Wealth International, Limited (trustprofessionals.com) : Where There’s W.I.L., There’s A Way

W.I.L. Finance Digest for Week of June 23, 2008

This Week’s Entries : This week’s W.I.L. Offshore News Digest is here.


Coverage of the semi-annual Barron's Roundtable continues from last week.

Art Samberg

Barron’s: What gives with this market, Art?

Samberg: The commodities market has a lot of unfinished business. The bubble is not going to burst; it is going to continue to expand. We have not reached the animal-spirits stage yet. This run-up is economically justified.

As for the stock market, a narrower and narrower list of stocks will work. We played some tech and materials names when both groups had major corrections a few months ago. But the stocks have come back, and I am not as interested any more. The lack of serious innovation is a huge problem for the country, and it gets manifested in technology stocks. The number of interesting IPOs [initial public offerings] is tiny, and the backlog is getting even smaller.

Because there are fewer compelling technologies, or because a choppy market is inhospitable to new stocks?

The venture-capital world is moving from a focus on information technology to green investing. There are not a lot of new, green-oriented ideas that will be significant in the short term. Health care usually is a good feeder of IPOs, but the macros there are dismal. Much of what is new in tech focuses on consumers. Those stocks are boring.

At the beginning of the year financial institutions were way overlevered. They have brought leverage down quickly, and the rate of return on capital industrywide is falling. When the unwinding ends, financials will sell at book value, not multiples of book.

So they are boring, too?

They could be boring for another two, three or four years. The market will be down this year, and next year will not be much better. It could be worse. There will be bigger problems with consumer credit and trouble in commercial lending. Before it is over, every financial institution will be embarrassed in some way. This is the mother of all credit cycles, at least in my lifetime, and that is the way they end.

Will things improve by 2010?

I am optimistic about 2010. The U.S. will look good relative to other markets. For now, the only thing left to invest in is inflating assets -- copper, natural gas, coal. I recommended Ultra Petroleum [95, UPL] in January. We still love it. Natural gas now trades above $12 per million British thermal units, up from $7 in January. Southwestern Energy [48, SWN] is another natural-gas play. In the first quarter a lot of commodities rallied, but the related equities did not. You are starting to get an equity catch-up play. Because gas is rising, there is a double play.

We are big owners of Freeport McMoRan Copper & Gold [120, FCX]. Copper used to be obtained through surface mining, but the ore grade has deteriorated and now you have go underground. There is not enough electricity in places like Chile, and there are water-scarcity problems near many mines. Nationalization is also an issue. We also like Xstrata, the Anglo-Swiss copper miner. They have a lot of South African coal. Eskom, the South African electric company, cannot produce enough electricity, so it is hard to get this stuff out of the ground. Prices will escalate until the infrastructure is built to accommodate the market, and the rate of return improves significantly.

You have been a big fan of Companhia Vale do Rio Doce, or CVRD [34, RIO], the Brazilian commodity giant. Do you like it still?

It is super-cheap. I am still recommending it. Nothing has changed. My last pick is Halliburton [49, HAL], which makes equipment for oil and gas exploration. The bad press surrounding Halliburton has gone away. [The company, which has close ties to Vice President Dick Cheney, was accused of profiting from government favoritism in Iraq.] I could mention almost any commodities producer: The story is the same. I am either dead right on commodities, or dead wrong.

Here is hoping you are dead right. Thanks, Art.

Fred Hickey

Barron’s: Do things still look bleak to you, Fred?

Hickey: A witch's brew is hitting the economy, including the biggest housing-market collapse in U.S. history. Home prices are declining by 14%, year over year. Oil is $135 a barrel, up almost 40% since January. Food prices are soaring, unemployment is rising and wages are stagnant. Lending standards are tightening. Auto sales are plunging. States have a budget crisis. This combination of problems is unprecedented unless you go back to 1929.

Which we are not. Are we?

Well, they have not taken protectionist steps yet. But they are talking about it. The U.S. is in a recession. The only people who do not believe that are on Wall Street. The stock market has had a classic bear-market rally, triggered by the Federal Reserve saving the world again. Supposedly. Previously, significant declines in interest rates would lead to corresponding drops in mortgage rates. Not any more. Lending standards are tighter, and consumers have record debt and no savings. Who would want to lend to them?

Good point. How will these problems get solved?

They have to play out. Housing prices have to fall to the point where homes become affordable to the general population. So far, stocks are not even down 20%. The market will get killed when companies admit the second-half rebound is not going to happen.

I am still buying gold and selling "horsemen," the most popular tech stocks. Gold hit $1,000 an ounce within a few weeks of the January Roundtable, which I expected. I slashed my position by 75%, and in March I got out of all my puts on stocks. I have been on the sidelines, though I bought tech stocks such as Microsoft, Oracle, EMC, Hewlett-Packard and Apple. Recently I sold them -- my intention was to rent them -- and re-entered my put positions.

What, specifically, are you shorting through puts?

The SOX, or Philadelphia Semiconductor Index. The severe downturn in the economy has led to lower sales of technology products. Inventories are building at wholesalers. SG Cowen recently calculated that inventories are at a 5-year high. Cellphone sales have fallen 16% in Western Europe. A classic inventory correction is coming within a recession. Yet the SOX is up 20% from its lows! The SOX could correct at least to its March lows, and probably more. But do not short, except through put options.

Any longs these days?

Gold stocks have been hammered. Junior mining shares have been destroyed. Golden Star Resources [3.00, GSS] is not a junior. It has real mines, in Ghana. Yet its price is destroyed. A new CEO came on late last year from Newmont Mining, which also has big operations in Ghana. Recently he brought in a new chief operating officer, also from Newmont. Golden Star could become a takeover target, with Newmont a likely buyer.

Gold production in Ghana is expected to rise 60% this year. But it is dependent on technology. Golden Star was bringing on a new processing plant last year and ran into problems. If it can get this plant working properly, production will increase. The stock is at 3, and the market cap is $700 million. The shares could easily double. My biggest positions are in bullion. As fear returns to the market, gold will rise again. I am buying mostly through GLD, or StreetTracks Gold Shares, an exchange-traded fund.

The horsemen continue to gallop. Research In Motion is up almost 30% since you recommended shorting it through puts in January. Are you skeptical still?

RIM has a market valuation of $75 billion, but just 1% of the cellphone market worldwide. Nokia has a market cap of $100 billion, and a 40% market share. What kind of upside is there at this valuation?

Thanks, Fred.

Felix Zulauf

Barron’s: You predicted this would be a rough year for investors, and so far, you are right. What now, Felix?

Zulauf: This bear market does not look like 2000-02. It is a much more drawn-out affair, but a high-risk environment. There are enough reflation efforts under way in the U.S. and enough economic momentum in other parts of the world to prevent a global recession now. The economic expansion could run another two years or more. The market will remain choppy, with a downward bias lasting three to four years, as macro liquidity deteriorates. Investors' risk appetite is lower. There is not enough liquidity to push stocks to new highs, but there is still enough to support the dominant themes in the market.

It is a split market. Financials and consumer stocks will remain weak, and energy and agriculture-related issues will keep rising, with occasional corrections. Aside from the European Central Bank, nobody is tightening monetary policy to the point that it becomes restrictive. Therefore the business cycle will continue. Demand for energy will continue. China still has subsidized energy prices and accounts for 80% to 90% of incremental demand. In the short run, the oil complex could correct, but it is not the end of the trend.

Do you see any glimmers of a turnaround for financials?

Some of the value guys are beating the drums for bargains here and there, but I do not believe it. Restructuring bank balance sheets also will be a drawn-out affair.

The markets could make an interim low this summer, marked by another selling climax in financials. Stocks then will attempt another rally. Financials could jump 50% or so on short covering. After the elections, stocks will go down.

What are you buying -- or selling?

We are at the doorstep of the next inflationary period. You will not see greater inflation in the next one or two years, but prices will be much higher in 10 years. Bond yields will rise as inflationary pressures mount. The yield on 10-year Treasuries, now 4%, could hit 5.5% in 12 to 18 months. The U.S. Treasury bond is a short, though you will probably get a better entry point below 4% in the next few weeks.

Another short is Japanese government bonds, or JGBs. They yield 1.8%. Inflation is returning to Japan, which may be a good thing for Japanese companies. JGB yields could go to 3% in the next 12 to 18 months. What correlates best inversely with these bond yields? The Japanese stock market. It was in a bear market for 17 or 18 years due to the deflationary environment. Inflation would mean profit margins are normalized. I like the Nikkei for the next 12 months.

How should you buy the Nikkei?

Buy the futures. Japanese banks have restructured their balance sheets. They are sound. As interest rates rise they could charge better spreads. You can buy the banks through the Nikkei 500 Banks Index.

Investors should also be long commodities, through the DBC, the PowerShares DB Commodity Index Tracking Fund. This is a trading market. Based on real-estate cycles in other countries, the U.S. housing market will decline for another two years, bottoming in 2010. The consumer will be in such a precarious position that the government will have to step in to increase spending and support the economy. The Federal Reserve, despite rising inflation rates, has no choice but to leave short-term rates low. That means the dollar will not strengthen much either.

