AIRLINE MERGERS BEING PUSHED

A jump in airline stocks around 1 o'clock caused me to search the news. The Wall Street Journal put out a story at 1:11 that a hedge fund with ownership in Delta and United is pushing for a merger of the two. The company estimates the annual operating savings to be over $585 million. The company went on to suggest that a combination of CAL and NWA would also reap large rewards.

Because CAL is on a solid growth path, the management of CAL is happy to stay independent. However, if any other major combination goes through, CAL would probably act quickly to protect its turf.


Besides, I suspect that the $585 million savings is a bit of an exaggeration. All the major carriers have wrung out at least that much fat over the past several years. I expect cost to change direction and go up over the next several years. The good news is that revenues will go up faster than costs.

Record orders for new aircraft were once again set at the Dubai Air Show. These orders are for delivery in 2014. It is going to be a long time before capacity catches up with international demand. High demand and restricted supply will lead to high ticket prices and high profits. Mergers are not a necessary part of this story.

Please note that the hedge funds are pushing for a merger of equals trade, one where no cash is required. The surviving company will simply issue x number of new shares in trade for the outstanding shares of the company being bought. This type of combination is nice in regard to the tax angles. The risk are: 1) an incorrect relative pricing and, 2) a clash of cultures between the two carriers.

Again, the bump in prices was a result of speculation. It is nice to know that the investment community is now very interested in airlines. A few years ago, the consensus was that no one has or will ever make money buying airlines. We have reached the 90 degree turn but by the time this cycle is over the thought will have turned 180 degrees. Everyone will wonder why they had not bought airlines before.

COLD WEATHER HAS HIT NC, THE LEAVES ARE TURNING COLORS

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!

Home Improvement Question

The following question was cut from a response from a regular reader.

Do you think Home Depot or Lowes might be good investments? With the slump in real estate, does that lead to people doing more home improvement projects, rather than buying new homes? Both stocks have been down recently, but could be a buying opportunity?


Today, one of the big investment banks probably called a bottom on Home Depot when it down graded the stock and lowered the 12 month price target to about the current price. My guess is that either of the big two will do well over the long haul. As was stated in the question, it is true that home improvement projects tend to flourish during slow home building cycles.

On the other hand, David Dreman, the author of several books about contrarian investment strategy, wrote a long time ago that after a major "event" it is easy to jump in early. If one jumps in early, the wait can seem to be endless. One has to have great patience in these situations. What commonly happens is that after a year or two of mediocre performance, stocks in this situation have one more test of the low. It is a common mistake for those who got in too early to be flushed out by the test.

I have great respect for Bill Miller, manager of billions of dollars of funds at Legg Mason. Bill is one of those guys that exudes smarts. His record of beating the S&P by better than 2.5% for 15 years in a row speaks volumes. Bill says it is time to buy financial stocks and home builders. Because Bill builds huge positions, he must jump in early to accumulate all the shares he wants.

On more than one occasion, I have ridden his coattails with great success. For example, long after he bought Nextel, I bought shares at $2.90 per share and sold all shares at around $28. He has the great disadvantage of not being able to get in and out so easily. He still owns thousands of shares but has stated that he will trim a number of holdings to make his move into home building and financials. I have seen no indication that he plans to trim his substantial holdings in the airlines. One of his funds carries a weight of around 7.5% in airlines. He does not own CAL.

Dreman says it is usually best to wait about a year after a major "event". Again, I have had good success when using this strategy. The trick is to keep the stock in mind and not forget about it when it is not so "in the news."

By the way, the reader who asked the above question is the same one who brought CREE to my attention. I had followed the stock for a long time and had the intent to buy it some day. Many thanks for bringing this one to mind.

SEE - SAW, SEE - SAW, SEE - SAW

The see-saws are moving. When merger mania and hyper leveraged transactions ended, the big investment banks dropped. Regular banking activity is ready to boom. Business construction has largely taken the place of residential housing and the construction loans are being handled through "normal" banking transactions.

See-saws are all over the place. Exxon Mobile, at the king of the hill, has taken a hit. While the price of oil has moved from 82 to 95 the price of the stock moved from 92 to 95 and then back to 92. Believe it or not, the average price the consumer has paid for a gallon of gas this year is less than the average at the same time last year. The oil companies are having a more and more difficult time of passing through the higher prices of oil, demand destruction has occurred. Refining margins have collapsed. The traditional see-saw, oil on one end and high tech on the other is in evidence.

