Friday, August 31, 2007


One of my favorite economists is the guest host on Squawk Box this morning. He is on the money! This morning, he said that a very powerful combination event is about to happen. The President will announce assistance for sub prime borrowers this morning and Ben Bernanke will basically hold firm against inflation. Brian points out that the hedge fund players who have shorted the sub prime loan securities, using 20 to 1 leverage, could take a serious hit when many of these loans are suddenly worth 100 cents on the dollar.

Doing the right thing! It is an understatement to say that George Bush is not a very popular President. Still, Bush is once again "doing the right thing." A number of TV talking heads have said that the sub prime mess was caused by lending money to "people who did not deserve to own a home." My belief is that every American should be given the opportunity to own a home. Before the announcement that Bush will propose new rules that allow sub prime lenders to refinance, I correctly maintained that more than 85% of all those "poor credits" who were allowed to buy a home with no money down would continue to pay their loans. With the additional help, the number will be significantly higher than 85%. Given a poor person a helping hand is not a bad thing.

It is not like anyone is agreeing to pay the mortgage for the homeowner. Many times every day business loans are "restructured." Corporate CFO's have the experience to know that if a company has a short term financial problem that a deal should be struck to redo the terms of outstanding loans. There is often a long term cost or penalty but help is often available.

As Bernanke mentioned the other day, there are many creative ways possible to help those stuck in loans that have onerous terms. If a loan started out as an interest only loan and is about to be reset with a $500 per month principle payment, the terms could be modified to reduce the principle payment. No one would be hurt. The bank does not need $500 per month in principle to make the loan a profitable loan. Sure, if the principle payment becomes a graduated amount, for a few years, the loan would look like a 50 year mortgage but the graduated principle payment could increase a certain percent each year and continue to increase even after the $500 per month principle payment is reached.

Employment and wage growth are strong. A person who has successfully paid an interest only loan for the past three years might easily afford a $100 per month increase in his home payment this year and another $120 per month next year and so forth. The proposals to be made by Bush today will be along these lines. He will use executive authority for the government to guarantee the refinancing of 80,000 of these loans. This is the right thing to do. He will make other proposals, some of which will require the passage of congressional bills.


Those who have sold these mortgages short are suddenly being hammered. Short selling anything is risky business. One of the smart moves that was made recently was to eliminate the short sale up tick rule. Yes, once again a smart move has been severely criticized as an idiotic move. The removal of this rule has been blamed for the "extreme volatility" of the recent markets. What a joke!? To begin with, this market has not been "extremely volatile" and second of all the removal of the rule has the effect of reducing volatility not adding to it. This is just one more area where a lot of very smart people have "joined in group think" to get things upside down and backwards. Last night, John Brown repeated the oft repeated mantra that Ben Bernanke is between a rock and a hard place because if he cuts interest rates the dollar will fall. John and those criticizing the removal of the short sale rule are looking at one end of an elephant and concluding that it is a snake. Use the water level in a lake as an analogy, if one only looked at how much water was flowing over the dam, without ever knowing the level of the lake, one might conclude that the lake level is going down on a day when the over flow is very heavy. The truth is that if much water is over flowing the dam, there must have been heavy rains upstream and the lake is probably full to the brim.

Under the old rule, an artificial rule said you cannot sell short unless water is over flowing the dam. You were not permitted an exception because you had checked upstream to know that the "rains are coming".

There are a number of children's board games that demonstrate the point well. In many of these games, players will often attempt to "corner a market." In a "business game" they might consistently bid high on a certain resource in order to be the only one able to sell certain goods. The problem they discover is that they pay so much for the resource that their profit margins are low. The game of Risk is another game where one cannot win by being overly aggressive. The more you attack your neighbors, the weaker you become, leaving an opening for another player to put you out of the game.

In the same way that investors can buy all they want on the way up, they should be able to sell all they want on the way down. Think about it this way; how low can speculators drive the price of a stock? Even if they committed conspiracy and as a group shorted 200% of all the shares outstanding, would they drive the company out of business because the price of the stock was down to a very low price? No, a profitable business in this situation could declare a dividend and the short sellers as a group would owe 200% of the total dividend!

Certainly most investors understand that when they buy a share of stock on the market, they are not investing in the sense of giving the company money. When the shares were originally sold by the company, it got money. If you buy a few shares or sell a few shares it does not effect the balance sheet of the company one iota.


The point of the above paragraphs about short selling is that the pundits have found just one more thing to rant and rave about when they should be pounding the table saying BUY, BUY, BUY! In the old days, recessions were common at the mid cycle juncture. Certainly, the rollover has and will cause a little pain. The GNP numbers posted yesterday tell the story well. For the second quarter, the US economy grew at a real rate of 4%. The rants of those who say inflation is out of control must remember that this 4% has been adjusted downward to account for inflation. The problems in the housing market reduced this number by about 75 basis points. Therefore, if there had not been a problem in housing, the real economy would have grown by 4.75%!

Yes, the growth in the economy will be reduced by the recent "freezing-up" in the credit markets. Will there be a recession? It's not likely. Besides, a mild recession would not be a big deal. Recessions are announced after the fact and the stock market typically jumps up big time right in the middle of a recession. What happens during a recession is that the price of money goes down enough to increase the profit margins of companies. What has happened the past two months? The price of money has come down!


Smooth, smooth, smooth! The water in the big lake is smooth. Pundits have focused on a 250 point drop in the Dow on one day and a 250 point jump the next day and screamed VOLATILITY! This correction got to about 10% before reversing quickly. It is now less than 5%. In 1987, the correction was 23% in one day! Big Ben is proving his metal quickly.

Sure, those who believe $100 oil is just around the corner are screaming that Ben should lower rates. Those who have profited by prior wild swings in the market are ready for Ben to capitulate. Ben is about to disappoint these players. Under the current circumstances, Ben will probably lower rates a little. However, he is not going to stop fighting inflation. His move to lower the discount rate without lowering the Fed Funds rate was a master stroke. It was filled with common sense but it was a master stroke because it went against the grain of conventional wisdom. Many said that it was only a confidence building move but in reality it had teeth. A few days later, when all the big and strong banks took down chunks of money, the pundits said again this was just a confidence building move but it was much more than that. Slowly the numbers will be revealed. The banks that were in trouble did not go to the discount window directly but got "pass through" - loans from the money center banks. Liquidity was restored where needed without causing a run on the banks that needed the help. Had a regional bank jumped at the discount window, they would have been shooting themselves in the foot. They would have seen millions of dollars of withdrawals from their frightened depositors. The system is sound; fear in the eyes of pundits is going away and Ben will not need to lower short rates much. Smooth sailing ahead!


Early this morning, one of the Asian airlines announced profit growth of better than 25%!

What is a mid cycle turn? Before the turn, there is generally enough capacity to produce all the goods needed throughout the world. Sales are much stronger than they were during the previous recession but demand is generally satisfied without building new plants. By the time of the turn, the gradual growth of the population and the additional growth in standards of living means that production capacity is short. By the time of the turn, there is a need for more and more and more major capital projects. You have to have the plants plus the energy to run them. This is the reason that China has no less than 40 nuclear power plants on the drawing boards.

Capital projects consume huge quantities of resources. For example, Saudi Arabia and Kuwait each have a number of development projects on the drawing board. Indeed, they each have a single project that will cost over $9 billion dollars to develop. Specifically, the development of the Khurais field in Saudi Arabia is expected to increase total production from Saudi Arabia by 1.2 million barrels per day. This is an increase of about 10% by the worlds biggest producer. Several thousand workers will be required to build-out this field but once it's built only a few hundred will be required to operate it.

Business construction already requires more capital and more workers than were required by the housing market when it was at its peak a couple of years ago. Look at it this way, each one of these $9 billion projects are the equivalent of building cities of 45,000 $200,000 homes. I can't remember the average cost of the nuclear plants in China. I recall that the latest designs are smaller. $5 billion each is probably in the ball park for a total of $200 billion. The electricity from these plants will support many times the number of production facilities. We are talking about trillions of dollars of construction over the next several years.

It is only natural for the demand for money for major capital projects to squeeze out home construction. When the average Joe finds that money is available to buy a house, he goes for it. When money gets tight, he stays where he is. On the other hand, when a company is selling all the products it can make, it does not let the cost of money get in the way of expanding. When the "prosperity" phase of the business cycle is here, the FOMC has to hold tight. It has to lean against the wind. It has to keep short term interest rates up so that a bidding war does not develop. If five companies selling the same products are all selling out of goods, the one that can complete the next plant the quickest is the one that will reap the benefits of having goods for sale that are in short supply. Ben's job at this point is to focus on inflation even though the housing market is weak.

The constant argument that the consumer is the engine of the economy is a good argument for a different time. The new locomotive is the business locomotive. The consumer will come along for the ride. We simply should not worry so much about the consumer during these times. Most Americans spend the income they receive. This is the reason that payroll deduction works to build a retirement nest egg, even though, the person who will make regular deposits to a stock account will grow much more wealthy. The person who routinely saves to an an aggressive investment account is a rare individual.

