THE UPSIDE DOWN AIRLINE BUSINESS

From 1978 until recently, the little discount carriers flourished at the expense of the legacy carriers. Former majors such as Eastern Airlines, Pan American and TWA bit the dust. Others such as CAL, DAL, UAL and US Air went through bankruptcy proceedings at least once. Now the worm has turned.

Aloha and ATA have filed for bankruptcy. It is the "big boys" that are surviving the latest crunch. ATA was a direct competitor to DAL and CAL on flights to Hawaii and to UAUA on other flights. Consumers can be assured that the ticket price to and from Hawaii is going to rise. Shareholders of DAL and CAL can expect to see higher yields.

Speaking of higher yields, the latest report from CAL was posted by the media in the typical negative fashion. The typical headline was about the small decline in load factor. The careful reader could dig to find that CAL increased capacity by a significant amount of around 6% and increased revenue passenger miles by almost as much. Even after a small decline in load factor, the company still reported flying with almost every daylight hour seat filled. What could not be found in many of the "news stories" was the significant increase in yields. The revenue per available seat mile increased by better than 6%. While we still do not know the total increases in costs or the exact increase in revenues, the "news stories" that implied weak business growth were incorrect. Any business that is able to expand its volume of business substantially while increasing the price charged per unit of business, while facing the head winds of negativity, is a strong business.

The national airline of Italy is coming in for a crash landing. There are no open bids to buy this failing business. In healthy markets, weak players are allowed to go belly up. The efficient competitor increases its sales as the weak players leave the field.

The airline business has been turned upside down from where it used to be. Even now the highly paid employees have a hard time accepting that the return to yesteryear is not likely. KLM had an offer on the table to buy Alitalia but the entrenched unionized employees are like the former employees of Eastern who were willing to risk liquidation rather than accept a more reasonable wage scale. The traveling public was forced to pay airline employees exorbitant salaries for many years. The gig is up. The management that fails to keep costs in line in this newly competitive market will be punished. The managements at major carriers are taking the steps necessary to insure profitability. DAL just increased its fee for curb side baggage check-in by $1. This kind of increase seems like small potatoes but an extra dollar a few million times a year is worth the asking. The key is that the demand for service is strong enough that the charge can be made. The public is well aware that the fuel costs have risen. The person that is flying today is a person who is willing to pay the extra buck.

The real truth is that the airline business was upside down 30 years ago. It simply took a very long time to flip the business over. Now that ticket pricing has been almost rationalized, airport and airline service will grow in the areas of need. We know that market based systems work better than government dictated systems. Flying is more affordable today than ever before. There will be significant growth in the years ahead.

DRIP, DRIP, POUR

Another big gas discovery has been announced. This one in Quebec. More than 4 trillion metric feet of natural gas that is located near already constructed pipelines.

In the past five years, US importation from Saudi Arabia has declined 12%. During the same time, US importation from Canada has increased 30% (figures from energyandcapital.net). This is all before the coming development of the Bakken Formation.

The Bakken Formation was found in 1951. It covers much of two provinces in Canada, much of Montana and about all of North Dakota. In addition to holding about as much oil as is held by Saudi Arabia, it holds as much natural gas as the largest field in the world, which is 26 Trillion Meters of Gas in Qatar.

Oops, maybe I wrote that last sentence too quickly. The Barnett Field in Texas is now said to hold as much as the Qatar field. The reason these Bakken and Barnett have been left mostly idle for the past 50 years or so is that it took horizontal drilling technology and higher hydrocarbon prices to make these fields profitable. The combination of high prices and dramatically lower drilling costs have made these fields very attractive. Others are jumping into the act.

This week in Pennsylvania, the governor announced new leases on state forest lands. Pennsylvania sits on yet another undeveloped shale formation. A drip of oil here a drip of gas there and pretty soon the drips have turned into a pour.

I have to run but I just wanted to repeat a few words of basic truth to counter the constant stream of misleading words you are hear daily. During these confusing times, government officials and the news media are barking up the wrong tree while the raccoon is getting away. The amount of hydrocarbons being created daily, through natural processes that man could not stop if he wanted, can only be measured using scientific notation. The amount of methane gas that is bubbling up from the ocean floor daily is in the range of 10 to the 28th power.