If you don't believe these two segments see and saw, take a look at the past blow off peaks. During 1999, when the tech bubble was fully extended, the price of a barrel of oil was $12. During the oil record setting days of 1980, technology stocks were at selling at decade low PE ratios, Business Week's front cover was about the death of tech. The current boom in tech is well underway, tech stocks are up an average of better than 30% year over year. Even Microsoft, which had been stagnate for years, is moving up sharply relative to oil stocks.


Yesterday, the US Dollar rose on the same day that interest rates were cut. The pundits suggest this was because the FOMC cut only a quarter when they could have cut a half. The fact is that the US economy is very strong and growing and there is reason to buy dollars. The GNP grew 3.85% the last quarter, this is the inflation adjusted rate of growth and it is well above the long term trend. Real disposable income growth was off the chart. The "see" has already "sawed" in regard to export and import growth, in the past year, US growth in manufactured exports was over 16% and imports of goods grew by less than 3%. The see-saw in export-imports will lead to the turn in the dollar (assuming Congress fails to override the Bush veto of the billion dollar tax increases offered by Congress).

NO USED PIANOS PLEASE

In response to my piano story yesterday, I got feedback from a friend who just sold her baby grand. Her kids are almost grown and she needed the space for other things. She confirmed my story. The value of all but the very best of used pianos has fallen dramatically. Charities, churches and auction houses often refuse pianos. I feel compelled to reiterate this situation because it is the crux of the disinflation story and since writing the story I heard two more TV pundits talking about how the government inflation numbers are false. TV pundits, like "news" reporters, fall into the trap of telling half truths because only those who tell exciting stories get more air time. One pundit mentioned this morning that if you have children headed toward college then you understand that the inflation rate is still very high.

Sorry Charlie, the full price of college tuition is paid by only the very few. The great majority of students get very substantial discounts in one way or another. At my alma mater, UNC-CH, the top 10% of the students now get a totally free ride! By jacking up the price, the perceived benefit of the scholarships are greater. When a top student has the opportunity to accept the $100,000 scholarship from one school or the $80,000 scholarship from the other, he is inclined to take the free ride at the $100,000 school. Under such circumstances, the price at the $80,000 school is apt to rise quickly to the $100,000 price.

College tuition and the price of a hospital operation are just two of the misleading numbers people use to say that inflation rates posted by the government are false. Both are misleading because almost no one pays the full tuition cost and almost no one pays the posted hospital operation price. If the price of an operation soars from $20,000 to $40,000, was the inflation rate 100%? What if a number of new programs were offered to allow large discounts to those who have no insurance? What if the large insurance companies went from a 20% discount to a 50% discount? In other words, if the Medicaid reimbursement rate went from $7,000 to $9,000 and if the private pay persons best negotiated rate went from $15,000 to $22,000 and the insurance reimbursement rate went from $17,000 to $25,000 then the real inflation rate was a weighted average of the various payment rates. When the government agrees to pay x percent of the total price, there is strong incentive for the price to be raised.

The same phenomenon happens in private industry all the time. For example, airline seat pricing follows a similar pattern. One legacy airline might raise prices and wait to see who follows. Chances are, the price increases are rolled back on 70% of the routes due to competition from low cost carriers. Then many of the highest priced seats are offered "on sale." The net increase is often only a tiny fraction of initially announced price increase. There were something like 17 across-the-board ticket price increases in 2006 and 9 so far in 2007 but the average price of an airplane ticket per mile flown is still about 15% below the price available in the year 2000. The point is that one cannot look at the head line numbers to determine the rate of inflation.

TV pundits who like to obsess over the price of oil fail to consider the efficiency of the US economy. We use a tiny fraction of the oil we used 30 years ago to do any particular task. In the "old days" huge quantities of oil were used in "non-transportation" pursuits. Today, the problem to be addressed is to convert transportation away from the use of liquid fuels. That process will take time but the market will make the switch smoothly if the politicians will stay out of the way. As usual politicians shoot the smooth process in the foot by such things as silly regulations. They might enact CAFE standards to try to force the issue, but mandating high mileage cars takes away the incentive from the consumer to make the more fundamental changes needed. Why ride the buss or move closer to town if the price of fuel is held down through regulations? In other words, we need to let the see-saw in this area as it does daily in all other non restricted areas.

