Wealth International, Limited

Finance Digest for Week of October 16, 2006

Note:  This week’s Offshore News Digest may be found here.


Our list of the 200 Best Small Companies ferrets out the most robust, fundamentally disciplined public outfits with sales between $5 million and $750 million. To qualify a company must have a share price of above $5 as of September 29 on 3-month average volume of 10,000 shares. Candidates carry profit margins of greater than 5% with positive sales and profit growth, on average, over both the last five years and last 12 months. The result? Small, but growing, businesses designed to survive the ups and downs of market volatility.

These winners have come through a tough year, contending with suddenly high energy costs and a string of 17 interest rate hikes by the U.S. Federal Reserve. Not surprisingly, most of these 200 scrappy players carry low debt burdens. 21 companies grew too large for our list this year. Roughly 30% of last year’s members were not invited back, typically because of declining earnings in recent quarters.

Investors have, by and large, recognized the superior performance of these companies, and so their shares are not cheap, although they tend to do well in bull markets for growth stocks. Recently, value, not growth, has been the strong suit on Wall Street. Last year’s list has gained 6.5% over the past 12 months on a market value-weighted basis, compared to 12.2% for the Russell 2000 index.

Companies with steep growth trajectories often grow off of our list in short order. Many of the companies on the list are household names – Tootsie Roll Industries (TR), WD-40 (WDFC), Boston Beer (SAM), Yankee Candle (YCC), Oakley (OO), LoJack (LOJN) and K-Swiss (KSWS). But others find success in more obscure market niches. Disqualified from the list this year is Parlux Fragrances (PARL). The maker of Paris Hilton’s line of perfume is currently trading 74% off of its February highs, and is in danger of being delisted from the Nasdaq for, among other things, failure to file its quarterly report on time. For investors hoping to glean investment ideas from the list, take note. Parlux received a low Board of Directors Score on our list last year.

Link here.

Five value stocks to own now.

For the past two years the Stratton Small-Cap Value fund has made the Forbes Honor Roll, our roster of long-term performance champs. This plaudit shows that manager Gerald Van Horn, 33, knows what he is doing. Van Horn has run the fund for six years, overseen by his mentor, James Stratton, 69. Their stock-picking screen is pretty good at finding great values in small stocks. Van Horn starts with a list of 3,200 small companies (market caps from $200 million to $2 billion) and quickly eliminates 90% of them with a mechanical formula that emphasizes free cash flow. After that quantitative filter subjective judgment takes over, and he shrinks his buy list to 70 or so names.

If you want to copycat this approach, start with a target company’s free cash flow. To get this number take the “cash flow from operations” shown immediately after the profit-and-loss statement and subtract capital expenditures. (You want outlays for plant and equipment. Ignore sums spent on buying stakes in other companies.) Value players like companies with a low ratio of market value to free cash flow. Winners on this score tend to have low multiples as traditionally defined (low price/earnings ratios, that is), but the correlation is not perfect. A company can look cheap on a P/E screen but lose out in a free cash ranking if it is spending lavishly on plant and equipment. Conversely, a high-P/E outfit can look cheap in free cash terms if it chalks up a big paper depreciation charge but spends niggardly amounts on its factories.

Van Horn makes adjustments to the market value and cash flow figures to calculate what they would be if a company were all equity financed. He wants a company to fall at the cheap end of the spectrum for its industry sector. Two other factors that count less than free cash also come into play. One is earnings surprises: Desirable companies beat analyst forecasts. The other is momentum: A recent positive trend in a stock’s price is a good sign. The $640 million Stratton Small-Cap Value fund has returned 18% a year over the past five years and 14% a year for the past decade. The fund has handily beaten the S&P 500 and is also superior to 95% of the funds in Morningstar’s “small blend” category. The no-load fund charges a 1.3% expense ratio, not a bargain but less than the average for its sector.

We asked Van Horn to apply his techniques to our list of 200 Best Small Companies. He came up with five names that look good to him. In fact, he already holds three of the five in his fund. Value has done better than growth recently and the Best Small are by definition growth stocks. What Van Horn is doing this year is selecting what he views as the relatively better values to be found on our growth stock list.

Link here.
The Top 10 – link.
Where are they now? – link.


While the Dow Jones booms, commodities like oil and gas swoon. Jim Rogers, the man who called the raw materials rise years ago, is upping his bets. Economist Stephen Roach thinks that is nuts.

In three months crude oil has fallen 20% to $60 a barrel. A price drop in natural gas severely wounded hedge fund Amaranth Advisors. Gold and sugar are in bear markets. In August the Goldman Sachs Commodities Index fell, breaking four years of month-on-month increases.

To Jim Rogers, the man who called the commodity boom seven years ago, those are mere blips. This is a great time to invest in commodities, and he has backed this up by investing more of his own money. Supply of things like base metals, oil and rubber is crimped after years of underinvestment in mines and oilfields and farms, he says, so prices are heading up. And they will go up, with some transitory hiccups, well into the next decade and perhaps even the one following. Copper, zinc and oil have all at least doubled in the past three years. You will see more doublings in many more commodities.

That is the Rogers view. And then there is economist Stephen Roach, the Morgan Stanley bear every bull loves to gore. He thinks Rogers is dead wrong. Roach says commodity prices could fall another third from here, putting an end to silly notions of a so-called supercycle of commodity increases. The culprits? Slowing growth in China, a voracious buyer of commodities, and a U.S. housing recession that, he says, will slash demand for building materials like copper and weigh down the global economy.

If you have been distracted by whether the Dow Jones stock index will stay in record-setting territory, there is a less-noticed but raging debate about the future of commodities. The sparring recalls a famous exchange a quarter-century ago, during another price runup, when the ever-optimistic economist Julian Simon bet doom-and-gloom environmentalist Paul Ehrlich $10,000 that metals would fall over the next decade, ending 1990. Simon won. He was not a pessimist in the manner of Roach. His theory was that technology would eventually find a solution to any raw material shortage. We ran out of whale oil but found petroleum. Copper is expensive, but optical fiber is replacing a lot of it.

If the issue of resource scarcity is similar, the wagers today are a bit bigger. Hedge funds have put $70 billion into energy, double the level of two years ago. Investment banks have beefed up their trading desks with commodities experts. Merrill Lynch paid $800 million for an energy trading unit after unloading a similar business a few years earlier.

Rogers, 63, brings a lot of credibility to the bull case. He started a commodities index in 1998 when investors were caught up in the dot-com frenzy. The Rogers International Commodities Index has since returned 16.9% annually versus 13.9% and 11.8% for rivals from Goldman Sachs and Dow Jones-AIG, respectively. This year, Rogers’s is up 7% through August while Goldman’s is down 0.4%, and Dow Jones-AIG’s is up 3%. Rogers, author of Hot Commodities, says his optimism comes right out of the history books. The shortest commodity boom, which began in 1966, was 15 years, he says. The longest: 23 years. The current one: 7 years (forget the slump we are in now). The long trend reflects the fact that lots of commodities can not be produced quickly. By the time miners or drillers or farmers realize that demand has outstripped supply, it is too late.

Food inventories are the lowest since 1972, Rogers notes. Acreage devoted to wheat, for instance, has been falling for three decades. Cotton could also take off, he says, as clothesmakers switch to natural fabrics to avoid the rising cost of oil used in synthetics. He says “soft” commodities like grains, oilseeds and fabrics, which have generally not shared in the boom, are likely to outperform. Rogers is relatively bearish on zinc and copper, however; they could drop like an anvil after having more than doubled in a year. Then there is China. Sure, the country’s economic growth could slow, but over the long term Rogers is an unabashed bull. So much so that he has taught his 3-year-old daughter Mandarin and, in preparation for moving to a “Chinese-speaking” city with her, has put his Manhattan manse up for sale for $15 million.

Roach’s response is that China will be slowing, and that is a big problem. He says bank reserve requirements and rises in interest rates, combined with Beijing’s recent “administrative edicts” to rein in investments, will throw cold water on the “China mania” gripping investors who blithely assume 11% growth every year. It could also kill off a few of the mania’s side effects – like Mandarin lessons for kids and uprooting families to Asia – what Roach calls “Rogers’s whole schtick.”

Roach says crude oil prices are more likely to head down than up. Rogers says they will approach $100 a barrel before the commodity boom ends. Roach says cheap Chinese imports create “headwinds” against inflation and that rising U.S. bond prices wisely reflect that. Rogers says inflation, far from retreating, is rampant, and he is shorting U.S. Treasury bonds. Roach says the influx of money into commodities means trading “technicals” with no relation to fundamentals can cause investors to “overshoot”. Rogers notes that there are fewer than 50 mutual funds worldwide dedicated to commodities versus 70,000 for stocks and bonds, though he too fears man’s tendency to overshoot. It is Roach’s timing that is off, he says.

“Call me in 2019,” says Rogers, which he considers a more likely peak-price year than today. “I will say, ‘Sell commodities.’ And you will laugh and giggle and say, ‘Commodities always go up. You are an old fool.’” Roach might be thinking something along those lines right now. He apparently sees opportunity in the coming real estate crash. He jokes that he put in a bid of $1.5 million for Rogers’s house (eight bedrooms, five baths). “He hasn’t gotten back to me yet.”

Link here.

Getting to the bottom of it.

