down he will suffer profit declines. This kind of thinking would suggest that the huge profit growth experienced by Dell Computer in the 1990's was impossible. The fact is that as the price of computers fell, Dell sold more while maintaining or even increasing its profit margins. In the case of airlines, the industry lost a lot of money in 2003, 2004, 2005 and 2006 but it made a lot of money in 2007. The compounded fuel cost increase was very substantial but the profits did not start rolling in until after the price of fuel was very high.
One of many facts in favor of airline stocks is that airlines are a lot like buses with wings, the higher the price of fuel, the more economical it is to ride the bus. The fuel expended per mile per passenger is higher in a car than it is in a buss or a plane.
The real key to profits is the elasticity of demand versus the elasticity of supply. JAL airlines told the "elasticity story" in its most recent report. It seems that there is so much demand from Japanese business travelers that consumers are getting priced out of the market. JAL is still waiting for delivery of its huge order of new planes. When demand is great and supply is restricted, what can a business do? Around the world, the price of airline tickets are going up. JAL just joined the party with its announcement of a huge jump in profits.
The following are other interesting facts.
1) The world wide order backlog for new planes has never been any where near current levels.
2) Both Boeing and Airbus have experienced delays in bringing new planes to market.
3) China, India, and other developing nations have dibs on the great majority of planes to be delivered over the next couple of years.
4) US airlines are flying many planes that are 35 years of age with no hope of replacing these planes for 5 years.
5) These planes are gradually being retired, reducing the capacity of the carriers.
6) Many 50 to 100 seat planes are being added to the US system but these are being used primarily to feed traffic to international hubs.
7) For three years running, US carriers have set new records for full seats.
8) Another word for elasticity is flexibility and airlines have no flexibility in regard to adding enough seats to fill demand.
9) The only area of flexibility left is in setting seat prices.
10) After making 30 or so price increases of $5 per ticket over the past three years, the most recent increase was a $10 per ticket increase. Fuel prices are being passed along.
LETS SEE WHAT HAPPENS NEXT TUESDAY
Next Tuesday, December oil contracts expire. By Tuesday, those speculators who put on short positions some months ago must deliver the oil. Now that the oil futures market has returned to backwardization, there is no incentive for big oil companies to store extra oil. They can simply wait to buy real liquid oil for substantially less than the price offered by futures contracts. As a result, excess inventories have been bled off. Over the past couple of years, world wide excess capacity has grown from a very tight 1 million barrels per day to 3 million barrels per day, which is admittedly still tight relative to daily consumption of 82 million barrels per day.
HOW MUCH EXCESS CAPACITY IS ENOUGH?
Major development projects will be completed in just a few months with even bigger projects to be completed the next year and the next. If excess capacity were up to 4 million barrels per day would the risk premium fall?
The fear of conflict in Iran will ultimately go away, one way or another. When it does, oil could fall as much as $30 per barrel in a hurry. One of the ways that the risk premium could go away is already in the works. A year ago, big oil companies stored all the oil they could because they were being paid well to do so and the fear of supply disruptions was high. Today, when oil is available on the market for less than the price of a futures contract and the excess supply of three million barrels is enough to offset a significant disruption. The incentive to store oil is fading quickly. More and more stored oil is going to be released. More and more strategic oil reserves around the world are going to be capped off. As far as I know, France is the only country so far to actually use strategic reserves but other reserves are full or close to being full.
Warren Buffet has said that in the short run the market works like a voting booth and in the long run it operates like a weighing machine. Right now the speculators are voting for $100 oil but the weight of the supply and demand evidence is that oil should fall to $60 or less.
Airlines are selling at very low prices relative to projected earnings. Analyst have consistently under estimated airline earnings for at least 8 quarters. Each future increase in earnings will likely be met with increases in the price of the stocks.
I predict a "major positive event" will occur within three months. This event could be anything from intervention in the currency markets by the US government to agreement in the middle east to a Palestinian state. The good news will be a surprise. Chances are good that airline stocks will appreciate in value before the news is public.
RIDE THE BUCKING BRONCO
This is once again a Ken Fisher moment. The market is trying to buck you off the best horse. Hold on for a great ride!
The following response is to reader emails.
Resort real estate prices peaked in 1985 and again in 2005. After the peak in 1985, investors still had the opportunity to sell at slightly higher nominal prices in 1987. The loss incurred by owners from 1985 to 1987 was an opportunity loss, they could have made great returns in stocks while they were stuck waiting for the "last bounce" in real estate prices.
Today, we are in a similar "in between time". The peak in resort prices was in the spring of 2005 but the declines since that time have been relatively small in most cases.
The fact is that there are major forces playing a game of tug of war in regard to housing.
On one side:
1) residential housing is over built, and
2) the supply of empty homes has never been greater, and
3) the news media is having a field day reporting various real estate "problems", and
4) a couple of million "owners" of homes have no equity, and
5) we are near the end of the 17 to 22 year (18.3 year average) real estate cycle, and
6) the final down turn in the real estate market is "kicked off" by simplification of the tax laws.
On the other side:
1) their are more people of prime age to purchase a second home than ever before, and
2) mortgage rates have fallen over the past several weeks and are back to levels seldom seen in my life time, and
3) income and wealth is soaring, and
4) despite the current high price of oil, the percentage of income needed for the necessities of food, clothing and fuel has fallen dramatically over the past 27 years and the sharp declines continue, and
5) as a result of open trade and technological innovation, the people of the world are enjoying an "unknown level of prosperity", and
6) tax compromise that would eliminate interest expense deductions could take another year or two to come to reality, and
7) the past three economic cycles have been stretched and there are signs that this one will be the longest on record, and
8) the real estate bounce after the peak in 1985 reached its secondary peak in August of 1987 but well after the "big economic turn", and
9) the big economic turn of this decade is still an ongoing event,
10) the bounce in real estate could be significant given that next year will be the "year of prosperity" as the country moves through the presidential election cycle.
After the 1985 peak, it took better than 5 years to reach the next trough. The peak of "walking away" from resort property did not occur until early in 1991. Adding 5 years to the 2005 peak gets us to 2010 but, again, this cycle appears to be on its way to the longest in history. The real estate cycle has been measured for hundreds of years as a 17 to 22 year cycle. Adding 22 years to 1991 would project 2013 as the year of the next trough. As you may recall, Harry Dent, who has written a number of books detailing the demographics of the real estate cycle, has already updated his "Next Great Bubble Boom" from the Greatest Boom in History : 2005 to 2009 to: the Greatest Boom in History: 2005 to 2021. Since that rewrite, the cycle has been slow to progress.
One can argue that the business cycle has been tamed. Those who made that argument in the late 1960's rue the day. The second recession of the 1970's, the 1973 recession was one of the worst. More financial institutions went out of business in 1973 than in any other year in history.
The bottom line is that investors should avoid buying resort property for at least 3 more years. My family sold a lot of property in 2004 and 2005 and we should have sold more. We are prepared to lower our offering prices at the beach aggressively if the coming year of prosperity does not flow over to beach home prices. We expect to be totally sold out before the presidential election.
The big crunch is in the last year of the real estate cycle. In 1990, the average return on equity in commercial real estate was negative 40%! The numbers for resort properties is not available but it was probably worse. Those who choose to speculate on the current downturn may do well to buy resort property today and to sell in in less than a year. I believe the risk is too great relative to the potential reward.
Thank you all for asking questions. I hope the above is the information and opinion that will help you.
THREE SETS OF MAJOR NEGOTIATIONS ARE UNDER WAY
Condi Rice has been involved in negotiations concerning the "two state solution" in the Middle East for several years. She is preparing to hold a big pow wow with representatives of several Middle Eastern Countries. We know that big pow wows are not held to negotiate an agreement but to announce agreements that have already been reached. It seems unlikely that great progress has been made, but we should know more by November 14th.
We should all say an extra prayer or two for peace in the Middle East. Many of the battles in this part of the world have their roots in battles fought centuries ago. Some say there will never be relative peace in this part of the world but the truth is that peace has broken out in large parts of this area. Several countries in the area are progressing rapidly up the economic scale. One lesson from history is that well fed prosperous people are not as likely to initiate war with their neighbors. One of my reasons for believing so strongly in free trade is that neighbors who trade seldom go to war.