There is no energy shortage. There is temporary hysteria. Soon and very soon, enough new supply is going to be on the market to knock the price of crude oil down $20 per barrel or more. The investment opportunity is enormous.

YET ANOTHER 9 TO 1 DAY!

For the third time in less than a month the market experienced a better than 9 to 1 up volume to down volume day. The shorts are jumpy and there is a heavy rotation out of gold and bonds and into stocks. The fear that was driving people into gold and bond bugs is turning into fear of missing the next big move. If there is just the hint of new leadership, anxious investors jump on the stock or the sector.

At the same time, the majority of the public believes the US has entered into a recession. I don't. There are still too many areas of strength to push the average economic sector into negative territory. The belief in a recession that does not exist is another example of a public that wants to play the part of the oppressed victim, many folk seem to have a psychological need to believe that the end of the world is near.

My Sunday School Class has studied two of the books written by Brian Mclaren. Brian is one of the intelligentsia who can make your brain hurt. A simpleton such as myself has to wade through his work with a dictionary in hand. No doubt he is a smart fellow but as the excellent web site, The Kruse Kronicle, points out, Brian is a neo-Malthusian. The Reverend Thomas Malthus was the gloom doom economist of a couple of hundred years ago who believed that the world was doomed to fits of prosperity and then starvation. He could not see how resources could keep up with an expanding population. Since his time, there have been plenty of others to pick up on the theme that the earth is in a state of pending doom. These others include William Jevons, more than 100 years ago, Paul Ehrlich about 35 years ago and more recently, Jimmy Carter, Al Gore and Brian Mclaren. It is always fun to point out that in the early 1970's that Paul Ehrlich's belief in Global Cooling was widely accepted by those believing "The End is Near". In the 70's the fear was of another great ice age.

The mistake that Brian Mclaren repeats in his book, "Everything Must Change", is the same mistake repeated again and again by gloom and doomers, including Malthus and Jevons. During the industrial revolution in England, Jevons believed that England's economy was due to collapse when the country ran out of coal. Malthus saw starvation when the world ran out of food. Neither of these men understood the power of the law of substitution. I can confidently say the same thing about coal as I have said about oil, which is that we will never run out of either. The analogy I like to use is that the stone age did not end because man ran out of good rocks.

The law of substitution is the mother of invention and technology, if something is in great demand, an invention will come along to improve it and something else to replace it. Somewhere on the web there is a posting of an old chart done by John Caslin which shows the commodity price index in real terms. Commodities that cost $120 in 1862 only cost $20 in 1999. This chart is nothing more than the accumulation of substitutions made over the years. For example, this chart includes the move from copper water pipes to plastic pipes, from fabric over wood airplane wings, to thin sheet steel airplane wings, to aluminum airplane wings, to carbon composite airplane wings. The wings of today are many times as strong while being many times as light. There are other charts that show how a couple of tons of coal had to be burned two hundred years ago to perform the same amount of work that can be done today by burning only 5% as much. Other charts show that during the time that population last doubled, the amount of farm land increased by only 14% and the number of people eating grain intensive meat double and doubled again.

Alarmist gloom and doomers have either never seen Kuznets Curve or they have chosen to ignore it. When we make pollution the x axis of Kuznets Curve, (I think I saw this on the Kruse Kronicle web site), we see that pollution initially increases when peasants move off the farm and to the factory but that one of the "benefits purchased by prosperity" is clean water and clean air, the air in America today is cleaner than it has been in many decades and the streets are no longer littered with horse manure.

Another use of Kuznets Curve is to plot the famous inequality gap that the alarmist are always complaining about. What we find here is that when a nation gets an economic boost such that new wealth is created, the rich do initially get richer. There are two points missed by the alarmist; 1) the rich getting richer does not hurt the poor, indeed, the poor actually gain more in percentage terms than do the rich, and 2) in the longer term the balance is restored but at a higher level for everyone. The average poor man does not catch up to the average rich man but the gap is returned to normal with both being more wealthy.