INTERNATIONAL - DOMESTIC, SMALL - LARGE

The science of constructing an investment portfolio is a complicated process. The good news is that one does not need to understand the science of the internal combustion engine to drive a car well and one does not need to understand all the give and take involved in portfolio construction in order to invest well. Indeed, the person who thinks he is the best is often the person who has the biggest wreck or the one who goes out too far out on a financial limb.

As we move toward the end of an economic cycle, it will become more and more important to buy big companies. However, there is no rush to go all "big" right now. As a general rule, buying "big" adds a defensive element to a portfolio. Indeed it is intuitive to think that buying growth rather than value adds an aggressive element to a portfolio. Such cross currents can easily confuse even the "experts". As I have often stated, about 90% of performance is a result of asset allocation. Stock picking can be fun, exciting, highly profitable and very humbling but not at all a necessary investment skill. Indeed, most people would be better off using the dart board approach to stock selection. THE REASON THIS IS TRUE IS THAT STOCKS ARE SOLD THROUGH THE NEWS MEDIA AND IF A STOCK IS IN THE NEWS IT IS NOT THE BEST ONE TO BUY!

It is easy to conform to the opinion of others, the good news is that the herd is typically right during the first couple of years of the prosperity phase. Right now, one does not have to go it alone to make serious money.

At the current time, if an investor wants to try the dart board approach now, I suggest that he limit his dart board to big cap US companies. I say this knowing that over the long haul, small stocks beat large stocks and international growth beats US growth. I doubt that my message is clear because it is time to be very aggressive in the defensive area of "big cap".

When one end of a see-saw goes up, the other end must go down. The difference between see-saw movement and stock market movement is in order of magnitude and in terms of relativity. If oil stocks go up 20% over the next 4 years while tech stocks go up 100%, then there was a see and saw. Big oil integrated oil is "big cap value", the QQQ index is big cap growth. My forecast is that the QQQ will outperform big oil considerably over the next few years.

IT TAKES MONEY TO GROW A BUSINESS

Anyone with experience running a small business knows that the reason so many small businesses go out of business is because of inadequate cash. New business owners often incorrectly assume that profits are the key to success. Of course, in the very long run, a business needs to turn a profit. Having run a resort rental business, I can tell you that cash is king. Year after year, for decades we experienced tough cash flow and negative profits. The good news was that the value of the properties appreciated dramatically while all the rents and then some went to pay all the expenses.

Now that the economic mid cycle turn is here, the availability of financing is tighter. Starting a small business will be harder than it was over the past 5 years. Venture capital will be more and more dear. Funding will be available to profitable businesses but they will need solid balance sheets.

The reason to favor large caps in the current environment is that large caps tend to be "self funding." The current run up in Microsoft (most all of my friends own Microsoft through their ownership of the Q's) makes the point well. Microsoft has accumulated billions of dollars of cash and has all the more cash flowing-in. The coming build out of the mobile Internet (it will be an ongoing renovation over the next 50 years) will require huge amounts of money. Big companies which have the cash to move on opportunities have the advantage.

The smartest of the smart will continue to bring forth innovations. Facebook is an example of innovation capturing imagination and making the founder a multi-billionaire quickly. However, the only way for you to own a piece of Facebook right now is for you to own a piece of Microsoft. At the same time, Google is making big move after big move to compete directly with Facebook. It is my belief that churches, businesses and other organizations will soon adopt the Facebook "method of communication." Programs like Facebook and Myspace started as "virtual homes for teenagers" but are proving to be a valuable productivity tool for business. A number of businesses offer password protected communities of users. Email will eventually be relatively passe'.

The battle for dominance in all the the fast growth areas is ongoing. Millions of innovations fail to catch-on. Now is not the time to try to find the next Google, Yahoo, Myspace or Facebook. These companies have a head start on systems that have room to grow. As you all know by now, I believe Google's location specific mobile platform adds will be the most profitable of all time. Besides, by the time Facebook shares are available to you directly, they will cost an arm and a leg.

BIG PHARMA

Since a number of my readers work for big pharmaceutical companies, I must mention that the good times are upon you. The see saw of healthcare is swinging back into your direction. The momentum will grow at a gradual pace during the early part of the prosperity phase but like a see saw the speed will increase right to the apogee of the move. Within a few years, the compounded returns will be better than most "expert" expectations.

BUY, BUY, BUY!

NEGOTIATE, NEGOTIATE, NEGOTIATE

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.

BELOW AVERAGE, AVERAGE AND ABOVE AVERAGE RETURNS

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!