Negotiation Number 2
The negotiations continue between Iran and the International Atomic Energy folk. I never can remember the full name of the agency that is in the thick of the negotiations or even the head of the negotiations but progress has been made. Under the latest sanctions, the pressure on Iran to "make a deal" has increased. There is room for compromise. Russia, which is the supplier of nuclear equipment to Iran, does not have any desire for Iran to have nuclear weapon capability. Even China is too close to Iran for comfort. Over in North Korea, the USA will supervise the dismantling of the nuclear facilities. The world is a safer place when rouge governments are kept from having nuclear weapons. On September 6, 2007, Israel bombed the start of facilities in Syria. While the USA would prefer to reach a negotiated settlement, there is no doubt that either the USA or Israel will bomb the Iranian nuclear facilities before nuclear bomb capability is reached. As usual, an aerial campaign has limitations and the Iranian facilities have been spread out and hardened. I do not believe the situation will require bombing because I believe the Iranians have more to gain by negotiating peace. Scores of major projects, including projects to build out Iranian oil fields, will start soon after a compromise is reached. The USA has no problem with Iran use of uranium for the production of electricity. Russia has offered to supply the fuel for the plants. Countries such as Pakistan and India, which have nuclear capabilities, make leaders in Iran jealous but adding additional nuclear bombs in Iran does not solve other problems. Negotiations between the USA and India in regard to nuclear capacities are in progress.
Negotiation Number 3
The Bush administration is apparently focusing its budget and tax negotiations with Nancy Pelosi. Nancy has become know in the House of Representatives as the "Committee of One." She does not support the proposals made by Charlie Rangel's Ways and Means Committee. The word is that she especially desires to pass an energy bill this session. The problem is that the democratic solution to energy is the piling on of wasteful incentives. Hillary, for one, has openly declared war on oil company profits, saying that she will use these profits to fund alternative energy sources. As we know from Econ 101, the market will automatically find the most efficient resource allocation. Again, the current energy bill in Congress is an add on of CAFE standards, additional payments to farmers and other programs that actually harm the long term progress toward energy independence. For example, when the government forces people to buy cars that use less gas, they encourage people to drive more miles. A regulated price does not produce the same results as a free market price. Indeed, one of the seeds of the current problem is the price controls on US oil that were in place during the late 60's or early 70's. Can you imagine that at the time it was thought to be good policy to hold the price of US drilled oil to $4 per barrel!!
A statement was just released from the United Nations saying that the use of corn for fuel is a crime against humanity. I think I heard the official say that the 100 bushels required to make 13 gallons of ethanol is enough to feed a starving child for one year. The exact numbers do not matter because the point is valid; children are starving because wealthy people are paying to convert human food stocks to auto fuel.
WHAT IS CONGRESS WAITING TO DO?
One month after the start of the 2008 fiscal year, Congress has yet to submit a single budget bill to Bush. Obviously, there is still hope for a significant break through of some kind. It could be that democrats believe that they will ultimately force through the budget busting SCHIP bill (it was passed once again by the Senate late yesterday). Once Bush is defeated once, the logic goes, he will be weak and Congress can then steam roll through other measures. I doubt that the SCHIP will pass in its current form.
The more likely scenario is that a major compromise is still a possibility. The budget negotiations have been in progress for many months. Hank Paulson left his job at Goldman, one in which he reportedly earned about $200 million per year, in order to pass the real "mother of all tax bills." This would be a repeat of the big Regan (Kemp-Roth) compromise. As you may recall, in that case, Don Regan left a similarly powerful job as Chair of Merrill Lynch to negotiate what was the "mother of all tax bills" at the time.
As I have mentioned, based on the very powerful real estate market cycle, we are over due for a massive tax reform bill. Mike Huckabee is moving up on the right. He has become a dark horse possibility for the republican presidential nomination. He has proposed the eliminating the IRS. He would substitute a consumption tax. The Regan tax revolution began about 26 years ago. It has taken a lot of work and a lot of compromise to reach the point where a move to a relatively flat tax would not be risky or potentially too disruptive. The Ryan proposal, 10% tax on the first $100,000 of income and 25% on all over $100,000, with standard deductions but no itemized deductions, is a doable compromise. It would do away with the AMT while producing tax revenues equal to the current law. Of course, democrats would insist on a third bracket for the rich and tax payers would be given the option to take itemized deductions by filing under the current system. Huckabee has a great idea but the risk of a massive conversion is too great. The wisdom of the framers of the constitution is always most apparent when the boldest and most risky ideas gain momentum.
In the current political climate, a great compromise seems impossible. On the other hand, democrats know that despite their massive lead in the polls, that they are vulnerable. The "big issue" that brought them into power has turned. Progress in Iraq continues. The death rate has collapsed. It is too early to know for sure but it appears that the war will be a positive for republicans by the time the election rolls around. The left is not happy with the democratic leadership. No real progress has been made since the last election. Without compromise, there will be no progress. The best of government policy has always been a result of "ruling from the middle." Negotiators have no reason to suggest a deal is close or not. There is nothing to be won by coming close and there is much to be lost if expectations are raised immediately before all deals fall through. In any event, a budget compromise of significant magnitude must be reached. If you want to see a massive dump the incumbents movement, just let Congress try to leave town after only passing a "continuing resolution budget."
TOTAL WORLD MARKET FUNDS
A reader wants to know more about the "total world market funds" that I mentioned yesterday.
There are a number of funds that track the "total" world market. The word total might be inappropriate because there are always a few very small markets excluded. Vanguard is the market leader in very low cost index funds.
PLEASE NOTE: The US dollar is as cheap as it has ever been relative to the Euro and it is also very cheap relative to many other currencies. Even the Yuan has appreciated against the dollar during the past year. As such, I am a strong proponent of "buy the USA" right now. In particular I believe there are bubbles in the Chinese markets. As such, the "safe" way to invest right now is to focus on American stocks. Those who promote diversification on top of diversification disagree with concentrating on investments in any country but even most of these guys would say that if you are going to invest in only one country the USA would be the one.
Once again, I tell you that I am an aggressive investor. It is arrogant for anyone to believe that they are "smarter than the market" in the short run but history shows that there are those who can beat the market in the long run. I have made my share of mistakes but my record is strong. Over the next several years, the USA could prove to be the very best place to have all of ones funds.
OFFENSE AND DEFENSE
In any endeavor, it is easy to get caught up focusing on offense. A church friend of mine just reminded me of this truth when he told me about all the big gains he is enjoying. He named a number of high beta stocks he owns that have soared in recent weeks. I cautioned him and will caution you: remember to play defense.
How does one play defense in the stock market?
Most people would answer the above question with talk about bond allocations, cash allocations or portfolio diversification stories. All good answers but not answers that lead to championship results. If you play not to lose, you will have a hard time winning any championship. The more powerful answer is that one should buy the bigger companies when one is trying to keep running up the score without risking multiple interceptions. The offensive move is to buy the smaller stocks in the country that has the advantage. The problem is that the best time for small stocks, the years immediately after a major recession, has already come and gone during this cycle. Some small stocks will do very well during the years ahead but the proportion will shrink.
Near the end of the 1960's cycle, successful investors piled onto only 50 stocks, these were know as the "Nifty Fifty". At the end of the tech bubble of the 1990's, relatively few stocks had extreme valuations. Companies such as AOL were priced as if they would never stop their rapid growth.
Today, the big bubble is in China. Who knows how high a mountain will be climbed? I missed the big move but will not compound the mistake by "getting in near the top."
The bottom line is that the writer of this letter is currently very aggressive while buying many "defensive stocks." Once again, this is a different definition of defensive stocks that the popular definition. I am not buying consumer staples. I am not saying a recession is near. I am saying that big cap growth stocks, such as the top 100 stocks at the NASDAQ, are likely to do well over the next several years. Yes, I still have a massive overweight in the airline area and not even I can call this investment defensive. My overweight is in the "best of breed", CAL, and it is in American stocks but the company is highly leveraged in a volatile business. Investors should always seek out volatility in the "good times." Of course, volatility is a pocketbook breaker in "tough times."
Small international stocks are among the most volatile but, because I believe we are within 3 or 4 years of "tough" times, it is time to overweight the relatively safe haven of the USA and it is time to under weight international.
