It was just a few months ago when Wall Street put out an "all clear" sign for the US Equities with "always" optimistic analysts predicting a "high double digit" rebound in earnings for the latter part of 2008. Federal Reserve cheerfully predicted that inflation expectations will remain well anchored and thus are not of a particular concern. Unfortunately, recently situation took a rapid turn for the worse- with M2 Money Supply growth skyrocketing into double digits, excess liquidity had to end up somewhere and ever rising commodity prices offered a very safe refuge.

So instead of already being out of what could have been a relatively minor recession absent the rate cuts, we are now possibly only one hurricane away from oil prices clearing the $150 a barrel barrier and with it GM, Chrysler, Ford and major US airlines rapidly entering the insolvency territory. But even with all US indices now closing fast on the "bear" market territory, stubborn Fed still refuses to do its main job of fighting inflation, and keeps arguing that their lax monetary policy has nothing to do with high prices?

Come on Ben, give me a break- M2 Money supply growth in double digits during the first quarter of 2008, got very close to that of China, country whose GDP is growing at 10 times the rate of the US. Where do you think this liquidity has gone? Dah?

Anyway, enough rambling- Fed has made its decision, and while I think it was not a very smart one, I have to now figure out how to profit from it. My healthy short position has certainly helped me to preserve most of my gains, and being some 15% plus ahead of the market is definitely a terrific result so far, but now I need to figure out how to resume the upward trend.

I don't know what it might be, but absent a rate increase move from the Fed- oil and other commodities could very well go higher and when/if that happens- US indices could possibly now go much lower- say another 7-8% lower?. Plus with US Fed outsourcing the interest rate increases work to the emerging markets and European Central Bank, these markets could actually fall faster and harder than anyone expect them. This sell off is also likely going to produce some terrific buying opportunities, and thus with capital preservation goal as a major theme, I'll for now buy deeper into the defensive utilities and healthcare sectors...

I hope that I am completely wrong, but it certainly does not look pretty out there- with VIX nowhere close to the "fear" territory, capitulation of the major indices looks likely to continue for a while longer, so stay safe out there, Vad - skepticalcapitalist@gmail.com

"Promises are like babies: easy to make, hard to deliver"
Author Unknown

Here we go again. Ben Bernanke and Co last week delivered another strong message to the commodities bears all around the world- "we can't really tell if it was/is a bubble until after it blows up"... Unfortunately, it does seem as if my last week's prediction about Fed's inability to raise rates in the middle of the "political season" is actually becoming a reality.

Faced with a tough tradeoff between growth and inflation "Chairman Ben" and Co came up with a clever way, but also potentially dangerous way of solving the "Bernanke's dilemma"- "outsource" the inflation fighting role to other economies around the world instead of doing the dirty work themselves. In his speech last week, Fed's Vice Chairman Kohn delivered a message that seems to have not only borrowed major points from the stories of the "commodity" bulls, but also gave a pretty clear answer to "will they really raise interest rates in August?" question- "Not gonna happen!"

"The reasons for the trajectory and persistence of increases in prices of food and energy this year, as global growth has moderated, are not entirely clear.(VY-Heh?) The upward trend in prices of food and energy over the past several years, however, importantly reflects the pressures posed by rapidly growing demand in developing economies against relatively inelastic global supplies of commodities.

...Additionally, in those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability"

The translation basically goes like this- "US monetary policy has nothing to do with ever rising commodity prices. These high prices are merely an indication of sky rocketing demand from BRICs. And because the US Federal Reserve and the US Economy have had nothing to do with this rise, they should not be obligated to participate in the clean up. The "new guys on the block" (BRICs) and stubborn Europeans need to fight the inflation battle on their own!- slow down economic growth engines using all means necessary- raise rates, further adjust currency exchange rates etc. US won't be raising rates any time soon." -Case closed...

Mr. Market's reaction?- Dow down 400 points or so, Gold up $50, new multi year low for the DJIA, new highs for Crude Oil and virtual death sentence for some/(all?) the Big 3 US auto and RV/Boat makers. I certainly admire the creativity of this "heads I win, tails you lose" interest rate logic- it is almost guaranteed to win some political points here at home. But it is also a very dangerous one for the world economy- relying on China and India to remove the excess liquidity from the world's economic system, is in my mind equivalent to a firefighter waiting on his colleagues to return from vacation in the other state, to help him put out a house fire that has been already been raging on for a while- it is very possible that by the time they come back, there won't be a house to save...

Continued...

"The difficulties of life are intended to make us better, not bitter"
Author Unknown

I think after being in a relative silence for the last several weeks because of being consumed with the legal and administrative burden of starting my Pro career, it's time to catch up on the usual economic news and graphs.

The question on everybody's mind is whether the slump is likely to continue- unfortunately, I don't really have a concrete answer :) But there are some signs out there that it might not be quite over yet...

