Friday, September 28, 2007


Presidential candidates are apt to propose anything in hopes of getting elected. John Edwards, a former NC country boy, is a case in point. At the most recent Democratic debates, he and other hopefuls proposed raising the Social Security Tax dramatically. The idea is popular among those who hold the socialist idea that the primary purpose of taxes is to take from the rich while giving to the poor. There is a reasonable argument for a certain amount of this "income redistribution", there is also a powerful argument against killing the goose that lays the golden eggs.

The economic argument for income redistribution is that the marginal value of a dollar to a person who is hungry is much higher than the marginal value of a dollar to someone who is wealthy. On the other side of the issue, tax the heck out of wealth and several bad things happen. One is that the incentive to work more than a minimum goes away. Another is that the entire economic pie shrinks over time. The average size of each piece of pie goes down and down some more even while the pieces are closer and closer to the same size.

There are other "external effects" not seen immediately. A big one high US taxes results in a high loss of US jobs.

John likes to talk as if he would only raise taxes on the top 1% of Americans. In fact, by raising the tax on social security he would impose a significant extra burden on the small businesses of America. In particular, labor intensive businesses would see a significant increase in taxes. Adding an extra cost to American businesses is a good way to send more jobs over seas.

I am a strong support of free trade because in the long run, everyone wins by following the path directed by the law of comparative advantage. Under free trade, wheat will be grown in Nebraska, oranges in Chile, computers will be designed in silicon value and computers will be assembled in China. However, increase the tax on labor in America and less investment and economic activity will be performed in America relative to what is performed overseas and even those in Chile who trade oranges for wheat will see their costs go up. In particular America will be hurt by the confiscation of income. If it were true that the government used tax dollars more efficiently than those from whom the dollars are confiscated, the pie would not shrink. Surely you are not among the few who actually believe the government is efficient.

I encourage all of you to visit the blog written by Karl Fisch. The URL is (a hat tip to Keith Hayes of HayesAdvisory for suggesting the site to me).

An interesting set of data is presented on this site and on several YouTube Videos. A couple of key points made that relate to the issue raised above is that if all the jobs in America were sent to China, there would still be millions of unemployed Chinese. And if you think that only the low skilled manufacturing jobs will leave for China, the number of people graduating from college in China is a much higher number than in America. Perhaps the most interesting point is that in about 10 years, there will be more English speaking people in China than there will be in all of North America.

The tax increase proposed by John would take the top marginal rate up to 47%. Of course, such a burden would result in lobbying for loop holes and the tax system would gradually become all the more complicated. The competitive position of America would be damaged. Ironically, countries all over the world have begun to understand that high taxes kill the golden goose. Other countries are lowering their taxes. Should the US raise its taxes at the same time that others are being lowered, the hit to the US economy would be extra severe.

Some like to argue that the increases in taxes during the Clinton years prove that taxes do not hurt as much as "economic libertarians" argue. The fact is that fiscal policies have a delayed effect. A business that has made huge capital investments in plant and equipment is not going to throw his investment away. He will continue to operate for as long as his marginal revenues exceed his marginal cost, however, he will look elsewhere when making new investments. By the end of the Clinton years, the boom had turned to bust.

Over the past few weeks, many have argued that the excessively low interest rates set by Greenspan in 2003 led to the sub prime mess. Monetary policy certainly played a roll but central bankers work within the framework established by the fiscal policies set by the President and the Congress. Extremes in interest rates are typically the result of mistakes made in fiscal policy and in monetary policy. Greenspan had to "row the boat" very hard, upstream, to counter the lagged effect of the tax increases made in the Clinton years. Latter, he had to start holding back the fast moving boat when the Bush tax cuts kicked-in. The wild ride did not need to be.

Life would be easier for all if tax policy were tweaked instead of jerked all over the place. The huge tax increases proposed by John Edwards and the similar increases proposed by his competitors are exactly the wrong policies needed.

Yes, an increase in taxes would raise revenue to the government and the budget might be balanced (of course it would not be balanced if most of the additional revenues were spent on health care or any other government programs), however, if you want to see a recession indicator, look at all the times the government came even close to balance. Nixon actually came close to balancing the budget before he left office. Yes he came close in 1973. Would you like to live through another recession as tough as the 1973-1974 recession. Bill Clinton balanced the budget before he left office but the recession was already baked into the cake when he left. The fact is that the budget never has to be balanced. The debt could possibly grow for ever and, as a result of growing less fast than the economy, it could remain at a law percentage relative to our total net worth.

By the way, one part of the explanation for the dramatic fall in the value of the dollar is the reaction to the probability of tax hikes in America. Markets look forward. When multi-national businesses see tax hikes being considered in America while they see tax cuts being considered in France, it is only natural for them to consider making their next investment in France.

The mind set that sends so many politicians down the wrong trail is that businesses set the price of their products or that the central bankers set the price of money. Markets are much more powerful than any business or any banker. Markets set prices. When taxes take a higher portion of profit margins in one country, the activity is encouraged to go elsewhere. Excessive taxes are simply a dumb, dumb, dumb idea!


The congress continues to dance around the FAA funding bill. One idea after another has been discussed. Ideas like having government officials set the flight schedules. All of the ideas being floated by the congress are attempts to "fix the problem" without agreeing to fairly fund the system. It takes money to buy bread and money to provide air traffic control, there is no free lunch, someone has to pay.

The congress faces this problem because its past attempt to tax the rich and give to the "poor" has caused massive pain. In this case, the extra tax on the major carriers was partially to blame for sending these companies into bankruptcy and now it is partially to blame for forcing passengers to circle airports or to sit on tarmacs for hours. Of course, pointing fingers is not the way to correct the problem but a basic understanding of economics would help.

If the congress is going to continue to insist that the owners of small planes get "90% off" then small planes are going to consume the bulk of the service. Under the current system it is like the US government is operating a Starbucks where coffee is sold to all who do not have a job at 30 cents per cup. Those with jobs hate to go buy coffee because they must stand in line behind hoards of "free loaders". The big difference in this Starbucks and the FAA funding is that the government operates the only "store" for miles around. If you want coffee, you must stand in line or go the long way around. The really bad news is that your cost per cup is not the standard $3 but $8 because someone has to pay for the money lost on all the 30 cent cups! Even more bad news: the projected growth in the purchase of 30 cent cups is off the chart. In 2008, there will be more than 1,400 small jets added to the fleets of those who are enjoying the 90 percent subsidies. This is great for small plane manufacturers and for those who can make use of the small planes but it means millions of more delays for the passengers on commercial flights.

You see, even the $8 coffee is not enough to make up for the many cups of 30 cent coffee sold at a loss. The result is that the coffee must be rationed. There is demand to build many more stores to offer much more of this 30 cent coffee but there is a limit to what the traveling public will pay. The end of the John Edwards story above is that the "rich" small business must leave the USA or suffer and the end of the airline story is that the public must buy their own small plan or perhaps participate in protest marches in Washington. When planes loaded with hundreds of passengers sometimes sit on the tarmac for hours, while 20 million dollar private jets take off and land for pennies on the dollar, something has to be done and something will be done.

I don't believe the congress is willing to allow the airports to be partially closed even for a day or two. At some point, they must reach a workable compromise. The demand for air travel is growing rapidly, even while the horror stories created by congress are in the news daily. For a while, the finger of blame can be pointed at the carrier of the day that has had a problem. Sooner or later, the public will realize that the funding system is the problem and not the individual carriers.

Congressional leaders have tried to use health care for poor children as a foil to win sympathy votes. The congress has passed a bill to throw $35 Billion on top of a $5 Billion Dollar program. In terms of government spending the extra $30 Billion is small potatoes. Even so the congress has not been able to put together a veto proof majority. A continuing resolution has been passed. The government can continue to operate even though none of the 12 annual budget bills has been passed. Over the next several weeks, bills will be passed and the FAA will be funded. The big subsidy to "small jet owners" will not be eliminated but it will be reduced dramatically.


One reader believes that his increase in his cost for food and gas have been far more significant than his savings from the Internet. As I mentioned yesterday, each of us has an individual inflation rate that is a little bit different from all others. Besides, while the Internet and other information technologies provide great examples of savings, lower prices are in products every where. The savings that a business achieves though the use of the Internet shows up in all sorts of products and services.

One of the problems we have in seeing the lower prices is that we often choose to pay more for a new product that is then compared to the price of the old product. For example, the price of TV's have fallen and fallen and fallen. The real cost of a black and white TV that offers a great picture relative to the one I started watching more than 50 years ago is a tiny fraction of the cost of that old TV; the price has dropped in real terms by more than 90%. The price of color TV's have gone through the same process and in recent years the price of digital high definition TV's has been falling like a rock. In like manner, in real terms our monthly phone bills average much less than the phone bills of the past but this is for a mobile phone; a phone that has given us huge savings in other costs but that by itself is seen as an expensive toy by many people.

