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BET THE HOUSE
By a margin of almost 2-to-1, economists surveyed by WSJ.com last month judged that the worst of the residential real estate slump was history. House prices will soften in 2007, the sages predicted, but by only a little bit. In fact, 20 of the 49 respondents forecast a rise. Ebenezer Scrooge was a mortgage banker, and the arguments I am about to marshal for a hard landing in housing might sound un-Christmaslike. But during the just-pricked bubble, it was not the Scrooges and the Marleys who lent more than 100% of the purchase price of a house without bothering to verify the income or employment of the applicant, or even to insist that he or she pay down a little bit of the principal now and then. House prices soared on the wings of the modern, optimistic, growth-obsessed mortgage industry.
All can agree that the housing data are grim enough today. The question is whether the stock market and the famously resilient U.S. economy will continue to shrug off the bad news. Gary Gordon, a member of the investment committee of Annaly Mortgage Management, has built a coherent and persuasive case that they will not. The housing downturn will proceed in three phases, Gordon postulates. In Phase I, now under way, home sales will drop to cure what are politely known as “affordability issues”. In Phase II, starting soon, job growth will falter as the pace of lending and borrowing downshifts. In Phase III, lingering into 2008, mortgage lenders will relearn the fine art of saying no. The resulting withdrawal of easy credit will add new downward pressure on house prices and consumer spending.
Falling house prices in isolation would constitute no grave peril. A housing-induced downturn in job growth is what would cause a bear’s pulse to race. Gordon insists it is coming, because the formerly potent stimulus of above-trend borrowing growth is about to be removed. The bulls will counter that, at the first sign of serious weakness, the Federal Reserve would engineer a collapse in mortgage-borrowing costs. Gordon points out that the Fed can do only so much. Already, despite a still low jobless rate, delinquencies, foreclosures and other signs of distress are surfacing in the subprime segment of the nonagency market. Even a mild business downturn could cause a revulsion against the kind of easy credit that put so many houses within financial reach (or seemed to).
Investment strategies to deal with this predicament could involve two exchange-traded funds. Bears on residential real estate could sell or short the StreetTracks SPDR Homebuilders (XHB) or buy the puts thereon. To profit from a housing-induced drop in short-term rates, buy the iShares Lehman 1-3 Year Treasury Bond Fund (SHY) or its call option.Link here.
Use the good times to prepare for the coming bad times.
That old piece of wisdom could find considerable utility in the next year or two. Fellow Forbes columnist Gary Shilling has been unequivocal in predicting a recession triggered by a collapse in the housing market. Should his warnings come true in 2007, you can still prosper. That is, if you invest in fixed-income securities.
Income investors have refuges where they can profit from adversity. Even if the bad times do not come, they can do well, too. Diversification is the key to such a happy state of affairs. In the fixed-income world, diversification usually means buying securities from different issuers with different maturities and credit ratings. Take another tack. Allocate your capital among income sources that depend on different drivers – interest rates, energy prices, stock market performance and company- or industry-specific events.
Begin with securities sensitive to interest rates. I like trust preferreds and closed-end income funds because they are liquid and offer good yields. Put 40% of your fixed-income money here. Do not buy issues below a Standard & Poor’s BB or Moody’s Ba, the highest tier for junk. Put 20% in convertible securities. These pay you decent interest while you are waiting for the stock market to recover, so your securities can be switched into upward-moving shares. But stay away from mandatory convertibles. Get some exposure to energy. I have already recommended Canadian oil and gas trusts. Alas, the Canadian government has announced plans to end the trusts’ tax advantages in 2011 and prices have plunged further. The latest price slump has brought dividend yields for these trusts up to a 10% to 17% range, making them a better buy than we have seen in two years. Make a 20% capital allocation to this sector. The final 20% of your portfolio should be held in short-term investments (rates these days of 5% are not bad) and undervalued targets of opportunity.
My past columns have detailed specific trades that fit into this 40-20-20-20 allocation. A selection from those picks are summarized in a table available for your perusal on the Web. The 21 securities have a composite current yield of 9.3%. It is reasonable to expect capital appreciation too, but failing that you still stand a good chance of outperforming equity investors. Especially if that Shilling recession is around the corner.Link here.
As an antidote to investor exuberance that sometimes runs to irrationality, Forbes give space to James Grant, editor of Grant’s Interest Rate Observer. In his column and in his newsletter he can be counted on to say something skeptical about weakening greenbacks, overconfident hedge funds and the use of steep leverage in corporate finance. This time around Grant predicts a hard landing in housing, accompanied by a collapse in flaky mortgages and a desperate move by the Fed to prevent a recession by gunning the money supply.
How should investors bet on this outcome? Grant suggests selling home builder stocks and buying short-term Treasury notes. But maybe you want a stronger dose of Tabasco sauce than this. That is, you want a way to bet on recession and bankruptcy. High-yield bonds are ready for trouble. In their scramble for quick returns, hedge funds have been buying junk as if it were going out of style. That depresses yields. The holder of a bond rated single-B gets scarcely 3.5% of premium to compensate for what are sure to be nasty losses of principal whenever a recession hits. Junk guru Martin Fridson calculates that a 1990-91 recession coupled with today’s lax lending standards would give rise to a 17% default rate in junk bonds. He is not predicting a recession, just questioning whether bond investors are being adequately compensated for the possibility.
Taking a short position in junk bonds is a challenge for the retail investor. There is, however, a mutual fund that makes the bet for you: Access Flex Bear High Yield Fund. The $96 million no-load buys credit swaps that would pay off nicely if the economy goes to hell. The fund ha a steep expense ratio (1.6% a year), but I could not find a cheap alternative from Vanguard. The bearish fund, fighting a bull market for junk, is off 4% so far this year. All the better reason to buy now.Link here.
SUPPLY-DEMAND IMBALANCES EVENTUALLY GET CORRECTED. COLLEGE EDUCATION WILL BE NO EXCEPTION
College costs of $50,000 a year? That prospect seemed extreme when I wrote about soaring higher education bills in a 1989 column. Then, tuition and fees at private 4-year colleges averaged $20,000 in 2006 dollars. But 17 years later the tab has jumped 50% in inflation-adjusted terms, to $30,000 (see chart).
One reason for exploding prices is that schools can get away with it. Demand exceeds supply at high-end private schools. Americans have always associated education with career success, and college grads earn 45% more than high school grads. Many believe that college educations, not the innate talents of students, give rise to this earnings disparity. This presumption is unproven, and causality may run the other way. Also, the prestige of American institutions attracts hordes of foreign students. The irrefutable proof of excess demand is that universities pay legions of employees to turn down perfectly good business. Many first-tier universities admit only 10% of applicants.
Will additional government aid or alumni giving curb the tuition spiral? No. If the Democrats get their way and Congress provides more federal support, that would only increase higher education demand and allow colleges to make offsetting tuition hikes. Fatter contributions from alumni encourage more spending. Most institutions keep tuition and fees at a constant percentage of total income, including income from endowment. So more endowment means higher tuition.
Still, there are reasons to hope for an end to this plague of ever higher bills. One is increased competition by online education. Recall that not long ago the premium selling prices of prestigious retailers were immune to inroads from e-tailing. Not now. Demand for higher ed may also moderate as parents revolt. Some have been forced to limit their family sizes in anticipation of crushing tuitions. Parents also realize that more money is buying a deteriorating product. Many schools have abandoned core curriculums, along with any effort to influence their students’ morals and ideals.
Families, wondering whether the big-ticket schools are worth the money, should reflect on these nongraduates: Andrew Carnegie, Henry Ford and Bill Gates. Real wages of college grads fell 3.1% between 2000 and 2005. Supply-demand imbalances get corrected eventually. College education will be no exception.Link here.
THE FORBES 2006 COLLECTORS GUIDE IS OUT
Hey! That’s mine!
The more a piece of art is worth, the more likely that someone will come up with a creative theory about why you do not really own it. Solution? Take out an insurance policy.
Christie’s decision last month to pull from auction Picasso’s “Portrait de Angel Fernandez de Soto”, which had been expected to fetch as much as $60 million, jolted the art world. A suit by a man claiming that his great-uncle had sold it in 1935 only under threat by the Nazis called into question whether or not the seller, the Andrew Lloyd Webber Art Foundation, had legitimate title. And while a U.S. District Court dismissed the restitution action because it lacked federal jurisdiction, harm already had been done. The owner missed a crucial chance to sell.
The plaintiff’s claim has since been refiled in state supreme court. If the claim fails, Webber’s foundation will still be out the time and money needed to mount a defense. Had they bought the right kind of insurance, though, they would have been spared these costs. While disputes involving Nazi Reichsmarschall Hermann Göring’s plunder get the headlines, ordinary liens and encumbrances pose a greater threat to title. Liens due to divorce, judgments, taxes, or bank loans muddle ownership. So do questions of consignment, where a dealer may not have had sufficient authority to sell a work.Link here.
NOVEMBER SURVIVAL REPORT FOCUSES ON THE U.S. DOLLAR BREAKDOWN
In this month’s market summary, we are going to take a brief look at stocks and Treasuries and then get right into the big action in the U.S. dollar and update you on how the recent breakdown could affect commodities, especially gold and miners. Anyone who is long commodities should be aware of the implications of the recent action of the U.S. dollar. We will then follow with an update on Japan. The Nikkei has broken down from a short-term bearish formation, but the question is whether this breakdown will present us with a nice long-term buying opportunity or not. We will put the recent sell-off of the Nikkei into context of the larger bull market, and detail what we will need to see before buying into Japan.
