BYE BYE USAIR?

Delta has finally said enough is enough. It is time to rebuild the air traffic industry after several very tough years. DAL has lowered prices and liberalized many of the quirky rules required to get the best deal. USAIR and Northwest Air have answered the challenge with equally low fares. Northwest code shares with DAL, whereas USAIR is a direct competitor.

My Great Grandpa was know for advising farmers to "get into the chicken business when others are getting out", and some of my all time best buys have been in the eye of a storm. Sometimes the storm is a macro storm or economic recession. At other times, the storm has been a micro storm or industry recession.

Airline bankruptcies and route suspensions have cut capacity. Cost-cutting has made profits possible at lower fares. The liquidation of another carrier would be very positive for the remaining carriers.

Delta is putting the question to USAIR and USAIR employees; do they want to stay or go? United is still operating under bankruptcy court protection and liquidation is possible but USAIR is coming real close to liquidation.

Although my profits in CAL have been diminished by the declines of the past two days, I will stay the course. In fact, it is likely that I will buy buy more DAL and CAL or swap shares of one for the other to capture a tax loss.

In the same way that the exact wrong time to buy an industry group is at the peak earnings for that group, it is the right time to buy near the earnings trough. The latest round of discounted fares will initially lower earnings. However, most of the fares will be cut far less than 50% and traffic will gradually come back.

I expect revenues to rise in 2005 and cost to fall. In 2006, I expect revenues to rise again and for costs to level out. I expect revenues to be well above break-even levels by 2006. I will not speculate on USAIR or UNITED. The risk of liquidation is real and without liquidation the risk is that bond holders will take all the equity.

GOING DOWN? SELL SMALL! SELL METALS!

Over the past 3 days, the Russell 2000 Index (RUT) is down 3.5%, the NASDAQ is down 3.1% and the S&P 500 Index is down 1.97%.

In the past 9 days, Phelps Dodge (PD) is down 9.35%, Newmont Mining (NEM) is down 6.44% and the $XAU Gold and Silver Index is down 5.48%. At major turns, small caps and metals often turn together.

Yesterday, the one day declines in the $XAU was 6.79%, the Mexico sector ETF (EWW) 3.36% and the Industrial Metals Index ($GYX) a whopping 7.3%. See the charts of the GYX posted last week, which showed the Metals had risen to extreme levels. Crude oil prices rose 4.25%, short interest rates rose 3.99% and Airlines took a 5% fall.

In recent days, I sold shares of PD and NEM short. I liquidated retirement account shares invested in RUT and have purchased put options on NEM.

Why all the sudden gloom and doom?

Ironically the answer lies in too much relative strength in the US economy. At a time when the German unemployment rate is at the highest level since the 1990 recession (10.8%), when the rest of Europe is in a funk and when China is restricting government spending in order to slow excessive growth, the US economy is showing signs of accelerating growth.

US statistics show that US layoffs are at the lowest level since 1999. Unemployment is down in 259 Metropolitan Areas and is up in only 63. The jobless decline is in 42 of 50 states. Federal reserve reports manufacturing was up 1.2% in November, completing a four month run. The ISM index was up a strong 58.6% marking the 19th consecutive month of increase!

The strong manufacturing and job gains spooked the Fed according to the December 14 FOMC minutes (released today). Several board members expressed concern about rising inflation. This information startled the markets as the Fed is still in stimulative mode. Indeed the fed funds rate of 2.25% is only .7% above the PCE deflator. One must assume after the significant declines we have had in the US Dollar, that the inflation index will rise by at least a couple of hundred points over the next few months. If the fed continues to crank up short rates by .25% per month, it will take several months to get ahead of the interest rate curve. Once inflation gets a jump on the fed, it usually takes a while to catch up. Oil prices are likely to trade up again significantly by the summer driving season.

Right on cue, the Euro Dollar just made its biggest decline in 7 weeks. Clearly the market is discounting the strong US economy, our rising inflation and the likelihood of further short-rate increases.

No one knows for sure what is next. However, the up-trends in small stocks, metals and developing country stocks have broken down. Earlier, I mentioned the Mexico ETF and could have used other examples such as the Brazil or Argentina Funds.

I sold my developing country funds too early, held some small cap funds a couple of days too long and missed the top in the metals by a week or two. One should never worry about hitting exact tops and bottoms.

The important thing is to preserve principle in the tough times. My short sells and puts on the metals hedge my long-term long stock positions. Selling short is an aggressive approach. Other aggressive investors may want to move other funds to cash, particularly in retirement accounts.

Based on current long-bond rates, the S&P 500 is cheap. The most recent moves by the fed have actually brought long-rates down. The market is currently spooked by the fear of inflation. Until most recently, economic indicators were showing a strong US economy but not an over-heated economy. Should one decide to be aggressive and raise cash, one should be prepared to reinvest at a moments notice. Those that sell small cap funds or emerging market funds should plan to re-invest in larger cap funds after the storm is over.