And on that happy note ... Thanks.

Abby Cohen

Barron’s: How does the market look to you?

Cohen: The housing market peaked in the 4th quarter of 2005. Coming into this year, many people were concerned about what continued weakness in housing would mean for consumer spending and employment. On top of that, the financial markets, and financial intermediaries, ran into trouble starting last summer.

There are signs the U.S. economy may be stabilizing. The likelihood of a deep recession has lessened dramatically. Exports are strong. Business fixed-investment is ongoing. Some people say this will be the worst recession since the 1930s, but we never thought so. Not that things are wonderful, but the abyss? A saucer-shaped recovery is more likely.

Many financial companies have fallen into the abyss.

There were questions earlier this year not just about the price of capital, but whether capital was available at all. Now there are signs things are moving in the right direction, as some financial institutions show a willingness to sell assets below par. There is an important contrast here with Japan, where an illusion of health was kept up for years. Assets were kept on the books at purchase price. It was not until those assets began to move off the balance sheets of financial companies, albeit at lower prices, that the Japanese financial system was able to recover.

Why have oil prices skyrocketed this year?

There is the long-term structural move in energy, and a short-term, cyclical move. Long-term there is an imbalance in the market: Global demand is growing faster than supply. In the past two decades producers have not invested much in additional sources or refining capacity. That is coming home to roost. Short term, people are talking about the impact of a lower dollar, the activities of oil investors as opposed to users of energy, and geopolitical concerns. Also, some producing nations are not able to distribute out what they are producing. The general direction of oil prices is correct. On a trading basis, oil can move back toward the bottom end of its recent trading range. But on a long-term basis, the trend is up.

Financial dislocations and higher oil prices have helped sink the stock market this year. What is your S&P forecast?

The markets are in a tenacious trading range: 1325 to 1425 on the S&P 500. But by the end of the year, investors may become more comfortable with the outlook for 2009. We estimate fair value for the S&P will be 1500 at year end. In 2009, growth will be OK, not great. If companies begin to feel more comfortable about the future and create more jobs, 2009 could turn out to be better than the consensus forecast.

What sorts of stocks will do well in this environment?

Given that we do not see a deep recession, and that the Federal Reserve has done an outstanding job in trying to restore proper functioning to the markets, my first pick is in financial services. Bank of New York Mellon [40, BK] is a custodial company. It is a low-beta business, and the stock has not done much this year. It yields 2.3%. Bank of New York merged with Mellon, so we expect some enhancements to earnings from economies of scale. Also, a large trust bank benefits from global growth.

In honor of [retired money manager and Roundtable member] John Neff, my next pick is D.R. Horton [DHI].

John will be happy to read about one of his favorite companies, but why recommend a home builder now?

Horton is down 50%, to 11 and change. In housing, some regions of the country are closer to stabilizing than others. Goldman Sachs analysts think 2008 will be the last year of losses for Horton, and there is a chance profits re-emerge next year. We are talking about the most cyclical of industries moving into a healthier phase. The rating agencies recently downgraded many housing stocks, which was not unexpected. To be able to buy one of the better-managed companies in the industry, with historically strong cash generation, interests us.

How about another contrarian name?

SanDisk [SNDK], which makes flash-memory cards, has not had a good year. The stock is down about 40%, to 24.48. Earnings have disappointed because sales of products that use flash memory are weak. However, our analysts believe the company has done a good job over the years in identifying new uses and products for flash memory. The company has been pretty clever about marketing itself. It has a brand name, captive market share, and leadership in technology.

We also like Eli Lilly [LLY]; it is down 16%, to 47. There is always concern about pharmaceutical companies during election years, but the stock is yielding 3.9%, and that would seem to cover a lot of potential aggravation. Also, our analyst thinks Lilly's pipeline looks good. My last name is a golden oldie: AT&T [T]. It is a play on the rapid growth of wireless technology, which accounts for about 40% of revenue. The stock is 36. We do not see tremendous earnings growth, but the dividend yield is 4.3%.

Sweet. Thank you, Abby.

Meryl Witmer

Barron’s: What is your second-half forecast?

Witmer: We see what everyone sees. Things are slow, particularly in retail. The consumer is squeezed, although some businesses are benefiting from exports. Over time, inventory will clear in the housing market. Oil potentially comes down if this is indeed a bubble, and things pick up. But in the near term, it is slow. Yet, we see opportunities. Generally, we are still holding the stocks we recommended in January, and finding others. They are coming our way. The market could move up 10% to 15% from current levels. A lot of stocks are washed out.

You are the rare optimist.

Hopefully, the contrarian often makes the money. One stock we like a lot is Interface [IFSIA]. The company makes carpet tile, square pieces of carpet with a flexible backing. Carpet tile is in the sweet spot of the flooring industry. Interface's product is made largely of recycled materials. Because it is "green" and easy to install, it is growing nicely.

The original market for carpet tile was office flooring, where its penetration is about 60%. Growth areas include the education market and the hospitality industry, including public spaces and hotel rooms. About half of Interface's sales are in the office market, 10% for new construction. The Americas account for about 60% of revenue.

Is it breaking into the consumer market?

It is trying, with modest success. The consumer business is losing money, but it is an opportunity. The stock has fallen to 13 from 20 last July, because of slowing growth in Western Europe. The company earned $1.02 a share in 2007. It has a legacy cost of high-coupon debt, which it should be able to retire and refinance in a couple of years.

If you add back the loss in the consumer business and adjust interest expense to a more normalized 7%, the company earned $1.18 a share last year. The stock trades for 11 times adjusted earnings. Assuming modest growth this year of about 5%, and adjusting the earnings the same way, we get earnings per share of $1.30 for 2008. Given Interface's roughly 35% market share, a strong management team and the fact that more than 85% of a tile is made from recycled materials, Interface deserves a higher valuation. Our target is 20 in a year or two. If growth reaccelerates or the product gains more popularity with the consumer market, the return could be even higher.

Sounds goods. Thank you, Meryl.


With so many inflation hedge assets, such as gold and other commodities, having experienced substantial price runups and thus apparently signaling more inflation to come, a conundrum -- to borrow a turn of phrase from Alan Greenspan -- is that long-term bonds have such low yields. Either these "certificates of guaranteed confiscation" are forecasting something more or less the opposite of the inflation hedges, or they are subject to current forces that overwealm long-run considerations.

The author of this article thinks the T-Bond market is willfully ignoring all the upcoming inflation, and thus shorting them is a lead pipe cinch for making profits once the market comes to its senses. We find the argument simplistic, at least in the sense that hard experience teaches that the market can stay "irrational" longer than you can stay solvent. (In the words of Jesse Livermore: "I know of but one sure tip from your broker ... your margin call.") Moreover, analysts we respect such as Bob Prechtor and Gary Shilling are sticking to their deflation forecast guns, so maybe it is the inflation hedges that are riding for a fall.

What is the best way to ride the inflation wave?

There are some alternatives to hedge against inflation. The best know are buying TIPS (still a good opportunity but with limited upside and pegged to core inflation -- a measure that does not include the ever increasing food and gasoline prices), buying gold, or, even better, buying into timber assets, particularly international ones, as in the U.S timber assets are quite possibly overpriced already (look at the multiples at which Plum Creek Timber (PCL) is trading, for example)

In my view, however, the risk/reward calls for more aggressive action: shorting the 10-year (or longer maturity) treasury bonds. This could be done through Rydex Inverse Gov Long Bond Strategy Inv [RYJUX], but if you can, I would recommend actual direct shorting of the T-Bonds.

Marc Faber called it the short of the century.

Yields on treasuries across the maturity curve are substantially below the historical averages and although they have widened slightly in recent weeks, are still close to all time lows; therefore, treasury prices are close to all time highs (as yield and price are inversely related).

Let us look more closely at the risk/reward profile of this trade, which looks great:

10 year treasury yields are at 4.19% (6/23/98); the "real" interest rate according to the treasury department is 1.75%, based on a core inflation rate of 2.44%. This is really not much of real return, so it cannot go down much further, particularly if one considers that if inflation was appropriately measured (more on that below) it would be much higher than 2.44%; the "real" real return is probably close to zero. So the downside is very limited.

The upside comes from the inflationary ball that is building up around the world for a variety of reasons (fuel prices on the rise, food prices on the rise ...) and which Ben Bernanke has greatly amplified in the U.S. due to (in my view) very misguided monetary policies: lowered interest rates (expanding the monetary mass) and the devalued dollar. The devaluation of the dollar further fuels the commodity price run and has an immediate direct impact has imported goods (denominated in other currencies) comprise an important component of the CPI.

It is not hard to imagine inflation reaching high single digits or even double digits. This would naturally lead to a increase in the return demanded by investors in treasuries just to keep their real return a the same level. A 5% percent increase in the yield ... would lead to a 30% decrease in the value of the 10-year treasuries ... Not bad!

I would not recommend trying this at home, but for traders who can sell 10-year Treasury futures, while putting down perhaps 5% of the notional amount, with that leverage the returns could be 6X (of course the downside here would be more meaningful as well).

