"There is a very easy way to return from a casino with a small fortune: go there with a large one" Jack Yelton

Here it comes again... All over the media one can read never ending stories about another "sure thing" investment opportunity- this time it is agriculture and anything related to it. I mean, some times it takes a lot of effort on my part to understand, how could the public that is still recovering from the bursting of one bubble, is now herding en masse into another "sure thing" sector that is quickly becoming the next bubble of gigantic proportions...

I guess that's why being a skeptic, in my opinion, is a "must have" quality for anyone who aspires to be successful investor long term. Too often we all forget that in aggregate the stock market is simply a giant supermarket where two nearly identical products could be selling at vastly different prices just because one has a better advertisement, temporarily low supply or because it is simply more "fashionable" or "hot" at the moment.

If you are a permanent investing optimist who just accepts the "rosy" management projections and likes to move in a lock step with trendy "popular" opinion- you are very likely to one day learn a very painful and expensive lesson. Cheerful momentum and growth investors learned it in the late 90s when buying AOL was just as fashionable as buying MOS or POT is today. Even value investors, who once claimed that they would never do such a stupid thing like invest based on "hype", learned a painful lesson over the past 18 months. It all started with a same notion that one group of stocks or a sector deserved a "premium" over its "historical" valuations because "this time was different".

In a case of the tech crash it was the revenue growth and/or anything related to Internet, in the case of the "financials bust" of 2006-2008, it was the financial/banking sector that deserved a historical "premium" just because its earnings grew in healthy double digits for several years... The whole notion of cyclicality inherent in the financial industry was quickly forgotten even by the "rational" value gurus. We all heard numerous explanations why LEH, C, BAC and GS were supposed to grow in double digits forever and thus were "extremely" cheap even at historically "sky high" multiples...

"This time is different" stories that we all heard just a few months ago were just as prevalent during the "Shanghai boom" time last fall as they where during the tech boom. Now after 40% plunge- it's simply amazing to go back and read some of the explanations people came up when justifying why PetroChina was valued higher than Exxon, or why ICBC should be valued higher than BofA. We've heard stories about decoupling of emerging economies, a billion of hungry Chinese consumers etc...

The scary part in my book is that a similar bubble has now almost certainly formed in the agriculture related stocks. We are now hearing stories about "how the world is running out of food" and how the "same" billions of "hungry" consumers that were just recently predicted to make Asian economies immune to the woes of the mighty US, are going to put the "again never-ending" pressure on food prices for the years to come...

Come on guys, give me a break! No one is going to run out of food- world's population during the last several years has barely grown and while eating habits towards more protein consumption are increasing the demand of the AG commodities somewhat, the multi fold increase in prices of corn and wheat is definitely not the result of the increased consumption. Rather it is a direct outcome of the incompetent politicians doing what they do best- wasting money and excess sector liquidity driven by greed... Ethanol and other alternative grain based fuel subsidies are absolutely ridiculous, stupid and irrational. Period!

All the stories about how the farming industry is only entering the beginning of the next "sure thing" boom and thus super cyclical companies like POT and MOS deserve the ridiculous valuations because they will grow by 20% a year for the next 10 years are simply silly. Remember - we've heard that about China, Real Estate, AOL etc...

And just as like all other "booms" the agriculture is now sure to go through a "bust" cycle that will surely cost a lot of retail investors' money. Does one reasonably believe that pure commodity plays like Potash and Mosaic with 12,000+ employees and less than $2B in free cash between the two of them, are worth a $100 billion market cap just because there is a short term shortage of fertilizer????

Once again, let's get real here- how many years do you think the fertilizer prices need to go up by 50% a year to justify a sustainable cash flow sufficient to pay investors dividends worthy of current "sky is the limit" prices? How about the fact that both companies spend 50% + of operating cash flow on capital expenditures? How about the "sky rocketing" costs on everything from labor and industrial equipment, to energy required to produce the final product? How about the almost certain long term threat from substitutions that are virtually guaranteed to show up every time there is such a heavy shot term supply/demand imbalance? How about the fact that neither company has yet been able to provide some real return to shareholders through dividendsor stock buybacks?

