Archive for February, 2008

The Case For Energy Stocks

Friday, February 29th, 2008

Vincent Farrell, Jr., wrote a piece today analyzing oil prices and the likelihood that they will remain high. Since energy stocks are one of our largest holdings I thought you might like to read his thoughts. They very much mirror my own reasoning for maintaining an overweight position in energy stocks in spite of the main stream mindset that says in a recession you underweight energy.

Very near term, the price of oil is being greatly influenced by Turkey’s incursion into Iraq, Iran’s nuclear program, Exxon (XOM) vs. Chavez, violence in Nigeria and the consequent geopolitical instability and nervousness. All of these factors can reverse themselves — but I bet they won’t — and oil prices could calm down.

Looking beyond the immediate, I see nothing that would tell me that oil won’t stay high in price and move even higher over the longer haul. Supply and demand is in precarious balance. OPEC’s spare capacity is limited, and non-OPEC supply has continually disappointed. Oil is priced in dollars, and OPEC’s income vs. the other currencies they want and use is nowhere near what the dollar price says it is. Saudi oil fields are declining at a faster pace than they will admit.

The Saudis have never had as many rigs drilling with apparently little in the way of incremental production being brought on stream. People who figure such things say the Saudi budget would be balanced if oil were about $65 a barrel. Sixty percent of the Saudi population is under the age of 21. There is huge social network that the Saudis don’t dare let fray for fear of stirring even more issues with Islamic fundamentalism. Lip service notwithstanding, the Saudis want ever-higher prices.

Seventy-five percent of the world’s oil production is from fields discovered more than 25 years ago. Despite intensive drilling programs, the new fields are significantly smaller than the older discoveries. In other words, the easy stuff has been found.

Seventy-seven percent of the known oil reserves are controlled by state oil companies that, generally speaking, don’t like us very much. They have no incentive to do anything but maximize the price.

Demand continues to rise at an inexorable pace. The emerging nations let by the BRIC nations — Brazil, India, Russia and China — are now 30% of world GDP (the U.S. is 28%). Despite the U.S. housing crisis and the consequent credit crunch, these nations are still growing 5% a year. China, for example, has four times the number of people than the U.S. but only one-sixth the number of cars. Internal growth and the desire for life’s comforts — not to say status symbols — will continue to drive demand for oil. The U.S. uses about 25 barrels of oil per person per year. China uses less than 2 barrels per person. That number will soar as China’s middle class develops.

In 2005, the world consumed 31 billion barrels of oil, but the industry discovered only 12 billion. The inability to replace production has been an unfortunate constant the past few years. My best guess is that the price of oil will back off a bit as growth in the U.S. is, at best, sluggish. Oil averaged $72 a barrel in 2007. If I had to put a number on it, I think oil will average above $85 a barrel in 2008. I do expect seasonal softness as we exit the winter heating season, but for the factors mentioned above, I don’t think it will be too many years until we look back fondly at “only-$100-per-barrel oil.”

The logic above, in my opinion, is hard to argue with. We are in a different world than in previous recessionary times and the US is not the only game in town any longer. Stick with energy in your portfolio in spite of Wall Street telling you that Tech will provide superior long-term growth. The fundamentals are stronger with energy than tech, and your portfolio will perform better because of it.


WSJ Opinoin Piece on Inflation – A Must Read

Friday, February 29th, 2008

The Wall Street Journal today has a spot-on article on inflation and how its being encouraged by Fed policy. Its a must read for all of you that think my inflation thesis for investing is all wet…

The Bernanke Reflation
February 29, 2008; Page A16

For readers under age 30 who are wondering why they are suddenly paying $3.15 for gasoline and $2 for milk, the answer is that this is what an inflation looks like. Those of us of a certain age remember it well, if painfully, and judging by the noises coming from the Federal Reserve of late we had all better get used to it again.

