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

W.I.L. Finance Digest :: June 2009, Part 3

This Week’s Entries :


Barron’s Roundtable panelists foretold the recent rally. Now they say the market has gotten ahead of itself. Their picks, pans – and sage advice: Stake a claim in gold.

In the January Barron’s Roundtable the panelists were pretty bullish, correctly it turned out. Now they are cautious across the board. It makes for the usual interesting reading.

It is a pandemic, all right – a pandemic of bullishness that is sweeping stock markets here and elsewhere around the world. The Standard & Poor’s 500, to take the example nearest to home, has rallied more than 41%, to 945, from its intraday low of 666 in March, in celebration of the fact that our financial system somehow survived the swinish behavior of the past six years. Asian markets have caught the bug, too, and are off to the races on hopes that a global economic recovery will spur demand for the stuff the region’s factories make. Commodities appear to be infected with a strain of the same ebullience; how else to explain why oil has more than doubled in price in the past four months, to $72 a barrel?

Even the members of the Barron’s Roundtable are not completely immune, although a round of phone calls to our distinguished panelists in the past two weeks confirms they have contracted a less virulent strain. Many predicted at our January 5 confab that the stock market, oversold and under-loved, was due for a major bounce. Now they think stock prices have overshot corporate fundamentals and a correction is in order, but it will not take the Dow Jones industrials, the S&P and other market measures back to the March lows. That is because the economy could get a much-needed boost in coming months from the massive fiscal and monetary stimulus unleashed to support it.

Down the road many of our 10 investment experts fear there will be a bitter price to pay for today’s spending, in the form of hyperinflation and a run on the dollar. Hence, their fondness for that great inflation hedge, gold. In the near term, alas, the only other corrective for the debt-fueled binge of the past decade would be a great cleansing of the economy and the markets, and that is not something politicians – or the folks who elect them – want to bear.

So, where does that leave us? With POSP, or plain-old stockpicking, as Mario Gabelli likes to call it. And in that, our panelists do not disappoint. The pages that follow are filled with their best investment ideas for the back half of 2009, including some energy and technology stocks, a few financial shares, several emerging-market funds and much, much more. You will also find a statistical update on their January picks, for which they should take a collective bow. For the details, please read on.

Fred Hickey

Barron’s: You really nailed it in January, Fred, when you predicted a 40%-50% rally like the “little bull market” that followed the Crash of 1929. Please tell us history will not keep rhyming.

Hickey: The parallels are eerie so far, but what happens next is complicated. The market has rallied about 40% off its lows, led by the riskiest stuff. A selloff is coming because the fundamentals do not match Wall Street’s perception. Retail sales were terrible in May; 2/3 of companies reporting came in below forecasts. The rebound in stocks has been based on inventory restocking, but end markets have not improved.

That is because consumers are afraid to spend.

The savings rate rose to 5.7% in May, a 14-year high. Gasoline is up in recent weeks by about 40 cents a gallon. People are losing their jobs. Housing prices have not stopped falling. Mortgage delinquencies and foreclosures are up. One of every 10 homeowners is in trouble. A year ago we were handing out $90 billion of rebate checks; that is over, too.

If things were to follow the “little bull market” pattern, stocks would fall to single-digit price/earnings multiples. That would mean 4,000 or 5,000 on the Dow, versus 8,800 now. But that will not happen. The variables are different today.

That’s a relief. Isn’t it?

In the 1930s the money supply was falling even as the Federal Reserve cut interest rates. Now not just the Fed but other central banks are pumping money into the system like madmen. China’s money supply has grown by 25%. The money is not going into the economy. It is going into asset prices. Oil has doubled from a $32-a-barrel intraday low. Copper is up 80%. Russian stocks have rallied 80%. The situation is reminiscent of the past 14 years, when the Fed primed the pump and created bubbles everywhere.

Recently there have been some signs the insanity might be ending: The dollar has fallen, and yields on U.S. Treasuries have risen dramatically. But to short assets in the next six months would be suicidal. I have not been short since October, even though the long-term direction is down. How much longer will the Chinese be willing to sit on $800 billion of Treasuries and $2 trillion of mostly dollar reserves and watch our currency drop and our government spend $2 for every $1 it takes in?

At the moment, the alternative might be worse.

Not printing money and letting the system cleanse itself would be very painful. It would mean a great recession – not something politicians like. Therefore, the discipline will have to come from an external source – the Chinese. Ultimately, the dollar will collapse and we will be forced to defend it, as happened in the 1930s. Or, we will have horrific inflation. But we have put off the day of reckoning.

In that case, tell us what to buy in the next six months.

Buy value, and protect yourself against the threat of the dollar’s collapse and the return of inflation. I have been riding the gold wave for a decade, and the major secular bull market in gold is not over. I am twice as adamant now as in January about the need to own gold. I continue to like the mining companies. The GDX, or Market Vectors Gold Miners ETF [exchange-traded fund], is a diversified fund of some 30 mining stocks. I still like Agnico-Eagle Mines, and bullion, which you can own through the GLD, or SPDR Gold Shares ETF. My favorite gold miner is Yamana Gold. It is based in Canada but operates in Brazil, Mexico and Chile. It trades on the New York Stock Exchange. It rallied to 11 a share from 4, but is down from a year-ago peak of 19, even though the price of gold has recovered to almost $1,000 an ounce. The P/E is reasonable. The company has new mines coming on, and it is benefiting from lower costs.

Which tech stocks do you like?

Microsoft is unloved at 22, because of competitive threats from Google and an antitrust problem with the European Union. It is the best play in the tech world right now. It trades for 12 times earnings, something you do not ever see. The catalyst for the stock is Microsoft’s best upgrade cycle ever. In the next 12 months the company will introduce about a dozen new products or upgrades. Windows 7 will ship on October 22. It will kick off an upgrade cycle for the whole computer industry.

The other safe way to play tech is Verizon Communications. It will offer the Palm Pre in about six months, and new Nokia phones, and probably the iPhone. Just as eyeballs excited everyone in 2000, earlobes should excite them today. Verizon has 87 million wireless-communications customers. It has the biggest network in the country, and the best. The company has mostly built out FiOS, its fiber-optic telecom service. It yields 6.3%. Microsoft and Verizon are a lot safer than trying to catch Apple [AAPL] at $150 a share.

Thanks for the update, Fred.

Mario Gabelli

Barron’s: How does the rest of the year look to you?

Gabelli: The U.S. consumer remains hamstrung by his balance sheet, the stock market and housing. He is 2/3 of the U.S. economy. About 11% of Americans are unemployed, going to 12% or 13%. The consumer sector is not providing the necessary ballast in the short term.

The economy is benefiting from the absence of a drag from inventory reduction. Once the stimulus package kicks in, the recovery will have legs. The remaining drags are oil is up to $71 a barrel, and interest rates are starting to rise because of the bond vigilantes. But, on balance, the economic stimulus is coordinated and global, and powerful. The U.S. economy will continue to improve in 2010, helped by an uptick in auto spending and improvements in housing and capital investment. Exports could improve as the dollar weakens. There is upside leverage in earnings, partly due to cost cuts. In January I said the stock market would end the year up zero to 5%, and I am sticking with that forecast.

We will not try to dissuade you.

The secular themes are the U.S. deleverages and transfers its wealth to China. As a result, the strong get stronger. That is true in the auto sector, where General Motors and Chrysler now will follow the Toyota model in supporting one strong dealer in a given market. As capital is reduced in the industry, the remaining, entrenched capital will produce above-average returns. Another example, in markets like Las Vegas, is Wynn Resorts, which delivers a quality product and has an OK balance sheet. It will gain a share of the upper-end customer.

Is that a recommendation or an observation?

It is a comment. You see it on Wall Street with the strength of Goldman Sachs and Morgan Stanley. In a flat stock market, the emphasis is on POSP, or plain-old stock picking. Other themes include eco-friendly energy, and more deal activity. The fifth wave of transactions is starting. Deals were done in the 1960s to offset economic cycles. In the 1980s it was to energize lazy assets. The 1990s had serial acquirers and technology mergers. More recently, private-equity deals dominated. This time, the impetus will be global growth. Companies will buy growth on Wall Street. NetApp and EMC are engaged in a bidding war for Data Domain. Pepsico is buying its major publicly traded bottlers.

So you are buying shares of takeover candidates?

In some cases. I still like the stocks I recommended in January. Among new names, Legg Mason sold its brokerage to Citigroup in 2005, and bought Citi’s money-management arm. Legg is selling at 24. There are 143 million shares outstanding, and the company has to issue another 23 million in connection with an equity instrument that matures in 2011. Assuming 166 million shares, the company has an enterprise value of $3.7 billion. It has about $2 billion of cash and $2 billion of debt.

CEO Mark Fetting is doing a terrific job of overseeing the different businesses, which include Legg Mason Capital Management, run by Bill Miller, and other fund groups run by Chuck Royce, Buzz Zaino, Whitney George and others. The biggest, based on assets under management, is Western Asset Management, the fixed-income specialist. The businesses have benefited from coordinated marketing.

