Saturday, December 16, 2006

The Importance of a good bar

When the city of New Orleans began filling up with water shortly after Hurricane Katrina last year, bartender Marita Jaeger and her boyfriend decided to skip town. She called her boss, Johnny White’s Sports Pub owner JD Landrum, to see what he'd be doing with the place. At the time, Johnny White's was something of a local landmark. It's motto was "Never Closed," and indeed, the bar had never shuttered its doors. They didn't even have locks. To her surprise, even in all of this – no power, rising water levels, and reports of looting and lawlessness, Landrum refused to close the place down. “I have to keep it open,” Landum told her. “Because people need somewhere to go.”

I was born in the bayou state and have spent a few afternoons at Johnny White's place. It's a dump, but it was the only place open after the storm - indeed during the storm.

The idea that a bar could be such an important part of a neighborhood – important even to the identity of a city – seems lost on some lawmakers who, probably not coincidentally, happen to represent districts nowhere near New Orleans.

Take Virginia Rep. Frank Wolf. Late last year, the Republican congressman attached a provision to the federal Hurricane Katrina Relief bill that prohibited businesses that serve liquor (along with massage parlors, casinos, and – bizarrely – tanning salons) from getting any federal emergency aid or tax breaks.

This twit obviously needs to spend an afternoon at Johnny White's.

No inflation here, move along, nothing to see here...

Soaring metals prices mean that the value of the metal in pennies and nickels exceeds the face value of the coins. Based on current metals prices, the value of the metal in a nickel is now 6.99 cents, while the penny's metal is worth 1.12 cents, according to the U.S. Mint.

According to the government's Consumer Price Index, the inflation rate in the US is negligible, but it seems to me that this is a more accurate indicator of inflation.

Larry Summers

Larry Summers got fired from his last job at Harvard for making some insensitive statements about the lack of women in the sciences. His latest gig is as a columnist for the Financial Times and my guess is that the FT is hoping he'll place another foot in his mouth soon so they can send him packing as well.

It is neither fair nor efficient to audit disproportionately the tax returns of those in the bottom half of the income distribution at a time when most of the $500bn tax gap comes from those with high incomes. There is no policy justification for allowing the erosion of corporate income tax through pervasive use of corporate tax shelters and manipulation of transfer price rules. Not only does this cost the government revenue, it also puts undue competitive pressure on companies that want to meet obligations to their workers.

Much more can done in a range of areas, from disclosure of executive compensation, to ensuring that the government leverages the volume of its purchases, to making financing of education at every level more equitable, to making sure that businesses continue to take responsibility for their workers’ healthcare costs.

Unimaginative ideas written in drool inducing prose. I had thought Summers got a raw deal at Harvard, but if this is represenative of his intellectual skills, maybe they made the right choice.

High tax rates

PARIS (Reuters) - French rocker Johnny Hallyday, one of France's biggest showbusiness stars and a high profile supporter of presidential hopeful Nicolas Sarkozy, said on Thursday he was moving to Switzerland to escape French taxes.

"Like a lot of French people, I'm sick of what they make us pay in taxes," the singer told Europe 1 radio on Thursday, a day after his impending departure for Switzerland was first reported by the weekly L'Express.

"French rocker" just doesn't sound right does it?

When will governments finally realize that high tax rates have consequences?

Leisure Inequality

Here's an interesting article from the Economist about the increase in leisure time.

INCOME inequality may be increasing, but income is not the only measure of welfare. Those at the lower end of the income spectrum have growing amounts of time on their hands. In a forthcoming QJE paper Mark Aguiar and Erik Hurst find that, on average, the amount of time devoted to not working (this includes household work) has increased over the last forty years. How do Americans spend their new free time? Overwhelmingly, staring at the idiot box. Reading and socialising have dropped, despite the newfound leisure.

The interesting thing is that those on the lower end of the wage scale have seen a much larger increase in leisure time than the well off. There are a few explanations for that but my guess is that the rich are deathly afraid of not being rich any longer.

Economic law repealed

Here's an article about the likelihood that the new Congress will raise the minimum wage:

WASHINGTON (Reuters) - The incoming Democratic-led U.S. Congress intends to give a hand to dishwashers, fast-food cooks and America's other poorest-paid workers by raising the federal minimum wage for the first time in a decade.

With the gap between rich and poor widening, Democrats promised such a pay hike as a part of their campaign that saw them win control of both chambers of Congress in the November 7 elections from President George W. Bush's Republicans.

I have commented on this before and believe the macro economic consequences are minimal, mostly because so few people actually make the minimum wage. In a bit of wishful thinking Reuters, citing "some estimates" , believes this will raise the pay of other workers as well:

In addition to raising the pay of people who now earn less than $7.25 per hour, the proposed new minimum wage, an increase would prompt employers to increase the wages of an estimated 8.3 million other low-paid workers, according to some estimates

I think that is unlikely and next we'll be hearing about how more people are now making the minimum wage and therefore we need another raise. For those who believe the minimum wage has no effect on hiring, perform this mental exercise. Instead of raising the minimum to $7.25 why not raise it to $15 or $39 or $50/hour. Think that would have an effect on hiring? The last I checked, politicians did not have the power to repeal the laws of economics or to ensure prosperity for all.

Sarbaes Oxley changes

The SEC voted on some changes to Sarbanes Oxley designed to help small firms comply:

The SEC proposed new official guidance to companies about how to comply with the law. The proposed guidance is intended to reduce compliance costs and provide more flexibility, especially for smaller companies. The idea is to focus the review activity required by Sarbanes-Oxley on the search for, and identification of, material risks--the kind of problems that could change an investor’s view of a company. At the same time, ideally, the rules would not require expensive paperwork in situations where it’s unlikely to have any benefit. The PCAOB is scheduled to announce a related revision next week.