First, Fed Vice Chairman Don Kohn declared that, while inflation was worrisome, the Fed now views recession as the more urgent danger to fight. Then on Wednesday, Fed Chairman Ben Bernanke told Congress that the Fed will do whatever it takes to stop the credit squeeze from becoming a recession. That’s about as close as a central banker will get to saying that he’s thrown price stability to the wind. If inflation rises — as it now surely will — then the Fed will worry about that later, after the economy is safely past the credit crunch.

[Ben Bernanke]

Right on cue, the best indicators of inflation expectations hit new highs. Oil has surged past the once astronomical $100 mark and is now $102 a barrel; as recently as September, it was $70. Gold is nearly $975 an ounce, and the $1,000 threshold seems inevitable. The euro has broken $1.50 for the first time, while commodity prices in general are hitting record highs. These increases will roll through the rest of the economy and lift prices for food, energy, and countless other goods and services.

Call it the Bernanke reflation, though it’s more precise to call it the Fed’s second inflation gamble of the decade. The first was Alan Greenspan’s roll of the dice from 2003-2005, keeping interest rates too low for far too long in the aftermath of the dot-com bust. That spurred the first boom in commodity prices, as well as the subsidy for debt that led to the housing bubble and the credit mania whose collapse we are now dealing with. Mr. Bernanke was a Fed Governor during much of that time, and he seems to have learned his lessons all too well. He’s now going all-in for round two.

[The Bernanke Reflation]

Naturally, the Fed and its most vocal constituencies — Wall Street and politicians — see nothing much to worry about. Wall Street sees a reflation as a way to ease its credit problems, as price increases ease debt burdens and perhaps reflate housing values. Congress and the White House see a way to perhaps avoid a near-term recession, which might get them past the election.

As for the Fed, its Governors are dusting off their favorite intellectual justifications. We are told that inflation isn’t as bad as it seems because “core inflation” — which excludes food and energy prices — isn’t rising as fast as the consumer price index. However, food and energy are what most Americans are having to spend ever more of their paycheck to buy. Thus the Bernanke reflation is in part self-refuting even as a short-term recession antidote, because it robs consumers of some of their discretionary income just when the economy needs it.

Meanwhile, even the Phillips Curve is making a comeback. That’s the notion — popular before it was discredited in the 1970s — that there is a trade-off between inflation and economic growth. In its new version, argued by Fed Governor Frederic Mishkin, the Phillips Curve doesn’t exist in the long term but does in the short term. Thus the Fed can afford to open the monetary flood gates now because the slower economy could lead to lower prices later this year. Then when the economy recovers, the Fed can afford to tighten money again.

This is a beguiling intellectual construct, but it puts a great deal of weight on Fed Governors to know when to tighten again. They were supposed to do something similar in 2003-2005, but they were terribly wrong. Then as now they were also dismissing such forward-looking price signals as gold and oil and instead focusing on such misleading indicators as “core inflation” and the money supply. Mr. Mishkin may be seen as a monetary wizard at the Fed, but to investors around the world he is beginning to look more like a high-class inflationist.

The people who aren’t being fooled by all this are the American people. They don’t pay their bills with “core” dollar bills, and they know those dollars buy less with each passing month. This explains their rising economic anxiety — and anger — better than trade or job losses do, especially since the job market has remained relatively healthy. Inflation is the great thief of the middle class, as even Americans who don’t recall the 1970s are learning. With its all-in reflation bet, the Bernanke Fed is gambling with their money.

70's Style Inflation Returns???

Thursday, February 21st, 2008

Inflation and what investments to consider are discussed in the article below written by Gary Dvorchak. Much of what he says I’ve written about in previous posts, but he gives you some good investment ideas (most of which we’ve already bought for clients months ago) at the end of the article. Plus, there’s a trippy picture of President Carter with 70’s sideburns mid-way through that is worth the time to read the article…

That 70s Show?
2/21/2008 9:01 AM EST


Don’t lose sleep over the recession.
Worry about inflation, here it comes in full force.
Stagflation is the theme for the next year or two.