My take on it simple- while it is always difficult to predict when the bubble is going to burst, it is very easy to avoid suffering from the eventual consequences. In the game of "bubbly" musical chairs someone always loses, and one while one would hope that small retail investors won't be the ones left behind- unfortunately, more likely than not, they will end being the ones who are going to pay for the "greedy" mistakes of 'big" boys.

While neither MOS nor POT fit my short selling profile, I think that risk reward here is definitely not in the long side investors' favor. Don't be surprised if the AG rally could go on for a few weeks or may be even months- but it could also abruptly end Monday because while greed is a powerful momentum driver - in the long run- fear always wins and the outcome is likely to be quite painful for whoever is left holding the bag...

Stay safe and ignore the AG sector,
Skepticalcapitalist@gmail.com

The recovery in the value of Commercial Mortgage backed securities since Bear Sterns bailout has been simply stunning.

source: markit

Things are turning for the better even in the residential related securities.

source: markit

And while it's unclear whether these improvements will hold up as we are likely very close to the official end of the rate cutting cycle...

Being net short the market today is very dangerous...

Stay safe out there,
Vad

"Take your life in your own hands, and what happens? A terrible thing: no one to blame" Erica Jong

As some of the more frequent visitors to my blog might already know, my investing style is somewhat different from a typical money manager out there. A significant portion of my portfolio is selected based on somewhat mechanical basis- it is intended to serve as a "hedge" against my more aggressive short and contrarian picks. Remember, the quant screens I use, utilize a number of factors that I personally (not necessarily conventional Wall Street quant funds) consider important. A lot of well followed financial/accounting research out there is too widely followed, and thus is quite useless in my book as it is not going to generate you any excess return...

I repeat my exercise monthly, but absent a significant price decline in the original picks I only rebalance my list quarterly. Below is a group of new stocks that made it to my most recent scan. To my surprise many of the oil servicing stocks still managed to make it into the top 15 again... My skeptical mind is telling me that oil prices will have to fall over the next 12 months, but my quantitative side keeps telling me that it is still too early to sell the O&G servicers regardless of what the oil does in the short term... Oh, well I guess I'll just have to find a middle ground and will simply take smaller positions in these stocks than I would have otherwise...

I am not going to go into much detail explaining the rationale for these plays- consider this to be simply another list of ideas from your truly:

APH- Amphenol Corporation designs, manufactures, and markets electrical, electronic and fiber optic connectors, interconnect systems, and coaxial and flat-ribbon cable worldwide.

SPN-Superior Energy Services, Inc. provides oilfield services and equipment to serve drilling and production-related needs of oil and gas companies primarily in the United States.

RPM-RPM International, Inc., through its subsidiaries, engages in the manufacture, marketing, and sale of various specialty chemical products to industrial and consumer markets worldwide.

PACR-Pacer International, Inc. operates as a non-asset based third-party logistics provider in North America. The company operates through two segments, Intermodal and Logistics.

WSO-Watsco, Inc., together with its subsidiaries, distributes air conditioning, heating, and refrigeration equipment, as well as related parts and supplies in the United States.

NE-Noble Corporation provides various services for the oil and gas industry in the United States and internationally.

CELG-Celgene Corporation, a biopharmaceutical company, engages in the discovery, development, and commercialization of innovative therapies to treat cancer and immune-inflammatory related diseases in Europe and the United States.

CLB-Core Laboratories N.V. provides reservoir description, production enhancement, and reservoir management services to the oil and gas industry worldwide.

PPDI- Pharmaceutical Product Development, Inc. (PPD), a contract research organization, provides drug discovery and development services, post-approval expertise, and compound partnering programs.

Anyway, just thought I would spruce up my usual economic ramblings with some actionable investing ideas :) Don't forget that using stop losses with quant ideas is a very good idea :)

skepticalcapitalist@gmail.com

"Rule #1- Never Lose Money
Rule #2- Never Forget Rule #1"
Warren Buffet

Since referring to the wisdom of the world's greatest investor seems to be a common theme this week, I wanted to highlight again some of my own rules that I have developed/(borrowed?) by following his annual shareholder letters. These simple rules might help to explain why my Strategy Lab Portfolio looks so much different from everyone else's...

