PE EXPANSION IN 2006!

Conditions are ripe for the multiple to multiply in 2006. One way to measure the expected or fair PE ratio is to use the old rule of 20. The rule of 20 is better than the old rules of 18 and 22 because the average makes for easy comparisons and the rule is more of a guideline than a rule. There is not a precise mathematical relationship.

The rule of 20 says the current PE on the S&P 500 should roughly equal 20 minus the yield of the 10 year Treasury note. The current yield is about 4.35% leaving a projected PE ratio of 15.65.

There is a bunch of good news in the above projection; especially if you combine the above projection with the projection of future earnings and the projection of future yields. The bond market yield curve is currently projecting lower interest rates and, although the second derivative of earnings growth is down, an increase in earnings is predicted.

I like forecast derived from the bond market. This big institutional market is right more times than not. This market is clearly calling for lower interest rates. Think about it, if you were managing 10 Billion Dollars of 1 to 10 year paper would you invest in a ten year note at 4.35% or a 5 year note at 4.31%. You would have to have a strong belief that interest rates are headed down before locking into the then year paper.

Projections of earnings growth are complicated by numerous factors. For example, the trend has been better than expected earnings growth for four years in a row. Analysts have consistently been wrong but in a good way for those of us who have been bullish. Another factor is that much of the earnings growth has been in oil or oil related stocks. The rate of growth in the oil market rate of growth is slowing.

Ed Yardeni, one of my all time favorite economist, uses general economic statistics such as ISM indicators to project earnings growth. Suffice it to say that there are many indications that the rate of growth in earnings may slow in 2006 but the growth still could even possibly hit double digits again.

The bottom line is that it is rare for the PE of the S&P to be below the rule of 20 PE. In past instances, PE's usually expanded. In the past, a flat yield curve has usually correctly predicted a decline in interest rates. A decline in interest rates would increase the rule of 20 PE even higher. In the past few years, analysts have underestimated earnings. An increase in earnings would widen the spread between the S&P PE and the rule of 20 PE. Add all these indicators up and one can envision a 30% gain in the S&P during 2006.

WSJ.com - SAS May Cancel Routes, Cut Jobs After Review Of Airline Operations

Airline discount fares in America are changing business world wide. The big US carriers, such as AMR and CAL, have had to cut labor costs to compete with LUV. In doing so, AMR and CAL now have lower operating cost than other international carriers. SAS, Scandinavian Airlines in Sweden, is feeling the pressure.

CAL will increase international flights another 15% in 2006. It is neat to own shares in an expanding company and then to see competitors cutting back capacity. The DAL pilots have until noon today to approve temporary pay cuts. Should they fail to do so, DAL will seek court permission to impose permanent pay cuts.

After the cuts, the pilots will make $168,000 per year on average. It is difficult for most travelers to feel sympathetic to their plight. On the other hand, travelers are enjoying seeing amenities coming back. Airlines are gradually adding back perks that were taken away during the crunch of the past 5 years.

WSJ.com - U.S. Resists Building Refineries As Overseas Firms Move Ahead

The WSJ has finally caught up with me and Google.

For several weeks, I have written about the many refineries that are planned or under construction around the world. One point I have made that is not in the WSJ piece is that when 3 Billion Dollars is used to build an oil refinery in Viet-Nam, that is 3 Billion fewer Dollars available for other purposes. Using the US housing market as an alternative one can easily appreciate that the mortgage rate on 3 Billion Dollars of housing might go up just a little.

Using an average house price of $300,000 (higher than the actual average in America), 3 Billion Dollars is enough money to finance at least 20% more than 1000 of these houses.

In regard to oil, I have stated that crude is likely to dance around $55 to $58 for a while before breaking to the down side. I am confident that the price will be below $45 in the next two to three years but cannot guess what will happen between now and when more production comes on line. It seems that demand destruction is rapid when the price gets above $60. It seems that demand destruction also is happening daily at $55 to $58.

The WSJ reports 100 oil projects that could add 12 million dollars per day of "new" oil. It is just a matter of time before prices go down.

Response to Muckdog and Random Roger: Yield Curve Inversion.

Muckdog and Random Roger have noted the recent yield on the 2 year at 4.39% and the 10 year at 4.37%. The following is my response to their discussion.