The stock market has continued its advance from the July low, with the Dow industrials rising approximately 200 points over the past month before giving most of it back on the first post-Thanksgiving trading day. This rally appears to be in its final stage – and the Monday breakdown may have sealed the deal. There are across-the-board technical divergences, which we typically see at the end of a rally of this duration. Whether or not this rally from the July low is complete, it is what comes next that will give us the most information about the larger trend. Even though the Dow industrials have continued higher, the transports have still not confirmed. This six-month nonconfirmation is now a signal of similar magnitude as was seen at the 2000 top and the 2002-2003 bottom.
At times like these it is really important to take a step back and look at the context the stock market finds itself in. We have an inverted Treasury yield curve, which often leads a recession in the economy, a bear market in the stocks, and a lowering of the Fed funds rate. The dollar agrees with the bond market that interest rates will be lower in the U.S. (likely in response to economic weakness). The one market that stands out of that consensus is the stock market – or does it? Dow Theory divergences like the one we are currently seeing in the above charts are rare and come around at only very important turning points. From this perspective, the stock market is in agreement with the others, but you have to look close to see it – which is usually how it works with stocks.
When the rally from the July low is spent, the market will either start a modest correction or descend into a bear market that has the potential to rival the 2000-2002 bear market in the nontech indexes. If, despite the odds against it, the market is destined to continue its rally into 2007, we will want to exit our short positions during this correction and stand on the sidelines until it has exhausted itself. Other than the possibility of that particular scenario playing out, the odds clearly favor a larger decline in stocks. The question since the spring has been whether to play for the last few percent the market is willing to give up, or to recognize these bearish signals for what they are and batten down the hatches. For the sake of your financial survival, we have chosen the latter. Given the bearish signs we have been following and the complacency in the market, there is certainly the chance that the market could decline much faster than anyone expects.
Treasury bonds remain in their long-term bull market, and there are signs the decline from the high in yields this summer may soon accelerate. The chart of the 10-year Treasury bond yield below shows that significant support at 4.7% has been broken, clearing the way for a decline down to 3.9%. The long-term charts of both the 10-year and the 30-year Treasury bond yields show clear channels stretching back to the highs in the early 1980s. The tops of those channels were tested at the highs this summer, and the bottoms remain far below current levels: near 3% for both the 10-year and the 30-year. As long as Treasuries remain in their long-term bull trend, it is likely yields will again test the low end of their channels.
The shortened trading week during the Thanksgiving holiday in the U.S. is usually a nonevent. But this year the dollar was breaking down in a major way. In May, at the same time gold peaked, stocks reached their spring high, and Treasury yields hit their high, the dollar entered consolidation that lasted through last week. The chart below shows the U.S. dollar index from the start of 2006. The big red candles on the far right show the declines on Wednesday, Nov. 22, and Friday, Nov. 24. The breakdown of the dollar index was dramatic, and it was accompanied by a major technical break of nearly every component of the index. The euro blasted through resistance at 129. The British pound and the Swiss franc also broke out in major ways vs. the dollar.
The yen also broke out of its downtrend in place from a high in May. But unlike the European currencies, the yen has a well-defined long-term pattern in play that may give us a hint of things to come. The reversal of the yen off this long-term trend line strongly hints that a return trip to 99 is likely. That would be a 15% rally from current levels. If such a rally in the yen was accompanied by a similar rally in the European currencies, the dollar would be in serious trouble. The dollar index shows strong support near 80 that has provided a floor – less than 5% below where the index finished the week. A decline below 80 would be uncharted waters for the dollar. Those who have been on the watch for an uncontrolled plunge in the dollar have been silenced by a modest recovery by the dollar since the December 2004 low near 80. We will know soon enough whether this decline is the start of a major breakdown in the dollar.
While the dollar was moving swiftly lower, Treasuries, gold, and oil rallied. It has been curious to see the bullish setups in gold and oil stocks over the past few months, even while it became clear the official inflation gauges were peaking. This is not what we would typically expect. There was clearly something moving these stocks, an underlying current that perhaps revealed itself this month. The commodity bull market has been propelled by various forces over the past five years, and it is possible we may have just seen the first hint of what will power the next leg up – a decline in the dollar. A break below 80 in the dollar index in the next several months could be a very bearish move in the dollar that would propel many commodities and related stocks much higher.
Like the U.S. stock market, the Nikkei made a low in the summer and has rallied off that low for the past several months. However, this past month, the Nikkei parted ways with the U.S. and broke down out of a bearish rising wedge and appears to be headed lower. Japan is an export-driving economy, and when the yen strengthens, it is usually taken as bad news for the stocks in the Nikkei 225 average. So it is not just coincidental that when the yen began to rally off its recent low in October, the Nikkei began its current decline. If the yen has started a larger rally, as discussed above, that may well be a heavy weight on the Nikkei going forward. A breakdown in the Nikkei below 14,400 would signal that the rally from the 2003 low is over.
On a relative basis, the Japanese stock market is far cheaper than U.S. or European stocks. This is one of the reasons we remain biased to the long side as the Nikkei continues the current decline from the October high. If the Nikkei holds above its lower trend line and the yen continues to look healthy, we will likely take a position in either EWJ or JOF. If it breaks below 14,400, we will be the first to sound the alarm that the bull market for Japanese stocks is over.
Conditions are now deteriorating rapidly in the U.S.. The second month of negative PPI and now plunging CPI and personal consumption expenditures (PCE – Bernanke’s favorite measure of inflation) figures say that this expansion is over. The housing and auto sectors are in recession already. Given that the first 1-2% of GDP are hedonic and imputation distortions reflecting economic activity that simply did not occur, it is possible we are in a recession already. Inflation this cycle has peaked.
Japan is an accident waiting to happen. If Japan does not start normalizing interest rates, the yen might plunge, but if it does start hiking, there could be a disastrous unwinding of the carry trade. Things are slowing in Europe, as well, according to the latest reports from Eurostat, the EU’s statistical office. The U.K. is at least temporarily bucking the trend, but it is going to be interesting to see what happens there when the housing bubble there finally collapses. The consequences of consumer recklessness may have as bad a fallout as in the U.S. China may be slowing, but it still appears to be white hot. Nonetheless, as the rest of the world slows, China will soon overheat if it does not slow as well.
Conditions are not only deteriorating in the U.S., but worldwide as well. Inflation (as measured by CPI, PPI, PCE, and HCIP in Europe) is slowing rapidly. Bankruptcies are rapidly rising in both the U.S. and the U.K. Meanwhile, there are still threats of more hikes in both the U.K. and the E.U. Various Fed governors are also threatening more hikes, but the Treasury market does not believe them and neither do we.
The U.S./China dichotomy is headed for a massive breakdown if China does not slow down at a faster pace or, alternatively, pick up internal consumption at a much faster pace. The latter will happen over time, but time for this cycle has simply run out. A severe consumer-led recession is on its way in the U.S., and that will drag the rest of the world along for the ride. Odds of a worldwide recession in 2008 are rapidly increasing.
We spent very little time on gold in the recent monthly report, so we thought we would make up some coverage in this week’s email update. There is also probably going to be some interesting market action in gold and miners in the next few weeks, which we want you to be prepared for.
Since we recommended GDX on October 6, the HUI stock index (which GDX tracks) has gone almost straight up, nonstop. Not only has this given us a nice gain on our GDX position, but it has also greatly improved the technical outlook for the entire sector. Despite the rally, however, we have yet to make a move on the ETFs that track gold and silver for this reason: At the beginning of every major uptrend in gold and miners over the past five years, mining stocks have led the way and given the best returns. This is the case even when the metals themselves were not done on the downside. The best returns on the metals usually come after the trend is well established.
At the moment, gold and silver look somewhat vulnerable in the short term. It appears that this week’s decline has taken gold below its trend line from the October low. To our eyes, the chart of gold itself is now vulnerable to at least a short-term pullback and has an outside chance of a more substantial decline. But even though there is some ambiguity in the gold chart, we are still bullish for the following reason: The miners have always been a much better indicator for the future price of gold than the price action of gold itself, and right now the miners are looking very good.
The weekly chart shows the HUI index over the past two years. The correction that started in May consolidated in a contracting wedge shown by the blue trend lines before breaking higher last week. In contrast to the short-term chart of gold, this long-term chart of the HUI is very bullish. It suggests the decline from the May high at 401 was a correction, and the HUI will ultimately rally to a new high. It also suggests that a rally may already be in progress, and the prices at the low in October may not be seen again.
So we have a bullish-looking (over the long term) miner index and a potential bearish short-term breakdown in gold – a situation that seems ripe for some confusing market action directly ahead. Our best guess at an outcome is that both will correct in the coming weeks before ultimately heading higher. The HUI could easily decline to the 325-335 area and maintain its long-term bullish potential. So if there are some fireworks on the downside, keep this area in mind. If the miners hold up and maintain the recent bullish break while gold corrects, there will be little doubt that gold will ultimately follow the miners in a concerted advance to new highs.