First, I wanted to highlight an important factor for anyone who invests heavily into mutual funds. In my opinion the true investment talent could only be separated from luck in a period of bear market turbulence. During the go-go years of the roaring 90s it became too simple to claim that one manager is great at stock picking, just because his/her portfolio has done well during the period of widespread bull rally. In the end many of these funds have ceased to exist during the 2001-2002 bear market... From what we are seeing so far, a similar chain of events is unfolding today. Most of the former star "financial sector heavy" mutual and hedge funds have suffered blows that forced them to either halt redemptions or even led to outright closures. This pain could be avoided...

History of outperformance in the rough market should become one of the most important factors in any investor's decision when deciding into which mutual funds to invest. Next time instead of relying purely on the conventional Morningstar rating system, spend an extra few minutes and study the fund's performance during the last bear market-if you see heavy losses which were only made up later in the "go-go" bull times- my advice is- run for exits while and if you still can...

As the wisdom of the world's most famous investor states, the first objective of any investment manager should be to make sure he/she does not lose clients money-period. Swinging for the fences to achieve 40%+ returns could be a great strategy for winning a short term investment contest ,or earning a quick bonus if you working at the most prestigious legalized gambling area in the United States called Wall Street. But it could also quickly become a major pain for the unexpecting retail investor.

As I have stated before, I personally am an opinionated active value investor, who likes to disagree with the general public's opinion. I do tend to trade in and out of my losing positions much faster than a typical fundamental Buffet admirer. But explanation for this difference, in my mind, is very simple- even if you utilize all of the well known Buffet valuation principles (like focus on free cash flow, low multiples etc) when picking your own investments- let's be realistic- you can't possibly emulate his strategy perfectly.

You simply don't have the virtually unlimited resources, ability to talk/interview any executive in the country or ample liquidity to ride out any personal downturn. In addition, your time horizon is likely to be much shorter than that of Buffet- simply because he does not have to sell any of his holdings to pay the medical bills, kid's tuition or deal with unexpected medical emergency. So if you take any one of these factors from the complete "Buffet investment equation" - your results are likely to be much different than his and not to the positive side...

Anyway, back to the original point- here are some the risk management rules I follow to try to reduce the pain during the flat or down market:

1. Never have your money invested in one sector because your probability of losing a lot of money quickly increases drastically. It really does not matter how much you think the sector is undervalued relative to the overall market- sector bets are dangerous- period!

2. Don't be afraid to switch your stance towards a specific stock or a sector if the facts (like unexplainable severe declines...) tell you to do so. "Flip flopping" might bad if you are running for president but it is a necessary skill if you want to succeed in investing. Remember, that unless you have developed a disciplined way to deal with money losing positions, one day you are likely will have your gains wiped out completely or severely reduced by a prolonged bear market- a good example would be shareholders of BSC, MGI or FMD...

3. Even if you are a contrarian investor, and thus like to average down on stocks that are going through a period of a serious correction, at least don't take a full position to start. On my contrarian bet I usually begin with roughly 1/3 of my mental maximum position. Remember, you have to leave yourself some room for errors, as you are certain to make quite a few of them. Markets do overreact all the time but they also tend to be right over the long haul- so don't be too stubborn...

4. Don't invest more than 15% of your money in any one stock regardless of how cheap you think it might be (that includes positions were you averaged down several times as well)

5. Don't argue with the Fed in the short term- (like going a 100% short of gold/commodity related stocks when Fed keeps irrationally cutting rates...) I don't care how passionate you are about it and how wrong do you think the Fed is- don't forget Fed controls the dollar printing press and thus could win any short term battle by default

6. Don't listen to fools who tell you that you can time the market- your chances to do that consistently are not much higher than winning a lottery. Stay fully invested- if you aren't feeling good about the market and don't use short sales-hedge with lower beta stocks or short sells to reduce the overall sensitivity of your portfolio.

7. The smartest thing you could do to reduce the overall volatility/risk of your portfolio is by not being afraid to use short sales. It is not easy, and does require a whole different approach than pure "long only" investing but, if used correctly, could pay major dividends for you over the long haul. ( Vad's short selling rules)

6. Also, don't be afraid to disagree with everyone with anyone (except the Fed ) - but if you do go against the crowd (like shorting fertilizer, Chinese or dry shipper stocks when everyone is buying... )-make sure you have enough liquidity to stay solvent, if they (general public) turn out to be right for a prolonged period of time...