The economy and the stock market are going to look like “That 70s Show” for the next year or two, barring a major about-face from the Fed.

Yes, it’s possible we are in (or are about to enter) a recession. Some will argue about the depth and duration; I don’t think it will be terribly deep, and much may already be priced in to the market. What I am losing sleep over right now is the prospect for an aggressive bout of inflation, driven by the Fed’s (necessary) massive credit creation over the last six months. Yesterday’s CPI was up at a 6.8% rate over the last three months. That puts our Misery Index at nearly 12, not inconsequential considering that the Misery Index averaged 16 during the Carter years.

The evidence of accelerating inflation is indisputable. Look at gold, oil, other metals, foodstuffs. The charts are all up and to the right.

Weekly Gold
Click here for larger image.
One-Year Copper
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Many pundits try to explain any particular commodity by looking at its individual market.

  • Aluminum is up? Boeing orders are strong.
  • Corn is up? Ethanol.
  • Copper is up? Tech equipment demand.

And on and on. These pundits are completely missing the point.

The only way you can explain all these commodities rising in unison is that inflation has taken hold. There is no other reason for coffee and gold and oil and wheat and tin to all rise simultaneously. Some will point to declining house prices as a sign of “deflation.” Wrong. WRONG! WRONG!!!

Inflation is a general debasement of the value of a dollar that shows up broadly throughout the economy. During an inflationary period, it is certain that some items will still decline in price due to fluctuations in supply and demand. Just becaus
e houses are getting less valuable does not mean that the dollar is getting more valuable; in fact, the evidence points overwhelmingly toward the opposite — that the dollar is shrinking.

If you don’t think that the dollar is becoming less valuable, take a look at it against other major currencies.

U.S. Dollar vs. Euro
Click here for larger image.
Source: Yahoo! Finance
U.S. Dollar vs. Japanese Yen
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Source: Yahoo! Finance
U.S. Dollar vs. Australian Dollar
Click here for larger image.
Source: Yahoo! Finance

The dollar is in the midst of a sustained and severe decline vs. the world’s other major currencies. This alone confirms our thesis: The value of a dollar is shrinking, and that is the definition of inflation, folks.

As I mentioned earlier, this acceleration in inflation is being driven by the Fed’s massive (yet necessary) credit creation. Look at this chart of money of zero maturity, or MZM, a measure of liquid money supply compiled by the St Louis Fed.

Money of Zero Maturity
Click here for larger image.
Source: St. Louis Fed

The amount of money created is astounding, over 16% growth in the last year, far in excess of GDP growth, which is the benchmark for necessary MZM growth. A lot of new dollars are chasing the same amount of goods, which is the classic recipe for inflation.

So what are the implications?

    1. Long bond yields are likely to rally from here, driving down long bond prices. Doug Kass has been on top of this with his short iShares Lehman 20+ Year Treasury Bond (TLT) trade.

    2. Rising long yields and low short rates will steepen the yield curve, enabling the slow recovery of the financials.

    3. Rising long yields will abort any chance for much lower mortgage rates, so distressed borrowers will not get bailed out by refis and housing demand will not get jumpstarted by better financing terms. Don’t look for a recovery yet in the homebuilders.

    4. Position your portfolio for the best inflation plays. Ag is great: Look at Deere (DE), Mosaic (MOS) or Archer Daniels Midland (ADM). U.S. companies with substantial non-U.S. dollar sales will do well: Look at Hewlett-Packard (HPQ), which derives 69% of its revenue from outside the U.S. Any company with pricing power, such as consumer staples, will do well: Look at tobacco plays Altria (MO), UST Incorporated (UST) or Loews Carolina Group (CG). And, of course, pure commodity plays, such as Barrick Gold (ABX) or Freeport-McMoRan Copper & Gold (FCX) should be profitable.