It is becoming somewhat inevitable these days, that whenever a group of analysts, traders, or investors gathers to discuss commodity matters, sooner or later someone will portentously intone the formula, “Of course, a resource is ultimately priced at the limit set by the lowest marginal cost producer.” Given that this is usually trotted out as part of an argument that commodities are presently overpriced, sometimes this is qualified by the equally profound-sounding qualification, “… or at least it is in a bear market.”

The first thing that strikes one as odd here is that the latter addendum implicitly admits that prices are not always set by costs, but that apparently, this aberration can only apply in the upswing when the (unspoken) implication is that speculative forces can bring about such a divorce, something that they are seemingly unable to achieve in the downswing. In passing, it should also be observed that, if there were any merit at all to this lemma, it should hold universally for all businesses, for, surely, producers of commodities can in no way be thought to represent a special case in economics (at least, the cynic might remark, for anything other than their unenviable record as destroyers of capital over the cycle!).

That aside, we must protest that the statement is inherently incorrect for, rather than the most EFFICIENT producer being of importance to the establishment of some theoretical equilibrium and, so, for anything other than the shortest of short runs, a good will instead be priced no lower than the marginal cost of the least INEFFICIENT producer whose output is nonetheless still needed to satisfy total demand on the market. It is not the Saudis who set the price of crude with their 11+ Mbpd capability. Rather, it needs to be priced to reward those operating at great expense and considerable risk out at the edge of the continental shelf, or those coaxing a recalcitrant hard-to-refine sludge out of its matrix in the oil sands of Canada.

Just as bull markets deliver temporary windfalls to all, by setting bids at prices greatly exceeding existing marginal costs, bear markets can also push prices far below these levels – not least when margin-driven liquidations of those long and wrong of claims on the relevant resources are taking place! Nonetheless, it may be a useful rule of thumb for gauging when a market is clearing at too low a price to be sustained to say that, over a longer horizon, the most efficient company may well indicate the whereabouts of the lowest, long-term floor – as, arguably, the likes of Newmont were on the brink of doing when gold was at its 1999-2001 lows of close to $250 an ounce.

If you are looking for bullish arguments based on costs (while staying alert to the fact that they can never be predicative), listen to those who will tell you that a near 60% increase in oil E&P over the last two years was basically eaten up in higher outlays, that it now takes $1 million a day to run an offshore drilling program, or that some industry experts fret that barely half the investments needed to meet secularly-rising energy demands may have been initiated. Pay attention to miners complaining of operating cost hikes of as much as 30%, of “cost-curves” both moving up and steepening, of exploration costs rising by approaching 15% in the last 12 months alone.

When it comes to sustainable prices, consider that U.S. #2 natural gas producer Chesapeake idled 6% of its wells a few weeks back, saying spot prices “aren’t economically feasible.” Think of the impact on rig operators when spot has traded with a $4-handle, nearly 80% below the summer’s peak and a price not seen since early 2003. Think of OPEC vacillating over production cuts and grumbling about “security of demand” as it compares falling prices with its raft of multi-billion investment projects, many of which are already suffering budget overruns and input constraints. But, similarly, think about bad positions held on slender margins in speculative markets. Think about misplaced bets in the context of poor news flow and higher inventories. Reflect on a market still tending to overweight the bad macro headlines from the U.S. and to dismiss the positives originating both there and elsewhere around the word.

In short, remember that costs can only set a long-term foundation, never a short-term one, and that the urgency of some to quit losing trades can meanwhile force successive tranches of “least efficient producers whose output is nonetheless still needed” to curtail activity. Conversely, bear in mind that the long term trends for many of these key resources are so far unimpaired, that the hard-fought battle to match supply to demand is still far from decided, and now you may take a little comfort in thinking that the more the current – largely leverage-driven – weakness depresses output, deters new investment, and defers upgrades and expansion plans, the longer these key commodity markets will remain short of regaining any sort of reliable and durable balance.

Barring a significant slump in real activity, well beyond the current mild deceleration, and absent an outbreak of systemic woe in the Looking Glass world of casino finance, the economic verity still holds that it is the buyers’ appetites which set prices, and not the producers’ aspirations. This can only imply that – assuming it does not collapse the entire house of cards in the process – today’s distress-driven overshoot will be of tremendous help in laying the ground work for tomorrow’s gratifying rebound.

Link here.


Media pundits have been blaring the horns over the past week as the Dow industrials made a series of new all-time highs and the S&P 500 followed suit with a set of post-2002 recovery highs. Coincidental events during this rally have been a decline in Treasury bond yields and a dramatic decline in the price of oil. Yet the basic technical condition of the market remains the same – red flags all over, which remain despite the continued rally.

The S&P and the Dow have been stair-stepping higher for almost three months now, and it has been doing so in a very narrow channel only about 30 points wide. It reached the top of the channel last week, and the bottom lies just below 1,340. The short-term trend remains up until we see a break below that lower trend line. The transports remain far behind the industrials, and the potential Dow Theory sell signal remains in effect. We are now in month five of this nonconfirmation from the high in May, which is, time-wise, in range of the sell signal we saw at the 2000 top and the buy signal we saw at the 2003 bottom.

This rally has clearly gone far beyond where we thought it would end, and the famous quote from Keynes has been popping up a lot in the press this past week, “The market can stay irrational longer than you can stay solvent.” This certainly applies to the current market. Being aware of the current economic backdrop, along with the divergences we are seeing in the market itself, there is no way we can recommend being long the major indexes here. There is just too much risk built into the system and not enough potential reward. There are technical and fundamental signals all around that tell us that stocks are incredibly risky here. But, as we have now seen, the market can ignore that all it wants over the short term.

During short-term rallies like this, those who remain focused on the endgame of surviving this big bear market can be made to look like fools … for the time being. To be sure, being short this market lately has been wrong, and we are not about to make excuses for it. This has been a very difficult market not only for us, but for many hedge fund managers we have talked to. There is certainly a huge amount of short covering going on now. In addition, some hedge funds are now chasing the market, hoping to make gains back by plowing into the riskiest high beta trades around. Such tactics work until they do not, and those opting for that strategy are playing the game with OPM (other people’s money). That is not a luxury we have, but we would not play that game even if we did.

But this is not a game – this is about financial survival through one of the largest bear markets in a generation, so we have to remain vigilant about where and when we take on market exposure. We have kept you largely out of energy this year, because of the potential risks we could see developing, which looked like the wrong call until oil broke down and took everything energy related with it. We also remained on the sidelines with commodities in general for similar reasons, and now we have seen a tremendous fall in the CRB Index. So while we have not seen the breakdown in the stock market yet, many signals suggest stocks will eventually follow a similar path as some of the other breakdowns we have seen this year.

Another sector we remained on the sidelines of until last week was the miners. We had waited a long time to enter, but a good entry can make all the difference. Many mining stocks lost about 50% of their price during this correction. We recommended the Market Vectors Gold Miners Index Fund (GDX: AMEX) to take advantage of this upcoming rally. A break above the 20-day moving average at 295 on the $HUI index would be a good time to add to your position. We would usually recommend a 5% allocation to any one of our recommended positions (which you should adjust based on your own circumstances and risk tolerances), but a 10% allocation to GDX with a break above 295 could be appropriate for those wishing to overweight this sector higher.

One thing to consider is that gold has quite a bit of room to fall and still be in a long-term uptrend. We point that out as something to consider for those wishing to overweight the sector by scaling into a position. Also, keep in mind that mining stocks usually start to rally before the metals actually do, so it is not surprising we are getting a buy signal from the stocks first. We will probably add GLD as a proxy for physical gold when the time looks right. And beyond the short term, there is every reason to remain on the sidelines or short the equities market. The long opportunities are in Treasuries, and now mining stocks.

From most recent weekly Survival Report update.


One of the great innovations in finance over the past half-century was the index fund. These passive portfolios track the market at low cost and do an astonishingly good job of beating actively managed portfolios. The grand pooh-bah of all indexes, the S&P 500, has bested two-thirds of actively managed funds over the long term. Competition in the S&P index fund business has sent pricing down to a rock-bottom 0.10% of assets invested.

This market is a little too commodity-like for David Booth, the chief executive of Dimensional Financial Advisors. Booth has long believed, “Right down to my tippy toes,” that he can beat the standard S&P fund. For the past 25 years he has done just that, with automatic-pilot funds that resemble S&P funds but tilt toward stocks of smaller companies and/or tilt toward value stocks, those being the ones that trade at lower multiples of book value, earnings or dividends. DFA funds command slightly higher fees than the commodity S&P 500 offerings. This has been a good business for Booth, 59, and the DFA’s recently retired cofounder, Rex Sinquefield. DFA’s success in edging past standard benchmarks has drawn in $108 billion in assets, yielding close to $300 million a year in revenue to the 250-employee firm.

The conventional index fund, by its nature, is compelled to load up on stocks newly added to the index, even as other index funds are crowding into the same names. DFA dodges that problem by constructing its own baskets, typically with several hundred stocks. More important, standard index funds must ignore fundamentals like assets and earnings in favor of tracking the market’s passions of the moment. The S&P 500, or a fund designed to track it, is weighted by the market capitalizations of the companies in it. Thus an index fund getting a slug of new money in early 2000 was obliged to put a large amount of the cash into Sun Microsystems, because Sun was a favorite and enjoyed a market capitalization all out of proportion to its sales or earnings. Those late-arriving index investors fared poorly.