What is the outlook for earnings?

EBITDA [earnings before interest, taxes, depreciation and amortization] will be $800 million to $1 billion in three or four years. Legg could earn 80 cents for the year ending March 2010 and $2 the following year. You have focused management, an improved balance sheet, the elimination of problems that were bogging the company down, and products that could enjoy significant growth. You could get a double in the stock.

I recommended O’Reilly Automotive, an auto-parts retailer, in January, and nothing has changed except the stock, which is up to around 37.50 from 31. The integration of CSK Auto, which it bought last year, is going well. In real estate, O’Reilly is getting better locations at more reasonable prices, to buy or lease. The company could earn $2 a share this year. There are 250 million cars on the road. The guy who owns a 14-year-old car trades it for a 9-year-old car, and that guy trades his car for a 6-year-old car. That is good for O’Reilly, the leader in the business.

How about another idea?

Sumner Redstone controls Viacom through the A shares, which we own. We also own the B shares, which are more liquid but have fewer votes. There are 610 million shares, and the B shares trade for 23. I have been following this company for 36 years. Sumner took control in the mid-1980s. Viacom owns cable networks such as MTV, and Paramount Pictures. Today there are seven or eight motion-picture studios. A round of consolidation will occur in the next six to 12 months because of the costs of financing, prints and advertising, the benefits of globalization and such. We hear talk of something going on. Paramount will merge with someone – maybe Sony Pictures or Universal Studios. This year Viacom could earn about $2 a share, going to $2.40 next year. It could be a 20% grower for three or four years. It sells for 6.5 times EBITDA, and capital spending is de minimis. The company is a terrific cash generator and the balance sheet will improve. They might buy back stock.

Next, U.S. Cellular has 87 million shares, and 71 million are owned by Telephone & Data Systems [TDS]. U.S. Cellular has 6.2 million wireless customers, in contrast with Verizon and AT&T, which have 80 million-plus each. Sprint Nextel has about 50 million, and T-Mobile 30 million. A next-generation technology is LTE, or long-term evolution. Smaller companies like U.S. Cellular have to take advantage of it or sell out. U.S. Cellular will earn $2.50 a share in 2009 and grow by 15% a year for the next three or four years. It has a hidden asset in that margins are well below the industry average. Capital spending is flattening, and the balance sheet is in good shape. The stock is 43, and the value of the company is close to $100 a share. TDS elected two directors that we proposed.

So you could influence the sale of U.S. Cellular?

The Carlson family has been running TDS for almost 30 years. They have a strong economic interest, but an even bigger voting interest. There was speculation that U.S. Cellular had a buyer a year ago, but the company still does not acknowledge that. At some point Telephone & Data will have to harvest this asset.

Thank you, Mario.

Felix Zulauf

Barron’s: What is the view from Europe, Felix?

Zulauf: The structural forces in the global economy are unchanged from the past few quarters. A long-term imbalance remains between overspending in the U.S. and over-producing in China. The financial crisis was the start of a move to greater balance that implies lower growth for both sides. The deleveraging process also continues in many economies, with the exception of the U.K.. This process has only started. It will run for several years. We are shifting debt from the private sector to the government sector, which will lever up. These structural forces will continue to be a major restrictive factor in the world economy. In the cyclical arena, things look a little better, but not as good as you might think from the media reports.

So, fewer green shoots?

The green shoots are primarily the result of inventory restocking. Inventories have been cut around the world, and in Asia they have been cut to the bone. Now production is ramping up to get in line with demand. Inventories are being restocked in many industries. The process is far along in technology, but way behind in capital goods. The U.S. economy will look a little better in the next two to three quarters, due to inventory restocking and fiscal stimulus. But the improvement will not continue after mid-2010, when the economy turns bumpy again.

In Europe, Germany has structural problems, but virtually no cyclical imbalances. It is 1/3 of the European economy. The weaker parts of the Eurozone – Portugal, Ireland, Greece and Spain – are trapped in a euro-denominated system and should devalue their currencies to help their economies. They cannot, and therefore will deflate. They will be the poor guys for the next 12 months. The U.K. has not even started to adjust. Consumers there continue to borrow and spend. In the next year they will go through the same thing U.S. consumers have gone through.

What about Asia?

Asia is the major beneficiary of the inventory-restocking cycle here. It will have the best production numbers, much as it had the worst declines before. The pick-up will run into the middle of next year. China is the big exception. It decided to breach the global economic slump by subsidizing production and employment. It is playing a dangerous game.

The real danger comes from mid-2010 through 2011. This will not be a conventional business-cycle expansion, but a bumpy road. The economy will look like a square-root sign followed by corrugated sheet iron. The good news is the potential collapse of the system has been avoided. It was an open question for a while.

What does a corrugated-sheet-iron economy mean for the markets?

Governments and central banks will continue to support the economy. Short-term interest rates will stay low. Government-bond yields are rising for cyclical reasons. Around the start of this year, 10-year Treasuries were yielding 2.25%. Now yields have risen to 3.94% and could go to 4.5%. They will not go beyond that because the economy will not be robust. The bond market is normalizing after the threat of systemic collapse. Bonds are not attractive.

Investors are underinvested in equities. Money-market funds are bigger than ever when expressed as a percentage of global equity capitalization. That money is yielding virtually nothing, and a lot of it is in the hands of professional portfolio managers who have to perform. Eventually it will get redeployed into equities, which means economic and market developments for a time will move far apart. The market undershot into March, and will probably overshoot in the first half of next year. The first rally is just about done. The market might climb into July, but it will correct in the fall, with stocks retracing maybe 50% of the recent advance. That will provide an opportunity to buy for a rally next spring or summer. That is the whole mini-bull market. Economic conditions will not support more than that.

Are you still looking for a low in 2011 or 2012?

Yes. We will enter another bear-market cycle. I do not know how low it will go. In March the market made a cyclical low in valuation, but it was not a secular low. When the market makes a secular low, lack of interest in equities will be high.

Previously I advised buying financials and metals. Now the financials are done, perhaps for a couple of years. Bank balance sheets are not repaired. It is just camouflage. Today I like emerging markets and natural resources – after a correction of 15%. Investors believe in the long-term prospects for emerging markets, due to demographics and structural issues. That is where the money will go that is on the sidelines. Among ETFs I like the iShares MSCI Emerging Markets Index, the iShares MSCI Hong Kong Index and the iShares MSCI Singapore Index. In energy I like the SPDR S&P Metals and Mining Index, and in oil services, the Oil Services HOLDRs and the Energy Select Sector SPDR. Again, buy on corrections. Also, you have to own gold because governments have no solution but to reflate. Currencies will be debased, and gold will go higher. But do not buy bullion until it drops to around $850 an ounce. It is $950 now.

Thanks, Felix.

Oscar Schafer

Barron’s: What do you make of this market, Oscar?

Schafer: I am surprised the S&P 500 is up 40% from its March low, because the companies we speak to have seen their business go down and stay down. In many cases, April was even worse than March. In addition, there has been a huge increase in bond issuance. The government has done a great job of liquefying the system, but that has not led to a lot of lending.

How, then, do you explain such a powerful rally?

We have removed a depression risk and are dealing with a recession. A huge amount of money on the sidelines has gone into stocks and other assets. Many people think the stock market is a discounting mechanism, and the recovery in the economy will be like past recoveries. But I do not see it, given the leverage around the world and continued declines in home prices in the U.S. and other developed nations. You could make a bullish case for 1% to 1.5% growth and 3% or 4% inflation, but that may not justify a 40% increase in stock prices.

So you are expecting a correction?

There may be a setback as interest rates rise and housing refinancings slow. The maximum impact of tax rebates probably has been seen. The economy will grow slower than anticipated, which will surprise people, and therefore the discounting-mechanism aspect of the stock market will have to be rethought.

Nevertheless, we still find good ideas on the long and short sides of the market. Whereas [veteran hedge-fund managers] George Noble, Art Samberg and Jim Pallotta are leaving the business, I am just beginning to enjoy it.

Glad to hear that. What are you finding?

Metavante Technologies recently announced it will be acquired by a larger competitor, Fidelity National Information Services, in an all-stock deal. The combined company will trade as Fidelity Information Services. It will have a pro forma market capitalization of $7.5 billion and will be the largest provider of transaction and processing services to financial institutions.

The transaction preempts industry and customer consolidation and could generate significant shareholder returns. Management expects to realize about $260 million in annual synergies, creating $1.7 billion in shareholder value. The transaction also will allow both companies to cross-sell to each other’s customers. The combined company is in a much better position to take advantage of secular growth trends in process-outsourcing by banks, as well as the global shift to card-based payments from cash.

Just to clarify, you are buying the combined company through Metavante, the seller, not FIS, the buyer.