TIVO, GMST and ERTS TAKEOVER CANDIDATES?

I have reported to you that one of the reasons I purchased TIVO is because I think it may be taken over by a larger company. The same for Gemstar (GMST). My prime suspect for GMST has been Liberty Media. I reported the purchase of ERTS without discussing the possibility of a take-over.

Forrester Research Analyst, Ted Schadler, has completed a study that suggests a number of possible cross-industry mergers. Included as possibilities are the purchase of TIVO by APPLE, GMST by Google and ERTS by Disney.

My guess is that Liberty Media is the most likely to buy GMST but, if John Malone cannot squeeze GMST away from News Corp, he may go after TIVO. I would not be surprised to see Time Warner, Comcast or Disney go after TIVO or ERTS. Sumner Redstone has shown an interest in games and could certainly make a bid for either.

With the content owned by TWX and CMCSA, they each have an interest in owning the best media entertainment center. A recent article in the Wall Street Journal discussed how new devices, to be announced at next weeks trade show, will make it easier to convert TV, movies and radio to digital, transportable formats.

The shelf life of movies was increased significantly by the development of the three tier approach. The first run has been shortened but the rental and sale of DVD's add months and even years to the shelf life. As Google has shown, storage space is now cheap. With the coming of high speed wireless internet, movies will take on a significantly longer shelf life as they can sit on a server and be down-loaded virtually an infinite number of times.

Under the current system, only about 500 commercial films are made each year. The cost is incredible. There is an average of only one hit per week or 52 hits per year. The cost to produce a hit movie is typically 50 to 75 million dollars and it cost 30 to 50 million to market it.

Wal-Mart, Blockbuster, AMZN and NFLX are forcing changes upon the industry. However, the super change will come when movies are hosted by servers and when GOOG has indexed them for search purposes. I believe TIVO and GMST will be very important players in this new market. Video On Demand service is being pushed by TWX and CMCSA and Microsoft is pushing software into computers and other electronic devices. TIVO and GMST are small players compared to these other firms but the patents owned are valuable.

TSUNAMIS RELIEF

The United Methodist Committee on Relief is assisting flood victims in half a dozen South Asia and Southeastern Asia countries. You can help by sending $12.00 to provide a heath kit for a child, $100 for supplying a family with cooking utensils, sleeping mats, blankets and tarps or $1,000 to invest in long-term construction materials for a family's house.

UMCOR seeks to work with key partners such as local religious leaders. This ensures a holistic and integrated response, true to Christ's mandate to serve heart, mind, spirit, and body.

How to Give

Make your check to UMCOR and send to UMCOR, 475 Riverside Dr., Room 330, New York, NY 10115, or, make a
credit card donation at 800-554-8583.

If you prefer to give through the Red Cross, call 1-800-help-now.

"I have come into the deep waters, and the flood sweeps over me...Yet God's steadfast love is good." psalm 69;2b, 16

Additional information is available at http://www.umcor.org.

BAD RETURN POLICIES--TARGET, BEST BUY, AMAZON OR WAL-MART?

I like to buy market leaders. Although the market leader is not always a huge company, it often is. The market leader often has a "Morningstar Moat" around it; economies of scale, barriers to entry or systems in place that allow it to maintain profit margins in a competitive environment.

In the second half of an economic recovery, it is wise to own defensive issues--companies that sell groceries, tooth paste, under-wear, soft drinks or other items that are not cyclical in nature. On the other hand, one should tend to avoid companies that sell large items like cars and other goods that require financing; items where a significant part of the cost is the cost of money. Refinancing of homes has dropped sharply; folks are not receiving the big lump sums that many have received more than once in the past few years. Folks will continue to buy toothpaste out of ordinary income but they may hesitate to buy a car if their credit card payment is up on higher interest rates.

Of the four companies listed above, my family owns AMZN and WMT. Target (TGT) and Best Buy (BBY) are strong companies and my family shops at all four. Best Buy in particular leads its sector of the retail market. AMZN is the high flyer of the group selling at about 35 times 2005 earnings (55 times trailing earnings). AMZN is also growing the fastest.

WMT and Target fit the defensive criteria the best but folks will continue to buy books, cds and clothes through AMZN in good times and bad. Smith Barney down-graded AMZN this morning because of its high price to earnings ratio. AMZN is a long-term hold for me and I expect steady growth to eventually reduce the PE ratio.

All of these companies have a good customer-bad customer problem. The 80/20 rule works in retail and smart retailers are happy to send their worst customers to other stores. The bad customers are typically the ones who buy a product and then bring it back for a refund. It is hard for any customer to understand a restocking fee but the truth is that stores actually lose money on returns even if they collect a restocking fee. Of the time spent on a particular item, it takes at least 80% of the total time to restock and resell with only 20% allocated to the original process.