Let's start with another opinion- US Economy is quickly slipping into the "doom's day" scenario that could have been largely avoided if inflation was brought down under control last fall- quickly rising food and basic commodities prices, deteriorating credit situation because of additional write downs and massive simultaneous deleveraging around the world are starting to cause a chain reaction. Unfortunately, actual length of the recession/stagflation is now more important, in my opinion, than any absolute decline in any one sector. Think of it this way- any struggling business that thought that they had enough capital in reserves to weather a "usual" 3-4 quarter economic slowdown, now could be better off shutting down because things are not expected to get better in the short/medium term. Hence banks will have to write off more loans/ increase provisions for bad debt, because credit problems from housing related sectors (banks, mortgage lenders, home builders etc) are now rapidly spreading into sectors that would be your "usual" suspects when things out there get really nasty- autos, casinos, media, hospitality and/or anything that could be vaguely defined as consumer discretionary...

1. ABX indexes in pretty much all securities not rated as AAA have posted more declines and now are trading below the February lows. So much for the "write up" expectations that many have hoped for just two months ago...

Source: Markit

2. Situation with commercial mrtg backed securities is slightly better than it was back in February. It looks as if markets are becoming a bit more rational and instead of the "across the board" panic selling of March- you can actually clearly see the difference between securities of different "vintages", with AA and higher rated commercial mortgage backed securities issued in 2005 and early 2006 selling at relatively low spreads, but most of the lower grade and "younger" vintage paper is selling at spreads close to or higher than back in the early spring...

Source: Markit

3. Inflation expectations have been edging higher and higher and despite of all the "deflation" talk out there, represents pretty significant dilemma for the Fed. I am also starting to become really concerned that Fed's strategy of "monetary policy outsourcing" is going to significantly hurt the emerging markets and thus could possibly lead to a worldwide recession instead of the local North American one...

Source: ClevelandFed.org

4. What's more it now seems as if Fed Funds expectation have changed from the "virtually guaranteed immediate raise" in August predicted by futures several weeks ago, to an uncertain "maybe" in September...

5. So how close are we to the bottom? I've been growing more and more skeptical recently... According to a small research firm called TrimTabs Investment Research- BLS has been underreporting job losses by a pretty wide margin because of their survey deficiencies and thus things out there could be actually worth than headline numbers are suggesting. Below is the quote from their May macro release- while a bit late :) gives a pretty good summary why BLS's numbers aren't that good and are subject to some serious revisions- in contrast TrimTabs's numbers are based on daily treasury withholdings and thus are much better indicator of the real time health of the economy and they indicate things are getting worse not better...

"We believe the BLS is under reporting job losses for five reasons: The BLS survey period covered mid-April through mid-May, a period when the U.S. economy was just beginning to weaken. • The BLS applies flawed seasonal adjustments that typically mask subtle changes in the employment environment. • Only 40% to 60% of the BLS establishment survey is complete by the initial release date and is subject to large revisions in subsequent months. • Most of the initial respondents to the BLS survey come from government employment centers and large corporations so the survey does not adequately capture changes in employment in small and medium sized corporations. • The BLS applies a "birth/death" adjustment to their employment survey results which is nothing more than an educated guess."

To sum it up- may be my most recent shift towards defensive utilities/healthcare sectors hasn't been quite aggressive enough...

Stay safe out there, skepticalcapitalist@gmail.com

"Our blunders mostly come from letting our wishes interpret our duties"
~Author Unknown

Stock market's behavior of last 10 days or so has been a complete puzzle to me. It seems like with all the "technical" indicators and experts out there pointing towards an impending market crash and absolute collapse of the US Economy, fear has been making a slow but steady comeback into investor's minds and in my book it's a positive sign, but we by no means "all long" territory yet...

I think as it's becoming evident every day, what was initially perceived to be a short housing sector led recession/slowdown, is now quickly converging into a full blown capitulation of anything that could be vaguely defined as consumer discretionary. Last week a multitude of stocks in sectors most sensitive to the prolonged slowdown have established new lows- casinos, autos, lodging, recreational vehicles, regional banks, airlines, old media (newspapers and TV), construction, retailers. The list could gets long very quickly...

Even the formerly bullet proof oil and gas, materials and agricultural darlings have posted double digit declines in the last several days with more declines on the horizon... What is even more troubling- the VIX volatility index is still only trading at around 26, far away from the 30+ capitulation level reached twice earlier this year...

Why is it important? Let's step back for a second- what happened during the last few capitulation days- back in August 2007, January and March 2008? Every time when it seemed like things were almost slipping into the "sell everything and forget the stock market forever territory", Federal Reserve stepped and bailed investors out with the rate cuts. They first cut the discount rate in August in response to the "quant" hedge fund fiasco. More rate cuts followed again in a response to the worldwide stock market collapse that now seems to have been triggered by a rogue trader in Society General, and finally- one more emergency "super cut" was presented in response to Bear Sterns fiasco. "Liquidity magic" worked like a charm every time- indices pulled off spectacular rallies and recovered above the previous lows...

But now we come to today's situation. Fed is now clearly worried about rising inflation expectation and thus no more "savior" rate cuts could be expected. My guess is that we'll see more reactive actions from the government in the form of new stimulus checks, possible bailouts and infrastructure investments, but all of these rescues take time to pass and thus won't be a quick band-aid if things get really rough out there for a day or two.