Yes. One share of Metavante trades as if it is 1.34 shares of Fidelity. After the transaction, the combined company should trade higher. The new FIS could trade for more than the current seven times EBITDA and command a higher free-cash-flow yield than today’s 11%. Historically, payment processors have traded for 18 to 22 times free cash flow. 86% of Fidelity’s revenue is contractual and recurring and should grow by 6% to 8% a year. You are also getting a free call option on an eventual sale to a large software provider such as IBM, Oracle or Hewlett-Packard.

How about another idea?

Plum Creek Timber is overpriced. This REIT [real-estate investment trust] is the largest private owner of timberland in the U.S., with about 7.4 million acres in 19 states. The stock is trading for around 30 times consensus 2010 earnings estimates, and nearly 20 times estimated Ebitda.

At 35 a share, the market is valuing Plum Creek at more than $1,100 per acre. The company has tremendous assets and a high-quality management team, but investors are mispricing timberland as an asset class and Plum Creek as a stock. Our target price is $10 to $15 per share, or $600 an acre. Investors have bid up timberland prices to irrational levels. In the past decade pension funds and endowments flooded into this very small market as they sought to be like Harvard and Yale, early and successful investors in timber. Accordingly, timberland values have doubled in five years and nearly tripled in 10. Buyers are getting a long-term, illiquid asset at a 2% yield, with the hope that some land will be more valuable to a real-estate developer down the road.

It could be long road.

Timber has a seductive investment pitch. It grows organically. It grows while you sleep. It is an inflation hedge, and it is uncorrelated with other asset classes. The reality is the underlying cash flow is highly dependent on cyclical industries like housing, paper and newspapers. It is also tough to hedge inflation when you are a buying at an inflated price. This is the greater-fool theory at work.

Historical returns are excellent, however.

Timberland returned 18.5% in 2007 and 9.5% in 2008, when other asset classes were down more than 40%. When investors attempt to monetize the great returns they saw on their statements, it will create a race to the exits. Plum Creek has done a phenomenal job of recognizing and taking advantage of this asset bubble. It has been a net seller of timberland for the past three years. But the company’s earnings quality is low, and its capital-allocation policy is aggressive.

How so?

The core business of harvesting timber has been operating at break-even levels, while all the free cash flow is generated by selling assets. Liquidating your productive asset is not a sustainable strategy. Many Wall Street analysts ignore the fact that timberland sales run through the income statement while timberland purchases run through the cash-flow statement.

If you put a 10 to 15 multiple on mid-cycle cash flow of 65 cents a share, you are looking at single-digit equity valuations. It would take unprecedented demand from real-estate developers to make up the difference. In six of the past seven years, Plum Creek paid out more cash in dividends and share buybacks than it has generated. Management achieved this in part by adding leverage. This is not a sustainable strategy, either.

Thank you, Oscar.

Scott Black

Barron’s: What is ahead, Scott?

Black: The S&P 500 is trading for about 940. Analysts expect it to earn $54 this year. Strategists are using $43. On a bottom-up basis the market trades for 17.5 times earnings; top-down, it trades for 22 times. Either way, it is pretty expensive. Investors are chasing any glimmer of hope, such as fewer jobs lost in May, even though the unemployment rate climbed to 9.4%. There was a lot of cash on the sidelines. The train started pulling out of the station in April, and a lot of people missed the passenger cars, so they jumped on the caboose.

Are they about to fall off?

The market is ripe for a pullback, though it will not retest the 666 low. We screen 11,000 U.S. equities. With the exception of special situations, the market is picked over. The economy has not bottomed. Most of the $787 billion in stimulus money went to transfer payments and tax rebates, and has not found its way into job creation. The savings rate has climbed to about 5.7%. That is good for America in the long term, but not in the short.

On the positive side, Fed Chairman Ben Bernanke has done a good job. He got the federal-funds rate down to 25 basis points [a fourth of a percentage point]. He is probably the most valuable player on the American executive team. Public policy under the Bush and Obama administrations is not good. The money should have gone to restructure the mortgages of people underwater on their homes – 21.8% of the nation’s 93 million homeowners. Instead the government threw too many freebies to AIG [American International Group], Goldman Sachs and such. It had no business saving AIG. It should have isolated the toxic assets and put them in a Resolution Trust-type entity.

What is done is done. Let’s look ahead.

The economy will recover in the 4th quarter because there has been so much fiscal and monetary stimulus. But the recovery will not be strong because of our structural problems. Given the unfunded liabilities of Medicaid and Medicare, and ongoing deficits, the U.S. is going broke. In the short term I am not worried about inflation. Nor do I see a run on the dollar because it is still the reserve currency for the world. There will be a run on the dollar in the long term, however, if we keep printing money. The Fed has expanded its balance sheet to $2.12 trillion of obligations, up from $930 billion a year ago.

It had to rescue the patient.

The patient was on life support last fall. The Fed and Treasury have done a good job of restoring confidence to the markets.

I have got two stocks, both dividend-oriented, because you ought to have some protection if the market pulls back. Boardwalk Pipeline Partners is about 73%-owned by Loews Corp. [L], which is controlled by the Tisch family. It sells for about 21, there are 177.8 million shares outstanding, and the market cap is $3.77 billion.

Isn’t this a master limited partnership?

Exactly. It pays a dividend of $1.94 a share and yields about 9.2%. Historically, MLPs have yielded about three percentage points above the 10-year Treasury yield, which is now 3.94%. Book value, excluding goodwill, is $17.12. The stock sells for 1.2 times tangible book, which is not expensive. The company has all new plant and equipment. It operates three major pipelines running more than 14,200 miles in the Southwest and Southeast.

My earnings forecast is lower than the Street’s. Revenue will rise 20% this year, to $942 million. Margins of 35.2% get you to $332 million in operating income. Interest expense is $137 million, and profit before taxes, $195 million. Earnings, fully diluted, will be $1.10 a share. The debt-coverage ratio is excellent at about 3.9 times. In the past few years revenue has grown by 11.9%, compounded, while the dividend has risen about 10.5% a year. Plus, Boardwalk has good bank lines of credit.

What sort of return are you expecting?

The stock could rally to 28. That is 33% appreciation plus a 9% yield – or an expected total return of 42%.

My next pick is Cal-Maine Foods. The stock is 24.81, there are 23.8 million shares and the market cap is about $590 million. Cal-Maine is the #1 egg producer in the U.S., with a 15.8% market share. In the May 2008 fiscal year, it sold about 678 million dozen eggs – 535 million dozen were produced in-house. They have 22 million hens, whose laying life cycle is about two years. The stock fluctuates with the price of feed – corn. In the past year it has been as high as 48.80 and as low as 17. Earnings fluctuate, too. The company earned $6.40 a share in fiscal 2008, and we estimate they did $4.15 in fiscal 2009.

Take us through your model.

I see revenue of $1 billion in the coming year, up about 4%. Gross margins are 27.5%, or $275 million, and SG&A [selling, general and administrative expenses] is $95 million. The net debt-to-equity ratio is only 16% and interest expense is $6 million. Add it up and you get pretax profits of $174 million. Taxed at 35%, that is net income of $114 million, or $4.80 a share. The stock sells for 5.2 times earnings. That is ridiculous. Return on equity is 31%, and they will generate about $120 million in free cash. The company pays out 1/3 of income as dividends. The current dividend is $1.72, the yield, 7%.

About 85% of Cal-Maine’s customers are retailers; the biggest is Wal-Mart Stores. If Cal-Maine earns $4.80 a share in fiscal 2010 and trades for just eight times earnings, you have got a $38.50 stock, plus the yield.

You have been a buyer of energy and financial stocks. What is the outlook for both?

In energy, you have to separate oil from natural gas. There are so many gas-producing shale plays in the U.S. that we have a gas glut here. Gas is about $3.70 per million BTU and has not rallied with oil. I do not expect gas prices to spike, but XTO Energy [XTO] recently noted the forward strip [forward price curve] is north of $6 for next year and $7 two years out on expectations the economy will revive. When that happens, oil supplies will tighten. Crude could trade above $100 a barrel in 12 months, versus $71 now. It is better to own pure energy-and-production companies such as XTO, Whiting Petroleum [WLL] and Apache [APA] than the Exxon Mobils of the world, which have refining assets. We own offshore drillers such as Diamond Offshore [DO], Atwood Oceanics [ATW] and Ensco International [ESV].

In financials, regional banks have run up. Most are selling at or near book value and are under-reserved. They own lots of residential mortgages and the housing market is getting worse. A few look attractive, such as Prosperity Bancshares [PRSP] in Houston and Bank of the Ozarks [OZRK] in Arkansas. The earnings power of the bigger banks was based for a long time on proprietary trading. With less leverage and deal activity, earnings power will be diminished. Also, many super-regionals are under-reserved. That tells me S&P 500 earnings are overstated.

Thank you, Scott.

Abby Joseph Cohen

Barron’s: The S&P 500 has hit Goldman Sachs’ year-end target of 940 with seven months to spare. Now what?

Cohen: The concept of fair value can change based on assumptions about the market’s fundamentals. In January, even with a gloomy outlook for the economy and corporate profits, stocks were too cheap. In March, using an economic and profit forecast not too different from January’s, our models suggested the S&P was undervalued by 40% or more.