Kuznets Curve is nothing more than common sense. When applied to inequality the story is simple. A man migrates from the farm to industry or even all the way in one jump to the service economy, perhaps this man from a poor family gets his medical degree. This man has grown up poor and as a result is likely to be a saver. He lives a good life but he is never a "big spender" and thus he accumulates great wealth. He invest his savings and thus provides the capital for all sorts of other poor men to "get a leg up". His children grow up wealthy. They grow up with expectations of living the good life. Their advanced education is funded by their parents wealth and they move from a wealthy child hood to a wealthy adult life. This "children of wealth" are likely to be spenders. They buy big houses and big cars. They often feel that their wealthy parents were too strict, refusing to let go of a few dollars to make their childhood happy. The children of these children want for nothing. The next thing you know, these folk have hired a gardener and a house keeper. The poor immigrants they hire go from near starvation to the good life over night. The gloom and doomers chuckle at those who say a gardener and a house keeper are living the good life but, the perspective of gloom and doomers is prejudiced because they have most likely grown up as the children of the wealthy. They do not know what it is like to not have money for food, clothing and shelter. They have seen Mazlow's Hierarchy of Needs in a class somewhere but they really have not internalized that none of the higher needs matter at all to a man that is fighting to survive.

Last month was the 75th anniversary of the New Deal. We are currently flirting with a mild recession while low and behold the response of many is to push for the same policies that caused or prolonged the Great Depression. The problem is that the New Deal was well sold by politicians to the public. The policies of the New Deal were given credit for bringing us out of depression. At the Action Institute Blog, an interesting question has been asked, "if the New Deal Policies were so successful, why was the US unemployment rate at 19% six years after the start of the New Deal initiatives?". The "normal recession" last 6 to 12 months and at its peak the unemployment rate is up to 6 or 7%. Today, unemployment is around 5% and the democrats want to repeat the mistakes made by the congress, Hoover and Roosevelt.

The stock market crash of 1929 was largely a response to the Smoot-Hawley Tariff Act. This law passed the house in May of 1929. The law was an attempt to protect the US from foreign imports -- what a joke? Why does the American consumer need to be protected from low cost imports?

One thousand twenty eight economist signed a letter to Hoover asking him to veto this destructive bill. Long before the bill was finally passed into law, in June of 1930, the stock market had crashed and scores of other nations retaliated by passing their own protectionist bills. One important point to understand here is that even after the US had stepped in the manure bucket of protectionist trade policies, the rest of the world could have prevented the great depression by simply ignoring the damage done to the US by continuing to trade where possible.

I have to run to an appointment so I will sum this up as quickly as I can. Mistakes were piled on top of the initial mistake of increasing taxes. 1) Other tax increases were made, including the social security tax that was added onto payrolls. 2) The Fed took an inactive roll and failed to boost the money supply. 3) Regulations were passed that hurt businesses ability to profit, including price floors on inputs, the minimum wage performed a great dis-service. A "normal" correction was turned into a 10 year recession.

Today, the Fed has been active. Today, the democrats have so far tried but failed to raise taxes. Today, the regulations proposed by Paulson are only for political cover and there is little chance of passage anytime soon.

The market has seen that Bush can hold off the congress and there is a good chance that the next congress will not gain free reign to pass destructive policies. Thus, we had another 9 to 1 day. Nine to one up days, relatively rare beast, are coming one after another. Three in recent weeks. There are more good days ahead!

SENTATE HOUSING BILL

The US Senate has reached an agreement on how to pass a housing mortgage bailout bill. Once again our politicians created a big problem and have now jumped on their white horses to save the day. They were on their white horses when they passed the bills to encourage banks to lend like crazy and now they are on their white horses to bail out these borrowers. The good news for investors is that the prospects of this new bill will be positive for the markets in the short run.

OTHER POSITIVE "NEWS"

The import index dropped to 45 while the export index climbed to 56.5. Any number below 50 shows a state of decline below normal and any number above 50 shows expansion above normal. The 45 reading was the lowest since the mid cycle turn year of 1995. The spread between the two was the biggest since the bottom of the 1990 recession. Brian Wesbury has reviewed these numbers and maintained his first quarter GNP estimate at 2%. No recession here! The lagging inflation index number was very high at 83.5 but the gold price action, falling from over 1,000 to below 900 lickity split shows that inflation concerns are melting away.