Where are DFA’s customers’ yachts? The group’s largest fund, DFA U.S. Small Cap Value, has outpaced the Russell 2000 by 6.5 percentage points in annual total return over the past 10 years. The next biggest, International Small Cap Value, bettered MSCI EAFE by 4.3 points. The third, U.S. Large Cap Value, was 3.5 points ahead of the S&P 500. You will get some argument from index aficionados (notably, John Bogle, founder of the Vanguard Index 500 fund) about whether the superior performance of value stocks or small stocks is an eternal verity, not just a cyclical phenomenon. But there is no denying DFA’s appeal these days to the institutions running pension funds and to the financial advisers steering individuals’ portfolios.

DFA’s latest innovation is to tweak its beloved small-cap value model. Since September 2005 the firm has launched three new funds to practice its new theory. In that short period it has done slightly better than its conventional counterpart index funds. The justification for using small value stocks as the centerpiece is that from 1927 (when the first good market data emerged) until now these stocks averaged an annual return of 14.5%, well ahead of large value companies at 11.4% and trouncing small growth stocks (9.4%) and large growth (9.5%). But small value stocks come with more risk, as measured in volatility. The new Core Equity funds deal with this volatility by admitting a few big companies into the mix. General Electric and ExxonMobil can be found in the portfolio.

Booth also recommends an investor marry one of his new Core Equity stock portfolios tilted toward small value shares with shorter term bonds. The strategy involves a wholly new way of thinking about the role of bonds among your holdings, says Eugene Fama Jr., a DFA vice president. “Forget using fixed income for the returns. Think of it as a way to dampen stock volatility.” At this stage the bond appendages have not done much to a Core Equity holder’s performance, as bonds are not rallying and yields are low.

DFA sells its funds to the general public but not willy-nilly. Investors in DFA must buy into an academically dictated strategy if they want to get in the door. A DFA-approved financial adviser must first vet you to ensure you are not some hot-money type who wants to cash out early.

Booth is hardly alone in believing that he can surpass traditional indexes. Robert Arnott’s Research Affiliates has come up with its own approach to form indexes that eschew the market cap orientation. Instead, his RAFI indexes use such measures as dividends, sales, earnings and book value. Pimco debuted two funds in mid-2005 based on Arnott’s work.

Jeremy Siegel, a Wharton professor famous for predicting the bursting of the tech bubble, has a similar strategy to beat the indexes. He focuses on dividend-paying stocks. In July his company, WisdomTree Investments, hatched 20 ETFs with a variety of orientations, from the broad U.S. market to Japan’s. Siegel defiantly says his ETFs will surge past DFA’s funds in the fullness of time. He sees a few downsides to the DFA strategy. DFA’s reliance on book value rests on an accounting contrivance that means less in the 21st century. Dividends, he says, are one thing company managers cannot fudge. In addition, dividing companies into “small” and “large” requires drawing arbitrary lines that can exclude valuable stocks. Booth shoots back that many companies do not issue dividends at all – only 20% of companies overall do. Shun the no-yielders and you miss much of the small-stock action, he says.

One thing the Booth, Siegel and Arnott iterations share is their funds have relatively low, indexlike costs. Another: You will be hearing more about them.

Link here.


This was the first IMF conference I have been invited to (and probably the last) and I therefore have little experience of this annual gathering of mostly irrelevant people. However, I have a few observations to make about the IMF meeting. These events are gigantic in size, and one can only wonder whether the financial markets and the entire financial sector have outgrown their usefulness. Also, huge investors’ conferences are more symptomatic of extremely mature markets or market peaks, than of sectors that offer great buying opportunities. Our industry has far too many treasure hunters and it has become virtually impossible to identify truly unusual investment opportunities.

Moreover, the financial sector is now so huge, the costs associated with maintaining us – the parasites of the real economy – must be astronomical. These costs are, of course, directly or indirectly, borne by the clients and reduce their performance accordingly, since the majority of fund and hedge fund managers do not outperform the stock indexes. The rather reclusive Steven Cohen of SAC Capital recently expressed such in an interview: “It is hard to find ideas that are not picked over and harder to get real returns and differentiate yourself. We are entering a new environment. The days of big returns are gone,” he says, because the tailwind of low interest rates, low inflation, and strong profits has been lost. Cohen also worries that as hedge funds have become bigger, a sudden rush for the exit could spell trouble. And while not predicting such a decline for this year, he thinks that some time in the future, “There will be a real decline that may devastate hedge funds that have crowded into the same stocks.”

I should like to add that “a real decline” will devastate not only hedge funds but the entire financial services industry. For this reason, I continue to argue that, in the long term, the U.S. Federal Reserve has no other option but to print money, and that a decline in asset prices will occur in real terms (inflation adjusted) rather than in nominal terms. In my opinion, the asset bubbles are simply too big, and so much of the economy depends on them not bursting and seriously deflating that more and more money (credit growth) will be required to keep them going. This is not to say that individual asset markets cannot deflate despite expansionary monetary policies.

The demise of Amaranth Advisors, with $9.5 billion under management, is a good example. After having gained almost 30% through August, it lost more than 50% of its net asset value in two weeks, as natural gas prices declined – and this must be stressed – only modestly. If a trader could lose more than 50% of a firm’s capital on a 12% price move, one has to wonder how large losses will be in some markets once high volatility returns to the asset markets! With the flood of liquidity that continues to engulf the world, returns collapse so increased leverage is necessary to generate acceptable (to investors) returns. This increases risk and lowers returns further, producing a self-reinforcing spiral of higher leverage and increased risks.

It is one thing to be awash in liquidity generated from capital; it is a completely different matter to be awash in credit-based liquidity. That is why we are now seeing an increasing amount of hedge fund woes. The underlying problem is a hedge-fund return crisis due to excess liquidity and diminishing returns. That is what felled LTCM – they wrecked spreads across almost every market because they had credit liquidity that most others did not. And their continued pursuit of applying increased leverage to capture decreasing returns fostered their implosion. That same self-destructive practice is occurring globally now, but on a scale and magnitude that is multiple of what LTCM practiced.

In May and June of this year we had a taste of increased volatility when most fund managers did badly. Now, volatility is almost back to its lows of the last few years, indicating extremely complacent sentiment among investors. And whereas overall volatility could remain low for a while, a return to higher volatility in future is almost a certainty. While overall volatility remains low, we currently find widely diverging trends among different asset markets and economic sectors, which are likely to increase. There are thousands of investment managers – fund managers as well as hedge fund managers who need to outperform their benchmark – competing for investment ideas and superior performance. Most fund managers have access to the same information, attend the same conferences, and deal with the same trading departments of large banks or brokers. Therefore, the only way a fund manager can really outperform his peers is by increasingly taking large sector bets. Markets that lose momentum are sold, while sectors that turn up are purchased. This rotation among different countries, industrial sectors, commodities, and currencies leads then to enormously diverging performances for different asset classes and high volatility – not for the overall market – but for individual sectors, such as stocks, commodities, etc.

In the 1982–2000 U.S. bull market for stocks and bonds, investors who bought and held stocks and bonds, ideally with leverage, could not fail to do well. The same can be said of the bull market for all asset classes from October 2002 to May of this year. During these periods an investor who allocated his funds to, say, 100 different hedge fund managers (such as some funds of funds do) would have in general done well despite the high cost structure (2% management plus 20% performance fees). But if we now move into trading markets as opposed to trending markets, as I believe is likely, new strategies will have to be adopted by investors. If we move into the trading market, it is likely that some fund managers will do exceedingly well while others will fail badly because they are positioned in the “wrong” asset class. The problem will then be that the investor will pay performance fees to the performing funds and will not receive anything back from the poorly performing funds (in terms of performance fees). As a result, the entire fee structure will begin to weight heavily on the performance of the fund of funds or of an investor’s portfolio that pursues a similar strategy of allocating money to different managers who charge a performance fee.

I am fully aware that the wealthy investors and fund of funds people will say that they know how to pick the “right” managers among the 7,000 or so hedge funds and how to avoid the ones that are likely to fail. But if over 80% of long fund managers do not beat the indexes because they cannot identify sectors and stocks that perform better than the index, and also because of their fees (modest in comparison to hedge fund fees but nevertheless high enough to put them at a disadvantage compared to an index that has no fees), how likely is it that funds of funds will beat the indexes by having the ability to pick only the “good” hedge fund managers – especially given the fund of funds fee structure? Some very prestigious names in the investment business had money with Amaranth. Picking the “right” manager must be about as difficult as picking the “right” stock. It may be worthwhile to consider whether a similar or higher performance, with less risk, could be achieved by allocating money simply into a variety of exchange-traded funds (ETFs), based on some technical timing model – a strategy that would entail far lower fees.

In an environment such as the current one of easy money, markets can increase, at least in nominal terms, rather steeply. (If money was tight, it would unlikely be that the U.S. stock market is now close to a 5-year high!) In a sharp stock market rise, it would surprise me if hedge funds as a group performed better than the indexes, because following the May/June market weakness most hedge funds have reduced their net long positions. So, if the stock market were to surprise us on the upside, the hedge funds might be squeezed back into the market and forced – in order to perform – to increase their long positions. After that they would be equally as vulnerable as the ordinary ETF or individual stock investor should the market suddenly turn down.