At this point people should stop worrying about what letter of the alphabet the recovery resembles. Is it going to be a V-shaped recovery, or U-shaped, or the dreaded W? The pattern to think about is a staircase. When you look at the recovery phases from real bear markets – those associated with real recessions – they look like a staircase. First there is an upward step, a sigh-of-relief rally, which we have just had. Then you are stuck on the step awhile. Think of these steps as trading ranges.

You can also fall down the stairs.

The likelihood of that happening has declined as the possibility recedes of the system going down a “black hole.” Both the actions taken by the Federal Reserve and the stimulus package have gained traction. Also, market volatility has declined. Investors feel more comfortable. Equity issuance is up dramatically, as well, and demand is good.

In November, December and January, almost all the issuance in the fixed-income market had some sort of federal-government guarantee. In the past few months there has been a significant increase in issuance by entities without guarantees. Yield spreads have declined from record levels, another sign of diminished anxiety. At the turn of the year Treasuries and gold were viewed as the only safe havens. As nervousness recedes, investors have come back into equities and commodities, and out of Treasuries.

What is fair value for the S&P 500 now?

Our economics department is forecasting a sluggish recovery in GDP. It will turn positive in the third quarter but grow by only 1% or 2%. Given lackluster profit expectations, our six-to-12-month S&P outlook is 950 to 1,050. Goldman is forecasting S&P 500 earnings before provisions of $63 in 2009 and $71 in 2010. Regardless of the number, there is a discontinuity in the data. Some S&P 500 companies have disappeared, and recent quarters have seen extraordinary write-offs. There will be a major inflection point for earnings in the third or fourth quarter. Our analysts believe risk may be to the upside – that is, profits may grow faster than previously forecast.

Are you upbeat about the bond market, too?

The picture is mixed. In the past two years the normal relationships between issuers of different quality were torn asunder. Between 2004 and 2007, lower-quality issuers were able to borrow money for not much more than higher-quality issuers, and it was not just in corporates. Last year the relationships flipped, and yield spreads over Treasuries widened to unprecedented levels in low-quality corporates and municipal bonds. Recently there has been a move toward more normalcy. Corporate bonds are still appealing, but are no longer as attractive as they were early in the year, as they have had good returns, and Treasury yields no longer look so low.

How about some investment ideas for the second half?

Our energy team recently raised its price forecasts for crude oil and other energy commodities. This lifted the earnings prospects for integrated oil and refining companies. Crude is expected to reach $80 per barrel next year and $100 in 2011 due to demand recovery in the face of non-OPEC supply contraction. Hess benefits from the rise in prices and its ability to deliver growth in production while others are supply-constrained. The shares are down about 50% from year-ago levels. This year the company could earn $1.03 a share. Next year earnings could surge to $5.30, suggesting a P/E ratio of about 11 at current prices.

Lenovo Group [992.Hong Kong], known for personal computers including the Thinkpad, originally an IBM product, is expected to benefit from recovering global demand. Lenovo’s market share is about 27% in China, where growth is expected to rebound due to economic stimulus, demand for 3G netbooks and subsidy programs. Our analysts expect a global PC-upgrade cycle in 2010, bolstered by aging corporate PCs and Microsoft’s introduction of Windows 7. Lenovo had large losses early this year and has restructured. It could break even in fiscal 2010, which began in March, and earn three cents in fiscal 2011. The P/E is about 13. The stock has doubled since March to 3.02 Hong Kong dollars, but is 45% below year-ago levels.

Thank you, Abby.

Bill Gross

Barron’s: Treasuries have entered a bear market and other bonds look rich. What is an investor to do?

Gross: Treasuries offer paltry returns relative not only to other types of bonds, but also other asset categories such as stocks, commodities or real estate. The 10-year is yielding 3.88%, and even the 30-year bond, at 4.68%, does not offer much relative to the potential for greater inflation in 2012, ‘13 and ‘14. Treasuries have had an enormous problem this year in terms of supply: There will be $3 trillion of gross issuance and $2 trillion of net issuance, four times last year’s number. That is one reason yields have gone up.

Did the government have a choice but to issue this debt?

None at all. But the danger in injecting so much money to support the financial system is that the hangover, when it comes, could be worse than the original problem. The Fed is buying $400 billion of Treasuries. That leaves $1.6 trillion of the net $2 trillion to be purchased by you, me and the Chinese.

Agency mortgages have done so well since January that they do not make much sense, either. They yield around 4.50%. High-yield bonds, corporate bonds and even municipals and TIPS [Treasury inflation-protected securities] have some attraction, but they too have done well in the past five months.

Where does that leave you?

The one area that remains attractive is the hybrid-preferred market. These are similar to TARP preferreds – bank preferred stock the government bought with TARP [Troubled Asset Relief Program] money. The hybrids were issued to the public; they are really subordinated debt.

I like a Citigroup issue with an 8.3% coupon and a maturity of Dec. 21, 2057. The catch is that Citi plans to redeem it in two to three weeks with common stock priced at $3.35 a share. The offer has been outstanding for maybe two months, but the conversion is shifting into high gear. This is more of a stock play than a bond play. It is an arbitrage play. There is 15% appreciation potential relative to the current price of the common stock, which trades around 3.44.

What others appeal to you?

Barclays has an attractive subordinated preferred with a 14% coupon and a 2049 maturity. It can be bought around 110, so the current yield is 13%. We have been buying it recently. That is an excellent yield for an A-rated security. So, yes, there are sporadic values, but high-yield and corporate bonds in general, and Treasuries and even mortgage securities, are mediocre investments at the moment. An investor probably should expect 4% to 5% to 6% returns from the genre – nothing super.

Thank you.

Archie MacAllaster

Barron’s: Your usual optimism has paid off, Archie, at least since March. Are you still finding what to buy?

MacAllaster: The market was cheap in January, and it is almost the same price now. This is the worst market I have seen in more than 50 years in the business. But a lot of stocks are near a bottom based on multiples of future earnings. Some companies have even started to raise dividends instead of cutting them. The savings rate in the U.S. has risen. A lot of money was extracted from the market as people started losing much of their net worth, so there is a lot available to come back in. What we do not know is how big the deficit will grow, and what kinds of problems that poses for the economy, the dollar and the world itself.

Most people will disagree with me about the financials, but they still are cheap. You will do well if you can hang on for two or three years. Bank of America [BAC] trades for 12 a share. The 12-month range is 2.50 to 39.50. The bank earned 44 cents a share in the first quarter and probably will not do more than a dollar for the year. The dividend was cut to four cents from $2.56. Bank of America has the largest deposit base of any bank in America: more than 10% of all deposits. It used to make more than $4 a share and sell for 52 to 53, and yield 5%. The whole banking business will have to be run on a different basis, and relative to three or four years ago, Bank of America will be overcapitalized. In two or three years it will earn three bucks a share, and sell around 30. It might pay a dividend of $1.50 a share.

Are you a fan of the CEO, Ken Lewis?

They would be crazy to fire him. The company will have an enormous earnings base, including Countrywide Financial and Merrill Lynch. Bank of America is a good speculation.

My second pick is Protective Life [PL]. It has been around at least 100 years. Like other life insurers, it has had problems with its investments; book value was cut in half in the past 18 months. The company sold 13.5 million shares at 9 apiece last month, raising about $120 million of new capital. There are 85 million shares outstanding. In the past five years earnings have varied between $3.37 a share and $4.05. Last year they showed a net loss due to the revaluation of investments, but operating earnings were $3.37 a share. This year the estimate is about three bucks – the worst operating results in six years. The company cut its dividend but still pays 12 cents per quarter. The yield is around 4%. The stock trades for about 12.50. That is four to five times earnings, and around book value. In two to three years the stock could be 30 a share.

Financial stocks have had a pretty good rebound, but insurance companies such as Lincoln National [LNC], Hartford Financial Services [HIG] and Protective Life are cheap. If the stock market gets a lot weaker they will have trouble, but they are selling around book value, compared with a traditional valuation of closer to two times book. The other banks I like are Wells Fargo and JPMorgan. The big banks will be more heavily capitalized, and make a smaller return on capital, but the returns will be decent.

Thanks, Archie.

Marc Faber

Barron’s: What a rally, Marc. Are stocks due for a rest?

Faber: The S&P 500 has risen more than 40% from its March 6 low of 666. It could correct soon, maybe from higher levels. If it rallies to 1,000-1,050 by July, that could be the high for the year because the index is not inexpensive. But we do not see new lows. The 666 low is likely to hold, as is the November 21, 2008, low of 741. The market will not fall below 800 for the time being.

It is hard to know what happens in the next year because so much economic and financial volatility has been created by huge fiscal deficits and expansionary monetary policies. Governments can support economic activity through fiscal deficits. What concerns me down the line is the likelihood of much greater inflation because of all this stimulus. At some point the Federal Reserve will have to increase interest rates to combat inflation, and it will be very reluctant to do so.