After reading the press release at the SEC, I can't see where this changes things all that much, if at all. Sarbox needs a major overhaul as the costs have far outweighed any benefit.

Huey Long would be proud

What are the people of Lousisana thinking? Rep. William Jefferson has been reelected to the House. He's the one fighting corruption charges after authorities found $90,000 in his freezer. Amazing....

Tuesday, December 05, 2006

Irrational Exuberance Birthday

According to this post at the WSJ's blog, it's been 10 years since Greenspan first spoke the phrase "Irrational Exuberance" which has since become a well worn catchphrase.

It was 10 years ago tonight that Mr. Greenspan let the phrase slip. (In a nice touch of irony, it came in a speech before the American Enterprise Institute — home to the two writers who in 1999 penned DOW 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market.) Mr. Greenspan was talking about stocks, of course, but since then, writers have invoked his phrase to describe excesses in everything from hog bellies to Treasury bonds. A search on Factiva for news media mentions of “irrational exuberance” returns 23,131 articles. “Rational exuberance” (clever, that!) returns 776 articles. Talk about excess. The chairman himself some years later, in a Congressional Q&A session following testimony, referred to the speech as “turgid,” musing that the rest of his remarks likely caused people to fall asleep.

But here's what really caught my eye on this post; the Fed Funds rate was exactly the same then as now - 5.25%. The Fed has changed the rate 40 times since then, but one can't help but wonder if we wouldn't have been better off if they had just left it alone for the last 10 years. I suspect the answer is yes.

Sunday, November 26, 2006

Gift Guide

The Miami Herald published the annual Dave Barry Christmas gift guide today. Barry no longer writes a regular column for the Herald, but we still get him a few times a year. The gift guide is a favorite in our household. Click on the title and prepare to laugh.

US vs World Markets

US investors sometimes are guilty of myopia when it comes to investing. That is a bad thing as there are many opportunities outside the US, but international/global funds are now attracting most of the new inflows to mutual funds. This is classic performance chasing by individual investors. Investing in international markets can reduce the volatility of your portfolio if those foreign markets are not correlated to US market performance (which most developed markets are), but investing by looking at last year's returns is usually a bad idea. In looking at the latest issue of the Economist over the weekend, something in their Economic and Financial Indicator section caught my eye.

In this list, the S&P 500 has outperformed only the Japanese market this year. And of course, Japan was up big last year.

Looking at emerging markets doesn't help much.

On this list, the S&P 500 underperformed all markets except Pakistan, South Korea (and presumably North Korea),Taiwan, Colombia, Egypt, Saudi Arabia, and Turkey.

I would not be surprised if this performance does not repeat next year. The market always seems to act in ways that frustrate the largest group of investors. With individuals throwing money at international and global funds, it seems like time to be a little myopic.

Friday, November 10, 2006

Economic Nationalism

In a post yesterday, I worried that the anti trade wing of the Republican party would find allies in the Democrats who now control Congress. I'm not the only one worried. The title of this post links to a story in Slate, "The Lou Dobbs Democrats":

Most of those who reclaimed Republican seats ran hard against free trade, globalization, and any sort of moderate immigration policy. That these Democrats won makes it likely that others will take up their reactionary call. Some of the newcomers may even be foolish enough to try to govern on the basis of their misguided theory.

Greg Mankiw also touches on the subject:

Some of my best friends are Democrats. They often like to think that their party is good for international trade...

Those of you who want to delve into some deep thoughts on free trade might read this essay.

Dear Democratic Congress...Don't Even Think About It!

Dollar Declines After Reuters Says China May Diversify Reserves

By Daniel Kruger and Min Zeng

Nov. 9 (Bloomberg) -- The dollar fell to the lowest against the euro in more than two months after Reuters reported People's Bank of China Governor Zhou Xiaochuan said he has a ``clear'' plan to diversify the country's foreign-exchange reserves.

Is it coincidence that the Governor of the People's Bank of China chose yeseterday, the day after the Democratic takeover of Congress, to make this statement? I don't think so; it was just a couple of months ago that Sen. Charles Schumer (D-NY) and Sen. Lindsay Graham (R-SC) introduced a bill to impose a 27.5% tariff on Chinese goods if the Chinese weren't more accomodating in revaluing the Chinese currency upward agains the dollar. This was a shot across the bow of the new Democratic controlled Congress; pass the tariff bill and the Chinese will accelerate the "diversification" of their reserves, which are primarily US Dollar denominated Treasury Notes. The result was plain for everyone to see; gold shot up $18/oz and the dollar fell against most currencies.

The dollar traded at $1.2836 per euro at 2:06 p.m. in New York from $1.2757 yesterday. The U.S. currency touched $1.2848, the lowest since $1.2875 on Sept. 5. The U.S. currency traded at 117.91 yen from 117.84. The dollar earlier reached 118.59 yen....Gold rose after the announcement by the Chinese central bank's governor. Futures for December delivery increased $18.50, or 3 percent, to $636.80 an ounce on the Comex division of the New York Mercantile Exchange. A close at that price would mark the biggest gain for a most-active contract since June 30.

In a post yesterday, I said that anti-trade legislation is the greatest threat to the economy as a result of the Democratic takeover. This should be a reminder to everyone that our current prosperity rests almost solely on the continuation of the globalization process, which is characterized by trade liberalization. With reserves of $1 trillion, primarily invested in US Treasury Notes, the Chinese ability to punish the US for restricting trade is plain to see.