A short-term decline in the HUI and gold may or may not happen, so it is important to stay on the right side of the larger trend if you have already entered and just sit tight and let the market do its thing. There is no way you want to be caught on the sidelines and left behind if the HUI is destined to rally beyond the May high – it could be a very fast-moving rally. We will keep you updated if there are any significant changes to this outlook.
WHERE IS THE U.S. DOLLAR HEADED?
The following chart shows that the U.S. dollar is once again approaching long-term support. And once again, bearish sentiment against the U.S. dollar is rising. A recent cover of The Economist highlights the renewed bearish sentiment. Magazine covers in general, and Economist covers in particular, have a nasty habit of marking major turning points. Remember that it was “The Incredible Shrinking Dollar” cover of Newsweek that marked the bottom of the U.S. dollar in 2005 to within a week or so.
We also see big specs plowing heavily into both the British pound and the euro, and the unwinding of those trades (which I think will happen) would be supportive of the dollar. On the other hand, we still see a carry trade in the yen and Swiss franc, which has negative implication for both the U.S. dollar and U.S. equities if and when that trade unwinds.
Note that it is NOT a weakness in the U.S. dollar that may cause interest rates to go up. It is excessive expansion of money and credit within the U.S. that is causing the U.S. dollar to drop. It is imperative for people to put the horse before the cart, but nearly everyone puts the cart before the horse. If and when the U.S. stops blowing trillions of dollars it does not have in Iraq and other places (God knows when), and if and when U.S. consumers toss in the towel and stop buying more junk than they need (likely right now), the situation will change. Even still, the biggest factors on whether or not a currency rises or falls are (1) relative expansion of money and credit versus other countries, and (2) interest rate differentials versus other countries. Notice that the trade deficit is not on that short list. And as difficult as this may seem, credit is expanding as fast, if not faster, in the E.U. than in the U.S. Furthermore, interest rates are still sitting at 0.25% in Japan, versus 5.25% in the U.S. This is hugely supportive of the U.S. dollar ... at least until the carry trade blows up.
Once again, let us turn to John Succo, one of my favorite professors on Minyanville, to see if we can shed some additional light on this situation. On Dec. 5, addressing a reader question on dollar weakness versus deflation, professor Succo wrote:
“I am wrestling with ‘can central banks induce a round of hyperinflation, or has it already passed?’ My conclusion, however, is the same: Every hyperinflationary period (rising nominal asset prices) eventually is followed by a deflationary bust (the last bottle of booze). We are all trying to figure out where we are. But make no mistake: The weight of all that debt created by central banks will at some point be too much to bear.
“... I do not know when [the deflation] point will be reached. ... There are signs now of excessive speculation, but I saw that awhile ago too. But it is cumulative, so we know from deduction that we are getting closer and closer. When deflation does kick in, the dollar will rally, yes. But that may be from much lower levels. The only thing we can be sure of is the degree to which this situation has risen. The imbalances are immense.
Immense? Or insane? In regards to the U.S. dollar, one must remember that all fiat currencies are eventually doomed. That, of course, does not preclude a massive deflationary collapse first. In the meantime, one needs to remember that interest rate differentials and credit expansion matter most and the odds of additional rate hikes by both the U.K. and Europe may be overstated.
If the expectation is for more hikes in Europe and the U.K. and for cuts to occur in the U.S., and that expectation does not happen, look for the U.S. dollar to rally. It may rally anyway, based on current sentiment. To put my neck on the line, I suspect the U.S. dollar will hold the 80 level (or perhaps do a head-fake below, then reverse). Longer term, the U.S. dollar is indeed toast, but that can be quite a way off from here.
In regards to a deflationary collapse of the stock market, once again, the question here is timing, and of course, timing is nearly everything. That said, the amazing thing to me is that most do not even see the risks, let alone are they concerned about the timing of the upcoming debacle. Yes, I have been raising the caution flag for some time and the taunts are now getting shrill. “When, when, when, when? How long have you been calling for this now? When?” I received a post almost exactly like that last week. Shrill taunts out of the blue often accompany major market tops or bottoms. Let us see if history repeats.
In the meantime, one has to decide whether or not to play the “greater fool” game or not. Many that played that game with Florida condos are now facing bankruptcy. Others still have not the faintest clue as to what the risks even are. It is one thing to knowingly play the game. It is, of course, another matter to be playing the game and not even know it.Link here.
NOVEMBER JOBS REPORT ANALYZED. THE SECOND WAVE DOWN IS COMING
On December 6, ADP said “private-sector jobs rise 158,000” in November: “Hiring pace is consistent with ‘modestly below-trend’ economic growth.” The report shows that health care remains strong, although it is very difficult to say what percentage of those jobs are in a high-paying category. Leisure and hospitality jobs were also strong, but it is safe to assume that most of those are not high-paying jobs. Professional and business services expanded very nicely, and those indeed may be better-than-average-paying jobs, but manufacturing and construction jobs contracted, and those are also better-than-average-paying jobs. Given that it takes about 150,000 jobs just to break even with immigration and population increases, this was not really a good showing, but, arguably, not a disaster.
One of the more interesting things in the report was, “Employment in nonresidential specialty trades edged down in November, after trending up during the first 10 months of the year.” Also, 40,000 goods-producing jobs were lost, and of the 132,000 jobs that were created, 18,000 were government jobs (the last thing we need). Taking those two numbers into consideration, this was a fairly weak set of jobs numbers, and supportive of the idea that we are in an economic slowdown. The massively inverted yield curve also suggests that not only is a slowdown on its way, but that an out-and-out recession also is coming. It is simply illogical to assume that businesses would even want to keep expanding in the face of a consumer-led recession. Even if they did, it is important to remember that consumer spending is 70-75% of the economy (and possibly higher in THIS economy). So it is also illogical to expect that corporate spending can possibly pick up the slack even IF businesses were to keep expanding in the face of a consumer slowdown.
Nonresidential building has now shown a 4-month steady decline in jobs, even as nonresidential trade jobs are holding up over the same four-month period. This divergence is unlikely to hold. What we can see for sure is that huge cracks are starting to appear in the myth that “corporate expansion is likely to pick up where consumer spending left off.” In the dot-com bust of 2000, strength in consumer spending did pick up when corporate spending was slashed, but it is simply illogical to expect the opposite to be possible. When corporate expansion does crack, it will be part of a “second wave down” in construction and jobs, and will have a far greater economic impact than the decline so far in residential construction.
In “Bernanke’s Box”, I asked: “Can someone please tell me what we need more of? Home Depots? Lowe’s? Pizza Huts? Restaurants of any kind? Strip malls? Furniture stores? Nail salons? Wal-Marts? Office supply stores? Grocery stores? Appliance stores? Auto dealers? Banks? What? What? What?” Nothing is what. There is a veritable glut of every kind of store imaginable. The construction of all those places provided jobs. The bottom line is there is simply no need for businesses to expand into a consumer slowdown. Commercial construction always lags residential construction, simply because Wal-Marts, etc., finish their build-out after residential areas are built. This is only logical, but the mantra being sung by Wall Street pundits is that somehow corporate spending will save the day.
Watch what insiders and corporations are doing, not what they are saying. What corporations are doing is wasting money at an amazing pace on stock buybacks, while cutting back on existing expansion plans. In “Bernanke’s Box”, I also noted, Home Depot “Sales Falloff Kills Staff-Increase Plan”. For Home Depot to go from hiring plans to firing plans in a single month, things must have gone to hell in a handbasket in a hurry. There is no other rational explanation.
In summation, there is not a shred of evidence that suggests corporate spending is about to pick up, or that if it did it could possibly “take over where consumer spending left off.” The idea is not only illogical, it is unsupported by what is actually happening. What is happening, however, is subprime lenders are blowing up and throwing more people out of work, furniture stores are blowing up and throwing more people out of work, proposed financial mega-mergers (if they happen) will throw more people out of work, Wal-Mart has recently cut back on expansion plans, Home Depot did an immediate reversal of expansion plans, and now we see a 4-month decline in nonresidential building.
The second wave down is coming, and this one will have far more serious consequences.Link here.
REAL ESTATE AUCTIONEER’S PERSPECTIVE
I spoke with Carl Carter, public relations manager for J.P. King, following the auction of 40 condos at The Hamptons at Tampa Palms, Florida. 171 bidders from 15 states arrived and 40 units were sold. The planned sale was 40 absolute with another 60 units with a minimum bid. In addition, there were another 160 the developer still owned and wanted to sell.
“In short, developers overbuilt. The market was distorted by speculators who were flipping units for a quick profit, and that made it look like demand was higher than it was. When the speculators disappeared, reality set in. That reality is coming as a huge shock to many developers and flippers alike: Units are just not going to be sold for prices anywhere close to what was being offered a year ago – no matter what marketing method is used. In many instances, flippers are competing with developers to sell units. This is pushing prices down,” said Carter.
Is this a Florida thing only? Carter: “No, but Florida probably has the biggest oversupply. We are getting calls from developers every day, and several attended the Tampa auction just to see how it works. Some developers who last year had never even thought about an auction are seriously considering it. We have done condo auctions recently in Door County, Wisonsin; Austin, Texas; Florida; Alabama; and Michigan. ... Demand is still very weak, and supply is still increasing. From that perspective, it just seems very unlikely that we are close to a market bottom. ... I am speaking nationally, but when it comes to the oversupply, Florida’s the national situation on steroids.”