But that is not today’s problem.

Today the economy looks to be stabilizing after falling off a cliff. It probably troughed in February or March. Replacement demand is kicking in, but we will not return to the peak activity of 2006 any time soon.

If things deteriorate, the Fed will print more money. Mr. Bernanke talked a few years ago about dropping dollars from helicopters to stimulate the economy. It would be wrong not to take this statement seriously because that is the thinking among policymakers in the U.S. It is a disastrous policy but it can really make stocks go up – commodities, too. Since the lows in December, oil is up more than 100%. A lot of liquidity has flowed into commodities, which is a sign investors are concerned about the value of paper money.

Emerging markets have been especially strong. Are the gains justified?

The opportunities are far better than in the U.S. When hedge funds and funds of funds had massive liquidations last fall, Asian markets such as Taiwan, South Korea and Japan fell to generational lows. Investors should use setbacks in these markets to accumulate shares. Many stocks are yielding between 6% and 10%. Secondly, the world is undergoing a major shift in consumption. In March car sales in emerging economies began to exceed those in developed countries. China, Brazil and India have become important simply because of the size and growth of their populations.

There has been renewed interest in asset plays of all types. Stocks like Newmont Mining and Freeport-McMoRan Copper & Gold have soared. Along the same lines, there is renewed interest in Asian real estate, which is not expensive. Prices are lower than they were in 1997. I like Asian REITs [real-estate investment trusts] such as Parkway Life in Singapore [REIT.Singapore] and ARA Asset Management [ARA.Singapore], a Singapore property-management company. Hong Kong and Singapore will benefit from greater regulation of the financial markets in the U.S. and Europe. Also, the U.S. has large and highly sophisticated military installations in Singapore, and it does not want to antagonize Singapore.

That should bode well for Singapore-based companies.

Demand for water is a big theme in Asia. Singapore’s Hyflux Water Trust [HYFT.Singapore] pays out income earned from operating water-treatment plants. Education is a growth industry, as well, and Raffles Education [LS.Singapore] should benefit. Also in Singapore, I like Kingsmen Creatives [KMEN.Singapore], a marketing and communications-design company. In Thailand I like MCOT [MCOT.Thailand], a media conglomerate, and Dynasty Ceramic [DCC.Thailand], which makes floor tile, as well as two airline-related companies – Airports of Thailand [OT.Thailand] and Thai Airways International [THAI.Thailand]. In Japan I like Mitsubishi UFJ Financial [MTU] and the iShares MSCI Japan fund [EWJ].

You have been a big fan of resource companies. Are you still?

Mining companies such as Switzerland’s Xstrata [XTA.Switzerland] are good trades. The company got hit hard last year because it operates on leverage, but the concern was overblown. I like NovaGold Resources [NG]. Barrick Gold tried to buy them for about $15 a share a year ago. There was no deal and NovaGold fell below 2, although it has rebounded to 5.50. NovaGold has enlarged its asset base significantly. Today it is even more valuable than $15. Natural gas is a buy here. It is extremely depressed and at a record low compared to oil.

I would short U.S. Treasury bonds when the yield declines to 2.8% to 3% on 10-year notes.

Thank you, Marc.

Meryl Witmer

Barron’s: Is this still a good market for stock-pickers?

Witmer: I see some stocks to short, and some decent longs, but a lot of our focus has been in the debt arena recently. The stock market seems about right, but you have to be prepared to buy on the downdrafts and sell on those days when the market goes up dramatically. The volatility is being driven somewhat by the popularity of leveraged exchange-traded funds. On the economy, I spoke with a CEO who met recently with a large group of CEOs. The consensus among this group was that things have stopped going down, but growth is questionable.

The stock market’s behavior is suggesting otherwise.

The market went down too much, and now it has retraced much of the downdraft since the beginning of the year. We like Microsoft at 22 a share. The obvious reasons to buy it are its bulletproof balance sheet and lots of earnings. It could have $3 a share of net cash as of June 30, the end of its fiscal year, and earn $1.71. The Street estimates earnings of $1.90 in fiscal 2010. Net of cash, it is trading at 10 times earnings. It is very inexpensive. Three things have gotten my attention beyond the P/E and the cash. Microsoft is in front of a product cycle in its client division, which sells personal-computer operating systems. Microsoft is coming out with Windows 7 for the 2009 holiday season. Win 7, as they call it, has gotten great reviews, and the company has bent over backward to damp expectations about upgrade revenue. It could surprise on the upside, as corporations did not upgrade en masse to Vista, the prior operating system.

Rumor has it Win 7 is better than Vista.

It is much better. It does not take a lot of memory, and can go on an inexpensive PC. Microsoft probably will stop supporting the Windows XP operating system within six months of the release of Win 7, which encourages upgrades at many companies. Second, Microsoft, was never known to focus on costs, but now it has a laser-like focus. This may lead to upside surprises in earnings, return on capital and employee productivity. As further evidence of its newfound respect for capital, it held back on rebidding for Yahoo!.

Any chance it will try again, now that Yahoo! is cheaper?

It does not have to, because of the third thing that excites us: a new search engine, Bing. The look is clearer than Google, and you can preview search results by hovering your cursor over the link. It saves you from clicking pages and waiting for them to load. Most important, shopping on Bing is great because of a cash-back rewards program. Rewards tend to run from 5% to 10% of the purchase price of an item, and you get Bing cash, which you can use on many sites. The early results are good; Bing’s market share is up to 11% just five days after the launch.

Figure Microsoft earns an adjusted $2.05 a share in fiscal 2010. Unlike Google, it expenses options, so the earnings are real. Say it deserves to trade at 13 times earnings. Add back the $3 in cash, and a dollar or two for the Xbox division, and you get a target price of 31. There is further upside if Bing gains momentum. You could make 40% or more.

That’s sweet. Thank you, Meryl.


Mike “Mish” Shedlock and Robert Prechtor of Elliott Wave fame are today’s most visible proponents of the deflation thesis, which is that today’s credit contraction will eventually result in an unstoppable wholesale credit liquidation. Both of these gentlemen are entertaining and compelling in their writing. But are they correct? It is fair to say that this is one of most if not the most important question of the day with regard to setting an investment strategy.

Gary North is not a deflationist; he is the opposite, an inflationist. He is also an economics scholar. Most inflationists observe the governments’ all-out effort to prevent a credit contraction, and conclude the effort will be a success. They certainly have history on their side, but do usually directly counter the deflationist scenario that, e.g., yes, we will go through eventual possibly severe inflation, but first will will have deflation.

North looks at the actual mechanics of the money/credit creation process in today’s central bank administered fractional reserve system. Suffice it to say that he is not changing sides on the inflation/deflation debate. As long as the FDIC and Fed are stepping in and covering bad bets made by the banking system then credit contraction is being countered ongoingly. As for the argument that eventually this will cease to work, North replies: “Prove it.” No proof has really been provided so far.

Mike “Mish” Shedlock has one of the most successful financial blog sites [here]. He responds to articles from a unique point of view. This site is a convenient clearing house for information on articles from many sources.

He is known as a deflationist. He has positioned his site as the premier site that forecasts inevitable deflation. He has overshadowed Martin Weiss, the son of J. Irving Weiss, who was predicting price deflation back in 1967. I was predicting price inflation in 1967. Martin Weiss continued the family tradition all through the 1980s and 1990s. He had a near monopoly on the position, sharing it with A. Gary Shilling and a few others. Then Mish showed up. He has a far larger audience than they do. His site is far more informative than any other deflationist site. ...

Before he started his site, he was a highly successful photographer. This barely describes his achievement. He got his photos published in 85 publications, including covers. It takes years to build this sort of portfolio. You must eat, drink, and sleep photography. You must master the tools of the trade. You also need creativity. This is not a part-time occupation. It is not a hobby. It is a career.

I know what it takes. I used to be an amateur photographer. I gave it up in 1960. I knew I did not have the time to become really good and also pursue my work in economics, history, and markets. I had to choose. (Economist Thomas Sowell made the same decision.)

Mish launched his site in 2005, as far as I can determine. His photography must have suffered, because he spends a lot of time updating the site and commenting of the state of the markets.

He is known as a deflationist: a man who predicts price deflation. Yet he is also an inflationist. Let me provide examples.
Thursday, June 30, 2005
The deflation debate heats up

As debt everywhere is repudiated in a deflationary crash, the grand experiment in Fiat money backed by nothing will lead to reinstatement of the gold standard or a gold/silver standard and once that debt is all wiped clean and we start over from a complete K-Cycle deflationary debt purge, then we can see inflation take off.

Sunday, October 28, 2007
Basket of Insanity at OPEC

Eventually, all currencies (except gold) go to zero. The only difference is the speed at which they get there. Warranted or not on relative merits, the U.S. dollar is winning the race among major currency pairs.

Tuesday, June 02, 2009
Speculative Bets Against The Dollar Highest Since July 15 2008

Of course fiat currencies do not really float anyway. They simply sink at varying rates, slowly going worthless over time.