Lastly, if indeed “the days of big returns are gone” for the hedge fund industry, an investor might consider going back to basics simply by buying a diversified basket of companies with a reasonable track record and solid management with, say, 30% of his assets and parking his remaining funds in Treasury bills, short-duration bonds, and gold. With this strategy an investor would incur an opportunity cost should the stock market soar, because he would only have a 30% net long exposure. (However, his costs would be very low compared to a 2% management and 20% performance fee.) On the other hand, his risk exposure if the stock market fell would be limited compared to any fund manager or hedge fund, which would on extremely rare occasions have only a 30% net long exposure.

Bennet Sedacca of Atlantic Advisors recently sent me a figure showing the annualized 16-year return for the Dow Jones Industrial Average, which I found very interesting. This figure does not include dividends, nor is it adjusted for inflation, but the broad message is visible. Great buying opportunities occurred whenever the 16-year annualized returns were either below the mean, which was 6.6%, or ideally when it fell into negative territory, as was the case in 1932, between 1940 and 1945, and in 1982.

Conversely, when the 16-year annualized returns were around 11%, the market was a better sale than a buy from a long-term perspective. While the 16-year returns have come down significantly since 2000, they are still above 9% – significantly above the mean of 6.6%. Based on the figure, the likelihood that the annualized 16-year returns will move towards the mean of 6.6% – and eventually towards zero – is very high. The above 30% exposure in equities could be increased once the returns drop below the mean or towards zero, as the probability of returning from below the mean to the mean then increases significantly. There is, of course, also the possibility that the 16-year annualized could return, through a strong rise in the stock market, to the highs we saw in 2000, when they reached 16% per annum. However, we shall now analyse under what kind of conditions such high returns could be achieved.

There is a school of thought that argues that corporate profits will continue to expand for the next few years at around 12% per annum. At the same time, inflation will come down because of weakness in commodities and continuous import price deflation, thus bringing about lower interest rates and a P/E expansion. Furthermore, any weakness in housing would be offset by higher wage gains, strong capital spending, and a consumption boost because of lower energy prices. We should also consider the recent decline in interest rates, which is likely to support the housing market and consumption. It is true that interest rates are higher than they were two years ago, but higher interest income by households could at least partially offset higher mortgage rates. In other words, we have the perfect Goldilocks scenario!

Having been in the investment business for 35 years, I have learned to respect any view and never to dismiss any forecast as impossible. However, if we look at the current economic and financial fundamentals, a return to 16% annualized returns for several years would seem to be most unlikely. For one, it is far from certain that commodity prices will decline by much more, and even if they declined that inflation would decelerate and not accelerate. Inflation as measured by the Consumer Price Index (CPI) has far more to do with money supply and credit growth than with commodity prices. I am aware of the notion that globalization keeps wages down, but since most jobs cannot be outsourced, wage inflation could still accelerate or remain stubbornly high.

Corporate profits tend to expand strongly when wages as a share of GDP and of corporate revenues decrease. The optimists have to make up their minds! Either household incomes will continue to increase and offset weakness in the housing market but at the same time contain corporate profit growth, or household incomes will decelerate and cannot offset weakness in the housing industry. The latter outcome would then bring about a significant economic slowdown, which would obviously not be particularly favorable for corporate profits.

U.S. import price deflation may also be a thing of the past. In the Goldilocks scenario, U.S. interest rates are supposed to decline (leading to the expected P/E expansion). This, however, could weaken the U.S. dollar and lift import prices further. Some of my friends in the know think that the Chinese RMB should appreciate by about 20% or more against the U.S. dollar over the next two years or so. (According to some studies, the U.S. dollar is about 40% overvalued against the RMB.) A strengthening Chinese currency, combined with strong wage gains and higher input prices in China, would most likely lead to rising Chinese export prices and rising U.S. import prices. This could add to inflationary pressures in the U.S. The Goldilocks scenario crowd thinks that the Chinese currency will weaken against the US dollar!

The Goldilocks scenario is also dependent on the housing market only slowing down and not collapsing. Several economists have downplayed the size and vulnerability of the “housing bubble”. But I have the impression that we are at an extreme – if not in home values, then certainly in mortgage borrowings! This does not mean that a collapse is imminent. Like a good wine, a perfect crisis takes time to age and mature. This was the case for the Japanese banking crisis in the 1990s and the Asian crisis of 1997/1998. Housing may hold up for a while longer, as interest rate cuts are increasingly likely, and only collapse – at least in real terms – in a couple of years. But, if housing holds up, it is unlikely that inflation and interest rates will decline much.

Link here.


The headline question emerges from the clear picture of a global economy still awash in credit availability and liquidity. By any historic measure, this appears to be the case AFTER 17 rate increases by the Federal Reserve Bank. These increases are referred to in the conventional media as TIGHTENING. Some other central banks such as the ECB have also raised rates a little. Liquidity in such countries across the globe is still ample in spite of such pathetic efforts.

Each quarter, the Federal Reserve publishes a curious report called the Z1. It is otherwise known as “The Flow of Funds Report”. This may be one of the few of the more honest statistics available from our usually statistic spinning government. One area subject to this quarterly reporting is what is known as ROW – the “Rest of the World”. This interesting number tell us how much U.S. dollar Financial Assets the ROW holds. At the end of the 2nd quarter, this number has mounted to $11.6 TRILLION! At the beginning of 2003, this number was in the $7.6 Trillion range. This willingness to accumulate enormous incremental amounts of U.S dollar assets is one of the primary sources of liquidity. The largest percentage of such assets is in the form of debt with increasing willingness on the part of ROW to buy corporate paper, in addition to their longstanding accumulation of Government and Agency debt. The third quarter running rate for the year for the expansion of ROW was in the $1.3 TRILLION range, vs. the mere hundreds of billions a few years ago.

The author, with a rapidly depleting cadre of bears, has caviled at this expanded borrowing as unsustainable for an inordinately long time. Obviously, this analysis has, so far, been incorrect. What has occurred in, not only the growth of ROW, but also other measures, has been phenomenal. What is apparent several years after the Federal Reserve took rates to near 0% and engineered a consumer borrowing driven recovery in the U.S. is the gigantic expansion in the Trade Deficit. This resulted in humongous U.S. dollar flows into the exporting nation’s selling entities. They, in turn, sold the U.S. dollar to their banks and, in turn, to the central banks in these countries. Virtually all of the central banks purchased these U.S. dollar through a concomitant issuance/increase in their local currency. This expanded local currency money supply obviously spurred local economies and consumption and investment. This beneficial result has persuaded the various central banks to continue the cycle. The largest players, China and Japan, along with many of the Asian and other surplus states, have also been more able to hold their currencies from appreciating, continuing the export boom and completing the “virtuous” circle. The ROW have recently had the benefit of rising local house prices due to excess money supply creation and low interest rates in their economies nearly universally. Their stock markets, in recent times, have even surpassed the U.S. equity markets in rising prices. Unemployment globally hits new lows and consumption new highs.

The reflow of credit into the U.S. occasioned by the central bank repatriation of the borrowed trade surplus dollar went largely into U.S.Treasuries and Agencies. This has “freed up” the finance sector (banks, investment banks, hedge funds, private equity etc). in the U.S. to stoke the fires of “private equity deals” (formerly the invidious “leveraged buy-outs” of the 1980’s), the burgeoning world of structured finance and commercial real estate as well as the much publicized residential real estate expansion and price climb. All across the credit spectrum globally there has been an historic shrinkage in risk spreads. Global excess liquidity is certain to cause such shrinkage as the current era of unrestricted global money flows and yield/return seeking financial institutions searches out any modicum of increased return.

There has also been a global diminution in credit problems. With rampant liquidity and tremendous creation of unregulated pools of finance, the bad deals get refinanced by less risk averse entities rather than being allowed to find their economic demise as might have been the case in more normal liquidity environments. Underwriting standards have been considerably relaxed in this era of abundant liquidity.

The oceans of liquidity already and yet to be created are certainly dependent on the willingness of creditors to continue to accept newly generated U.S Dollar debt. To date that has not been a problem. The debt, in the last 18 months has also had the advantage of constantly rising rates/yield to the buyer. This has provided a differential and continues to provide a differential against debt denominated in most of the few other “global” currencies. There is still a 1.75% advantage against the euro and 5% against the yen on the short end with lesser but still significant favorable differences on the longer end.

The U.S. dollar, in spite of the harping of the bears, has held up well as the Fed went from a raising posture to a pause stance. The Asians continue to make certain that what appreciation occurs in their currencies, such as the renmimbi, is moderated and the others hold slavishly to their formal or informal pegs against the dollar. Gold, which was accumulated massively by the hedge funds along with all other commodities when the hints of inflation were the topic “du jour”, has collapsed along with energy and other hard commodities at the first signs of U.S. slowing. The recent run-up was not the return of gold as money but only the machinations of the return starved hedge fund and managed money crowd.

So, effectively, funds continue to stay and flow into the U.S. dollar and dollar denominated instruments, in spite of continuing increasing imbalances. Where the limit is reached is beyond prophecy. Many believed that it would have been reached well before the present totals but that has not been the case. Ultimately, there does have to be a limit as the external deficit has nowhere to go but up once the income situation has deteriorated to deficit as outlined above. In the meantime, however, it is the “Golden Age” of speculation based on the “Goldilocks” economy.