LEFT OF HILLARY
I continue to be amazed at how all the democratic candidates have run to the left of Hillary. Hillary has been able to run toward the center and has become the "most attractive of the liberals". Investors should pay attention to the coming election. The potential for moving the markets is great.
Got to run! Have a great weekend.
Few people are stock market "wizards." The good news is that one does not need to be a good stock picker to make lots of money. The asset allocation decision is the most important factor in investment success.
The bad news and the good news is that the great majority of investors achieve returns that are less than average. The reason this is good news is that the under performance of the many makes it very nice for those who decide to take above average returns.
The best way clear up the above comments is by way of examples. The actions of family A and family B tell the whole story.
A and B live almost identical lives. The primary bread winner in each family has the same job and makes the same money. Both families live in $300,000 homes in the same neighborhood. The big difference between the finances of the two families is that family A is paying off their home at a more rapid pace than family B. Family B has made smaller monthly payments each month but has invested the difference in a total world stock market index.
Family A has equity in their home of $200,000 and family B has equity of $100,000 in the home and another $100,000 equity in the whole world stock market index. Each home, being in a good community has appreciated just slightly above the average long term rate for homes and the stock market fund has also appreciated at just about average long term expectations. The following are the expected returns for the next 12 months.
Family A will see their home appreciate by 6% of $300,000 -- $18,000. Their return on equity will be $18,000 divided by $200,000 or 9%.
Family B will see their home appreciate by 6% of $300,000 -- $18,000. They will also see their stock account appreciate by 12% or $12,000. Family B will pay 6% of $100,000 or $6,000 more in interest on their home than family A. Thus the total return of family B will be $18,000 plus $12,000 minus $6,000 or $24,000. Their return on equity will be $24,000 divided by $200,000 or 12%.
The primary reason family A wants to get the home paid off early is for their "peace of mind." Forty years later, when family B has extra equity of $5,000,000, which is $6,000 invested and compounded annually for 40 years, I submit that it will be family B who has "peace of mind."
Family A feels good in the short run, family B feels good in the long run. Both have a huge advantage over family C because family C has run up $10,000 on credit cards. The annual cost of $1,800 could be invested at the stock market average of 12% to produce $19,000,000 during a lifetime. Family C gives up $19,000,000 in order to buy some stuff this year rather than waiting until next year.
In the examples above, Family A is the below average return investor, Family B is the average investor and Family C is the family who enjoys punishment. Now let's look at Family D, the family of high risk according to the jealous comments of A, B and C.
Family D also lives in the neighborhood in a $300,000 house. This family made the smallest down payment allowed and refinanced to a 30 year fixed rate loan when interest rates were low. They have zero equity in their home but they have $200,000 equity in the total world market index fund. Indeed, they actually own $250,000 of the fund and they have a $50,000 loan against the account. Over the next 12 months, again assuming returns equal to the long term averages, Family D will see their home appreciate $18,000. Their stock account will appreciate $30,000. They will pay $12,000 more in interest on their home than Family A (in this example I am using the payment toward the first $100,000 as the "owners rent"). They will pay another $3,000 in interest on the $50,000 stock loan. Their increase in net worth will be $18,000 plus $30,000 minus $12,000 minus $3,000 or $33,000. Their return on equity will be $33,000 divided by $200,000 or 16.5%.
The following are the returns achieved:
Family A 9%
Family B 12%
Family C 8.1%
Family D 16.5%
Like I said, family D will be perceived by the others as the family who takes high risk. The reality is that family D will achieve great wealth partly because family D has reduced its risk.
Let's suppose all four heads of household are laid off from work. Which families have a source of cash? Family B has $100,000 liquid and family D has $250,000 liquid!
Which family would have the negotiating power to miss a few house payments if push came to shove? If family A is behind on its house payments, it is in big trouble. The pressure in on his neighborhood banker to reduce non performing loans. If the bank forecloses on family A, the bank will get a non performing loan off the books without taking a financial loss. Family D will be last on the foreclosure list. Family D has no equity in the home so the bank will likely lose money should it foreclose on this loan.
Financial Advisors are by nature risk adverse. Big money is made by the Financial Advisor who can convince his clients to broadly diversify into high fee mutual funds. Many an advisor has built themselves annuities by accumulating large positions in funds. Year after year the advisor "earns" his fee without any additional work on his part. Advisors often promote Mutual Fund Families for "annuity reasons." If a client gets frustrated with the performance of one fund, they might switch to a different fund in the same family and keep the river of fees flowing to the investment advisor. Financial Advisors know that frogs will boil to death if heat is added to the pot slowly. They also know that rapid changes will cause the frogs to jump. Financial Advisors make big money off of those people who are willing to sit for years in funds that offer mediocre returns. Advisors frequently promote "lifestyle funds", "balanced funds", "income funds" and many other variations and combinations of "diversified" funds. The result is the problem noted by John Maynard Keynes so many years ago, that with maximum diversification there is no profit.
The moral of this story is that it is easy to be an above average investor. All one has to do is allocate ones assets for long term growth while avoiding paying high fees.
MORE WORDS ON THE TURN, TURN, TURN
I was asked if I thought Merrill Lynch is a good investment now that it has dropped so much in price. My answer is an emphatic NO!
On several occasions I have described the economic turn as being similar to turning around a battleship. It takes a long time to turn around an economy or a battleship and once the turn is made, each will run in the new direction a long way. In each sector, there are first half and second half stocks. In the financial sector the first half stocks are the big investment banks but in the second half it is the small regional bank. During the second half of the cycle, small companies grow their business. When they expand, they are likely to borrow funds. The typical small business will do its borrowing from the small regional bank. The merger and acquisition fee train will slow during the second half as the Merrill Lynch's of the world will not be involved when the typical small business opens one new factory.
Another reader wants to know how I can be so sure that there is abundant supplies of energy? My answer is that I have seen the coal trains leaving Wyoming and Colorado. Did you know that there are 150 new coal fired power plants projected for construction in the USA over the next 10 years? DID YOU KNOW THAT CHINA IS ADDING AN AVERAGE OF ONE NEW COAL FIRED ELECTRICAL PLANT PER WEEK? DID YOU KNOW THAT THE NUMBER OF GAS RIGS DRILLING FOR NATURAL GAS IN THE USA HAS FALLEN BY 95 IN RECENT WEEKS AND THE REASON IS THAT THERE IS NO MORE STORAGE ROOM FOR NATURAL GAS?
The fact that China is building electric train engines to haul their coal is perhaps the most powerful way for me to get my point across. The law of substitution is more powerful than the rules or regulations of any government. Yes, it is a time consuming process to replace transportation fuels. The first step is to continue the process of removing oil from the power generating equation. This process is well underway. Everyday, trillions of decisions are made to increase the us of electricity and to reduce the use of the internal combustion engine. Over the next several years, more and more oil refineries will come on line, but even more importantly, enough time will have passed for substitution projects to have "kicked-in."
At the turn in 1995, the price of oil or gold did not collapse at the first hint of the turn, however, by late in the year, the dollar was soaring in value and the price of gold and oil was falling. Over the past 5 years, oil in dollar terms has risen about 240% but in Euro Dollar terms it has risen half as much. Once the dollar starts to appreciate, it will be the Europeans that feel the heat of the price of oil.
GDP
This morning, the GDP report came in at 3.8%! No recession here! However, as we know from recent data and from the price of treasury securities, the economy has slowed. The risk of recession has grown. This is one of those "bad news is good news stories". The pressure is on the FOMC to reduce short term rates. A cut in these rates will provide the "fuel" for economic recovery from the mid cycle correction. Investors should be sure to remember that the market leads the economy by at least 6 to 9 months. The weakest of economic numbers this cycle will be reported over the next two quarters. The market is already looking past this economic down turn and to the boom, boom, boom of the election year. Join the party now. Don't sheepishly accept below average returns! There is safety in keeping more of your assets in liquid investments that perform best over the long term!
BUY, BUY, BUY!
TWO REPORTS TODAY BECAUSE THE BIG TURN IS HERE!
Many investors are holding back because they fear the economy is entering a recession. For me, the economic question is, "Are we in the late stages of the mid cycle contraction or are we in the early expansion phase that follows the mid cycle correction?"