This also demonstrates why we believe that holding a position in commodities is not just a nice way to diversify your portfolio, but a necessary safeguard against the economic illiteracy of politicians. If populists in Congress succeed in imposing trade restrictions on China, the result will be much worse than the knee jerk reaction yesterday - and the best way to protect your assets is to own commodities, particularly gold.

Wednesday, November 08, 2006

Rumsfeld Resigns

Donald Rumsfeld resigned as Secretary of Defense today. He will be replaced by Robert Gates, current President of Texas A&M and a former CIA Director under the first President Bush. Too bad its not Bill Gates.

Election Effects

Yesterday's mid term election produced a mostly expected result. Market participants anticipated the change of control in the House. Senate control is still up in the air with the Virginia and Montana races still undecided - and recounts widely expected. I think it is likely that both those races will eventually go to the Democratic side as well.

What does this mean for us as investors? As I've stated numerous times, I don't think it makes a lot of difference - at least in the short term. While new Speaker Pelosi has promised greater civility and compromise, I don't expect much to be accomplished in the two years remaining until the next presidential election. Compromise is not in any politician's nature and no matter the words spoken on election night, a Democratic majority in Congress will make little difference in the legislative outcomes.

Prior to the election there were a number of issues that could affect the market and despite a change of control in Congress, the issues remain the same:

1. The expiration of various tax cuts in 2008 and 2010. The current Congress, despite Republican control, was not able to extend the tax cuts. The likelihood of extension is now even more remote. Most important to the markets are the dividend and capital gains cuts which expire in 2010. That was always going to be an issue in the 2008 election and nothing has changed.

2. Minimum wage increase. Minimum wage legislation is likely to pass the House and probably the Senate as well. Bush will likely veto, but there is no guarantee on that since he has yet to veto anything of any importance. I have stated before and still believe the economic impact is minimal. Indexing the minimum wage to inflation would make the legislation worse, but that will probably be resisted.

3. Anti Trade sentiment. There has always been a segment of the Republican party that is anti trade (see Pat Buchanan) and Democrats have been basically anti trade (they call it fair trade, but that is just rhetoric with no basis in economic fact) with the exception of the early Clinton years. This is probably the worst outcome of the election. Free trade (read globalization), by increasing the flow of low cost manufactured goods primarily from Asia, has allowed the Fed to pursue a less aggressive monetary policy by holding down consumer inflation. Were Congress to enact legislation that limits trade, especially from Asia, the result will be higher inflation and likely higher interest rates.

4. Demonizing of corporate scapegoats. The Pharmaceutical and Oil companies should start staffing up the legal departments now. The wind fall profits tax on oil companies - as bad an idea as has ever been tried - is likely back on the table. Hopefully, someone in Congress will be adult enough to point out that this has been tried before and failed miserably. Republicans and Democrats will both be looking to blame someone for their own failures on energy and health care policy. I don't expect any legislation to pass over a veto and therefore this is probably just headline risk.

5. Budget Deficit. I actually don't think the current deficit (or total national debt) is anything to worry about, but politicians sure want to make it an issue. Our national debt, at about 60% of GDP, is among the lowest in the developed world. It's less than Germany, France, Canada, Italy and Japan for example. Would I like to see a lower deficit? Of course I would and I feel certain that any normal person could eliminate the deficit over a long weekend, but don't expect any Congress to seriously address current or future spending. One fear I've expressed here before is that with Democrats in control it will just mean an even worse deficit as they add more domestic spending while the defense spending has to continue (no, I don't expect Democrats to get us out of Iraq).

The bottom line is that little has changed, at least for investors, since yesterday. The change in control of Congress should not change anyone's investment plans and should have little impact on the economy as a whole. Our investment thesis is unchanged.

Monday, October 23, 2006

Commodity Debate

The latest issue of Forbes has an interesting article highlighting the debate about the future course of commodity prices between Jim Rogers and Stephen Roach:

While the Dow Jones booms, commodities like oil and gas swoon. Jim Rogers, the man who called the raw materials rise years ago, is upping his bets. Economist Stephen Roach thinks that's nuts.

We have been underweight commodities recently and in our latest tactical update to be published this week, we maintain that position. However, Jim Rogers makes a good case for a long term commodity bull market. Stephen Roach always seems dour about something - he's known as a permabear on Wall Street - but he was right about stocks a few months ago. He was ridiculed at the time because he got more bullish right before the correction, but I'd say he's been vindicated.

I tend to think commodities are reflecting the general view that the economy is slowing. If that proves short lived, commodities could add some return to your portfolio. We'll be watching closely.

They Couldn't Hang Him

Jeffrey Skilling, former Enron CEO was sentenced today:

HOUSTON (AP) -- Former Enron Chief Executive Officer Jeffrey Skilling, the most vilified figure from the financial scandal of the decade, was sentenced Monday to 24 years and four months in the harshest sentence yet in the case that arose from the energy trading giant's collapse.

I don't think this requires further comment.

Barron's on the Election

This past weekend's Barron's cover article makes the prediction that the Republican's will hold their majority in the House and the Senate:

JUBILANT DEMOCRATS SHOULD RECONSIDER their order for confetti and noisemakers. The Democrats, as widely reported, are expecting GOP-weary voters to flock to the polls in two weeks and hand them control of the House for the first time in 12 years -- and perhaps the Senate, as well. Even some Republicans privately confess that they are anticipating the election-day equivalent of Little Big Horn. Pardon our hubris, but we just don't see it.