A little quick math on the auction results shows that any investor who bought at last yea‘rs prices is now 45% underwater on average, not counting maintenance fees, property taxes, insurance, interest payments, etc. Also, the developer is still holding 60 additional units he was hoping to unload at the auction, but failed to. The developer also has an additional 160 units waiting in the wings. Pent-up supply? 40 units sold, but how many of those were to the next flipper hoping to unload at a higher price? Did this auction, no matter how successful, reduce any supply? Even if it did (which is debatable), what about the condos still under construction in Miami, Tampa, Las Vegas, San Diego, Chicago, Boston, D.C., Seattle, and countless other places?
What have we learned from this?
Panic has still not set in, but it will eventually. That event could be years off.Link here.
THE FUTURE WILL NOT RESEMBLE THE PAST
In spite of Fannie Mae’s $7.9 billion earnings write-off for the years to 2004, and failure to provide accounts for the last 7 quarters, the stock is substantially up during 2006, and analysts are mostly recommending it. This reflects a particularly counterproductive habit of financial analysts and economic commentators. They assume that the future will resemble the past. Time after time, particularly since 1995, that has proved to be a mistake.
This mistake has been made before. In the 1930s, commentators from Treasury Secretary Andrew Mellon down assumed that the post-1929 downturn was an ordinary recession, similar to that of 1920, and that similar policies would pull the U.S. through it quickly. In practice, policymakers, led by President Herbert Hoover, did not follow the policies that had been so successful in getting out of the 1920 recession. Instead they raised tariffs, increased business subsidies, raised taxes and (largely accidentally) contracted the money supply – all counterproductive. Whether the recession would have followed previous patterns if left to develop alone is unclear. In any case, with those extra burdens it did not.
After 1995, there is in retrospect no doubt that the Internet and its associated telecom revolution caused a step change in the world economy. Contrary to much excited commentary at the time, however, it did not revolutionize U.S. productivity. Instead, it greatly increased the efficiency with which products and services could be outsourced to the Third World, particularly India and China. The result of the changes that happened around 1995 is only gradually becoming clear. U.S., European and Japanese inflation since 1995 has been effectively suppressed to the tune of probably 1.5-2% a year by the inflow of new products and services from China and India. Thus a monetary policy far easier than seemed appropriate, with M3 money supply growing by 10% per annum or close to it, produced no surge in consumer price inflation but simply a series of fantastic increases in asset prices.
However Alan Greenspan also got it wrong. On December 5, 1996, 10-odd years ago, he denounced “irrational exuberance” in the stock market. That was a reasonable extrapolation from past history. The Dow, at 6,400, was well above what before 1995 would have been considered a sustainable level. Had he proceeded with the normal next step of a responsible Fed Chairman, he would have raised interest rates in order to choke off the developing stock market bubble. In that case, economic expansion would have continued vigorously, while inflation would have dropped to below zero. In essence, the U.S. economy would have returned to its position of 1873-96, in which expansion and productivity growth were rapid, but consumer prices had a steadily falling trend. Instead, in July 1997, Greenspan, possibly seeking reasons to justify the continued effortless elevation of Wall Street, compounded his error by professing to find a productivity miracle in the U.S. economy, which justified stock prices far higher than would previously have been thought appropriate. This was wrong. More than a decade after its introduction, the Internet’s effect on retailing, for example, is still significant but minor, because the U.S. had efficient retailing and distribution systems already.
The great advantage of the Internet (and its associated telecom revolution) was to make instantaneous communication with the other side of the world cheap, and simultaneously make both public and private information accessible to those without easy physical access to mass media and good libraries. Thus Indian software engineers could access the latest technical periodicals and the gossip columns and job listings appropriate to their trade. Chinese manufacturers, too, could communicate with their customers and take immediate orders for shipment across the globe. It was Indian and Chinese productivity and output, not American, which were revolutionized by the Internet. Those countries that resisted globalization, notably in Latin America, fell rapidly behind.
By recognizing a U.S. productivity miracle that did not exist, Greenspan left monetary policy far too loose, as it has remained ever since. This produced an excessive level of investment, first in dot-coms then in housing, depressed U.S. saving to an unsustainable level, and by artificially increasing U.S. consumption produced a dangerous and unhealthy trade deficit. Since 1995, or at least since 1997, the U.S. has been living beyond its means. The hollowing out of U.S. manufacturing has proceeded further than it needed to, as foreign capital has propped up the dollar artificially, being attracted by the U.S. asset bubble. Interest cost differentials between low and high risk credits have been artificially reduced, producing a wave of investment in doubtfully creditworthy Third World countries and an acceleration of outsourcing from the American heartland. Profits have been artificially raised, as asset price increases and operating cost reductions have flowed to corporate income statements, further boosted by the artificially low cost of capital.
This has been enormously beneficial to some within the U.S., and has hurt others. Most obviously, it has benefited Wall Street, rentiers and top corporate management. Conversely, it has damaged Middle America, whose jobs have been outsourced, it has damaged savers, who have been unable to get a decent return on their money except by speculation and it has damaged the asset-poor, who have been priced out of the housing market.
Those who expect current conditions to continue, money to remain loose, asset prices to remain inflated or even inflate further, and inflation to remain quiescent are equally deluded today. (This group would include most of Wall Street, Fed Chairman Ben Bernanke and the CEO of luxury homebuilder Toll Brothers, who announced that the housing market had definitely bottomed out.) They are expecting the future to be like the past, and for continuing outsourcing of goods and services to Asia to keep suppressing prices in the West, allowing cheap money speculation to continue.
At some stage, however, outsourcing’s artificial suppression of price inflation will stop. The enabling of outsourcing by telecoms and the Internet is a step change. It has already happened, no further major improvements are in store, and the remaining difficulties of international sourcing, primarily language/cultural barriers and transportation logistics, will remain in place and not enjoy more than modest improvement. Its enormous effect on the prices of outsourced goods will no longer dominate the world economy and suppress Western inflation. Wage rates are rising rapidly in China and India, in turn pushing up the prices of their output and reducing the cost gains achievable through outsourcing.
Once this happens, either inflation will reappear or, in the unlikely event that money creation is held back to prevent inflation reappearing, the Western economies will decline and asset prices, in particular, will collapse. Probably both. In either case, the U.S. trade deficit will reverse, the dollar will decline sharply, U.S. consumers will start saving again and U.S. demand will go into a multi-year slowdown. This may currently be happening. Far from a “soft landing” the U.S. economy appears to be about to dive headfirst below the water. The Japanese malaise of the 1990s (but probably not the Great Depression) will thus repeat itself in the U.S., albeit with a different pattern, as asset values return to normal.
And what of Fannie Mae? It has enjoyed 25 years of declining interest rates, which have boosted house prices (thereby reducing loan defaults), while allowing it to benefit from borrowing cheap short term money and investing in long term home mortgages. Analysts and its own management therefore forecast its future by extrapolating its past, assuming continuation of the exceptionally favorable environment it has enjoyed. That environment is about to become much darker – house prices will decline and long term interest rates will rise. The result will be far greater loan losses than Fannie Mae is used to, “gapping” losses between old low mortgage yields and suddenly more expensive funding and a sudden lengthening in the maturity of its mortgage portfolio, as consumers stop refinancing. That in turn will cause Fannie’s derivative portfolio to stop working as a hedge again – just when they thought they had got it in order.
Watch Fannie Mae’s 2005 and 2006 results, if and when it produces any. If they are unexpectedly poor, you will know that the world has changed. Fannie Mae can act as the canary in the U.S. economic coal mine, telling you when the air has become unbreathable. If Fannie’s auditors do not move fast, however, economic asphyxiation will have arrived in other sectors before Fannie can report its distress. That would be a pity. Fannie Mae would otherwise for the first time in its existence have served a genuinely useful purpose.Link here.
SUPPLY, DEMAND, AND SHAMANISM
For the better part of four years now, commodity prices have been rising as the unexpectedly rapid pace of urbanization of Asia, running in a not-entirely unrelated concurrence with the deepening industrialisation taking place in Eastern Europe, Latin America, the Gulf, the FSU – and even parts of Africa – has boosted demand to levels totally unforeseen during the resource industry’s famine of the 1990s.
Given both the scale of the increase and its longevity to date – and taking account of Wall Street’s predilection for memorable marketing tags – some pundits have gone so far as to call this episode a “Supercycle”. Others are not so sure and point out that such reasoning smacks rather too much of the cries of “it’s different this time” which eventually accompany any boom – and whose increasing stridency usually signal its imminent demise.
While not wanting to give any credence whatsoever to the Peak Oilers’ and Climate Catastrophists’ dismal Malthusianism by claiming that mineral and energy resources are in any meaningful sense “finite”, what we must recognize is that the world’s diggers, drillers, dairyman and dirt farmers will have to spend ever more prodigious amounts of capital, while employing ever more sophisticated techniques, in seeking to exploit finds in ever more remote, physically extreme, and politically uncertain regions, if they are to meet the basic needs of this, the ongoing, second industrial revolution.Link here.