Having gone on record that there is no present visible reason for reversal of the liquidity flood and bowing our head to the wisdom of “Don’t Fight the Fed” and “A market can stay irrational longer than you can stay solvent” (as it has for some of the bear persuasion), the question is can the liquidity onslaught continue indefinitely? Leaving aside as outside the author’s area of competence the chance of geo-political convulsion, the only two areas likely to lead to an “event driven” contraction in liquidity are CREDIT and CURRENCY. The situation vis a vis the U.S. dollar seems to be that the collective forces continue to have sufficient faith and a willingness to continue to accumulate the now $3.5 TRILLION per day in excessive dollar liquidity occasioned by the afore-mentioned trade and investment global situation. Confidence in a currency is not necessarily a stable condition but the alteration is usually started by another exogenous event.

We still come back to the question of credit condition. Excess liquidity is a given but credit excess occasioned by excess liquidity has ALWAYS been a “given” historically and we are not yet ready to totally adopt the “It’s different this time” on the old as mankind question of the state of the world of who owes who. What follows would be a random listing of large puddles of credit which could disturb the present blessed equilibrium.

To sum it all up, this ongoing liquidity explosion, in the terms of the immortal Yogi Berra, “It ain’t over ‘til it’s over!” The willingness of the global central banking community to continue “what has worked” has not yet faltered. Up until recently the author had been dismayed to find Steve Roach of Morgan Stanley writing as if UNBALANCED was no longer a dirty word with inevitable dilatory consequences, but an article from him today gets back on track with this thought: The longer the growing imbalance is permitted to continue, the less likely the so-called “soft landing” can be achieved.

Link here.


Newpark Resources (NR: NYSE) provides drilling fluids, technical services and disposal of exploration and production (E&P) waste to drilling sites in the U.S. Gulf Coast, West Texas, the Rocky Mountains, Canada, Mexico and areas of Europe and North Africa surrounding the Mediterranean Sea.

The business can be broken up into three main services. (1) Drilling fluids. While Newpark management says its biggest competition from major firms falls in this category, the company holds several patents on fluid technology that help keep it in the mix. (2) Composite mat products. The company manufactures and delivers interlocking composite mats to E&P sites that allow the oil company’s heavy machinery to have access. Essentially, these mats form a temporary highway and work station in remote, environmentally difficult locations. These mats are patented by the company as well, and are used as an alternative to traditional wooden mats. (3) Waste disposal. The company hauls E&P waste from offshore rigs in a fleet of 48 double-skinned barges. It also operates injection wells in Texas, where waste is forced into the ground. 25-30% of the waste the company removes is recycled as road base or construction fill. Increasingly strict environmental regulations help grow this side of Newpark’s business, where the company says that the scope of services required by oil and gas companies has increased.

Newpark derives 39% of its revenues from its top 20 customers, and no one customer accounted for more than 10% of its consolidated revenues. Thus losing one customer would not significantly affect the company’s bottom line. The company is making money, its operating margins are better every year and it is in a high-demand, growing industry. There is nothing here not to like … But despite its promise, Newpark has gotten itself into trouble this year over stock option backdating. An internal investigation was launched and earnings were recently restated all the way back to 1998. While the earnings restatements did not significantly impact the company’s progress over the past few years, the investigation has left investors in the dark almost all year.

That is where the gamble comes in, and where you could capitalize on Newpark while its share price is depressed. We have not heard from Newpark for almost a year. The company has delayed filing its quarterly reports, and now expects to announce Q1, Q2 and Q3 earnings all on November 9. And because the company has stayed mum during its investigation, its share price has taken a beating, falling from over $9 early this year to under $6 currently. The company has this year, however, announced that it had shut down its water operations in August. In connection with the shut-down, Newpark expects to record a $20.0 million impairment charge for Q3 2006.

Despite all its trouble, Newpark could record substantial profits from hurricane rebuilding efforts in the Gulf. The company lost $7.9 million due to Hurricane Katrina in 2005, and mentioned in its annual report that rebuilding offshore rigs in the Gulf will provide some more business for Newpark, and it is expanding even more in other areas of the world and with other product lines. While Newpark’s long-term profit potential looks bright, the next few weeks are a solid gamble until we are all brought up to speed on its progress.

Link here.


New technology is about to make shortages of potable water a thing of the past. I recently met with a representative of the AirWater Corp. in California, and it is but one of a collection of companies capable of, well, making water from thin air. Wired News reports that the technology is winning acceptance from the military. Defense Advanced Research Projects Agency (DARPA) seeded the research by backing a few early stage companies including LexCarb and Sciperio. However, an independent company is leading the pack. Aqua Sciences was first to market with a system capable of delivering water in places with unforgiving climates, such as Iraq. A 20-foot machine produces 600 gallons of water a day with zero toxic emissions or byproducts.

According to Aqua Sciences CEO Abe Sher, “The atmosphere is a river full of water, even in the desert. It won’t work absolutely everywhere, but it works virtually everywhere. … We figured out how to mimic nature, using natural salt to extract water and act as a natural decontamination.” While the economics of replacing conventional sources of water with “air water” have yet to be convincingly demonstrated, AirWater Corp. believes its process will ultimately produce water at 7 cents per gallon. Clearly, such pricing will make it an attractive alternative to trucking water into disaster areas or military theaters. Further, as deep aquifers begin to be depleted in places such as Las Vegas, expect these units to become an attractive alternative to bringing in water via truck, train or diversion of rivers. All of those alternatives carry a tremendous cost in fuel, infrastructure or environmental consequences. Bringing water via C-17 cargo planes costs $30 a gallon!

While many technologies can produce water this way in theory, the Aqua Sciences’ machine needs just 14% humidity. This makes it suitable for most places on Earth. What is the significance of this? Many forward-looking thinkers have made the case that fresh water is the “next oil crisis.” Supplies in many parts of the world have been diminishing as demand has been rising. Global warming will disrupt ecosystems, further reducing supplies and – if predictions of more severe weather prove accurate – increasing need for disaster relief sources of water. But there is a practically unlimited supply of fresh water in Earth’s atmosphere.

This water from air is but the first of a series of emerging technologies that will shortly arise to address the need for potable water. I am also aware of nanotechnology membranes that use minimal amounts of electricity to separate salt and all other substances from ocean water, cutting the costs of reverse-osmosis dramatically. These membranes are not yet being produced in volume. Once volume production is underway for new approaches, whether nanotechnology membranes, air extraction or others, costs will plummet as they always do. I am looking to see which small public companies will lead this transformation.

Link here (scroll down to piece by Jonathan Kolber).


In her gem of a book, Coal: A Human History, Barbara Freese clarifies why coal has proven such a boon to modern civilization. In essence, the Earth’s rich coal seams are a solar bank account, packed with eons worth of sunshine. By measure of energy output versus input, man is undoubtedly the most successful species of them all. He became so by tapping into the latent energy of fossil fuels. The process of moving from there to here – from zero to present day – was conceptually a bit like stacking hay bales. With enough bales, you can begin with level ground and build a stairway to the sky. Start with just three bales – one on top, one in front, and one on the bottom – to make the first step. Then just keep on going, stacking higher and extending further ad infinitum.

Prehistoric man’s first hay bale, Freese informs us, was his super-efficient metabolism. The ability to do more with less gave our ancestors the energy edge they needed to invest in bigger brains. Bigger brains in turn led to the use of fire, which gave man the power to harness an external energy source for the first time. Coupled with the challenges of population growth, fire enabled early civilization by way of slash-and-burn agriculture (not to mention useful fire-treated trappings, like bricks and pottery and swords). The first accounting systems were probably tied to crop dealings. After that, it was just a matter of getting more sophisticated at building and burning things.

Man greatly extended his domain by learning to consume energy he did not create. In financial terms, he has accomplished a similar thing. He has learned how to consume income not yet earned. When a person signs on the dotted line for a 30-, 40-, or even 50-year mortgage (thank you California), he or she is committing a stream of future earnings to a purchase. The money to be paid usually has not yet been earned; for all intents and purposes, it does not yet exist. Financial leverage, like fire, allows man to access a power source external to himself. The invention and explosive proliferation of the mortgage, in its own way, is as meaningful an advance as England’s transition from wood to coal in the High Middle Ages.

Unfortunately, we are on track to relearn a painful lesson. Financial disasters can be just as ugly as environmental ones. The first may be caused by careless use of leverage, the second by careless exploitation of resources on a grand scale. In both cases, lax attitudes, lolling complacency, and rampant greed are often to blame.

The literal translation of the word “mortgage” is along the lines of “engagement ‘til death.” That is an appropriate description of what late-to-the-party homeowners now face, particularly those saddled with adjustable rate mortgages (ARMs). Some homeowners, faced with the reality of upside-down properties and upside-down lives, will choose financial death – bankruptcy – over the prospect of indentured servitude. Keys will be left in mailboxes. Politicians will foam and froth. Bernanke will call in the helicopters. And gold, of course, will skyrocket.

The credit-driven housing bubble fiasco, enabled by a potent cocktail of easy money and exotic mortgages, is an example of what happens when the hay bales are stacked recklessly and haphazardly. In his lust to conquer new vistas of consumption, man has constructed a financial Tower of Babel. At this point, we can only hope to glean knowledge (and profit) from its collapse.

Meanwhile, Wall Street is content to live in shiny-happy land, where every down tick in oil and gold is a sign of Utopia’s return. Uncharitable as it may be, this attitude reminds us of a Bertrand Russell quote: “Most people would rather die than think; in fact, they do so.” We are happy to take advantage of the Street’s shortsightedness – just as many great investors have done. In 1974 [late into a horrendous bear market], Warren Buffett told Forbes he felt like “an oversexed man in a harem.” Though not quite that amorous, we are certainly licking our chops at some of the bargains to be had here.