One can certainly argue that we might have seen the lows for the year- as stock prices now have approached levels not since late 2005. I've also read many different experts saying that VIX is no longer a good "indicator of fear" because of lower holiday volumes, summer vacations etc... But I am personally afraid that the "talking heads" are likely to be wrong again- I think VIX is low simply because this time the declines of the major indices are not disorderly or unexpected... They are completely reasonable and based on the actual economic picture- markets have been simply getting better in pricing the actual dire economic situation into the stock prices. The excess liquidity generated by the silly actions of Federal Reserve washed up in the most logical but very unwelcome place- basic materials, oil and gas and other commodities, which in turn made the already unhealthy economic situation much worse...

Now, any company that is heavily reliant on the US consumers driving, dining out or buying the next new "ipod", "iphone" or "blackberry" is feeling the pinch. Finding good stocks to "short" has actually been easier lately than finding good "long" ideas. If the company provides a service or sells a product that could be considered as vaguely discretionary, and also has a lot of debt, negative cash flows and might need refinancing in the next 6-12 months, it spells TROUBLE...Think GM and Ford, or pretty much any of the indebted automotive suppliers, RV manufactures or casinos and/or lodging companies that could not make money even when the economy was much stronger... Plus the usual safe heavens in the form of emerging markets are no longer bullet-proof. With Fed outsourcing its rate tightening job to other central banks around the world- the whole world economy is rapidly slowing down...

In addition to that- I am now growing a bit more skeptical whether we will see the usual "earnings pop". It certainly doesn't seem that we had much success so far- FDX, NKE and RIMM come to mind for now. We'll see if AA and GE do any better this week- but for now simply try to stay safe...

Please feel free to e-mail me your questions at skepticalcapitalist@gmail.com

"Wisdom is knowing what to do next; virtue is doing it"
David Star Jordan

Q&A
Why did I cut my short exposure in the MSN portfolio last week? Answer is a bit complicated but here is some good news/bad news logic:

We are on the verge of the full blown start of the earnings season and given how erratic and volatile stock behavior of most stocks has been during the last several weeks, with double digit up/down moves intra-day becoming very routine, I am not very confident whether the direction of the next major move is going to be up/or down. So I decided to lighten up and rather simply maintain the spread with indices instead of trying to widen it...

Random thoughts about the overall economic direction

Fannie and Freddie debt fears are in my opinion overblown- government is very unlikely to let either to fail- shareholders could certainly get diluted or even wiped out, but given how widespread the holdings of FNM and FRE debt is- Fed is certainly likely to step in if necessary.
Excerpts from Treasury's Paulson news release:

"GSE debt is held by financial institutions around the world. Its continued strength is important to maintaining confidence and stability in our financial system and our financial markets. Therefore we must take steps to address the current situation as we move to a stronger regulatory structure. In recent days, I have consulted with the Federal Reserve, OFHEO, the SEC, Congressional leaders of both parties and with the two companies to develop a three-part plan for immediate action. The President has asked me to work with Congress to act on this plan immediately."

Translation- another bailout is likely and thus FNM and FRE debt holders should do just fine...

On the other hand - ABX indices have been simply devastated over the last few days and thus banks are likely to record a lot higher losses that anyone expected. Even formerly firm AAA prices have plunged and most of the BBB is now trading like it's worthless...

source: markit.org

http://www.markit.com/information/products/category/indices/abx.html

Commercial Real Estate spreads have widened dramatically again but still held up better than residential ones...

Source: Markit

GE's earnings numbers actually looked ok to me- a little surprising they did not beat the estimates. One would have thought that knowing that missing guidance would have meant a an almost inevitable resignation from Immelt, GE would have cut something to beat "at all costs", so may be the "core" numbers were in fact a bit weaker than headlines could lead you to believe.

Oil is certainly looking to march on to the $150 level- if it is in fact a bubble, in my opinion the oil bull market can only end with a major "super spike" rather than slow and steady climb, so it might not be over quite yet...

VIX almost hit 30 intraday Friday- which implies that we might be relatively close to the short term bottom and rebound could be in the works... But on the other hand the two bottoms, VIX jumped to the 35 level so we might have another one-two large down days to come...

Stay safe out there and watch your shorts, these could swing violently in the next few weeks...
skepticalcapitalist@gmail.com

After reading through the WSJ's most recent article about failure of IndyMac, I think it became quite clear that the list of banks that are going to fail in the next several months could get very lengthy very quickly...

IndyMac release...

http://www.fdic.gov/news/news/press/2008/pr08057.html

"The fact is that for insured depositors, IndyMac's conversion has been largely a non-event. The more than 200,000 customers of IndyMac with deposits of $18 billion are fully protected. It's important to keep in mind that the small percentage of uninsured are still covered for their insured amounts and half of their uninsured money. As assets of IndyMac are sold, they may receive even more. They have had continued access to their funds through ATMs, debit cards, and writing checks over the weekend, and on Monday morning, it will be business as usual"

The worrying part is that depositors have only received half of their money above the $100K limit so far... I think it is quite possible we might see several runs on the smaller banks in the next few weeks and might even see things get really ugly for a large bank or two...