At the risk of sounding like "this time is different", I must say that there are a lot of things that used to be true that are no longer true. In the old days, a dramatic down-turn in autos was a sure sign of pending recession. A slow down in housing was even more ominous.

Now-a-days, the economy is much more resilient because it is a service based economy, less dependent on cyclical industries.

Another major change between the old days and now-a-days is that more and more loans are variable rate loans. "The glass is half empty crowd" seizes on variable rate loans as another reason "the recession" is going to be rough. As usual, economic variables do not correlate well with markets; at the very least, there is a time shift. A simple but great example is that one should buy cyclical stocks when earnings are low, not when earnings are at their peak. The market is already discounting the day when rate increases stop. Smart investors are buying the transportation index and other strong business cycle stocks while rates are still on the rise.

While theoretically consumers have been hit hard by 13 increases in short rates, the economy has been resilient. Suddenly, the higher rates are finally slowing record home sales. For five or six weeks in a row, fixed rate home mortgage rates have come down. Thus, by the time sales are down, the market is already adjusting to make houses more affordable.

The important reason the yield curve is flat is because long rates will not go up! Long rates, clearly have sniffed out declining inflation rates and are lower now than when short rates were lower.

The inference to draw is that with autos and housing experiencing a slow down, long rates will continue to trend down. The FOMC is facing declining inflation, a slow-down in autos and a slow down in housing. The pressure is on to stop raising short rates. Indeed, the Bank of England is reported to be considering a rate cut.

On February 1, 1995, during a similar mid-cycle correction, the FOMCmade the last increase in a string of rate increases. Only 5 months later, on July 6, 1995, the FOMC was forced to make the first of several rate cuts.

Gold and oil have hit highs and lost momentum; in 1995, Gold continued to trade up a little when the FOMC was forced to cut rates. However, Gold started a very long plunge the following year. Oil has recently traced out a classic head and shoulders top. I see odds building of downward movement. I happen to agree with about 85% of the forecast made by my friends at haysadvisory.com (subscription required). This year, oil supply growth relative to oil demand growth was the strongest since 1998!

One of my most valuable market "secrets" has been reinforced by the wise words of Ken Fisher as published in Forbes Magazine. He reports that if you can find a "true fact" that is widely disbelieved, you can make a lot of easy money. To be specific, oil production grew by 1.25 million more barrels than oil consumption during 2005, the second year in a row of excess production and the best result since 1998! If you want to track the energy markets closely, I suggest you subscribe to the WTRG Economics service produced by James Williams. He believes natural gas will be pushing down on $10 early in 2006.

Oil industry forward earnings projections will turn-down if energy prices continue to correct. So, we will have one more block built in our wall of worry and another reason for a short-term stock sell off, and, another reason for long rates to decline.

Housing is levered to long interest rates. Housing will catch on fire again if mortgage rates keep coming down. Many an American now wants to own a vacation home or two as the best way to get a visit or two from the grandkids. The majority of Americans, having done a poor job investing in stocks, know that first, second, and even third homes are great investments.

During the first half of 2006, I will not argue against the idea that a slowing of GNP might occur. After all, who can expect a blistering 4.1% real rate to continue? However, without total idiocy by the FOMC or a terrorist attack on US soil, I see no recession in sight.

With mortgage rates down 5 weeks in a row, with a record number of Americans turning 60 and with American family wealth exploding upward, you can count on heavy buying of second homes in 2006. With the highest levels of inheritance occurring in history (the Bob Hope generation is fading fast), you can count on housing upgrades by the recipients.

Barry put up a great chart on his Big Picture Blog that shows the declining influence of the inverted yield curve. In the old days, the curve predicted something like 10 of 8 recessions. It is about to miss again.

PCWorld.com - Google Creates Spinoff

It is good to read that Google is "keeping the faith". "There will be no banner ads on the Google home page or Web search results pages. There will not be crazy, flashy, graphical doodads flying and popping up all over the Google site. Ever."

Googlehas gone the extra mile to show that AOL will not get preferential treatment. The AOL stake will be segregated into a separate holding company so that when the time comes, the shares can be "spun off". This arrangement helps TWX establish the value of AOL while keeping TWX and Google in an arms length transaction.

The key issue for me has been how TWX can make its tremendous video and magazine content available on the internet? I remain frustrated that one cannot quickly find an old movie or a "walled off article". Note that the ice jam is breaking-up. The linked article in this case is from PC World computer magazine.

