My Two Cents – Extemporania

Last time we discussed the concept of valuation for some different types of investments and the formation of themes that can be used to help zero in on potential areas for focus. This week we’ll take a look at some ways of breaking down industries and sectors, sizing companies, then connecting the dots between economic themes and investment needs.

If you go to the NYSE website, you will be able to find what is called an Industry Classification Breakdown or ICB. There are ten major industries with varying numbers of supersectors, sectors, and subsectors under each major heading. Now let’s say for example, in your reflections on what the major economic and investing themes happened to be that you zeroed in on consumer staples as an area that is positioned for success. At this point we are assuming that you’re not interested in just finding an ETF or Closed-End Fund that gives exposure to firms that produce consumer staples, but are interested in becoming more acquainted with some of the individual firms themselves. Once you have performed your basic analysis, you’ll know which firms you’d want an ETF or other Fund to include or can purchase them outright and will be an informed shopper so to speak.

That said, when you go to the ICB listing for Consumer Goods, you will find the following:

Clearly you are not interested in examining all of these areas. Your focus as decided above is on staple goods. Immediately, the broad category of Leisure Goods can be eliminated. Automobiles can probably be eliminated as well if we’re focusing totally on staples or necessities. This leaves a wide sampling of categories. For the purposes of this discussion and in the interests of brevity, we’ll limit our analysis to a single sub sector – Food Products.

Before we continue, some limitations of this search methodology must be identified as well. The NYSE search is only going to show the firms that are listed on NYSE. It will not show international firms that are listed on other major exchanges, but not on the NYSE. The good news is that many of the larger firms are dual-listed. The bad news is that by limiting your search to only NYSE-listed issues, you will likely miss some good possibilities. Many of the other major exchanges such as the TSX also have similar search capabilities and by spending a little time, you can quickly assemble a rather comprehensive list of investment possibilities within any given sub-sector.

A look into the Food Products sub-sector reveals no less than 46 US-listed companies and their related securities. The information provided is limited to the name of the firm, the ticker symbol, last trade / trade date, volume, change($), and change(%). At this point, the biggest tendency for individual investors is to scan the list, find the name of a firm they know and start their search there. This is not the way to go; emotion has already entered the equation and in your mind you’re already playing favorites and biases have taken control of the process. At this point, you must consider your own objectives:

• When will you need this money?

• What do you anticipate eventually using the money for?

• How much money do you have to work with?

• What is your risk tolerance?

The answers to these questions will help you decide on what types of firms you’re looking for. Do you want large companies with low volatility that pay high dividends? If you’re approaching retirement, this might be the way to go. If you’re younger and are looking for capital appreciation, you might consider looking at some of the smaller companies that are more volatile, but have more room to grow. Are you risk averse? The fact that you’re looking at consumer staples to begin with might say something about your willingness to accept risk (wait, I picked that category!).

This is an important part of the process. We are now connecting the economic themes that we decided will be important with our own personal situation. The worst thing anyone can do is take his or her own themes, then just grab someone else’s prepackaged strategy without considering if it actually fits. It is the financial equivalent of buying a pair of trousers without bothering to look at the size, choosing rather to buy them because you thought they looked good on somebody else.

So in our hypothetical analysis, we decided that the economy is in recession and is likely to be there for some time, and have come to the conclusion that people will cut back on discretionary spending (which they have). We realize that inflation is a problem, and so leaving our capital in a bank account is not the greatest idea if we expect to maintain our purchasing power. Food products will certainly not be the only theme we invest in, but it is a good starting point.

Large or Small?

The next issue becomes the determination of what constitutes a large company and what constitutes a small one. Obviously, there are a number of characteristics that may be used to determine this, but one of the most generally accepted definitions is the firm’s market capitalization. Market capitalization is the share price multiplied by the number of outstanding shares. Another way of expressing market cap is that it represents the public opinion of the value of the company. The sizing of companies can generally be lumped into the following brackets:

• Large-Cap Companies $10 Billion – $200 Billion (or more)

• Mid-Cap Companies – $2 Billion – $10 Billion

• Small-Cap Companies – $200 Million – $2 Billion

• Micro-Cap Companies – Less than $200 Million

Using the Food Products sub-sector as our continuing example, of the 46 issues in that category, the breakdown is as follows:

As is evidenced by the chart above, there is a solid distribution of firms in this sector according to size as measured by market capitalization with most of the companies (33) falling in the small or mid cap range. This distribution is good news as it means that no matter what your investment goals and risk profile, you should be able to find a reasonable number of firms that are desirable for addition into a portfolio, or are firms that should be looked for when looking at ETFs and open/closed end funds.

Using this methodology it is fairly easy to drill down to potential specific investment possibilities from a variety of economic themes. What we need to accomplish next is creating a definition of value and the parameters by which we will measure it. Next time we’ll take a look at some of the popular valuation metrics and develop a few of our own as well, which we can add to our toolbox as we continue to chase the oftentimes elusive concept of value.

Individuals interested in learning more about the major macroeconomic themes should take a moment to listen to some of our informative podcasts. We’ve recently had guest experts like Laurence Kotlikoff; John Williams of shadowstats.com, and Bill Murphy of GATA appear to discuss their areas of expertise. For more information or to listen, please take a moment to visit www.my2centsonline.com/radioshow.php

We have recently had an exciting lineup of guests on our two podcast series. Please take a moment to hear the interactions and gain valuable information.