Quote from the WSJ article

Some industry officials say large depositors are increasingly likely to yank their money out of struggling institutions. "Consumers believe that there is an implicit guarantee from the government that the large banks aren't going to fail. When they look at the smaller banks, they have less comfort that is going to be the case," said Aaron Fine, a partner in the retail-banking practice at consulting firm Oliver Wyman in New York.

As a result, some customers are moving their money to larger banks, he said, noting that the first-quarter deposit based increased by 6% from the fourth quarter of 2007 at banks with more than $10 billion in deposits. Deposits at small banks grew by just 2%.

Bankers say that local businesses and municipalities, which often stash hundreds of thousands of dollars at a single bank, are likely to shift some or all of their funds out of institutions that are perceived as especially risky. Small and midsize banks are most vulnerable to losing a few big depositors, but larger banks that are struggling can also feel the pinch.

In the meantime, the FDIC will bear the bulk of the financial burden of IndyMac's failure, predicting that its collapse will cost the deposit-insurance fund between $4 billion and $8 billion, possibly making it the costliest bank failure ever. If an expected surge in bank failures materializes, other financial institutions, which pay assessments to the FDIC to capitalize the fund, may be forced to provide the agency with more money.

I am worried that even if we get a rally tomorrow because of the FNM and FRE bailout, things might get worse as the week progresses...

List of banks that failed in the current cycle :

Bank Name Closing Date Updated Date
IndyMac Bank, Pasadena, CA July 11, 2008 July 11, 2008
First Integrity Bank, NA, Staples, MN May 30, 2008 May 30, 2008
ANB Financial, NA, Bentonville, AR May 9, 2008 May 9, 2008
Hume Bank, Hume, MO March 7, 2008 July 1, 2008
Douglass National Bank, Kansas City, MO January 25, 2008 June 17, 2008
Miami Valley Bank, Lakeview, OH October 4, 2007 April 28, 2008
NetBank, Alpharetta, GA September 28, 2007 April 28, 2008
Metropolitan Savings Bank, Pittsburgh, PA February 2, 2007 April 28, 2008

Stay safe,
skepticalcapitalist@gmail.com

None of these thoughts below is a recommendation to buy or sell anything in any way, shape or form but rather simply verbal thoughts on the earnings of big players so far...- read the disclaimer..

GE- not bad really: Financial services earnings - surprisingly up y-o-y; healthcare- positive; infrastructure -good; backlog (future revenues) is up all around; cash flow is up slightly. The only negative is really on the softer side- given the fact that this was a "meet the number or get fired" quarter for Immelt- I am a bit surprised GE did not beat the numbers by cutting some silly expenses, which could be an indication of a stretch...

JNJ- reported decent numbers but with two thirds of the increase driven by the weak currency, I wouldn't give them too much credit. One clear theme is emerging- healthcare is slowly becoming the only Safe/er? "Heaven" out there...

INTC- not bad really, growing, winning market share but I do think the third quarter will look worse as the big drop off in the emerging markets demand only began a month or so ago... Surprisingly stock did not really move much- tells you - there are many scared people out there who aren't willing to commit at this price...

KMB- bad news- inflation is starting to hit hard where it really hurts- profit margins- look for of the same from many more commoditized companies...

USB- surprised me on the upside- yes loan provisions went up but earnings still held up quite well. But US Bank is unique because of their processing sub- NOVA which is benefitting from the cash to electronic payments winds and thus I don't think one could use USB as a good indicator for other banks...

DNA- not bad really, but not that great either- the fact that stock rallied confirms that "smart" money is moving into "growth" healthcare/biotech sector...

STX/NVDA- terrible numbers- tells you profit margins are suffering all over the IT hardware sector...

WYNN- selling Vegas is quickly becoming a favorite bet of many investors out there. Macau is taking away the big gambling dollars- bad news for the once "hot" market...

ORCL/ADBE/INTU- to me the software sector earnings so far have not been too bad, so sell- off is a bit surprising. We'll see how GOOG does- right now it is priced as if the growth is poised to slow down big time...

skepticalcapitalist@gmail.com

"When written in Chinese the word "crisis" is composed of two characters - one represents danger and the other represents opportunity"
John F. Kennedy

I think one thing is finally becoming clear to most of the former critics- US Economy is slipping into a more than moderate (I don't know if you call it severe yet either...) recession. But what's actually more important for investors out there- the emerging markets "decouping" story is looking more and more like a myth...

Cracks are starting to appear all around, and absent a very fast and severe crash in the price of oil which does not really seem very likely to occur in the short term, what started as US/UK only recession, will probably end up dragging the entire world into a recession/slow growth. Look for many more real estate/bad loan related bank failures all over the world.

Strong Euro is killing hopes that Germany, France and Co will be able to avoid the recession and with both Europe and United States entering the zero growth zone, in my opinion, China and Co are going to cool off much faster than most people out there are actually expecting. Brazil and Russia will probably hold up a bit better, but that's only if commodities prices stay high, which simply can't last forever...