The writers base this on the amount of money available to the candidates which has been a good predictor in the past. Interestingly, the last time it didn't work that well was 1994 when the Republicans took control. I place more faith in the futures markets which are predicting that the Democrats will take the House while the Republicans will retain the Senate.

Friday, October 13, 2006

Divided Government

MSN Money has an article today called "An investment Guide to the MidTerm Elections" which addresses my comment from a recent post that investors were probably hoping for a Democratic takeover of Congress because they perceive divided government as good for the market:

Forget politics. Before you cast your ballot in November, think how it will affect your portfolio.

Some on Wall Street expect the stock market to benefit if the Democrats gain enough seats to take control of the House of Representatives. The linchpin of this idea is that political gridlock is good for stocks. A Congress divided between a Democrat-controlled House and a Republican-run Senate and White House reduces the chance that lawmakers will upset the legal and regulatory status quo.

I don't really agree with the analysis, but I do believe that a lot of people think this way. The idea seems to be that gridlock reduces the chances of legislation passing and therefore spending may be brought under some kind of control:

But if bonds make up a big part of your portfolio, you may want to support Democrats this year, the study suggests. It shows that during periods of divided government, bonds generally beat stocks. Johnson and his colleagues conclude that gridlock does lead to a slowdown in legislation and to slower growth in spending. That should mean smaller budget deficits, which means the government needs to issue less debt. That could lead to lower interest rates, and since bond prices move inversely with yields, bond holders tend to benefit.

My fear is that divided government at this time in history will just result in the same spending from Republicans on defense and increased spending on domestic programs from Democrats. Discretionary spending growth under Republican control has already been growing at rates faster than inflation. Luckily, it has grown slower than the rate of increase in tax revenues and that coupled with above trend GDP growth has reduced the deficit as a percentage of GDP. However, with the Baby Boomers starting to retire, the current deficit pales in comparison with the long run budget problems created by Social Security and Medicare. Divided government will certainly make it less likely that Congress will address those issues.

Tuesday, October 10, 2006

Bad News? No Problem

The resiliency of the stock market has been amazing. The yield curve is inverted, bonds are rallying even as inflation and wages rise at 4% per year. House prices show the first price fall in over 10 years and housing stocks outperform. Oil, even after a 25% correction, is around $60/barrel. Republicans lag badly in the mid term election polls. North Korea tests a nuclear weapon (maybe). Iran defies the world in continuing nuclear research (well most of the world anyway). And the Dow makes a new all time high. What gives?

It always pays to remember that markets are discounting mechanisms. What markets do today reflects investors view of the future, not the present. Yes, current inflation is too high, but commodity markets are signaling that the peak is past, so stock market investors believe inflation is under control. Yes, the housing market is weak, but with interest rates falling, refinancing activity picking up and homebuilders in good financial shape, investors believe the downturn will be over fairly quickly. And if history is any guide, they are probably right. Yes, oil is high by historical standards, but its falling, OPEC is talking about production cuts and there have been some major new finds recently. OPEC doesn't have a good track record when it comes to controlling prices either so even the threat of production cuts is having little impact. Investors are looking past the current price and factoring in the increased cash flow of consumers as gas prices fall.

North Korea and Iran certainly seem scary, but the paucity of yield in the North Korea test signals either a lack of fissionable material or maybe even an outright hoax. Iran, while acting obstinate, is probably further away from a bomb than the doomsayers think (but probably closer than we would like). They may be a problem down the road, but that assumes that the current regime survives. With a restive, young population that is probably a longer shot than the mullahs think. Did anyone notice the confrontation between Iranian citizens protecting a dissident ayatollah (who thinks that clerics should stay out of government) and government goons? Read about it here.

As for the midterm elections, apparently investors have adopted our view that it makes little difference who controls Congress. Will Republicans lose control of the House and Senate? Futures markets are currently predicting a 36% chance they will retain control of the House and a 63% chance they will retain the Senate. Frankly, with the advantages of incumbency I think the odds of a Democratic takeover of the House are somewhat lower than that, but then I'm not betting on the outcome. Investors seem to be saying that it doesn't matter. In fact, I believe a lot of investors are thinking that divided government would be better than one party control. And they are probably right.

Another factor to consider in the recent runup is sentiment. We typically like to bet against the crowd and this rally has plenty of sceptics. The latest AAII (American Association of Individual Investors) poll still shows more bears than bulls (46.7% to 37.8%) so the little investor is still scared of the market. He's probably thinking about the spring when a run at new highs was turned back by a nasty correction. That's okay; when the bulls start running we'll be looking to cut back, but for now the wall of worry is still fairly tall.

Predicting the future is always a tricky business, but especially when it seems there are so many potential problems. Are investors too optimistic about the outcome of all these things? Maybe, but for now, there aren't enough optimists to make us worry. When the small investor starts to jump on the bandwagon, we'll start to worry. For now the small investor is still chasing last year's returns - inflows to international funds are swamping inflows to US funds even as the US outperforms. It seems dangerous to us to invest (or drive) by looking in the rear view mirror.

Thursday, October 05, 2006

New High for the Dow

There has been much ink spilled this week about the Dow Jones Industrial Average making a new all time high. Frankly, it's just a number and it doesn't mean all that much. The components of the Dow have changed pretty dramatically since 2000 so the average making a new high now is not comparing apples to apples. More like apples to kiwi.

More important to us is the relative performance of the various asset classes in which we invest our clients assets. Our large cap emphasis has paid off recently and we expect that to continue. We have also been underweight the commodity indexes and that has certainly turned out to be a good move with the GSCI taking a pounding over the last couple of months. Unfortunately, our crystal ball isn't perfect so we do have exposure to commodities and that has hurt our performance somewhat during this time, but overall we've had a good 3rd quarter.