Link here.


Do not get relaxed about the housing industry, because it is going to get much, much worse. That is the message from Gary Gordon at Annaly Capital Management, a firm which invests in mortgage-backed securities. Mr. Gordon is looking for substantial further declines in housing starts and sales, which will result in a recession beginning in 2007. He is on the pessimistic side of the Great Housing Debate. The optimists took the uptick in home sales in August as a sign of bottoming. They see homebuilders responding aggressively to rising inventories, and cutting prices to quicken the industry’s return to equilibrium.

The real issue is, how much consumer spending has been funded by rising home prices and how vulnerable is the economy to a fall-off in home values? Bears argue that the consumer has used his home ownership as a piggybank that is now ominously empty. They point out that mortgage equity withdrawals have climbed almost without pause since the early 1990s. Today, these borrowings are plummeting, a development that the folks at economics consultancy ISI call “unprecedented”. Equally without precedent is that existing home prices may actually decline this year. Further gumming up the works is that confidence in rising home prices turned lenders into enthusiastic coconspirators. Mortgage lenders have required less information about borrowers and less regular payments on loans than ever before. As an example, 62% of non-agency loans made last year had low or no income verification, up from 24% in 1998. Also,52% of such loans made in 2005 had zero or negative amortization requirements. In 1998 there were no such loans.

Standards have become so lax that the Comptroller of the Currency issued new lending guidelines last month, which require greater reserves against non-traditional loans and greater disclosure by borrowers. These new standards are slowly filtering through the system and will likely lead to a tightening of credit in the mortgage markets. ISI reports that last week New Century, a sub-prime lender in California, announced that it is tightening its requirements. Little wonder. Apparently 88% of its loans are sub prime, 17% of loans are interest only, and 42% are stated income – meaning there has been little background check done on the applicants.

The August bounce should not be mistaken for the bottoming of the cycle, says Mr. Gordon in a piece sent out to clients last week. He expects existing single family home sales to bottom at 25–30% from the mid-2005 peak level of 7.2 million. Currently, sales are off 12% from that level. He thinks prices for new single family homes will likely end up 5% to 10% off the $275,000 peak rate, vs. off about 2% today. As we said, there is more to come. Mr. Gordon says that affordability is key. Many people are simply priced out of the market. He predicts that a slowing in debt growth will lead to a faltering economy, and ultimately a falloff in job growth. The ISI analysts report that American mortgage payments have never been higher when compared with wages and salaries. That excess is not supportable.

Not everyone is as pessimistic as Mr. Gordon. Jim Glassman at JPMorgan Chase, says “There’s more to life than housing. Consumer spending is driven by jobs and income growth, the stock market, and the housing market. Two of those are doing fine. And, consumers are getting a little break on energy.” Bradley Gendell, from hedge fund Cumberland Associates, points out that the housing industry is regional. He says that the pricing bubble on the East and West Coasts has received undo attention and has distorted the picture. His firm thinks some homebuilders are attractive at current deflated prices.

Link here.

Hitting the Easy Button / Pent-Up Housing Supply

Following is Mike Morgan of real estate brokerage Morgan Florida’s latest housing update he e-mailed me.

“My recent update on what we’re seeing in the housing market generated a couple dozen calls from some very large financial institutions, REITs, hedge fund mangers, public builders, and a variety of financial experts. Those callers are not just callers from the U.S., but from Germany, Australia, and the U.K. I have had so many calls that I found myself on the phone 8-10 hours a day discussing the housing industry. I learned as much as I shared, if not more. So here’s a little bit of what I heard.

“The Street is scared – scared to death that we are in for a housing crash that will rock our economy to its knees. … Let me tell you, simplistically, what we see and hear on the front lines. On the street we are dealing with builders and sellers every single day. And both groups are trying to leap-frog the other on the way down. That means lower margins or no margins for the builders. And that means the banks that have financed the millions of homes flippers bought, as well as the ATM cash drawn down with ARMs, will wind up owning a lot of property they cannot sell. Sure, most banks sell their paper. OK, so the guys like Fannie Mae will own hundreds of thousands of homes they cannot sell. The result is the same. Massive amounts of inventory flooding the market at foreclosure sales. And prices drop further.

“On the other end, here’s what I am hearing from the desperate builders. ‘Mike – we’ve got to unload inventory. Bring me offers. Please, Mike, we’ll look at anything.’ And from the big money that have financed many of these builders? They want to know how bad it is … and how bad it is going to get. … And from the guys with smart money sitting on the sidelines? ‘Mike – we’re ready, and we’ve got a billion dollars to put to work. Should we start buying?’

“The answer is no, a very simple NO. Sellers are desperate. Builders are desperate. But with a 6-1 ratio of listings to sales, the markets are still being flooded with inventory. Builders are trying to monetize land by building spec homes at cost, but cost is not selling. And even though builders are unloading inventory at attractive prices, the worst is yet to come. And here’s why.

“We are still not at positive cash flow when you evaluate the rental income of housing. We’re close, but not there yet. And until it makes financial sense to buy a single-family home or multi-family project, prices will continue to drop. … The soft money we saw for the last three years from flippers is gone. The funny money drove prices up more than 100% in just three years in many markets. Irrational exuberance was a replay. History repeats again. Surprise? No. So even though we are down 30-40% in many markets year over year, we now have more inventory than we have ever had in the history of the world. … Too much supply and too little demand. So housing prices will fall further and the entire economy will suffer for our irrational exuberance. Far more so than we suffered during the dot-com boom. …

“As we enter Q4, all of the builders are scrambling to unload inventory, reduce land exposure, and bone up on hard-core centralized prayer. But it’s too little, too late. You can’t stop a tidal wave, and you can’t stop the effects of the housing crash. When in the history of the United States have you seen 20-40% drops in housing prices? … [Y]ou’d have to look back about 77 years. The fallout is nationwide. … This crosses all industries and the entire U.S. economy.

“For November I already have booked most of the month with bankers, REITs, hedge fund managers, and industry experts that want research and tours of the housing markets. One caller, an institutional client with more than $5 billion invested in real estate, wanted to know whether it should sell and convert to cash. I looked at the Staples Easy Button on my desk and replied without hesitation, YES. Then I hit the Easy Button and heard the familiar voice say, ‘That was easy.’

“It was an easy call because of the basic fundamentals we learned when we were kids … supply and demand.”

Ah yes, supply and demand. The interesting thing to me is the big disconnect with what you hear from media pundits who have for weeks now been calling for a bottom on the flimsiest of evidence and actual field results. We have also seen upgrades out the wazoo lately in the face of clearly deteriorating figures. Talk of pent-up demand or a stabilizing market are both ridiculous. Who does not have a house that wants one? Contrast that with those still wanting to cash out in a bubble market and move somewhere cheaper. Add in desperate flippers. What is going to happen if and when Morgan’s institutional contact (and those in the same seat) sitting on untold billions in real estate holdings all hit the “Easy Button”?

Pent-up supply is coming from every nook and cranny. There is no way this is the bottom, and there is no way we have a soft landing, either.

Link here.

Housing slowdown creating “ghost towns”, says Fed Governor.

The housing slowdown has turned some parts of the Phoenix and Las Vegas metropolitan areas into “ghost towns”, where many unsold homes stand empty, said Janet Yellen, president of the San Francisco Federal Reserve Bank. Yellen said that she heard the ominous description from a “major home builder”, who told her that the share of unsold homes in some subdivisions around the two Southwestern cities has topped 80%. “Though the situation isn’t that bad everywhere, a significant buildup of home inventory implies that permits and (housing) starts may continue to fall, and the market may not recover for several years.”

The housing slowdown was one of several factors Yellen cited in which she argued that the current level of interest rates is “moderately restrictive”, and that it makes sense to keep it that way “for a time.” Nationally, inventories of unsold homes have climbed as housing became less affordable, Yellen said in a meeting with reporters after her speech. Speculation had been quite high in areas such as Phoenix and Las Vegas and now that prices may not be heading higher anymore, those speculators seem to be dumping inventory on the market, she added. “The market (in these regions) has seized up to some extent and inventories are building.”

Yellen is a voter this year on the Federal Open Market Committee, which sets U.S. monetary policy. The FOMC will meet next week, with most observers expecting a vote to keep overnight interest rates steady at 5.25%. “Holding the stance of policy steady for a time makes sense to me,” Yellen said. “We have yet to see the full effects of the series of 17 federal funds rate increases – some are probably still in the pipeline.”

Link here.
Home prices fall in some California markets – link.

Phoenix: Prices, sales tumble, but that is “getting back to normal.”

Asking prices in the Phoenix area have dropped about 25% this year, says David Khalaj, an agent at Realty Executives. Existing single-family home sales tumbled 34% in the first nine months of the year compared with the same period last year, and condo sales were off 24%. Construction permits for single-family homes were down 23% through August.

The declines appear so dramatic because Phoenix’s housing market last year – and for the past several years – was so hyperinflated. “Last year was just one of those atrocities that happens rarely,” in terms of bidding wars and soaring prices, says Camille Sullivan, also an agent at Realty Executives. “I’ve never seen it before, and I’ve been doing this for 25 years. It was a very difficult time.” Sullivan says the market is “stabilizing and getting back to normal.” There are now about 47,500 homes for sale – about an 8-month supply, near the national average.

Link here.