If you ask me- by the time it's over- US economy is actually going to hold up much better than our Asian and European counterparts, with weak dollar serving as a buffer to the "severe depression" scenario. Look for non auto manufacturing to make a major comeback in the next 12 months or so with smaller, non unionized southeastern states receiving most of the benefit...

Some quick headlines from around the world...

First one from WSJ:

The critical change has come in Germany. Stung by the strong euro and rising costs, Germany's previously booming manufacturers have suffered declining new orders for six months in a row. Blue-chip companies including engineering giant Siemens AG, consumer-goods maker Henkel AG and printing-machine maker Heidelberger Druck AG have all announced large-scale job cuts lately, blaming problems including the high euro, raw-material prices, slower global growth and the credit-market mess that has shaken confidence on both sides of the Atlantic. A stronger euro makes goods priced in the currency more expensive for buyers in the U.S. and other nations.

"I'm asking myself: Which markets are still functioning?" says Rainer Hundsdörfer, director of Michael Weinig AG, a midsize German company that makes wood-processing machines used to build furniture and fittings. He says new orders from the rest of Europe "are crumbling," weak business in the U.S. has been made worse by the high euro, and many customers in Asia and Latin America have stopped investing in new machines because they rely on exports to the slowing U.S. economy. A backlog of orders is keeping the company busy for now, but 2009 could be a difficult year, Mr. Hundsdörfer says.

Second one- first big failure from Spain today: from Financial Times

One of Spain's largest property companies yesterday filed for creditor protection owing €5bn ($7.9bn), spurring a Madrid stock market sell-off and forcing banks to admit to an initial €550m in related bad loan provisions. Martinsa-Fadesa said in a regulatory filing it had lodged a petition for court administration, marking the start of Spain's largest bankruptcy process since the introduction of new rules in 2004

skepticalcapitalist@gmail.com

I really think they have done wonders to my photo :)

http://www.ledger-enquirer.com/102/story/371774.html

skepticalcapitalist@gmail.com

US consumers finally said enough is enough, and started to permanently (temporarily?) alter their energy consumption behavior. One could certainly say that it wasn't just the price at the pump but rather combination of several economic woes was what has lead consumers to finally cut back, and I actually agree, but only to a point. I don't think it was by accident that sectors that declined the most recently (auto manufactures, airlines, convenience stores, casinos, hotels, car rental companies, restaurants etc) have one ingredient in common- they are particularly affected by high energy prices...

So instead of debating the rationality of current oil prices ("peak oil" supply theory, China's "permanently growing" demand concept or "offshore drilling" and "solar credits rationale") I think that we should all thank Ben Bernanke and Co and Wall Street for finally showing us how this oil dilemma could be actually be solved - by "making sure that prices for energy stay high long enough".

I think it could only be accomplished by making sure that the prices for the most widely used petroleum product- gasoline, never again decline below the level that seems to have triggered change somewhere around $4 a gallon. Yes, that's exactly what I said- raising taxes today would likely make things better not worse. Before cheerfully sending another "I hate taxes" e-mail- consider instead sending a letter to your politician asking him/her to actually raise taxes.
However illogical it might sounds- once again look at the facts. Damage to the most energy sensitive sectors has been done already and all US consumers are already paying the "hidden oil tax" today. But instead sending of our money to Washington, we are now sending it to the other governments around the world, and it's not a small bill to put it lightly- in 2007 US petroleum bill came to an astounding $330B and for the first 5 months of 2008 we have already paid $122B...

Yes, even though I personally believe that government intervention is usually a very bad thing, establishing a variable gasoline tax that assures that gasoline never declines below the "magical" $4 a gallon ever again, could potentially alter the entire dynamics of the current world economic situation and ensure that US economy maintains its economic leadership status for the years to come.

As one of the most prominent proponents of the Pigovian tax on gasoline - Gregory Mankiw estimated - $1 tax on gasoline could potentially raise $100B in new tax revenues that could and should be used to reduce the ridiculously high US corporate tax rate, which should in turn lead to more jobs and potentially better pay in all domestic industries...

"Target price", "variable" tax on gasoline, would also accomplish another important objective- the "emotional"-"prices might come down one day and thus I shouldn't care about my short term pain" one. Knowing for certain that gasoline prices are never coming back to the $2 a gallon level, both consumers and manufactures are likely going to accelerate rapidly the recent shift towards more fuel efficient vehicles. This would in turn once again reduce long term gasoline demand expectation and could lead to potentially lower short term energy prices for the struggling "energy sensitive sectors" of the US economy. I certainly don't expect any politicians will actually have enough courage to propose this logical "raise gasoline taxes" solution during an election year, but who knows, maybe if plenty of us ask, they'll at least listen.