If you want to see savings, productivity and dis-inflation, take a look at the cost of data storage. In 1981, electronic data storage cost $700 per megabyte. The latest designs bring the price down to $.002 per megabyte. Go back further in time and you find that the price of an IBM 5MB drive in 1956 was $50,000. Even at $10,000 per megabyte, savings were realized over the "old system". The huge savings comes in the time spent retrieving the data when needed and the electronic method would not have been adopted at all if it was not cheaper than the old paper and file cabinet system. So, the cost of data storage during my life has fallen from $10,000 to $.002, a factor of 5 million times! My friend will probably respond that he does not buy data storage and that he does not understand what data storage has to do with the cost of his food and gas. In reality, he does consume large amounts of data storage and he does benefit greatly from the decline in the price. When he goes to the hospital to get a heart operation to save his life, he will benefit from data storage. Neither the hear operation or the data storage even existed some years ago.

Perhaps this reader does an occasional "Internet Search"; since there will be 2.7 Billion Google Searches done this month and since 57% of all searches will be done on Google, lets assume the search is a "Google Search". Google did not exist 10 years ago. Before Google came along, how would my friend have gotten the information? Would he have driven to the public library, done a free search in a card catalog to discover the location of a source, visited the stacks to locate the source and then searched the table of contents to find the section, etc? Compare the cost of one data search and one can surely see that costs are going down not up. Inflation is really about productivity. What can we do today that will substitute a cheaper resource for a wasteful expenditure?

We are living in a time of accelerating innovation. We keep doing more and more while spending less and less. In the short term, care must be taken to not "jump ahead of ourselves". With massive numbers of citizens of the world just now able to afford the "good life", again due to the deflation of costs, we must try to maintain a reasonable speed limit. We cannot expect billions of more goods to be produced until infrastructures are in place to support the production and delivery of those goods.

Yesterday, the government of China made a few more tweaks to try to slow growth. The interest rate on second homes in China was raised to 10% higher than the rate for first homes. The projected slow down in growth from 11% to 7% in China would help the "capital markets catch up". Time is needed for resource capacity to be increased or diverted.

The markets are forcing resources that have been being devoted to building residential housing to business "housing". It would be inflationary to try to build homes at the pace of the past several years and to manufacture the 1,400 "small jets" and all the rest of the new capacity needs in our growing economy. So far, believe it or not, the switchover has been relatively smooth. New house sales figures have fallen sharply in America but the rate of sales is still in the area of 800,000 homes! We live the "good life" and find it hard to appreciate how good we have "it". We have plenty of houses available for a while. As the "business side" gathers speed, incomes will continue to rise and houses will become affordable for many more people but the emphasis of the market will remain on the "business side" for the next several years.


Your answer to a question might help explain the current action in the oil futures market. If you were an institutional money manager and you found yourself holding billions of dollars worth of energy stocks and if you decided to reduce your holdings only to find that none of your fellow institutional investors had an appetite to buy shares, how would you go about making the reduction? Chances are you would negotiate a deal with one or more of the major retail brokerage houses. You would sell shares to the brokers "for distribution" to the public. With billions of dollars involved, the selling of these shares would take many months. To get the "job done", the brokerage houses would crank up their publicity machines. One of the ways to make news would be to bid up the price of oil futures.

In the long run, markets set prices, however, in the short run markets can be pushed around a little. The action in the coal yards and the natural gas caverns tells the story. It is an amazing story. Coal trains are having to suspend service because utilities are over stocked with coal. Natural gas production is being slowed or stopped because storage caverns are full. The prices of coal and gas have fallen. The BTU equivalent price of natural gas is in the neighborhood of $47 per barrel of oil. Because the coming decline in oil price is so obvious, people in the business of suppling oil are not purchasing supplies for inventory; they are waiting for prices to fall. Ironically, the publicity machines have been able to use the fall in inventories as a "fact in support" of higher prices. The overwhelming majority of individual investors do not buy futures contracts but they do buy oil stocks and mutual funds that own oil stocks. By losing a relatively small sum on futures contracts, the "big boys" are talking the public into holding and buying billions of dollars worth of oil stocks.

Yes, some would dismiss this theory as the "conspiracy theory of a kook". No matter. I am a patriot and I believe in free enterprise. This means I also believe in "buyer beware". I do not believe that the price of oil shares are going to suddenly drop. Large institutional investors have a hard time in beating the market because they are the market, like the Captain of a battle ship, they must turn slowly and they do not even try to dock the boat, or hit the exact peak in the market price. They must sell and sell and sell at an average high price, some shares way too early and some too late but few at the exact top.

Warren Buffet has said time and again that making above average returns becomes more and more difficult the greater the size of the investment. My favorite analogy is the story of "The Cincinnati Kid". The Kid was a fantastic poker player. He could beat the pants off all the local players. He even showed that he was good enough to play against the top professionals but he still went broke. The top player simply had the resources to out last him and the willingness to lose a lot of money on a bad play in order to set up a big win. It is a very old Steve McQueen movie that you should watch.

It is virtually impossible for the largest of the mutual funds to sell all their energy stocks if they wanted to do so. On the other hand it is easy for individuals to go to a zero weighting. The ability to make such bold moves gives the small investor a huge advantage but it also opens the door to the possibilities of making huge mistakes. Learn to make such moves with confidence based on sound knowledge and you will have Warren Buffets problem one day!

History tells us that it is DUMB, DUMB, DUMB, to run too long with the crowd. The crowd is convinced that energy prices still have momentum. The data tell a different story. The USA uses more coal than oil and the price of coal has fallen. Given time to convert and coal will be used to produce the electricity that will be used to fuel cars. Don't believe the "news" when the "facts" tell a totally different story! Big money is going to be spent on products that help us avoid wasting money on oil. BUY, BUY, BUY, GROWTH STOCKS; SELL, SELL, SELL OIL STOCKS!

Thursday, September 27, 2007


During my army days, I learned how to slow a race car into a curve while trying to come out of the curve with the maximum possible momentum. Understanding the concept and executing it correctly are two different things. One army buddy of mine could do it better than anyone else in the company. It was amazing that he did not have to be in the fastest car to win his race. He would make up the difference by maintaining maximum velocity in the curves and by hitting the gas hard a half a second before the next driver. His timing was so precise that he would be still be braking with one foot while applying gas with the other. Other drivers were fighting an "over-steering" problem that he solved by accelerating at just the right time. To me, his move was like the difference between a baseball bat swing and a golf club swing; the baseball bat swing is natural and instinctive whereas the proper golf swing must be learned. Hey, don't take me to task if my sports analogies are weak; the only individual championship I won in "sports" was shooting marbles in the 5th grade.


I have written about the velocity of money before but not in the sense of knowing how to speed up after the economic turn. As we make this huge mid cycle turn, the velocity of money is a critical question. My confidence in Big Ben Bernanke continues to grow. It appears to me that he has hit the gas with a 50 basis point cut in the Fed Funds Rate at just the right time. Prior to doing so, he delayed moving too early by making the master stroke of cutting the Discount Window Rate. His work is not done. He will probably have to hit the accelerator at least one more time. Ben cannot decide his next move in advance because he must adjust to the national and international situation as the turn progresses.


The good folk at GaveKal have written an excellent article about the above "Fisher" equation. This classical economic equation says that the money supplied times the velocity of that money must equal the quantity of goods times the price of those goods. All current yak, yak, yak we hear about inflation is coming from people who believe or who want to believe that Big Ben's move to boost the money supply will result in a sharp increase in the price of goods. These folk try to make the formula read, an increase in M = an increase in P. At the same time, the "poor" union folk, who have a firm hold on a number of members of congress, try to make the PQ increase by holding Q down while increase P; this is typically done by restricting where the Q can originate. Of course, all the citizens of the world are better off if they are free to buy goods from the low cost producer, no matter the location or nationality of the producer, but, as we expect, the unions try to "win" an extra slice of PQ for their members. In the same way, unionized businesses with contract negotiations pending, may be pleased to see a slow down in the product of PQ because a slow economy may help them keep their input costs low and thus increase their slice.

The formula has two inputs and two outputs and the emphasis on what the government can do to help our "free economy" achieve the most has changed over the years. In a press conference last week, President Bush stated that he is a "supply side president". Supply side economist believe that one of the best ways to keep the price of goods affordable is to make plenty of goods available. In other words, while Milton Friedman was absolutely correct that inflation is the monetary phenomenon of too much money chasing too few goods, one solution to inflation is to not change the amount of money but to change the quantity of goods. In the past, when inflation got out of control, the medicine of cutting the money supply was often bitter medicine. Had the goods available been increased, for example though free trade, the inflation problem could have been solved without causing the suffering inherent in an economic recession.

Of course, the FOMC does not control policy and can only work with the tools it has available. The good news for all consumers is that the union strangle hold reached a clearing price the day that Ronald Reagan fired the air traffic controllers. The unions have continued the fight but on balance workers have had to accept wages that are more and more in line with the value of the work done. Low and behold, GM workers just accepted this concept. GM workers will earn a contracted rate plus a bonus that is commensurate with the profits of the company. Such a plan is so powerful and right. It is absolutely a fair thing for workers to benefit if their productivity goes up and if they align their interest with the interest of the company.

The AMR contract is not up until May of 2008 but the company has proposed a similar plan. The pilots will get a raise by agreeing to fly more than 19 hours per week. Bonus money will be paid when appropriate.

"Sticky wages" have been "the big economic problem" for centuries. In the old days, when the sales of a company slowed, the only viable option was to lay off or fire workers. Laws designed to help workers, such as over time pay, resulted in the hiring of too many people in the good times and the firing of lots of people in the tough times. Schumpter helped us understand that we should not want or expect to go to work for one company and stay there all our lives. The old union plan that "locked" an employee into a job for life was viewed as a wonderful benefit but it often proved to be a curse. I personally am thankful to have worked in several different industries and to have done scores of different jobs during my life.