Adrian Salbuchi tells “Spin Cycle” the story of the assault by private banks on the economy of Argentina. Are we seeing the same thing again here in the US? Tune in to find out! Listen Here

On “Spin Cycle” Professor Laurence Kotlikoff discusses the fiscal gap of the United States and some possible solutions to the
mounting stack of unfunded liabilities that endangers the financial stability of our country. Listen Here

On “Spin Cycle” we discuss the energy side of the cube this week with Zapata George including a timely discussion of the ‘revelation’ that proven oil reserves have fallen. Stay ahead of the curve on Spin Cycle! Listen Here

Our special guest on “Spin Cycle” is John Williams of shadowstats.com. We break down inflation, money supply, GDP, and unemployment in an eye-opening discussion. Listen Here

Our special guest on “Beat the Street” is Fred Carach, author of “Forty Years a Speculator”. We discuss commodities and how our financial markets have become dysfunctional over the decades. Listen Here

Our guest on “Beat the Street” is Joe Cristiano of Liberty Talk Radio for a discussion on the impact of nationalization. We also tackle the long bond problem as yields head higher. Listen Here

In an age of green shoots, fluff, and spin, it is probably worthwhile to put our feet on the ground every so often and take a look at some old fashioned ways that we might value a project, a firm, or capital stock. Too many times over the past 15 years in particular, investors have been lured into various valuation traps. Probably the most noteworthy was the dotcom era of the late 1990’s and the first part of the 21st century. Not a great start to a new millennium. And so the trend has been that each time the investing public deviates from the ‘old fashioned’ rules of finance and analysis, there is always a good whipping waiting just around the bend.

Unfortunately, turning on the television won’t do much in the way of helping one to find answers in this regard. Much like the medical community, the financial and investing world is littered with incomprehensible jargon, which can be downright boring at best, and impossible to follow at worst.

The Elusive Concept of ‘Value’

So how exactly does one ascertain the value of a stock? This is absolutely the wrong place to start, and this is one reason why many folks never get their investing careers off the ground. You cannot start with the capital stock and back your way into the value of the company, its product pipeline, revenue streams etc. First of all, there are many flaws with stock prices, the biggest being the fact that there are emotional and irrational human beings involved in the formation of those prices.

Just think of the dotcom blowout a few years ago. Anything with ‘E’ in front of it headed for the Moon, but ran out of rocket fuel halfway there. Those carcasses of financial recklessness are still drifting in outer space and should be a testimony to the rest of us of what can happen when we allow our emotions and irrational nature to control our investment decisions.

The second is that there is generally some level of incomplete information. The Internet has helped mitigate this to some degree, but at any given instant in time, there are some buyers who know a whole lot more about a firm than others. And to compound matters, occasionally firms will withhold negative information from the markets until a certain time such as the end of trading for the day or week. What was a ‘rational’ price at 4PM ET on Friday might suddenly become an irrational one when the market opens Monday morning as irrational people scramble to catch up with the information.

In my opinion this is where the Internet has actually had a deleterious affect on accurate stock price formation. People aren’t investors anymore; they’re traders. They buy black box software that spits out red and green arrows, and then click mouse buttons based on those arrows. They know nothing about the underlying security, nor do they care to know anything. Just make me rich they say. I’d say the smart money would bet on their financial demise and be right more often than wrong. The proponents of such systems will be the first to tell you that their methodology takes the emotion out of trading. But they neglect to tell you that their system is based market data, which is the result of all the other emotional traders out there. So how devoid of emotion is it really? We could go on for pages on this topic, but I think the point is clear.

It would certainly seem that when the accurate (but by no means complete) analysis above is considered that the deck is stacked against someone who is truly inclined to be an investor. Not so at all. Navigating today’s markets is all about being a filter. Filtering noise. Filtering meaningless ‘events’ in favor of information that might change a trend or an assumption that one has made. It is about conviction. It is about being able to sit back and watch while the rest of the world goes absolutely berserk. It is also about recognizing that prices oscillate around the approximate tangible value of any financial instrument much like a sine wave. Obviously once you’ve identified your target stock, you want to buy when the price is oscillating below your measurement of its real value. In other words, you buy it on sale. Conversely then you would want to sell it when the price is peaking above the real value thereby selling it at a premium and maximizing your profit. If it were truly that simple however, I wouldn’t need to write this article at all. The market throws enough curve balls at investors as it is. If we can nail down an approximate real value of the financial instruments we are interested in purchasing, we have a fighting chance of doing well.

One important carryaway message from all this is that you must have patience. Our world has fallen prey to the doctrine of instant gratification. Everything must be instant or immediate. Processes that used to take days and weeks to initiate and complete now take minutes and hours. Two prime examples come to mind. The time it takes to purchase a home and the time it takes to invest money. It used to take weeks of shuffling papers to buy a house. Now it can be done in a few days’ time if everyone is properly motivated. The same is true for investing. People opened an account, purchased their stock and then watch the Sunday paper from week to week and charted their progress. Look at all that has happened because making large financial decisions has become too easy and the rational thought process became susceptible to impulse. The problem is that patience just isn’t cool anymore. It isn’t en vogue. After all, the rabbit always beats the turtle….right?

It is my goal over the next few weeks to give readers a window into valuing financial instruments. Once the value of an instrument is known, then it is just a matter of waiting for your price. However, it is not really appropriate to think in terms of things going on sale at your favorite electronics outlet. There are only two reasons someone buys a financial instrument. They are either purchasing a cash stream as in the case of a dividend-paying stock or they are purchasing the instrument in the firm belief that someone will come back at a time point in the future and buy it from them for a higher price than they paid. When you go to your favorite electronics outlet, you’re buying something to use and the thought process is different.

Zeroing In on Value

Probably the first mistake people make in beginning their search for suitable financial investments is they start with a preconceived notion of what is ‘hot’. They get a tip from a friend or see the name of a firm in the financial section of a magazine or newspaper and decide to begin searching. In reality, the best way to start valuing financial instruments is to first figure out which of them are actually worth valuing in the first place. This approach is often called the ‘top-down’ approach and it starts with coming to a general understanding of the economic environment under which one is operating. What is the direction of interest rates? Is the borrowing environment friendly or restrictive? Are consumers extending or retrenching? What is the condition of the labor market? Are trade conditions favorable due to currency and political factors? And what about energy costs for product transportation?