Stay safe and please feel free to send me your comments at skepticalcapitalist@gmail.com
Vad

"One of irony's greatest accomplishments is that one cannot punish the wrongdoing of another without committing a wrongdoing himself"
Anonymous

Man, you have to love the the mystical world of private equity... Not only most of the PE heads are treated like royalty in the financial press but now in a bazaar twist, marquis private equity shops that have been able to profit handsomely from the leveraged buyout craze, now stand to benefit once more on essentially the same transactions... Here is a quote from a WSJ article:

"Private-equity firms helped create billions of dollars in debt during the leveraged-buyout boom. Now some of those funds are eyeing and buying that very same debt at discounts as its value plunges...

Borrowed money has been the fuel of the deal boom in recent years. Private-equity firms loaded up the companies they purchased with huge debts -- bank loans and bonds -- to finance their purchases. Those loans, arranged by Wall Street, were then sold to hedge funds and other investors in a deal machine that chugged along energetically for years.

But the recent credit crunch has thrown a wrench in the gears by frightening off many buyers of those loans. That has left the banks that arranged the financing holding some of the debt while other debt issued before the current turmoil in the debt market rapidly drops in value.
Three weeks ago, with investors increasingly spooked, the banks that arranged financing for private-equity giant Kohlberg Kravis Roberts & Co.'s buyout of Goodlettsville, Tenn.-based retailer Dollar General agreed to sell some of that debt for as little as 87 cents on each dollar owed. Hedge funds led by TPG-Axon, an affiliate of TPG, swooped in, attracted by returns of close to 18%..."

I mean this is almost as hilarious as the recent "developments" in the mortgage world- mortgage brokers that helped to fuel the mess in the real estate market by pushing the "liar" payment-in-kind subprime loans now trading at 10 cents on the dollar, but who are now switching sides and accepting "new" jobs as credit "counselors" who will certainly help the same "duped" customers to work through the foreclosure process...

Another "pearl" from WSJ:

"Legislation approved by Congress and signed into law by President Bush in December provides $180 million of federal funding this year for counseling aimed at helping borrowers avoid foreclosure. NeighborWorks America, a nonprofit organization chartered by Congress 30 years ago, is charged with distributing those funds among state agencies and government-approved counseling organizations...

While the mortgage industry shrinks, many nonprofit groups are expanding to cope with a surge in the number of distressed borrowers seeking advice on how to keep their homes.

Mortgage brokers like Bill Whitehouse thrived on commissions during the housing boom amid lax lending standards. Now, with mortgage defaults soaring and lending volumes plunging, some former brokers and loan officers have converted to a new occupation: counseling borrowers who are trying to avert foreclosure."

I thought a little irony might help you to lighten up the mood...
Stay safe and cheers,

Vad skepticalcapitalist@gmail.com

"Success is 10% inspiration, 90% last-minute changes"
From a billboard advertisement

A quick note- I have received several e-mails from readers asking me why I insist on being a 100% invested at all times. Doesn't safety of cash offer a valuable protection against the declines in the bear market? The answer is quite frankly a very simple "NO" in my skeptical mind - moving large portion of your portfolio into cash amounts to nothing more than a "timing bet".

And as I found, attempts to time the market tend to be useful only if you trying to underperform the market over the long haul. Don't forget, that even if you think that your ability to predict the market's next move is higher than 50%/50%, the odds are still not in your favor, as you not only have to time when to sell, but also when to jump back in, which means you need to make two concurrent predictions of where the prices are heading, with each prediction likely being around 50%... You don't need an MBA to realize that your odds are stacked up heavily against you...

I don't want to bore you with exact calculations, but depending on several assumptions, you need to have an average predictive ability of 70% to 85% to actually beat the fully invested average market portfolio! How does that sound? You can find a quick quantitative primer with exact calculations and formulas here

My recipe for dealing with market timing is very simple -good investors should keep their portfolios fully invested at all times. When at cross roads- it's ok to protect the downside with short positions or invest in low cost ETFs if you are not exactly sure which stocks to buy. Don't waste money on commissions -those damn brokers make too much money from me as at is.