Peak oil and gas, energy cornucopia, and reality.
For guidance on the most likely trend of future natural gas prices, I find it useful to pay attention to the growth strategy of the world’s best-managed oil and gas exploration and production (E&P) companies. An 11/6 article in The Wall Street Journal discussed the rapid evolution of Chesapeake (CHK: NYSE). How was Chesapeake able to expand natural gas production so rapidly in the U.S., where total production has been stagnant for years? Chesapeake has been a very aggressive acquirer of both drilling leases and smaller E&P companies, and has chosen the right areas in which to invest capital. Half of the company’s growth over the past five years has been organic, or “through the drill bit,” with the other half coming from acquisitions. Chesapeake now accounts for about 3% of total U.S. natural gas production, with this share likely to grow by double digits over the next several years.
In 2001, Chesapeake’s base gas production was contracting at an 18% annual rate, but has been improved to 9%. The blue area of this chart is what the revenue trend of a North American gas-focused E&P company would look like if it decided to enter “harvest mode” and not reinvest its profits into drilling and acquisitions. CEO McClendon has spearheaded the company’s effort to shift its portfolio of reserves toward unconventional gas basins. But this aggressiveness is tempered with savvy use of natural gas futures contracts. Chesapeake’s balance sheet is basically a concentrated “long” position in natural gas, so by periodically selling short natural gas futures, the company can lock in current spot prices for gas that may not be produced until a year or so into the future.
As the WSJ article explained, Chesapeake locked in agreements amid relatively high prices. Until recently, it had contracts covering 80% of 2007’s planned gas production – far more than any comparably sized energy company. When prices dipped in October, Chesapeake unwound commitments to sell its own gas in the future, lowering its coverage to 59%. “Since bottoming out in early 1999, Chesapeake has used its hedge strategy to become one of the largest U.S. natural gas producers.”
Chesapeake had a near-death experience in 1999 after becoming too aggressive investing for a high-price gas environment that had not yet arrived. As gas prices rebounded sharply over the next few years, the stock recovered and the company implemented its “land grab” strategy early on. Now Chesapeake has about a 10-year drilling inventory on acreage that as it is drilled over time has the potential to triple the company’s current proved reserves. No other large independent E&P company will come close to the kind of organic growth that Chesapeake will deliver over the next 10 years. In a stagnant North American natural gas supply environment, this will lead the stock market to assign CHK stock an industry-leading earnings multiple.
Right now, finding and development costs are only in the range of $2-3 per thousand cubic feet in most unconventional gas basins. Many will look at this figure and conclude that the free market will direct a surge of capital investment into new gas production, considering that the profits and incentives are so high with spot gas prices in the $6-8 range. But we must remember that finding and development costs are dynamic, and certainly trend higher over time as the more expensive, hard-to-find oil and gas becomes a larger share of total production.
The single greatest variable in finding and development costs is the average “dayrate” charged by available rigs. Right now, the rig fleet is working at close to full capacity, so drillers have considerable power to negotiate higher prices and earn higher profits. Day-rates have already surged dramatically, yet there is potential for them to increase even further and remain in the current range longer than the market currently anticipates. The kicker for Chesapeake is that the company built up a wholly owned drilling and oil field services subsidiary near the bottom of the investment cycle. CHK’s management team has a very impressive track record of timely decisions, and they spent the past year reshuffling and expanding the size and capabilities of their land rig fleet. After being tossed about by the whims of the spot natural gas market of the late 1990s, the company has emerged stronger than ever and now practically controls its own destiny in a market in which the long-term fundamentals have shifted decidedly in its favor.
In Chesapeake you have a company that is rapidly boosting its production and reserves of a rapidly depleting energy source. This is a very attractive investment profile. Maybe that is why CEO Aubrey McClendon, himself, holds such a large number of Chesapeake shares.Link here (scroll down to piece by Dan Amoss).
ONLY THE EXPERTS KNOW FOR SURE
Last week, IPO players found a new way forward by riding Heelys to a 55% gain in the first day of trading. Heelys are designed for action. Accompanying each Heely is a wheel meant to snap into the heel of the shoe, thereby transforming an ordinary tennis shoe into one-half of a skate. That the Heely is not a full skate like the bulkier combo tennis shoe/roller skate already on the market, has not posed a problem for the company. It recently reported $117 million in revenue in the nine months ending September, vs. $29 million in the year-ago period. Apparently, Heely wearers enjoy the thrill of leaning backwards at an angle that is something just short of vertical and, with luck, well short of horizontal. Naturally it is the thrill of one-wheeled riding and the risk of concussion that makes the Heely popular with skate boarders and other extreme sports lovers who fear neither the pull of gravity nor the taste of concrete.
Apparently, the experts who brought Heelys public are bullish on the number of extreme sports enthusiasts specifically, or are bullish on courage generally. The experts also must figure that Heelys will continue to outperform the entire inline skating industry without suffering its fate. For the record, the Sporting Goods Manufacturing Association expects U.S. inline skate sales to come in at $113 million this year – down from more than $600 million a decade ago. With Heelys trading for around $30 this week, the company boasts a market cap of $810 million, or more than one times the sales of the inline skate industry at its peak.
Speaking of experts, a couple of weeks ago rumors began circulating that private equity investors were going to buy Home Deport for $100 billion with a little help from the credit markets. At least one Wall Street analyst did the math and concluded that with enough asset sales and deferred spending, such a deal would deliver an IRR of 20% annually over five years. In other words – it would work. In this and similar evaluations, experts point to the stability of Home Depot’s cash flows as one of the keys to making the deal a winner. That must be why they call them experts, because it is difficult for the average guy to see how if housing continues to drop off a cliff that Home Depot’s cash flow will not go “splat” along with it.
According to the Commerce Deptartment, homeowners have been devoting an increasing portion of home improvement spending to “improvement”, rather than maintenance. An average guy, however, might think that the former is much easier to defer than the later, and with the house suddenly looking more like an albatross than an ATM, improvement spending, and Home Depot’s home improvement related products, might falter. A little. For awhile.
For Home Depot to remain unaffected over the next few years, a person would have to believe that despite a bubble in new home building, existing home sales, vacation/investment home buying, and remodeling, we will experience a less than average retrenchment, or at least a retrenchment that will not adversely affect the hammers, lumber and installation services sold by Home Depot. Maybe the optimism on Home Depot’s cash flows comes down to a lifestyle choice. There are people who like to hold onto handrails and there are people who like to skate down them. It looks like the experts are the ones on one wheel.Link here.
PUTTING THE GOLD IN GOLDEN YEARS
Only rarely can you look into the economic future and see what is coming, at least in time to take advantage. This is one of those times. After a century of abuse by pandering politicians, encouraged at every step by the clamoring masses, the U.S. economy is headed for an iceberg, Moby Dick and a U-Boat. Clarity is possible because of a combination of factors that, taken together, leave nothing but hard choices ... assuring the government will try to paper over its many obligations with cheap money. Only this time, inflation will trigger a monetary crisis the likes of which few living today have experienced. The good news is that if you prepare for it, this once-in-a-lifetime crisis is a once-in-a-lifetime opportunity for profits.
U.S. government debt now tops $9 trillion, before taking into account its unfunded obligations for Social Security and Medicare – debts that the retiring boomers will soon have their hands out to collect. After adding in Social Security, Medicare and all the government’s other pay-later obligations, the current debt actually comes in at over $60 trillion. Let us try to put that number into perspective. A trillion is 1000 X 1000 X 1000 X 1000, or a million millions. In his first address to Congress, President Reagan, himself a big spender, accurately pointed out that a stack of $1,000 bills four inches high makes you a millionaire, and that a trillion dollars would be a stack 67 miles high! The U.S. government owes 60 of those sky-piercing stacks of $1,000 bills.
It is a lot of money. And it is not just any kind of money. Amazingly, this unbacked currency of a bankrupt government is still the reserve currency of virtually every nation in the world today. But not, we think, for much longer. To service its debt and keep the game going, the U.S. government must sell on the order of $2.5 billion per day in new Treasury bills, much of it to foreigners already sitting on something like $6 trillion of U.S. paper. Absent the foreign buyers, the whole scam begins to unravel. And once it begins to unravel in earnest, with wealthy foreigners and then governments rushing to switch out of dollars, the speed and steepness of the monetary collapse will be breathtaking.
While millions of boomers will be lucky to scrape by for a year or two of hard living in a trailer park, their meager assets will not carry them through the 20 or 30 years of retirement that medical science now promises. For that, they will have to rely on scraps from Washington. In fact, according to the Fed, a majority of retired Americans already rely on Social Security for 80% or more of their income. And that makes Social Security and Medicare politically untouchable, no matter how badly the programs trap the U.S. economy.
Recognizing that the U.S. has little capacity to rein in its profligate spending and has neither the intent nor the ability to actually pay off its $60 trillion debt in money worth anywhere near what it is worth today, foreigners are increasingly leery about accumulating more greenbacks. On November 9, for instance, Reuters reported that, “The bond and foreign-exchange markets were struggling to come to grips with comments from China’s central bank governor Zhou Xiaochuan, who said his country had a clear plan to diversify its $1 trillion in foreign-exchange reserves and is considering various options to do so.”