These are just a sampling of the questions that you will need to find answers for. It was by this process that it was easy for me to eliminate most things dealing with the consumer discretionary sector as the economy dove into recession in late 2007. Seeing that recession ahead of time prevented misallocations and the subsequent losses that would have occurred. There were other sectors though that had their problems. Some have already since emerged in dramatic fashion, while others have yet to.

Once you have some answers and a basic economic analysis, you can pretty much tick down through a list of industries and themes and find the ones that will be well-served by the current environment and those to stay away from. It is perhaps even more important to form something of a forecast for at least the next year to two years. Once you get past two years, it becomes exceedingly difficult for even the most gifted economist to be accurate given the complexities of a modern world and financial system.

Themes versus Forecasting

One of the biggest problems with economic forecasting is that it is both time and resource intensive and is a full-time job. That said, forecasts are easily purchased from a myriad of sources at a cost. Perhaps another way of looking at things and deciding on which areas are worth further scrutiny is by using themes. It is pretty simple. Take the debt situation that exists in the United States today at a government, state, local, and personal level. It would seem to be a pretty good bet that this will impede economic growth well into the future, and thus absent a lot of monetary creation and stimulus, it is unlikely to see consumer discretionary spending accelerate all that much. That is a theme. Realize we aren’t dealing with percentages, statistical analysis, or anything more fancy than sitting down and applying some common sense to our current realities and coming up with some likely outcomes. We can easily use such themes as a basis for either including or excluding certain sectors for further investigation and analysis.

Notice we haven’t even used one math formula, a calculator or pulled a single stock quote and I’ll bet you’re already thinking of a number of potential themes and comparing them to what is in your current portfolio. If so, congratulations! You’ve taken the first step in performing basic financial analysis. Next time we’ll take a look at identifying the players both large and small in a given sector and looking at the potential benefits and detriments of each. This will assist us in forming an appropriate mix given our risk tolerance and other objectives.

06/05/2009

Despite the calm appearance on the economic waters of late, there is quite a bit of turbulence building beneath the surface on a multitude of fronts. Several developments have emerged that fly directly in the face of the idea that we’re headed for a green shoots recovery. Even more surprising, when you take a deeper look at these issues, some rather remarkable inconsistencies emerge in that the methods being used in some critical areas virtually guarantee that they will not be successful. We’ll take a look at two of these areas, but first, let’s discuss maneuvering room.

A compressing timeline – less time for proactivity

Last week we presented a chart of the spread between 10 year and 2 year bonds and noted how with each interest rate ‘cycle’ that the spread is getting bigger. For reference, that chart is included below.

What is perhaps even more alarming than the increasing spread with each successive cycle is that the timelines are becoming compressed meaning that there is less time for recovery with each subsequent cycle. Such as has been the case in many other fiat systems when they begin to degrade. Volatility increases while the business cycle compresses. This is exactly what we’re seeing here. Firms and cohorts become reactive rather than proactive and it seems they’re always a day late and a dollar short. Not only do they have limited time to properly position for the next cycle, but with each subsequent cycle, they emerge with diminished resources as well.

No Green Shoots for Consumers?

Consumers are not far behind in this regard. As consumer prices continue to be on the increase due to the recent blowout in the monetary base (M1), expectations will switch from deflationary to inflationary.

However, there is a problem in this regard; the fuel for this inflation is not present. In order to see a meaningful inflation at the consumer level, money or credit has to find its way into the hands of consumers to monetize demand. Wages have been remarkably stagnant, with the most recent data suggesting that wages are increasing at a 1.2% annual rate. Consumer credit, which is another potential source of spending money, has been in a contractionary pattern over the past 4-6 months.

Fiscal stimulus by the federal government has largely left consumers out of the picture as the government has opted to try to initiate consumers to spend their own money instead of monetizing demand directly through rebates or other types of transfer payments. The shift from the direct stimulus method, which was used at the beginning of 2008 to the indirect method of using tax credits, has been important. Ostensibly, from a financial perspective it doesn’t really matter which means are used. The government will either spend money directly or lower future tax receipts as people take advantage of the credits.

The message here is clear. The government would prefer that people didn’t save, opting rather to borrow and consume in the present and avail themselves of a tax credit at the end of the year.

This is evidenced by the ever-growing list of tax credits that are available for doing various things like buying a home, putting in alternative energy systems, or installing energy saving devices. The problem is that in order to take advantage, consumers must have access to the money and/or credit to make the expenditure in the first place. This is probably the worst way to stimulate consumption in a cohort that is already grossly overextended. Consumers, to a certain degree have sniffed this out as is evidenced by increased savings rate in recent months. Job losses haven’t helped to encourage spending and certainly won’t do much for consumers’ willingness to borrow. If the government was interested purely in consumption, there are much better ways to stimulate it.

It would seem possible that there are some ulterior motives at work here. Namely that the government would prefer that consumption remain tepid or even contract without them actually coming out and saying it. More on this a bit later.

Mortgage bond yields continue to rise

The Federal Reserve publicly plans to purchase $1.25 Trillion in mortgage bonds this year alone in an effort to keep mortgage rates down. However, rates have shot up from just under 4.8% to nearly 5.5% in just the past few weeks. One would wonder what exactly is going on here. How can this be, given that the Fed has pledged its undying support to this market? It would appear they have, at least for the meantime, reneged on their pledge. Consider the following:

As of April 30th, the Fed held a total of $367.728 Billion in mortgage backed securities. That number increased to $384.115 Billion on 5/14, $430.485 Billion on 5/21, and reached a peak of $430.902 Billion on 5/28. However, as of yesterday, Fed holdings of MBS actually fell to $427.612 Billion, meaning the Fed sold over $3 Billion of MBS during the past week.