The point of the above discussion is that the system has changed. Today the formula MV = PQ is a much more dynamic formula than in the past and at the same time the product of PQ is much more stable than ever before. This is great news. Who wants live during times of uncertainty? Who wants to live in constant fear of an economic downturn? Who wants to fear losing their jobs?

Governments all over the world have come to realize that taxing the heck out of the producers of Q is the sure way to reduce the total supply of goods and to increase the price of those goods. Lower taxes have enabled consumers to purchase more goods and live better lives while avoiding many hassles created when governments try to provide services that should be provided by private enterprises. The recent irony has been that even control economies such as Russia and China have given more economic freedom to the people and the results have been substantial. Hundreds of millions of people are living better lives as a result of economic freedom. Russia has back tracked on the ownership of major businesses but their continues to be great strides toward economic freedom around the globe.


A relatively small portion of US mortgage debts are in default. Today's mortgage market place is very different than the one prior to the recession of 1973. Thousands of savings and loans went out of business during this recession and many more followed during the recession of 1990. These businesses bore the brunt of the inevitable downturns in the housing market. In recent years, the risk of these loans was split up into small pieces. The most secure of these loans ended up being owned by the billions of people who have money invested in money market accounts. The risk of these accounts is extremely small but, as a result of mistakes by rating agencies and of aggressive purchases of the high risk pools of mortgages, at extreme levels of leverage, several large companies will lose hundreds of millions of dollars and a few will lose a billion or two or three. A relatively mild down turn in housing has caused a bit of a panic. Savers stood in line for days to withdraw money from a bank in England that was caught with too much invested in these mortgages.

The above review of what just happened in the mortgage market was written to explain that the velocity of money slowed violently in recent weeks. People around the world have "hunkered down" to various degrees. The first response to the "news hype" about the "financial crises" was naturally to hoard ones cash. To stop the panic, Big Ben and other central bankers have pressed the accelerator hard. Money is routinely created when it is lent, deposited and relent again and again. High powered money is created when the central bankers hit the gas. In this race around the track, the big curve was entered, the brakes were applied to avoid going through the curve too fast and gas is already being supplied to shoot us out onto the home stretch.


The 50 point cut in the Fed Funds Rate receive the reaction of jubilation! The markets reacted more strongly than all but a few days in the history of the US markets. Up to down volume was 30 to 1 while the Dow soared 300 points. History tells us to expect average market gains of 20% or better over the next year.

However, it was not just stocks that went up in price. Gold, oil and the Euro Dollar all jumped. As stated earlier, many are looking at the actions of the FOMC to pump in money with the expectation that prices of goods will soar. This is a misreading of the situation.


For the past couple of years, Ben and his fellow central bankers have been hunting "whales". You probably know about the country boy that fished by dropping sticks of dynamite in the lake. Each time a stick exploded, he would wait to see what floated up before dropping another. He did not bother collecting the little fish but kept on dropping dynamite until a "big whale of a fish" floated up.

For a long time, Ben and company have been well aware that there is a limit to how long the world economy can grow very fast. At some point in time, if there is too much growth the PQ side of Fisher's formula goes out of whack. When the supply of goods is limited because there is no spare capacity, the price of goods must rise or the growth in the product of PQ must cease. In the summer of 2004, Ben joined the hunt; he and Mr. Greenspan dropped the dynamite of 17 quarter point increases in the Fed Funds Rate. No whales showed up but other central bankers continued to hunt. You see, there are always small or medium sized businesses suffering or dying. The way the bankers know that they have dropped enough dynamite is to "float a whale". Recently, the run on a bank in England (North Rock Bank is the name that comes to mind), was the whale that stopped the dynamite. Now, part of what Ben has to do is watch the other hunters. Should, for example, the Bank of England, lower rates, Ben may be able to hold off the next move. Again, he does not want to lose any more momentum while rounding this curve than he absolutely must.


I have written much about the supply of oil because this has been the most obvious area where capacity restraints have held down Q and of course forced up P. The good news is that the worst is already behind us. GaveKal Research reports that in 2008 there will be 1.4 million barrels per day of new refining capacity on line. Of this, the new 700,000 barrel per day refinery in China will process the sulfur heavy fuel oil that is in abundant supply. In other words, the oil is available now but just needs a place to be processed. With the rest of the world refineries running at only 92% and with conversions being made to other refineries, the sulfur heavy fuel is the equivalent of making a major oil discovery. Speaking of major discoveries, billions of barrels have been discovered time and again over the past few years. The process of developing those fields is in various stages at the various locations. By 2010, there will be ten million additional barrels of refining capacity available.

In any event, inflation need not "get out of control". No doubt, China needs to take action to avoid problems but Ben holds a lot of power in his hands and, besides, much work has already been done. Should you plot the Fed Funds Rate, the price of commodities and an inflation index on the same page, you would see that the three series follow closely together, with the Fed Funds Rate taking the lead from time to time. The current situation tells us that it is wise to expect inflation rates to moderate in the months ahead and since we know that the best time to own stocks is during periods of low to moderate inflation, BUY, BUY, BUY, BUY!

Again, how do the people who are bidding up gold and oil know that M is growing too fast? Do they know how fast V is falling? Is it possible that Ben will do a great job and increase M by just about the same amount of decline in V?

By the way, I do not believe it is total coincidence that there has been much saber rattling by Iran and the USA right here at the turning point. I believe $10 to $15 of the current oil price is an "insurance purchase". An exciting time lies ahead!

Wednesday, September 26, 2007


Many thanks to those who respond to my emails. It is humbling to know that you took the time to read my words.


I have used the example of newspapers and magazines to show that some prices are falling from something to zero; I could have used long distance phone calls, transferring money or maps instead. I personally read many articles from many magazines online without buying a subscription to those magazines. I use a map that plots where I am, calculates the distance and time to my destination and talks me through the turns. Using today's technology, the distribution costs of these services is almost zero. Therefore, the publisher can offer the services in exchange for goodwill or for advertising space.

At least one reader believes inflation is a lot worse than I. This reader still subscribes to his local paper and he notes that his cost of food has soared. One issue this raises is that we each have our own personal inflation rate; the national numbers are the average for all consumers. The consumer who is an early adopter may have inflated his costs when he waited in line all day to buy one of the first iPhones. He paid a high price in time and money. Another consumer can buy today for a substantially lower price. In very short order, the first iPhones are going to be relatively obsolete. They access the internet at a very slow speed relative to what is already available on other networks and extremely slow relative to networks that will be built over the next several years. The price of the next great innovation may be sold at a much higher price but that will not be an inflated price. The fact is that the price of new inventions start high and typically fall and fall some more. The first Xerox machines were leased because few businesses had $100,000 to spend.

Food is important to all of us. Very poor people spend the great majority of their income on food. The sharp run up in the price of food in recent months has caused many very poor people to go hungry. In America, the percentage of incomes spent on food has fallen for as long as charts can be found. I recall a chart from a year or so ago that compared spending on recreation to spending on food. The chart made a big X. The average American spends less than 6% of his income on food. He spends many times as much on recreation. Broad measures of inflation capture the price of all ski lift tickets purchased and the price of all hamburgers purchased.

The typical reaction to the preceding statement is to say, "Oh, so those who can afford a ski lift ticket are the ones who are not seeing inflation." In fact, for the great majority of people, this is exactly wrong. It has been the cost of services, most often purchased by the wealthy, that have gone up the most in price. The inflation rate for a college education, for a heart operation or indeed for a ski lift ticket, have all climbed many times more than the price of a hamburger. One of the wags at GAVEKAL Research quips that "it has never been so expensive to be rich."

Biased people can "mine the numbers" to always show that inflation is better or worse than it really is. We all know that one can prove anything with statistics. The all time best and most consistently correct inflation forecast has been supplied by the bond market. The FOMC likes to look at the implied 5 year and 10 year inflation estimates derived from the spreads on 5 year and 10 year TIPS bonds versus standard 5 and 10 year bonds. Old timers like to rely more on the structure of the treasury market. In other words the willingness of investors to buy 5 year treasuries paying 4.6% says a lot about the markets inflation expectations. Don Hayes uses the 10 year treasury rate chart, to plot inflation a few months into the future. The stats are that this method gives off an r square close to 90! In case you have not noticed, the ten year bond has stayed in a tight range for several years and is currently closer to the bottom of that range than to the top. The inflation risk in today's market is very moderate.


Many a coincidental indicator shows that the world economy is slowing down. Weak economies are most often accompanied by declines in inflation rates. As I noted yesterday, even the decline in interest rates that occurs during slow downs or recessions is by definition a lowering of inflation rates. The USA holds the trump card! Many pundits have "talked-up" their international portfolios. The common theme has been that the world economies have been stronger than the US economy and the stock markets have out performed. The key words in the prior sentence are "have been". Smart investors do not invest in what has been but in what is likely to be. What is likely is that the economy that has the strongest currency is actually "set-up" to suffer the worst during the slow down.