MarketWatch is reporting, “La-Z-Boy Stock Slumps 10% on Profit Warning”: “La-Z-Boy said it now expects to post earnings for the quarter ending Oct. 28 to range from a penny to 4 cents a share, versus its previous view of 11-15 cents a share. … President and chief executive Kurt Darrow said … that lower-than-expected sales volume is impacting both its wholesale upholstery and casegoods businesses, as well as its company-owned retail stores. … La-Z-Boy said it expects its core wholesale business to show improving margins, but said the decrease in sales volume is having a ‘significant impact’ on its expected operating results in its retail segment.”

That is quite a miss. But I am pondering the statement, “La-Z-Boy said it expects its core wholesale business to show improving margins.” Well, I suppose La-Z-Boy could raise prices in this slump to improve margins, but how many units would it sell? Perhaps the company has something else in mind, such as firing people and moving more operations to Asia. Is that the ticket?

The Courier-Post of New Jersey is reporting, “Bankrupt Storehouse Liquidating”: “Storehouse is selling off its sleek sofas, modern rugs, and hip accent pieces and closing its doors, an early casualty of the slowing housing market. The Atlanta-based home furnishings chain is liquidating after failing to attract a buyer. Storehouse’s parent company, Rowe Cos., of McLean, Va., put the store on the block in September after filing for protection from creditors under Chapter 11 of the U.S. Bankruptcy Code.”

Are new home sales supportive of furniture? The soft-landing theorists believe so. Please consider “Centex Reports Preliminary Second-Quarter Results”: “Housing operating earnings for the fiscal second quarter are expected to approximate $230 million, based on 8,525 home closings. Net sales (orders) for the quarter were 6,828, a decrease of 28% from last year’s second quarter. These results reflect current record levels of home sales contract cancellations, driven in many cases by the inability of buyers to sell their existing homes. … The company expects option deposit and pre-acquisition walk-away costs to be in the $85-95 million range this quarter. Additionally, land valuation adjustments are expected to approximate $40-45 million, which includes the company’s share of such amounts for a joint venture. The company continues to place emphasis on free cash flow generation and building balance sheet strength in this environment.”

Falling land prices? Is that inflation? If it was inflation on the way up (as all the inflationists were screaming), then why is it not deflation on the way down? Centex is reporting cancellations due to inability of buyers to sell homes. Could it be that falling prices put would-be buyers in the red on their existing homes? Is that inflationary?

It is rather odd, to say the least, that prices of all kinds of things are plunging, such as those for oil, natural gas, copper, dining out, gasoline, private tutors, houses, and now furniture, yet the Fed is more concerned about inflation now than it was when gasoline and home prices (and everything else) were soaring. Is it prices the Fed is worried about, or has it turned Austrian by worrying about credit expansion, leveraged buyouts, merger mania, the yen carry trade, trillions in derivatives, and rampant stock market speculation?

Of course, the Fed cannot let anyone know what inflation really is. Or that the Fed and the government are both to blame. Or, for that matter, what is really on its mind, now, can it? Then again, perhaps the Fed is simply as dumb as it sounds. Occam’s Razor would, in fact, suggest the latter. For the record, no, this is NOT deflation – not yet, anyway – as credit still seems to be expanding. What we are seeing, however, is massive deflationary forces at work. This puts the Fed in a quandary about what to do with the mess it contributed to itself. Forget what I just said before about the Fed being in a quandary. Economic Zugzwang sounds more like it.

Link here.


We take it for granted that power and money are flowing from West to East. It is one of our Big E trends. How much? How fast? We do not know. But in both theory and headlines, the East is rising. There is also no theoretical or practical reason why this big trend should end any time soon. At the same time, we also take for granted that anyone who invests casually in China will get what he deserves. You can be very right about a major trend, dear reader, and still lose all your money betting on it.

China is the same country that put up with Mao Tse-tung for three decades. Only a generation ago, mobs of lunk-headed Chinese filled the streets … dragging some poor “intellectual” or “capitalist roader” along so that he could be humiliated, tortured and even executed. What kind of a crime did you have to commit to deserve that treatment? None at all. China was clearly the wrong place, and the 1960s was clearly the wrong time. Only a damned fool would have wanted to be there. But now, say the expensive suits, the new China is the place to be. Foreigners cannot wait to get there. And if they cannot get there in person? They send their money.

Fixed-asset investment as a percentage of GDP has reached nearly 50%. This is partly the reason the East is growing so fast, and partly the result of it. Rapid growth requires huge amounts of capital investment. Rapid growth also entices capital. Investors want to get in on it. Investors in China expect to make a lot of money from the “rise of the East.” They have taken a trip or two to the middle kingdom, and they are probably convinced that it is in the center of a vast transformation – and probably fairly sure they can make a buck on it. They have seen the building cranes, watched the factories going up, seen the numbers mushrooming, and perhaps a speeding Mercedes has almost run them down. Whatever the case, they cannot help but think that they are onto something big. So they bring in more investment capital to take advantage of it. But here is where the thinking seems to stop.

Yogi Berra once remarked of a restaurant, “Oh, nobody goes there any more; it’s too crowded.” In the investment world, soon, too much capital is chasing too few good opportunities. Initial investors in a new trend often do well. They are able to choose the best opportunities at the most reasonable prices. Those who come along later have progressively less and less choice, and progressively higher and higher prices. As prices rise, so do expectations. But as expectations rise, thinking declines. Logically, as the amount of money flowing into a market increases, prices should rise and the attractiveness of the opportunities should recede. But investors are not merely thinking beings, and not even primarily thinking beings. That they think at all is open to argument. But that they let themselves be driven by emotions rather than thoughts is beyond question.

Asia began pulling itself together many years ago. One country after another has picked itself up, dusted itself off, and zoomed to the top of the list for foreign investors. Singapore was the darling of global investors in the mid-‘80s, with a ratio of fixed-asset investment to GDP equal to China’s today. Then, Japan hit the charts, and soared until 1990, when it dropped off for the next 16 years. The late ‘90s brought Thailand, Malaysia, Korea, and Singapore to the financial headlines – first, because they were hitting ratios of fixed-asset investment to GDP over 40%, and then, because they were crashing.

And now it is China’s turn. Such a big country it is, and such a big opportunity, that it is gobbling up a huge part of the investment capital of the whole region. China alone has a fixed-asset to GDP figure over 30% – closer to 50%! What comes next for China? A crash of some sort is our guess.

Link here (scroll down).


We gasped to ourselves when we first observed the squiggles on the chart below. Squiggles on a graph rarely elicit an “Oh wow!” from your even-tempered California editor. Typically, he reserves his “Oh wows!” for animate, three-dimensional phenomena. But in this particular case, he simply could not stifle his amazement. Why are the commercial bond traders SO short the bond market? Why are they are holding their largest net short position – by far – of the last 20 years?

The short answer is that we simply do not know why the “Commercials” are so short. We only know that this situation is VERY unusual and, at the margin, NOT bullish for 10-year Treasury notes. The commercial futures traders tend to position themselves correctly in advance of major turning points. They tend to “buy big” just before major rallies and “sell big” just before major corrections. These “smart money” guys are not ALWAYS so smart, of course. They often find themselves on the wrong side of a trade for a long time. But whenever the Commercials hold extremely large long or short positions on a specific commodity future, investors ignore this fact to their peril.

During the summer months, for example, the Commercials had amassed very large net-long positions in wheat and very large net-short positions in crude oil. Shortly thereafter, wheat soared and crude oil tanked. The Commercials may not always be so smart, but neither are they often very stupid. The fact that the Commercials are holding an extremely large net-short position in 10-year T-note futures does not mean that the Treasury market is about to tank. But neither does it mean that it is NOT about to tank. For the last few months, the Treasury market has been enjoying the favorable tailwinds of falling inflation expectations, evaporating rate-hike expectations and record-high foreign buying. Every bond market analyst on CNBC now seems to know that interest rates are heading lowing. Likewise, every investor in America now seems to know that interest rates are heading lower. … Every investor except for the commercial traders of T-note futures.

Perhaps – and we are only guessing now – the commercial T-note traders believe that the 10-year Treasury note is already priced for perfection. Perhaps they believe that the 10-year’s lean 4.77% yield already reflects a world of falling inflation, falling interest rates and eager foreign buyers. If any or all of these favorable trends were to slacken or reverse bond prices could fall rather quickly. Perhaps they realize that perfection often yields to imperfection, and that imperfection often produces lower prices. … But we are only guessing.

Link here (scroll down to piece by Eric J. Fry).


There are 5,586 small-cap stocks that trade on a major exchange right now. But you should only consider investing in six of them. Two days ago, I ran my favorite screen looking for solid small-cap companies worth owning right now. Unlike many small-cap companies, these all have solid business plans. They are all making money. They are generating cash from operations. They have little (if any) debt, tons of cash and, most importantly, they have gotten stronger and stronger over the last 3-5 years. Each company on this short list had to have:

Over time, these are exactly the kinds of companies that will make shareholders wealthy. So without further ado, here are the only six companies that currently meet all five wealth-generating requirements:

  1. Diodes Inc. (DIOD) is a global supplier of semiconductor products for advanced electronic devices including digital audio players, notebook computers, flat-panel displays, mobile handsets, digital cameras and set-top boxes.
  2. Forward Industries, Inc. (FORD) makes cell phone cases, clips and accessories for major manufacturers like Motorola and Nokia.
  3. Internet Security Systems, Inc. (ISSX) is a security company that provides software, appliances and services to global enterprises and world governments to protect their information technology (IT) infrastructure against Internet threats.
  4. The Knot, Inc. (KNOT) provides wedding products and services to couples. The company offers both online and offline services to the wedding market.
  5. Palomar Medical Technologies, Inc. (PMTI) designs, manufactures, markets and sells lasers and accessories for use in medical and cosmetic procedures such as hair removal, cellulite and wrinkle reduction.
  6. PetMed Express, Inc. (PETS) is the leading online pet pharmacy in the U.S. It sells all the most popular items (medicine, leashes, collars, etc.) at a discount to what you would pay at the vet.