Anyway, feel free to e-mail me your questions at skepticalcapitalist@gmail.com. By the way, for anyone interested, you will be able to ask me questions in person at MSN Strategy Lab Panel and/or MSN's Booth at Money Show in Vegas, Vad

Stay safe, Vad

"How many legs does a dog have if you call the tail a leg? Four! Calling a tail a leg doesn't make it a leg" Abraham Lincoln

Last's month's rally probably made the big picture quite a bit murkier in the minds of most investors...Despite (or because?) of the widespread predictions of impending "doom and gloom" markets shined with many beaten up "value plays" casually rebounding in high double digits and Dow up almost 10% off its March lows... But is this rally a true sign of things to come? Has anything changed fundamentally since the early March lows? Is it now safe to assume that US Economy is out of the woods? I don't think the answer is very clear at the moment, and thus anyone who answers this question with great confidence is likely to be simply wrong...

While on the surface last month's comeback could have hardly been any more convincing, it was not triggered, in my opinion, by solid and consistent economic data, but rather was a chain reaction in response to Fed's bailout of Bear Sterns. The implicit government's guarantee of virtually all and any counterparty risk has in effect eliminated a "bankruptcy threat" for any medium to large financial institution in the United States. This in turn led to drastically improved liquidity and lower spreads in the commercial mortgage backed securities market.

With fear dominating the headlines for the majority of the first quarter, volatility inflicted a severe pain to hundreds of large hedge funds out there, which in combination with Fed induced leverage crackdown on major investment banks, led to another simultaneous unwinding of leveraged short bets and triggered a massive short covering rally. Combine all of the above with seemingly never-ending gains in most commodities related stocks, add all the technically driven "signs" like higher lows, higher highs, "triple bottoms" etc and you've got yourself a recipe for a "healthy" rally

But let's be realistic. According to data from WSJ, of 678 companies that have reported so far (through Friday 18th) are down an astounding 22% year over year. It is true that Wall Street currently predicts a familiar "hockey stick" jump in earnings in the last two quarters of the year which, according to WSJ, is going to lead to almost a 15% full year gain in earnings for the S&P500? But I just simply don't buy into the notion that with economy at a virtual standstill or even in recession, total earnings could possibly grow in healthy double digits for the year. I think that earnings expectation for the second part of the year are still way too high, and thus markets will likely be disappointed come third quarter of the year...

But does it really mean you should sell your stocks today and run away? I don't think so. With so much cash still on the sidelines, and with momentum/technical investors finally jumping on the rally bandwagon, DOW could easily go up another 500 points... But in my opinion ,however, the total potential upside for the remainder of the year is limited to no more than 5% or 7% from today (roughly breakeven for most market indices). And if recession turns out to be more severe than what's currently expected (6-7 months of flat/negative growth), downside target would probably mean retesting January lows or roughly 7-8% from here.

It is true, that given the significant improvements in the values of commercial mortgage backed securities we might have already seen the ultimate lows in the financial sector. Tech sector is still growing in healthy double digits and industrials are benefiting from growing exports. But with commodity bubble looking increasingly unstable, and Fed's rate cutting cycle closing to an end, the current (3-6 months) risk/reward trade off is overall quite balanced in my opinion. So most of the potential upside from here will now likely come from picking better stocks and sectors, rather than from simple buy SPY and hold strategy...

skepticalcapitalist@gmail.com

What a joke! A little cheer up video for all the "booya's" out there... Next time when he comes on the show- FLIP the channel or at least MUTE it out...

And to finish it off - another "economic expert"- on recession. (P.S. Politics aside I agree with him on NAFTA though...:)

"One cannot and must not try to erase the past merely because it does not fit the present"
Golda Meir

I've been taking a short vacation on the West Coast and thus fell back slightly on my blogging- it's time to catch up... I'll start tonight with some important headlines and quotes from various sources that I think might be pointing to a slightly different tilt in my portfolio over the next few weeks.

First, key developments in the overall economy- as I pointed out before- values of both commercial and residential real estate securities have recovered dramatically since the Bear Sterns fiasco. They (values) held up quite well even after a steady flow of negative news on the real economic front in the last several days. And while this should theoretically be considered very good news for large banks, I believe that one of the threats, that seem to have been largely ignored during the past several weeks, could easily become a source of headline troubles again- I am talking about the potential downgrade of ABK and even may be of MBI...On one hand despite the bigger that expected headline loss of $1.66B, S&P said that it won't downgrade ABK's debt. On the other hand - shares hit a new all time low and so did its actual credit default swaps.

