Wednesday, August 6, 2008

Many Reasons for Optimism

From the Desk of Joe Rollins

The news regarding the stock market and the economy has been just dreadful for the months of June and July. It seems that every day we are confronted with a new avalanche of selling on the stock market and negative news being reported by the media. For example, the largest mutual fund provider, Fidelity Investments, only had one fund in their entire portfolio of equity investments that is positive year-to-date through July, 2008. Virtually all of their mutual funds are in double-digit negatives for the year with only Fidelity Real Estate up a meager .8% for the first seven months of 2008. Even their more conservative funds, like Balanced and Puritan, have losses of 9.3% and 9.4%, respectively. This has been an unusually difficult year from an investing standpoint, but I’m a long way from throwing in the towel from a financial perspective.

Since it was a slow weekend anyway, I decided to sit down and read as much as I possibly could on current economic and investing news. I typically spend this time of year watching a considerable amount of Atlanta Braves games. This year, however, the team has become irrelevant (especially since Skip Caray is now on permanent D.L.), and frankly I am having a hard time finding anything else on TV to be worthy of my time. Therefore, I decided a good weekend activity would be to sit down and read all of the newspapers, Internet postings and reviewing other matters related to the news of the world and investing. I think some of my comments below might enlighten some of you regarding future investing.

My research project was initiated based on a couple of television events this week. The howling fool, Jim Cramer, declared this week to be the end of the bear market and the beginning of a new, more powerful bull market. Jim Cramer doesn’t say a whole lot that I agree with – this isn’t entirely his fault; he’s just become a slave to his own celebrity.

In any event, I watch at least a portion of Jim Cramer’s Mad Money practically every night, and I’ve come to realize that he’ll often change his opinion on a particular stock within the same week. To those who don’t watch the show consistently, it would be hard to pick up on these contradictions in stock recommendations. The pressure of trying to come up with new observations and ideas is perhaps limiting Cramer in giving the type of advice most investors need.

To Jim Cramer’s credit, it was he who, one year ago on August 3, 2007, set YouTube on fire with the clip of him exclaiming that “They [the Fed] know nothing!” It was Jim who first brought the credit crisis to national attention and brought the inaction of the Federal Reserve to the forefront. With his howling frustration about the Fed and his correct assessment of the credit crisis, he was the first to acknowledge that the Fed was just sitting on the sidelines doing nothing.

Perhaps because of (or in spite of) Jim Cramer, the Federal Reserve has picked up the ball and has performed brilliantly. I’m so impressed with Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson and their current actions. While none of us can forecast the future, it appears a major financial crisis has been averted by the swift actions of the Federal Reserve and the Department of Treasury.

This past week also brought out the shadowy figure, Dr. Alan Greenspan. He once again made national news by opining that the U.S. economy had a 50/50 chance of recession. It’s somewhat interesting to note that at this same time last year, Dr. Greenspan was forecasting the odds of a recession in the United States to be 70%. It seems that his projection has fallen as the months pass. A recession has yet to be realized.

I couldn’t help but note Dr. Greenspan’s thoughts on deflating the financial bubble in housing. He should be a prime candidate for understanding how the bubble could be deflated. Since he is the one who created the bubble, surely he must know how to pop it. If there is any question that I didn’t correctly predict Dr. Greenspan’s missteps, please read any of my prior writings on the subject of his fallacies.

Furthermore, just so I’m clear, I have no empathy for the problems on Wall Street. The housing industry didn’t create the troubles on Wall Street; it was completely the other way around – Wall Streeters created the housing problems. Due to Dr. Greenspan’s irrational setting of low interest rates in the early years of this decade, Wall Street abused what was originally the banks’ function of lending on housing and created its own chaos.

By packaging and selling literally millions of sub-prime loans, Wall Street allowed builders and prospective buyers to create a complete nightmare. Homes were built that never should have been while buyers with unworthy credit were able to purchase homes with loans that never should’ve been extended to them. It seems somewhat ironic that for the billions of dollars that Wall Street made on selling these toxic sub-prime mortgages, it was they that ultimately paid the dear price. While the homeowners will suffer from the unwinding of this real estate fiasco, it will be Wall Street that suffers the true economic loss. While housing prices have come down over the last 12 months, they still stand substantially above their values going into this decade.

I thought one interesting piece of news from last week was incredibly ironic. At the same time that Dr. Greenspan was speaking on TV on Thursday regarding his forecast that there is a 50% potential for a U.S. recession, the Federal Reserve made an extraordinary announcement. They announced that the M2 money supply figures for the week jumped up a staggering $49 billion. What’s unusual about their announcement is that it came after a full three months wherein no money was created by the Fed.