Now another way to look at the situation and reach similar results, without requiring the same extent of acceleration in reported inflation, would be for investors to stop looking at the "official" core inflation but to realize that in fact "real" inflation has been and is higher. I read somewhere the following funny but insightful comment stating that the situation with the way inflation is measured in the U.S. currently is a little bit like parents who invent Santa Claus stories for their kids but over time end up believing in them themselves!

Bill Gross's [PIMCO] June investment outlook newsletter has some interesting insights on inflation figures in the U.S. Some of the key changes that have been made over time on how inflation is measured and monitored in the U.S. which have had a moderating impact including:
  1. Replacing house purchase prices for owners' equivalent rent (this got rid of the rampant house price inflation in the last 10 years or so, although currently it would have a deflationary impact).
  2. Including adjustments in the weighting of the CPI to take into account substitution effects. E.g., if chicken prices increase and turkey prices do not, I will reduce my consumption of chicken and increase my consumption of turkey.
  3. Including adjustments to take into account increases in the quality of products over time. E.g., the computer I bought today may cost the same as the one I bought five years ago, but the cost per [unit of performance] has decreased a lot. Actually, 46% of the CPI comprises durable goods and other products subject to hedonic adjustments -- even textbooks!
  4. Introduction of a distinct concept of core inflation and headline inflation where the first excludes food and gas. Core inflation is relevant to monetary policy makers in that it excludes items which often have temporary fluctuations.
The slight problem with these is that oil and gas prices have been steadly going up for the last six years, so there is nothing temporary about it. Most other countries do not use these "sophisticated" methods, although one country is now revising its methodology to include some of these -- Argentina, whose government is suspected of having manipulated their inflation figures for a while with unofficial estimates of inflation running at about twice the official figures (most forecasters expect inflation in Argentina to raise by 25-30%).

Bill Gross estimated in 2005 that without the quality and substitution effect, inflation in the last decade or so would have been about 1% higher and real GDP growth 1% lower. Also, consider that headline inflation has been running at least 1% higher than core inflation for several months/years. Add these up and you are talking about a real difference!


An unidentified, very active, trader thinks his heretofore very successful short play in financials is, well, played out in the short term.

I am cutting Ultrashort Financial (SKF) [an ETF that represents a bearish bet on the financials] to nearly 0. I know the financials are the bane of the market. But here we are approaching January 2008 and March 2008 highs in the chart. In fact if I did not know better this looks like a chart for a coal stock since early May: 55% gain since that time -- it has been a good ride and a wonderful hedge -- and this does not mean it cannot continue going up.

SKF did move up to 150 as of the end of Friday, after the selloff of all stocks and the end of the week.

I just think this is nearly played out for this "cycle" and/or risk/reward stops being in my favor. Just following previous correction playbooks -- when SKF reversed on me in the past it caused a lot of dislocation (fancy word for losses) in our portfolio. By ignoring the serial bottom callers on TV since last summer -- "time to buy financials!" -- we have made this our 2nd biggest winner in the fund, now approaching +$40,000 in gains (akin to nearly 4% of our entire fund performance since last August).

For a short term trade only (I reserve up to about 10% of the fund for shorter term actions) I am eying Ultra (long) Financial (UYG) -- but not yet. I have cut back Ultrashort Real Estate (SRS) to about a 0.6% stake as well. I am keeping the hedges in the parts of the market everyone loves ...


This article, which makes a case that Amazon is overvalued (the author has a short position in Amazon, so that is certainly part of the agenda) without actually saying so, brings up several interesting issues in the process: Are earnings or cash flow a better way to value companies? Should the two not equate over time? And is one of the few respectable survivors of the dot-com mania reasonably priced or not?

Questions: It seems that some analyzing Amazon are ignoring Net Income and using FCF to justify its valuation or a target price. There is no clear consensus on the definition of FCF. This can lead to confusion on what is the most meaningful definition and for the formula to use for its computation.

Free Cash Flow, strictly speaking, is the amount of money left over from the operations of a company that is available for distribution to the owners of the capital employed in the company.

There are various formulas to compute FCF. Whatever method is used, adjustments can be made to get a quality figure. In evaluating a company, analysts use various definitions of FCF, including "True Free Cash Flow", "Structural Free Cash Flow", "Maintenance Structural Free Cash", etc.

Below are two methods to compute Amazon's FCF. Formula 1 is very popular with analysts and liked by the company. It includes, in FCF, short-term cash received from customer sales in one quarter that was paid to suppliers in the following quarter. The second Formula is based on earnings, and ignores that short-term cash. Also listed is FCF, based on Formula 1 for the Quarter ended March 31, 2008, showing FCF at a negative $(706) million.

Two methods of computing Amazon's FCF for 2007:

(1) Cash Flow From Operations of $1.405 billion, less Capital Expenditures of $224 million, equals Free Cash Flow of $1.181 billion.

(2) Net Income of $476 million, plus Depreciation of $246 million, less Capital Expenditures of $224 million, equals Free Cash Flow of $496 million.

The difference between the formulas is $685 million.

(Negative) Free Cash Flow for the quarter ended March 31, 2008 is:

(3) Cash Flow From Operations of $(645) million, less Capital Expenditures of $61 million, equals (negative) Free Cash Flow of $(706) million.

Amazon is a company that has been in business for over 14 years and still has an Accumulated Deficit in Retained Earnings of $(1.2) billion, as total net losses exceeded their net Income. For 2007, they had earnings of $476 million; at the current stock price ... they have a P/E ratio of 68. For the past 6 years they had total earnings of $1.5 billion, which is extremely low for a company with a valuation of $34 billion.

Amazon has had good growth in sales, but with their history of no or low earnings, slim profit margins and a high P/E, some analysts and the company had to come up a ways to help justify their valuation. One method was to tout their FCF alleging that FCF is more important than earnings.

Some in the investing media feel that earnings per share and P/E ratio may be misleading. They state that FCF is the only true way to measure a firm's cash generating ability and is a more useful metric of investment attractiveness than earnings. This argument begs several questions, including the definition of FCF, the quality of the FCF and what should be included in the computation.

Funny how alternative metrics to the P/E ratio, however theoretically justified they may be, get trotted out as a means to justify high stock prices.

Many analysts reported $1.181 billion as Amazon's FCF for the year 2007. How meaningful is that number? Why does it differ greatly from the computation in example 2 above? Examining the Statement of Cash Flow it can be seen that over $800 million of the $1.181 billion is derived from a net change in working capital, most from the $1.2 billion year over year increase in liabilities. Cash did increase as did Accounts Payable.

Cash increased $1.1 billion for the Y/E 12/07 over 12/06, mainly from the increase in Accounts Payable that would be paid to suppliers after 12/31/07, which decreased cash by $1 billion at March 31, 2008. ...

The author now shows total debt increasing from $3.3 to $4.4 billion, year-end 2002 to 3-31-2008, while cash increases from $1.3 to $2.1 billion over the same period. So there was very little change in the net debt (debt minus cash) position over that 5-odd year period.

Amazon had Net Earnings of $476 million for the year, all of which belongs to the shareholders. How much does the "FCF" from this short-term cash mean to the shareholders? It seems only the investment income Amazon is earning on the float.

This short-term cash should not be considered Quality FCF and it is not equivalent to Net Earnings, which belongs to the shareholders. According to example 3 above Amazon had a negative $(706) million for the March quarter, or 40% of the $1.181 billion FCF that many claim Amazon had for the year.

Is the 2007 FCF of $1.181 billion, that many are touting, meaningful when in the following quarter their FCF came out to a negative $(706) million? How much is that "FCF" really worth to the valuation of the company, except for the relatively small amount of investment income they earn on it? It seems many are trying to equate "FCF" ... to Net Income, which it is not. This cash was temporary, vanished the following quarter and does not belong to the shareholders. Some analysts have increased target prices and target market valuations equivalent to tens of billions of dollars on this temporary "FCF".

Accounts Payable are a legitimate source of interest-free funding in some circumstances, but not if they represent a seasonal lump that has to be paid off next quarter, as is the case here with Amazon. If the (receivables + inventory - payables)/sales ratio demonstrates consistent behavior over time, we think it is reasonable to treat the payables as a source of cash to offset working capital requirements.

Warren Buffett, when analyzing a company and its FCF, uses computation #2 (above) that begins with Net Income. When valuing a business he would not consider the short-term cash held to pay liabilities as FCF and he would not pay multiples for it. FCF does not equal Earnings. It can be easily manipulated-increased by stretching out payment terms, as the Goldman Sachs comment below mentions.

Goldman Sachs's recent recommendation [of Amazon] mentions FCF and increasing it by obtaining longer payment terms in their attempt to help justify a target price. They completely ignored earnings. (Goldman owned 7.5 million AMZN shares at March 31, 2008):
... Trading at around 20X 2009E free cash flow, Goldman believes Amazon stock can outperform on rising revenue if margins are only flat; RAPID REVENUE GROWTH ASSISTS FREE CASH FLOW BECAUSE AMAZON USES ITS IMPROVING CATEGORY SHARE TO NEGOTIATE LONGER PAYMENT TO SUPPLIERS in categories such as books ...
In certain companies, FCF can be very important as it gives the company access to cash for expansion without borrowing. With Amazon, this benefit is not that great. They have substantial cash and even have enough to repurchase $100s of million of their own stock. Amazon's FCF is not consistent, using their definition. They showed FCF of $1.181 billion for the year ended December 31, 2007 and for the March 2008 quarter a negative $(706) million.