So not only has the Fed slowed its support of this endeavor in the weeks leading up to 5/28, they are now contributing to higher mortgage rates by selling into an already weak market. I would contend that they never should have been buying MBS in the first place, but since they decided to monetize this market, why all of a sudden are they content to allow rates to jump nearly 15% in two weeks by withdrawing their support? Every piece of Fed testimony would lead one to believe they firmly attach the success of the housing market to the success of the overall economy. So why pull the plug on that support just when there seemed to be at least something of a bottom forming? No doubt the quick increase in rates will scare buyers away. A three quarter percent increase in rates will quickly eat up any tax credit the government is providing.

Again, similar to the issue with consumers, it would seem as though there is an attempt being made to throttle recovery without coming right out and admitting it.

One possible answer – The $100 Trillion consumption gap?

It has long been the view of this weekly editorial that our climbing debt levels would eventually be what sank the US as the premier economic world superpower. Even more than the debt itself is the impact such debt will have on future generations. Unfortunately, this is one angle that is rarely looked at. Most government reports reflect the national debt, trade, and budget deficits as a percentage of GDP. Using this measure, it is easy to look at the debt picture of the US in a rosy light. On a purely percentage basis, the debt looks manageable and is not out of line with other industrialized nations. The problem lies in the ability of both the economy, and the working class young to repay the debt. In other words, we never look at the impact of the debt, but rather choose focus on the size of it.

When one starts to examine the impact of our mounting debt and take into account generational and demographic factors affecting our population, it becomes immediately clear that not only is our current standard of living unsustainable, but it is downright foolish to expect that it can continue. This week on our Spin Cycle podcast, we talked with Professor Laurence Kotlikoff who can easily be considered an expert in the field of generational accounting. He pointed out during our discussion that there was more than a $100 Trillion gap between our ability to produce, and our appetite for consumption. Such studies are stretched out over many years with the future dollars being discounted to the present so we can compare apples with apples.

Certainly those in the upper levels of government and finance are aware of these realities and realize that there is simply no way we can continue to consume at our present rate, enjoy the same standard of living, and ever have any hope of paying for it without a massive hyperinflation and the resultant economic and social discord. Another contributing factor in this analysis is the growing likelihood that not only has global oil production peaked, but that our ability to procure ever-increasing amounts of other materials necessary for our standard of living has peaked along with it.

For more information about generational accounting and our current fiscal and consumption gap, listen to our interview with Professor Laurence Kotlikoff by visiting our podcast page: www.my2centsonline.com/radioshow.php and looking in the ‘Spin Cycle’ section. Next week we’ll conclude our cubic analysis with a discussion of energy and natural resources with Zapata George Blake. That podcast will be available on 6/10/2009 and may also be found at the above link under the same section.

Today’s special guest on ‘Spin Cycle’ is Laurence Kotlikoff, Professor of Economics and Research Associate for the National Bureau of Economic Research. In today’s show, we discuss the fiscal gap that exists in the United States from both a government and consumption perspective.

Professor Kotlikoff will be speaking at the Cato Institute on 6/8/2009 at 4PM and will address these issues as well as some common-sense solutions. Please contact your Senators and Representatives and urge them to attend.

The interview may be heard by clicking here

Professor Kotlikoff’s site may be visited here

In a mid-February editorial we took a look at some factors that were beginning to confirm one of our proprietary indicators that pointed to a bottoming in consumer prices in December 2008. Writing such an article at the time was a big risk since it flew in the face of a trend that had been firmly in place for the past half-year. The price of nearly everything was falling – or so it seemed. For those who understand and appreciate the function of money supply in the determination of prices, the article made perfect sense. However, for those who believe that economic growth or the absence thereof determines prices, there was a great deal of consternation regarding our assertions.

Nearly three months have passed since then and almost every piece of data that has come across this desk has validated the claims made back in February.

Just aside of the factors we mentioned in the February article, which were the CRB Index, Gold, and West Texas Intermediate Crude, there is another major indicator of this phenomenon and that is the stock market. From the 3/6/2009 bottom through today, the Dow Jones Wilshire 5000 Index raced from 6935 to 9342; an increase of 34.71%. More importantly though, lets look at it in terms of dollars. The value of the Wilshire 5000, which is one of the broadest measures of US market capitalization increased by $2.407 Trillion during that relatively short period of time.

It is utterly preposterous to assume that Mr. and Mrs. America dug in the couch and found that kind of money and decided to invest it. It is even more preposterous considering the environment that the real economy is dealing with at this time. Job losses have been staggering and persistent, it is demonstrably difficult for the unemployed to find work, and house prices are still falling like an elephant dropped from the Empire State Building. How else do we know this increase didn’t come from the real economy? Let’s look at past behavior. When the government handed out $168 billion in stimulus checks – essentially ‘free money’ – did the public invest it in the stock market? No. The public paid bills, or saved it – much to the consternation of the government.

So where did this dramatic bear market rally come from? In my opinion, it came from large institutional investors – many of the same people who had their coffers stuffed with TARP money over the past 6 months and the same folks who were essentially given a free pass a while back when the rules for mark to market accounting were relaxed. So what we have here is largely an inflationary rally. Certainly, this is not the first such rally, and it will most assuredly not be the last.

But it isn’t just the stock market. It is the commodities markets as well, and this is where it gets bad for consumers. We are about to witness a wave of inflation, a magnitude of which has never before been seen in America. Dr. Marc Faber had this to say about the subject:

“I am 100 percent sure that the U.S. will go into hyperinflation,” Faber said. “The problem with government debt growing so much is that when the time will come and the Fed should increase interest rates, they will be very reluctant to do so and so inflation will start to accelerate. He also added, “The global economy won’t return to the “prosperity” of 2006 and 2007 even as it rebounds from a recession”.