As any follower of economic activity knows, unless the money supply is increased growth in the economy can’t occur. As we have seen, banks have cut off financing for housing and for economic expansion due to a lack of an adequate money supply. With this flood of new money into the system, banks will have no choice but to lend now. For this reason, I think it is almost assured that economic activity will pick up in the coming months.

In my own cynical mind, I wonder whether the Fed’s announcement regarding the explosion of the money supply was not a “We will show you, Dr. Greenspan. There will be no recession!” statement since it was released on the very day of Dr. Greenspan’s televised speech. I’m sure the timing was just coincidental, but it was entertaining nonetheless to those of us who study economic trends.

I have several other news items to cover, but I thought I would go through them in the order of importance. There was an interesting article that didn’t receive much publicity, but that I ran across in the New York Times, of all places. The article reported the results of The Conference Board’s consumer confidence report, reflecting that for first time in the poll’s 20-year history, 55% of all consumers expect the stock market to fall over the next 12 months. Given the inundation of negative sentiment, one would question why that percentage isn’t even higher.

What makes these poll results so interesting is the history of its consumer confidence results and what actually happened in the stock market in the 12 months after. There have only been six times when the results exceeded 36% of respondents being negative. Remember it is now at 55% -- an all-time high – and I’m referring only to the six prior cases when it exceeded 36% negative sentiment.

In each of those incidences, the subsequent 12 months following the poll were extraordinarily good times for the stock market. In November of 1987, the next 12 months brought gains of 19%. In October, 1990, the gains were 29% after such a reading. In December, 1991, preceding the first war in Iraq, the gain was muted at 4%. In April, 1994, the following 12 months had a gain of 14%. In October, 1998, there was a 24% gain, and in March, 2003, there was a 33% gain.

Just for comparison purposes, there has never been a negative 12 months after such an extreme bearish reading. Additionally, there has never been a bearish reading as high as the current 55%. From strictly a contrarian point of view, it would be hard to identify a more encouraging barometer. Additionally, if you will note the dates quoted in each of those time periods, the U.S. economy was in much more severe economic distress than it is today.

June and July gave us a complete breakdown in commodities speculation. During the last two months, we have seen corn prices plummet. Additionally, coffee, oil, heating oil, soybeans, and natural gas have dropped markedly. While all are still at elevated levels, they are significantly below their levels going into June. There should be no fear in anyone’s mind regarding inflation over the next few years. With the deflating of housing prices and the moderation of the net increase in commodities, inflation should be restrained. The current yield on a 10-year Treasury bond is 3.92%. You may rest assured that if bond traders felt that inflation was a significant threat to their principal over the next 10 years, they would not be trading the U.S. Treasury bonds at historic low levels.

It should’ve become obvious to all after last week that Iraq is no longer an issue. Due to the stabilization in Iraq, it should be clear that this is one potential fear we no longer need to worry about. Regardless of who becomes our President, stabilization in Iraq is now readily assured. It seems that the timetable for withdrawal by the current President and the candidates running for office are materially indifferent. Regardless of who is elected, there will be 40,000 to 50,000 American troops in Iraq as a peacekeeping force for years to come. While it is certainly not desirable that we would have to maintain a long-term presence in Iraq, surely none of us are so naïve to forget that we still have a large military presence in Germany, 63 years after the end of WWIII. And in Korea, 55 years after the end of the Korean War, there are still American troops present.

Contrary to the ill-advised proclamations of one of the candidates running for President, Afghanistan is not critically important, but Iraq is both significantly and strategically important to our economic future. A stabilized Iraq will reign in Iran and provide a buffer between Saudi Arabia and Iran. While Afghanistan will have to be dealt with in short order, it has no economic value to the United States today.

Once Iraq is completely stabilized, there will be adequate troops transferred to Afghanistan, the land of rocks and opium, to stabilize that country. It will only take a short order of significant troops to once again stand Afghanistan on its feet. However, the difference between Iraq and Afghanistan is that in Iraq, they’re generating billions of dollars a day in revenues from the sale of oil. Afghanistan has virtually no natural resources and little Gross National Product. In the coming years, Iraq will only increase their significant revenues from oil and Afghanistan will continue to struggle. While it is true that the war on terror must be fought in Afghanistan and Pakistan shortly, to assert that it is more important than Iraq is naïveté beyond comprehension.

Did you happen to read this week that President Hugo Chavez unexpectedly announced the nationalization of the largest Spanish-owned bank in Venezuela? Over the last few years, Chavez has nationalized industries such as oil, telecommunications, electricity and steel making. Now he is attempting to nationalize the banks in his quest for a complete socialistic government in that country. Nationalizing is when a government steals, by force, businesses from private companies – many of which are owned by Americans.