I just had a bad experience with Target. A friend gave me a DVD for Christmas. The movie, Bruce Almighty, is a good one that I already own. I took the new DVD unopened back to Target where the friend had paid $13.64. Target had a whole display of $13.64 movies, including this one. The clerk offered me a $9.99 credit for my copy because the computer showed it had been on sale for $9.99 in the past 90 days. Of course, had I had a receipt, the policy would have been to give me full credit for the purchase amount.

I made a few points to the Target clerk and then to the manager. My friend told me he paid $13.64 and the clerk took my name to verify that I do not abuse the return policy. The movies are sitting in the rack at that price right now. More importantly, I was not asking for money back. I simply wanted to trade for another movie from the same rack. As a cheap-skate and as a matter of principle, it was difficult for me to give up a brand new movie valued at $13.64 and pay and extra $3.65 for a movie of the same value. The insult to injury was that the policy pointed out that my friend had over-paid in the first place.

Last night, in a few moments of searching the net, I found thousands of complaints against every retailer I tried. The most common complaint was in regard to return policies. Best Buy has received credit by analyst for wise policies that discourage "bad customers" from returning. However the net is filled with complaints and the company receives a low consumer rating. Target gets more ratings of praise but it too is lambasted for its return policy. These guys need to be careful!

I am not a "bad customer" but one of many new customers to have received the wrong gift. As the owner of ocean front resort properties, I buy tens of thousands of dollars of furnishings annually and maintain a large movie collection. The word will get around.

For now, I will not be investing in Target or Best Buy, primarily because I am more likely to invest in real defensive stocks such as Colgate, Pepsi, Proctor and Gamble, Wal-Mart and, maybe even a Winn-Dixie.

On the other hand, I don't plan to buy my movies from Target. For fun and education, I will take my Bruce back to Target again to see if I can get better luck. These guys are going to spend $3.65 in employee time whether they take my movie back or not. My ultimate goal is to help them improve their policy. They really do not want their policy to result in customers feeling as if they are bad shoppers or liars.

TIVO TO GO

Last week, we purchased more TIVO in two accounts. For months, we have anticipated the announcement of TIVO TO GO and more importantly we are still waiting for "Internet TIVO" or "NFLX--TIVO".

It has been some months since TIVO purchased the software it expects to use to create "Internet TIVO". It has been several months since TIVO and NFLX announced the plan to offer internet NFLX--TIVO service. One must give TIVO credit for walking the narrow walk required to offer consumers "new technologies" while keeping the content providers from going bananas. Providers need to have confidence that they will be paid with advertisement space or subscription fees.

TIVO has now announced TIVO TO GO and the stock bounced this morning. This service will allow subscribers to download certain recorded shows to PC's, Lap-tops and portable video players. Content providers will be able to tag their programs to prevent down-loads and encryption software is designed to prevent unauthorized distribution. In many ways, the current struggle is similar to what happened years ago when the recording industry tried to make cassette tape recordings illegal. In the long run, broadcasters must be willing to allow paying consumers to make extra personal copies of shows. The next step will allow one to down-load recorded shows over the internet--again while protecting against unauthorized distribution.

TIVO is only one of many firms attempting to establish themselves in this market. Family members of mine own Liberty Media (L), Real Networks (RNWK) and TV Guide (GMST) because we believe L and RNWK will put together a competing system. Southwest Bell (SBC) just signed a deal with 2Wire which will allow SBC-TV customers to offer many of the "TIVO" features. Subscribers will be able to record shows and even program the devices over the internet.

One interesting fact is that Direct TV--TIVO customers will not initially be permitted to use the TO GO feature. SBC and Direct TV currently offer package deals. Gradually, alliances will be made such that there will likely be three or four major providers of services like TIVO and TIVO TO GO. Next generation APPLE i-pods will offer the same types of services. I am comfortable speculating on the possibilities with positions in TIVO and GMST.

The information contained herein is for purposes of education and entertainment.

INDUSTRIAL METALS EXTENDED

Industrial Metals Extended (click image to enlarge)

On December 28, I posted the above chart showing that either bonds are very cheap or industrial metals are over-extended. My timing was good and lucky. The next day, the non-ferrous metals group was the worst performing group-- down better than 5% for the day.

In a couple of aggressive accounts last week, we sold Phelps Dodge short. (We borrowed shares of PD and must return them later). Phelps Dodge has been a strong stock for several years and the company has solid earnings. The price earnings ratio is low. The key question is the future price of metals--primarily copper and gold.

On December 1, 2004, Bear Stearns took the stock off its recommended list citing concerns about metals prices. South American stock markets have been out-performing for several years while the US Dollar declined. My guess is that the long run is over. PD has met strong resistance near $100 per share. The increase in short US interest rates and the slow down in the growth of China seem to be affecting the market. One report indicates that China expects to actually be a net exporter of steel this year!

Selling stocks short is an aggressive action. Most investors should avoid the practice. An aggressive investor who holds positions on margin should fully understand the ramifications before using short positions as a hedge. The ultra conservative investor should appreciate that the above chart shows metals as very expensive in relation to bonds. It is entirely possible that bonds will appreciate more in value than metals will fall in value.