"Credit default swaps on Ambac Assurance Corp started trading for the first time at an upfront cost of 11 percent, in addition to annual premiums of 500 basis points, according to data provider CMA DataVision... This means it would cost $1.1 million as an upfront payment to insure $10 million in debt for five years, in addition to annual payments of $500,000"

I think that both S&P and Moody's are definitely smoking something if they believe ABK really deserves AAA rating? AAA means probability of losses on the secure debt is close to zero- do you think that if GE reported negative earnings for 9 months they would still be AAA? Both debt and equity markets definitely disagree with jokers at S&P and Moody's... The more I look at the most recent actions of debt rating agencies, the more I begin to agree with many critics- they really have no clue about what's really going on out there. And while the potential downgrade probably won't have a severe impact on large players who already raised lots of fresh capital, it could very well force some of the smaller banks out of business...

And if the bond insures woes weren't' enough- quick mention of some other potential sources of trouble-First, the leveraged buyout related bust seems to be only starting, and thus the 80-90 cents on the dollar price for LBO related debt is not quite a bargain...

"

April 23 (Bloomberg) -- The looming wave of bankruptcies is unlikely to be kind to bondholders. And they have only themselves to blame... Rather than receiving the historical average recovery of 42 cents on the dollar in a default, owners of a third of high- yield, high-risk bonds rated B+ or lower may get no more than 10 cents, according to New York-based Fitch Ratings. About 22 percent are likely to get 11 cents to 30 cents."

How about another few potential sources of joy for banks :)?- Credit cards and home equity lines...

"Standard & Poor's said delinquencies on home-equity lines of credit issued in 2005 and 2006 shot up in March, underscoring continued trouble in the U.S. economy...S&P said that 9.19% of lines issued in 2005 and 11.45% of loans issued in 2006 are delinquent, up 6.49% and 6.51% from February. Serious delinquencies, where lines are 90-days plus overdue or in foreclosure, shot up 8.83% and 8.75% for 2005 and 2006, respectively, representing 5.3% and 6.34% of the years' total issuance"

"April 22 (Bloomberg) -- Target Corp., the second-largest U.S. discount chain, said it wrote off an annualized 8.1 percent of its credit-card loans in March as consumers grappled with job losses and the biggest housing slump in a quarter century. Defaults during the month totaled $55.5 million, the Minneapolis-based retailer said in a regulatory filing today. The annualized charge-off rate was 6.8 percent in February"

And to finish it off, how about a quote from a bellwether of US economy- UPS... Things seem to have gotten a bit worse in March...

"UPS's first quarter results illustrate the dramatic slowing in the U.S. economy. At our investor conference on March 12th, we told you that volume growth in January had been up 3%. But in the six weeks prior to the conference, it had been negative... We also said if these trends persisted through March, we would not achieve the earnings guidance we had provided for the quarter. [The] trends did continue. Many have become sharply more negative in the last two months. ... The great unknowns are the severity and the duration of the current economic slowdown. Many of our customers have tightened their belts resulting in a shift away from our premium air products to ground shipments"

But it's not all doom and gloom- most of the tech sector seems to be holding up quite well and earnings are still growing handsomely there year over year... There are also some indications that most industrials could whether the recession "ok" driven by lower dollar...More on that tomorrow...

skepticalcapitalist@gmail.com

"Nature gave men two ends - one to sit on and one to think with. Ever since then man's success or failure has been dependent on the one he used most" George R. Kirkpatrick

It's been full four weeks since I decided it was time to go long the market. At the time being bullish was quite unpopular, as fear was still ruling the market and thus it was a relatively easy call for me that in hindsight seem to have been precisely on target. However, situation today is different- for the first time in quite a while, when people ask me whether I am now bullish or bearish, I say that I am not yet sure...

And there are a number of reasons why. On one hand my skeptical mind simply refuses to comprehend how one could expect the economy to hold up well in a face of so many challenges? Residential construction is virtually at stand still, commercial construction is showing signs of severe strain. Banks are struggling to repair their balance sheets and are so risk averse now, that in some cases they refuse lending without tangible collateral to even some of their best clients. Retailers and restaurants seem to be struggling with a strong headwind of rapidly rising costs and slowing consumer spending.