The market is starting to anticipate a rate cut by the Fed and that has been the driving force behind this stock rally. The economy is slowing with housing leading the downturn. No surprise there; we've been talking about that for a while too. However, we still believe the housing market will not take the whole economy down for the count. Just this week, the Mortgage Bankers Association reported that mortgage applications jumped impressively over the last month. Refinance applications were up more the 17% and purchase applications were up about 7%. Lower rates are having the expected effect. There's probably some more pain to be seen in the housing market, but so far the correction has been rather orderly.

As for the Fed, we don't expect them to cut rates anytime soon. The yield curve is still inverted and all Treasury rates are less than the Federal Funds rate, but with the way the banking system works today, we don't think that means as much as it once did. The market is setting rates and the Fed, while not irrelevant, is certainly less important than it once was.

We continue to see a lot of positives about the stock market. Sentiment is still pretty negative and valuations, while not cheap, are certainly reasonable. And large cap stocks are still the cheapest part of the market. Falling commodity prices seem to be saying that inflation is moderating and that should be positive for stocks and interest rates.

We'll be publishing our Tactical Update next week.

Wednesday, September 27, 2006

Market Update

I was out of commission for a few days fighting a stomach virus so it seems appropriate to review some of the recent market happenings.

The market got a bit of a growth scare last week as several economic data points seemed a bit weaker than expected. The Philly Fed Survey was much weaker than expected and spooked the market quite a bit on Thursday and Friday. The Conference Board also released the Leading Economic Indicators on Thursday which were interpreted as weak. These two reports were enough to worry some that the economy is weakening too rapidly and could fall into recession. The yield curve continued to invert with the Ten Year Treasury note yield falling almost 3/4% below the Fed Funds rate. I must admit that level of inversion certainly makes me nervous. However, without further evidence, we continue to expect a slowdown that doesn't develop into recession.

The market has recovered to new highs for the move this week as consumer confidence and a report from the Richmond Fed cooled the recession fears. The Dow now stands a mere 33 points or so from its all time high. We expect that level to be broken soon, especially with the end of quarter window dressing that is happening this week. For those of you who don't know, window dressing is a practice that happens at the end of every quarter. It refers to the fact that mutual fund managers must reveal their portfolios at the end of every quarter. If it has been an up quarter, as this one has, those portfolio managers don't want to show too much cash on the books lest anyone actually read their quarterly report and complain that they weren't invested enough to take advantage of the rally. The reverse occurs when it's been a down quarter and those same portfolio managers will sell in the last week to make it look like they were holding cash. It's a silly game, but we know it gets played.

So, I was out for a few days, but nothing has happened to change our view. We are still overweight large cap stocks (which have outperformed during this rally) and underweight commodities (which have dramatically underperformed over the last two months). We do expect to see some consolidation of the recent gains in October as the election nears. Some will start to fear a Democratic takeover (although as we've pointed out, that's an unfounded fear) and sell stocks in anticipation. Political prognostication is not our area of expertise, but with the way incumbents have twisted the system in their favor, we don't think a huge turnover in Congress is likely. We think there is still upside to the market once the election is out of the way.

Oil in the Ground

Max Singer has an article in the Weekly Standard about oil prices and predicts that oil will average $30/barrel over the next 50 years. Mr. Singer's opinion carries some weight as he was one of the few who predicted lower prices in 1980 when the vast majority thought prices could only go higher.

The basic price of oil for the next 50 years will be about $30 a barrel. Some of the time it will be higher, but I would bet that a lot of the time it will be lower. The key point is that any investments made in oil or oil substitutes that depend on oil prices staying well above $30 a barrel stand a good chance of losing money. They are imprudent, risky investments--although nobody can say for sure that they won't pay off.

One thing I would like to point out about Mr. Singer's prediction however. He is referring to the inflation adjusted price. In other words, a 50% devaluation of the dollar during that time would result in an inflation adjusted price of $45/barrel. And that is one of the main reasons we always maintain investments in commodities. We fear the Federal Reserve's corrosive effect on the value of the dollar much more than we fear running out of oil or any other commodity. Dollar devaluations - or inflation since it's the same thing- show up in the price of commodities much sooner than the general price level.


Apologies for the lack of posting recently. I've been under the weather with a nasty stomach virus. I'll catch everyone up on recent market happenings in the next day or so.

Wednesday, September 20, 2006


For our clients who own Oracle Software, it's nice to report that the company reported great earnings after the close yesterday and the stock surged over 11% today. Net Income was up 29% on a 30% increase in revenue. Larry Ellison seems to be proving his detractors wrong again. With the acquisitions he's made over the last year, it now appears to be down to Oracle and SAP. I know who we're betting on. Click on the title to read the press release about the earnings. Here's a link to the conference call.

FOMC Meeting

The Federal Open Market Committee today voted 10-1 to maintain the Fed Funds rate at 5 1/4%. This was widely anticipated and the statement accompanying the vote also provided little in the way of new information. We have been saying for some time now that the Fed is likely done with this rate tightening cycle. None of the data released recently has changed our view.

We are becoming more cautious about the stock market however. Sentiment is becoming more bullish by the day and while it is not at an extreme yet, we are increasingly uncomfortable being in the majority. Bullish sentiment in the AAII poll, which surveys individual investors, has been creeping up with the market and stood at 48% last week. Bears still represent 38.4% of those polled so we don't think sentiment is at any kind of extreme yet. If the bear percentage starts to fall down into the 20s and the bulls get over 50%, we would start to expect some kind of correction. We'll keep you posted.