Remember Free Cash Flow is not equal to Net Income. The quality of the FCF is very important in valuing a company. Earnings and Cash Flow differences occur because of timing. Over the long these two measures must converge.

That is stating it a bit strongly but, yes, when using reasonable accounting standards, reported earnings and cash earnings should at least not notably diverge. It is almost the definition of reasonable accounting standards. There is the small issue of timing. Accounting depreciation that is much larger than a major asset's degredation in economic value, for example, will artificially depress current earnings. (That would be reflected by properly calculated maintenance capital spending being much lower than depreciation.) Down the line, when the asset is fully depreciated, earnings will either be modestly inflated or equivalent to cash flow, but until then one should emphasize cash flow analysis more strongly than under normal circumstances.


Doug Noland questions the soothing words emanating from Ben Bernanke and the Wall Street talking heads.

Despite the unwelcome rise in the unemployment rate that was reported last week, the recent incoming data, taken as a whole, have affected the outlook for economic activity and employment only modestly. Indeed, although activity during the current quarter is likely to be weak, the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.” ~~ Federal Reserve Chairman Ben Bernanke, June 9, 2008

I will make just brief comments as to why I believe Dr. Bernanke's view is too optimistic. First, since March the Fed's Wall Street bailout and the concurrent collapse in market yields played a significant role in artificially bolstering the U.S. economy. The unwind of market hedges also worked to support marketplace liquidity and likely artificially boosted credit availability -- especially for conventional mortgages and the investment grade corporate sector. I believe these forces have by now likely run their course. Moreover, market liquidity will likely suffer as hedges are put back on.

The risk that our economy has entered a substantial downturn has actually increased markedly over the past several weeks. Importantly, energy costs have risen significantly to the point of being economically destabilizing. The combination of spiking energy and food costs has created the worst global inflationary backdrop since the '70s -- a dangerous predicament only belatedly appreciated by global policymakers. Central banks across the globe have begun to react, and vulnerable global bond markets are under heavy selling pressure. There is today great uncertainty as to the consequences of a global spike in bond yields.

Importantly, the Fed's aggressive "reflation" is being stopped dead in its tracks by market forces. U.S. market yields are moving sharply higher, with benchmark Mortgage Baced Securities yields now all the way back to last summer's levels. This is forcing another round of speculative de-leveraging in the highly leveraged mortgage credit market, which is tantamount to a further tightening of already tight mortgage finance conditions. This is another huge blow for the vulnerable bubble economy.

The University of Michigan Consumer Confidence index posted its high of 112 back in the first month of 2000. By the beginning of 2003, it had sunk all the way down to 78. Yet during this period of weakening consumer sentiment and general economic conditions, benchmark MBS yields dropped from over 8.0% in mid-2000 all the way down to 4.2% by June 2003. Repeatedly over the past ("disinflationary") 20 years, waning economic activity has been bolstered by sinking mortgage yields and resulting stimulus to housing and home-equity withdrawal. It was like clockwork, but now this important cycle has been broken. Since January, Consumer Confidence has plunged from 78.4 to 56.7, while MBS yields have jumped from 5% or so to above 6%.

I have argued that the Fed's latest reflation would prove problematic. On the one hand, reflationary forces would bypass burst bubbles in Wall Street finance and U.S. real estate markets. On the other, an over abundance of cheap U.S. and global liquidity would further destabilize heightened inflationary pressures globally and stoke acute monetary disorder. As has become clear of late, the upshot to this dynamic is intensifying inflationary pressures in the face of a weakening U.S. economy. Indeed, one can look to spiking energy, food and borrowing costs and make a strong case that Fed reflationary policies have become dangerous and counterproductive.

From examining Q1 "Flow of Funds," one could identify how double-digit growth in Bank Credit, agency MBS, and the Money Fund Complex was carrying the load for a busted Wall Street securitization credit apparatus. Recent developments, however, have the sustainability of robust Bank Credit and MBS in serious doubt. And while 9.7% fiscal y-t-d federal spending growth has thus far played a meaningful role in supporting the economy, the bond market for the first time in years must come to grips with the confluence of surging yields and the prospect of massive ongoing federal deficits. Similar to the Fed's reflation policies, federal government stimulus is not without significant costs and risks. Acute global inflationary pressures ensure the old "free lunch" monetary and fiscal stimulus come these days with a hefty price tag.

It has not taken long for Stage II of this unfolding historic crisis to demonstrate some of the classic old financial and economic headaches. I have always believed the most problematic scenario for the highly leveraged U.S. credit system and bubble economy would be an inflationary surge and resulting spike in market yields. Curiously, just as the possibility of such a dismal scenario gains momentum a bullish consensus develops that the worst of the crisis is behind us.

Good Inflation?

More from Doug Noland, this time trying to put to bed any notions that there is such a thing as "good" inflation. Paul McCulley is a Managing Director of bond fund giant PIMCO (along with the better known Bill Gross). He seems to have great faith in the ability of the Federal Reserve to administer just the right amount of inflation, such that asset prices do not deflate but consumer prices do not rise too quickly ... whatever that means. The trouble is that: (1) There is no reason in theory to think this will work with people who have any adaptive capacity at all. (2) It has never worked in practice. Besides those two objections, the recommendation makes a lot of sense!

And the essential fact right now is that the American economy needs an inflation rate above the Fed’s comfort zone.” ~~ Paul McCulley, "A Kind Word for Inflation", June 16, 2008

I have elevated the status of my old "analytical nemesis" to that of the most dangerous monetary analyst in the country. He has been preaching inflationism for years now, and the more obvious the flaws in his framework the more creative he becomes in crafting his sermons. And he has become so adept at this game that many might actually buy into his flawed yet seductive logic.

Essentially, if I am reading [PIMCO Managing Director] McCulley correctly, he is arguing that because of an unusual "trade shock" from rapidly escalating energy costs, the Fed must employ negative real interest rates to avoid a "modern day depression." I will continue to espouse the view that today's ridiculously low interest rates are part of the problem rather than the solution.

Back in 2001/02, the inflationists were keen to monetize the wreckage from the technology bust through the inflation of mortgage credit. Not uncharacteristically from a historical perspective, this inflation ran out of control and amuck. Now, with much greater and generalized financial and economic post-bubble wreckage, the unbowed inflationists are subscribing more generalized consumer price inflation as part of the medicine to ensure asset prices and the real economy avoid sinking into a deflationary spiral.

The old Keynesian hair-of-the-dog nostrum. It is hard to believe that anyone still believes this junk.

A book could be written explaining why the inflationists are so wrong. This evening I am limited to the briefest synopsis.

Today's inflationary forces have been developing over a period of many years. Importantly, the key dynamic is one of a highly unusual strain of acute global inflation. The impetus for this inflationary backdrop has been the massive inflation of dollar financial claims, in particular a bubble in Wall Street asset-based lending that spawned unprecedented distortions to both the U.S. credit system and underlying "bubble economy" (and, increasingly, the global economy). This massive dollar credit inflation ("currency" debasement) opened a Pandora's Box for similar unfettered expansions in domestic credit systems across the globe.

Oil is inarguably the most important commodity in the world. The massive ongoing inflation in energy prices is and will continue to have momentous economic, financial, and geopolitical consequences. Comparisons to the ‘70s and ‘70s-style inflation, however, miss key aspects of today's inflationary dilemma.

There are three interrelated dynamics that are driving current inflationary forces. First, there is the massive flow of dollar liquidity inundating the world. Despite huge dollar devaluation, a major credit crisis, and economic downturn, our system is on track for yet another year of $700 billion plus current account deficits ... Global economies, especially booming Asia, are awash in dollar liquidity to use to bid up the prices of oil and other strategic resources. Second, today's massive dollar flows have increasingly gravitating to speculative endeavors (hedge funds, sovereign wealth funds, commodities speculation, etc.) -- each year ballooning the "global pool of speculative finance" that by its very nature chases rising prices ("liquidity loves inflation"). Third, the confluence of the flood of global liquidity and unfettered domestic credit systems has exerted its greatest stimulatory effect upon the highly populated countries of China, India, and Asia generally. This, then, has created a historic inflationary bias throughout the energy, food and commodities complexes.

McCulley and others prefer to "monetize" the current oil price "shock" through ongoing artificially low interest rates, arguing that recent price effects are a temporary phenomenon. This short-term jump in inflation is said to be, in the words of Mr. McCulley, "Good Inflation." Supposedly, it will help buttress the general prices level and generally help support asset prices, while tepid wage growth ensures that a 1970s-style wage price inflationary spiral will be avoided. Yet such analysis seems oblivious to the nature of the underlying risks associated with the current inflation.