I could easily argue either case because in the late contraction phase the bond market rallies and in the early stage of expansion technology stocks lead the way up. The key point is that there is almost always an overlap in the bond market rally and in the move in stocks. For example, during the 80's mid cycle turn, the bond market rallied from June of 1984 until November of 1986. The stock market rally was slow to crank up but did well in 1985, not bad in 1986 and then exploded up in 1987.
The overlap is already here. The bond market has rallied for months. Indeed the current rally started all the way back in July of 2006. The excitement is in the stock market. The big move by Microsoft today shows that the next economic phase of expansion is underway.
The fly in the ointment has been the price of oil. In the typical cycle, the peak in commodity prices would occur just before the big up turn in stocks. The current blow off in oil makes it look too early for the big upturn in US growth stocks but the weight of the evidence is that the big turn is already here. The blow off in oil is just that. Oil option speculators are making such high returns that they are now giddy with delight. This is a sign of a top. As always, I must state that tops are impossible to call. They are much tougher to call than bottoms which are also almost impossible to call. Yes the infinite is even bigger than we think!
Just because the big turn is here, it does not mean that stocks will go up in a straight line. There is still much uncertainty about tax laws that congress would like to pass. The majority in Congress are hungry for new dollars to spend. The democrats in control desire to shift the automatic tax increase of the AMT to other taxes. The fact is that the government has done well without these new taxes. The 20 million or so taxpayers who have not been subject to AMT will not know the difference if the AMT was repealed. The game of substituting other taxes increases for these tax increases is nothing more than the power hungry wanting more power.
The good news is that the Bush veto will hold. Only minor tax increases will pass this year. I still believe there is a tiny chance that a major reform will be negotiated, but the more probable scenario is that this Congress will leave town as one of the many "do nothings". There has been thousands of hours of talk but so far no accomplishments. Gridlock at the federal level is often a good thing.
Given the likelyhood of no major damage to the economy, large US companies are in the sweet spot. Foreign investors will buy American once the dollar turns. Small profits will be amplified into big profits. There are BIG MARKET PROFITS AHEAD!
At the turn of the twentieth century, about 70% of all Americans live on a farm. Today, 2% live on farms. In China, there are a billion people ready to leave the farm if work can be found. What will all those people do?
The poor are not concentrated in China. In Asia and Africa there are billions of people who live off the equivalent of $2 per day. Suddenly, the cell phone is changing their lives. Poor "peasant farmers" now scrap together $20 or so to purchase a used cell phone. They pay a high per minute usage charge, but they are extremely frugal with their minutes. Indeed, they prepay for a few minutes or even for just a few seconds of time. They make very short phone calls or they send abbreviated text messages.
When I was in the 7th to 10th grades, I stayed after school for extracurricular activities such as football practice. When practice was over, I would start walking toward home which was four miles from school. Before starting to walk, I would send a "flash" message to my home. In those days, the pay phone across from the school required a nickel to make a 3 minute local call. To save the nickel, my siblings or I would call our home (party line) number and let the phone ring less than one complete ring and then we would hang up. Since the call was not completed, our nickel would come back. In later years, a prearrange "flash definition" might mean that a family member was leaving the Atlanta airport which meant it was almost time to drive to the Greensboro airport to pick up the traveler. A "flash" would also be sent upon arrival back at college.
Going to such extremes to save a nickel on a local call or a dollar and a half on a long distance call seems silly today but the $1.50 long distance call was equal to three hot, dirty and hard hours in the tobacco fields for the older kids and 6 hours of handing up by the younger kids. My oh my how do things change!? When my Dad was a boy, he worked in the tobacco fields for 12 cents per day. It is hard to believe but true that millions of Americans were as poor in the 1930's as billions of Africans are today. I am thankful that the "flash" has come to Asia -- Africa.
Business Week magazine reports that the cell phone is literally saving lives. It is also having a huge impact on the economies of the poorest of nations. One very short message might save a peasant farmer a 20 mile walk to a market or it might encourage him to head to the market where his particular goods might be in short supply. Phone transfers are even being used to send money. Cell phone communication beats banging on a drum any day of the week. Usage is surging and profits are substantial! While each phone generates only a few dollars of revenue per year, the total revenues are substantial because there are billions of phones. The number of cell phones in under developed nations just went over the 3 billion mark and the 5 billion mark is expected to be reached in 7 or 8 years.
WE ARE LIVING THROUGH EXTRAORDINARY TIMES!
Those who believe a mile US economic slow down is going to turn into a world wide recession or depression are ignoring the most tremendous "boom" in world history. While this boom has resulted in a temporary strain on the worlds resources, it has also resulted in enormous benefits from free trade. The productivity gains in many cases are by factors that are almost beyond belief. Can you imagine a three letter text message saving you a 20 mile walk through a rain forest?
The citizens of the USA are benefiting greatly. The demand for our goods and services is soaring. The annualized rate of growth of US services is currently running at better than 13%! The rate of growth in exports of goods is running at better than 16%! Jobs in America are plentiful and unfortunately a large number of excellent but "illegal citizens" are in the process of being thrown out of work in America. I am still hopeful that Congress will pass an immigration reform bill before essentially closing down for the 2008 elections before Thanksgiving. So far, the only "progress" being made is to fund a $3 billion fence that will not do diddle squat.
Exports from America will continue to soar because the world economy is super strong but all the while the really big growth in jobs and incomes will occur over seas. It is hard to believe but America is no longer the land of the free. Today, the USA taxes American businesses at higher rates than do foreign governments. One problem is that in America, we tax business profits when they are made and then we tax them again when the owners of the business shift money from one pocket to the other through the payout of dividends.
TAKE ADVANTAGE OF THE WORLD WIDE BOOM!
All of those billions of phones require computer chips, communications networks and knowledge to operate them. Powerful rifle shot ads will be "pushed" through billions of phones and Google will send a substantial number of these ads. Hardware, software, educational facilities and airlines are just a few areas that will see benefits from the massive build-out that is underway. Google has opted to partially fund a new under the Pacific fiber optic cable in exchange for wholesale priced usage. The name for the number of bytes of information that will be sent is some thing like Tera bytes. The total amount of information being sent and received will grow at exponential rates for many years to come.
BEARS, BEARS AND MORE BEARS!
Stock Market Bears are more than plentiful. One of today's problems is that market players, myself included, tend to look back at history to discover a "similar time to the current time"; there has never been a time like this. Even the industrial revolution does not compare. It took a few hundred years for the industrial revolution to creep all the way around the world and it never did make it all the way. The information revolution has spread like wild fire. The powerful thing is that it is a powerful dis-inflationary force. I think the bears would have an easier time understanding if they would focus on the huge productivity gains instead of on the inflation of food and energy. Food is now a very small part of GNP and the amount of energy used per dollar of GNP has fallen dramatically. As I have said before, the stone age did not end because man ran out of rocks but because he learned to use metals to his advantage. In the same way, we will never run out of oil. Indeed, the planet earth is a carbon sink that is experiencing net growth in resources daily.
ONE BULL AND ONE BEAR REACH THE SAME CONCLUSION!
Bill Gross is the most famous bond investor on the planet; bond investors are by nature pessimistic. Don Hayes is an optimistic and successful growth stock investor. Both men believe that short term and long term interest rates are going to fall over the next year or so. Bill says that the Fed Funds Rate will drop to 3.5 to 3.75% because the USA will experience an economic slowdown. Don Hayes offers the same interest rate forecast but his reasons are largely what I have detailed above; strong gains in productivity and low prices because of technological advances and free trade.
I am mostly in the Don Hayes camp because I believe the stock market will soar by 30% or so over the next year. However, I am not convinced that interest rates will fall so hard. I see low inflation but also very strong economic growth. Certainly, the current quarter will be a bit below trend as the "hit of the credit market freeze-up" and the housing building slump will have an effect. However, by the second and third quarters of next year, we just might see 5% real growth. Even if inflation is down to 1.25% or so, the long bond will likely be trading at 6.25% or better. Such "high rates" might even become a part of the Wall of Worry that the stock market will climb.
BUY BUY BUY GROWTH STOCKS, SELL SELL SELL BONDS!
It may be patriotic to BUY AMERICAN, but it is fair to buy from the low cost producer. By doing so, the poorest of the poor will get earn food for their families and Americans will spend their time more productively. It was psychologically hard for American families to leave the farm and today it is psychologically hard to believe that America does not need manufacturing jobs. The fact is that goods are plentiful for a fair price. Be happy that you do not have to "flash" a phone call to save a penny and be kind to those who must!