Normally, the more skeptical foreign investors become, the higher interest rates must go to entice them to continue raising their hands at Treasury auctions and to keep them from dumping their existing holdings. But even that route, at least for now, is closed. Higher interest rates would devastate the already weak housing market and bring ruin to a heavily indebted populace, especially cash-strapped boomers, and further ratchet up the cost of government borrowing. In other words, raising rates is not an option. So what are nervous bureaucrats to do?
The answer is to depreciate the currency – and as quietly as possible. That allows the government to meet its obligations, but with ever more worthless dollars. It is their only way to buy time. Make no mistake, it is a desperate strategy, but it is the only option for a government whose decades of reckless spending have led the economy into a box canyon, the floor of which is covered in quicksand. There is no way out. The best they can hope for is to stall the inevitable for as long as they can.
In this age of instant communication, the government cannot hide the truth for long. So, no matter that they have stopped publishing M-3 money supply numbers, recognition that we are between a rock and a hard place is spreading. Reckoning Day is not far off. And when it comes, it will rush in faster and more brutally than almost anyone expects. The world’s financial picture will be redrawn from scratch, and a painful unwinding of the economic dislocations built up by decades of political pandering will begin.
While no one can say with certainty how the disaster will play out, there is one truth you can take to the bank. Throughout all of human history, gold has always held its value as a monetary instrument. That sort of shock-proof durability cannot be claimed by any paper currency, certainly not by the dollar. With the dollar untethered from gold, the worth of the $20 bill in your pocket is headed for its intrinsic value ... as a recyclable.
In the weeks, months and years just ahead, gold, silver and other tangible assets are again going to become much more than financial obscurities tucked away on the commodities page. They are about to become front-page news. When that happens, the prices of the metals – and of high-quality gold and silver shares – are heading much higher. Hopefully, enough of the 78 million baby boomers will catch on to the underlying realities of their situation early enough to take advantage. For many, it may be their last chance at enjoying dignified golden years – instead of laboring through their 8th decade under the Golden Arches.Link here.
S.E.C. ISSUES FLURRY OF PROPOSALS, SOME LOWERING COSTS TO PUBLIC COMPANIES
Responding to criticism that regulators had overreacted to years of major corporate scandals, the S.E.C. issued a flurry of deregulatory orders and proposals intended to lower costs to public companies. It said the moves would not reduce investor protection. In a daylong proceeding, the commission proposed a loose interpretation for smaller companies of an auditing provision of the Sarbanes-Oxley Act of 2002 that has come under attack from many companies. It also proposed a rule to make it easier for foreign companies to withdraw their securities from American markets. A number of companies have asked to withdraw, and officials said the current rules discouraged companies from listing on U.S.exchanges if they did not have the option of withdrawing later.
Among other noteworthy proposals the S.E.C. issued was one that would increase the financial qualifications for investors in hedge funds, to a net worth of $2.5 million from the current standard of $1 million. Officials said the proposal had the effect of adjusting the original rule for inflation, just as hedge funds are becoming more popular among some less wealthy people. The agency also proposed a new provision on fraud to protect hedge fund investors. Some officials said the two proposals could blunt attempts to impose other tougher regulations or disclosure requirements on hedge funds. The S.E.C. also adopted a rule that would save corporations the expense of mailing financial reports and proxy statements by enabling them to communicate with the vast majority of their investors through the Internet. And it proposed rules that would make it easier and less costly for banks to offer brokerage services.
Taken together, the proposals and rules are expected to provide enormous savings for public companies and Wall Street investment houses. The S.E.C.’s deregulatory push came a day after the Justice Department, in response to similar complaints, imposed new limits on federal prosecutors in white-collar corruption cases. Under those new guidelines, prosecutors in the field will now have to obtain permission from senior officials before trying to get companies that are under investigation to waive their attorney-client privilege. In weighing whether to seek the indictment of a company, the prosecutors will also no longer be permitted to consider whether the company is paying the legal fees of an employee involved in the inquiry.
The commission’s votes on all the measures were unanimous, testimony to both the changed regulatory climate and the political skills of the agency’s chairman, Christopher Cox, a former Republican member of Congress. He tailored the changes to avoid the divisiveness that had troubled the tenure of his predecessor. Mr. Cox said the unifying theme of the proposals and the new rules was to increase the competitiveness and transparency of companies and markets.Link here.
SMALLER KIDNEY DIALYSIS MACHINES COULD MEAN BIG PROFITS
More than 1.7 million people – 450,000 in the U.S. alone – around the world suffer from chronic renal failure, sometimes known as chronic kidney failure. Chronic renal failure occurs when the kidneys lose the ability to properly filter waste from a person’s blood. This causes the kidneys to become overworked and scarred, until they eventually lose almost all ability to perform their function. Life is difficult for someone who has to deal with chronic renal failure every single day. For those who are waiting for a transplant or cannot get one, there are visits to a clinic a few times a week for dialysis. All of this medicine and treatments cost the average patient about $70,000 a year.
One small company is looking to change all of this – NxStage Medical (NXTM: NASDAQ). This $250 million company boasts that it has created the first truly portable home dialysis machine. So instead of spending three hour sessions at clinics every week, patients have the option to learn how to use a portable dialysis machine in their own homes. The machines are so portable you could even take it with you traveling. Take a look at some of the pictures on the company’s website.
“In recent years, hundreds of peer-reviewed articles have reported on the clinical and quality of life benefits experienced by patients on more frequent and/or home therapies -- whether in a short or long daily format,” according to NxStage. Yet even though these findings are widely known, NxStage claims that less than 1% of these patients receive home dialysis. This is a huge, relatively untapped market. Thus there are plenty of reasons to be excited about this company. In 2004, NxStage brought in a little bit less than $2 million in revenue. The company tripled its revenue to $6 million in 2005, and has brought in $13.5 million in the first three quarters of 2006. While it is still in the red when it comes to earnings, this kind of growth cannot be ignored. This month, NxStage announced that more than 1,000 patients are now using its portable home dialysis treatment. NxStage has still only penetrated a miniscule section of its potential market. NxStage also has $77.9 million in cash with only $5.3 million in long-term debt.
Is that enough excitement for you? I hope so. For me, one of the most rewarding activities is finding penny stocks like NxStage. It really can be exciting when you uncover small stocks that have big potential. And it should be. After all, it is the smaller stocks that have the best stories to tell.Link here.
VENTURE CAPITAL RISES TO DOT-COM BUBBLE LEVELS
The volume of money invested globally in venture capital is set to top $32 billion this year, more than has been seen for four years, putting investments closer to levels seen during the dot-com bubble, research by consultancy Ernst & Young has found. “We came out of the bubble with much stronger technologies and with better entrepreneurs,” said Gil Forer, global director of E&Y’s venture capital unit. “The quality of technology is much better and that is driving more investment.”
As in the dot-com bubble of 2001, when VC investment reached $51.2 billion, much of the focus this year has been on technology companies. Biotechnology and internet and other computer-based technologies are among the hottest sectors, with technology to reduce burning of fossil fuels or to cut emissions also attracting a large proportion of funds. About 56% of venture capital investment in the first three quarters was in IT companies, with 29.5% devoted to healthcare companies. Venture capital investing is increasing fastest in economies such as China and India.
Mr. Forer does not expect it to reach 2001 levels again for several years: “I hope we won’t see the levels of 2001 again because I want to believe and I think there is reason to believe that the industry has learned a lesson.”Link here.
A POULTRY POWERHOUSE IN THE MAKING
Frank Perdue, Donald Tyson and Harland Sanders all got rich selling chicken. Today you have an opportunity to follow in these men’s footsteps. I found an up-and-coming chicken producer with a #1 share of a growing market, which is flying below Wall Street’s radar screen. And it is dirt-cheap at today’s prices. It is trading for less than Pilgrim’s Pride, ConAgra Foods and Gold Kist, and is in better financial shape than every one of its peers. While no business (or stock) is guaranteed to rise, people have to eat. And no matter what happens to the economy, the housing market or the stock market, chicken is one food that will remain on almost everyone’s menus.
Here in America, we eat more chicken than any other meat. Unlike beef and pork, chicken is low in calories, sodium and cholesterol. It is a fantastic source of protein, vitamins and minerals. Plus, it is relatively inexpensive. A pound of chicken costs 50% less than a pound of ground beef. The balance between nutrition and price is the main reason chicken consumption has grown 2.3% a year in the U.S. since 1980, while beef and pork consumption have both declined. Chicken is not just popular in the States. Take it from someone who has traveled: If there is one food you can always get – whether in Asia, Europe or South America – it is chicken. Worldwide, 30% of all meat produced is poultry. Since the late 1990s, chicken consumption has increased in every country from Saudi Arabia to Australia to Brazil.
But, despite the nice growth statistics, I have seen the massive disparity in the amount of chicken consumed in rich and poor countries. The average American consumes 48 kg. of poultry a year – the most of any developed country. Meanwhile, the Chinese and Russians eat only 11-13 kg. of chicken a year. And our neighbors to the south in Mexico consume only 20 kg. a year. If you study this chart, you will notice a clear relationship between meat and wealth. As people make more money, they can afford to eat more meat. And as they eat more meat, chicken and meat stocks rise. For instance, take these recent examples of emerging countries:
Like Brazil, South Africa and Thailand, Mexico is still very much a developing country. Its per capita GDP is $10,000, or 1/4 that of the States. But in the last quarter alone, Mexico’s GDP rose 4.6%, compared with a rise of just 2.2% in the U.S., and is predicted to grow at a 3-5% clip over the next 20 years. So Mexico is much poorer than the U.S., but it has a lot further to grow – especially when it comes to chicken production and consumption.