    5. Brace yourself for the cessation of Fed cuts and quick increases as soon as it believes that the financial sector stresses are abating. I truly doubt that the Fed believes its own B.S. of inflation being “anchored,” and it will turn its attention to the issue as soon as conditions allow.

Inflation Numbers Increase (Again)

Wednesday, February 20th, 2008

Oil is above $100 and Gold keeps pushing higher. This has many perplexed as a recession generally pushes prices for commodities down. This is not like a normal recession, if we are in the midst of one. The factors driving commodity prices higher transcend the US and its economy. The demographic changes around the world that have increased the demand for middle class lifestyle material goods is having a bigger impact than most pundits realize.

The article below discusses the growing inflationary pressures in our economy and the potential solutions available to the Fed, and whether the Fed will act on those in an election year. This is a new chapter in the economic playbook that the economists and the Fed appear not able to grasp. How it plays out will be a learning experience for everyone.

Another Discouraging Inflation Report

posted on: February 20, 2008 |

Anyone who thinks inflation isn’t a problem isn’t looking at the numbers. It’s not a huge problem, not a catastrophic problem, but it’s still a problem, and one that requires attention. Left untended, it’ll only get worse. And once the public thinks it’s destined to get worse, the Federal Reserve will be looking at a much bigger problem that could take a generation to reverse. The good news is that the problem is still manageable. Nonetheless, the clock is ticking.

This morning, the Bureau of Labor Statistics reported that consumer prices rose 4.3% during the 12 months through last month. As our chart below shows, that’s near the peak for the past 10 years. Core inflation (which excludes food and energy prices) is also pushing higher these days, running at a 2.5% annual pace, which is near its highest levels in recent years as well.

click to enlarge

Headline inflation is now far above the overall growth rate of the economy, which expanded by a paltry 0.6% in annualized real terms in last year’s fourth quarter. Even GDP’s 3.2% growth in nominal terms remains comfortably under CPI’s pace.

The inflationary pressure is all the more troubling with the Federal Reserve aggressively lowering interest rates of late, a course which increasingly looks like the monetary equivalent of throwing gasoline on a fire. Fed funds are currently 3.0%, down from 5.25% as recently as last September. As a result, Fed funds are now negative in inflation-adjusted terms. And more rate cuts may be coming. The April ’08 Fed funds futures contract is priced in anticipation of another 50 basis-point cut, which would bring rates down to 2.5%, or nearly 200 basis points below CPI’s pace.

Meanwhile, no one should mistake the inflationary momentum as a statistical artifact. The bubbling pricing pressure is evident in several crucial corners of goods and services. Food, energy, transportation and medical care prices are all advancing at annual rates above headline CPI’s pace, according to today’s government report.

The Fed has been expecting that the slowing economy would take the edge off inflation. So far, however, nothing of the sort is happening. As GDP’s pace has slowed, inflationary pressure has only risen. So much for wishful thinking. That leaves the traditional solution, which is one of embracing a hawkish monetary policy, at least relative to what currently prevails. That’s an awkward prescription in an election year, especially one in which recession threatens. But no one ever said that running a central bank is a short cut to popularity. It remains to be seen just how much popularity Mr. Bernanke and company seek.

Economic Stimulus or Vote Buying…You Decide

Wednesday, February 13th, 2008

Below is an article from the Wall Street Journal from Arthur Laffer discussing the impact of the stimulus plan. Arthur’s analysis leads us to believe that we just have election year vote buying that ultimately negatively impacts the economy. The article is a great example of classical economic analysis, something that is sorely missing from our government’s policies. Get prepared to put on your “Whip Inflation Now” buttons as we seem to be repeating the past yet again.

That ‘Stimulus’ Nonsense

February 13, 2008; Page A27

Bipartisanship, a notion that stands as anathema to our basic political premise of checks and balances, has resulted in a stimulus package that will do enormous damage to the U.S. economy.