The longer term picture, in our opinion, still seems fairly bright. Oil fell under $61 today and that should help the US consumer, which is still the crucial piece of the worldwide growth puzzle. Other commodities also continue to correct with natural gas back under $5/mcf and gold now well under $600/oz. We believe the money coming out of commodities will be increasingly deployed in the stock market, particularly large capitalization stocks. The dollar seems to have stabilized which may help to attract more assets from overseas to stocks (although admittedly the flow of funds data recently released indicates that last month saw less foreign interest in US assets; we think that is a short term phenomenon related to Japanese repatriation of foreign exchange). The Mortgage Bankers Association today reported that refinance activity jumped by 9.5% last week. Falling mortgage rates are obviously having an effect even if not on the purchase side.

Things seem to be going pretty much according to our script and that makes us wonder what we're missing. We have said many times that predicting the course of the economy and/or the market in the short term is basically impossible. That applies to us as well as everyone else trying to predict the future. So, while we are happy that things seem to be going our way, we are worried that our outlook is starting to gain mainstream acceptance.

Tuesday, September 19, 2006

Thai Coup Haiku

Thaksin at UN
Tanks in the Streets are rolling
The Baht is Falling!

Alright, I'm not much of a poet and Haiku really doesn't work in English anyway, but this story about the market today from AP is absurd:

Stocks dropped suddenly Tuesday after Thailand's military launched a coup against the country's prime minister. Traders watching Thailand closely are certain to remember how trouble in the kingdom had worldwide implications in the past: The Asia currency crisis that erupted in 1997 began with the devaluation of the Thai baht, then snowballed into a currency crisis in emerging markets around the world.

I guess since the "Asian" crisis back in '97 started with the Thai Baht coming unglued, the AP thinks that US stocks will now react to every wiggle of an Asian currency. Of course, conditions then were much different than now, but economic research is not exactly the AP's strong suit. I suppose this could turn into something bigger, but I don't think traders decided to sell today because the Thai military (why does Thailand even have a military?) decided to kick the PM out while he was visiting the UN. This has been so widely rumored that even I had heard about it and I don't usually waste my time on Thai politics - Thai food yes, Thai politics no.

I think a more likely explanation for today's minor pullback is that we've had a nice run and some found this morning's housing numbers a good reason to take some profits. Housing starts and permits were both less than expected this morning as was PPI (wholesale inflation). I didn't find anything surprising about either stat and the market shouldn't have either. We still stand by our often stated view that housing will continue to slow, but won't push the US into recession. With interest rates falling again today -- more than we think is warranted by the way -- we suspect housing will find a bottom in the next couple of quarters.

Monday, September 18, 2006

Orchid Blogging

As some of you know, I am an orchid and tropical plant fan. My collection is expanding but still small (about 100 orchids and various tropical plants) by the standards set by some of my friends (you know who you are). Anyway, it's been an exceptional year for blooms and I thought some of you might enjoy some photos:

More on Commodity Allocations

PIMCO recently commissioned a study by Ibbotson Associates regarding the use of commodities in Strategic Asset Allocations. The study provides indepedent confirmation of our own research into the use of commodities in our portfolios. The study is available through PIMCO's web site, but it is quite technical and is probably only suited for the true investment geeks among us. Here are some highlights:

This paper studies the role of commodities in a strategic asset allocation. Commodities are real return, real assets that are part of the consumable/transformable super asset class and the storeof-value super asset class. There are several methods of obtaining exposure to commodities. This paper focuses on the type of exposure to commodities produced by a fully collateralized total
return commodity index.

Using historical capital market assumptions based on annual data from 1970 to 2004, we found that including commodities in the opportunity set resulted in a superior historical efficient frontier, which included large allocations to commodities. Over the common standard deviation range, the average improvement in historical return at each of the risk levels was approximately 133 basis points.

No matter which set of returns was used, including commodities in the opportunity set improved the risk-return characteristics of the efficient frontier. Furthermore, commodities played an important and significant role in the strategic asset allocations. Given the inherent return of commodities, there seems to be little risk that commodities will dramatically underperform the other asset classes on a risk-adjusted basis over any reasonably long time period. If anything, the risk is that commodities will continue to produce equity-like returns, in which case, the forwardlooking strategic allocations to commodities are too low.

Most strategic asset allocations consist primarily of allocations to the three “traditional” asset classes—stocks, bonds, and cash. Expanding the investable universe beyond these three traditional asset classes improves the risk-return characteristics of a strategic asset allocation. Asset classes with low correlations to the current opportunity set of asset classes provide the largest benefit.

In the last paragraph above, notice the phrase "Asset classes with low correlations to the current opportunity set of asset classes provide the largest benefit". At AIM we include Commodities and REITs in all our portfolios for exactly this reason. Both REITs and Commodities have low correlations to the traditional asset classes of stocks, bonds and cash. We believe using these assets in our portfolios will produce, over time, higher returns and lower volatility for our clients. Click on the title of this post to read an interview with PIMCO SVP Bob Greer. Full disclosure: AIM sometimes uses PIMCO funds in our allocations, specifically the PIMCO Commodity Real Return Fund.

Why Our Portofolios Always Maintain Exposure to Commodities

At AIM, one of the essential components of our portfolios is exposure to commodities, usually in the form of an index fund. Based on interactions with clients, there is some confusion about why we think this is essential. This article by John Tamny in National Review provides a good answer to the question:

Returning to current monetary blunders, every supposed oil and commodity “shock” since 1971 has occurred alongside a major drop in the value of the dollar versus gold, and subsequently all commodities. Since both oil and copper are world commodities, the fact that their prices have risen so substantially in dollars as opposed to euros in recent years makes plain the impact of dollar instability on the nominal price of commodities.