Of the people I help, only a few of them make regular additions to their accounts. Most wait until the account has moved up strong and then they add chunks of money. It is too much to expect them to lean against the wind as they should and add chunks of money while the market is down. Therefore, regular monthly deposits are a rare blessing. Big irregular deposits make my job very difficult but I accept the challenge freely. The main point is that during the "prosperity phase" jobs will remain plentiful and wages will increase. Consumers will not be as apt to refinance their homes but they will have steady income and they will spend it. The year over year growth in personal income is currently running at about 300 million dollars!

Yesterday, I said that Big Ben is about to shoot the starters pistol. He is, but the actions to be announced by President Bush will address the "sub prime crisis" more specifically than a Fed Funds rate cut can do. Cutting the Fed Funds to solve the sub prime crisis is a bit like going deer hunting with bird shot. As a result of "help" in the mortgage market, the need for Ben to cut will be much reduced. This may cause great disappointment by those screaming FIRE but holding firm against the wind is the right thing to do. I expect a minor cut of 25 basis points at the September 18 meeting and not much more later in the year. More importantly, the second half of the business cycle is underway without a severe crunch at the "turn".

Consumers who are paying 50 cents less per gallon of gas are buying electronic toys. New toys are on the way. The new toys are typically connected to one another. Kids are playing games with other kids from around the world on their cell phones. Business people are able to "get things done" quicker than ever before. The build out of this new system is not even half way done.

The energy/electricity investments must always come first and indeed they are in the works. I do not believe there has ever been as much energy/electricity under development. The poorest of the poor are starting to feel the effects; oil projects in Africa are starting to enrich millions of people. The newest OPEC member, Angola, will add about 200,000 barrels of production per day this year. The good news is that this is just the start. It takes time to develop an oil field but there are hundreds under development.

Production from China has been held back by the scarcity of electricity. This scarcity is in the process of being filled. The 15% growth rate of China is unsustainable because the law of large numbers will be in the way but billions of dollars of new production will continue to hold the lid on inflation as long as Big Ben will keep one foot on the brakes.

You will know that the world has hit hit 4th gear when products begin to hit the market that take advantage of super highway broadband wireless networks. These networks will allow more to be done at lower costs.


Thursday, August 30, 2007


When corporate officers buy, buy, buy stocks, smart investors join them! Depending on markets surveyed, insider buying is at about the same high level that was hit around October of 2002 or even higher at about the same level that was hit in 1995. Both of these years were great times to buy stocks. BUY, BUY, BUY.

Do your friends and associates a big favor and send them this message. If they are like most Americans they are paying hidden mutual fund fees for below average performance. It may not be obvious in the short run but over time, the hidden fees zap performance. NOW IS THE TIME TO INVEST 100% OF GROWTH ASSETS IN STOCKS!

Wednesday, August 29, 2007


In recent weeks, big oil seems to find one excuse after another not to operate at full capacity. Utilization keeps bouncing around 90%. A fire here and a leak there are the stuff refineries are made of. Refining oil is the process of heating flammable liquids to high temperatures in order to separate the various chemical components. The occasional fire or even explosion is something to be dealt with on a relatively routine basis.

Refinery capacity is growing around the world, including in North America. The expansions include refineries in Indiana and in Illinois. New refineries are under construction in at least two Canadian provinces and are on the drawing boards in at least two states. In the US, relatively small corn oil refineries continue to come on line.

Around the world, many projects are underway. The ones that make the news are the ones that are behind schedule. One former Soviet state has discovered a 7 Billion Barrel field that will begin producing oil in 2010. The big find in Ghana is still a long way from production as is the latest of the Newfoundland fields.


Sooner or later, price cures price. A run up in a commodity price and subsequent crash is not a new event. In the days of Jezebel, something like 600 BC, a prophet correctly predicted that soaring wheat prices would collapse overnight. The trade routes of the ancient world were made for the purpose of importing salt! Can you imagine putting your life and total net worth at risk in order to import salt, one of the cheapest and most common commodities?

I know, I am saying the opposite of what the "big boys" are saying. Lehman Brothers put out a report this week that says energy is in a long term secular bull market. The demand will remain strong for the next decade. I was just a young child when my Daddy taught me not to ask the auctioneer how much to bid. Never-the-less, go to an auction sale early and you will always find people asking the auctioneer how much an item is "worth". Like my Daddy always said, "it is worth what you can sell it for".

I am not saying that Lehman is a bunch of crooks. I am saying that they are likely to have a major position in the oil market and as professional traders they are likely to make more money if they can talk novice traders to take positions. In the short run, trading is less than a zero sum game. The brokers take their commissions and spreads to the bank. If you guess wrong and they guess right, their total profits are increased.

Remember that the market is an opinion poll in the short run but a weight machine in the longer run. The current bounces in the oil market say little about the new world of the months ahead, when more and more production projects come on line and when more and more substitutions lead to demand destruction.

I believe the reason oil supplies in the USA are dropping is because the "big boys" are in no rush to buy at today's price. There is no need to keep the tanks full with plenty of available supplies and OPEC pushing on a string. Unlike two years ago, both OPEC and the refineries have excess capacity. Yes, the possibility of detestation from a hurricane is real but the season will be more than half over in two weeks and so far there has been no major event.


Those who believe Ben Bernake is doing a great job are suddenly few and far between. The calls for an interest rate cut are bouncing off the inner walls of TV tubes across the globe. The CEO of AutoNation says that the FOMC needs to cut by 2 full percentage points to avoid a recession. If times are so tough, why is "Big Ben the Gorilla" still holding the US economy down?

As anyone will tell you, the FOMC can only control the short interest rates. The market controls the price of stocks, the long term interest rate and the value of the US dollar. However, saying the FOMC only controls short term interest rates is like saying that the flood master at a dam only controls how much water he releases. Certainly, the flood master looks at the height of the water level before making his decision and, indeed, if the water level of the lake goes down, he might lower the amount of water he allows to spill over. If the flood master knows that the snow is melting in the mountains, he may increase the amount of water he releases, even though the water level is low.

"Big Ben" has a much tougher job than the flood master. In addition to the water in the "big lake", "Big Ben" must keep his eye on the levels of several series of lakes, including the newest biggest and the overflowing "China Lake". Twenty years ago, and perhaps even five years ago, if anyone had told any economist with a brain that China would grow its economy at an average nominal rate of better than 15% for four years in a row, 2004 through 2007, they would have been laughed out of house and home. How could this be possible? It is not just possible, it is real.

China is on a mission. It wants to do all it possibly can to prepare for the 2008 Olympics. The country has built the equivalent of the entire US Interstate Highway system in the past several years. It has employed 100's of millions of new workers. The magnitude of the growth in China is simply not fully appreciated by most of the people of the world. China has done the impossible because they have been focused on doing the impossible.

The response of the government has been to continue to pull out all stops no matter what. When it became obvious that China could not import enough gasoline to grow so fast, they instituted odd-even days. China cars with license tags that end in odd numbers can only be driven on odd numbered days. The people are getting to work but driving half as many cars. The interest rate push has been less than forceful. In 2003, the Chinese economy was growing at a nominal rate of about 10% with the official lending rate at 5%. The rate finally moved up a small amount after the nominal growth rate had jumped all the way to 15%. The whole next year, rates stayed about the same. Last year, Secretary of the US Treasury, Henry Paulson made several trips to China and Ben Bernanke accompanied him on at least one of these. Since that time, the Chinese have raised their official lending rate many times but always by small amounts. The chart of rates looks like the chart of US rates that were increased 17 times beginning in June of 2004.

Wow, 7% interest and growth of 15%! Have you heard about having your cake and eating it too? The people of China have died and gone to Heaven! The trouble is that it cannot last.

It is mathematically impossible for the growth to continue at such at rate. Sooner or later the law of large numbers must get in the way. The rule of 72 tells us that 15% compounded growth creates a double in only 4.8 years. The Chinese economy has suddenly become the third largest in the world. The strain on resources, including energy resources, has been incredible. Ironically, with the experience of the 1970's in mind, the major oil companies have done an incredible job of meeting the demand. Again, had you told any economist that energy demand would have grown so much in the past 5 years, he would have said that it would be impossible for the market to have filled the supply. He would have predicted shortages and gasoline lines.


One of the many big, very big, misses the market pundits spew out of their mouths is the relationship of short term interest rates to the value of a currency. Think of "Big Ben" as an 800 pound Gorilla sitting on the US economy. By raising interest rates, "Big Ben" has said to the rest of the world, "Hey, guys, we are slowing our economy down!" "This means that we are going to stop importing so many goods from you guys, and fewer of us are even going to come to your country for a visit!" "Furthermore, because our dollar is going to depreciate in relation to yours, our goods are going to be very competitively priced and we will sell more stuff to you even though we will buy less stuff from you!"

Most people focus on money flows and suggest that when interest rates are high that foreigners will buy more dollars so that they can invest these dollars in the higher US rates. What they fail to realize is that the FOMC can soak up dollars like a sponge. On a daily basis, the FOMC must decide how many dollars to create or how many to destroy, the FOMC controls the printing press.