In the year 2000, the US dollar was very strong. In 2000 and 2001 the USA was the only major country to suffer through a recession. Yes, 9/11 influenced the US economy but the economic down turn was well before September of 2001. Right now, numbers are starting to flow showing a slow down in Europe. The weak US dollar is a wonderful blessing in these circumstances. US businesses can easily compete with others because the exchange rates with many other nations gives us a strong boost. The great news is that the slow down will lower short interest rates more. We might easily see another 50 basis point cut by the FOMC before year end and with new great prospects for strong growth in the USA we could see the dollar climb out the roof. The big money is made by buying near a currency bottom, just like buying a stock near the bottom.


This morning I read a story about a German oil drilling company that has hit another oil gusher in Libya. The company, RWE, has moved from $19 to $88 over the past 5 years. Late last year, it briefly traded above $90 per share. The price had settled back down to about $80 before the gusher was hit. I hope you can how the fact that the price is lower now than it was last year is a signal. The time to buy this stock was 5 years ago. The exact best time to sell the stock was last year when it was trading above $90. The momentum is gone. Those who moved from energy to technology when this stock was at $90 have done well.

The total investment process required to "catch up to the new price of oil" still has many years to play-out. We know many things about the way this process will be completed. For example, we know that Shell and the Saudi will spend $7 billion to more than double the capacity of the Port Arthur, Texas refinery and we know that Kuwait has increased its budget on its new refinery to over $14 billion. We expect that the Port Arthur upgrade to be completed in 2010 and we expect the Kuwait refinery to start-up in 2012. Others refineries will start-up before and after each of the above. While it takes a lot of faith to spend $14 billion on a refinery that will not start until after scores of others have been completed, it does not require faith that the price of oil will stay above $50 per barrel.

The existing Port Arthur refinery has paid for itself many times over at much lower after inflation adjusted prices. It was started way back in the Spindle Top days. It has refined billions of gallons of oil and it is being expanded so that it can refine even billions more over the next many, many years. The investment is being made because the investors expect to make better than a 15% gross return on their investment. They can do that even including a forecast of oil falling back below $50 per barrel. Long term investors can certainly buy oil drilling stocks, hold for decades and make solid returns. However, with the crowd pushing oil stocks hard, you should expect to see these stocks under-perform the market for the next 5 to 10 years. Innovative companies, the ones that are generally finding ways to do things while using only small amounts of energy will do well. Transportation companies that consume large quantities of fuel will also do well.


After I wrote that AMR faces tough union negotiations in the weeks and months ahead, one reader mentioned that a pilot friend believes AMR is about to be forced into bankruptcy. I strongly disagree. AMR made it though a very difficult time, after 9/11 without filing bankruptcy. Since that time, the company has dramatically reduced its costs and dramatically improved its balance sheet. It has even survived the spike in fuel prices and it will earn at least 65 cents per share this quarter after paying an average of $2.11 per gallon of jet fuel. A few pennies decline in the price of fuel, not due to a recession but due to growing supplies and demand destruction, would boost earnings by perhaps dollars per share.

The big argument being made by the pilots union is that they gave up 30 percent of their pay when it was necessary to save the company from bankruptcy and they now expect to get this pay back. There are at least a couple of big ugly flies in the soup! After AMR pilots "volunteered" to cut their pay, other pilots at other carriers gave up an even higher percentage of pay. In several cases, such as DAL and NWA, the negotiations to reduce costs were held while the companies were in bankruptcy. In the case of CAL, the total give-backs of all union employees were more than a billion dollars per year. The other big fly is that even after the give backs, the AMR pilots are very well paid. So, what you have is a situation where the pilots want 30% raises that cannot be supported by the current market.

It so happens that just this morning the GM -- UAW deal was completed. Thirty years ago, it would have been incredulous to suggest that one day GM workers would give up their company paid health benefits or to accept a contract with no annual cost of living increases. American consumers can rejoice. We have been paying an average of $1,500 in healthcare benefits each time we have bought and American car. Many who can not afford health insurance have paid for it for others.

It is a totally new, global, world in which we live. AMR pilots face the same problem as the GM workers. The fastest growing airlines, which are not based in the USA, expect to dramatically increase their flights to and from the USA. Without doing the searching to prove the point, I am confident in saying that the senior pilots in China do not earn $170,000 per year for 30 hours of work per week. $5,500 per hour plus benefits is not a bad gig but only a very small percentage of the worlds pilots get that rate. Ironically, if the public were willing to trust highly reliable electronic systems, which are much more dependable than the average pilot, the pilots would be not needed at all. Ouch! Believe it or not, in the not too distant future, the competition for travel will include 100% auto pilot crafts. Of course, the politicians would have to stand aside for this to happen and when it does happen it will start with small planes at remote locations.


The new satellite based air traffic control system will be a blessing. It will cost a lot of money but the investment will cut the operating cost of the carriers while, most importantly, reducing the time in the air for tens of thousands of flights daily. Millions of people will save hours daily after the plan is fully implemented. As usual, when the government is the provider of a service, politics get involved and one result is a huge amount of waste. It is only common sense for a 10 passenger jet to have a financial incentive to give up a prime landing spot at a major airport for the benefit of a 300 passenger jet. Giving up this slot should be based on the micro-economics of the situation. In other words, the price of the landing spot should be determined by the market, so that some operators would voluntarily choose smaller airports. Only the individuals involved can determine how important it is to land at the major airport. The government imposed system is the equivalent of Soviet Union system of deciding how many pairs of blue jeans the country should make.


Investors need to avoid taking one small data point and drawing harmful general conclusions. The core facts are that airlines are operating at record capacity and making money at the start of the prosperity phase of the business cycle. The solid growth in the revenues of these highly levered companies is leading to spectacular growth in earnings. Here in the middle of the mid cycle correction, it was "big news", a couple of days ago, when AMR announced that revenues for the quarter would grow at only 3 to 4%! When a business with very high operating leverage grows revenues by 3%, profits might rise 20%!

What will be the story a year from now? Will the unions still be fighting for a 30% raise that is not going to happen? Are these employees frustrated? Certainly! Do they really expect to make 30% more than their friends at other carriers? Most do not.


The "news" this morning was "bad." Orders of durable goods declined. Duh! Housing starts are way down so there are not as many furnaces or hot water heaters being purchased. The down tick is the "bad news" needed to push interest rates lower and inflation down more. Yes, this is circular logic but that is why they call it a business cycle.

Just remember that interest rates and commodity prices tend to move together. Right on cue, oil supplies recovered a bit this morning and oil prices slipped. The process is slow but sure.


Thanks again for the feedback.

Tuesday, September 25, 2007


Yesterday, I received a fair question. What happened to the airlines? One fellow was kind enough to note that his Google and Garmin are at record highs but he is in the hole on more than half of his airline shares. I took a look and his QLD has done quite well also but then I have to admit that I have been aggressive on CAL, aggressive for good long term reasons.

The casual observer thinks that airline shares were down hard because of a modest tweaking of guidance at AMR. AMR reports that non fuel costs will be slightly higher this quarter and that revenue growth will be slightly slower. Sure enough, some analysts cut AMR's estimates from as much as $1.04 per share to $.66 per share. This was a bit much, especially considering that the company corrected the figures a bit later in the day to say that cost per mile would come in at $11.98 versus the $12.06 that the analysts were using. Even so, the cost figures were up and the spread between AMR's cost and the costs at CAL, NWA and DAL has grown.


It has become clear that Congress is going to practice a game of "rope-a-dope", also called Chinese Water Torture. As we all know, it is difficult for congress to complete a budget on time. The US fiscal year begins on October 1 and none of the 12 budget bills have been passed. There is little budget discipline to be seen anywhere in the process. For example, the Senate is just about through hammering out the defense appropriations bill and it is loaded with about 300 amendments that do not relate to defense in any real way.

The old "Christmas Tree" game is being played. In this game, one member agrees to support the goodies wanted by another member and another and another until they can cobble together a voting block and attach what has traditionally been called "pork" or "pork barrel spending" to bills that "must" pass. Today Congress calls pork barrel spending "ear marks". Politicians from both sides of the aisle work very hard at "winning these goodies" for their home states or districts. Get a large enough group together and a real government boondoggle will be passed.

A good example of a boondoggle is the corn ethanol subsidies. By agreeing to build 200 small refineries in 200 different counties across the country, enough votes were added to the farm belt votes and to the "environment-at-all-costs crowd" to pass the very wasteful ethanol fuel program.

The way the "rope-a-dope" strategy is going to work is that Congress will drag out the budget process until the November 16 adjournment date and perhaps even into a "recall" session in December. Congress will send Bush bills for him to veto. Then they will send him a continuation bill. Even the continuation bill will not be "clean". If the government gets closed down for a day or night, they will act again but try to blame Bush for the closure. All the while, horse trading will continue; a vote for this will be traded for a vote against that. Of course, subsidized "health care for the children" and attempts to cut off funding for the troops will be trotted out again and again.

In case you are too young to remember, "rope-a-dope" was the strategy used in a famous boxing match 30 or so years ago. The one fighter covered up and allowed the other to hit at his arms and gloves. The blows were largely reflected by arms and gloves and eventually the hitter wore himself out. Congress is going to try to wear Bush out. Bush will have to veto spending deals that include "goodies" for all the districts before the budget is finally passed. The Democrats hope that they can gradually offer the right combination of "goodies" so that they can peel away enough votes to over turn a Bush veto.