Eventually, every fiat currency in existence is headed for zero. Gold is not headed to zero.
So, he sees some nations returning to a gold standard. Others will not. This is a political prediction. We have not seen any country return to a domestic gold standard since 1933, when the USA, the last gold standard nation, abandoned it by Presidential fiat. We have not seen an international central bank gold standard since 1971, when the USA abandoned it by Presidential fiat.

You must understand his scenario before you judge the plausibility of his criticism of those of us who predict mass inflation. He says that every currency that is not gold-backed will fall to zero. The world will be a two-standard economy for a while: gold standard currencies and fiat currencies. Then the fiat standard currencies will all die: fall to zero. That will leave only the worldwide gold standard currencies. We will see what the 19th century did not: a universal gold coin standard, with full redeemability of paper money and credit money on demand.

As you might imagine, I regard this as utterly Utopian, but wonderful. The thought of the whole world on a gold coin standard, with no more central banking, no more fractional reserve banking, and free floating private currencies. That is either heaven on earth or else the final stage of Jesus’s postmillennial kingdom.

But, in his scenario, for those nations that refuse to adopt a gold standard, there will be hyperinflation. To avoid predicting this for America, he necessarily must predict mass deflation – years of a secular decline in prices – followed by a return to full gold convertibility for the dollar.

You can evaluate the likelihood of such a scenario. Then you should place your bets.

But how? Do you buy gold coins now? Why? Why will gold not fall in price before today and the collapse of prices in mass deflation? Why not hold dollars (cash currency – greenbacks), and then buy gold when the dollar appreciates (prices fall) to the maximum? Isn’t buying gold today jumping the gun? He recommends gold. But why?

He says that gold does well in times of deflation. This is an astounding argument. Copper falls. Lead falls. Zinc falls. Every other commodity falls. That is the meaning of price deflation: currency appreciates. Yet gold supposedly does not fall. Here is what he wrote in 2007 on gold as an investment.
A Hedge against Deflation

Deflation is the other end of the spectrum. For reasons outlined above I think that is where we are headed. Gold has done very well historically in deflation. Think of the great depression. Who did not want gold coins? The purchasing power of gold soared in the depression. But isn’t this contradictory? Can gold rise in all situations? The answer is that it is not contradictory because gold does not do well in all situations. Gold does poorly in “normal times.” In normal times stocks and bonds are the place to be, not gold. Gold does well at the extremes, very well in fact. Hyperinflation and deflation are the extremes. Once again consider it an insurance policy, and one likely to be needed one way or another as well. Bankruptcies and rising unemployment with a consumer led recession is all that it may take to set thing off. I believe a severe consumer led recession is coming. With that recession, rising unemployment is a given. Once again consider gold as an insurance policy. I think it will be needed.
He wrote: “Gold has done very well historically in deflation. Think of the great depression. Who did not want gold coins? The purchasing power of gold soared in the depression.” This is true. Why was this true? Because gold had a fixed price in dollars guaranteed by the U.S. government. Gold soared along with the dollar. Put differently, most other prices fell. Why did gold match the dollar’s appreciation? Because it was the legal equivalent of dollars. If you brought gold to the Treasury, you were given $20 an ounce.

Then gold coins were made illegal by Roosevelt’s unilateral fiat command in 1933. Americans had to turn in their gold coins to the government at $20. In 1934, the government raised the price of gold to $35. It was a bonanza for the government. That increase made gold mining shares go through the roof. But this was a rigged market.

That dollars-for-gold market ended on August 15, 1971, when Nixon unilaterally abolished the gold standard for international transactions. He “closed the gold window.”

On January 1, 1975, it became legal for Americans to own gold. There was no government-guaranteed price. Its price fell from just under $200 an ounce to $105 in mid-1976.

So, there is no historical evidence – none – that gold does well in times of price deflation, unless there is a government-run gold standard, which means a fixed dollar price for gold guaranteed by the government. We have not seen price deflation since 1955 (one year, 1% down). The world has not had a fixed price for gold ever since the Treasury ceased paying $35 an ounce for gold sold to it by mining companies and foreign central banks in 1971.

In times of deflation, gold’s price will fall. I covered this in a 2006 article. I covered it again in a 2009 article.

The only argument against a falling gold price in a time of general price deflation is John Exter’s: “pushing on a string.” He says there will be a rush for gold as the most liquid asset. Here is his pyramid of solvency.

It was an untested theory in 1973. It remains untested.

Notice that Exter put currency just above gold. This theory is logical. Cash money in hand rises in value in times of price deflation. This is the definition of price deflation. That is what happened in the Great Depression. Banks went under because of bank runs: withdrawal of currency. He who had currency when the banks closed was a winner.

I have shown why Exter’s argument was wrong with respect to central banks’ supposed loss of control over the money-creation process: Pushing on a String? (2001) and Pushing on a String (2009).

To summarize Mish’s scenario:
  1. The debt pyramid will implode.
  2. The Federal Reserve will not be able to stop this.
  3. There will be serious, bankrupting, depression-creating monetary deflation.
  4. There will be long-term price deflation.
  5. When prices finally reach bottom, or close to it, thereby reversing 100+ years of FED inflating, the government will restore the gold standard.
  6. All nations that do not copy the USA will experience hyperinflation: money with zero value.
  7. Then there will be only the gold standard.
This is what I gather from what I have read. If my summary is incomplete, then he needs to write a book detailing his scenario: the economic evidence, his theory of political action, and the chain of events that are likely to bring scenario to pass. I have done this for gold in my book, The Gold Wars. He should do the same.

If this scenario is inaccurate, and if we do not go back to the gold standard, then the USA will experience hyperinflation: money of zero value. Then we will have to go back to the gold standard, or start all over again: mass inflation.

Your assessment of Mish’s arguments against me and all other predictors of price inflation depends on your assessment of the accuracy of his forecast.

What would systematic price deflation do? We would see a collapse of overleveraged large banks and overleveraged insurance firms all over the world, a huge increase in unemployment, an increase in bankruptcies, and double or triple the number of home foreclosures. We would see the Great Depression.

What then? He is saying that the voters all over the world will respond by adopting Ron Paul’s view of the gold standard and central banking. They will force the politicians to restore the gold standard and shut down the central banks, so that the banking system cannot undermine gold again.

This is a theory of political action, not a theory of inevitable economic processes. He is implicitly arguing that in a time of incomparable economic crisis, Congress will abandon Keynesianism, monetarism, supply-side theory, and rational expectations economics in favor of Austrianism. Congress will do this, despite the opposition of 99.9% of all economists and business school professors. Meanwhile, the voters will not cry out for more government money. The voters will demand budget cuts, a balanced Federal budget, and the abolition of the Federal Reserve System.

My assessment: somewhere, over the rainbow, way up high.

Mish needs to answer the 10 questions I have proposed for all deflationists to answer. Let’s see if they agree with each other. Let’s see if they try to duck these 10 questions. [See immediately below.]

10 Questions for Those Forecasters Who Predict Inevitable, Systemic Price Deflation

“Show me the non-money!”

Over the years, there have been a tiny handful of hard-money industry forecasters who have predicted that there will be an inevitable era of falling prices. I do not mean stable money with slowly falling prices due to increased productivity, such as with falling computer prices. I mean a period of deflationary depression, where the central bank is powerless to stop falling consumer prices by pumping in fiat money.

These forecasters have been wrong. No post-World War II industrial nation has experienced falling prices as much as 2% per annum. Japan has had a few years where prices fell by 1%, followed by years where prices went up slightly. Japan’s experience contradicts the deflationists: no secular price deflation. See the chart. Yet Japan is always the #1 example used by deflationists. This is because they have no other example. They never refer to this chart or any other verifiable statistics. They just talk endlessly about Japan’s deflation, as if it were a reality. If you see any argument touting Japan as an example of inescapable deflation, you are being misled. Ignore the person making the argument. He does not know what he is talking about.

With respect to consumer prices, Japan’s central bank has achieved what no other central bank has: price stability over many years. There are reasons to criticize the Bank of Japan. But its success in achieving stable prices is unique among central banks.

What would have been best is stable money and price deflation of 1% to 3% in response to greater productivity, but no depression. No central bank has achieved this since World War I began in 1914. To understand why not, read my mini-book, Mises on Money.

There are 10 questions that the deflationists need to answer. If your favorite guru predicts inevitable price deflation, send him this article and ask that he respond on-line to these 10 questions. If he refuses to answer all 10, with a link back to this article for his readers to see, find a new guru.

1.) Was price inflation after 1933 caused by central banks and fractional reserve banks? The answer is yes. If they answer anything else, they are crackpots. They will not.

2.) Is price inflation primarily a monetary phenomenon? Ludwig von Mises said it is. Milton Friedman said it is. See if the deflationist has another answer. Make sure he points to detailed studies that prove his answer: several books and a lot of scholarly articles on price history.