As a result of the tightening by the FOMC, the US economy has slowed and indeed the rate of growth of imports has slowed. China now runs a bigger trade surplus with Europe than with the USA. The increase in US rates put a lot of pressure on other central bankers to follow suit and they have. Australia, for example, shot right past our 5.25% and went in to the 6's some time ago. The ECB has been steadily raising rates and was all set for another increase but is having second thoughts now that credit problems are surfacing.

What about the flood master who controls the water level at "China Lake"? What is this guy doing to control the water? Nothing! There is no flood master in China. China does not control its own money supply. The government has pegged its currency to the US dollar. Therefore, "Big Ben" must operate like a tugboat. He must pull China along for the ride. The problem is that the China boat is too big for him to pull by himself. He must have and he has had the cooperation of other central bankers. So far, he has pulled and pulled and pulled and the world has started to move. All but China.

China is in the middle of a financial bubble. The stock market in China is more over priced than the US market was overpriced in 2000. If the growth rate of all of China is going to remain at 15% or better for many years to come, then I am wrong, the China market is not over priced. But, with local pundits starting to scream as loud as Jim Cramer, saying that the "FED MUST CUT RATES!", "Big Ben" is sitting tight waiting to see that there is movement in China. We should remember, that moving a battleship is easy once you get it started. You certainly do not want move a battleship too quickly in tight waters because once you get it to move it is impossible to stop it in a hurry.


I send you my thanks for sticking with me through this complicated story. I do not know if it makes sense or not. My point is simple; despite the growing chorus of complaints about "Big Ben", I believe he is doing a fantastic job. Moving from a consumer lead expansion to a business prosperity cycle has never been easy. Indeed, historically, up until the 1980's and 1990's, the move was typically accompanied by a recession. This time, the most recent GNP numbers are around 4% real growth. That is after all inflation! The pundits who are kicking and screaming are generally on the wrong side of the market.

Can you appreciate the magnitude of the problem. A tiny move by the FOMC, or the failure to make a tiny move, could easily cause millions of people to starve to death. Those who feed their families during the inflation days of the 70's do not want the FOMC to be too easy again and those who lived through the great depression do not want the government to have all the money.


Many a sign has been posted that the actions of the FOMC are having the desired effect. Indeed, the pain being experienced by hedge funds in the hyper leveraged credit markets is a strong sign that the actions of the FOMC are working for the greater good. One key market indicator is the interest rate on the 10 year treasury bond. Again the typical market pundit gets the relationship upside down and backwards. They expect the long bond rate to rise when the FOMC raises short term rates. The effect is exactly the opposite. When the "Big Gorilla" sits down with all its weight on the economy, the effect is to slow the economy. It is a simple story of supply and demand, when the economy slows, the demand for everything is reduced. The home builder will buy less lumber, less land and he will borrow less money. The home buyer will not take out a 30 year mortgage if the builder does not build a house on a 180 day construction loan. The higher the short term rate goes, the lower the demand for both the short term money and the long term money.

In the past several months, the 10 year rate has fallen. Because the 10 year rate is nothing more than the real GNP plus the inflation rate, one can improve ones guesstimate about the strength of the economy and the inflation rate by studying the term structure of interest rates. In recent days, the market rate for 90 day t-bills has dipped to very low levels. Part of this dip has been a result of the dying demand for construction loans. Which is the cart and which is the horse? Long rates have headed down because the demand for mortgages has fallen, the short rates are down because the demand for construction loans has fallen.

Over time, the FOMC must simply stay out of the way and let the market decide. Much of the time, the FOMC is able to do just that, stay out of the way. In other words, the Fed Funds Rate will normally simply follow the 90 day t-bill rate.

The actions of the FOMC are again a bit like the actions of the flood master. Alcoa finds itself in a similar position on a number of lakes it controls. Alcoa must use millions of gallons of water daily when its smelters are running. If it uses too much, its lakes will run dry and the public will be very upset because their source of recreation has dried up. The 10 year rate is like the water level on the lake. The flood master does not want the lake level to gyrate out of control. The FOMC does not want peaks and valleys in the economy or in the 10 year rate. In a similar period of great demand for natural resources, the 1970's, the FOMC did not have the psychological wherewithal to hold rates high enough to ward off inflation. The ten year rate went up to 15 or 16%. This is when I earned my T-Bond moniker. In hind sight, I was much too timid but at the time, when I borrowed heavily at short rates in order to lock in 14% rates for 30 years, I was going against the conventional wisdom and was perceived to be "off my rocker". Those bonds appreciated 60% over the next few years and the leverage multiplied the move and increased the cash flow.

The lake level is going to be a little bit low for awhile. The GNP will slow from 4% this past quarter to a lower rate by the next quarter and the inflation component of this rate is likely to fall to the low 1% range. With exports growing at better than 11%, it is hard to see a recession in the near future. The lake can easily hold 5% volumes of water. The China Lake has been out grown. The lake has to be expanded. It is the world wide expansion that is causing the temporary problem. When the population and thus demand for goods and services grows, during the recovery phase, "new lakes" do not need to be built. We are now in the later phase of the cycle, demand growth means new capacity must be built.

Those calling for a quick drop in the Fed Funds Rate may be sorely disappointed. Ironically, the price of oil is holding up partly because many believe that the FOMC will "chicken out" early. If the FOMC holds its ground, oil prices will fall. The inflation portion of the 4.58% could easily fall to the 1% area. If it does, the FOMC will have every reason to lower rates. Again, the gyrations of the past are in the past. It is entirely possible that the US economy can transition from the recovery phase to the prosperity phase without another move by the FOMC.

It is too early for the pundits to be calling Ben Bernanke an idiot. An argument that you seldom will hear is that the FOMC is a political animal and that it might be trying to help keep the congress from making damaging changes to the tax laws. Let's not go there but instead lets just hope and pray that no great damage will be done. One of the great beauties of the American system of government is that it is difficult for one party to swiftly swing policies from one side of the middle to the other. Only in times of great stress can big changes be made. The current level of stress is modest at worse. Indeed, throughout much of the history of the USA, we would have been happy to see real GNP of 4%, unemployment of only 4.6%, mortgage rates of 6.5%, prime rate of 8.25%, cash on the books of the average corporation, twenty quarters of double digit profit growth, and inflation of around 2%.

Times are good. Those who buy aggressively now will be very happy a year from now!

Since I have been writing these letters, the only time the numbers have been as positive for future price appreciation was in the fall of 2002 and the spring of 2003.


Tuesday, August 28, 2007


The economic news this morning; lower home prices and lower consumer confidence. Long term stock market investors know that bad news is also good news. Just like there is no gain without pain, there is no good without bad.

Right now, each time there is a piece of bad economic news, the odds of an interest rate cut increases. A decrease in interest rates is to the economy like lighter fluid is to charcoal. The business economy and the housing market competes for money. The slower housing market has already resulted in lower interest rates. The long term bond rate hit around 5.4% in July of 2006 and is now below 4.9%. A half a percent interest on about 11 trillion dollars is lighter fluid for profits. The bigger move is in short rates. The 90 day t-bill currently trades well below the Fed Funds Rate. The rule of thumb is that when the t-bill trades at 10% below the Fed Funds Rate, you can expect interest rate to be cut. The second rule of thumb is that the stock market starts to move about a month before the first Fed Funds Rate Cut. After falling about 10%, the market has recovered about 5%. This recovery started about one month before the September 18 FOMC meeting.

As I have noted, I place more faith in the growing economy than in the probability of a rate cut. However, ever piece of "bad news" will increase the odds for a rate cut. RIDE THE BUCKING BRONCO! BUY BUY BUY!


Back in the 1990's when NAFTA was passed, the fear was that relatively low capital and wage intensive industries such as textiles and furniture would move out of the USA. That fear has been realized, but YOU AIN'T SEEN NOTHING YET! Yesterday, aluminum stocks in China surged 10% when it was announced that China expects to become an aluminum importer. There is not a lot of aluminum used in the manufacturing of socks or furniture.

Investors should keep in mind that this is good news not bad. It means that more and more goods are going to be produced at lower prices. The goods produced at low costs might include everything from autos to airplanes.

This is good news for the people of the USA. An US union auto worker can stop dreaming that his son will one day get a job on the assembly line. There is honor in all work but no need to spend ones life screwing fenders on cars. Machines can do that for us.

Yesterday, it was also announced that mice were healed with cell injections into their damaged hearts. The world of manufacturing is changing. More than enough goods are being produced. The price of manufactured goods is coming down. When the cost of living go down, people always find something else to buy. In the coming years, larger and larger sums will be spent on health care. Those of us who have already reached the age of 55 should expect to live to be 95. Those of you who are 35 should expect to live to be 105.

There is a connection between aluminum imports to China and a long and healthy life. Times are good. Investors should invest for the long term because most investors have more long term to live than they even realize. BUY, BUY, BUY!