The system I see developing is one of access via a search engine to lots of content but then a steady dose of encouragement to the consumer to subscribe to expanded services. The subscriptions offered should include something like a "literary pass" to multiple publications.

Consumers must pay for content in one way or another. Consumers want content without being force fed advertising. Consumers want to see advertising that helps them make decisions. Consumers themselves often do not know what they might buy. I just happened to run across a Christmas present yesterday that was exactly what I was looking for. I believe, Google would have helped me find this item if it knew more about me. As far as I know, Google is only slightly aware that I will soon have my first grand child. To this point, I am seeing no special advertising that relates to the coming birth.

Give Google time and it will help me and you find the stuff we want. Products we want to buy and content that we want to watch or read. The deal with AOL will open the doors to much more content. AOL and Google will learn much more about me when AIM and Google Talk start working together. The benefits will be to me, AOL and Google. Do the Google Gulp; the growth in revenues has only started.

IMF sets $685 million Iraq loan package - Banks - Financial - Financial Services - War & Terrorism

The process of converting Iraq into a vibrant nation with a strong economy just took an important step. Iraq is on the path to prosperity.

The $685 million dollar loan package is small potatoes by US standards but a significant chunk of change for an emerging nation. The debt swaps conducted also set the wheels of commerce in motion.

No one can say how long it will take for Iraq to ramp up oil production. Now that the Sunnis have voted en mass for the elected government, one can only hope that destruction of oil facilities will diminish.

U.S. and British troop withdrawals will begin this year. Progress in Iraq will see peaks and lows but, a year from now, the progress will be obvious. Merry Christmas and Happy Holidays to all who are in Iraq in service to the noble ideal of freedom!

2006 LOOKING GOOD FOR MAKING MONEY

Natural gas and interest rate declines are setting the table for a good, possibly great 2006. After Katrina hit, the US temporarily had 8 Billion Cubic Feet of natural gas production shut-in. By December the number was down to 2 Billion while supplies on hand were higher than average. Another 300,000 feet came on line this week and by January the shut-in supply will be less than 1 Billion Feet. (Data provided by James Williams.)

In recent weeks the price of gas pushed $15 and it will soon be pushing down on $10. There are indications that fuel oil has been substituted for gas as much as possible for the past couple of months. There are also indications that fuel oil is being used carefully. Airlines, which burn a mixture that is very close to fuel oil, have done a terrific job of conserving fuel while by combining all reasonable flights possible. American reported lower fuel costs of 61 cents per gallon during the 4th quarter. These lower costs are only possible because the current price of fuel is destroying demand. Consumers are using hundreds of methods daily to reduce demand. My Mother just insulated a new room addition to an r-48 level.

In the meantime, mortgage rates are down five weeks in a row. The real estate "bubble bust crowd" sees the decline in mortgage rates as the end of the housing boom. This crowd simply does not appreciate the power of compound interest or the size of several population cohorts. Compound interest, according to Einstein, is the most powerful force in the universe. The cost of a home today at 6% interest is dramatically lower than the cost of a home 5 years ago at 9% interest. Lock in a 30 year mortgage at 6%, an after tax rate of about 4.2%, and you can enjoy living in a nice home for free! The value of the home is likely to go up as much or more than the cost of the mortgage. Americans will be jumping on homes again as soon as the FOMC lets up on the brakes. Variable rate loans will reduce prices by thousands of dollars when the yield curve reverts to its normal slope.

Americans, wealthier than ever before, average the prime age to buy a first home, move up to a larger home or to buy a vacation home. Those folks who are between 59 and 65 years of age have historically bought the most expensive homes of their lives including the most expensive ocean front properties. For the next 10 years, the US will set higher and higher record numbers of folks in this age cohort. Those predicting a housing bust are about 5 to 10 years early. The younger baby boomers are between 48 and 54 years of age; the prime earning and spending ages. Those who worry about consumer spending have not seen many doting first time grand parents. Marilyn and I are expecting our first grand child and can not resist buying for this yet to be born child.

Inflation hawks have been squawking up a storm for the past several months. However, number after number shows that inflation is well contained. With lower interest rates, low inflation, consumer spending, business expansion and lower fuel prices, the concerns about 2006 are over done. 2006 is shaping up to be a beautiful year!