So for now the direction of the entire US stock market and the economy will once again be more likely determined not by economic or earnings news, but rather by the direction oil prices are heading. And given how painful last week's losses must have been to the seemingly bullet proof Wall Street "buy energy" -"short financials" strategy, one would expect that Goldman Sachs and Co are now busy preparing another "Oil prices to hit $200 by Labor Day" report and writing big donation checks to the powerful ethanol and environmental lobbies that might just lead to another "super spike" and more nervous breakdown admissions at London's clinics...

Stay safe out there, feel free to e-mail me at skepticalcapitalist@gmail.com

"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

On the surface, market's behavior on certain days of June and July 2008 was so illogical that my brain simply refused to accept it. Double digit intraday swings in prices of stocks without any material new catalyst became so routine that as Bloomberg reported last week -

"The number of men in the City who sought help for depression and stress rose 47 percent from a year earlier..."

But hopefully last week's trading has finally explained what should have probably been very clear for while - while current economic trouble might have started with the "lax credit/underwriting" standards and ensuing subprime fiasco, they will likely end/continue based on the behavior of the other, seemingly unrelated macroeconomic input- oil prices...
Forget the "naked short selling" hype or Fanny and Freddie talk- these are simply headline grabbers and symptoms of the underlying core illness of today's US economy that Federal Reserve conveniently calls "noncore" (read oil) inflation. And while my article below might not necessarily accomplish the main purpose of the Strategy Lab exercise-sharing new investing ideas, I hope that given the upcoming finish of the current round, readers will cut me some slack for simply sharing an opinion on the widely discussed topic...

Someone famous once said- "The solution to high oil prices is called high oil prices". However naïve or cruel it might sound on the surface, unfortunately the reality of the most recent several months seems to support it. The seemingly unstoppable rise of oil prices over the last several years has brought chaos and pain to so many sectors of the US economy that even the "presumably conservative" US politicians have called for the "gas tax holiday", which is supposed to give consumers a short term "relieve" at the pump.

Unfortunately in my opinion, the solution to our current economic woes lies actually in the exactly opposite direction- making sure prices for the main final product of oil- gasoline stay high long enough...Before you start judging too quickly- let me explain...
Many very famous economists have been arguing for years that gasoline demand is so inelastic, that even doubling or tripling of the oil prices was not going to make any difference. US consumers are supposed be so addicted to the "gas guzzling" trucks and SUVs, that even a suggestion that demand could possibly decline at some point has been ridiculed by pretty much every politician/economist out there.

What's more, one might argue that this notion was even actually supported by hard data- even when oil prices doubled and tripled from their multiyear lows of early 2000s, the growth in demand did not really slow... Amazingly enough, contrary to the conventional beliefs, early this year, in April of 2008 to be exact, the unthinkable finally happened- sales of cars have overtook truck/SUV sales and gasoline demand finally faltered... According to the data from the Energy Information Administration, gasoline demand in the US has been running consistently below last year's levels since the beginning of 2008. And while, it is certainly difficult to pinpoint the exact price level that triggered this seismic change, the demand for the supposedly inelastic product started to decline somewhere around the "magical" $4 a gallon.

Continued...

Below are some graphs from the EIA showing the current situation with US inventories of petroleum products- the punchline in my mind is- current prices aren't necessarily based on fundamentals...

The demand is going lower and supplies are going higher...

Source is EIA web site:

Gasoline demand in US

Gasoline stocks

Gasoline production

Distillates

Gasoline Prices

Just looking at the US gasoline supply /demand graphs- it is certainly hard to justify the long term "bull case" for oil

WASHINGTON--A panel of top business leaders testified before Congress about the worsening recession Monday, demanding the government provide Americans with a new irresponsible and largely illusory economic bubble in which to invest.

"The U.S. economy cannot survive on sound investments alone," Carlisle added...

You can finish reading here

theonion.com

Cheer up :) Life is tough as it is!

The world is round and the place which may seem like the end may also be only the beginning." -- Ivy Baker Priest

We have only a few days left in this round of Strategy Lab, and while my portfolio return has been fluctuating around the double-digit range for the past several months, it has also been solidly beating all the indexes pretty much from the beginning.

All in all, I am extremely happy not only with how well my strategy has performed but also with how enjoyable the experience has been.

I can't stress enough how fortunate I feel to have been able to share my investing ideas in the Lab over the past six months. Given the positive feedback from readers, I think I've done reasonably well. I've also enjoyed competing against the Lab's pros, and thus my personal thanks go to all of my colleagues, whose posts I've enjoyed reading.

For my last article in this round, I want to summarize some of the core principles I've outlined in the various articles throughout this contest. Take them for what they are.

Opinions are suited only for this particular strategy and are not a silver bullet. Successful investing requires flexibility at all times and acceptance that no one is always right.

General principles

-Markets go up in the long run due to inflation, so being 100% short is reckless.
Reduced risk and volatility in your portfolio are best achieved through the active short-selling of stocks.

-Timing the market by moving into and out of cash is an inferior strategy because of the "black swan" effect (large one-day gains account for the majority of long-term returns).

-Moving into and out of index exchange-traded funds, however, is a viable alternative.
Focusing on less admired names increases the probability that a security has not yet been efficiently priced and mitigates the emotional attachment.