As should be obvious by now, the current hyperinflation in energy and food prices risks global chaos. There is today such a robust inflationary bias in globally priced necessities that spectacular (NASDAQ ca. 1999) price moves have become the norm rather than the exception. As such, U.S. monetary policy that accommodates $700 billion current account deficits and massive speculative outflows to the world is courting monetary disorder disaster. To be sure, the current trajectory of U.S. financial outflows ensures an acute inflation problem for key things everyone wants and needs. Or written differently, efforts to "monetize" mortgage losses and energy inflation here at home will be invalidated by a global push to exchange excess dollar (and other currencies) liquidity for real things of necessity and tangible value.

A major flaw in the "Good Inflation" argument is that surging fuel, food and other costs in reality are administering a further crippling blow to the over-indebted U.S. consumer. Grossly inappropriate short-term U.S. interest-rates are today directly stoking serious price inflation, in the process reducing consumer discretionary incomes and the capacity to service enormous debt loads. The collapse in SUV and truck prices -- and the resulting huge "negative equity" in auto loans -- is the most obvious example of household sector creditworthiness taking a direct inflationary hit. This has created a major additional burden for millions that bought the big new home out in suburbia. And because of the worsening credit backdrop, mortgage and consumer debt borrowing costs are rising in spite of Fed rate cuts. Moreover, households are suffering further from the sharp reduction in returns on their savings, not to mention the inflation-related decline in many stock prices.

The ‘70s inflation saw consumer prices rise, incomes rise, home and asset prices rise, and wage-based inflation spiral higher. The current inflation dynamic is a different beast. Sinking home prices and surging energy and food prices are causing bloody havoc on general creditworthiness, a huge dilemma for the faltering financial sector and the finance/consumption-driven bubble economy. The bust in Wall Street finance is driving a major shift in economy-wide spending patterns, putting downward pressure on wages, incomes and profits in some sectors, while other sectors enjoy huge inflationary boosts. The breakdown in Wall Street "alchemy" has ensured that this round of Fed-orchestrated reflation bypasses home prices as it hastens problematic inflation elsewhere. A very strong case can be made that the nature of the Wall Street finance and asset-based lending boom nurtured a degree of financial and economic imbalance and vulnerability unlike the wage-based inflation of the ‘70s.

And while headline inflation numbers today may not be approaching the ‘70s double-digits rates, I would argue that an even more problematic economic adjustment is in the offing. I simply see no way around the necessity of sharply reducing the amount of new credit and imports required to sustain the U.S. economy. I see no alternative than a long and wrenching adjustment period while the household balance sheet is repaired, financial sector stability is restored, and some semblance of economic balance is achieved. Students of the sordid history of massive inflations are familiar with the inevitable pleas for just a little bit more inflation and a little more and a then lot more ... McCulley wants us to believe the Fed is doing the right thing by providing us some "Good Inflation." This really upsets me. I have repeated over a number of years a lesson learned repeatedly throughout history: Inflationism is a "Road to Ruin." This road has become all too visible.


It is perilous to call the top in a booming market, but the price of oil may be peaking in the current range of $130 to $140 a barrel.

This piece from Barron's does a decent job of summarizing the positions of both sides of the "Is oil in a bubble?" debate, while supplying helpful pieces of fundamental data along the way. From the article title, one knows they come down on the affirmative side, but the prediction is that the price only retreats to the $100 range. The term "bubble" is a misnomer under that scenario. The price may have overshot on the upside, thanks to a variety of factors including an excess of speculation that a greater fool is out there to enable your intended capital gain. But that is not the same as a move divorced from any semblance of true value, which is true bubble territory in our lexicon.

Oil's sharp move up -- prices have doubled in the past year -- caught the world by surprise, including almost everyone involved in the petroleum market, from major exporting nations to big energy companies to the global analyst community. The rally has emboldened oil bulls, who argue the world is bumping up against oil-supply constraints, and that demand will rise inexorably, despite sharply higher prices, as the 4 to 5 billion people in emerging economies like China and India get a taste of the energy-intensive good life, replete with the cars, air conditioners, refrigerators and computers that Americans and Western Europeans have long enjoyed. Statistics support their view that demand growth is in its infancy in the developing world: U.S. per-capita oil consumption is 25 barrels annually, while Japan uses 14 barrels per person. China's 1.3 billion people consume just two barrels each per year, however, and India's 1.1 billion use less than a barrel a year.

In the next decade, oil indeed may hit $200 a barrel. But prices could fall to $100 a barrel by the end of this year if Saudi Arabia makes good on its pledge to increase production, global demand eases, the Federal Reserve begins lifting short-term interest rates, the dollar rallies, and investors stop pouring money into the oil market. China raised prices on retail gasoline and diesel fuel by 18% Thursday [last week], in a move that is expected to curb demand.

It is tough to know how much of the surge in crude-oil prices -- up 40% just this year -- reflects fundamental supply and demand, and how much is due to other factors, including the dollar, commodity speculation and interest from institutional investors. Like some others, we suspect the run-up was fueled by more than economics.

There is growing talk of an oil bubble, though evidence of asset bubbles is not conclusive until they burst. The trajectory of oil prices in the past eight years looks eerily similar to the Nasdaq's 8-year run to a peak of more than 5,000 in March 2000. More than eight years later, the Nasdaq is at half that level.

"My basic message to those who say that prices have to go up forever is that the oil markets have been cyclical for 140 years. Why should that have stopped?" says Edward Morse, chief energy economist at Lehman Brothers.

Saudi Arabia, the world's biggest oil exporter, has pledged to boost production from a recent 9.5 million barrels a day to about 9.7 million in order to reduce prices. The Saudis are hosting a summit of oil producers and consumers on June 22.

"The analytic community is divided on what the recent Saudi comments mean for the market," says Morse, who believes the Saudis will put more oil on the market as they raise production. "That, combined with a declining rate of consumption, should create an inventory surplus that will be palpable as the year progresses." Morse thinks oil could fall to $100 by year end.

Skeptics say the Saudi vow to boost production is merely talk, and that the country is struggling simply to maintain production because of aging, overworked fields like the huge, 60-year-old Ghawar reservoir. The Saudi government refuses to allow in outsiders to evaluate the state of its oil industry, which has fueled talk the Saudis are hiding something.

Likewise, the size of speculative positions and commodity indexers is impossible to determine, as most trading occurs away from the major commodity exchanges in over-the-counter transactions.

It is hard to argue that oil demand supports $135 crude. Now at 86 million barrels a day, global demand could show little or no increase this year after averaging 1% gains in recent years. Sanford Bernstein analyst Neil McMahon projects that by the fourth quarter, global oil demand could be running below Q4 2007.

Consumption is down in 2008 in the 30 member nations of the OECD, which includes the U.S., Western Europe, Japan and Australia. OECD nations account for 57% of global oil demand. While Americans are married to their cars, $4-a-gallon gasoline has begun to bite. The number of vehicle miles traveled in the U.S fell in March on a year-over-year basis for the first time since 1979. Further declines in gasoline consumption may follow as drivers opt for more fuel-efficient cars, and as innovations like plug-in cars reach the market after 2010. Major U.S. airlines have announced widespread capacity reductions, which could cut demand for jet fuel by 5% or more later this year.

Oil demand continues to grow in the developing world and the Middle East. In Europe, stiff energy taxes generally blunt the impact of higher prices, but diesel fuel, now at nearly $10 a gallon in Britain (double the American price), may be at an unsupportable level. Demand growth could cool in emerging markets, too, as subsidies in many Asian countries are reduced. There is also speculation China has been hoarding diesel fuel ahead of the Olympics in August, in order to cut the use of coal for power generation around Beijing in the hope of cleaning up the city's notoriously polluted air. Once the games are over, China will go back to burning cheaper coal, the story goes.

The supply/demand argument for higher oil prices has some merit. "Name another commodity that has gone up 2 1/2 times in 3 1/2 years and the world has not found a way to make more of it," says Byron Wien, chief investment strategist at Pequot Capital Management. "The world is not finding oil fast enough to replace the 3% to 4% that gets pumped every year."

Wien's boss, Art Samberg, who heads [Pequot], stated in Barron's midyear Roundtable [lead off interviewee, coincidentally, in our coverage of the Roundtable, Part 2 above], that the commodity bubble "isn't going to burst. It is going to continue to expand." Older oil fields in Mexico and the North Sea are running dry while new sources in places like Kazakhstan and Brazil may prove difficult to bring on stream. In addition, oil increasingly is in the hands of government-run monopolies that may be more interested in maximizing future revenue than boosting current production.

The dollar's slide and the Federal Reserve's neglect of the greenback have supported commodity prices, oil in particular. But Fed Chairman Ben Bernanke and his colleagues finally seem to have realized that the Fed's aggressive easing actions since last summer, which dropped the key federal-funds rate to 2% from 5.25%, may be fueling global inflation. If the Fed moves to lift rates later this year, as financial markets anticipate, it could buttress the dollar and spur an exodus of speculators from the oil market.