Even formerly "recession proof" healthcare industry (excluding biotech for now) seems to have caught on a deadly decease of rapidly rising costs combined with decreasing revenues driven by massive simultaneous top drug patent expiration and decreasing population of people who can actually paid for provided services (hence insured). The list can go on pretty much forever, with virtually every industry in the US Economy, except probably agriculture and oil & gas, experiencing severe turbulence. And let me tell you something, I am a great believer of a concept that without healthy and well functioning credit market, all the other sectors of the economy are bound to slow down (read Jon Markman's most recent article on the banking sector)

However, here is the flip side of the coin. Federal Reserve has embarked on the most aggressive rate cut series in recent history. And while I personally believe that these moves will come back to haunt us in the years to come due to the spiraling out of control inflation expectations, one can not underestimate the impact this monetary stimulus is making in the short term. It is pretty astounding, but even though earnings of the all companies that reported so far (about 30% of firms) are down 20% year over year (according to WSJ's market data center) , if we exclude the negative impact from financial sector ($36B y-o-y shortfall so far), earnings have actually increased slightly!?.

And while the strength in basic materials and oil and gas sector earnings could be easily explained by what's looks increasingly looks like another bubble in the making, actual earnings in the technology, telecom and industrial sectors have been coming in handsomely above the last year's level. Technology sector's earnings are running 9% above last year, telecom-48% and industrial- 3%. Considering all the headwinds- these numbers are quite startling.

It increasingly looks like the weak dollar and higher oil prices are actually starting to make a tangible positive impact on competitiveness on several sectors of the US economy that seem to have been written off a while ago like "good-old" manufacturing. Yes, you did not misread what I just said- positive impact. Now let me explain what I mean.

About a week or so ago I had an opportunity to spend a few hours talking to the CEO of a small manufacturing company based in the Southeastern United States. Just like many other businesses around the country they have been hurt badly during the recent years because outsourcing. The lost business first to Mexico and most recently to China...What's more, he gave me a concrete example of one large contract lost to China several years ago. They initially quoted this piece of business at $1.60 a pound with a cost of goods of roughly $1.20. In contrast, their Chinese competitor quoted it at $.60 a pound, and even with shipping to the final destination in the US the final cost was only $.90. So you get the picture- it was not even really a contest- all of the business was gone within months- case closed...

Now fast forward to today and the picture is quite different- Chinese labor salaries have been increasing in healthy double digits for the last several years, currency has been steadily gaining on the dollar at the pace of 7-10% a year and finally - yes here is where the high oil prices come in play- transportation costs have simply spun out of control...So let's get back to the same little company in Tennessee- the same order that was once lost because of the almost a 80% difference in costs- has not only closed the gap dramatically because of the rising salaries and rising currency, but when transportation costs were added back- this gap became virtually nonexistent- it is now only about 5-10%...

This cost advantage is now is simply not sufficient to justify all the risks related to outsourcing to China. What's more, after you make adjustments for the increased inventory levels required to support the multi-week shipping cycles, and account for unpredictable shipping costs, the outsourcing case becomes even murkier. You get the picture...

Now, I am in no way trying to say that all the manufacturing is going to come back to the US, as most of the manufacturing done in China today, has a labor content that is a lot higher than the example I just mentioned. What's more- I am pretty sure most of the jobs lost are never coming back- period. But don't forget- manufacturing leads the business cycle- usually losing millions of job in a normal recession. But this time around, at least for now, the tide of heavy manufacturing job losses seems to be turning the other way. What's more we can reasonably expect that many of the European and Japanese manufactures will actually continue to expand their capacity in the US which means potentially adding net new jobs over the long haul.

And the same can be also said about the technology jobs- Indian IT salaries have been increasing dramatically and in combination with higher inflation you can expect the slowing tide of IT outsourcing to again cushion the US economy.

Now here is the punchline- assuming the job market keeps holds as it has so far - the initial recession might be a bit milder than market is currently expecting. Yes, once again I said the initial one :), I think that Fed will have start raising rates again before 2008 is over and we will be into another cycle of pain once that occurs, but for now- my mood is still quite neutral as opposed to the bearish one...