ONLINE VIDEO BOOM

The GigaOM site reports that CISCO router sales are jumping. Management claims that by 2011, the equivalent of one billion DVD's will be sent online per month. Just in the past 9 months, high speed router sales have doubled.

GOOGLE CONTINUING TO EXPAND

Google continues to be willing to sacrifice short term profits to build huge future businesses. The latest "news" about declining clicks is nothing but a function of moves made by Google to increase market share down the road. In another development, Google is reported to be "moving in on" Amazon. Amazon offers a number of computer services for fees. Google is beginning to offer some of the same services at the Google price (free of charge).

No one can be sure if Google really expects the government to allow the use of spectrum between TV channels for a new wireless Internet network or if Google is simply using this space as a negotiating tool to further open up private wireless networks. Never the less, Google has the support of MSFT and many others in its petition to open up this "white space". This space holds the promise of bringing down the cost of cell phone and wireless Internet service by substantial amounts.

REDRAWING THE GLOBE

The land areas of countries have in a state of constant change for millennium. The last major redrawing of maps was done after WWII but there have been many other redraws since. Today, we are in the middle of a redrawing of maps without changing the physical boundaries. The Ukraine, a former state of the Soviet Union is about to become a member of NATO. Iraq is well on its way to being a democratic republic. Even Cuba is showing signs of change. The early changes in Cuba are changes to permit individual freedoms. For example, last week the citizens gained the right to own cell phones. Once the freedom cat is out of the bag, it will be difficult for the leaders to put it back in the bag.

The drawing of maps is typically a huge event. As mentioned in an earlier post, Seward bought Alaska for 1.9 cents per acre. Only in hindsight has America realized the wisdom of this purchase. The redrawing of the maps is often done at the expense of blood and also for the benefit of preventing future bloodshed. Russia has once again invited Iran to sit down with the group of 6 nations to discuss its nuclear program. The US continues to offer both carrots and sticks to Iran in the hopes of reaching a negotiated truce. Iran continues to support armed conflict in Lebanon, Iraq and Palestine. The negotiations about nuclear power are entwined with the attempt to negotiate a lasting truce in the region.

I am confident that many of the Americans who protest the US presence in Iraq have little understanding of the total picture. I certainly do not understand the nuances of US geopolitical strategy. To some extent, it is necessary to trust our leaders. I am often reminded of what it is like to have every decision made by a Church committee second guessed by Church members who have not been involved in the decision making process. Once a committee is elected, it is most often best to let them do the job to the best of their ability and to stay out of their way.

THE ELECTED SENATE

Our senate leaders have reached a compromise. The result will be a bill to help restructure defaulted mortgages. As is usually the case, by the time the government solution arrives, the problems will be largely behind us.

KLM-NWA-DAL JOINT VENTURE

For the next couple of years, international air carriers are restricted to 25% ownership of US carriers. By treaty, US carriers can purchase up to 49% of international carriers. These restrictions will eventually be negotiated away. In the "new free world", the weight of the evidence is that restrictions to foreign ownership of US lines should be eliminated. Indeed, people from all around the world have recently come to more fully understand the laws of the free market and in particular the law of comparative advantage. If any peace loving private investor from any country in the world wants to buy a piece of America and if the seller is willing to accept the price offered, this "free trade deal" is one that should benefit both the buyer and the seller.

One fact that is surprising to many is the amount of outsourcing being done by India. Most Americans are aware that a growing number of American workers work for Toyota, BMW or some other international company and that a growing number of American companies hire people in other nations when that is the best deal available for the company. Americans are perhaps less aware that people in Ireland, the USA and many other countries work for Indian companies. India sends hundreds of thousands of modest wage contract construction workers to many a "hot spot" in the middle east. At the same time, India does not have all the highly educated and trained people it needs to perform other business tasks. As a result, in a manner similar to American companies, businesses divide themselves in ways that move certain jobs to other countries while maintaining certain jobs within India. Because America is a land of highly educated people, some of the best and highest paying jobs of Indian companies have been moved to America.