I find it interesting that Venezuela’s economy is now practically on the edge of breakdown. The vast majority of the country doesn’t even have reliable social services and economic chaos is ensuing. This is even more surprising given the oil producing capabilities of Venezuela. However, without foreign capital, the country is suffering from a severe downturn in oil production and technology.

This is just the most recent example of the inability of a socialist government to function in a democratic world, similar to Russia, North Korea, Iran, and many other socialist countries that have failed. Don’t you find it somewhat ironic that a socialistic government cannot and will not work, yet sometimes people in our own country, including certain politicians, believe that we are in need of socialistic reform? There is currently a plethora of misinformation in the United States that a socialistic government here would be better than the democratic one we enjoy today. Duh?!?

Have you noticed that the immigration issue has fallen completely off the radar screen as of late? Last week, the center for immigration studies estimated that 1.3 million illegal immigrants have left this country since Congress gave up the comprehensive reform bill a year ago. Many, of course, were deported, but most just went back to their homelands on their own accord. It seems the combination of stricter immigration enforcement along with a slowing U.S. economy has solved the issue for itself. Given that we now know enforcement works, it seems that this issue can be solved peacefully. Another threat to the U.S. economy has now been averted.

I am incredibly amused by the arguments in the political arena regarding windfall profits. You don’t have to be much of a scholar in economics to understand that in a slowing economic environment, the absolute last thing you want to do is increase taxes. To increase taxes on the oil companies that essentially control our future regarding energy issues is practically insane. Without giving the oil companies incentives to explore and find new oil, we certainly will have even bigger issues in the future. Absolutely no one questions the need to go to alternative fuel. However, during the next decade we really do not have a choice. The answer to the energy issues in America is simple: do it all. Drill, use wind and solar power, alternative fuels, seek additional energy sources – even fill up your tires with air and get a tune-up! The absolute wrong answer is to have a windfall profits tax.

Do you realize how many Americans could be put to work seeking new energy in high-paying, meaningful jobs in this country? Why any person (or politician) would rather spend this money by purchasing from unfriendly governments belies logic and intellect.

Here’s an interesting tidbit of information that you might’ve missed this week: Exxon Mobil reported a record second quarter net income! Indeed, it’s the highest quarterly profit for any corporation, ever. However, with corporate profits also come a substantial payment of U.S. taxes. As economist Mark Perry has noted, Exxon Mobil will pay more taxes this year to the U.S. Treasury than the bottom 50% of all taxpayers combined – a staggering $61.7 billion for the six months so far this year. So let me get this logic straight: we want to tax a corporation more that is paying as much in taxes as 50% of our residents in order to give a rebate to the people who pay no taxes?!? Once again, the basic law of economics does not support the conclusion.

I’m fond of philosopher and poet Georges Santayana’s expression, “Those who do not study history are doomed to repeat it.” It’s not as if we haven’t tried a windfall profits tax before. In fact, as recently as the 1970’s, Jimmy Carter’s windfall profits tax led to a 6% drop in net domestic output and a surge of as much as 15% in oil imports, according to the Congressional Research Service. Some politicians clearly haven’t retained much from history if they’re proposing a tax that was such a miserable failure in the past.

Perhaps those politicians would rather use Winston Churchill’s philosophy. Churchill is one of my favorite politicians from history, and his statement on the subject of using history as a lesson was a classic: “History will be good to me, because I intend to write it.”

Maybe you haven’t read about the absolute explosion of new energy discoveries in the world. Due to the high price of oil, new findings are occurring virtually daily. There was a finding in Louisiana of natural gas that will double the known natural gas reserves in the United States. With the explosion of the expansion of wind power in Texas and the drilling of natural gas wells in downtown Fort Worth; Texas is moving rapidly towards energy independence. It is now believed that the largest deep water oil reserve that has ever been explored was found off the shores of Brazil. This field is larger than all the known fields in Saudi Arabia.

It is believed that there is as much oil in the Antarctic as all the known reserves in the entire world. While certainly the cost of exploring and recovering this oil is gigantic, with the high cost of fuel it is making the possibility of recovery more likely. There are significant oil findings in shale in Colorado and in the Rocky Mountains. Unfortunately, our Congress had to go on vacation before they could get around to voting on policy as important as the cost of fuel in every consumer’s life. I do not think any Americans would actually have a complaint with Congress if there was a straight up and down vote on energy exploration in the United States. But the fact that it cannot even be brought to a vote should be an embarrassment to all Americans.