Historically, the "big move" starts 30 days after a cut in the fed funds rate. Based on prices in the futures market, the fed will cut at the September 18 meeting. Prices suggest the FOMC will cut again in October and the Fed Funds Rate will be down to around 4.5% by year end.

I continue to sing praises for the job done by the FOMC under the leadership of Ben Bernanke. A good way to describe the actions of this fed is with the word smooth. Greenspan's last act was to coach the Fed Funds Rate up to 5.25% with quarter point moves. In the past, the moves were more violent. Bernanke has since held steady. Allowing the markets to "catch up" with the FOMC. In reaction to credit problems, the FOMC lowered the discount rate, which is the rate at which banks can borrow directly from the government, but they did not lower the fed funds rate.


The numbers due from the housing part of the economy are expected to show more weakness as a result of the credit crunch. Many a potential home buyer now erroneously believes that mortgages are not available. In truth, now is a good time to buy a house if you need one. The traditional mortgage is still very available. The traditional mortgage requires 20% down payment. Other more aggressive mortgages are still available but the teaser loans that were offered by mortgage brokers over the past few years are gone.

The numbers to be reported will be bad but they will also mark the bottom of the housing market. Baby Boomers are still in the market for second homes. Generation Y members are still in the market for their first homes. The sharp decline in new construction and the continued growth in total demand will gradually work off the excess glut of homes. The key fact is that jobs, jobs, and more jobs are still plentiful. If we had people in America to do the jobs, our economy would grow at a faster pace. In the absence of an effective immigration policy, many a new project is being forced over seas. Still, the average wage earners real income is rising at a steady clip. The housing market will rebound quickly as soon as the news media stops telling the world that the housing market is falling apart.


The stock market is rocking back and fourth between "old plays and new plays". Yesterday was an old play day. Energy and material stocks bounced and the rest of the market did less well. It still takes only a small refinery problem to send this "inflation complex" jumping.

The average peak of the hurricane season is September 10. Between now and then, we can expect continued volatility in the price of oil. We also know that when congress comes back to town, Democratic leaders such as Chris Dodd and Charlie Rangle are chomping at the bit to "FIX THE PROBLEMS WITH AN EXPANSION OF GOVERNMENT". One idea that will be hard to beat down is the idea of government subsidy of mortgages by allowing the expansion of ownership by the quasi government companies of Fannie Mae and Freddy Mac.

The congress has a lot on its plate. Basically the entire budget of the US Government and the funding of it needs to be settled in about a month. One of the bills that interest me is the funding of the new, satellite based air traffic control system. This new system will be similar to the GPS systems in cars. The plane will know its own exact location relative to other planes in the area and the air traffic controllers will also see a precise picture. Where this system has been implemented, accidents and near accidents have been reduced by 40%. The system will also save the airplane operators hours of flight time. One reason the delays have been long is because, under the current radar system, distances between planes must be kept large.

The big question is the funding of this 18 Billion Dollar system. Right now, airline passengers pay a 7.5% tax on each ticket. This means that a corporate jet flying just a few passengers takes many of the prime landing times while under paying for air traffic control, it takes just as much time, effort and energy to service a corporate jet as it does to service a 777.

Often times, normal economic cycles are exaggerated by the acts of congress. For example, the kick off to the first phase of the real estate cycle, the down phase, is typically accompanied by tax increases by the congress. The big down phase in real estate is still at two or three years away but we already know that the congress is planning to let capital gains tax breaks expire. In the airline area, congress took away the landing rights of the big carriers back in 2000, just before the airlines went bust and it is likely to restore some level of fairness by the September 30 deadline. A fair bill will be great news for the big carriers. It is hard to compete when the government offers corporate jets a subsidy. The average ordinary citizen who does not fly on corporate jets is tired of waiting on the tarmac while the rich take their spot without even paying for it.


Because the FOMC has played this cycle smooth, the ups and downs have not been nearly as tall as the typical mid cycle turn. Perhaps the turn still has more to go, in terms of time and movement. It is hard to tell. The pundit consensus is that the FOMC will be forced to cut at the September 18 meeting. The market would be sorely disappointed if it did not. The price of basic materials and oil in particular would take a hit. By maintaining a steady hand, this Fed Chairman would build a strong reputation as an inflation fighter. In truth, this Fed Chairman is only the first violin player in a big orchestra. The big sounds coming out of China still need to be orchestrated with the rest of the world.

I do not want to exaggerate the situation in China. The rate of inflation in China is not too bad while the economic growth rate is still incredible. I suspect Ben Bernanke and a number of other central bankers would like to a little moderation in China before backing down rates. Ben has already stated that he expects economic growth in the USA to slow during the second half of the year. The second quarter was almost a barn burner with real growth of better than 4%. Four percent growth in the middle of a serious housing and auto slump. In the old days, a decline in housing and autos at the same time was not possible without putting the whole US economy into the tank.

Again, no one knows how badly the recent sub prime mess will spill over into the rest of the economy but my belief is that the strength in the world economy will continue to provide the spill over effect. NEVER BEFORE IN HISTORY HAS THERE BEEN SO MUCH INTERNATIONAL COMMERCE! How can we believe the US economy is going to be in recession when our exports are growing at an annual rate of 11%!!!!!

I read a wonderful chapter last night. I forgot to note the name of the book but I recall that the title asks an economic question about Sex. Anyway, the author notes that he has recently started to travel a couple of miles to a neighboring town because it has a new Barnes and Noble book store. He notes that since this store was built that he has had a new steady trade deficit with this town. He does not understand all the excitement about trade deficits as he has much enjoyed the books he bought at the Barnes and Noble. On the other hand, his neighbor recently took a job at the Barnes and Noble and is enjoying a significant trade surplus with this neighboring community. Both the author and the neighbor are very happy. They are both better off because the store was built.

This is the nature of the new international commerce. The USA is not the only country that is enjoying dramatic growth in exports. Indeed, many nations are. The results benefit all. In this situation, the law of comparative advantage works its magic, more goods and services for more people at lower prices for all.


Predicting the exact actions that taken by the FOMC is a silly game. The FOMC knows more about the conditions of the economy than any of the rest of us know. Conditions may change between now and then. More importantly, conditions are ripe for a continuation of dramatic world growth. Corporate profits are likely to stay strong. Inflation is likely to stay relatively mild. Larry Kudlow, on CNBC, continues to speak of the Goldilocks Economy. He is pretty close to the mark. There are likely to be a few more bumps in the weeks ahead as the pressure is still on those who purchased homes with little or no money down and the pressure is on those who leveraged the purchase of these mortgages using short term paper. At high leverage, even a small change in spreads can hurt or help a lot.

Bernanke has arranged for credit to be available to those who are sound enough to buy up the "bad paper". The buyers will do well. The great majority of the principal and interest on these loans will be paid. The economy is simply too strong for the housing market to collapse. Before it becomes clear that the worst is over, the stock market will soar!

Remember the history shared above; the stock market liftoff is normally about one month before the first cut in the Fed Funds Rate. Since the FOMC did not over do it on the way up, it may not need to cut. If it does not need to cut, the reason will be that the economy is more than strong enough. The action you need to take to profit from this situation is to BUY, BUY, BUY. Even if there are some more bumps in the weeks or even months ahead, a year from now you will be looking back at very nice profits. THIS IS MY ADMITTEDLY AMATEUR OPINION! BUY BUY BUY!

Monday, August 27, 2007


A year from now, don't say I did not tell you to BUY, BUY, BUY. I know I sound like a broken record but conditions are ripe for a three year market boom. Those who have significant amounts of money in money market accounts today will rue the day.


One mistake often made by novice investors is to focus too much on certain fundamental indicators. The PE Ratio is one of the numbers that is widely followed into blind dark alleys. Companies that reach the peak of their earnings cycles typically trade at very low PE ratios. Looking at PE ratios can be much like driving a car by looking in the rear view mirror. Take housing stocks as an example, two years ago the entire group was on a multi-year profit run and the stocks sold at 5 times earnings of less. The stocks are much better buys today even though earnings have collapsed. These stocks traded down because their estimated earnings over the next five years is low. Energy stocks are trading in a similar pattern. They are trading at low PE ratios. The world wide boom will keep upward pressure on oil prices but sooner or latter profits will decline after oil prices go lower. These are highly leveraged situations. Profits will decline at a higher percentage rate than will revenues.

Still, PE Ratios do provide a picture of history and we can learn from history if we are willing to invest the effort. Right now, one thing we can say about the average stock is that it is selling at the lowest PE ratio in 12 years. Twelve years ago, in 1995, we were working our way through a mid cycle correction, right before the big boom, boom, boom of the second half of the decade. In 1995, sentiment of the market place was sour. Today, the average investor actually believes we are close to a recession even when GNP is estimated to be growing at 4% or better. I expect the sub prime mess to slow growth a little but I also expect business construction and sales to pick up most of the slack. Market indicators show that inflation is slowing while real growth is hanging in quite well.