Let’s revisit our charts and positions from February and see how much things have changed in just three months:

Reuters/Jefferies CRB Index

The 15% increase in just the past 3 months will not immediately be seen on store shelves, but it is already being seen at the gas pump and in the prices of many consumer items. It must be noted that the US economy contracted at a rate of 5.7% (annualized) in the first quarter of 2009, which is on the heels of a 6.1% decrease in the fourth quarter of 2008, yet consumer prices, commodities, and other inflation assets are rising. If this doesn’t strike down the notion that demand (economic growth) alone determines prices, then nothing will.

West Texas Intermediate Crude Oil (WTIC)

This one says it all – a 45% increase in the price of oil just since the middle of February. Keep in mind this increase in price has occurred during a period of a contracting US economy. It is high time that the mainstream press and every one of us stop being US centric when it comes to oil – and everything else for that matter. World demand has remained robust, but at the same time has not exploded over the past six months for sure. The problem is there are untold trillions of dollars parked around the globe. Remember last fall that it wasn’t just the US Fed who was printing like crazy. The Europeans were following suit, much to the dismay of any country that possesses a scarce resource.

Gold – Contract Price

Despite a major rally in equities and assertions from media and government alike that the economy has bottomed and will begin to heal soon, Gold has not taken the bait. After once again breaking through the $1000/oz level for a brief period in late February, Gold was pushed down to the $860 area, but has rallied nearly $100/oz in relentless fashion and is looking for its fourth straight week of gains. It is very obvious that the powers that be would prefer if Gold remained below the psychologically critical $1000/oz mark. A serious breakout to the upside would once again light the 1970’s-esque fire of inflationary expectations.

The US Dollar – Heads they win, tails we lose

The story for the US Dollar over the past year has been a fairly simple one: if there is a major crisis and stock markets are falling 700 points in a day, then people want dollars. Otherwise, forget it. So the only way holders of dollars get a break is if the wheels are falling off everything else. During periods of relative calm, such as what we are seeing now, the Dollar has retaken its outcast position as the whipping boy among currencies. The damage done by numerous bailouts and stimulus packages is common sense. The future damage of persistent trillion dollar annual deficits and tens of trillions in unfunded liabilities from Social Security and Medicare still remains.

The 11% move in the Dollar from 2/20/09 to the present will result in higher prices paid for imports, and in part has been one of the reasons for oil’s recent surge. However, oil’s move has been far in excess of what would have been necessary to merely keep pace with the dollar’s decay. Look for a return to higher trade deficits unless demand drops concomitantly, which is entirely possible.

The return of the Bond Vigilantes

Perhaps worst of all has been the Fed’s inability to keep bond yields under control. Despite open monetization to the tune of $300 Billion, and the 2009 purchases of upwards of $1.25 Trillion in mortgage bonds in an effort to keep rates low, bond rates have shot up dramatically. Perhaps even worse, mortgage bond yields are now starting to move up as well. The most alarming trend is the 10-2 spread for 10-year and 2-year Treasury notes. It cannot be ignored that with each recession, the spread grows. That is because each time the fears of inflation as well as actual inflation itself increase dramatically. It cannot be ignored that with each spike we have seen a large bolus of inflation enter the system resulting in a period of ‘prosperity’.

Anyone care to stretch their thinking a bit and notice how those periods of ‘prosperity’ are getting shorter and shorter despite greater infusions of fiat cash?

It should now be apparent to all that a massive inflationary wave has been unleashed. Policymakers are aware of this and are already preparing the public by discussing deficits in the trillions rather than billions as the government will make a futile attempt to keep pace. What is most alarming in all of this is the precarious position of the consumer. Nearly wiped out in 2008 by job losses, falling home prices (which had previously been regarded as income), stagnant wages, and dramatic losses in retirement and other investments, the consumer is not in the position to deal with the inflationary blow that is now in progress.

The green shoots theory was a nice try, but those shoots are about to be buried under an avalanche of another type of green – the green of increasingly worthless fiat paper money.

In our ‘Spin Cycle’ podcast, we are currently doing a 7-part series in which we depict the factors affecting the US economy as sides of a Rubik’s Cube – independent, yet interrelated. On June 3rd, we welcome Professor Laurence Kotlikoff to discuss generational accounting and our mounting unfunded liabilities. To listen to this or other shows, visit www.my2centsonline.com/radioshow.php

Professor Laurence Kotlikoff’’s paper entitled “Is America Bankrupt?”

Treasury International Capital (by Country) – Click Here

If you take a short walk down memory lane, it will not take you very long to find the carcass of New Century Financial along the side of the road back in March 2007. It would be a full 12 months before the word recession would be mentioned in the US mainstream media and stock markets would roar into their all-time highs six months after the disintegration of New Century. Much of the early portion of the credit crisis as it was called focused on mortgages and after that, mortgage-backed securities. Wow, haven’t heard that term in a while, have we?

Much of the scuttlebutt at the time centered around the ratings which were assigned to these mortgage bonds and people started asking questions about how all of these Triple-A rated bonds could suddenly be worthless and why bonds with this high of a rating were paying historic spreads above and beyond US government debt of the same maturities (which are also rated Triple-A).

An Example of the spread between Triple-A rated securities

Of course the foundations for this comparison in the first place are the quality and status of US government debt, which, until recently, was sacrosanct in borrowing circles. In the past week there have been headlines galore (again) that the US is in jeopardy of losing its Triple-A credit rating. Given what we already know about the government’s finances, how can a pristine credit rating and Uncle Sam be mentioned in the same sentence? And perhaps more importantly, can ratings issued by the major agencies be worth more than a defaulted mortgage tranche after the ratings fiasco of the past few years? Consider the following:

“According to the Financial Times report, “Internal Moody’s documents seen by the FT show that some senior staff within the credit agency knew early in 2007 that products rated the previous year had received top-notch Triple-A ratings and that, after a computer coding error was corrected, their ratings should have been up to four notches lower.” Yet the ratings were maintained at Triple-A.”