3.) Is newly created money from a central bank or commercial banks created by purchasing an asset, usually a debt? It is. Since deflationists rest their case on this fact, they will answer in the affirmative.

4.) Do commercial banks have an incentive to lend money to solvent borrowers? The answer is obviously yes. The debate comes when defining “solvency.”

5.) Do commercial banks pay interest on deposits? The answer is yes. Even in zero-interest accounts, such as checking accounts, the bank provides services that cost it money.

6.) How can commercial banks afford to pay interest on deposits? They pay it by taking in more from borrowers than they pay to depositors. They make it on the spread between these two rates. The deflationist knows this.

7.) When a central bank lends money to the government to buy its bonds, what does the government do with the money? The correct answer is “spends it.”

8.) When someone receives a check from the government, what does he do with it? The correct answers are: (1) deposits it in his bank; (2) cashes it at a local bank or Wal-Mart or other check-cashing service.

9.) What does the check-cashing company do with the check? The correct answer is “deposits it in its bank.”

10.) What does the bank do with the check? This is the central question. This divides inflationists from deflationists. Let us look at the possible answers.
  1. It sends all of it to the regional Federal Reserve Bank as reserves and also excess reserves. The Federal Reserve pays the federal funds rate on excess reserves. These days, this is about 0.15% per annum. This is less than banks pay depositors. They lose money on the deal. The FED does, too: it does not lend this money. It is like vault cash.
  2. It sends the minimal reserve (10% or less) to the regional Federal Reserve Bank and lends the rest. Whatever it lends is in the form of a check. The check is deposited in a bank. At that point, the receiving bank must decide what to do with it: A, B, or C.
  3. It converts some or all of the money to vault cash. Vault cash is a legal substitute for reserves held at the FED. It pays no interest.
The deflationist argues that at some point, commercial banks will hold most of their money as vault cash or excess reserves. This stops the fractional reserve process. This stabilizes the money supply. But this argument does not answer this question: “How does a refusal to lend shrink the money supply?” Stabilization, yes. Contraction, no.

The inflationist says that banks can and do hold some (not all) deposits as excess reserves. This is a short-term policy. Banks cannot hold all deposits as excess reserves or vault cash. This is because banks must earn a return higher than what they pay to depositors. Otherwise, they go out of business.

Bankrupt banks’ really bad assets are bought by the FDIC, which must sell T-bills to come up with the money, or else borrow from Congress, which must sell T-bills to come up with the money. The FDIC then pays depositors with checks. These checks are deposited in other banks.

The rest of the busted bank’s assets are bought by other banks, which then are added to their balance sheets. This allows them to lend money.

So, the “how to pay depositors” problem does not go away from the banking system as a system. It is merely transferred from insolvent banks to solvent banks. The money supply does not shrink. There is no monetary deflation.

Why Banks Will Eventually Lend

The inflationist argues that banks must eventually lend. When they lend, this begins the fractional reserve money-multiplication process.

The deflationist says, “There are no credit-worthy borrowers. Banks will not lend.” The inflationist says this:
As long as a bank accepts deposits, it must eventually lend the money. The proof that bankers expect to have plenty of credit-worthy borrowers in the near future is the fact that all banks accept deposits.
This answer is the heart of the debate between deflationists and inflationists. This is the crux of the matter.

For the deflationist to make a logical case, he must explain why a bank accepts a deposit if it has no income to pay the interest on the deposit. He must explain what motivates bankers to accept deposits when they have no intention or possibility of lending the deposit.

Short-term, yes. A bank can hold excess reserves or vault cash, and pay depositors from the higher income on credit cards, consumer loans, and so forth. Long-term, no. The banks must lend to stay in business. The M1 money multiplier will go positive. Fractional reserve banking will then turn the central bank’s balance sheet into fiat money.

The deflationist ignores the obvious: banks today honor credit card purchases. A credit card purchase is an extension of a loan to the user who uses his card. This is an unsecured loan. Banks honor these transactions.

The deflationist rests his case on banking as a system of currency in a mattress. Currency in a mattress explains anti-bank thrift. The person takes money out of a bank and hides it in a mattress. He forgoes interest. That is deflationary. This has not happened to the American banking system since the creation of the FDIC in 1934. That was why the government created it.

Banks cannot make money with vault cash. They do not make enough money with excess reserves. It is a holding operation.

They can make money lending the U.S. government money. They can buy bonds.

If they collectively face bankruptcy as a system, the Federal Reserve System and Congress can simply compel them to buy bonds. The deflationist must argue: “The Federal Reserve System would never do such a thing. Also, Congress would never do such a thing. Besides, no President would sign such a law, no matter how large the Federal deficit gets.”

Ha, ha, ha. And, I might add, ho, ho ho.

I am not arguing that price deflation is impossible. If the Federal Reserve stops buying assets, or especially if it sells assets, there will be a depression and price deflation. The FED might do this if its economists believe that hyperinflation is more destructive than price deflation. That is a policy issue.

What I am saying is that the decision rests with the central bank. We are not facing a situation in which the central bank cannot prevent price deflation. The deflationist argues that this will be the case some day, and maybe today.

To which I respond with two questions:
  1. Why does every bank accept deposits?
  2. How can a bank stay in business if it accepts deposits and holds 100% of them in vault cash or excess reserves with the FED?
I am waiting for clear-cut answers to these two questions.

The Case Of The Missing Textbook

Note to deflationists: You must show how a bank accepts a liability (deposit) without creating an asset (loan). Begin with the T-accounts in Murray Rothbard’s book, The Mystery of Banking. It is here. Free.

It is time for a deflationist to publish a comparable book that shows why all previous money and banking textbooks are wrong. He must show how and why a bank’s T-accounts are created with liabilities (deposits) but no assets (loans).

Until we see this textbook, inflationists will say with confidence to deflationists: “Case not proven.”

We are now 35 years into this debate. The deflationists have had time for one of them to write such a textbook on money and banking. They comfort themselves with this thought: “We don’t need no stinking textbook!”

Their position necessarily contradicts 600 years of banking practice and 700 years of accounting practice. They really do need a book showing how all bankers and all economists have been wrong about how banking works.

If a bank’s asset falls to zero, it must call in loans to cover for it, or raise bank capital. Is this not deflationary? It would be if the central bank and the FDIC did not intervene to keep this from happening to the system as a whole. But they do intervene. The deflationist argues that at some point, this intervention will not save the system. They argue – or at least assume – that FDIC assets and Federal Reserve assets – checks written – will not really be assets, i.e., they will not create deposits that banks will lend.

I say, “Prove it.”

Sorry, I cannot resist: “Show me the non-money!”


The march of science halts for no recession, but sometimes it slows. Just ask the leader in laboratory equipment and supplies.

Thermo Fisher Scientific is another example of a high quality company which is selling at a much more reasonable multiple than it has for quite some time. A measure of just how high quality is that the laboratory instrument maker converts most of its earnings to free cash flow while supporting a mid-single-digit organic sales growth rate. Currently the free cash, management says, is earmarked for acquistions. Its acquisition record indicates this is a value-enhancing use of the cash, assuming it stays within its industry.

As customers have done everywhere, Thermo Fisher’s customers have gone into cash-hoarding shutdown mode – which is unprecedented in Thermo Fisher’s history. Barron’s reasons this cannot last forever. Instrument technology is continually evolving; eventually one needs to upgrade.

The stock certainly looks interesting in the mid-30s.

The march of science halts for no recession. But in a particularly bruising downturn, the march slows.

This lesson has become clear to Thermo Fisher Scientific, the leader in laboratory equipment and supplies, a company that once expanded sales and profits in steady lock step, but since late last year has seen its business downshift uncharacteristically.

Many global companies last quarter would have welcomed the 15% drop in earnings per share that Thermo Fisher experienced, but minus signs are unfamiliar to the company and its investors.

A former growth-stock favorite that had always sported a premium valuation multiple, is now available at an attractive price.

Thermo Fisher’s shares (ticker: TMO) sank from more than 60 last summer to the mid-30s, and earnings forecasts for 2009 have been tempered from once-aggressive to more-reasonable levels. As a result, the instrument maker, a former growth-stock favorite that had always sported a premium valuation multiple, is now available at an attractive price.

The company, produced by the 2006 merger of Thermo Electron and Fisher Scientific, sells a comprehensive array of laboratory equipment, instruments, supplies and services to the health-care, biotechnology, university and industrial sectors. Its products are a crucial, if uncelebrated, part of drug discovery, chemical development and environmental-quality projects.

The idea behind the merger was to unite the old Thermo’s research-equipment offerings with the consumable lab goods sold through the old Fisher’s ubiquitous trade catalogs. The result was an attractive balance between consumables and capital goods, and a revenue stream that came from several end markets, as the accompanying charts confirm.

Thermo Fisher’s chief executive, Marijn Dekkers, who led Thermo Electron beginning in 2002 and engineered the merger, says the deal’s rationale is playing out well. “We have made progress with our larger clients in persuading them to centralize and standardize their purchasing,” he says, rather than allowing, say, each scientist in every lab at a hospital or university to decide on what kinds of products to buy.