In Winston-Salem, NC a heated debate has been raging about requiring middle school foreign language classes. Because the US covers the North American continent from "sea to sea" and because our media dominates the world markets, we are automatically more isolated than the typical developed country. A few months ago, I got into a heated discussion in regard to making the English language the official language of the US. Did you know that there are now more non native people who speak English than there are native speaking English people? The beauty of America is that it is the land of the free. You can speak any language that you wish to speak. People have come to America from nations all around the globe and they have been free to speak their "home language". It is the concept of freedom that has drawn these people to American and English is tightly associated with freedom. As a result, people in Russia, China and all over want to speak English. Some want to speak English simply so they can easily communicate with their grand children who have grown up in America speaking English.

Even though English is widely spoken around the world, it is my hope that my grand children will learn to speak several languages. The most successful people in our "new free world" will be those who feel comfortable in other nations.

The justice department is expected to grant KLM-NWA-DAL permission to do an international joint venture. These three airlines will share routes, costs and profits on international routes. Should NWA and DAL merge, it will be all the more easy and profitable for these companies to share resources. As always, the consumer and business are best served by a careful balance between competition and cooperation. Businesses engaged in pure competition can not earn a penny of economic profit. Businesses that fully cooperate with one another charge the consumer exorbitant monopoly prices. The consumer needs profitable airlines that are free to enter and leave markets at will. The regulated system of long ago resulted in extraordinarily high prices and air travel reached relatively few markets and was used by relatively few people. The other extreme was reached when discount carriers entered markets at lost leader pricing to drive out competition. Today we are approaching the "great middle". Profitable companies are offering flights to double the number of cities of just a few years ago. The world does not need hundreds of international carriers. Maximum efficiency cannot be a constant but it can be approached. The KLM-NWA-DAL deal will lead to AMR-BA deals and other deals which will improve the travel experience and provide profit opportunities for the carriers. The big growth in air traffic is going to be between underdeveloped nations and developed nations. The US carriers will maximize their share of profitable traffic by continuing to form partnerships with foreign carriers. If memory serves, CAL now has 227 partnerships. People around the world can buy one ticket from a local source that will take them to hundreds of locations in America. We ain't seen nothing yet!

WHAT A DIFFERENCE AN HOUR MAKES

The message I just sent was delayed when my grand daughter arrived. I am thankful for the interruption and pleased to look at the market after writing the words. The dollar is up, gold is down, oil is down, the market is up and sentiment is on the rise. We know how fickle markets can be but it certainly looks like a new trend has been established. Put as much as you can on board this train because it is leaving the station!

GOLD UP, DOLLAR DOWN, SENTIMENT TURNING

A lot of attitudes are turning now that there is clear weakness in the price of commodities; the price of gold and oil have dropped 10%. The turn in the dollar has been less but, after dropping to extreme lows, the price of American assets and goods are very cheap. Government officials are talking about all sorts of "recommended repairs" but the big drop in interest rates from 5.25% to 2.25% is the very powerful stimulus.

THE US GOVERNMENT

We live under the best system of government. We elect leaders but we handcuff them to their opponents so that they cannot run too far in any one direction. This system of checks and balances prohibits the violent power grabs seen throughout history. The thirst for power is a trait seen in leaders in all systems of government. Ironically, communist countries, set up on the theory of trying to make all people economically, socially and politically equal, have been the worst offenders. Millions and millions of communist have been killed by the politically powerful. Powerful vicious dictators have surfaced from the ranks of kings and peasants alike but they have lived in fear. Most have been fearful of violent overthrow to the point of paranoia. King Herod the Great was not the only King to have executed his own sons in order to lessen the likelihood of a palace coup. He killed his wife and sons and at least 11 of his closest relatives to protect his power.

One of the reasons the US government is among the best is because our constitution granted the freedom of speech. This "fourth branch of government" in many cases holds politicians feet to the fire. On other occasions, the press supports the worst of the worst ideas and people. This support and non support can be for or against the congress, the president, the judiciary and even for or against the press. When the bias of the media is easily discernible, such as CNN versus FOX, we benefit by checking one against the other, the bigger problem is when our most trusted elected officials sell a bill of goods to our "main stream media" and suddenly the people believe in the falsehoods of the day.