So why the big todo about the US Government and its Triple-A rating? The point is it shouldn’t have one to begin with. While I am sure this statement doesn’t constitute a revelation to anyone, it is a point that most in the main stream media are once again missing. Some big names have lost Triple-A credit ratings over the past few months. General Electric and the venerable Berkshire Hathaway are two notable examples. AIG lost its Triple-A rating in 2005, and bond insurer Ambac lost its Triple-A rating in 2008.

In the case of normal businesses, the credit rating is a reflection of the firm’s financial position and the market forces that are likely to impact the firm over various periods of time. The firm’s balance sheet is examined. Its revenues and obligations are dissected. The credit rating is then assigned based on the preponderance of these factors and indicates to investors the likelihood of default on the firm’s debt. Investors are then able to make informed decisions. At least this is how it is supposed to work.

Moody’s / S&P Default Probability Models

However, there is one major difference between a normal business and the US Government. Unlike a normal business enterprise, the US Government has a bank on retainer that can create money from nothing and is willing to lend at ridiculously low rates. It can accomplish this task in many ways, but the most direct is called monetization, which consists of the Fed buying bond issues directly from the government. Ostensibly, this is done to prevent the government from having to fund its massive appetite for funds externally. As if there is something honorable about owing your future to a private bank as opposed to another sovereign nation. Further evidence of the Fed’s willingness to monetize additional debt emerged this week:

“Some members noted that a further increase in the total amount of purchases might well be warranted at some point to spur a more rapid pace of recovery.”

Is an entity that requires this type of arrangement for its financial survival deserving of the highest credit rating? How about an entity that is going to have to borrow 46 cents for every dollar it spends during FY 2009? How about an entity that is institutionalizing trillion dollar deficits for the next decade? How about an entity that has a bare minimum of $53 Trillion in contingent unfunded liabilities (nearly four times GDP)?

After this most recent bevy of news headlines regarding the rating situation, Treasury Secy. Tim Geithner promptly got on TV to talk about cutting the budget deficits.

“It’s very important that this Congress and this president put in place policies that will bring those deficits down to a sustainable level over the medium term,” He added that the target is reducing the gap to about 3 percent of gross domestic product, from a projected 12.9 percent this year.

Putting this in the context of our current situation, this would require the deficit to be cut from a projected $1.8 Trillion to just $418 Billion – which is where it was before the current blowout. This is an important distinction as promises by government officials to actually balance the budget are fading quickly into the ether. Now we’re only worried about carrying ‘sustainable’ debt. The problem is that none of these debts are ever paid back and as such, they accumulate all the while piling on interest.

In order to pay off our debt, not only would we have to stop running deficits, we’d actually have to run surpluses. If we ran could manage a surplus that was 3% of GDP each year, it would take us over 30 years to pay off what we already owe on the national debt. That is three decades of smaller government, bare essential expenditures, and the complete dissolution of the ‘cradle to grave’ mentality our government has espoused for the last half century.

Geithner, 47, also said that the rise in yields on Treasury securities this year “is a sign that things are improving” and that “there is a little less acute concern about the depth of the recession.”

This is nothing more than just economic pumping. What the rise in yields is really saying is that when the Fed doesn’t step in and buy US Government bonds that nobody else wants them either. Why would any sane individual lend to somebody that is up to their eyeballs in debt and isn’t even the least bit interested in changing their behavior? To make matters worse, why would any sane individual lend to an entity that proposes to repay the loan in currency that is losing its value?

30-Year Bond Yields

In the above chart, we can see the yield for the 30-year bond. The Fed began indirectly monetizing in the fall of 2008 as the proceeds of TAF, TSLF, etc. went directly to the Treasury window driving yields to nothing. Another spurt of direct Fed monetization in March led to a quick drop in yields, but since then they have been moving relentlessly higher. Foreigners have not stopped buying US Treasuries by any means, but they have certainly slowed their purchases. This leaves the Fed as the buyer of last resort. Certainly Secy. Geithner understands all this, especially considering he used to be the President of the NY Federal Reserve Bank.

Does any of the above sound financially virtuous and deserving of a pristine credit rating? In the end it matters not what Moody’s or S&P have to say about the creditworthiness of the US Government. Our creditors are already speaking. And they aren’t singing our praises.

In our ‘Spin Cycle’ podcast, we are currently doing a 7-part series in which we depict the factors affecting the US economy as sides of a Rubik’s Cube – independent, yet interrelated. On June 3rd, we welcome Professor Laurence Kotlikoff to discuss generational accounting and our mounting debt. To listen, visit www.my2centsonline.com/radioshow.php

05/15/2009

While it may seem rather inappropriate to talk about hedging strategies while the markets are retracing at least a portion of 2008’s devastating plunge, common sense continues to support the position that the worst is yet to come. Granted, focus has shifted to ‘less bad’ economic data and the anointing of government spending as the elixir that will return the American economy to prosperity. Yes, that whole “We’re going to spend our way to prosperity” mantra is once again in play. Make no mistake about it; what we are witnessing right now will be viewed years from now as the biggest suckers rally in history – so far.

That said, now is the time to start talking about protecting portfolios from the next move down. The techniques below were used either singly or in tandem to drastically limit losses in our client portfolios during the 2008 liquidation. Some of these strategies have been sold to the investing public as ten feet tall and bulletproof, but don’t work out too well unless the intricacies are understood. And still others are exceedingly complicated to execute and rely on a preponderance of difficult predictive successes to be beneficial.