The "heath care for poor children bill" has lots of supporters even though it extends Medicaid to families making $85,000 per year and even though it adds to the mess of Medicare and Medicaid. The strategy of the Democrats is like a sacrifice pawn move in chess - by loading the health care system up with inefficiencies it is believed that the whole system can be scrapped in exchange for a comprehensive government plan.

Hillary's latest plan is far better than the one she attempted to pass more than 10 years ago but it is still a "take-from-some-to-give-to-others government confiscation". In her plan, those who are young and those who take care of themselves are forced to over pay in order to subsidize those who are slothful.

The analogy is constantly drawn to the area of auto insurance. It is said that just like all drivers are required to carry auto insurance, we must all be forced to buy a certain kind of health insurance. I agree that a lot of folks drive up the cost of medical care by not carrying insurance and then going to the "free" emergency rooms to get very expensive care for non-emergencies.

However, the analogy to auto insurance only works to a point. Individuals can choose to carry only liability auto insurance and even then only a base level is required by law. More importantly, those who drive carefully pay much less than those who are repeatedly caught speeding or violating other traffic laws. In the Hillary plan, the young guy who eats properly and exercises pays far more than his fair price while obesity is subsidized.


Both the house and the senate passed bills to fund an important upgrade to the air traffic control system. Of course, as usual, the Democrat majority passed a bill that would increase taxes and one that would continue to force the major airlines to pay for an extra large share of the system. Like the subsidized heath care for the obese, they would give the corporate jet fleets a major break; small jets now pay only 3% of the cost of running air traffic control systems but they consume 16% of the services provided. In one way this is no big deal but when day after day thousands of passengers are delayed, routinely by 30 minutes or more and sometimes by several hours or even days, as a result of waiting on small jets to clear, the problem is real. As always, when the government sets the price, great harm is done to some while others are given great gifts. The Soviet Union fell apart for the very reason that central planning is wasteful; markets are the most efficient means to set price.

Charging set rates for FAA services is similar to what has happened in NC to the highway system. In the old days, all the gasoline tax dollars were used to build roads. In order to have great roads, NC citizens went along with one of the highest gasoline tax rates in the country. Many years ago, Governor Hunt, who had preschool education as a priority, started finding ways to take money from the highway trust fund. The annual "withdrawal" is now around $175 million per year. Not a huge amount in terms of state government but enough to service the debt to build about $3.5 billion worth of roads.

Over the years, NC roads have suffered and the current governor is pushing to build toll roads. Of course one idea behind toll roads is that of a user fee. Another idea is that politicians tend to want to raise revenues (taxes) and they can because the government knows how to spend money better than the market place.


The old saw that a camel is a horse designed by a committee contains truth about collective wisdom; folly follies when "group think" wins. On the other hand, the wisdom of the crowd has been proven time and time again in markets all around the world. Markets are not perfect but they are far more perfect than are "group think" asset allocations.

The following is an example to show the wisdom of the crowd. If a large number of people are asked a question about which they know little they will tend to offer an average answer that is better than the one derived at by a committee. Specifically, if 10 to 1000 city folk at the fair are asked to guess the weight of an large animal, it does not matter if it is an elephant or a jersey cow, the average guess will be very close to the right answer. The more people that guess, on average, the closer the average guess to the actual weight. However, ask a group of 10, 20, 30, or more to get together to choose one best guess and the wisdom of the crowd goes away. The dominate members of the group pull the group toward their guess rather than toward an average estimate.


Congress has passed continuation funding for the current air traffic control system. Three months worth! The huge sums of money spent lobbying Congress for the past several months is simply not enough! Give the passengers sitting on the tarmac three more months to soften them up! In the mean time, AMR and its unions will have their own little slug fest. AMR is the only major line to have made it through 9/11 without filing bankruptcy. The AMR pilots took big cuts in pay to "save the airline". After bankruptcy, DAL, NWA and even UAUA have lower cost structures in place. The pilots are in the unenviable position of asking for their wages back even though they are already earning more than most other pilots. They are asking for wage increases of more than 30%. I doubt they will get more than 10 or 12% but the fight is on. The lowering of guidance by AMR yesterday was probably related to the negotiations ahead. This is one of those times when the airlines are accounting for every expense they can find.

CAL just put an extra $50,000,000 into its pension plan. As I recall, the accounting on pension deposits is a complicated mess but all in all I suspect that CAL was able to lower its current earnings by some portion of this addition and the prior ones made.


The cash hordes being built by the major carriers tells my story. Until sentiment turns and the "feel good factor" boosts these stock prices, the "accounting game" can hide a lot of stuff but the billions in unrestricted cash says a lot. One might guess that these cash hordes will be used to fend off a hostile takeover but we all know that financing the purchase of a company is much easier if the company to be acquired holds lots of cash. One might argue that the cash will be used to buy new planes but in reality planes are usually leased or acquired with long term financing.

A couple of weeks back, Alaska Air announced a share buy back. It seems that the wisdom of the stock buy back might finally be spreading to the airline business. The pay negotiated at AMR will effect all the other carriers but once a deal is done, a share buy back announcement by any major carrier could be the catalysts to sentiment change. CAL is currently selling at around 7 times trailing earnings and 5.7 times forward earnings; boost these numbers to the market average and you get a jump in share price from $30 to $80 lickity split.

Of course, the change in sentiment is not the whole story. A buy back of shares will increase the earnings per share. The normal roll over that will take place in the oil market over the next few years will also result in higher earnings per share.


CAL has quickly added a lot of flights to its new hub. Many of these flights are on "feeder sized" planes. The big jets will still be used to leave the hub for profitable long haul flights.

If you do not appreciate just how much growth there is in international business, take a look at the recent action by Google. Google will partner to put a new communications cable beneath the Pacific Ocean. Google will gain access at cost rather than the current extra high Pacific rates. These rates have been pushed up because demand is great relative to available space. A fellow on one of the business shows said it well last night. He notes that just because the world has been blessed to be able to bring a few hundred million Chinese out of poverty over the past 20 years it does not mean that we should forget about the 2 billion others. He says the globalization story is still in the early stages. There is no doubt that air traffic is growing most rapidly within the borders of China and India but US International Carriers will get a fair share of the traffic that spills out to the rest of the world.


Being of virtue is tough. Patience was never my strong suit. However, in regard to market moves, I have had to learn to wait, wait, wait, wait, wait and wait some more. The current situation takes my memory all the way back to the summers of 1982 and 1974. In each case, waiting for the market to make its big move was like waiting for paint to dry. The 1974 time was more exciting than the summer of 1982 but not in a good way. In 1982, most of the shares I purchased just sat there. They did not keep going down much but it seemed that the start of the "big bull" would never come.

This time we have had a number of fits and starts. For example, it was late July of 2006 when value lost its momentum to growth and when small lost its momentum to large. Even so, value stocks and small stocks keep making surges. Our QLD has made us happy but the last dip was large and the recent very strong run has just now put us back close to a new high. An upside break out from here would probably run-up another 15% pretty quick but who can time the market? We are left with the charge to be patient. Congress will eventually get its work done and the odds are good that no major new taxes will be passed. The drain to the markets will not be great enough to kill this bull.


One thing that will help you be patient is to recognize that right now, bad economic news is actually good news! With T-Bills trading at 3.75%, it seems that the FOMC will need to cut the Fed Funds Rate by another 50 basis points pretty soon. Big Ben and company many feel the need for cover. Bad economic news would do the trick. If personal spending slows or if there is an increase in unemployment claims, the FOMC may have all the ammunition it needs to give the patient another high powered electrical jolt.


One of the funny things is how short sighted prognosticators can jump to the long term view at just the wrong time. We all understand that those who want to be negative can always find a reason to do so. In the case of lower interest rates, the negative always jump on the risk of higher future inflation. While it is true that if interest rates are too low for too long, the economy is likely to overheat and there is likely to be inflation, but that process does not happen in days, weeks or even months. The immediate effect of lower interest rates IS LOWER INFLATION!

The decline in the cost of money from 5.25% to 3.75% is a tremendous price reduction. For many a business, it is like a 28% cut in the cost of raw materials. TV pundits seem to love to talk about the decline in home prices and inflation in the same breath. Again, those who are looking for "bad numbers" can find them or they can make them up. When the price of gasoline was rising, inflation was terrible. Now, with the price of gasoline back down to $2.62, it is the price of oil that is the problem.

The facts of life today include that each and every day a large number of people stop paying for certain magazines and newspapers. These folks have found that the Internet provides all the news they need. The marginal cost of this Internet news source is ZERO! The price of the newspaper falls from 50 cents to ZERO! The law of substitution lives and breathes. The bottom line is that publishing a newspaper online is far more economic that physically printing a newspaper. My old boss, the President of Legg Mason Wood Walker was fond of saying, "In the long run, economics wins!"


Put all of Grandma's CD's into just a few big stocks such as GE, MSFT and WB and she will do well. She will no longer be on a fixed income as her profits will grow over time.

Be sure that the grandkids own Google in what I call an ABC portfolio. My only grand child owns APPL, BIOGEN, CAL, Dell, Etrade, Google and Sprint. We plan for her to own the rest of the alphabet before too long. We pay no mutual fund fees and no commissions except for the initial purchase. The educational value for her to own small quantities of so many companies is worth more than the millions she will eventually earn. We live in freedom! We are blessed beyond measure! Praise the Lord!