Pundits have argued that we are at the top of a profit boom. They wave-off the 13.5% profit increase of the last quarter by noting that this quarter was number 20 in a row of double digit profit growth. They see this profit as being similar to a gambler who rolls 20 straight 7's. A common mistake among gamblers is called the gamblers fallacy, in which the prior rolls supposedly change the odds on the future rolls. They would say that the odds of another seven are incredibly low because the odds of rolling 21 sevens is a row is in the neighborhood of a trillion to 1. I would strongly disagree. Indeed, if someone has rolled 20 sevens in a row, I would be inclined to bet the next roll is a seven. The real odds with a fair set of dice are 1 chance in 6 of rolling a seven, however, if someone has rolled 20 in a row he must be rolling a loaded set of dice.

This is the situation with the world economy today, the dice are loaded! Numerous technologies that did not exist 10 years ago have loaded the dice in our economic favor. Last year at Christmas, a homemaker and her husband agreed to try to live for one year without buying anything made in China. They have had to do without a lot of goods and in other cases they have had to pay as much as 15 times the price!


You know the story, technology is changing our world for the better. A recent story I enjoyed was about ocean going submarine robots. Scientists from around the globe are participating in deep ocean exploration from the comforts of their offices and homes. They take turns controlling an ocean robot that is exploring the deepest waters ever viewed by man. They spend hours videoing sea life and structures that have never been seen before.

One of the things that Al Gore and friends seem to miss is the size and scope of the earth's water cycle. One tree can release over 200 gallons of water vapor in a day. The human body is about 65% water. Water is the most common element on the planet. The cartoon page this past Sunday featured water. Given unbiased information, ten year old kids can appreciate that the earth and the water cycle are much bigger and more powerful than all the humans on the planet. Water is the only element on earth that is found in all three states of being, gas, liquid and solid. It is a resource that must be protected but it is also a resource that is to be used. Water is "automatically" recycled. It is entirely possible that you drank water molecules today that were previously drunk by an Egyptians some 5,000 years ago.


I have not lowered my target price for CAL to the 40's. Indeed, the purpose of buying options that only break even at $43 per share is because I believe the stock will go much higher. Buying options is a loser's game. It is a fool's game. Still, please don't make me out to be a total idiot. I would not buy the right to buy a stock at $43 if I thought it was not going much higher!

In 2005 and 2006, I wrote that I planned to "ride the bucking bronco" through the mid cycle correction. I said that the risk of being out of the market was greater than the risk of being in it. Now that the correction is in the sight of all market participants, some are ready to declare a recession is near and others simply want to sit in cash as they wait to see what happens next, BIG MISTAKE! Chances are that the next move of more than 5% is a move of 30% to the upside. The big splash has probably already hit the pond. The ripples are still in evidence and there is fear of another even bigger splash. However, the world economy is too strong for this splash to hurt much more. Central bankers have unleashed their money machines. MZM (the monetary base) was about flat 2 years ago, at the real start of this slowdown. In recent months, MZM has been growing at better than 9%! Money is available, sentiment is ripe and stocks are cheaper than at any time since 1995! BUY, BUY, BUY!


The fuse to a potential news bomb has been lit. So far, there has been little reaction from the market but the fuse is burning.

Yesterday, a deal was made in Iraq that met some of the demands of the Sunni minority leadership. The deal will allow former members of the Bathist party to participate in the new government, opening up many potential jobs including the police force and the military. The pressure is the leadership of Iraqi to make this deal along with an oil revenue sharing deal. Progress on the one is moot without progress on the other. That is most likely the reason for the moot reaction so far. Still, progress is progress. Should a deal be made, a rapid increase in oil production in Iraq should be just around the corner. An increase of 2 million barrels per day would be on the immediate horizon (of less than 2 years). An increase of 3 to 4 million barrels per day would be on the more distant horizon.

Investors should note that President Bush will pull out all stops to get this deal done while he is still in office.


If a deal is made to share the oil, the Iraqi people will have a strong economic incentive to end the blood shed. The bad guys will be asked to leave or be reported to the army. On September 15, General Petraus will report that the surge is not working perfectly but it is working well. A new political coalition and a new oil sharing deal would support this contention. The war is not lost. Terrorists are active in countries around the globe but the number of countries actively working together to stop them is as high as ever and the number of countries quietly supporting them has declined. The world is a safer place than it has been in years. Conditions are ripe for economic deals of many kinds to be made between many governments.

The BOOM, BOOM, BOOM is here.


The world wide economic boom continues, yes, including in the USA. While it is true that the gradual rise in short term interest rates around the globe have slowed the growth rates in a few countries, the world wide boom is like the Energizer Bunny. Even the USA is humming along nicely.

The housing bust in the USA has gotten a lot of attention and it has caused a lot of bankers, pundits and news sellers to use the word recession. Quite a few prognosticators now put the likelihood of a US recession at better than 50% odds. I disagree. The odds jumped in the weeks leading to the discount rate cut but they have fallen sharply since.

Indeed, the aggregate numbers could not be much better. It appears that the USA is running at close to 4% GDP real growth and it appears that inflation rates are on the way down to less than 1%!!!

The boom in the USA is coming from the business side of the economy and from export growth. Past declines in the US dollar are working their magic. Contrary to popular belief, the USA is still the king of manufacturing and our exports are growing at an annualized rate of around 11%. Business construction is very strong and business equipment sales are strong.

Have you noticed the significant drop in gasoline prices? US refineries are running at lower capacity but producing more fuel. Airlines have increased passengers hauled by several percent and reduced fuel consumption at the same time. China grew its economy 11% this past year while growing its fuel usage by only 5%. The growth in the economy was stronger than most projections and the use of fuel was weaker than most projections. The Chinese are going to great lengths to cut consumption.

Less than 15 years ago, South Korea was a fuel hog. Today, South Korea is about as efficient as the USA.


Ben Bernanke is playing first fiddle in the central bank orchestra. His latest moves have been masterful. The big roller coaster rides of Greenspan are gradually giving way to confidence and stability. By opening the discount window and then using big proxy banks to take away the stigma, Ben was able to pump significant amounts of liquidity into the system without throwing away gains made in reducing inflation. With no change in the fed funds rate, the full court press to keep inflation in check is still in effect. With durable goods orders running at a 5.9% annual growth rate, it is clear that the US economy is still humming along.


Pundits keep talking about the unwinding of the carry trade. While it is true that much of the turmoil in the markets the past month has been related to uncertainty of profitable carry trades, the carry trade is still alive and well. In the old days, the bankers took the risk to borrow short and lend long. Because it is "normal" for short term paper to offer lower rates than long term paper, it is usually very profitable to take in short term money to make long term mortgage loans. In the past few weeks, the US curve has reverted almost back to "normal". Hedge funds and other risk takers are likely to continue to borrow short and to lend long. Because the risk of a stronger Yen has increased, borrowers may require higher rates for long term mortgages but the world is still in a time of disinflation of manufactured goods. Therefore, short rates are likely to remain low relative to long rates.

The fly in the ointment is the massive amounts of capital that will be needed to build coal and nuclear power plants in the coming years. There is definitely a high demand for construction money. Still, the situation is not the same as the last similar cycle during the 1970's. There are only 40 nuclear power plants on the drawing board in China. Think of these as new resources to produce low priced goods. China is growing as fast as it can but is being held back by the lack of electricity. As more electricity comes available, hundreds of millions more peasants will leave the farm and trillions of more dollars worth of goods will be made. The price of manufactured goods will continue to fall!

There are many ways to play this world wide BOOM, BOOM, BOOM. My family has made a significant bet on the airlines. We ask the question, what if international flight demand growth continues at 10% or better and what if significant fuel savings are realized by CAL after it takes delivery on 30 new planes on 2008? Is it possible that revenues will rise by 5% or more while fuel cost will decline by several hundred millions of dollars? We think this scenario is not only possible but is likely.

Three of our better performing stocks so far this year have been Biogen, Cree and Garmin. Those who regularly add money to their accounts continue to hit big winners. Regular monthly deposits is the way to play this game. Many thanks to all who are making my work easy by making regular contributions.

Thursday, August 23, 2007

Thank You, Thank You, Thank You

A regular reader has purchased January 2009 $35 call options. My family has a substantial position in this strike. These are very risky securities. The current price is $650 per one hundred shares. If the stock is selling at $35 or below on the third Friday of January 2009, the value of these options will be zero.

Members of my family have made a substantial bet on our belief that CAL will be selling for much more than $35. Indeed, the breakeven point at the current price is $41.50 which is the sum of the current price of the option plus the strike price. Looked at on a breakeven basis as of January 2009, the stock has to go up 36%. As I said, this is a risky bet.

Should the stock have a great run, the upside is huge. The stock is selling for about 6 times projected earnings. Should sentiment shift in the airlines favor, the stock should sell for at least 15 times earnings. In other words, if the stock were currently selling at an "average" price, it would be selling for $63 per share. Based on the average analyst estimate for earnings in 2008, the company is selling for only 6 times earnings and a reasonable price target based on these estimates is around $75 per share.