One little-discussed way the U.S. could try to bring down oil prices is to sell oil from the strategic petroleum reserve (SPR). The SPR, intended as a source of oil for national emergencies, now holds 705 million barrels of crude, equal to about 35 days of domestic consumption. With prices higher, Congress moved in May to stop adding to the SPR as it neared capacity. A sale of 100 million barrels of oil would shock the markets and potentially drive down prices.

Long term, the U.S. could benefit through lower oil prices if Congress and the states back President Bush's proposal to allow drilling off Florida, the East and West coasts, and in the Alaskan National Wildlife Reserve, where billions of barrels of oil may lie.

A sharp drop in energy prices would help whole swaths of the U.S. economy, including retailers, food and household-goods makers, auto makers and transportation concerns. Beleaguered U.S. airlines would benefit because they are expected to spend $61 billion on fuel this year, up $20 billion from 2007.

The writer suggests that independent exploration and production companies like Devon Energy, Apache and XTO Energy are vulnerable after sharp runups this past year. The majors, on the other hand, may be the best energy values because they trade for less than 10 times this year's earnings and around eight times estimated 2009 profits -- the later reflecting an assumption of only $100 crude. But if oil does hold at $130 and natural gas averages $11 per thousand cubic feet, vs. around $13 currently, the majors look cheap indeed.

Oil-market experts acknowledge that commodity-indexing strategies employed by endowments, pension funds and other institutional investors have helped push up prices in the past year. Such investments are thought to have totaled $260 billion as of March, up from $13 billion at the end of 2003, according to Michael Masters, the head of Masters Capital Management, an Atlanta investment firm. Some $55 billion may have flowed into commodity investments during the first quarter alone. The energy complex is the largest commodity market, and gets a disproportionate share of fund flows. Masters estimates index participants may control over 1 billion barrels of crude.

Managers of leading university endowments, including those at Harvard, Yale and Princeton, in recent years have generated outsized returns from investments in hard assets, prompting other investors, such as the giant California Public Employees Retirement System, with over $200 billion in assets, to attempt the same. CALPERS is upping its commodity exposure to $7 billion from under $500 million.

This activity is spurring a backlash in Congress, where pension funds and others have been accused of driving up food and energy costs through their increased commodity investments. Lawmakers including Senator Joe Lieberman have proposed a ban on commodity-related investments by pension funds, which Masters supports. Last month he told Congress that commodity regulators need to close a loophole that lets indexers evade commodity-position limits by purchasing over-the-counter swaps and other derivatives.

In effect, the argument is that we have another market driven by mania-type "logic". Everyone is piling in because the strategy has worked well, which helps the strategy continue to look good, which brings in more participants, and on and on. These fads always look good until they don't, at which point -- and seemingly only then -- do people question whether their logic had a few holes in it, e.g., they notice that what they bought was way overvalued.

A selloff in oil and other commodities could cool the ardor for index strategies. Ross Margolies, head of Stelliam Investment Management, in New York, says financial investors would do better buying the shares of commodities producers, not actual goods. Over time, it may be more difficult to make money in commodity investing because holders effectively incur financial costs to carry and store commodities, even if they never take physical delivery.

Though little noticed, short-covering by independent oil and gas producers might have contributed to the recent strength in oil and gas prices. U.S. exploration and production companies like Devon, XTO and Chesapeake Energy have hedged an average of about 40% of their 2008 production by selling oil and gas futures, options or derivatives, according to Credit Suisse analyst Jonathan Wolff. As prices have surged, the hedges have slipped underwater, and some producers have sought to unwind their money-losing bets.

Newfield Exploration recently announced a $500 million hedge-related loss, and more red ink could follow. Total hedge losses among E&P companies could top $15 billion for 2008, and $8 billion for 2009, Wolff estimates.

These hedge losses are purely theoretical, in the nature of the "If only I had waited until the price went up more before selling" lament that everyone has some experience with.

While supply challenges could continue to dog the oil market, current prices seem excessive in light of weakening demand and other factors. But it is impossible to know with precision when the bubble will burst. ... [I]f prices start falling, the downturn could accelerate, sending crude back to $100 -- where it would be cheaper, but still far from cheap.


David Galland of Casey Research brings a rather different perspective on the oil situation than that expressed in the Barron's article above. In this first article he introduces a model which shows how quickly the combination of declining oil production and increasing demand can turn a country from a net exporter to an importer. The mathematics are elementary, but Galland contends that the implications are underappreciated.

As far as we can tell the idea is this: The oil market in toto may be represented as a big "bathtub." Producers dump their oil in the bathtub and all the consumers pump their oil out. But the oil actually traded on the world market among nations is a fraction of this, equaling the amounts the net exporters put into that market. As that quantity is a residual it is more volatile than the total -- perhaps much more, as when the residual becomes a smaller portion of the whole. And when multiple countries are making the above-mentioned transition from net exporter to importer, the situation becomes tricky to an unprecedented degree. Perhaps this is what we are witnessing now. And in the absence of major increases in supply, for "Peak Oil" reasons, prices will need to increase enough to kill off some demand.

You do not have to have an awful lot of gray hair to remember the excitement around England's massive North Sea oil fields. While discovered in 1969, it was not until well into the 1980s, on the back of surging oil prices, that the fields came into full production. Turning up the taps, the United Kingdom (as well as Norway and Germany, who also have North Sea production) became a significant exporter of oil.

But then, in 1999, something happened: The UK's North Sea production hit peak ... that tipping point after which reservoirs go into decline, setting in motion both reduced production and progressively higher costs related to extracting the remaining oil.

While the experience of North Sea oil production provides yet another useful example of the validity of the Peak Oil theory, what concerns us today is a critical but usually overlooked aspect of the discussion: exports.

At the time that the North Sea peaked in 1999, the U.K. was exporting 1 million barrels of oil per day. By August 2004, it had become a net importer. What happened to cause the situation to turn around so quickly?

To understand the importance of exports when discussing peak oil, ask yourself the question: "What is more important: the fact that global oil production is falling ... or that the oil exporting nations are cutting off their exports?"

While the two questions are clearly linked, it is the nuance of the export question that clearly matters the most. Especially if you live in a country such as the U.S., which currently imports about 70% of its oil.

Which brings us to the Export Land Model (ELM). The basic thesis expressed by students of the ELM is that, to fully appreciate the impact of Peak Oil, you cannot look only at the production declines so presciently anticipated by ML Hubbard in 1956. You also have to look at the rate of local consumption and the importance of that consumption on the ability of a country to export their oil. The ELM graph here looks at both sides of the equation, and the result as it applies to exports.

As you can see, for illustrative purposes the ELM assumes that, after a country's oil production hits peak it will decline at a rate 5% annually at the same time that local consumption increases by 2.5%. The red line then shows the impact those two metrics will have on the ability of the country to export its excess production. Using these assumptions, the ELM shows that exports reach zero in nine years.

Real world data shows that the metrics used in the ELM are quite conservative. The chart below plots the hypothetical ELM against the actual data from the United Kingdom and Indonesia. While the ELM forecast hypothesizes nine years between peak to the end of exports, Indonesia's exports ceased seven years after peak, and the UK's exports stopped just six years after peak.

The important take away here is not that the UK and Indonesia are no longer receiving the oil export income of the good old days -- that is entirely a localized concern. Rather it is that the global market is now deprived of those exports. Between UK and Indonesia alone, the change over the last decade alone amounts to a swing in the wrong direction of a total of 2 million barrels per day. And those are just two of a number of important countries that have swung from exporters to importers in recent years. ... In the case of China, they went from a net exporter in 1993 to importing 4 million barrels a day today ... with those imports projected to rise another 50% over the next 10 years.

This is what is creating so much international competition for the remaining supplies of oil. And why the trend for higher energy prices is so well entrenched. And if the ELM is right, things are about to get far worse ... far sooner than many people expect.

Midnight Oil

David Galland follows up the previous article by exploring further the implications of the so-called Export Land Model, which uses simple mathematics to show how fast a country can go from being a net oil exporter to an importer -- especially once production starts to decline. He adds a little politics to the mix, claiming that a country's leadership will go into some sort of panic mode when it suddenly has to start importing a commodity that it formerly exported. We do not find that convincing, but it is not necessary to the primary thesis.

We think part of what we are witnessing may involve this phenomenon: When you hit full capacity utilization in any capital-intensive industry, the pricing situation can change suddenly and dramatically. Producers who previously were happy to recover their variable production costs plus a small margin now have to cover those costs and the cost of adding additional capacity. Or pricing has to go high enough to suppress marginal demand if more capacity is not forthcoming. If the cost of adding capacity is small, the effect on pricing dynamics will be small, but not so if the cost is large. With oil, the cost of adding capacity keeps going up, at least when you smooth out the fluctuations around the trend, due to the depletion effect. The Peak Oil thesis is essentially that the cost of additional capacity -- overcoming built-in depletion plus adding some more -- has gotten large enough to bite. The transition from excess capacity to capacity-constrained could explain the move from $20 oil to $120 (or to $80, if you think there is some fluff in the price).