Monday, September 24, 2007


The following is yet another snippet of history to show that now is a good time to BUY, BUY, BUY.

A decline or near decline in the price of the average house is a rare phenomenon. Right now, it is interesting to notice that the cost of new construction, including a lot in a good location continues to rise, even while folks belly ache about a fall in the value of homes. One of the tenets of economics is that "clearing prices" are reached. Yes, the supply of unsold homes on the market is large, especially when looked at in terms of months needed to clear the inventory at the current sales pace. The problem with this popular measure (especially popular with those making the bear case) is the "double leverage" involved. Other numbers show that building permits and starts have fallen dramatically. On the demand side, the numbers show that mortgage applications are already on the rise. In just the past two or three weeks, the bears have said again and again that mortgages are not available.

I am trying to make two points here: 1) that the housing "debacle" is not as bad as it is perceived to be, and 2) the housing debacle has not killed the bull market in stocks.

The following are the 5 times during my life that housing prices were flat or negative over a full year and the increase in the S&P 500 over the next year.

September 1982 44%
November 1990 33%
July 1992 15%
February 1993 8%
April 1995 39%


I like the last entry the best because April of 1995 was right at our previous mid cycle turn. The most recent pattern is in my opinion the one that will be most closely followed in this cycle.


The financial news media is always in search of the next headline. The recent one has been the fall in the US Dollar. Here again, I like the pattern set in April of 1995, when the dollar bottomed just as the pundits were saying that housing was killing the economy.

There are logical reasons why the bottom in the housing market coincides with the bottom in the dollar. Canadians are currently in a state of euphoria over the value of the Loonie. For the first time in 31 years, Canadians can trade a Loonie for a dollar and get back change. For a number of years, Americans could trade a US Dollar for a Loonie and get a quarter or more in change. This is big news for Myrtle Beach and many other coastal communities. When I was a kid, Myrtle Beach had Canadian Day Parades. These celebrations were held during the early spring, when it was still too cold for Americans to consider Myrtle Beach as a vacation destination. Florida resorts are also celebrating the return of the Loons!

The Euro Dollar has also appreciated substantially. The European can trade for a dollar and get more than 40 cents change. Just a few years ago, Americans could trade for a Euro Dollar and get about 20 cents change.

In April of 1995, the winds of change were blowing as they are now. Many a European and Canadian will make out very well by purchasing a US home now. The European might use one million Euros to buy a $1.4 million luxury home in the states. The price of this home will appreciate substantially as soon as the market clears. Even if it were to only hold its value, the return would be 40% to the European if he held the home until the US Dollar and the Euro Dollar reach parity again. While there is no guarantee that parity will ever be reached again, the history of the move after the mid cycle correction of 1994 says that it will.


Should the US dollar strengthen, the price of oil in terms of Euro Dollars will soar. The law of substitution, which is already going 90 miles per hour in 3rd gear, will hit overdrive. No one knows where new supply smashes into new demand but it is clear that that there is going to be a collision between millions of small cars and scores of super large oil refineries. In Port Arthur, Texas, Shell and Saudi Arabia will more than double output about a year after the first of the Vietnamese super refineries comes on line.

Just in recent weeks, wholesale traders in the US have been reluctant to hold inventories of oil as the amount of natural gas in storage is near record levels, gas producers are being forced to slow down or shut down production and the price of natural gas is down to 47% of the price of oil in BTU terms. Of course, natural gas storage capacity is not enough to supply all our winter time needs with natural gas but a mild winter could see a steady decline in the price of heating oil. Any facility set up to burn gas or oil will go with the less expensive gas until supplies are diminished.


Ken Fisher notes that when the financial press cannot find negative economic statistics to whine about, they write about global warming or Paris Hilton. Ken avoids making this a political point but in truth it is. The steady push in most media outlets is anti-Bush, anti-business, anti-war and pro-government "solutions". Of course, the exceptions to the rule, such as talk radio outlets and Fox News, prove the rule. Pretty soon, the stock markets should benefit from a change in sentiment. A "Feel Good Factor" is going to emerge. We have moved into the prosperity phase of the business cycle. During this phase, real wages and incomes of the average citizen will rise to the point that the constantly negative "news" will not sell well. As Andy Warhol taught us many years ago, the "news" is a reflection of the feelings of the people. During a time when the "bad news" does not sell, "good news" will be more prominent. Of course, the market top will come after the public has received a steady diet of "good news".

My "good news" for you today is that the process of building a market top is just getting started. Keep a close watch and you will notice a very gradual shift in the news. Also keep in mind that the kinds of advertising that you will see will also change. You will see lots of ads for companies like Boeing that are making all the planes they can make. Of course, the right time to buy shares in this company was several years ago. It will not go down in price for many years to come but its upward price momentum has already peaked. It takes a long time for the "big boys" to distribute their holdings to the public. Of course, the media outlets that sell these large corporate ads will be the outlets that survive. Do you think it coincidence that positive "news" articles and corporate ads will accompany one another, or soon before or after?

Yes, be a skeptic but be a wealthy skeptic. A fun market is headed our way.


No one knows the ultimate outcome of the current fight for budget and campaign dollars. Funds are flowing in all directions. Powerful "special" interests are playing hard ball. In this crazy but necessary game of horse trading, many in power are willing to vote to spend billions annually for years to come on all sorts of wasteful schemes, provided they "win" the goodies they want for themselves. Senator Grassley, a Republican from Iowa, is one of the current key power players. I do not believe Grassley is for a $35 Billion add on to a disruptive health care plan, but he is willing to vote for it to establish a strong bargaining chip. Almost everyone in the House and Senate would agree that health care reform is needed but none of them would honestly say that the $35 billion dollar would be their personal first step.

Again, I have good news. So far, Congress has been unable to pass much of anything. This is good news for America and good news for the markets. As we have seen time and again, lots of bad legislation passes when one party is in control. Bush will veto the worst of the spending. Unfortunately, to get a dose of his own sugar, he will swallow some bitter medicine. Still, all in all, the compromises reached will not harm the economy badly. As a general rule, the economy will do very well for as long as the government stays out of the way.

BUY, BUY, BUY the fight will be over in a few weeks and members of congress will go home to take credit their "wins". That is one of the good things about a good compromise, all can claim to have won. These wins will become part of the "FELL GOOD" cycle discussed above. When corporations, the news media and the congress combines to tell the "good story", it will be natural for the masses to "FEEL GOOD". BUY, BUY, BUY!

Friday, September 21, 2007


Jaywalk reports that another analyst has moved from a hold on CAL to a strong buy recommendation. The Jaywalk numbers are now, 1 strong sell, 0 sell, 9 hold, 10 buy and 4 strong buy. The Thompson numbers are 0 sell, 1 under-perform, 4 hold, 5 buy and 3 strong buy. The consensus estimate for 2007 is now at $4.27 and the estimate for 2008 is now $5.19. The $4.67 has been increased about 10% over the past several weeks.

The house has passed a bill to pay for the new air traffic control system by raising taxes on jet fuel. The bill will also allow airports to increase the ticket tax from $4.25 to $7. President Bush has pledged to veto the bill. Last night after the bill was passed, the President said in a press conference that he got a B in economics but an A in holding down taxes.

All the strong buy ratings in the world will not push the price of CAL up. However, the stock has become an obvious value. What analyst is willing to put a sell on a company that is growing earnings dramatically even while enduring very high input prices?


I have struggled to keep a few accounts on board in regard to the airlines. I get few complaints about my other stock selections. Google is still the most fun stock to watch. Google makes dramatic moves week after week. The Google presentation package is similar to prior products designed to take market share from Microsoft. The package is a good basic package that is free to use. It does not have all the bells and whistles as PowerPoint but it is more useful to those who enjoy the free and easy collaboration across the Internet. Google has the money to move in any direction that it wants but it has clearly chosen to allocate a lot of resources to mobile communications. The world is changing as we speak. Millions of people are taking their home phones mobile. One day, the internet is going to be everywhere! Google is on the way to $100,000 per share!



When US Fed Funds Rates hit a peak on February 1, 1995, the dollar began a blow off plunge. Record lows were made in March and April. Suddenly, on July 6, 1995 the FOMC had to change directions. The FOMC cut rates by .25. Each cycle is a little different. The second .25 cut did not come until December 19, 1995. For the next 5 years, the dollar index and the stock market climbed while real estate agents searched for a bottom in housing. Does this sound somewhat familiar?

The market climbed, inflation stayed tame and commodity prices rolled over. New production of commodities overwhelmed new demand.

Part of the reason many investors stay in a confused state around major turns is the J curve effect. The J curve is one of the "normal" paths that numbers take. For example, the relationship of blood pressure to the incidence of cardiovascular disease follows a J curve. There is a good chart of British Pound Sterling posted on the internet that shows the J curve that took place at the mid cycle turn in 1995. A good way to understand this phenomenon is to think through the process when there is a turn in a trade balance. When a currency is devalued, the higher cost of imports hits hard. Take gasoline as an example. When the price jumps, everyone does not go out and buy a new fuel efficient car the next week. Indeed, even though they may cut back on total miles driven, their total gas bill goes up. However, if the price stays high, more and more cars are traded and eventually the total fuel bill goes down because the reduction in the volume used eventually is bigger than the increase in price. We all know this to be true. We all understand that the laws of supply and demand dictate that the higher the relative price of a good, the less of it is used. Economists talk about the process in terms of elasticity of demand. Their point is that it may take more or less time to adjust to price swings for certain goods but the law of supply and demand still holds.