We invest in commodities because we don't trust the Federal Reserve (or the US Government if you prefer) to maintain the purchasing power of the dollar. History tells us that fiat currencies are inherently unstable and are ultimately undermined by the governments that use them. Since our mission is to protect the wealth that our clients have worked so hard to accumulate, we believe it is essential to maintain some exposure to commodities at all times. We can and do vary the percentages we have invested in commodities based on current conditions, but since so many crises are associated with commodity spikes, we think it is prudent to maintain some exposure at all times. We are currently undeweight commodities and in the current correction even that has hurt our performance, but we'll take some short term pain to ensure that our clients purchasing power is protected in the long term. Click on the title to read the whole story.

Liberty Dollar

Here's a weird little story:

WASHINGTON — The government Thursday warned consumers and businesses that it is illegal to use alternative money known as "Liberty Dollar" coins, which organizers promote as a competitor to the almighty dollar.
"We don't want consumers to be fooled," U.S. Mint spokeswoman Becky Bailey says, noting U.S. Attorneys offices across the USA have noticed a marked increase in inquiries about the coins.

The coins are produced by an organization called NORFED:

Evansville, Ind.-based National Organization for the Repeal of the Federal Reserve Act and the Internal Revenue Code, otherwise known as NORFED, has been making the Liberty Dollar coins for eight years and claims $20 million is in circulation. The group says the money, unlike official U.S. cash, has a hedge against inflation because it is made almost entirely of silver and is backed by stocks of silver and gold in a vault in Idaho.

I don't know anything about these coins, but isn't it ironic that the government deems it illegal to produce a coin that has more intrinsic value (it must since official government coins no longer contain silver or gold) than the official version? And why exactly would it be illegal to produce coins, but not jewelry?

Economic Calendar

Click on the title for this week's economic calendar. There's not much on tap this week except for the Fed meeting on Wednesday - and that shouldn't produce any surprises. Housing starts and building permits will give us clues about the housing market. PPI tomorrow should be benign. We expect crude inventories to continue to push oil lower.

Who Needs the IMF?

Newsweek has a story this week with the same title as this post. Unfortunately, they chose Kenneth Rogoff, a Harvard Econ Prof and former employee of the IMF, to write the article. Here's the opening graph:

Sept. 25, 2006 issue - As the international Monetary Fund holds its big fall meetings in Singapore this week, it faces a financial world that has been turned on its head. Traditionally, the Fund has helped out bankrupt emerging-market governments using loan money collected mainly from Western nations. But now, the Fund is being asked, in effect, to play a much broader role in helping maintain financial stability in a world where the lenders and creditors are trading places. With the United States borrowing two thirds of global net savings and Euro-zone countries like Italy, Greece and Portugal struggling to control their government finances—while emerging markets sit on mounting foreign-exchange reserves—many worry that ground zero for the next big global financial crisis could be somewhere in the wealthy West. Given that Asia now accounts for almost 40 percent of global income, and an even larger share of its surpluses, it makes no sense that IMF voting rights and leadership posts are still dominated by the United States and Europe.

First of all, the IMF was established to administer the currency regime known as Bretton Woods that was established after WWII. Since Nixon severed the dollar's link to gold and essentially killed Bretton Woods in the early 70s, the IMF has been looking around for a job. I guess it would have made too much sense to disband an agency whose mission was no longer valid. Second, the IMFs more recent role as lender of last resort to emerging market economies has produced questionable results at best. The moral hazard created by the existence of an IMF prepared to bail out any country that digs a deep enough hole means that profligate governments never receive the market punishment they deserve and that would teach them to follow basic, sensible economic policies. And lastly, the US is the biggest contributor to the fund; why should we give up any leadership position at the fund when it is lending our money? Who needs the IMF? No One! Click on the title to read the whole story.

Friday, September 15, 2006

Inflation or Lack Thereof

The Labor Department reported the Consumer Price Index this morning rose 0.2% in August:


The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.2 percent in August, before seasonal adjustment, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. The August level of 203.9 (1982-84=100) was 3.8 percent higher than in August 2005.

Energy was only up 0.3% in August vs a 2.9% increase in July and of course we've seen a significant drop since August so inflation continues to moderate. We have stated previously that we believe inflation peaked in April or May and we continue to believe that to be the case.

The tame CPI and slowing economic growth should continue to keep the Fed on the sidelines. Industrial production and capacity utilization were also reported today and while production dropped 0.1% that was mostly due to a drop in utility output as the summer heat waves passed. Manufacturing output was flat vs July but up 5.4% year over year. Capacity Utilization was down slightly to 82.4%. All this points to an economy that is slowing but not falling into recession, which is what the Fed is expecting.

Our current investment stance is unchanged: underweight commodities and REITs and overweight Large Cap. Small cap is slightly underweight. We believe that as the economoy slows, investors will move toward the larger company stocks and away from the more economically sensitive small caps. While we don't expect a significant fall in the small cap indexes we do believe that Large Cap will continue to outperform as it has over the last year and by an increasing amount as the year progresses.