Flight to Cash and Equivalents

This move is an obvious one and constitutes either a partial or total exit from the market in question and the capitalization of whatever gains/losses existed to that point. Depending on the type of account you’re dealing with you will have a taxable event. Under many circumstances, it may be detrimental to sell out of the market. This can especially be the case if you are one of those folks who have invested in a dividend-producing portfolio and need the income from those investments for living expenses. Obviously, people in this position don’t want to see their portfolio go down in value, but can’t necessarily afford to sell those assets either.

In terms of the average investor, this is undoubtedly the easiest hedge to execute with the opportunity costs being commissions, possible tax consequences, and the forfeited gains if you’re wrong.

Going Short the Market

Shorting shares and/or indexes is one way investors will choose to hedge portfolios during times when they believe markets will head lower. Let’s use the DJIA as an example.
Let’s say that an extremely prescient (and lucky) trader identified the last major top in the Dow Jones on 5/19/2008 at 13,028.16. That day he shorted 100 shares of DIA at a price of $130.23 for a total of $13,023 with a $10 commission. So our trader has $13,013 in his pocket, knowing he’ll have to cover those shares at some point. Let’s assume once again that our trader gets lucky and picks the precise bottom on 3/6/2009 with the DIA at $66.23 and decides to cover. He buys 100 shares for $6,633 ($10 commission) and has $6,380 as his gain.

Obviously, this is a best-case scenario, and ironically enough, this is often how many investment ‘get-rich-quick’ schemes are presented.

The following is the flip side of shorting the market.

In this scenario, our trader, having seen his brokerage account drop by 25% since the beginning of 2008 decides to short DIA on 10/22/08. He is scared to death of a further decline. He shorts 100 shares at a price of $84.59 on the DIA, pays the same $10 commission and has $8,449.00 in his pocket. Unfortunately, he has picked a short-term bottom and the market rallies substantially immediately after he takes his position and our trader is scared into covering on 11/4/08 at $95.19. Including commissions, his short position just cost him a quick $1,080 – in just 9 trading days.

With the benefit of 20/20 hindsight we can easily point out that our trader would have been much better off waiting a few more weeks to cover. He would not have lost anything, and in fact would have helped his portfolio.

The take-home point here is that shorting is not for the faint of heart. You’d best have a solid understanding of market behavior and fundamentals before even considering short-selling shares. As we learned above, the risk to the trader is unlimited. Lets say the DJIA would have gone all the way back up to its 2007 high after our trader shorted on 10/22/2008. He’d have been out over $5,700. In shorting, the rewards are finite (a stock can only go so close to zero) whereas the risks are theoretically infinite.

For the average investor, shorting shares is difficult in that you must pledge the balance of your account as collateral in case your bet goes bad. This nullifies the ‘qualified’ status of IRAs therefore IRA custodians will not extend margin privileges to IRA accounts. Standard brokerage accounts may be used to short stocks and such an account could be used to hedge other investments. While this strategy may bear occasional fruit, it is not for everyone, particularly those with short time horizons or a low appetite for risk.

Inverse Funds – Not what they’re cracked up to be?

Before beginning this segment, a few things must be said. For those who read this column regularly, you know that I rarely use specific companies or funds in these discussions, and tend to stick to sectors, fundamentals, and macroeconomic conditions. However, in this article, specific examples are going to be used to illustrate the points made and to show investors how these funds don’t always perform the way they’d expect. This is not to imply that there is an attempt to deceive on the part of the fund sponsors, but rather a misunderstanding by the investing public of the stated objectives of these funds.

Dow Jones UltraShort Profund (DXD) – The stated objective of this fund is as follows:

The Fund seeks daily investment results, before fees and expenses that correspond to twice (200%) the inverse (opposite) of the daily performance of the Dow Jones Industrial Average.

Let’s use a couple of hypothetical examples to illustrate how a leveraged inverse fund works. We enter our position when the DOW is at 10,000 and the price of DXD is $100/share. For the purposes of the example, we’re going to forget about the expense ratio. While the expenses must be considered, they are not necessary to make our point.

So over the course of our hypothetical 10-day trading period, the DJIA lost 8.28%. Conventional wisdom would have expected DXD to come in at a 16.57% gain. However, it only returned 14.44% (before expenses). Granted, this is not a big difference, but when you start putting it in the context of a million dollar investment you’re talking about some serious money.

Now, for the sake of argument, let’s use DOG, which is the non-leveraged inverse ETF for the Dow Jones Industrial Average, and see what happens.

The performance of the non-leveraged inverse ETF wasn’t quite as bad as it netted 7.64% (before expenses) when compared to an 8.28% loss in the Dow Jones Industrials Average.

Now let’s apply a real-world example from earlier this year and watch what develops:

On February 9th, 2009, the Dow Jones Industrial Average closed at 8270.87. The Ultrashort DOW ETF (DXD) closed at $58.07 that same day. Now, shortly before close on 5/13/2009, the Dow Jones Industrials Average is at 8274.05, while DXD is at $51.33 – a difference of $6.74 from the 2/9/09 price. Conventional logic would have surmised the DXD prices would be within a few cents given the trivial difference in DOW levels. For comparison, the non-leveraged ETF (DOG) closed at $71.82 on 2/9/2009 and sits at $68.60 shortly before the close on 5/13/2009 – a difference of $3.22. Conventional logic would have also expected the price of DOG to be very similar. What is going on here?

Here’s what. It is all in the objective of the fund. Remember how it mentioned the daily performance? These funds track the index on a day-by-day basis, but as time goes on, the tracking becomes more and more sloppy. Volatility enhances this condition as was evidenced in our 10-day hypothetical study from above.

It is due to the fickle nature of mathematics that a 10% drop followed by a 10% gain doesn’t put you back where you started. This is where the inverse funds fail to protect portfolios in the longer-term. Now, if prices always moved in straight lines, the inverse funds would do fine. Obviously prices don’t behave that way. The above analysis should not be construed as an indictment of the DOG and DXD inverse funds, but rather suggests they only be used with a clear understanding of their objectives. Furthermore it must be realized that you might not get quite the level of protection you anticipated even if you’re right and the market goes down but takes a lazy path to get there.