The accumulated effect of the decline in the dollar has put US exports growth on a solid growth J curve. Indeed, because the Yuan is linked to the dollar, the growth of Chinese imports has been spectacular. Indeed, a clearing price is near. The "blow off rally" has hit in several markets, including the Euro Dollar, the Canadian Dollar and Crude Oil. We are talking about a "capitulation rally." What's happening is the investors, including any hedge funds, that were on the wrong side of this market have gotten so tired of losing money that they are closing out positions. Specifically, those who were short oil future contracts are buying oil at all time record levels.

Congress has the responsibility of passing the 12 massive spending bills by September 30. One of these bills includes big tax increases on the oil industry. Of course, those who put the tax increases in the bills like to talk about how they are closing loop holes granted to the oil industry (by many of these same politicians). One of the ways the Democrats want to increase spending is by adding middle class children to the government health insurance plan. Bush says he will veto this "Trojan Horse" which is designed to build a European style government health plan.

Bush has said he is prepared to veto 5 of the 12 spending bills as they are currently written. He and Congress will grin and pretend to enjoy the signing ceremonies on the other seven as both sides will be holding their breath to avoid the stink of compromise. The Dems will probably go all out to force Bush to veto the children's health bill. As we all know, the jockeying for the best position in the 2008 elections is the point of this health bill. We all know that major healthcare reform is needed. In the mean time, points will be scored by two sides. Solving an issue is often not the best path to being elected to office. Politicians need an issue to run against to be successful.

The markets are to some extent hostage to this political process. Investors cannot be sure about what congress will do about the "BIG BILL". The BIG BILL is in regard to AMT (alternative minimum tax). Something must be done! Neither Congress nor the President would want to be responsible for 23 million middle class families to pay extra taxes this year.

The bottom line is that the deadline is due in 9 days. A continuing resolution could drag the deadline out another week or two but the pressure is continuing to mount. While I do not believe that the oil industry has manipulated prices at the pump, the timing of the blow off rally in oil seems to be about perfect for the industries political purposes. Of course, it makes all the common sense in the world for the industry to reduce investments when under the gun of a Congress bent on taxing the one industry in order to subsidize others. As usual, whenever politicians try to "drive the markets" they make very expensive wrong turns. The American people need an education in economics. They all should understand that the invisible hand of Adam Smith will lead to efficiency whereas the heavy hand of government will lead to excessive costs.

Once the bills are passed, a lot of uncertainty will have been washed away. Conditions are ripe for a continuation of this great bull market. Since the market bottom in October of 2002, big returns have been realized. Even in this seemingly tough year, the average stock is up about 10%. There has been a J curve dip in a number of areas but the staff of the J is going to be climbed over the next several years. Hold onto the bucking bronco and ride like the wind! BUY, BUY, BUY STOCKS, SELL, SELL, SELL LONG BONDS.

Thursday, September 20, 2007

UP and UP and Up

CAL earnings forecasts keep going up and up and up. The increases are only pennies at a time but the pennies are adding up in the face of record oil prices. The forward PE is now at 6.38%. What would this number be if a savings of $2 per share were to materialize?


The key point of the "black swan concept" is that a surprise can happen at any time from most any direction. The thing is that one can often see the potential for spotting a black swan in areas where the great majority see no possibility. So far, no one has been able to reasonably explain the "air attack" of Syria by Israel on September 6. Did Israel drop a bomb on nuclear supplies bond for Iran, explosive supplies bond for Iraq or was it just a reconnaissance plane that mysteriously dropped extra fuel tanks on the Turkey -Syria border?

In any event, rumblings continue about a potential deal in regard to Palestine and Israel. Don't hold your breath but don't be shocked if this is the "surprise" that ignites the next big move in the market. The odds of a particular event may be very small but the accumulated odds for one of many possible events is great. How many times have you heard someone say that such and such could not happen again in a million years?

My favorite once in a life time story is my golf story. I had a clear shot at the green except for one problem, a very small dogwood tree was directly in my way. It was at least 30 feet away and my partners told me to aim for the tree because I couldn't hit it in a million tries. My ball hit the tree dead center looped upward and landing exactly in the spot I had just hit it from. After a good laugh my partners said that that the shot was truly one in a million. They said to aim for the tree again. Yes, I did. I hit the tree the second time in a row. You had to be there to know how unlikely the shot was. I honestly believe that I could go to the spot and try a million times to hit that small sapling again and never succeed.


Even after the cut in the Fed Funds Rate, the psychology of the market place is still one of disbelief. Yes, there were huge inflows of funds to mutual funds but a large amount of this money flowed into "old news stocks." Money is flowing into international, energy, basic materials, gold and other inflation plays. WHY? Because people are doing what the "big boys" suggest. Goldman Sachs just announce an earnings jump of 70%! They make most of their money trading against the crowd. They are saying that oil is headed much higher. Believe them at your own peril.


The facts are that the CPI was up 2% year over year and down .1% in August. At the same time, the real, inflation adjusted earnings of the public, were up 4.4% year over year. Over my 57 years of life, there have seldom been better numbers. Even the price of gas has not gone up for close to two years. During the same time, the price of a very useful electronic map has fallen by thousands of percent.



Congress has failed to pass 12 of the 13 budget bills. The deadline of October 1st is also the date the debt ceiling runs out. Is there going to be a replay of the 1995 government shutdown? I don't think so. A very smelly compromise or two may be in the works.

One bill likely to pass will be the "Airline Passenger Bill of Rights and FAA Satellite Air Traffic Control and Airline Flight Path Correction Bill." No, Congress will come up with a shorter name but to "get the votes" the bill will include provisions to soothe the wounds of the unhappy. This bill will regulate payments and benefits granted to those who are stuck on the tarmac for hours on end. Of course, once the airlines get a bill passed to fund a new high tech satellite navigation system, the problem of being stuck on the tarmac will miraculously be solved. CAL has already spent at least $50,000,000 building a new hub in Cleveland to relieve the congestion at Newark. There is no question that the big carriers have been paying more than a fair share of the cost of FAA services. After the bill has passed, smaller planes will save a lot of money by avoiding taking a prime landing spot from one of the big carriers. Smaller airports will be utilized more by these smaller planes.

The airline industry and the traveling public will all be big winners when a compromise is reached. Among the losers will be the owners of homes that are in the direct flight path to the major airports. Part of the huge cost savings will be more direct flight paths near these airports. The savings will be in terms of money and time. Many a flight will cut 20 minutes off its landing time. Connecting flights will see improved scheduling. The cost of the system will be upwards of $50 billion but it will be well worth it. A compromise should be reached very soon.


Senator Grassley of Iowa is trying to steer Congress toward the elimination of the AMT along with making the 15% rate on capital gains taxes permanent. Grassley argues that Congress does not need to offset or score the loss of revenue from the AMT tax because the government has never expected or budgeted this income. Of course, Charlie Rangle and the rest of the Democrats are pushing other ideas. The idea that the democrats will fight the hardest for is the closing of the "loop holes" in regard to "carried interest." They know they have a "winner" in regard to attacking the taxes paid by hedge fund managers. The fact that a change in the law will not cause even a twitch in the tax revenue collected gauge does not matter. Many a business will have to be restructured to avoid the extra tax but, again, the amount of new taxes collected will be minuscule. Indeed, the normal, reasonable and rational decision of many an investor will be to avoid realizing the gain on investments once the tax rates go up. The free flow of capital is one of the things that makes the US economy dynamic and prosperous. The passage of extra taxes also includes a hidden "tax surcharge."

Senator Grassley needs 60 votes to get a bill through the Senate. The Democrats need the 60 votes to get a bill to the President but it needs 67 to over ride a veto. Congress currently "enjoys" a favorable rating of 27% of the citizens and the disapproval of 64%! I don't recall lower numbers. Do the Democrats really have the stomach for closing down the government? When the Republicans tried in 1995, they caught too much heat to handle.


Twenty five long years ago, when I was an investment broker with Merrill Lynch, an event happened two times that has not happened again until the day before yesterday. The up to down volume on the New York Stock Exchange was greater than 25 to 1. Such an event, according to The Sentiment Trader, has happened only seven times. In addition to the two times in August of 1982, it happened in 1950, 1951, 1957, and 1978. In most cases, the market jumped, then stumbled around for a week or two and then jumped again. In all seven cases the market was up strongly within three months and the average increase of the average big stock was 9.4%. If you appreciate how "heavy" is the S&P 500 or the Dow Jones Averages, they you appreciate that serious money was made during these historic moves.

The up to down volume this past Tuesday was better than 30 to 1!

One possible scenario is that the market will struggle for the next couple of weeks and then have another huge up day when Congress passes a reasonable compromise. Of course, when Congress lumps 12 massive appropriation bills into one grand package, all sorts of extra billion dollar earmarks get funded. Yes, I can already smell the stink of the compromises coming but the process of "muddling though" is as good as government gets. Government is a necessary evil, generally the less the better.