One of my favorite economists is the guest host on Squawk Box this morning. He is on the money! This morning, he said that a very powerful combination event is about to happen. The President will announce assistance for sub prime borrowers this morning and Ben Bernanke will basically hold firm against inflation. Brian points out that the hedge fund players who have shorted the sub prime loan securities, using 20 to 1 leverage, could take a serious hit when many of these loans are suddenly worth 100 cents on the dollar.
Doing the right thing! It is an understatement to say that George Bush is not a very popular President. Still, Bush is once again "doing the right thing." A number of TV talking heads have said that the sub prime mess was caused by lending money to "people who did not deserve to own a home." My belief is that every American should be given the opportunity to own a home. Before the announcement that Bush will propose new rules that allow sub prime lenders to refinance, I correctly maintained that more than 85% of all those "poor credits" who were allowed to buy a home with no money down would continue to pay their loans. With the additional help, the number will be significantly higher than 85%. Given a poor person a helping hand is not a bad thing.
It is not like anyone is agreeing to pay the mortgage for the homeowner. Many times every day business loans are "restructured." Corporate CFO's have the experience to know that if a company has a short term financial problem that a deal should be struck to redo the terms of outstanding loans. There is often a long term cost or penalty but help is often available.
As Bernanke mentioned the other day, there are many creative ways possible to help those stuck in loans that have onerous terms. If a loan started out as an interest only loan and is about to be reset with a $500 per month principle payment, the terms could be modified to reduce the principle payment. No one would be hurt. The bank does not need $500 per month in principle to make the loan a profitable loan. Sure, if the principle payment becomes a graduated amount, for a few years, the loan would look like a 50 year mortgage but the graduated principle payment could increase a certain percent each year and continue to increase even after the $500 per month principle payment is reached.
Employment and wage growth are strong. A person who has successfully paid an interest only loan for the past three years might easily afford a $100 per month increase in his home payment this year and another $120 per month next year and so forth. The proposals to be made by Bush today will be along these lines. He will use executive authority for the government to guarantee the refinancing of 80,000 of these loans. This is the right thing to do. He will make other proposals, some of which will require the passage of congressional bills.
WOW!
Those who have sold these mortgages short are suddenly being hammered. Short selling anything is risky business. One of the smart moves that was made recently was to eliminate the short sale up tick rule. Yes, once again a smart move has been severely criticized as an idiotic move. The removal of this rule has been blamed for the "extreme volatility" of the recent markets. What a joke!? To begin with, this market has not been "extremely volatile" and second of all the removal of the rule has the effect of reducing volatility not adding to it. This is just one more area where a lot of very smart people have "joined in group think" to get things upside down and backwards. Last night, John Brown repeated the oft repeated mantra that Ben Bernanke is between a rock and a hard place because if he cuts interest rates the dollar will fall. John and those criticizing the removal of the short sale rule are looking at one end of an elephant and concluding that it is a snake. Use the water level in a lake as an analogy, if one only looked at how much water was flowing over the dam, without ever knowing the level of the lake, one might conclude that the lake level is going down on a day when the over flow is very heavy. The truth is that if much water is over flowing the dam, there must have been heavy rains upstream and the lake is probably full to the brim.
Under the old rule, an artificial rule said you cannot sell short unless water is over flowing the dam. You were not permitted an exception because you had checked upstream to know that the "rains are coming".
There are a number of children's board games that demonstrate the point well. In many of these games, players will often attempt to "corner a market." In a "business game" they might consistently bid high on a certain resource in order to be the only one able to sell certain goods. The problem they discover is that they pay so much for the resource that their profit margins are low. The game of Risk is another game where one cannot win by being overly aggressive. The more you attack your neighbors, the weaker you become, leaving an opening for another player to put you out of the game.
In the same way that investors can buy all they want on the way up, they should be able to sell all they want on the way down. Think about it this way; how low can speculators drive the price of a stock? Even if they committed conspiracy and as a group shorted 200% of all the shares outstanding, would they drive the company out of business because the price of the stock was down to a very low price? No, a profitable business in this situation could declare a dividend and the short sellers as a group would owe 200% of the total dividend!
Certainly most investors understand that when they buy a share of stock on the market, they are not investing in the sense of giving the company money. When the shares were originally sold by the company, it got money. If you buy a few shares or sell a few shares it does not effect the balance sheet of the company one iota.
BUY, BUY, BUY
The point of the above paragraphs about short selling is that the pundits have found just one more thing to rant and rave about when they should be pounding the table saying BUY, BUY, BUY! In the old days, recessions were common at the mid cycle juncture. Certainly, the rollover has and will cause a little pain. The GNP numbers posted yesterday tell the story well. For the second quarter, the US economy grew at a real rate of 4%. The rants of those who say inflation is out of control must remember that this 4% has been adjusted downward to account for inflation. The problems in the housing market reduced this number by about 75 basis points. Therefore, if there had not been a problem in housing, the real economy would have grown by 4.75%!
Yes, the growth in the economy will be reduced by the recent "freezing-up" in the credit markets. Will there be a recession? It's not likely. Besides, a mild recession would not be a big deal. Recessions are announced after the fact and the stock market typically jumps up big time right in the middle of a recession. What happens during a recession is that the price of money goes down enough to increase the profit margins of companies. What has happened the past two months? The price of money has come down!
BIG BEN IS KEEPING HIS CALM WHILE PUNDITS ARE YELLING FIRE!
Smooth, smooth, smooth! The water in the big lake is smooth. Pundits have focused on a 250 point drop in the Dow on one day and a 250 point jump the next day and screamed VOLATILITY! This correction got to about 10% before reversing quickly. It is now less than 5%. In 1987, the correction was 23% in one day! Big Ben is proving his metal quickly.
Sure, those who believe $100 oil is just around the corner are screaming that Ben should lower rates. Those who have profited by prior wild swings in the market are ready for Ben to capitulate. Ben is about to disappoint these players. Under the current circumstances, Ben will probably lower rates a little. However, he is not going to stop fighting inflation. His move to lower the discount rate without lowering the Fed Funds rate was a master stroke. It was filled with common sense but it was a master stroke because it went against the grain of conventional wisdom. Many said that it was only a confidence building move but in reality it had teeth. A few days later, when all the big and strong banks took down chunks of money, the pundits said again this was just a confidence building move but it was much more than that. Slowly the numbers will be revealed. The banks that were in trouble did not go to the discount window directly but got "pass through" - loans from the money center banks. Liquidity was restored where needed without causing a run on the banks that needed the help. Had a regional bank jumped at the discount window, they would have been shooting themselves in the foot. They would have seen millions of dollars of withdrawals from their frightened depositors. The system is sound; fear in the eyes of pundits is going away and Ben will not need to lower short rates much. Smooth sailing ahead!
BIG PROFITS
Early this morning, one of the Asian airlines announced profit growth of better than 25%!
What is a mid cycle turn? Before the turn, there is generally enough capacity to produce all the goods needed throughout the world. Sales are much stronger than they were during the previous recession but demand is generally satisfied without building new plants. By the time of the turn, the gradual growth of the population and the additional growth in standards of living means that production capacity is short. By the time of the turn, there is a need for more and more and more major capital projects. You have to have the plants plus the energy to run them. This is the reason that China has no less than 40 nuclear power plants on the drawing boards.
Capital projects consume huge quantities of resources. For example, Saudi Arabia and Kuwait each have a number of development projects on the drawing board. Indeed, they each have a single project that will cost over $9 billion dollars to develop. Specifically, the development of the Khurais field in Saudi Arabia is expected to increase total production from Saudi Arabia by 1.2 million barrels per day. This is an increase of about 10% by the worlds biggest producer. Several thousand workers will be required to build-out this field but once it's built only a few hundred will be required to operate it.
Business construction already requires more capital and more workers than were required by the housing market when it was at its peak a couple of years ago. Look at it this way, each one of these $9 billion projects are the equivalent of building cities of 45,000 $200,000 homes. I can't remember the average cost of the nuclear plants in China. I recall that the latest designs are smaller. $5 billion each is probably in the ball park for a total of $200 billion. The electricity from these plants will support many times the number of production facilities. We are talking about trillions of dollars of construction over the next several years.