For a useful way to think about energy exports and prices, Dallas based geologist Jeffrey Brown points to the current situation with global rice supplies. Brown among others worked on the Export Land Model (ELM), a model that reflects the decline in oil exports as a result of Peak Oil.

As long as there are abundant local supplies of rice, countries are happy, eager in fact, to export excess production in order to generate foreign exchange. But as soon as local consumption exceeds locally available production, then all hell breaks loose and the next thing you know countries are banning exports, a move that has already been undertaken by Vietnam and a number of other countries.

In that scenario, price eventually no longer becomes a factor in the availability of the commodity. Vietnam, for example, is not going to let its people starve just because higher global prices would allow it to earn an extra $10 a bag of rice.

And so in the face of the prospect of any serious shortage of an important resource -- energy being maybe the most important -- export markets freeze up and the price begins to be set at the margin, literally based on a global competition for the dwindling supplies that manage to leak out around the edges. "People are crazy not to be focusing on the oil export situation," Dr. Brown told me.

Of course, the question of energy alternatives is a big topic and one which needs a far more extensive discussion than space allows for here. Will viable alternatives be developed to help mitigate a domino collapse of oil exports? Absolutely. Of those alternatives, nuclear, solar and heavy oil seem to hold the greatest promise. But the sheer scope of the problem -- with the world now consuming the energy equivalent of one billion barrels of oil every five days -- assures that we are probably decades away from a real solution.

In the words of Jeffrey Brown:
"If you look at the situation in terms of presidential terms, looking at fossil fuels plus nuclear the world burned through the equivalent of 10% of all oil ever consumed in Bush's first four-year term. And, in our model, we are going to burn 10% of all remaining conventional crude in the second four years of Bush's term.

"That is the equivalent of around 25 billion barrels a year. So that is 100 billion barrels every four years, and we have burned 1,000 billion barrels. It gets interesting when you consider that current estimates are that we have only got 1,000 billion barrels of conventional crude remaining. I think with natural gas liquids, we have got a little bit more. But of the conventional crude oil, we have got 1,000 billion remaining. Which then begs the question, how fast can we bring on the tar sands and everything else?"
Grasping for straws, I asked Jeff about an article I had read recently about the Bakken oil shale reserves around North Dakota. [See here.]

"They are talking about somewhere between 200 billion and 500 billion barrels in situ, but the USGS recently came out with a mean estimate of between 2.5 and 4.4 billion barrels recoverable, as an outer limit," he replied, before continuing. "In 1966, they said, if Lower 48 ultimately recoverable is 150 billion barrels, then the U.S. would peak in 1966. If the recoverable oil from the Lower 48 ultimately came in at 200 billion barrels, then the U.S. peak would come in 1971. The higher-end estimate probably turned out to more accurate, and the U.S. peaked in 1970. But the point is this: a one-third increase of estimated ultimate recoverable -- a total increase of 50 billion barrels -- postponed the peak by all of five years."

The trend for sustained higher energy prices appears solidly in motion. If Brown and the ELM are correct, energy prices will double then double again.

Even if he is wrong and prices do not rise geometrically, the global dogfight to replace declining supplies -- decidedly exacerbated by the loss of Mexican and maybe Russian exports in the near future -- is going to get ugly and expensive.

So, what is the investment angle? Paradoxically, the larger energy companies are probably a bad bet, because they are forced to replace their depleting reserves, which is getting harder and more expensive to do with each passing day.

This is a very different investment perspective on the majors than in the "Bye, Bubble" article above.

It is our contention that, because the solutions to the world's energy problems are going to involve a variety of energy sources and technologies, you have to build a portfolio that is equally varied. That assures you are well positioned to profit from the broader trend, while avoiding the risks of being overly exposed to a single sector. (As an example, solar has had a great run, but most solar plays are now overvalued.)

The good news is that there are no shortage of high quality energy-related investments available ... in coal, heavy oil, LNG, photovoltaics, natural gas consolidators, "run of river" hydroelectric, uranium and small to mid-cap oil companies with the potential for significant near-term gains in reserves or production.

In the final analysis, it comes down to two choices; you can either suffer the consequences of persistent higher energy prices, or use the work Jeffrey Brown has done with the Export Land Model as an early warning and get positioned to profit. The decision is yours, but do not wait long to make it.


Behind rising agricultural commodities prices and food prices on store shelves is the rising costs of energy needed to grow and deliver the stuff. Commodities analyst Kevin Kerr pays a visit to some farmers in the U.S. Midwest and observes the gap in understanding between food producers and consumers.

I know what is going on inside the heads of the farmers. This spring, I went to visit farms in the Midwest, as I do every year.

It was a Saturday in mid-April when I pulled up to the Miller Armstrong Building in the sleepy farm town of Waseca, Minnesota. Waseca is also home to a federal penitentiary and Jeff Skilling, former Enron CEO and allegedly one of the "smartest guys in the room." ... I drove into town and watched the cattle grazing outside the prison. I wondered for a moment if those cows knew they had a famous neighbor. They did not seem to care. The cows seemed more concerned about where to find some food. It was certainly foreshadowing what I was about to hear from the farmers.

I was greeted by my friend and Outstanding Investments subscriber Geb Singlestad. Geb escorted me to a casual meeting at the Armstrong hall building. Charlie Nedoss of Peak Trading and about 15 other farmers accompanied me. One reporter showed up. Everyone introduced themselves, and we all grabbed some coffee. I spoke with the reporter for a few minutes, and the meeting began.

The thing about small-town America is everyone is friendly, but cautious. Geb invited all these farmers to the meeting. ... The meeting was scheduled to last about 45 minutes, but once it got going, we covered so much ground and there were so many questions that we ended up being there for two and a half hours.

The questions came fast and furious. One farmer asked, "Do these people in Washington or in the cities know how much we are paying for our input costs? Do they have any clue how much the farmer is being squeezed?" The best question of all, in my opinion, was asked a few times. "What will it take? How high will prices have to go to get people to change?"

I said that I think prices will have to go much, much higher before urbanites even consider switching off "American Idol" and protesting in the street. The farmers realize that most people in the country have no idea about either the process or the cost of what it takes to get their dinner from field to fork. One farmer belted out, "As long as they have groceries on the shelves, lights on, the ATMs working and their jobs, then all is well. They don't have a clue."

There has always been a line between city and suburb dwellers and their rural counterparts. Most people in urban areas have little understanding of how much work goes into generating our food supply and then transporting it to each and every city. Just the volume of diesel fuel usage to grow the crops is astounding. Agriculture is a very fuel-intensive undertaking. With diesel prices topping $5 and rising, the costs continue to climb at the grocery store.

After our meeting with the farmers, Geb took Charlie and me to see the newest ethanol plant being built in Janesville, Minnesota. This new structure is a 110 million-gallon ethanol plant. It has several rail lines being built to run directly into the plant. The outside of the building itself is huge. The towering cranes were working full tilt while we were there, and the parking lot was full of workers' cars. The one thing that neither Charlie nor I saw was a water supply. An ethanol plant uses a huge amount of water, so where will it come from?

It seems with ethanol, as with so many things, the answer from the government often comes after a major project is already well under way. For the last eight years, the Bush administration has seemed to be more likely to do first and fix later. What is the old saying?: "Better to ask for forgiveness than permission."

Anyway, the ethanol plant has provided many good jobs in the area and is slated to produce a real boom for the local economy. That is all well and good, but is it sustainable?

With egg prices surging 26% and milk prices near record levels, consumers are making very difficult choices. My own aunt leaned into me at dinner recently and said, "Ya know, I bought a container of whipping cream and it was $7. That's crazy." Yes, it is crazy, and the even more insane thing is that prices may well have much further to go.

The farmers I met with are struggling with some of the highest input costs they have ever faced, and for some, it means that with all the massive expenses of running a farm, their margins are shrinking fast. Most of the farmers wondered what I think would happen if food stopped showing up on shelves in the city and the power went out and the ATMs shut down. You know what would happen? Panic.

The divide between the food source and the end-users is wide. As costs continue to skyrocket, we better begin to appreciate and support our farmers, because the long emergency is here and time is running out.

As I said my goodbyes to the farmers, Scott walked with me on his farm and showed me all his new farm equipment. One tractor, a John Deere, looked brand-new. He told me that Deere simply has no equipment in stock, because sales are so red-hot. He said it is much the same for Caterpillar and others. So even as the farmers complain about higher input costs and consumers in the cities complain about higher food costs, the beat goes on.

The solutions are not at all clear, but it is obvious that we need to begin to think locally. Food sources will need to be closer to the final consumers. The old way is simply not sustainable anymore.

In the brave new world, we will all likely have to become "locavores." A locavore is someone who eats food grown locally. That would be a major shift difficult for most of us to fathom. But like it or not, it is a change that is not going to be a choice. It will happen regardless of how much we fight it. Really, the question is how high of prices are we willing to pay in the meantime.

Agricultural Shortages

"Due to Peak Oil, the prices of agricultural commodities are going much higher," writes Kevin Kerr in another piece.

In my own portfolios, I have exposure to soybeans, wheat, and corn. I also think the soft commodities are much undervalued: coffee, cocoa, sugar, and cotton. These markets are also poised to move much higher ...