Please feel free send me e-mails at skepticalcapitalist@gmail.com

"In matters of style swim with the current, in matters of principle-stand like a rock"
Thomas Jefferson

Someone famous once said "Invest in inflation. It's the only thing that is going up" and you know what- I could not agree more. In this world of fiat money one thing is guaranteed - your money will be worth less tomorrow than today. As you might have guessed from my previous posts I am not a great believer in politicians' abilities to guide/understand the economy in general, and definitely get extremely irritated when some of the most vocal and most popular of them try to give advice to the Fed. This advice usually says something like this:" I can't believe you have not reduced rates yet... What the hell is taking you so long-my constituents are suffering and you are doing nothing about it... etc." I think there should be a prize of some sort that is awarded annually to a politician that actually asks to increase rates for once- the only problem is - this prize could go unclaimed for years...

I've posted my opinion on the subject of Fed's rate cuts many times in the past and instead of reinventing the wheel will just repost some of my previous thoughts as I think they have not yet lost their relevance...

I think the next few weeks will determine the direction of where the world largest economy will be heading for the next few years. If you read most of the mainstream press it sounds like this direction is clear- another rate cut, followed by shallow recession and bright future from thereon forward. Not so fast...It's definitely easy to be a politician and make it look like all of the world's economic problems could be magically wiped off the face of the Earth by a swift downward hand movement of a wizard called Ben Bernanke...

The truth, as usual, is that popular opinions always swing too far. Rate cuts are rarely followed by a period of short term market out performance and thus problems will not just simply go away. What's more in most recent rate cut cycles the decisions when to start cutting were relatively simple (9.11, debt crisis etc) and most of the time were on target. The more difficult decision is when to stop cutting rates and that's where we might've had less success with the outcome- at least some of the current problems are due to what many believe was one of the few mistakes Alan Greenspan has made- cutting rates too low.

This time Ben's decision is neither easy nor warranted by a consistent pool of homogenous data. There wasn't a major stock market crash (5% YTD decline is merely a correction), corporate earnings outside of financial sector are still climbing (albeit very slowly). What's more oil has just hit a new all time high just a few weeks ago, copper is pushing multi months highs, wheat is at all time high as well. Inflation overall is still stubbornly high and is above or in the higher range of the desired 1-2% corridor; dollar is pushing all time lows against the euro, agriculture bubble is only getting fluffier every day, rents are still climbing, consumers are still spending...

The question now is whether all of the above is just a lagging indicator of the irrational behavior from the excesses of the last five years. Liquidity struggles of the last six months have not yet been resolved completely even though normality is slowly coming back into the financial system. So the real issue is whether Ben is going to bow under pressure and will swim with the current of the "cutting mood" or will he acknowledge that maintaining price stability is the most important role that Fed plays and that buckling under popular pressure is the easiest way for introducing unnecessary volatility and excesses into the otherwise well functioning economic machine. Inflation beast has not been defeated yet and until that occurs everything else (growth or unemployment) to me is less relevant.

Playing with size of cap of Freddie's and Fannie's mortgage portfolios, accepting new forms of collateral for the Repo agreements as well as introducing new regulation into the lending world are purely matters of style and thus in this case my advice for Ben would be to swim with the current. Let politicians have their time in the light- it's not worth fighting over.

However maintaining price stability IS the matter of PRINCIPLE and standing like a rock is the only appropriate stance that Ben Bernanke should take. I've been wrong before, but I hope that Ben and Co will now realize that dropping Fed Funds rate any further is simply going to add more gasoline to the "commodities bubble" fire. We have to be realistic- inflation expectations have to be brought under control until it's too late. And the best way to do it would to finally buck the market desires and DO NOT cut rates, otherwise, Paul Volcker might just have to eventually take on Ben's job and expectations for a V shaped recession could very well become a W or may be even WW one...

My neutral stance towards the equities is starting to turn somewhat bearish due to the fact that too many mainstream "talking heads" started to sound bullish again and decline in the VIX index shows that people may be starting to feel too optimistic again...

P.S. I've had some issues with the portfolio tracking system here at MSN where some of the holdings showed up one day and disappeared the next one, which made it difficult to assess what my holdings actually looked like. It will probably take several weeks just to clean my portfolio up and bring it back into the correct long/short/cash balance. For now, I have exited most of my O&G/alt-E plays (SLB, DO, NE, JASO, ESV) and incurred some losses on the short side...

Feel free to e-mail me at skepticalcapitalist@gmail.com