Despite the fact that these companies are solid businesses with great numbers, investors are opting not to invest in them. Rather, they are putting their money into far more speculative companies with no real business plans. You can see that is the case if you take a look at this chart comparing fundamentally sound companies with companies with “garbage” fundamentals. Eventually, this trend will change. Companies like the six mentioned will make a handful of people a lot of money.

Link here.


The rise in the prices of wheat and other grains has led analysts to caution that the world could face a crisis within the next 12 months if there is another disappointing year of global production. “We are not near a crisis yet, but if we have another bad year of harvests because of droughts and poor weather then we could be looking at a very serious problem,” said Abdolreza Abbassian, commodity analyst at the UN. Michael Lewis, head of commodities research at Deutsche Bank, said global wheat demand had outpaced crop production in six of the last seven years.

Food companies, already under pressure from high energy prices (which raise packaging and transportation costs), are feeling the impact of higher wheat and grain prices and are passing some of the cost on to customers. Food commodities overall are higher than they were a year ago, with increases in the price of rice, wheat, barley, oats, corn, cocoa and coffee offsetting declines in butter and milk, according to Bernstein Research.

Market volatility for wheat futures traditionally peaks in October as information about the spring harvest in the southern hemisphere and the first indications of likely production from hard winter wheat in North America are digested. This year there are several causes for concern, including the fact that stockpiles of wheat are at the lowest level in 25 years and the level of wheat stockpiles relative to consumption has hit the lowest level on record. All of this has led to rising prices. Soft red winter wheat futures on the Chicago Board of Trade have risen more than 19% since the start of the month and 55% this year. The prices of other grains, including corn, have also risen. Deutsche Bank estimates global corn stockpiles have fallen to their lowest level since 1979. Gary Sharkey, head of wheat at the National Association of British and Irish Millers, said the rise in wheat prices this year would encourage farmers to plant more wheat this year, which might yield higher production next year in the right weather conditions.

But weather has been a problem this year, especially in Australia, which accounts for 14% of the wheat traded worldwide. A severe drought there has led to expectations of production being less than half of last year’s, and there is fear that weather could be a problem next year as well. The shrinkage in Australian wheat exports will mainly affect Japan, Indonesia and South Korea, which will have to seek imports from the other big wheat exporters of North America, western Europe, Russia and the Ukraine. The market for grains has also been changed by the sheer amount of speculative capital being invested by hedge funds and other investors who are enjoying easier access to the commodities market thanks to advances in electronic trading.

Another concern is the rise in demand for fuel created from crops. Indeed, commodities such as corn and wheat are expected to face sustained price increases. Mr. Lewis said corn and wheat prices were at relatively low levels historically, adding that they would need to rise 135% and 60% respectively to reach their 1996 highs in inflation-adjusted terms.

Link here.


I spent some time in New York a couple of weeks ago to attend the Grant’s Investment Conference. These gatherings always showcase some of the best investment minds in the business. One of the most engaging speakers at this particular conference presented a very compelling case for buying beaten-down Canadian paper stocks. The speaker was Amit Wadhwaney, fund manager of the excellent Third Avenue International Value Fund. Wadhwaney began his presentation by describing a favorite investment strategy at Third Avenue: Seeking out industries in distress. Under the right conditions, he explained, an industry in distress is an industry full of opportunity.

The Cloudspotter’s Guide, a new book by Gavin Pretor-Pinney, is a sort of field guide for cloudspotters. In the book, e.g., one can read about the common cumulus clouds with “puffy white cauliflower mounds.” Though it is unmistakably a cloud, the cumulus is a fair-weather cloud, containing only tiny amounts of water. Likewise in investing, not every cloud portends a deluge. Wadhwaney described five conditions that can lead to sunny results. All five must be met to validate a new investment:

  1. Most of the companies in the industry are losing money.
  2. Companies, discouraged and bloodied with losses, are leaving the industry – hopefully, for good.
  3. Bankruptcy threatens those that decide to hang on.
  4. There is a clear low-cost provider and, thus, a clear survivor.
  5. Valuations are extremely low, reflecting investors losing interest – and heart – in the sector.

Wadhwaney then described times in years past when Third Avenue scored big in sectors in which such conditions prevailed. Zinc mines, in 2004, were one of those times. Coal, circa 2002 was another. In both instances, the industry satisfied the five points and investors made some large multiples – the numbers resemble hat sizes – on their initial investments. So Wadhwaney offered up another sector in which such conditions prevailed – the Canadian paper industry in general, and Abitibi Consolidated (NYSE: ABY) in particular.

Abitibi owns a lot of stuff–- 19 paper mills, 20 sawmills, wood plants and hydroelectric assets spread over 70 countries. The company also manages oodles of Canadian woodlands. It is also the biggest recycler of newspaper and magazines in North America. Despite these terrific assets and operations, Abitibi, like most of its paper company peers, struggles to produce a profit. The chief villains are falling demand for newsprint, along with rising fiber and electricity costs, which, according to Wadhwaney, represent about one-third of total costs. Most of the paper industry, in fact, has lost money since 2003. Check off condition #1. Capacity is also shrinking. When you are losing money, you tend to want to lose less, and hence make less of what you are losing money at. That, at least, is the rational response. Bankruptcy risk threatens many – including Abitibi. But Abitibi has worked off a lot of debt – about $2.5 billion worth – in the last five years. It seems now that the worst is over.

As to who is the low-cost provider, it is Abitibi. Its Georgia facility, for example, is perhaps the most efficient in the world – certainly the most efficient in North America. Meanwhile, Abitibi continues to work at cutting costs, and prices in newsprint are finally going up. Another point in its favor is that the U.S.-Canadian rift over tariffs seems near an end. If the current settlement goes through, Abitibi could see a $220 million windfall. That works out to about 50 cents per share, which is not an insignificant number.

And finally, as to cheapness, Wadhwaney was unequivocal on Canadian producers generally: “I have never seen them this cheap before.” Far from an industry cheerleader, Wadhwaney has avoided these stocks for years. Only recently has he begun buying them. Abitibi is his favorite. He said that Abitibi trades at only 15-20% of replacement cost. Make no mistake, Abitibi is a risky stock. But the potential reward for investors who stick with Abitibi over the long haul looks very large indeed.

Link here (scroll down to piece by Chris Mayer).


Do not unload your oil stocks just yet! A few months ago we posed the question, “Does Peak Oil Matter?” In other words, has global oil production actually peaked? And if so, how should investors respond. We posed this question in the context of the fact that North America oil shale holds billions of barrels of “theoretically” recoverable oil. Theoretically, therefore, global oil production may not have peaked. We are skeptical. We doubt that U.S. oil shale deposits will be yielding their bounty anytime soon. There are just too many impediments – logistical, political and environmental – to make that happen in the near future.

But what about the Athabasca region of Canada? America’s northern neighbor has Saudi-sized reserves in the form of oil sands. These oil sands are already producing one million barrels per day. The “Peak Oil” skeptics place a great deal of hope on nontraditional sources like Athabasca. The most hopeful estimates suggest Canada’s oil sands output will eventually hit 10 million barrels a day. But how to get there from here … ah, there’s the rub.

One of the biggest inputs in the oil sands recovery process is natural gas. To get oil out, you have to put natural gas in. LOTS of natural gas. In a fascinating piece from CNNMoney entitled “Curing Oil Sands Fever”, energy economist Peter Tertzakian observes that, “It takes the equivalent of 0.7 barrels of oil to create one barrel of oil sands product.” In the process of extracting and refining the oil sands to make light sweet crude, other forms of energy get used up. And unfortunately, much of what gets used up is clean-burning natural gas. “What bugs me about oil sands,” says Marlo Raynolds, executive director of the Pembina Institute, an environmental research group based in Calgary, “is that it is a resource that is being inefficiently used. We’re using natural gas, which is the cleanest fossil fuel, to wash sand and make a dirtier fuel. It’s like using caviar to make fake crab meat.”

The process also requires huge amounts of water. You have no doubt heard about the water crisis. If oil sands are the answer, then the North American water crisis is about to get a lot worse. Athabaska cannot ramp up its oil sands production without encountering formidable water challenges. But let us go back to natural gas for a second. In order to really ramp up oil sands production, Canada will eventually have to become a net IMPORTER of natural gas. Think about that. Natural gas is another area in which the energy optimists really have their “heads in the sand” – pun intended.

The bottom line is that it takes energy to make energy. Solving our oil headaches by way of oil sands is only going to create new headaches. Demand for natural gas is slowly and steadily increasing not just in the United States, but elsewhere around the world, and energy-intensive operations like Canada’s oil sands will only magnify that effect. It takes energy to make energy … remember that phrase. It could potentially make you a lot of money over the next decade. We are on the crest of a great wave here, folks. The best is yet to come. Do not sell your oil stocks just yet.

Link here.
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