Investors should always look forward when making investments but taking a look back can give one an indication of the future. For the past 12 quarters, the analyst have underestimated CAL earnings by an average of .24. Add 24 cents to the forward projections and the stock is only selling at 5 times earnings. A reasonable adjustment to the price target would be an additional $14 per share or $89. The beauty is that should the above happen, the momentum buyers would join the party. They would likely drive the stock to 20 times earnings, taking the price up to $120. Again, based on history, during the "prosperity" phase of the economic cycle, which is the phase we just entered, the earnings will grow dramatically more than the projections. My family hopes to exercise the options before January 2009 so that we can continue to ride these share to the $150 level.


Using the first target price of $63, the option that currently sells for $6.50 would be worth $63 - $35 or $28. The gain would be $28 - $6.50 or $21.50. Of course, the gain would be much larger if the other target prices are used. An $89 price would make for a gain of $47.50 off a $6.50 investment.

I do not recommend option trading. It is too risky as one has to be right about a big move in a stock in a relatively short period of time. It is hard enough to be in a stock that increases 15% in value over a year or two. Betting that a stock will do better than 35% is a gamble.

Still, I am thankful to the reader who purchased options. This bucking bronco has shaken a lot of people off at exactly the wrong time. Stocks are cheap and the economy is strong.


We have entered a time similar to 1995 to 2000. This time, the tech stock boom will not nearly as crazy but it will be real. Business travel will continue to set all time records.

Yesterday, American Airlines announced new daily service from Chicago to Buenos Aires, Argentina. Boy, I would love to have the franchise for that one daily flight. Think of the incremental revenues produced. Some low ball numbers show how much international demand is adding to the bottom lines of major carriers. For example, if the plane carries only 120 passengers per day and if the average ticket price is only $400, the daily revenues would be $48,000. Assuming 6 flights per week, the annual revenues would be $15,000,000. This does not count all the continuations to places other than Chicago. My numbers could easily be half the actual numbers. Continental will add 30 new planes in 2008. Revenues should grow by 20% or more. Profits could easily grow by 50% or more. GO CAL GO! BUY BUY BUY, MULTIPLE CARRIERS.

My family does not have all its airline eggs in one basket. The rumors about consolidation continue. The old saw about buying the rumor often works. I do not know who will buy whom. By owning shares in AMR, LCC, DAL and UAUA my bets are hedged.


Google announces new deals and new services daily. Google continues to take market share, in the USA and around the world. Even where it has been weak, China, it is making deals and gaining share.

The latest neat service offered by Google is a virtual telescope view of the universe. Neat stuff.

The big play is still on the horizon. Phone companies continue to spend billions annually to prepare for high speed mobile Internet service. Google will probably bid on wireless spectrum in the upcoming auction. I believe the US Government will take in a huge amount of money. Google suggested earlier that the company would bid at least $4.6 billion. The total bids will likely be much higher. Good timing for the politicians and good news for America. New high speed mobile services are going to spur productivity and change the way you live.


The mid cycle turn, turn, turn is here. Japan did not raise short rates today but its economy is expected to grow by better than 2.5% this quarter. Japan's economy will strengthen over the next several years. Growth in emerging markets will slow. The politicians who have bashed China for accumulated trade surpluses will be surprised to know that much of that trade deficit will disappear as China pays for the construction of 40 nuclear power plants. It is pretty amazing that Japan will actually build some of the plants in China. Who would have believed these two would be in business together?


The turn does not mean that the US housing market is about to collapse. Despite the pounding the housing market has gotten in the news, the market is ready to recover. Yes, many of those who fall victim to the "news" will panic and sell at any price. Many a rent house will be auctioned off. This is not the beginning of the problem but the end. The market has been weakening for almost 2 years. The worst of the down turn is over. Bargains are available for the careful shopper. It is a buyers market. The seeds of recovery have already been planted. The supply of homes on the market will soon start to decline. By next spring or summer, the "news" of the housing recovery will be all around.

Mortgages will still be available from banks and credit unions. Terms will not be as good as 2003 terms but even a 3% spread over the one year treasury index does not look bad. The one year index has fallen over the past couple of weeks. Throughout most of my life, mortgage rates were higher than what is currently available. Don't get suckered in by the hype. It is time to be an aggressive investor.


Wednesday, August 22, 2007


This past quarter, CAL earned almost as much as it did in the same quarter of 2000. This is no small accomplishment, given that fuel costs were up about 400%. The story is told well by looking at the unrestricted cash on hand. CAL spent 8 of the last years with unrestricted cash of close to 1 billion dollars. In the past three years, cash has soared to almost 3 billion dollars.


During the current quarter, fuel costs have fallen significantly. Most of the drop has happened in the past few days but, as you may recall, gasoline prices peaked in late May and have been on a downward trend all summer. Based on current wholesale prices, gasoline should be selling for around $2.46 retail in just a few days. Jet fuel prices are more difficult to follow but each decline of 1 cent lowers CAL's annual cost by $18,000,000.

Last fall, we went through a similar swoon in prices only to see prices of crude oil bounce all the way back to the prior peak by July. What is different this time? Many things! What a difference a year can make!

What is not different is the breaking of all prior traffic records. Month after month the old records fall. Based on the record for the first 21 days of August, the airlines are about to set another all time record for full seats. Full seats, lower cost and higher fares is a formula for PROFITS, PROFITS AND MORE PROFITS!


I had another good laugh yesterday when yet another good politician said "so and so should have known" about three times in one paragraph. One of the "should have knowns" was that Ben Bernanke should have taken action long ago to prevent the sub prime mess and another one was that companies should have hedged their fuel costs.

Hindsight is always a powerful tool in hindsight. Foresight is nothing more than a powerful gamble. In other words, it cost money to hedge fuel expenses. If you hedge an expense and you are wrong, you just wasted the money you spent on the hedge. CAL takes the right approach.

CAL works day after day to make its fleet the most fuel efficient in the industry. The company recently sold 10 of its older planes and finished the installation of wing tips on many more. It will take delivery of 30 new planes next year. The company has decreased fuel consumed per available passenger mile by more than 35% in the past 4 years. In other words, the best way to hedge a fuel expense is to eliminate it.

To the extent that CAL has pre-sold tickets, it has purchased fuel hedges. CAL management philosophy is one of simple elegance, there is no need to hedge prices next year as ticket prices will be forced to rise if fuel prices rise. To the extent that seats have been sold forward, fuel must be purchased forward to "lock-in" a profit. There is that word again, PROFITS, PROFITS AND MORE PROFITS!


Last year, I wrote that the 5.25% fed funds rate was starting to BITE, BITE, BITE. Because the USA is a smaller portion of the total world economy now-a-days, the BITE of the FOMC is not as powerful as in the old days. The US economy was slowed by the higher rates but the economies of the rest of the world continued to soar. In the year after the FOMC stopped raising rates, other nations played a slow game of catch up. Rates were raised numerous times from Canada to Australia to Europe and to most points in between. The BITE of higher rates has finally had a slowing effect on the European economy while resource rich nations like Canada and Australia have seen their currencies rise and rise some more. Strong currencies are good but they also impose huge costs. The price of goods produced in Canada and Australia are now very expensive to the rest of the world and tourist to these areas also pay dearly. Because the US dollar has been weak relative to all major currencies with the exception of the Japanese Yen, the current cost for Americans to travel over seas is very high.


The amazing economic reality is that even the weak dollar has not caused the average cost of manufactured goods to rise. YES, there is still DISINFLATION of goods prices. WAL-MART continues to lower the price of goods sold! The people of the world are enjoying a better life as they continue to be able to spend more on "the good things" because their basic needs can be covered with a smaller and smaller portion of their disposable income. Put another way, the cost of a college education continues to soar because more and more people willingly "buy the product".

All the while, the Chinese economy has soared. Even though yesterday's increase in interest rates was the fourth one China has made this year. No one knows when these rate increases in China will start to BITE, BITE, BITE but the odds are that at least a modest slow down in growth is on the horizon.


In some ways, China has more economic tools available than fully democratic nations. Two examples of recent moves, the government recently put a moratorium on new airline companies. No matter how much money a business or individual has available and no matter what the supply demand story, a new airline simply cannot be started in China. China has also taken a page out of the American play book from the 1970's. It has instituted an odd-even day for driving cars. If your license plate ends in an odd number, you are not allowed to put your car on the road on an even numbered day and vice versa.

Odd - Even Days is just one of many steps that are being taken to drive down the cost of fuel. One of the more interesting technologies being deployed is electric power generation by wave turbines. In Portugal, massive floating tubes generate electricity when powerful ocean waves lift the sections. This system reminds me of the ram pump my Dad put on a creek to water his garden. He was able to pump water more than 1,000 feet while using no electricity. He converted water pressure into mechanical energy to divert a small portion of the creek up a big hill and all the way to his house.

I have never been a fan of windmill power as the total amount of concrete and steel used per kilowatt of electricity is huge and, since the wind is unreliable, the cost of back up generation power must be factored into the total cost of windmill generation. Also, wind mills must be widely dispersed which means that high transmissions costs must be included.