-Consistent focus on macroeconomic developments allows for identification of sectors that are more likely to outperform in the short to medium term.

-Owning a less attractive stock in an outperforming sector is preferred to owning an attractive stock in an underperforming sector.

-Earnings of the overall market in the long run should grow at the nominal gross-domestic-product growth rate of roughly 5% to 6%, in addition to a dividend yield of 2% to 3%. Thus passive investors are unlikely to realize a total market return of more than 7% to 9%.

-Accordingly, achieving double-digit returns requires fairly active investment strategy.

Short-selling principles

-Do not short-sell stocks based on pure valuation. Short only when a company has a reasonable chance of going out of business in the next 18 to 24 months.

-Do not short-sell stocks without debt or a significant liquidity problem (consistently negative cash flow combined with a low cash balance).

-Short-sell only stocks that are already in a downtrend and have high short interest.

-Short-sell only stocks with low margins and negative or declining cash flows.

Risk-management principles

-Avoid shorting stocks in biotech or any other sectors heavy in high-end research and development.

-Short positions should be smaller than the average long position.

-Try to eliminate emotions from the selling process. Limit double-digit losing positions to two or three at a time.

-Don't "double down" on more than two or three positions in the portfolio at any specific time.
Avoid investing more than 40% of your portfolio in a single sector or more than 10% in a single position.

-Avoid initiating a "full" target position in a stock that has been in a "falling knife" pattern for a prolonged period.

-Review positions daily for significant moves, but avoid trading more frequently than once a week.

-Avoid a "sell at the top" strategy. Instead, sell after a normal short-term correction threatens to become a true decline.

-Watch for the important technical support/resistance levels as potential indicators of investor psychology. Though stand-alone technical analysis should not be a part of a core strategy, it's important to pay attention to it because it is slowly becoming a "self fullfilling prophecy"

-Look for high or increasing short interest in your long positions as an indication that the companies may have fundamental flaws. Evaluate all possible explanations for the short interest. If no reasons are found, limit the number of positions with high short interest to five or less.

Hope this is useful, stay safe out there and please feel free to e-mail me at skepticalcapitalist@gmail.com

Two more... Expect many more each Friday afternoon...

http://www.fdic.gov/bank/individual/failed/fnbnv.html
On July 25, 2008, First National Bank of Nevada, Reno, NV, was closed by the Office of the Comptroller of the Currency (OCC). Subsequently, the Federal Deposit Insurance Corporation (FDIC) was named Receiver. No advance notice is given to the public when a financial institution is closed. As of June 30, 2008, the former First National Bank of Arizona, Scottsdale, AZ, merged with First National Bank of Nevada and is included in this action.

http://www.fdic.gov/bank/individual/failed/heritage.html
On July 25 2008, First Heritage Bank N.A., Newport Beach, CA was closed by the Office of the Comptroller of the Currency (OCC). Subsequently, the Federal Deposit Insurance Corporation (FDIC) was named Receiver. No advance notice is given to the public when a financial institution is closed.

Locations are not really surprising- Nevada and California...I'll post more this afternoon but FYI- even though bank's stocks rebounded over the last week or two- value of most securities on bank's balance sheet hasn't- what's more commercial spreads set new highs (high is bad- means lower prices) on Friday...

skepticalcapitalist@gmail.com

"Be glad that you're greedy; the national economy would collapse if you weren't"
Mignon McLaughlin

Merrill Lynch reported another write off and major dilution after hours today. One might ask- "Who cares? Banks have been writing staff off for a year already..." However, in my mind this was no ordinary announcement and regardless of what kind of story Wall Street is going to come up with tomorrow- this press release is over loaded with bad news for the whole sector, lot's of it...

Actually, the numbers in my opinion are so ugly, that it does not really matter what analysts say or how much praise will Thain receive for "cleaning up the "messy" balance sheet"- this will go down in history as a textbook example on how and astounding amount of shareholder wealth could be quickly destroyed by the "bonus driven" greed of a chosen few...

http://biz.yahoo.com/bw/080728/20080728006329.html?.v=1

Notable quotes and my comments:

"On July 28, 2008, Merrill Lynch agreed to sell $30.6 billion gross notional amount of U.S. super senior ABS CDOs to an affiliate of Lone Star Funds for a purchase price of $6.7 billion. At the end of the second quarter of 2008, these CDOs were carried at $11.1 billion, and in connection with this sale Merrill Lynch will record a write-down of $4.4 billion pre-tax in the third quarter of 2008"

Read- $30.6B original worth of assets -only $7B sale price- OOOUCH... How about the 40% deterioration in value during the last month????? Holy smoke...

"Merrill Lynch will provide financing to the purchaser for approximately 75% of the purchase price. The recourse on this loan will be limited to the assets of the purchaser. The purchaser will not own any assets other than those sold pursuant to this transaction. The transaction is expected to close within 60 days"

Read- we sold a bunch of paper for very little money and even had to finance it?