It is only natural for the demand for money for major capital projects to squeeze out home construction. When the average Joe finds that money is available to buy a house, he goes for it. When money gets tight, he stays where he is. On the other hand, when a company is selling all the products it can make, it does not let the cost of money get in the way of expanding. When the "prosperity" phase of the business cycle is here, the FOMC has to hold tight. It has to lean against the wind. It has to keep short term interest rates up so that a bidding war does not develop. If five companies selling the same products are all selling out of goods, the one that can complete the next plant the quickest is the one that will reap the benefits of having goods for sale that are in short supply. Ben's job at this point is to focus on inflation even though the housing market is weak.
The constant argument that the consumer is the engine of the economy is a good argument for a different time. The new locomotive is the business locomotive. The consumer will come along for the ride. We simply should not worry so much about the consumer during these times. Most Americans spend the income they receive. This is the reason that payroll deduction works to build a retirement nest egg, even though, the person who will make regular deposits to a stock account will grow much more wealthy. The person who routinely saves to an an aggressive investment account is a rare individual.
Of the people I help, only a few of them make regular additions to their accounts. Most wait until the account has moved up strong and then they add chunks of money. It is too much to expect them to lean against the wind as they should and add chunks of money while the market is down. Therefore, regular monthly deposits are a rare blessing. Big irregular deposits make my job very difficult but I accept the challenge freely. The main point is that during the "prosperity phase" jobs will remain plentiful and wages will increase. Consumers will not be as apt to refinance their homes but they will have steady income and they will spend it. The year over year growth in personal income is currently running at about 300 million dollars!
Yesterday, I said that Big Ben is about to shoot the starters pistol. He is, but the actions to be announced by President Bush will address the "sub prime crisis" more specifically than a Fed Funds rate cut can do. Cutting the Fed Funds to solve the sub prime crisis is a bit like going deer hunting with bird shot. As a result of "help" in the mortgage market, the need for Ben to cut will be much reduced. This may cause great disappointment by those screaming FIRE but holding firm against the wind is the right thing to do. I expect a minor cut of 25 basis points at the September 18 meeting and not much more later in the year. More importantly, the second half of the business cycle is underway without a severe crunch at the "turn".
Consumers who are paying 50 cents less per gallon of gas are buying electronic toys. New toys are on the way. The new toys are typically connected to one another. Kids are playing games with other kids from around the world on their cell phones. Business people are able to "get things done" quicker than ever before. The build out of this new system is not even half way done.
The energy/electricity investments must always come first and indeed they are in the works. I do not believe there has ever been as much energy/electricity under development. The poorest of the poor are starting to feel the effects; oil projects in Africa are starting to enrich millions of people. The newest OPEC member, Angola, will add about 200,000 barrels of production per day this year. The good news is that this is just the start. It takes time to develop an oil field but there are hundreds under development.
Production from China has been held back by the scarcity of electricity. This scarcity is in the process of being filled. The 15% growth rate of China is unsustainable because the law of large numbers will be in the way but billions of dollars of new production will continue to hold the lid on inflation as long as Big Ben will keep one foot on the brakes.
You will know that the world has hit hit 4th gear when products begin to hit the market that take advantage of super highway broadband wireless networks. These networks will allow more to be done at lower costs.
BUY, BUY, BUY! LIFE IS GOOD!
A year from now, don't say I did not tell you to BUY, BUY, BUY. I know I sound like a broken record but conditions are ripe for a three year market boom. Those who have significant amounts of money in money market accounts today will rue the day.
PE RATIO AT 12 YEAR LOW
One mistake often made by novice investors is to focus too much on certain fundamental indicators. The PE Ratio is one of the numbers that is widely followed into blind dark alleys. Companies that reach the peak of their earnings cycles typically trade at very low PE ratios. Looking at PE ratios can be much like driving a car by looking in the rear view mirror. Take housing stocks as an example, two years ago the entire group was on a multi-year profit run and the stocks sold at 5 times earnings of less. The stocks are much better buys today even though earnings have collapsed. These stocks traded down because their estimated earnings over the next five years is low. Energy stocks are trading in a similar pattern. They are trading at low PE ratios. The world wide boom will keep upward pressure on oil prices but sooner or latter profits will decline after oil prices go lower. These are highly leveraged situations. Profits will decline at a higher percentage rate than will revenues.
Still, PE Ratios do provide a picture of history and we can learn from history if we are willing to invest the effort. Right now, one thing we can say about the average stock is that it is selling at the lowest PE ratio in 12 years. Twelve years ago, in 1995, we were working our way through a mid cycle correction, right before the big boom, boom, boom of the second half of the decade. In 1995, sentiment of the market place was sour. Today, the average investor actually believes we are close to a recession even when GNP is estimated to be growing at 4% or better. I expect the sub prime mess to slow growth a little but I also expect business construction and sales to pick up most of the slack. Market indicators show that inflation is slowing while real growth is hanging in quite well.
Pundits have argued that we are at the top of a profit boom. They wave-off the 13.5% profit increase of the last quarter by noting that this quarter was number 20 in a row of double digit profit growth. They see this profit as being similar to a gambler who rolls 20 straight 7's. A common mistake among gamblers is called the gamblers fallacy, in which the prior rolls supposedly change the odds on the future rolls. They would say that the odds of another seven are incredibly low because the odds of rolling 21 sevens is a row is in the neighborhood of a trillion to 1. I would strongly disagree. Indeed, if someone has rolled 20 sevens in a row, I would be inclined to bet the next roll is a seven. The real odds with a fair set of dice are 1 chance in 6 of rolling a seven, however, if someone has rolled 20 in a row he must be rolling a loaded set of dice.
This is the situation with the world economy today, the dice are loaded! Numerous technologies that did not exist 10 years ago have loaded the dice in our economic favor. Last year at Christmas, a homemaker and her husband agreed to try to live for one year without buying anything made in China. They have had to do without a lot of goods and in other cases they have had to pay as much as 15 times the price!
TECHNOLOGY KEEPS ON KEEPING ON
You know the story, technology is changing our world for the better. A recent story I enjoyed was about ocean going submarine robots. Scientists from around the globe are participating in deep ocean exploration from the comforts of their offices and homes. They take turns controlling an ocean robot that is exploring the deepest waters ever viewed by man. They spend hours videoing sea life and structures that have never been seen before.
One of the things that Al Gore and friends seem to miss is the size and scope of the earth's water cycle. One tree can release over 200 gallons of water vapor in a day. The human body is about 65% water. Water is the most common element on the planet. The cartoon page this past Sunday featured water. Given unbiased information, ten year old kids can appreciate that the earth and the water cycle are much bigger and more powerful than all the humans on the planet. Water is the only element on earth that is found in all three states of being, gas, liquid and solid. It is a resource that must be protected but it is also a resource that is to be used. Water is "automatically" recycled. It is entirely possible that you drank water molecules today that were previously drunk by an Egyptians some 5,000 years ago.
NO, NO, NO!
I have not lowered my target price for CAL to the 40's. Indeed, the purpose of buying options that only break even at $43 per share is because I believe the stock will go much higher. Buying options is a loser's game. It is a fool's game. Still, please don't make me out to be a total idiot. I would not buy the right to buy a stock at $43 if I thought it was not going much higher!
In 2005 and 2006, I wrote that I planned to "ride the bucking bronco" through the mid cycle correction. I said that the risk of being out of the market was greater than the risk of being in it. Now that the correction is in the sight of all market participants, some are ready to declare a recession is near and others simply want to sit in cash as they wait to see what happens next, BIG MISTAKE! Chances are that the next move of more than 5% is a move of 30% to the upside. The big splash has probably already hit the pond. The ripples are still in evidence and there is fear of another even bigger splash. However, the world economy is too strong for this splash to hurt much more. Central bankers have unleashed their money machines. MZM (the monetary base) was about flat 2 years ago, at the real start of this slowdown. In recent months, MZM has been growing at better than 9%! Money is available, sentiment is ripe and stocks are cheaper than at any time since 1995! BUY, BUY, BUY!
The world wide economic boom continues, yes, including in the USA. While it is true that the gradual rise in short term interest rates around the globe have slowed the growth rates in a few countries, the world wide boom is like the Energizer Bunny. Even the USA is humming along nicely.