Since the deal concluded, free cash flow has surged to $1.2 billion in 2008, a level the company expects to match or slightly exceed in 2009, despite an anticipated dip in earnings this year to a range of $2.80 to $3.10 per share from last year’s $3.13.

The company converts nearly all earnings to free cash flow – a sign of a potent business model.

This essentially means the company converts nearly all earnings to free cash flow – a sign of a potent business model. Assuming free cash flow gets to the anticipated $2.80 a share, the stock would sport a free-cash-flow yield above 7.5%.

Though Thermo Fisher fell to 42nd from 8th place in the latest Barron’s 500 ranking of large companies, based on return on capital, the company remained in the top 10% of Corporate America by this measure. Thermo Fischer has a $15 billion stock-market value. Its $500 million in net debt (debt minus cash) is less than half its annual cash flow.

Investors with short memories are pressing Thermo Fisher to spend its cash reserves or take on more debt to repurchase more of its stock.

Ironically, at a time when so many companies are being punished for their wounded, debt-stressed balance sheets, investors are pressing Thermo Fisher to spend its cash reserves or take on more debt to repurchase more of its stock. There remains $400 million in a current buyback plan, but Wall Street wants more – a stance that could be short-sighted.

“Investors are preoccupied with what to do with our balance sheet,” Dekkers says. “They are saying, ‘Why not buy the heck out of the stock at these levels?’”

Instead, Dekkers insists, he would “like to keep our powder dry. We are in a fragmented industry and we would like to be able to do acquisitions.”

A mid-single-digit organic revenue growth augmented by a few percentage points via acquisitions has added up to 20%+ EPS growth.

Historically, Thermo Fisher has achieved mid-single-digit organic revenue growth, augmented by a few percentage points via acquisitions. It also has enjoyed 20%-plus earnings growth. The company has spent a total of $900 million for a dozen acquisitions since the 2006 merger that created it, while also repurchasing $1.1 billion of stock. Yet Dekkers hints of a stronger current appetite for deals.

“We have a lot of platforms and a long list of opportunities in lots of areas – [potential] deals [totaling] in the billions that are best done for cash,” he says, in elaborating on his balance-sheet strategy.

Like many big, high-quality stocks, Thermo Fisher’s shares have largely sat out the recent rally.

There is a chance that the Street’s wariness about possible big acquisitions will continue to dampen enthusiasm for Thermo Fisher shares, which are roughly flat on the year. Like many big, high-quality stocks, they have largely sat out the recent rally.

Equipment buyer’s strike cannot go on for long.

And, for sure, other headwinds persist for the company. In the first quarter, cash-hoarding hospitals and university labs all but stopped buying routine supplies, producing an almost unheard-of inventory flush. Analysts say this phenomenon has continued to a degree this quarter, though it cannot go on for long.

Big pharmaceutical mergers threaten to shut down redundant research-and-development projects, a minor concern. And the industrial segment remains quite weak, with many idled chemical and other plants sapping demand for certain products.

Yet by now, such factors appear well-incorporated into Thermo Fisher shares and the Street’s newly tempered earnings expectations for this year. The company, in issuing preliminary guidance for 2010 last week, is using conservative assumptions for the timing and pace of any economic lift, and it is managing its costs accordingly.

The stock consistently garnered a premium multiple to the broad market before late last year – sometimes as much as 40%. Currently, the stock is at a 10% discount to the Standard & Poor’s 500 trailing and forward multiples.

Further, BCA Research notes that health-care-equipment stocks have a strong record as a leadership group exiting bear markets, and it points out that lean inventories and the continued growth in health-care-facility expansion are favorable.

The Obama stimulus package contains an allocation of billions for several research-and-development programs, which could supply a positive jolt to demand. More broadly, too, the increasing need for sophisticated diagnostics, tests, targeted drugs and environmental aids means Thermo Fisher is in an enviable position as the leading supplier for such needs.

Analyst sentiment toward Thermo Fisher is, admittedly, lopsidedly bullish. But it is “under-owned” by institutions.

Analyst sentiment toward Thermo Fisher is, admittedly, lopsidedly bullish, with all 13 analysts covering the company rating the shares a Buy. This is sometimes a concern for investors, when contrarian reasoning prevails. Yet the stock appears under-owned by institutions, given that its three largest shareholders are big passive index-fund firms: Barclays Global Investors, Vanguard Group and State Street.

This suggests there remains room for investors to discover, or rediscover, the stock, which seems not to hold much downside risk in view of Thermo’s balance-sheet strength. If there is increasing confidence that the company can reassert its growth path, the shares would easily merit a price/earnings multiple of 14 or better, which could push the stock up into the mid-40s as 2010 rolls into sight.

Even though the market has rallied 40% since March, a 30% potential gain for a high-quality stock should hold some appeal.


The market has risen 40% since March – a long climb – but is down 40% from its 2007 high and flat on the year. Has it gone up a bunch, down a lot, or nowhere? The answer is yes.

The stock market is making a lot of noise ... full of sound and fury – signifying what? Suffice it to say the signal-to-noise ratio is very low.

In this short Barron’s piece, technical analyst Michael Santoli says the market is not inexpensive, and its technicals are suspect. “Yet, to argue the March low is not The Low amounts to a prediction of a third mini-crash – not the highest-probability forecast.”

We believe the non-highest-probability forecast to be a bit of a strawman. A mini-crash is not required to set a new low. A regular bear market will do the trick. Maybe not highest probability, but non-zero for sure. Timing? Next question.

Not to puncture beach-blanket legends on Memorial Day weekend, but you do not actually hear the ocean when putting a conch shell up to an ear. The shell, it turns out, simply concentrates the ambient sounds that otherwise go unnoticed.

Yet focusing this noise in a way that makes it clearer has its uses. Consider what follows a conch shell of sorts, only the sounds are those of skeptics, voicing doubts about the stock market’s major indexes now that they hover just below recent highs.

Listen, listen closely.

Companies, especially banks, are swamping the market with stock offerings, which turns the supply/demand balance negative. So far in May, more than $50 billion of equities have been sold in secondary offerings. That equals about half of one percent of total U.S. stock-market value.

Should it continue, this will become a negative – at that moment when new deals quit being absorbed by investors who feel insufficiently exposed to stocks. Besides, dilution at the company level is punishing, and will act to retard per-share earnings growth for banks for years.

On the brighter side, when asked what would mark an end to the financial crisis, a common answer from observant, history-conversant commentators was, when banks can access private capital again. Now they are doing so, and so far the supply has been absorbed.

TREASURY YIELDS HAVE jumped quickly, which could squelch any nascent economic rebound. The 10-year Treasury yield hit 3.45% Friday, its highest tick since mid-November, up from 2.75% in mid-April. The first part of this lift may stem from “OK” reasons – increasing risk tolerance. But last week, evidence the Federal Reserve might not be able to anchor rates with its Treasury purchases, and thus might have trouble grounding mortgage rates, seemed not so OK.

THE RALLY HAS FED on short-covering, which has run its course. Not really. An analysis of aggregate hedge-fund positioning by Goldman Sachs strategists last week suggests short-covering was a strong theme in April’s stretch of the rally, when heavily shorted stocks trounced others. But it was not a big factor in March, or so far in May.

THE MARKET ACTION on a daily basis is “hinky:” too much whipping-around of leveraged exchange-traded funds, grabbing for low-priced stocks and such. There is plenty of this kind of noise evident in the hour-to-hour flow. A half-dozen or so bank stocks and financial ETFs account for more than a third of NYSE volume many days, due in part to the exertions of high-frequency computer-trading shops chasing what moves fastest and flashes brightest.

For a decent bellwether that embodies many dominant market themes, see DryShips (DRYS), a bulk shipping stock that is constantly among the market’s most manically traded. It is a serial diluter via equity offerings, with proceeds going to relieve severe balance-sheet stress. It represents an ultra-leveraged play on short-term sentiment on global economic prospects and commodities, with a single-digit stock that trades, on average, 20% of its newly enlarged share base each day. This stock is the market’s id, as viewed through a quote screen.

THE MARKET IS NOT cheap, as measured by, say, the Dow industrials’ trailing price/earnings ratio above 40, or even the S&P 500’s P/E of 17 on 2009 operating-earnings forecasts. Some conservative valuations based on long-term normalized earnings settle around a fair value of 900 for the S&P 500 (we are there now). Yet the median P/E of S&P 500 companies, based on 2009 forecasts, is 12.7,, meaning half the index is cheaper than that. The whole is not a bargain, but there are plenty of well-valued particulars.

THE CONCH DISTILLS the disparate sounds, but it does not divine the course from here. Yet, to argue the March low is not The Low amounts to a prediction of a third mini-crash – not the highest-probability forecast.

All we know is the market has risen 40% since March – a long climb – but is down 40% from its 2007 high and flat on the year. Has it gone up a bunch, down a lot, or nowhere? The answer is yes.

Is anyone else rooting for a summer lull?