"Merrill Lynch executed an agreement to terminate all of its CDO-related hedges with XL. The transaction is expected to close in early August 2008. When the transaction closes, all of Merrill Lynch's CDO-related hedges with XL will be terminated in exchange for an upfront cash payment to Merrill Lynch of $500 million. These hedges had a carrying value of approximately $1.0 billion at June 27, 2008. As a result of this transaction, Merrill Lynch will record a pre-tax loss of $528 million during the third quarter of 2008".

Read- We managed to "LOSE" a ton of money even on our hedges against the losses????? Heh? No comments!

"Merrill Lynch is also in the process of negotiating settlements on certain contracts relating to CDO hedges with MBIA and other lower-rated monolines. If Merrill Lynch were to receive no payments in connection with the settlement of these hedges, the maximum loss Merrill Lynch expects to record would be their current carrying value, $0.8 billion"

Read- MBI and Co guarantees are not worth anything...

...-Gain on completed sale of Bloomberg for $4.425 billion in proceeds -Estimated gain on closing planned sale of a majority of FDS amounting to substantially all of the enterprise value of approximately $3.5 billion, marking remaining stake to sale price. -The offering of 310,000,000 shares of common stock at a price of $27.52 per share (the closing price as of July 25, 2008) for total proceeds of $8.5 billion, less $2.5 billion paid to Temasek in satisfaction of obligations under the reset provision, and including 13.5 million incremental 'if-converted' common shares to reflect the exchange for a new mandatory convertible preferred stock issuance...

Read- Even after selling two of our best assets, we had to dilute existing shareholders by roughly 30-40%... Case closed...

P.S. Anyone calling a bottom on financial stocks needs to make sure he/she has enough "shorts" to hedge the potential losses... I am not quite sure it's over...

Skepticalcapitalist@gmail.com

Slate- check them out :)

"The trouble with most people is that they think with their hopes or fears or wishes rather than with their minds"
Will Durant

Ever since the "buy natural resources/sell financials" strategy driven by excess liquidity created by the "trigger happy" Federal Reserve went into mainstream last year, prices of most commodities and natural resources producing companies, seem to have left the realm of fundamentals and instead entered a whole new era of "buy tangible resources at any price" and "what went up recently will go much higher" strategies.

"The world could absorb all the steel, iron ore, corn, wheat, oil and gasoline produced in the world, virtually at any cost" or so said the media...The fact that growth of the US Economy has slowed to virtually nothing (ignore the noisy headline GDP tomorrow) never really seem to have bothered the "commodity" bulls.

Terms like "decoupling" of other emerging markets and "hundreds of millions of new Chinese and Indian middle class consumers entering the world economy" were thrown at anyone who had the unfortunate courage to question in any way the validity of $145 a barrel price of oil...

But the reality is always more crude to the loudest "screamers"- just like tech boom had to end some day, the "behavior-changing" $4 gasoline and corresponding drop in gasoline demand, seems to have finally overpowered the "world is running out of everything" stories. The commodity run now seems to quickly coming to it's conclusion- "super spike" break out followed by a violent drop...

I could certainly still turn out to be too early, but it does seem as if the Wall Street's "lemming-like" behavior, that has taken on some extreme forms with "momentum" strategies outperforming almost every strategy out there until very recently, is now rapidly swinging the other way. And that in itself could be a very tricky sign for stock market...

Consider this - it wasn't so long ago when WSJ reported that

"By the end of June, a model portfolio of momentum stocks had returned 71.3% year-over-year, while a model portfolio of value stocks with high book-value-to-price ratios was down 54.8%, according to Joseph Mezrich, head of quantitative research at Nomura Securities"

Looking at the chart provided with this article, leads to an interesting observation -the last two times when "momentum" strategy has outperformed "value" by such a drastic margin was: right at the peak of Tech Bubble and then second time right before the markets started the 2003 "Bull" Market.

Obviously, the outcomes of these two events were drastically different, and thus correctly predicting which way markets are going to swing this time, is exactly what one needs to do to stay ahead of the market during the next few year. But that won't be easy- economic data has been very inconclusive so far.

The only way I could describe the current state of the US Economy and stock prices is that, surprisingly enough, it's one of the rare situations where both bulls and bears could make an a sound and believable argument to support their case. US corporate profits have held up better than many feared and commodity prices have suffered a hefty double digit declines during the last several weeks.

On the other hand, economic fortunes of other key developed countries in Europe and Asia are deteriorating much faster than anyone could have expected and strength of the US dollar is now threatening the shut off the "real" engine of growth in US corporate earnings during the last several quarters- currency translation gains... So let's call it a draw for now and assume that bulls and bears will keep fighting it over for a while, before one side finally wins.

I have not yet made my own judgment call and probably won't really be able to do that until the TA driven rebound runs its course. S&P Index does seem likely to at least test the 1325-50 level, so I am just riding along for now...

But on the other hand, another trend is becoming more or less clear every day- during the next stock market round, whichever way it finally goes, "value" strategies are likely going to outperform the "momentum" ones and thus investors should carefully review their portfolios to make sure they are positioned accordingly.

Stay safe out there, skepticalcapitalist@gmail.com