The planet is not running out of food, but it might be running out of cheap food. So stock up your pantry and start shopping for the kinds of investments that will prosper during the coming agriculture boom.


Stocks of machinery makers and grain processors have stumbled, setting in motion a chain of events that could bring down more farm-related stocks.

This is a technical piece of analysis which conceptually complements the preceding article. Much technical analysis is close to useless as far as we are concerned, but that does not mean you should ignore it. As a dear old broker friend used to say of chart watching, "It helps improve the hand-eye coordination."

The floods plaguing the Midwest and the crop-growing regions of the country are having widespread effects in the financial and commodity markets. They are also tipping the scales in the debate over ethanol and its value as an alternative energy source.

What we can deduce from the markets is that a chain of events has been set in motion that could derail leading agriculture sectors, knocking out one of the market's last remaining legs.

While corn accelerated its already steep rally last month, companies that use it as an input are naturally getting squeezed. One look at any of a dozen or so stocks classified as ethanol makers shows that trends in the sector have been down for one year if not two. In a similar vein, the same thing is happening with oil refining companies as these stocks are also in one-year down trends as crude oil soars to record highs. We can believe analysts when they tell us margins in these businesses are thin.

The market is telling us that ethanol is in trouble because nobody is making any money producing it. And if companies stop making it, then demand for corn will drop. That, in turn, reduces the need for new farm machinery, seeds and fertilizer.

To be sure, ethanol is but a part of the overall global demand for agricultural commodities. But as stocks in the agriculture businesses falter, we still get an idea that the current trends in both commodities and stocks are not sustainable, at least not at their current paces.

For example, farm machinery maker Agco (AG) has been in a rising trend for the past three years, just as we would expect for a stock in a global growth industry. However, since setting its high water mark of 71.95 in December, it has traded sideways in what appears to be a topping pattern (see chart). ...

Taking a few liberties with pattern construction, we can see a trading range between 51.50 and 71.95. However, it has been two months since the stock was able to trade near the top of this range while hovering just above the range bottom. This is a technical sign of weakness and portends a breakdown is coming.

Further, the on-balance volume study shows that money has been fleeing this stock all year. By keeping a running tab of volume on days when prices rise minus volume on days when prices fall we get an idea of whether bulls or bears are more aggressive. That, in turn, tells us which way money is flowing and for Agco that direction is negative. ... [T]he chart for peer Deere (DE) looks very similar, so a potential reversal of fortune is not just company specific.

Indeed. Another peer, irrigations systems maker Lindsay Manufacturing (LNN) reported lower than expected earnings June 19 and dropped 17%. It is now on the verge of confirming a massive "double top" pattern with a move below support at roughly 94.50 (see chart). ...

That what was once a book value bargain now sells at 38 times EPS after having quintupled in the last two years and change should give one pause enough.

So far, fertilizer stocks are still in rising trends. But if we look at food producers such as Archer Daniels Midland (ADM) we can see that the good times ended last month (see chart). The tumble has taken the stock to the bottom of a two-year range and technically that is a support level. But the point is that the bull market here has ended no matter what the world's demand for food products may be.

Maybe the bull market in feeding at the federal government trough is reaching its limits.

So, if producers of agricultural commodities have stumbled and some of their suppliers have stumbled, can the other suppliers be far behind? It is just a thought and I certainly will not fight the rising trends wherever they exist but the mantra of continually rising food prices that is currently in vogue may have a sizable flaw.


The folks at Elliott Wave International put Thursday's stock market in perspective, kind of.

The Dow Industrials lost more than 3% today [Thursday, June 26], so you can expect the financial news to trout out stuff like "low for 2008" and "prices decline to levels last seen in September 2006."

That much (and more) is true, but the stock market will have to fall a lot further to get close to a number that has been a lot more painful for a lot more people: $24,300. That is the dollar figure you get when you quantify the 11%+ decline in the median sales price of existing homes, since the peak in 2006 -- and that is using the data conservatively ($221,900 in 2006 vs. $197,600 through Q1 of 2008).

I have not seen this simple calculation appear anyplace. So, dear reader, humor the repetition: $24,300. Given the choice, I would take a 3% fall in the Dow any day of the week. While I am at it, how does that "tax rebate check" that most of us got last month look by comparison? Heck, does it make you feel better that the mighty Federal Reserve cut interest rates NINE TIMES in 2007-2008, because "tight credit conditions and the deepening housing contraction are likely to weigh on economic growth"? Take that to your friendly neighborhood lender and see if they will give you back any of the home equity you have lost since 2006.

If that does not work, maybe this will -- it is a quote from 2006 (February 15), from the central bank's chairman himself:

Our expectation is that the decline in activity or the slowing in activity will be moderate; that house prices will probably continue to rise but not at the pace that they had been rising. So we expect the housing market to cool but not to change very sharply.

In other words, "This was not supposed to happen." They expected your home price "to cool but not to change [by -$24,300]." Earlier this week, big-name economists were still publicly saying "we may be 2/3 of the way there" in the home price decline. It was not supposed to happen, and "the worst is over" with every new grim economic report. Just a moment ago, a colleague forwarded a Bloomberg article about today's stock decline, with the headline "U.S. Stocks Tumble, Sending Dow to Worst June Since Depression." The story quoted some fund manager who said, "The write-offs have been far worse than anyone would have imagined."

What a crock. Our books and monthly publications not only "imagined" what is unfolding now -- we warned subscribers EXPLICITLY of what was coming. ... I suggest that the worst will "be over" for individual investors only when they start to rely on independent sources of information ...


Goldman Sachs downgrades GM ... after it hits a 53 year low.

Elliott Wave International's Peter Kendall explains why Goldman was a little late on the draw.

Here is a story from [Friday's] New York Post:
GM Stock Crashes on Goldman Downgrade

Faced with a potential cash shortage, General Motors crashed yesterday to close at its lowest price since the dark days of 1974.

Shares had initially tumbled 12 percent intraday to a new trading low of $11.21 after Goldman Sachs downgraded the auto giant, warning investors to dump it because struggling GM is likely to go hat in hand to investors for more money.

The last time GM's stock was ever that low was in 1955. Humiliated GM now has a market value of $6.5 billion -- less than Bed, Bath and Beyond's $7.3 billion. GM closed at $11.43, off $1.38, or about 11 percent.

GM chief Rick Wagoner disputed analysts' predictions that GM would need to raise more capital by the end of the year. It had about $31 billion in cash and credit at the end of the last quarter but analysts say the pot could empty quickly.

"We have a lot of options to fund beyond that," said Wagoner without giving any details. Some investors believe sovereign funds might come to GM's rescue with new cash infusions.
Goldman Sachs downgrades GM to "sell" after a decline of 88% to a 53-year low! Why did they wait so long? It is just the Wall Street way. Here is how The Elliott Wave Financial Forecast explained this time-honored practice with charts GM and Ford in May 2003:
The Reason Analysts Strike Out

At Elliott Wave International, we don't get the markets right all the time, but consider the alternative, as shown in all its glory in the charts at right. In recent months, Wall Street research has become the object of close public scrutiny. "We have serious weaknesses in the research department," said one broker about his own firm in Monday's edition of The Wall Street Journal. Later that day, securities regulators unveiled details of an investigation that shows "the nation's top securities firms misled investors through overly optimistic research reports."

The chart of GM illustrates that ratings agencies, which have no inherent conflict, are just as bad. The real reason that brokerage firms ratings are so far behind the curve of the market is that they are based on corporate "fundamentals," which can be known only when the trend change is well past. The object of market analysis is to call the market, not corporate fortunes. Technicians do a better job of staying on top of a trend because they use signals that are derived from prices. The best tool for staying in front of the trend is the Wave Principle because it offers a basis for insight into the future form of price movement.
With the help of the Wave Principle, Elliott Wave International has long argued the case against GM and other U.S. automakers. Here is a glimpse of our long-term outlook from the May 2005 issue of EWFF:
The lowering of prices by up to $2000 on some of GM’s most popular SUVs in the middle of a model year is considered "highly unusual." It is still the early stage of a trend that will surely lead to the failure of at least one of the two remaining U.S. car companies.
GM is still in business, the long-term viability of all three U.S. car makers is in question, and a "shunning of SUVs" is one of the big reasons. In the wake of the 2000 peak [?], the July 2000 issue of EWFF identified a correlation between a fall in stock prices and a fall in the prestige of large cars. At that time, the correlation appeared as "a rising chorus of protest against SUVs." The latest sell-off (which began last October) brings a full-scale buyers strike that is so strong some dealers refuse SUVs as trade-ins.

If history is any guide, Goldman's downgrade simply acknowledges setbacks that are fully apparent in GM's stock price. What EWFF readers need to know is what the "news" tells us about future stock prices. Turns out, within the context of the Wave Principle, there is a critically important message behind Goldman's downgrade. This month's issue The Elliott Wave Financial Forecast explains.

The Post offers another clue to the direction of the overall stock market when it says GM may "go hat in hand to investors." This impulse is also covered in the Investor Psychology section of this month's letter.