With the recent explosion of nuclear power plants, you will see a conversion from coal and natural gas plants to nuclear in the coming decades. There are absolutely no negatives to this trend – only positives. The fact that we haven’t built nuclear plants in this country over the last 25 years should be an embarrassment to all Americans. Genteel and socially conscious France produces 87.5% of its electricity with nuclear plants while the U.S. produces 20%. What is wrong with this picture?

How all of the foregoing affects stock market investing is the most exciting part. I sit in amazement when I read the stock quotes every night and am baffled at the inexpensive pricing of stocks. As of yesterday, AT&T is selling at less than 10 times next year’s earnings with a 5.3% dividend yield. Likewise, Verizon is similarly priced and has a dividend yield in excess of 5.1%. The large cap technology stocks are selling at bargain basement prices; companies such as Microsoft and Oracle are selling at historic low prices, yet they continue to trend down on a daily basis. I could go on and on… Earnings have been extraordinarily good all but for the banks and car manufacturers. We are seeing current prices on great stocks that frankly I have never seen before in my investing lifetime.

I projected that we would see bank stocks rally significantly off of their lows and now they are up 30-50% in only a period of less than three weeks. I think we are seeing an upsurge of the combination of high earnings, low prices and an improving economy that will lead to significant gains over the next 12 months.

Even with my background in analyzing stocks and evaluating economic markets, there’s no way for me to forecast the movements of the gigantic hedge funds or the momentum players. Frankly, no one can make those predictions, and none of us really need that knowledge. Investors simply can’t compete with a group of hedge funds representing billions of dollars that collectively make decisions to go long on energy and short the financial stocks. When hedge funds work in concert with one another, they accomplish exactly what has happened this year: energy prices go into the ionosphere while financial stocks go to bargain basement, penny stock prices.

Truthfully, forecasting movements by hedge funds or momentum players has nothing to do with investing and more to do with speculation; my intent is to evaluate stocks on a long-term basis and determine when they are cheap and a good time to buy. If we tried keeping up with the momentum players, we’d suffer from wild swings in asset values, which is detrimental to everyone.

I’m sure there are readers of this blog saying, “Oh yeah, but what about the unemployment report this week?” First and foremost, this report, while unfortunate for those losing their jobs, was actually encouraging. An unemployment report of 5.7% is not anything close to major concern. While it may be true that consumers are cutting back, as long as they have jobs they will continue to consume. The most important economic reality is that unemployment is a trailing indicator. Increased unemployment, while certainly an unfortunate situation for the unemployed, is actually encouraging. It means that businesses are cutting back on excess employees and preparing for the future.

The stock market is a forecasting device and anything that happens in the rearview mirror is somewhat irrelevant. There has been a significant increase in GDP over the last three quarters. While it’s definitely still at a low level, it is increasing markedly on a sequential basis. This bodes well for future economic activity.

At the current time, there are an absolute record number of open “short interest” positions on the New York and NASDAQ stock exchanges. Those shorting the market believe that stock prices will be going lower, and therefore, they have sold stock they do not own. The encouraging part of this from a stock market investing perspective is that at some point, they will have to repurchase those stocks in order to cover their short sale. Investors shouldn’t care where the purchasing comes from, they should only care that they repurchase. I project that there will be a significant reduction in short interest in the coming months, and this will be an economic boom to the stock market as the shorts unwind the transactions.

Many of the mutual funds that we own have large concentrations of energy stocks. Due to the sell-off in oil during June and July, many of these mutual funds have performed poorly. However, it is our intention to stick with these particular mutual funds. First, because these funds have been incredibly successful over long periods of time, they make them well-suited to hedge against the future. Secondly, and more importantly, these energy stocks are incredibly cheap.

Most of the major oil companies perform their projections and value their reserves assuming $70 barrel oil, which is what they view as the true fair market value of oil. Given that the current price is $125 per barrel, this makes the stocks even more inexpensive. Realistically, I do not envision oil selling for $70 per barrel anytime in the coming couple of years; we will have to see a dramatic increase in the supply of oil or significant decline in demand for this to happen. While clearly there is conservation and moves to switch to alternative fuels, in the most optimistic forecast we are still five to ten years out for that to make a serious difference.

Admittedly, it’s hard to be optimistic in light of the avalanche of bad news we’re barraged with. While I try to remain objective, it’s sometimes difficult to sift through the negative news and focus on the optimism built into these stories. Yes, I understand that if you get your news solely from the national media, you need to understand that it is extraordinarily limited. If you put the entire script of the nightly news in print, it would probably only cover less than one-half the front page of the New York Times. Given the documented bias by some of the major news outlets meant to affect the political outcome of the upcoming election, I think you would be better served to review and analyze the news from other sources.

It has not been much fun investing over the last seven months. However, I do have an instinctive feeling that our odds for success have gone up dramatically over the last several months.

Source: New York Times

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