The housing bust in the USA has gotten a lot of attention and it has caused a lot of bankers, pundits and news sellers to use the word recession. Quite a few prognosticators now put the likelihood of a US recession at better than 50% odds. I disagree. The odds jumped in the weeks leading to the discount rate cut but they have fallen sharply since.
Indeed, the aggregate numbers could not be much better. It appears that the USA is running at close to 4% GDP real growth and it appears that inflation rates are on the way down to less than 1%!!!
The boom in the USA is coming from the business side of the economy and from export growth. Past declines in the US dollar are working their magic. Contrary to popular belief, the USA is still the king of manufacturing and our exports are growing at an annualized rate of around 11%. Business construction is very strong and business equipment sales are strong.
Have you noticed the significant drop in gasoline prices? US refineries are running at lower capacity but producing more fuel. Airlines have increased passengers hauled by several percent and reduced fuel consumption at the same time. China grew its economy 11% this past year while growing its fuel usage by only 5%. The growth in the economy was stronger than most projections and the use of fuel was weaker than most projections. The Chinese are going to great lengths to cut consumption.
Less than 15 years ago, South Korea was a fuel hog. Today, South Korea is about as efficient as the USA.
GREAT JOB BEN!
Ben Bernanke is playing first fiddle in the central bank orchestra. His latest moves have been masterful. The big roller coaster rides of Greenspan are gradually giving way to confidence and stability. By opening the discount window and then using big proxy banks to take away the stigma, Ben was able to pump significant amounts of liquidity into the system without throwing away gains made in reducing inflation. With no change in the fed funds rate, the full court press to keep inflation in check is still in effect. With durable goods orders running at a 5.9% annual growth rate, it is clear that the US economy is still humming along.
CARRY TRADE WILL NOT END!
Pundits keep talking about the unwinding of the carry trade. While it is true that much of the turmoil in the markets the past month has been related to uncertainty of profitable carry trades, the carry trade is still alive and well. In the old days, the bankers took the risk to borrow short and lend long. Because it is "normal" for short term paper to offer lower rates than long term paper, it is usually very profitable to take in short term money to make long term mortgage loans. In the past few weeks, the US curve has reverted almost back to "normal". Hedge funds and other risk takers are likely to continue to borrow short and to lend long. Because the risk of a stronger Yen has increased, borrowers may require higher rates for long term mortgages but the world is still in a time of disinflation of manufactured goods. Therefore, short rates are likely to remain low relative to long rates.
The fly in the ointment is the massive amounts of capital that will be needed to build coal and nuclear power plants in the coming years. There is definitely a high demand for construction money. Still, the situation is not the same as the last similar cycle during the 1970's. There are only 40 nuclear power plants on the drawing board in China. Think of these as new resources to produce low priced goods. China is growing as fast as it can but is being held back by the lack of electricity. As more electricity comes available, hundreds of millions more peasants will leave the farm and trillions of more dollars worth of goods will be made. The price of manufactured goods will continue to fall!
There are many ways to play this world wide BOOM, BOOM, BOOM. My family has made a significant bet on the airlines. We ask the question, what if international flight demand growth continues at 10% or better and what if significant fuel savings are realized by CAL after it takes delivery on 30 new planes on 2008? Is it possible that revenues will rise by 5% or more while fuel cost will decline by several hundred millions of dollars? We think this scenario is not only possible but is likely.
Three of our better performing stocks so far this year have been Biogen, Cree and Garmin. Those who regularly add money to their accounts continue to hit big winners. Regular monthly deposits is the way to play this game. Many thanks to all who are making my work easy by making regular contributions.
THE MID CYCLE CREDIT SQUEEZE!
US Real estate went up and up some more for most of the years after WWII up until 1966. Then, suddenly, the market, in cooperation with central bankers and politicians engineered a credit squeeze. I remember this well because my mother was a real estate agent at the time. The banks and savings and loans had money to lend, they were financially solvent but, due to arcane laws about interest rates (Banks could not legally pay more than 7.5% on a certificate of deposit), it made no sense for them to make mortgage loans. Suddenly, it did not matter how good your credit was, no one could get a home loan. Review the economic history of that year and you can see the chilling effect this development had on the economy. Still, there was no recession, only a mid cycle rotation.
This time around, the credit squeeze will not last as long. It will take time to unwind the carry trades but money will be available at a price. Lenders are still making loans today. Jumbo loans of greater than some $400,000 plus are temporarily hard to find but ask your local credit union and you will find good loans available at good rates. The re-sell market is temporarily dry for the big loans. This time, the bankers could generally could make the loans if they wanted but they are not sure where interest rates will settle once the highly leveraged carry trades are unwound. With a world wide capital spending boom in place, the concern is that business borrowing is going to push rates up. The good news is that inflation rates are low, causing loan rates to stay low.
THE SUN RISES OVER JAPAN!
The Japanese economy has been in a funk since 1989. Interest rates have been so low in Japan that hedge funds have been willing to borrow at low interest rates in Japan and to re-lend in other nations around the globe. The problem is that doing this trade exposes the practitioner to currency risks. If the Yen appreciates in value, the borrower of Yen must payback the appreciated currency value, not the currency that he borrowed. For as long as Japan was "in the funk", the deal paid handsome rewards. Now that the economic mid cycle turn is here, the Yen is "steadily" appreciating, these borrower-lenders must scramble to collect their funds as quickly as possible so they can buy the Yen before it goes even higher. To some extent, this is at least a temporarily self fullfilling action as the demand for Yen puts all the more lenders into a temporary bind. On the other hand, some of the central bankers of the world that were injecting emergency funds just a few days ago are now regularly withdrawing excess liquidity; the big ripples in the pond are getting smaller day by day. Another big stone could ripple the waters again but the worst is over.
It is ironic that Greenspan has been blamed for keeping the fed funds rate too low at 1% for too long. The truth of the matter is that it was Japan that suffered deflation for the past couple of decades and it was Japan that offered the world cheap cheap cheap money. For many years, the central bankers of Japan could hardly lend Yen at zero interest. They said take the money please!, pay us back when you wish and there will be no interest added to the principle. As the currency was declining in value, the deal could only be made when foreign, profitable projects could be funded with this money.
NO MORE FREE MONEY!
The world economic recovery is real. The world's economy in the past year grew as fast as it ever has in history. Japan, which is still much more dependent on manufacturing than is the USA, was hit harder than others by the competition from China, India, et. al. Now that the mid cycle correction is well under way, Japan will enjoy the late cycle capital goods spending boom that is underway. For example, Japan will build a number of the 40 nuclear power plants planned in China. Much of the the excess currency reserves built up in China over the past 20 years will be spent on items such as 787 DreamLiners and nuclear power plants. In the mean time, there are still a few hundred million Chinese who are willing to work for more than food. The growth in China continues. The speculation in the China market has sucked up money from around the globe. The mid cycle correction will be over by the time there is much of a slow down in China.
OTHER NEWS
While the sub prime mess gets more than its share of the ink, the other news around the world is interesting. (The sub prime story is the news media's way of talking about the unwinding of the carry trade. Saying the world is coming to an end as a result of a "crash" in the residential real estate market demands a bigger audience than saying that speculators can no longer borrow in Japan to lend elsewhere).
One item of note is the move by some airlines to sell or spin off their frequent flyer programs. Canadian Air completed its spin off last year and others are at least taking a look. It has been said that UAUA was offered $7.5 Billion for its program. Flyers on UAUA would still earn frequent flyer miles but they would be managed by an independent company. A major difference in some of these programs is that all flights become available for frequent flyer rewards. The points needed to fly at peak demand time might be higher but, since an average of 17 percent of these points are never redeemed, it makes sense for an independent system. Points can be used for all sorts of purchases, everything from upgrades to consumer goods.
PRESSURE ON IRAN, IRAQ AND USA
The pressure to make a deal is still on Iran, Iraq and the USA. The time is drawing near for a number of deals to be struck. President Bush is applying new pressure on Iran. The administration is about to declare the Iranian Revolutionary Guard to be an organization that supports terrorist. This is a significant action as the Revolutionary Guard is an industrial-military complex. It is a "machine". It takes in a lot of money from many sources and uses these funds to support terrorist in Lebanon, Afghanistan, "Palestine", Iraq, etc. By proclaiming the status, the USA can disrupt the commercial activities that are used to support this organization.