On the other hand, water power is typically much more reliable and much less costly. Some of the cheapest electricity in the world is hydro-electric power. Ocean waves are also reliable and water flowing through a turbine is much more powerful than wind. A ram pump is a simple device. If a turbine is fixed to turn only one way, then with each wave, water flows backward to no effect but then powers the turbine on the "down hill" stroke. In a long set up, the motion becomes similar to that of a piston engine where one cylinder fires while the next one spits out its exhaust. In the soon to be completed first phase, Portugal will be supplying 1,500 homes with wave generated electricity. The second phase will take the level to 15,000 homes. Wave power will not eliminate the need for oil but it easily supply as much as 10% of the total power needs.


Another innovation comes to us through a company called ZipCar. Many a city dweller has found that they do not need to own a car. The number who do not has recently been jumped in the cities serviced by ZipCar. ZipCar places cars of various sizes and styles all around a city. After signing-up, customers can go online to find cars parked nearby. They can order the car for an hour or more online and then use their personal id card to unlock the vehicle. The car will not start unless the driver is in possession of a valid "company card". In major cities, many folk use mass transit for their daily commute to and from work. Many folk own a car just for occasional errands or the week end trip. Scores of folk are finding that they can "rent for less". Many are excited because they rent the size and style vehicle they need for each occasion for a total cost that is far below the cost of ownership.

The fuel saved by the increased use of ZipCar may not be obvious but it is real and potentially huge. The big difference is in the marginal cost of usage. A person who has already invested 30K in a car, pays only the operating costs to drive across town. While the total cost to the ZipCar user might be dramatically less, the margin cost are dramatically higher. Given the option to walk a couple of blocks to the subway or to pay the rental cost for an hour, many a trip by car will be avoided.

As more and more of us become constantly connected to the Internet through mobile devices, the practicality of ZipCars becomes all the more real. If you are on one side of town and realize you need to be home in a hurry, you simply call up the location of a nearby vehicle on your mobile device. The code to unlock the car might even be sent to your mobile device.


Marilyn and I will be making our "move to town" in about 6 months. Winston-Salem does not have much to brag about in regard to mass transportation but, even so, our total mileage should decline sharply. With restaurants, parks, libraries, banks, the YWCA and many more places and services close, we will drive less. The city has made plans for a new electric trolley that will include a stop at our new home. As residents of big cities know, new homes and apartments will be built near subway stations and trolley lines. This is the old chicken or egg coming first story. High energy prices will encourage some to move to town, others will move after the new population is sufficient to support new services. The downtown crowds encourage festivals, events, restaurants, art shows, museums and more crowds. Suburbanites who enjoy these new events and services will consider moving to be close. Once started, demographers say such cycles last about 40 years. In Winston-Salem, the "big move out of town" started around 1964. The "big move back" started around 2004. "Big moves" start slow, like a train, but then pick up unstoppable steam. The current mortgage crunch has slowed the "big move" like a train moving up a hill but the crest of the hill is in sight! It took 40 years for America to become a land of suburbia, over the next 40 years, the center cities of suburbia and the old "down towns" will see the big growth.


City dwellers who do not own cars will likely vacation in resort towns where cars are not needed. Getting to the resort will likely be by air. Again, the marginal cost of driving a car will demonstrate that most airfares are cheap. Yes, the process of globalization is a decades long event. The airlines will see good times and bad times within this long term cycle. The good news is that we have entered the "good part" of the business cycle. Over the next few years, business travelers will pay big bucks to go to points here and yon. CAL grew revenues 17% last year. In any business, if you grow your capacity by only 5% but your revenues by 17%, then you are racking in the dough. The difference is in more sales volume or a higher price per sale or a combination of both. Generally volumes lead prices. Therefore, much of the 17% increase last year was an increase in full seats. With virtually every day time seat flying full, the next big move is in price. CAL could easily increase revenues 17% for many years in a row without increasing capacity by much. Let the good times roll!

Monday, August 20, 2007


Today, the mortgage mess continues to weigh on financial stocks and the index is down 1.14%. There will be continued bad news out of this sector but most of these stocks have already hit bottom. On the other hand, the energy sector is down .91%. This sector is in for a prolonged period of under performance. It will be years before the sector makes its final bottom and when the big up move starts, this sector will see gains. Relative to other sectors, it will do poorly.

In contrast, the tech sector is down only .02 today. When the novice looks at this market, he or she will see the red ink and think this is bad news but this is a sector that will do well over the next year or two or three and being down .02 when the average stock is down more is a relative win.

The transportation index is up .62%. Of course, this is a reaction to lower fuel prices and of course fuel prices will continue to be volatile. Still, this is one of the sectors that will do well in the coming years.

One of the toughest things for many novice investors to learn is to buy relative strength after a turn. There is a temptation to buy the stocks that have dropped the most on the thinking that they will bounce back the most. Home builders would be a good buy based on this strategy. They might do well but one investors should note that they went up and up and up and up over the past 6 years before they fell 50%. The 50% drop is nothing compared to the climb they made. Because mortgage rates will stay high relative to the past 6 years for the next several years, one should not expect the home builders to soar and soar and soar again anytime soon.

Investors should try to buy what will do well over the next several years, not what has gone down a lot after doing well for a number of years. This leaves out energy and home builders as candidates for investment.



Last Wednesday the 90 day T-Bill rate declined by more than 9% in the one day. The rate fell below 4% even though the Fed Funds rate is still pegged at 5.25%. The Fed Discount rate was lowered to 5.75% last week.


Friday, a very smart man said BUY, BUY, BUY. The man, Arthur Laffer, is a "common sense" professor, my kind of guy. I like smart people who know what to do with their smarts. Art, was an economic advisor to Ronald Regan but most famous for his discovery of what is called "The Laffer Curve". The Laffer Curve shows that governments can increase tax revenues by raising taxes only to a certain point. If tax rates get too high, revenues go down. There are several reasons that excessive taxes hurt. Two of the key problems are that economic activity is penalized and "games" are begun for the purpose of avoiding taxes. It is simply human nature to resist government when it becomes oppressive.

Economic freedom is key to a prosperous world. You can find a number of "poverty" maps that show the strong relationship between wealth and economic freedom. The relationship is obvious as common sense tells us it should be. In countries where free markets are allowed, the average per capita income per person is very high. In countries where oppressive governments exist, per capita income is very low. In between, you have a highly correlated scale. You find that the direct relationship between economic freedom and income is highly correlated.

It is interesting to note that political freedom does not correlate as strongly as economic freedom to incomes. China is the prime example where economic freedom has opened the doors of prosperity to the common folk while political freedom does not exist. The good news here is that economic freedom fosters political freedom. A society of relatively wealthy people are not as easily "bull whipped" into going along with the whims of a dictatorial government.

In example after example, when a political leader gains too much power and takes away economic freedom, the people are soon worse off economically than before. Venezuela is a prime example, the oil companies were nationalized and theoretically the people were enriched by the oil revenues. It worked as a temporary measure but the incentive to produce more oil is gone. Who among us would spend billions to develop oil production if the "profits" were to be distributed to others?

Art Laffer says, BUY, BUY, BUY, but he says to avoid energy stocks. He says the law of substitution (which is a sub law of the law of supply and demand) has not been repealed. Day after day, trillions of decisions are made to substitute something else for oil. The list of substitutable items is a list of millions of items. We tend to think in grand terms such as the building of a nuclear power plant or on a family basis for the purchase of a 40 mile per gallon car versus a 15 mile per gallon car. Most of these trillions of decisions are much smaller in scope but together a powerful force. In thousands of factories per day, millions of relatively minor tweaks will cause a very minor increase in efficiency. When a home is built, scores and scores of minor changes are made to save. Just a little better insulation practice around windows has continued to lower the heat lost for years and years to come. The move to improve is constant. The urgency of the move to improve jumped when the oil price moved up sharply from 2000 to 2006.

The past two years, we have been in a "topping process". No one can say, which straw will be the one to break a camels back and no one knows exactly which new production facility will break the oil markets back but we all know that a camel can only carry so much straw and we all know that gas at $3.00 per gallon will cause some people to move closer to work, to walk to work, to bike to work or to stop going to work because the costs are just too much. In today's environment, $3.00 per gallon seemed to be an inflexion point. However, the guy that trades his truck for a Honda Civic will not be quick to trade back if the price drops only to $2. He will continue to brag about his high mileage to his neighbor who still drives a truck.

Art Laffer says, buy retail, buy technology and buy industrials. These all happen to be the next sectors on the "Market Cycle Wheel" posted on my office wall. Airlines are a subset of the industrials sector. Art made his statement to buy, buy, buy on Kudlow and Company this past Friday. He did not mention to avoid material stocks but materials and energy are the two sectors on the "down side of the Market Cycle Wheel" and they tend to trade together.