The Department of Agricultural and Applied Economics at Texas Tech University published a paper on Mexican chicken patterns. Based on extensive research, the school found that chicken consumption among the highest decile of Mexican consumers (i.e., the richest) increased more than 880% between 1984-2002. Meanwhile, for the 4th decile (the middle class), consumption increased 480%. And the 10th decile (the poorest) saw a 250% increase. The two main reasons for the growth are the implementation of the NAFTA, which took effect in 1994 and limited the number of cheap U.S. hindquarters that could be imported into Mexico, and Mexico’s improving economy. With the Mexican middle class larger than ever – 40% of all Mexican families, vs. 30% a few years ago – the market for chicken is at an all-time high. It will only get bigger from here. According to the Texas Tech study, Mexico’s population is expected to grow over 1% a year between now and 2015. Per capita chicken consumption is projected to increase by at least 64% in the next 20 years.
Add it all up and Mexico’s largest chicken producer, Industrias Bachoco SA (IBA: NYSE), is set to grow quite considerably in the years to come. The Bours family, which owns about 80% of the company’s stock, founded Industrias Bachoco in 1952. It started out as a small table egg operation in the Mexican state of Sonora. The rest is history. Thanks to several key acquisitions over the last several years and significant organic growth, IBA is currently Mexico’s largest chicken producer. IBA is to Mexico as Tyson Foods is to the U.S. I love owning industry leaders. They tend to have better pricing power, brand recognition and visibility in the investment community.
Bachoco, as it is referred to in Mexico, has 700 production and distribution facilities in that country. In FY 2005, the company raked in $1.36 billion in sales, of which 80.1% stemmed from chicken sales. The rest came from table eggs, feed and swine. IBA has a dominatant 32% share of the entire market. By comparison, Tyson has a 26% share of the U.S. chicken market. And unlike Tyson, Bachoco is both cheap and financially strong. IBA currently trades for less than book value. It is rare to find a large company that trades for less than book value. And on top of that, IBA has virtually no long-term debt and tons of cash. Take a look at this table comparing IBA with its major peers. And the company is sitting on $313 million in net cash. That is a lot of money IBA can use to expand operations, endure some lean years or reward shareholders.
One way I think IBA could reward shareholders is by maintaining its attractive balance sheet and letting someone like Tyson or ConAgra buy it outright. This is a realistic scenario for IBA shareholders. In Tyson’s latest annual report Tyson denoted Mexico one of the key areas to explore and expand in in the future. It seems IBA would be a perfect takeover target for Tyson. No stock is risks-free, and IBA is no exception. There are four main risks to its business:
For this reason, I am not recommending IBA in my newsletter. But I wanted to bring it to your attention. Should IBA plunge on Bird Flu fears or come down with the overall market, this is a stock you might consider buying for your own portfolio. IBA could make investors double- or triple-digit profits in the coming years. But you will need to be patient. Buy on the dips.Links here and here.
HEDGING 2006: A YEAR TO READ THE CAVEATS
For Global Alpha, the $10 billion hedge fund run by Goldman Sachs, 2005 was a stellar year. By the close of the year, the fund, which manages money for some of the firm’s wealthiest clients and employees, was up 40% after fees, a performance that helped contribute almost $600 million to Goldman’s 2006 first-quarter earnings. But through November this year, Global Alpha was down almost 11%. The average fund in Global Alpha’s style of investing, known as equity-market neutral, is up 5.8% for the year, according to Hedge Fund Research. By comparison, the S&P 500 was up 12% through November.
For hedge fund investors, 2006 has been a year when many fears were realized. A $9 billion blue-chip hedge fund collapsed in the space of a week and Goldman’s woes revealed a painful truth of investing in these secretive, lightly regulated, high-fee investments: hedge-fund investing is hard, and no one – not even Goldman Sachs – is infallible. This year “is the third straight year that the global equity markets and long-only managers outperformed hedge funds,” said Christy Wood, senior investment officer for global equities at the California Public Employees’ Retirement System. So is CALPERS pulling back? No. Ms. Wood helps to oversee $4 billion in hedge fund investments and has another $3.5 billion to invest. She is satisfied that hedge funds have delivered exactly what CALPERS wants from them: equitylike performance with bondlike risk.
More than $110 billion flooded into the hedge fund industry in 2006 through the third quarter, compared with $47 billion last year and a record $99 billion in 2002, according to Hedge Fund Research. Institutions like CALPERS are fueling that growth. In one way, hedge funds are victims of their own success. More managers chasing more returns in more corners around the globe means big returns are harder to come by. And yet, money continues to pour into hedge funds, with fees generally unaffected. Like any year, some of those funds went to managers who soared, and some went to others who flopped.
Another major fund, with a different strategy than Global Alpha, faces a far different year-end. Atticus Global, a fund within Atticus Capital, was up 11.5% in November and 32.2% for the year, according to one investor. (A spokesman declined to comment.) At $4 billion at the end of 2004, the fund has more than $13 billion today. Its style – buying large positions in stocks – is risky, and this year paid off well. But big bets can also go the other way. It was only three months ago that Amaranth Advisors, a once-highflying fund that started the year with more than $9 billion in assets, disclosed that it lost more than $6.5 billion on bad bets in the natural gas market. But the lesson that big bets with big leverage translate into enormous risk has seemingly been lost as the markets have soared.
For many funds, the markets and the pains associated with fast growth have hampered returns. North Sound Capital, founded by Thomas McAuley, an alumnus of Tiger Management, informed investors last week that the fund, which peaked at $2.9 billion earlier this year, will end the year with $1.4 billion, as investors have taken nearly $1 billion out of the fund. Its Legacy International fund is down 3.1 percent this year through November. At least half a dozen research analysts have left, as lower returns clearly mean less incentive compensation to go around. Many investors thought the fund got too big too quickly. Others chalked up the numbers to a bad year. The result, however, was investors flocking to the doors.
Goldman’s Global Alpha may not face the same redemptions as North Sound, in spite of the fact that its performance is far worse than that of Legacy International. Global Alpha’s investors are wealthy Goldman Sachs clients who may be less likely to move their money out as fast. And Global Alpha markets itself as a risky fund, a caveat borne out in recent years. So while clients may be disappointed, they cannot be completely surprised.Link here.
AS EMERGING MARKETS HIT NEW HIGHS, RISK RISES TOO
It is always nice to see patience rewarded in investing – and even nicer if it happens without a long wait. Just ask investors in mutual funds and ETFs that specialize in emerging-markets stocks. We have enjoyed just such a happy experience in 2006. A knockout punch of selling in May and June wiped out about 25% of our money. But by early December we got it all back.
Times sure have changed for these markets, in up-and-coming economies around the world from South Korea to South Africa, India to Brazil. When the emerging markets hit a spell of trouble in the early 1990s, it took them 10 years to recover. Now they can do it in six months. There is a big difference in the economic fundamentals too. It has been a great story for investors. The iShares MSCI Emerging Markets Index fund has soared at an annual clip of almost 40% since it made its debut in early 2003. Lists of the top-performing U.S. mutual funds in 2006 bristle with single-country and regional funds from within the emerging-markets realm. A Bloomberg screen I looked at recently of the top 15 funds through early December included four China funds, two Russia, and one each from Mexico, the Caribbean Basin and Singapore. One of the top gainers, the closed-end Greater China Fund managed by Baring Asset Management, sported a return of 89% since last New Year’s.
Gratifying as such results may be, they also raise warning flags. “Emerging markets remain expensive despite the recent sell-off,” said Lehman Brothers in a November note to clients. “Emerging market equities may not be as resilient as developed market equities in the face of slower global economic growth.” In any risky investment, it is a good idea to crash-test one’s position every now and then. As it happens, emerging-markets funds make this exercise easy by regularly demonstrating in real life the kind of losses that can occur. A brief look at the history of the Morgan Stanley Capital International Emerging Markets Index gives us plenty to work with.
Reading from a table of the index’s annual changes, we can estimate that if you had invested $100,000 in the index at the end of 1988, you would have seen your stake balloon to about $400,000 by the end of 1993. Then, in the next five years, about $180,000 of your new-found wealth would have disappeared. You got a big chunk of it back in 1999, but then $200,000 or so vanished again in the bear market of 2000-02. Losses of 25%, 35% or more are not just possible in this market, they happen over and over again. Sometimes they come quickly, sometimes they take years.
Granted, these markets and the economies in which they are situated have matured a lot in the past couple of decades. They now trade to a significant degree on real and present growth, not just hopeful visions for the future. They have gained a measure of respect that wasn't accorded them in the 1990s, when a particularly long spell of disappointing results earned them the sobriquet “submerging markets”. Even so, these markets remain vulnerable to political and economic surprises that may hit them harder than stocks in developed markets. Some new terrorist attack, or something like a crisis for the dollar in foreign exchange, would fit that description. The way the world economy is developing, emerging-markets stocks present an opportunity that cannot be overlooked. With all that glitter, though, their risks are as big as ever.Link here.