For the average investor, inverse funds are an easy way to ‘short’ the market without actually taking the full risk of shorting. Think of it this way: if you invest in an inverse fund and the fund goes to zero, you’ve lost only your initial investment. Your actual risk is known going in. A second plus is that inverse funds may be bought in non-marginable accounts like IRAs. The major drawback, outlined above, is that you may not get the performance you expected for your buck – particularly over extended periods of time.

Using Options to Hedge Portfolios

Another potential strategy for hedging portfolios is through the use of options. We have previously discussed covered call writing for the purposes of generating income, but this week’s topic varies considerably and requires looking at things from a totally different perspective. This discussion focuses on using options for protection ONLY – not for day trading or other speculative activities.

While this is not intended to be a primer on options trading and involves prerequisite knowledge, there are some important concepts that must be highlighted when using options for hedging purposes. For most average investors, hedging with options involves the purchase of put options, which can be done from many types of accounts. However, individual brokers have their own restrictions on what can and cannot be done in particular types of accounts.

Time – Options are good for a specified period of time and after such time has passed expire worthless. Even in the month (or sometimes more) before their witching (expiration), options begin to degrade in value and investors find that they’re not doing their job in terms of protecting the portfolio. Options have ‘sweet spots’ and if you’re going to use them to protect a portfolio you’d better be able to align the option’s sweet spot with the period when the market’s decline will be most dramatic. Otherwise you’re not getting the full benefit of the option and your portfolio isn’t being protected. This is no easy task by any stretch of the imagination.

Strike Price – In the case of the Dow Jones Industrials Average, put options could be purchased on DIA. If you feel the decline will last 6 months and start today, you’d look at options that expire 11/2009 or beyond. In the case of DIA, 12/2009 put options are available. Now you must decide how far you think the market will fall. Buying an option with a strike price that is too low may result in it staying out of the money in which case you might not get the full performance; especially if the decline is not as steep as you anticipated. Buy an option at a strike price that is too close to the current price of DIA and you’re going to pay a hefty premium for the option. If your prediction ends up being right that won’t be an issue, but if you are wrong, you just wasted a lot of your money.

Know Your Portfolio - A common mistake of investors who use options for hedging is that they buy the wrong option. It is imperative to understand the components of the portfolio that you’re trying to protect. For example, hedging a portfolio of junior gold mining stocks with Dow Jones Industrials Average puts is probably not a great idea. While the junior gold stocks may trace the DJIA to a certain extent there are plenty of times when such is not the case. Using a simple statistical correlation study between your portfolio’s value and the value of different market indexes can help you identify which markets your portfolio tends to track and you can then hedge more effectively.

The major benefit of buying options is that you’re taking a known level of risk. Your outlay for the option and related commissions is the extent of your risk. If you are wrong and the market moves up your option will expire worthless and you lose your initial investment only. It must be noted that this defined risk does not apply when one is writing uncovered (naked) options. These types of activities are extraordinarily risky and are highly inadvisable merely for hedging purposes.

In conclusion, there are many other factors that play into hedging and would require a dissertation to elucidate all of them to proper justice. Each investor must consider their own objectives and risk tolerance and should also consult a qualified advisor before implementing any investment strategy.

The important thing to take away from this discussion is that if done properly, hedging can provide relative comfort during periods of market mayhem such as we just witnessed last year. However, if undertaken without a solid understanding of both the benefits and detriments of the hedging methodology you choose to employ, not only will you not enjoy comfort, you’re quite likely to be a regular in the antacid aisle at your local pharmacy as well.

Improper hedging techniques and use of hedging vehicles are some common mistakes investors make. Consider taking a look at our free report about 7 additional mistakes investors make – and how to avoid them. To get your copy click the following link: www.sutton-associates.net/7mistakes_report.php

Dear Current and Interested Subscribers,

Back in 2006, Marketwatch Columnist Mark Hulbert made the comment that those who had invested at the 2000 market top had finally gotten their money back.A long six years to get back nominal dollars that had decayed significantly by the time they were ‘gotten back’.

We wrote the pilot issue of the Centsible Investor in early November 2007; right after the market peak. Was this an accident? Hardly. Our keynote article in that issue dealt with our purchasing power coming under attack and we vowed to put together a portfolio model that would fight inflation by providing a high rate of current income with a secondary goal of capital preservation.

Today, I am proud to announce that while the Dow, NASDAQ and S&P are all down (38%, 39%, and 40% respectively), that the total return on our Portfolio Model is now positive at .51% as of close of business 5/8/09. Where traditional investors had to wait several years from the bottom to get their dollars back, our Portfolio Model has accomplished the same feat in just over 2 months – and has paid great dividends while we waited!

For those who have been subscribers over this 18 month roller coaster called the markets, I am hopeful that our publication has demonstrated its worth and you will consider renewing. For those who have not subscribed to this point, I am hopeful you will consider doing so. The attack on our purchasing power is only beginning and will feed on the inflation created to support unsustainable government spending and the various bailouts. Vigilence is required now – more than ever.

As an added incentive, we are currently offering $30 off our one year subscription. Get 12 issues plus interim updates for just $99. This special will last through Memorial Day.

The Centsible Investor’s Subscription Page may be found below. If you have any questions or need assistance, please reply to this email.

http://www.sutton-associates.net/newsletter.php

Best Regards,
Sutton & Associates, LLC

DISCLAIMER: The statements made in this communication are for informational and educational purposes only and do not constitute an offer to either buy or sell any security, nor should any statements herein be construed as investment advice. Neither Sutton & Associates, LLC nor any contributor to the materials contained in the above-referenced report shall be liable for any losses as a result of these or any other investments.