One should buy materials and energy during times of excessive strength in the economy. Over the past two years, central bankers one after the other have raised and raised again short term interest rates in their attempts to weaken excessive economic strength. The excessive strength is a two sided coin. It would have been impossible for China to grow by better than 10% average over the past several years had the rest of the world not been strong enough to import the products from China. Because hundreds of millions of low wage workers were employed, the super growth was in China and in other developing nations. Most recently, the higher interest costs finally started to slow more economies. Europe, which has enjoyed a very high Euro currency, has finally started to pay the price in economic growth. The slow down of the developed nations will cause the developing nations serious problems.

In the old days, when the US economy was very large relative to the rest of the entire world, the saw was that when the USA catches a cold the rest of the world catches the flue. After super strong global growth, it took more than slower growth in the USA to slow the rest of the world. Now that the USA and Europe have a cold, the rest of the world will slow down. The demand for energy will slow along with a moderation in world wide growth.

Because this is only a mid cycle correction, I believe the worst of the slowdown is already over in the USA. The slow down has arrived in Europe and it is yet to come in China. Investors should avoid international mutual funds!

It is not clear that the carry trade from Japan has been fully unwound. Indeed, from one perspective, the carry trade will never go away. Carry trades are part of the constant open market between nations. Global economies are linked together today like never before in history. The carry trade is really nothing more than an important part of the currency market. For smooth commerce to occur between foreign governments, an active currency market must exist. Do you remember the days when Jimmy Carter bartered millions of bushels of wheat to Russia? Russia used to trade its oil and natural gas for specific products, often agricultural goods (collective farms never worked well). Today, Russia holds billions of foreign reserve credits. It can trade in the open market just as easily as you and I can buy at Wal-Mart. Getting paid a dollar in wages and using that to buy goods is a currency trade at work.


With commodity prices on the way down, inflation rates will moderate, allowing Central Bankers to ease off on the credit brakes, allowing users of commodities to enjoy extra profits (businesses) or extra disposable income (consumers). Low inflation is a key ingredient to real economic profits. The best of this economic cycle is yet to come. Those who positions their investment accounts properly will do very well.



Saturday, August 18, 2007


Many thanks to Al and Bob for their good comments. Because the new median home size declines when mortgage rates go up, the actual decline in home prices is almost nil. Of course, there are some very tough markets that have seen major declines but the value of the average home across America is holding up well and the value will jump several percent as soon as people realize that the bark of the sub prime market is much worse than the bite.

The hypocrisy is that many legislators who were all for letting everyone have a shot at the American dream of home ownership are now the ones saying how awful it is. The fact of the matter is that 86% of all sub prime loans are current and most of the rest will be made current. The truth is that many families have gotten into a home and are making payments and are building equity. We reached the highest percentage of home ownership ever and many of these good folk will never again return to the rental market.

Bob is correct that we must be concerned about the potential legislative action but grid lock is the good news in this regard. With a deeply divided congress under Democratic control and with a Republican President, the only bills that will be passed will be centrist compromises. There will be some bad junk passed but all in all the damage is not likely to be great.

Thanks again!

Friday, August 17, 2007


An economic turn is not a smooth corner three turn. It is a tricky turn where the central bankers of the world have to pay attention to what one another is doing and avoid a number of obstacles littered across the roads. Ben Bernanke, the current chairman of the FOMC, has done a fantastic job of navigating the hazards. This morning, he added what I believe will be the master stroke! He has lowered the discount rate by one half of one percent and loosened the rules. Financial institutions will, for the foreseeable future, be allowed to deposit subprime and other assets as the collateral for loans. THE FED WINDOW IS OPEN FOR BUSINESS!

Does this mean that all stocks will go up from here? NO! Does it mean the momentum players that were driving down weak stocks by short selling are caught in a noose, YES!

One key way to observe and understand the turn is to note that basic material stocks and financial stocks are on opposite ends of a "see-saw". This is a generalization because there are certainly many differed species of financial and basic material stocks. In other words, a regional bank that makes most of its money by lending businesses is very different from a mortgage broker. Still, again, it is generally true that at the turn, the basic materials will start to perform relatively poorly at about the same time that financials start to outperform.

Look at the recent action. Yesterday, the financials lead the market during a huge afternoon rally. The two day average of financials is a gain of 3.4%. The two day average of energy stocks is a loss of 1.3% and materials lost .5%. Over the past 4 days, financials were down .8% WHILE MATERIALS WERE DOWN 5.9% AND ENERGY WAS DOWN 5.5%. OVER THE PAST 21 DAYS, MATERIALS STOCKS WERE DOWN 14.8%.

Understanding the relationship between financials and materials requires just a little thought and a little common sense. Suppose the US economy is about to move into what is commonly called the "prosperity phase" of the business cycle. In this phase, businesses expand because profitable ventures can be easily found. Under this environment, the demand for business loans is substantial. Thus, cheap money, the type used to build million dollar ocean front beach homes is no longer available, but business rate money is available for borrowing. At an 8% prime rate, many a business loan makes sense in this environment as business might make one expansion after another where there is a 15% return on invested capital. The 8% loan is hard for a beach home owner to swallow.

With the demand for business money being high, real interest rates stay high. When real interest rates (the interest rate minus the inflation rate) stays high, those who have hoarded basic materials face a high cost of carry. In other words, during times of cheap money (when interest rates are close to or even below the inflation rate), it makes sense to hoard oil, gold, and other materials.

The other thing that has happened is that capacity to produce materials has soared over the past few years and new capacity is set to come on line again and again over the next few years. Put another way, when the price of gold soared from the $300 range to the $700 range a few years ago, the price went way above the cost to produce it. Thus, for the past several years, miners have expanded capacity as quickly as they can. The same situation exists with oil. Just a few years ago, it was widely known that Canada has more oil in tar sands than Saudi Arabia has in desert sands, but virtually none of this oil was being extracted. Today, refineries in Detroit and Illinois are being expanded to handle the new oil flows and a mega refinery is planned for South Dakota. In addition there is a new refinery under construction in Canada and others are being expanded. Tons of oil is being produced at a cost of about $35 per barrel. With oil likely to trade at more than $35 per barrel for many years, you can expect rational oil men in Canada to continue to expand production.

Does it make sense that the price of oil is showing signs of rolling down substantially? Does it make sense that energy stocks have taken it on the chin hard during the past few weeks while financial stocks that have underperformed for years are suddenly showing signs of life!


PLEASE FORWARD THIS EMAIL TO A FRIEND SO THAT HE OR SHE MIGHT UNDERSTAND THAT A MAJOR MARKET MOVE IS ABOUT TO GET UNDERWAY. As always, I cannot promise that there will not be more bumps in the road. Conditions are ripe and the FOMC has opened the gates in a major way. The FOMC did not break the damn. It did not lower the Fed Funds target rate and the discount rate is still one half percent higher than the Fed Funds target. Still, relief is there for a lot of problems. Valuable paper that has not been tradeable for the past week or more is now acceptable collateral for loans. Banks will be able to buy tons of loans at significant discounts. The discounts will be dramatically reduced quickly as the huge majority of all these mortgages are "good money". The borrows will pay every cent!

Thursday, August 16, 2007


I am not a great fan of technical trading but I do watch technical indicators to help with my long term perspective. By the same token, traditional fundamental analysis can also be very misleading. The best buys I have ever made were based on a good top down view of the world. Most of the best buys were washed out stocks where the conventional wisdom saw no hope of recovery. The stocks typically were not attractive from a technical or fundamental perspective. The P/E ratio on a washed out stock is often infinite. A good example, of course, CAL which traded at $4 a few years ago and which had no earnings or net assets. Still, technical indicators have a place in ones investment tool bag.

Jamie Baker upgraded CAL to his market focus list today. He has posted a 12 month price target of $37. He gives fundamental reasons why CAL should do well as a company but he also mentioned the old down 30 in 31 airline rule. This rule has worked for airlines because they are cyclical momentum plays. The rule says that if an airline drops 30% within 31 days, it will rally strongly over the next 6 months.

The rule sounds like an old wives tale, but it has worked rather well. I'll always remember the time a smart investor friend told my poker buddies that US Airways was a goner. He and I had a heated argument and I invested all I had available at $6 as soon as the stock started moving up. Many years later the company did file bankruptcy but the stock was trading at $4 when my friend and I argued and the stock zoomed to $65 per share over the next few years. Folks, if you ride one stock hard on margin over such a move you will make a fortune.

CAL has moved from $4 to $54 and back down to $26 in five years. The second leg of the move is ready to roar. No one can say that the carry trade unwinding is over. Liquidity problems are still all around. The bottoming process may take a while longer. However, there is a real probability that the world economy will slow enough to take the pressure off oil prices. Should CAL save 10 cents per gallon, without reducing revenues, it will make almost $2 extra per share. WOW! What if it were to save 50 cents per gallon?

The top down view is that the world has never seen such strong demand for international air travel. As far as the eye can see, the growth in China, India, et. al. will increase demand for travel. Check the web and you will find an article about how China has decided to limit the number of new airline start ups. Under new code sharing agreements and new ticketing agreements, it becomes more and more important for airlines to have partnership deals. The little guys are going to get squeezed by the majors.