The idea is simple enough — just have the government write everyone a rebate check, and these rebate recipients will spend most of the money and create enough demand to pull the economy out of its slowdown. With a little luck, the people who supply the rebate recipients with their newly demanded products will also spend part of their added income on yet more products, and so on and so forth until the full effect of the rebate is multiplied manifold and provides a much greater and much needed boost to the U.S. economy.

This logic is totally correct as far as it goes. Unfortunately it doesn’t go far enough.

The proposed rebate of about $600 per man, woman and child is transferred to people based upon some characteristic other than work effort. In fact, if you’ve worked too hard and earned too much, you won’t get a rebate. So in some instances the rebate actually requires the absence of work effort. Now it’s true that some of the people receiving the rebate may also be workers, but working is not the reason each person receives the rebate; it’s simply because he or she is a human being. Thus rebate recipients are given command over real resources for doing something other than working.

In this world of ours, those resources going to the rebate recipients don’t come from the Tooth Fairy. They have to come from workers and producers. If the resources come from workers and producers who thereby receive less for their work than they otherwise would have received, won’t they in turn spend less? Of course they’ll spend less, and the people who now supply them with less will also spend less, and so on down the line.

As my former colleague and friend Milton Friedman liked to say, “There’s no such thing as a free lunch,” and this rebate is exactly what he meant. The net effect is that the reduction in demand from those who pay the real resources will be exactly the same size as the increase in demand from the rebate recipients. It’s sad but true. Income effects always net to zero in a closed system.

To see this point from a more generic standpoint, if the price of apples rises, it is true that apple growers are better off. Their income effects go way up, and they can spend more. But apple consumers are worse off because their incomes go down by the exact same amount, and they have to spend less.

All of the stimulative effects of the rebate to the recipients will be 100% offset by the destimulative effects of the increase in liabilities of the workers and producers who have to pay for the transfer of resources to the rebate recipients. There is no stimulus from a rebate, period.

But even though the income effects net to zero, the substitution effects accumulate, and they accumulate in a most unpleasant way. This should be obvious to even a person untrained in economics. Ask yourself why not a $40,000 rebate per person, indexed for inflation of course, if a $600 rebate is so good. Heck, why don’t we give rebates equal to GDP, so that everyone who doesn’t work and doesn’t produce receives everything, and all those who do work and do produce receive nothing?

GDP would go to zero in a New York minute if workers and producers got nothing for their work effort. And, as fate will have it, any rebate will reduce output because it reduces incentives to produce output. The larger the rebate, the greater the reduction in the incentives to work and the greater the reduction in output. It’s as simple as that. This $170 billion rebate camouflaged as economic stimulus will deal a serious blow to the economic health of the country.

But there’s also collateral damage. Few in Congress understand or care. They think their actions either don’t matter or that they would see a positive impact from their actions if only they did more. If the economy worsens and when their political sensors become alarmed, they’ll up the dose, and goodness knows just how far this vicious cycle will take us. A quick glance back at the 16 years of presidencies of Lyndon Johnson, Richard Nixon, Gerald Ford and Jimmy Carter should give you pause. Whenever you observe bipartisan cooperation, hold on to your wallet and run to the basement.

Retest of Lows – Painful But Productive

Friday, February 8th, 2008

The chart above (courtesy of Doug Kass from The Edge) shows the chart of the S&P 500 superimposed over the chart of New 52 Week Lows.

You can see that during the corrections in August, November and January, the market was making a significant number of new lows. The current pullback toward the January low does not show anywhere near the same number of new 52 week lows that the others have shown.

To me, this means we are just doing a retest of the low from last month, but that the broader market and the companies in the market are showing strength. If this is the case, we could see a bottom finally put in and a resumption of the bull market.

If the new 52 week lows increase and the index drops below the January low, then we are likely in for continued volatility and further price declines.

More later!