“The encouragement of mere consumption is no benefit to commerce because the difficulty lies in supplying the means, not in stimulating the desire for consumption; and production alone furnishes those means. Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption.” – Jean-Baptiste Say, A Treatise on Political Economy, 1803
From discussing politics back to discussing economics. Just as before, though, it remains a dialogue among the deaf. The great majority of economists has its eyes stubbornly focused on apparently positive features for the U.S. economy, like the sharp fall in the oil price, abundantly available liquidity, tame inflation, low and falling interest rates and strong profits. A minority of economists, in contrast, keeps just as stubbornly stressing that the economy’s famous gross imbalances and structural distortions and the associated debt explosion are inexorably undermining economic growth. Generally, however, optimism distinctly prevails about the U.S. economy. It is not the old buoyant optimism. Yet it is optimism in the sense that some true malaise, like a crash in the asset markets and a recession, let alone a deep and prolonged recession, are absolutely out of the question.
Let us start with the hard facts. For six, seven and more months, U.S. economic data are overwhelmingly surprising on the downside, and moreover, the surprises have been going from bad to worse. It is an old wisdom that the scale of the boom excesses essentially determines the severity of the following process of economic and financial readjustment. For us, the most important, and also easiest, measure of excess is the associated credit expansion. The use of credit in the wake of this housing bubble has been simply bizarre, outpacing all past experiences by far. The second highly important point to see is that this housing boom was the first one in the U.S. to impact the economy at a vastly broader scale than just the building activity. As private households, using the rising house prices as collateral for mortgage equity withdrawals, stampeded as never before into debt to finance additionally other kinds of spending, the whole economy developed into an outright bubble economy. It was a boom that plainly went to extraordinary excess in various ways. As a rule, this suggests a very severe aftermath of painful corrections.
The first effects of the housing bust have definitely been bigger and more abrupt than most experts had expected. Yet hopes are riding high for a benign adjustment. What strikes us is how promptly the change in the housing market has impacted mortgage borrowing. It peaked in the Q3 2005 at $1,225.9 billion at annual rate. It was down to $819.6 billion in Q2 2006. This sharp decline was, however, to a small part offset by higher consumer credit. Remarkably, the sharp decline in new mortgage borrowing since the third quarter of last year has occurred even though house prices were still rising, albeit at sharply slowing rates. As the price climate is sure to deteriorate for some time to come, it seems a reasonable assumption that this initial sharp slowdown in mortgage borrowing has some way to go yet. This may well take some time to materialize, because the housing market is notoriously sluggish in its reactions.
Federal Reserve Vice Chairman Donald L. Kohn takes comfort from the fact that the present housing downturn, in sharp contrast to past ones, is not caused by credit tightening. We think, though, that he is drawing a totally false conclusion. All downturns caused by tight money were followed by vigorous recoveries. A downturn happening despite low interest rates and loose money seems to us the most worrying kind.Link here (scroll down to piece by Dr. Kurt Richebächer).
MARKETS MAKE DELUSIONS
Betting against a year-end stock market rally is a little like betting against tomorrow's sunrise. Even so, we think this might be a bet worth taking...against a year-end stock market rally, that is. It is a fact that year-end rallies arrive almost as reliably as the daily sunrise. Only 13 times in the last 78 years has the stock market fallen between December 13 and New Year’s Eve. In other words, it has rallied 83% of the time. That is why the so-called “Santa Claus Rally” has become a canonized article of faith on Wall Street. Everyone knows that it will arrive every year.
The year-end rally does not only arrive predictably, it also arrives powerfully. It seems to overcome whatever macro-economic obstacles stand in its path. Despite the ravages of the Great Depression and the traumas of World War II, the Santa Claus Rally arrived every year from December 1934 through 1953 – a 20-year span that delivered average year-end gains of 3.0%. More amazing still, the cumulative gains from these 20 year-end rallies totaled 86%, or more than half of the stock market’s total gains during that 20-year period.
However, these awe-inspiring statistics merely suggest probabilities. They do not guarantee anything. Last year, the stock market slipped 1.4% between December 13th and New Year’s. But 73 years have passed since the last time the stock market stumbled during two consecutive year-end trading periods. In the back-to-back Depression years of 1932 and 1933, the stock market produced slim losses between December 13th and year-end. But 2006 is not a Depression year ... except for the short-sellers of emerging market stocks. 2006 is a celebration year. The housing market may be crumbling, Iraq may be imploding, the dollar may be collapsing and the ice caps may be melting, but the stock market seems to celebrate it all. Since bottoming out at 10,706 on June 13, the Dow Jones Industrial Average has soared more than 1,600 points – 15.2% – without ever pausing to enjoy the views on the way up.
Share prices have been rising for so many months now that most investors trust stocks to continue rising. It is common knowledge that stocks are a “buy”. Unfortunately, “common knowledge” might just be a polite phrase for “mass delusion”. Stocks are not always a “buy”, especially not when everyone knows they are. Since highlighting extremes of bullish sentiment in our November 30th column, the Dow and the S&P 500 have gained slightly, while the Nasdaq and the Russell 2000 have dipped slightly. In short, the market has gone nowhere. But we think it is about to go somewhere ... like down.
Over the last two weeks, most measures of investor sentiment have become even more extreme. That is not a favorable omen for share prices. These latest readings stand in stark contrast to the downbeat sentiment readings of mid-June. The recent stretch of seven positive months for the Dow Jones Industrial Average is the longest monthly winning streak in more than 10 years. So it is little wonder that investors have become excessively optimistic. Meanwhile, “There are 19,976 reasons to be worried,” warns colleague Graham Summers, editor of Inside Strategist. That is the number of corporate insiders who sold shares in their own companies last month. November’s insider sell/buy ratio was the highest it has ever been, according to Summers.
Heavy insider selling, extreme bullish sentiment and frothy market action do not guarantee an imminent top in the stock market, but neither do they signal a low-risk buying opportunity. Place your bets.Link here.
OVER THE TOP
People love to exaggerate. And no one loves hyperbole more than we do. Hyperbole is what distinguishes America from other countries. It is what makes us what we are. Everything about the place is oversized. The cars, the houses, the people, and the country itself. Practically every movie, every shopping mall, every great American novel, every popular song, even the wide open spaces are a form or hyperbole. Look at what drives down the streets. Is not the Hummer a superb example of exaggeration? Look at Pamela Anderson!
Americans love hyperbole. British humor may be based on understatement. But American humor is based on over-statement ... exaggeration ... hyperbole. But Americans, of course, are no greater fools than anyone else. They like hyperbole because it provides insights that would be lost the dull details of daily life. Amid the constant background noise of TV news and cocktail chatter, the boom of hyperbole wakes us up, and brings to life the nuances, curiosities, and absurdities of the world we live in. “Words must be a little wild,” said the great economist John Maynard Keynes, “for they are the assault of thoughts on the unthinking.”
At The Daily Reckoning we take aim at the unthinking every day. We cannot help but notice that much of what passes for conventional, reasonable and moderate – is really even more absurd than the “over the top” palaver of its critics. What is more, the hyperboles do not get you into trouble. It is the exaggerations and absurdities that you do not even notice. The man on the street believes he can make money by just buying stocks “for the long haul.” He thinks his house will make him rich. That he can “get something for nothing” is not merely an idea – but the basis of his retirement program! A falling dollar? Don’t worry about it! Record deficits? They will work themselves out somehow. Yet, none of these preposterous ideas is thought to be “over the top”.
The expression “over the top” was used in WWI. Then, it was considered perfectly reasonable – indeed, it was the conventional wisdom – that a man would leave his trench, going “over the top”, and walk across open ground while other men tried to kill him, usually successfully. No one knew exactly what the point of it was, but at the time, almost everyone agreed. It was the thing to do. “Get Your Butt Shot to Hell in No Man’s Land” could have been considered very reasonable, moderate and responsible journalism in its day. The trouble is, you cannot always tell what is “over the top”, and what is not, until you are lying dead.
Years ago, we took up the issue in London. We went to visit the financial regulators in that city – England’s equivalent of our SEC. They had a rule against used hyperbole or fear in financial advertising. We wanted to find out what they meant by it. So we posed the question: “What if we wrote a prediction: The world will soon enter its worst war ever. Twenty million people will die. Almost all the major governments of Europe will fall. Our country will be bankrupted. Our currency will be ruined. ... What if we wrote that in 1913?”
The regulator squirmed in his chair. He did not know what to say. He was a smart man. He knew that it would have been almost impossible to exaggerate the horror of what was to come in 1914. No “fear” tapped out on a mangy journalist’s typewriter could come close to the real fear that was soon to be felt by the millions of young British men who would have to go “over the top” into the maul of modern war. And no sorrow conjured up by a gifted imagination could match the real grief of millions of widows and orphans.
Hyperbole and fear are not fixed stars upon which a man can steer, but inconstant moons that wax and wan according to the circumstances. That is the trouble. Hyperbole never reaches the scale of real life. And that is the trouble with real life. It refuses to confine itself to our hyperboles. But it is Christmas. It is time to go overboard again. And enjoy it.Link here (scroll down to piece by Bill Bonner).
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