Yesterday was the 141st anniversary of "Seward's Folly". The purchase of Alaska from Russia in 1867 was ridiculed by the press as Seward's Icebox and as Andrew Jackson's Polar Bear Garden. Horace Greeley was one of several "news paper men" who lambasted the administration for making the purchase. So much "stink was raised" that it took the congress more than a year to vote to appropriate the money for the purchase. Looking back with hindsight, we say, "What a deal?". We bought Alaska for 1.9 cents per acre. The total price was $7.2 million dollars. Adjusted for inflation, our cost was less than a day or two's production of oil. The "newspapers" said that there is nothing of value in Alaska but fur bearing animals. Sometimes the government makes the right decision. In recent years, politicians from both parties have cooperated with the "news media" to promote the belief that corn oil as fuel is the solution to our "environmental problem". As a result, billions of barrels of oil lie dormant in underground storage in Alaska while 100 million acres of rich topsoil is sprayed with fertilize and pesticide to such an extreme that millions of acres of Gulf coast waters have been poisoned. Today's folly is in not using the oil purchased by Seward some 141 years ago.

PAULSON'S CALL FOR REGULATION

Secretary Paulson's call for new bank regulation will not earn a place in history on par with Seward's purchase of Alaska. Government officials, from the house, senate and executive branch are making speeches and proposing new laws to "fix our problems". While there are certainly good reasons to reform the US banking laws, most of what is being proposed now is for the purpose of providing political cover. The fact is that Paulson does not expect any of his recommendations to be passed this year, if ever. The fact is that the congress is not ready to give any more power to the FOMC and the FOMC did not even use its power to open the discount window to the investment banks for 9 years. Indeed, the FOMC waited until after Bear Sterns was in deep trouble before the window was opened.

Thomas Jefferson, among the most learned of men, was not a fan of "news papers". This man was know to study an average of 15 hours per day but he felt that reading "newspapers" was a waste of time. In his political battle with Alexander Hamilton, he fought to limit the power of the federal government. Jefferson was one of the all time great fans of liberty. Another great fan of liberty, Milton Friedman, gave us the truth that the free market should be the provider of first resort and that the government should be the provider of last resort. Yesterday, I was asked what I thought about Paulson's proposed reforms. I hope it is clear from the above comments that I do not wish for any branch of the government to become too powerful. I also hope it is clear that the current "news about this problem and that problem" should not be the focus of the investor. Games will be played in the months ahead to determine if new banking regulations will be passed. However, over the past two months, the FOMC has dramatically lowered the cost of trillions of dollars of financing. This lower cost is like the building of a fire in a steam train boiler. It takes a while for the fire to heat the water, for the water to turn to steam and for the steam to drive the train wheels, but, once that train starts moving, it is hard to stop. The government will send out about 140 million $600 checks over the next couple of months to make sure the train engine gathers quick momentum as it rolls out of the station.

GOLD UP, DOLLAR DOWN AND CASH IN OUR POCKETS

As Charles Dickens taught us, a man with a few extra coins in his pocket is a much happier person than the man who owes a few coins and has none in his pockets. The US central bank has put the US economy through a roller coaster ride. While our roller coaster is gathering speed down the interest rate hill, other economies are facing very different circumstances. For example, the Australian central bank has been raising rates while the European Central Bank has been holding steady. The growth rate in the US is ready to soar relative to these economies and the US Dollar is going to climb the next step mountain.

DIRECT FOREIGN INVESTMENT IN THE USA

The TV pundits have it all wrong. Last night on Kudlow and Company, Joe Lavorgna tried to protest when the other guests agreed that a capital flight from America is causing the US Dollar to fall. Joe's voice on this point was drowned out. The numbers support his point of view even though the voices of the crowd said the opposite. Direct investment is flowing into the USA, more than two to one over China and India. The numbers are showing up in stock prices even while the relative strength of US stocks is being hidden by the downturn. The fact is that for several months, US stocks are going "up" relative to most foreign stocks. When this steam train gathers momentum, the trickle will become the flood. Hold on to your hat because GOOD TIMES ARE HERE!