Google continues to charge ahead with innovative "solutions." The coming advertisement revenues from "rich media sources" is going to make the revenues from the current text ads look very small. Google is ready to patch together its innovative "gadget" ads with its current operations and with the DoubleClick system as soon as the closing of the purchase is complete.

Mobile ads are also ready to explode. INTC, TXN and others are making dramatic strides in reducing the battery power needed to operate sophisticated hand held, wireless computers. Those children born this year are going to live in a very different world than the one that you and I know.


After falling hard for 4 years, the value of the US Dollar is about to turn. As a general rule, the turn will mean that the performance of international investments will weaken and the performance of US investments will improve. Part of the reason that China has been growing at unprecedented rates has to do with the value of the US dollar. As the dollar and the yuan (which is pegged to the dollar) have fallen, the price of Chinese goods sold in Europe has fallen. The ECB is still in need of an increase in Euroland short term rates to slow the European economies. Job losses are going to be very large in Euroland unless they can reverse the growing advantage of the Chinese manufacturers. ECB rates are at 4% and the US Fed Funds rate was just reduced to 4.75%. Under the circumstances, one cannot expect the dollar to climb until the market is confident that either the spread is going to switch from a -.75% to a plus something.

Yes, I am saying the opposite of what the TV pundits repeat at least a few dozen times each day but history and common sense are on my side. The price of oil and gold is being pushed by fear of an "Iranian Event", by the falling dollar and by the belief that lower short term rates will stimulate the economy and thus the consumption of oil. Since 1978, Iran has been isolated from the rest of the world. Over the past couple of years, hundreds of deals have been made that will bring Iran out of isolation. The current situation is much like the negotiations to buy a business. Outsiders can often discover that negotiations for a takeover are in progress but only the insiders can make an highly accurate, educated guess as to weather the final deal can be closed. It would be a silly move for insiders to openly state their educated guess. If one suggests that a deal is close only to see it fall through, then the party has embarrassed himself with no potential gain. If sabers are rattled putting the prospects of a deal into great doubt, then a successful conclusion provides relief to all parties.

Iran has fastidiously maintained its right to develop the peaceful use of nuclear power. I believe Iran will develop said nuclear power after a deal is made that will reduce the threat to the rest of the world. Obviously, almost everyone would prefer that all nuclear weapons were destroyed. It has never been a comfort to know that Russia or India or Pakistan or others have the capacity to start a nuclear war. The deterrence of self destruction just does not seem very powerful when dealing with people who are willing to commit suicide to insure a trip to heaven. Still, I suspect that the final deal will give Iran the "supervised" right to develop nuclear energy.

Our French Friends have added a bit of pressure. I smell a compromise in the works but it has been more than a year since I first caught a slight scent in the air. Only time will tell but the combination of a few deals in Congress and a couple of deals in Iraq and Iran could make for a huge stock market rally before the November elections.


Wednesday, September 19, 2007


The rest of the world followed the USA lead over night; markets around the world soared! The part I love the most is that at least half the talk is about the boom in oil and gold. A lot of money is pouring into the "tired end" of the market while the "jump" in the "other end" is just getting under way. Part of the reason is that many investors falsely believe that inflation is about to soar.

Yesterday a reader sent an article that suggested investors should hide out in bonds until the "worst" is over. My SELL, SELL, SELL on bonds is looking pretty good right now; bonds have fallen while stocks have soared. Economics professor, James Hamilton, issued a follow up study yesterday that suggests that the whole curve shifts down when the Fed Funds Rate is cut. Oops! Not this time! My belief is that even the good professor tends to get the cart before the horse. In the past, central bankers waited too long to cut short rates; the economy has often reached "free fall" before the start of the rate cuts. The first move in rates is never enough to float a falling lead hot air balloon, it is only enough to slow the fall. After the second cut or two, it is only common sense for long rates to go up, stimulating an economy is positive for future real growth and for future inflation.

The great news is that inflation continues to be very well behaved. The massive purchases of raw materials in Asia continues to be converted into lower priced goods around the world. The dramatic fall in the US dollar continues to "put the wood" to the seat of the pants of all the other industrialized nations. Exports from the USA and from China (which pegs its currency to the US Dollar) are soaring. You won't read this hardly any where else but, Bush has made some great chess moves in recent months. He has sacrificed a pawn or two in order to set up the democrats. If you were a democrat senator right now, what bill would you propose and expect to get signed into law?

The big push by democrats to "bring the troops home now" has failed in its purpose while pushing the democratic presidential candidates to take left wing positions that will not help them in the general election. The American people want to be safe from terror. Bringing the troops home in the middle of the war is not the winning position. The latest attempt to disrupt the war, forcing the troops to spend a lot of "down time" is unraveling.

On the energy front, the "big oil" man, Bush, has forced the environmentalist to admit that ethanol is not the answer. Bush caved into the democratic game of "paying off corn farmers." By doing so, he helped start the back lash to wasteful subsidies for bio-fuels. Many folk on both sides of the isle have started to understand that it would consume far too many food resources to replace even a small portion of our energy needs. Even the carbon sequestering schemes are starting to be seen as just more government boondoggle. The fact of the matter is that the most effective scheme for sequestering carbon is managed forest growth. New growth sequesters carbon much faster than old growth. China is now moving hard in the direction the USA headed over 100 years ago. The USA has reforested millions of hectares. The fear of environmental activist, those who want to leave the forest alone even if it means the occasional fire burns a few billion acres, has impeded the process but common sense prevails over the long haul.

The wealthy are always attacked by the left but, of course, wealth allows the "right thing" to be done. The poorest of the poor continue to use up the forest. Countries like Bangladesh are down to 7% forest coverage. A country like China, which moved rapidly from the poorest of the poor to a developing nation, can now afford to join the USA in its reforestation program. Of course, much more could have been done in the USA. The USA continues to pay farmers not to grow crops on land that could be growing trees. Like I have said before, an acre of forest sequesters more carbon annually than what can be saved through the growth of ethanol in 50 years. As usual, people (particularly democrat people) tend to try to do for nature what nature will do for itself. It is hard to do better than God!

With the price of oil at all time highs, as a democrat senator, would you fight for carbon taxes when the science continues to show that many of the schemes to cut carbon dioxide are proving to be inefficient boondoggles? Would you push for tax increases in the middle of a housing recession and credit crunch?

The tide is turning. Senator Obama just proposed a tax cut for the middle class. No doubt, he would pay for it by eliminating slapping shackles on the rest of the economy but at least it is a mention by a democrat that taxes need to be kept low. One of the economic things least understood by the democrats is corporate taxation. The bulk of the taxes paid by corporations are passed directly through to consumers. The big company is easy for democrats to attack but the attacks hurt the "little people" the most. Today, corporate taxes in the USA are high relative to the rest of the world. The same politicians who complain about jobs being lost to competitors overseas are willing to make the situation worse. Countries in Western Europe, Eastern Europe, Asia, Africa and South America have lowered corporate taxes. The manufacturing boom in Eastern Europe, for example, is not an accident. Tax policies do matter and the general principal holds that individuals make better decisions than the government in regard to how to spend the peoples money. There is waste all around; waste committed by individuals, governments and businesses. Schumpter won the "battle" with Galbraith long ago. Even totalitarian regimes do well when they allow the people economic freedom; the Chinese do not have a bill of rights but they are buying homes and buying and selling goods.


Ben Bernanke has demonstrated his understanding that the price of oil will ultimately take care of itself. The economic train does not need to be slowed to a crawl in order to halt inflation. Inflation is always a problem in the balance of goods and money, but given the opportunity the market will find substitution goods if the money is available. The big oil energy projects are still under construction but price does cure price. Much of the current run up is a continuation of speculation. It has always been true that market tops are much harder to see than market bottoms. The topping process is one where momentum is lost and where relative declines occur long before there are actual nominal declines. From 2005 to 2006, the price of oil clearly went up. From the peak in 2006 to the peak in 2007 there has been no real increase. The momentum is gone even though the dollar has fallen to record lows. The dollar is about to turn and go up for the next 5 years or so. All the while, new energy supplies will come on line. Let me put it this way, who would have ever guessed that Russia would sign contracts to supply China and Korea with electricity?

The invisible hand of Adam Smith has been at work and it will continue to work its magic. Is it not just wonderful how the slack in the housing market comes just as construction of refineries, power plants and industrial facilities is gathering steam? Is it not neat that the build out of WiMax net works will occur just as Intel and many others are ready to supply the world with incredibly cheap chips that will dramatically change the way we communicate?

Once again, the price of a computer chip, this time made incredibly small by nano-technology, will drop by thousands of percent. Those who focus on oil to say that inflation is terrible have simply not considered the growth in computer chip sales relative to oil sales. Over the past 30 years, the people of the USA have used less and less oil per person. Sure the nominal price has gone up but the total increase in dollars spent on oil lost its momentum long ago. At the same time, the number of silicon chips purchased has gone up many thousands if not millions of times. The price of these chips has fallen and fallen and fallen some more and are ready to fall once again.

Huge quantities of chips will be sold in coming years. All the ways these chips will be used to boost productivity are not known and not knowable. One known and easy example is the huge savings from avoiding the wrong turn. When GPS is everywhere, a few trillion wrong turns will be avoided each year. Yes, GPS will serve as a substitute for trillions of gallons of fuel.