The Iraqi prime minister is under great pressure and he is pressuring others. Iraq needs to increase oil production as this is the primary source of revenues for the government. Most of the Iraqi interest groups understand that the country needs to settle its differences in regard to the sharing of oil revenues so economic progress can be made. Once it is clear that the central government is a long lasting entity, the rational for cooperating through the government will increase. I still have faith; establishing a free government is no small challenge, one that takes time to build.
RECESSION PROBABILITY
The most recent sub prime mess will contribute to slower growth in the US economy. However, with exports growing at 11.2% and with a capital building and spending boom in progress by American businesses and with year over year profits rising at better than 14%!, I see no recession in sight. I say this, knowing that we have had a slightly inverted yield curve for about a year and that growth in the monetary base is at recession levels.
WOW! Car sales down, housing sales down, hedge funds and mortgage brokers going belly up and NO RECESSION! I believe there is about a 20% chance that we will actually see a recession. Who knows how scared the public has gotten as a result of the "bad news". For most US citizens, the Yak, Yak, Yak about sub prime is of little importance. The unemployment rate is near record lows and, while this is an incidental indicator, leading edge numbers still show great strength in the economy.
WOW! If profits are up 14% and with the business spending boom continuing and with competing treasury securities selling for higher and higher prices, STOCKS SURE DO LOOK ATTRACTIVELY PRICED!
Oil futures keep trading up each time a storm is named but the OPEC oil sellers continue to report that selling oil is becoming like pushing on a string. For the past 5 years, anyone who had oil did not need to hang out a sign. Buyers would find the sellers. Now buyers are getting choosy. They are not running their high cost refineries and are buying fuel that is easy to refine. Why "cook" heavy grades of junk at high temperature if the sweet stuff is available. On the other hand, one refinery after another with access to cheap Canadian tar sand oil is expanding or converting production.
Hurricanes usually miss most of the production assets. As each one misses, you can expect the price to retreat. The unwinding of the carry trade will reduce the money available for all sorts of speculations. With Ben and company holding real short rates up, I expect the commodity complex to see some pain in the coming months. Commodities down; technology stocks up!
BUY BUY BUY!
SHARE SHARE SHARE!
Donald Trump was just on CNBC saying that he longs for the days of Alan Greenspan. He believes that Ben Bernanke has held short rates too high too long. He went on to say that Ben should hold an emergency meeting of the FOMC to cut interest rates. He believes that the coming recession could be one of the worst in a long time.
The President of the Federal Reserve Bank of Richmond wrote a nice rebuttal to Trumps tirade. It was published as the President's message in the "RegionalFocus", spring of 2007. The summary point of the article was, "Monetary policy works best when it allows the real economy to respond appropriately to economic fundamentals, rather than attempts to insulate the economy from shocks by tolerating swings in inflation."
Ben could have lowered rates to "fix" the sub-prime problem. Such would have been like castrating at dog to prevent breeding. Ben has injected reserves into the system so that those who are running scared can hoard all the cash they want at relatively low market returns. The fed funds rate nor the discount rate was changed. In a few more months, Ben will be getting high praise for standing firm to bring inflation expectations to very attractive levels.
In the mean time, "talking heads" will continue to make "much to do about nothing".
I like optimistic people. A few of my favorite optimistic friends are Don Hayes, Brian Wesbury, Jerry Bowyer and James Pethokowkis. This morning Don Hayes wrote that the "common sense" of the talking heads is "short term thinking common sense". Their "wise" council during turbulent times is to "raise cash, get defensive, and stress quality". He notes that he learned a lesson in 1974 when long term common sense was to BUY, BUY, BUY, while others were using short term common sense.
Jerry Bowyer wrote yesterday about the "sub-prime mess". He notes that of the 44 million mortgages in America, 14% are sub-prime. Of those, 13% are currently at least one payment behind, however, the large majority of the late payers are still paying and many are working with lenders to restructure payments. The bottom line is that there are about 250,000 mortgages that moving to foreclosure. The total value of these loans is about 7 Billion Dollars. If these houses are worth 30% less than what is owed, the total money lost will be in the neighborhood of 2 Billion Dollars. Americans have net worth of $53 Trillion Dollars. The "total hit" will be in the neighborhood of .003% of value. Oh My! Lions and Tigers and Bears!
The good news is that the baby gets thrown out with the bath water during times like these. This is good news because smart investors can pick up babies on the cheap during times like these. IS THE PRICE PRESSURE COMING OFF THE OIL MARKET? What if the current weakness in oil were to persist? Based on current market prices, the price of gasoline will be down to $2.50 within a week or two. Based on current jet fuel prices, CAL will save about $360 million dollars on fuel over the next year (about $3.24 per diluted share). Is the "roll over" or "rotation" finally here?
Over the past 21 days, the XAL (airline index) has fallen 8.99%. During the same time the XOI, oil index, has fallen 13.24%, the XBD, broker dealer index, has fallen 14.16% and the BKS, bank stock index, has fallen 7.88%. This sure looks like a classical mid cycle rotation but, as always, we will not know for sure until after it is well underway. If Big Ben had "chickened out" and cut rates, then I would have to say that the price of commodities might take off again, however, Ben has been as solid as a rock. He has fed the markets enough cash to allow the markets to work. He has not driven down the price of money, thus he has avoided stoking inflation and he is thus setting us up for a very strong second half cycle.
The second half of the business cycle is the time of small business expansion. The first half of the cycle is all about recovery from the worst of the prior down turn. During the second half, those businesses that have done well during the recovery will borrow to expand. Business lending is the mothers milk of profits for the average bank. During the past few years, the big investment banks (broker dealers) have had a fun ride. In recent days, they have been routed. Again, the entire index is off 14.16% during the past 21 days. Take advantage of the turbulent markets to add money to your accounts. It is time to do some BUYING!
MARKET PSYCHOLOGY
A major reason to buy now is because market psychology indicators are screaming BUY, BUY, BUY. I will not go over the indicators in detail but they show that emotional, trend traders who typically have a lot of short term fun at major turns are as "tilted" as they have been in a long while. These traders make money for a while and then lose their collective shirts when the new trend takes off.
Brian Wesbury wrote a nice piece for the Wall Street Journal yesterday. In it, he pointed out that while the over whelming majority of professional forecasters see no recession soon, the majority of Americans believe we are already in a recession. Indeed, the public is fed such a rich diet of gloom and doom by the media that they hold a negative bias about the state of the world. Even a majority of the 64% who say they have personally never been better off, say that the world is falling apart.
Brian makes the excellent point that even the shows that "present the fair and balanced" point of view, tend to always have a "bull" and a "bear" debate. The more appropriate debate should often be how to make money now, versus am I going to win or lose. Market investors who stick to the task at hand consistently make money.
Making money this week, month or year is far more doubtful than making money this decade. We are living through exciting times.
James Pethokowkis is correct that there is a risk that we will be pulled off course by vote hungry politicians. Yesterday, I enjoyed his comments about the "broken window fallacy" trap that Hillary Clinton is willing to lead us into. In this case, Hillary wants to spend a lot of money to "fix" global warming. She talks about a "win-win" scenario. Ironically, she recently voted against the trade deal with Columbia that would have provided a "win-win-win". In her version of a win-win, she would tax Americans directly and indirectly to reduce global warming. She thinks that all the government spending to fix the problem would create lots of jobs and she is correct on this point. The problem is that the jobs thus created would not be equal to the jobs created if the free market were allowed to "fix" the same problem.
HOW MANY TIMES DO WE NEED TO LEARN THE LESSON THAT GOVERNMENT IS NOT AN EFFICIENT CREATOR OF JOBS!
BIG BUSINESS AND BIG POLITICIANS
Soon, politicians will attempt to pass laws to "fix" the energy "crisis". The most common "democrat" solution is a cap and trade system for pollution. This is nothing more than another opportunity for big business to win special favors by spending big bucks to lobby politicians.
If seriously want to curtail energy use, a tax increase on fuel usage should be passed. It should be offset by an equal tax credit for health care or reduced income taxes. NO MORE BIG GOVERNMENT. WE ALREADY HAVE DEMOCRAT AND REPUBLICAN BRIDGES TO NOWHERE!
Got to run. Bye, Buy, Buy!
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