Thursday, September 14, 2006

Send More Witch Doctors

The title of this post is the retort that supply side economists used when others disparaged their thinking as "Voodoo Economics". Of course, many have talked about the irony of Bush the Younger using the Voodoo Economics that his father disdained. I am not a supply sider - I think of myself more along the lines of a classic liberal -- but some of the policies that supply siders advocate, such as cutting marginal tax rates, fit in with my philosophy. In fact, the Laffer Curve was first demonstrated in Congress way back in the 1830s to demonstrate the futility of raising tariffs too high by none other than John C. Calhoun. So, much to my father's chagrin, my family has a long history with Voodoo Economics. This story from National Review Online by Ashby M. Foote III discusses the disparity between the two employment surveys.

If you have one of the 3.3 million jobs the Labor Department can’t explain, please contact Secretary Elaine Chao at That’s right: 3.3 million new jobs is the cumulative difference between the Labor Department’s two ongoing surveys (payroll and household) since the current economic expansion began in November 2001.

The gist of the story is that the household survey captures new small businesses that are formed while the establishment survey only captures the jobs created by larger companies. The disparity is caused by the ease of new business formation and the changing ways that technology allows people to work. Glenn Reynolds, of Instapundit fame, talks about this in his book, "An Army of Davids" and the author of this article mentions Chris Anderson's "The Long Tail" both of which I enjoyed and generally agree with. However, I would point out that over time the household survey and the establishment survey tend to even out so I'm not sure there's anything to this. I would think that if the economy were creating that many jobs, consumer confidence would be appreciably higher. Maybe all those "Davids" have created a job because they couldn't find one at an established firm?

If you wonder what a "classic liberal" is, I'll just say it has nothing to do with the current usage of the term and point you to this book "Reviving the Invisible Hand: The Case for Classical Liberalism in the Twenty First Century" by Deepak Lal.

I think I'll have a Drink

I stop by the Reason Foundation website regularly to see what the hard core libertarians are talking about. I ran across this today and had to share it with everyone. They've done a study that purports to show that social drinkers make more money than non drinkers.

A number of theorists assume that drinking has harmful economic effects, but data show that drinking and earnings are positively correlated. We hypothesize that drinking leads to higher earnings by increasing social capital. If drinkers have larger social networks, their earnings should increase. Examining the General Social Survey, we find that self-reported drinkers earn 10-14 percent more than abstainers, which replicates results from other data sets. We then attempt to differentiate between social and nonsocial drinking by comparing the earnings of those who frequent bars at least once per month and those who do not. We find that males who frequent bars at least once per month earn an additional 7 percent on top of the 10 percent drinkers’ premium. These results suggest that social drinking leads to increased social capital.

This seems like an opportune time to mention that we'll be hosting a wine tasting at the end of the month. Details to come......

Oil Prices/Commodities

The title of this post links to a story in the Seattle Times that quotes an energy consultant:

"All the hurricane flags are flying" in oil markets, said Philip Verleger, a noted energy consultant who was a lone voice several years ago in warning that oil prices would soar. Now, he says, they appear to be poised for a dramatic plunge.

I don't know if prices are about to plunge, but the story does make some good points. Much of the run up in oil prices to over $70 per barrel really had little to do with supply and demand and a lot to do with speculation in commodity markets. Much of this speculation was based on political factors such as unrest in Nigeria and the Middle East. Others speculated that global warming would continue to produce hurricane seasons like last year that would disrupt supplies in the Gulf of Mexico.

Oil traders bet that such worrisome developments would drive up the future price of oil. Oil is traded in contracts for future delivery, and companies that take physical delivery of oil are just a small part of total trading. Large pension and commodities funds are the big traders and they're seeking profits. They've sunk $105 billion or more into oil futures in recent years, according to Verleger. Their bets that oil prices would rise in the future bid up the price of oil.

That, in turn, led users of oil to create stockpiles as cushions against supply disruptions and even higher future prices. Now inventories of oil are approaching 1990 levels.

There isn't exactly peace in the Middle East but at least the Israeli Army has pulled back. Nigeria is still a dangerous place but the world seems to have adjusted to that reality. Hurricane season has so far been a non event. And inventories are so high there are reports of some oil companies leasing tankers for storage. In other words, the market has responded exactly as one would expect.

Oil isn't the only commodity that seems to have peaked. Gold and other metals have fallen too. The commodity indexes have seen some pretty severe corrections over the last couple of months. We tend to think it has more to go and remain underweight the commodity stocks and indexes.

The drop in commodity prices also tends to reinforce our belief that the Fed is at the top of it's rate raising cycle. The drop in oil and particularly gold should give the Fed some comfort that they haven't release the inflation genie from his bottle. With housing slowing (but apparently not crashing; see the uptick in purchase mortgage applications reported yesterday) and commodities correcting, we may be headed back to the days of moderate growth and inflation -- at least for a little while.

Wednesday, September 13, 2006

Chicago Fed Housing Boom Study

The Chicago Federal Reserve Bank recently published a study that attributes the housing boom not to loose monetary policy but a host of other factors out of the Fed's control. In a related story, my daughter recently disclosed that the mess in her room was caused by an invisible troll who lives in her closet.

Our main findings are as follows. First, it appears that the housing boom has not been driven by unusually loose monetary policy. This is not to say that monetary policy has not been unusually loose, but that to the extent it has been loose, this is not what has been driving spending on housing. Second, the current levels of spending on housing are largely explained by the wealth created by dramatic technological progress over the previous decade. Third, changes in the demographic, income, educational, and regional structure of the population account for only one-half of the increase in homeownership. ... The last finding is that substitution away from rental housing made possible by technology-driven developments in the mortgage market, such as subprime lending, could account for a significant fraction of the increase in residential investment and homeownership. The current spending boom thus may be a temporary transition toward an era with higher homeownership rates and a share of spending on housing that is nearer historical norms.

So, the Chicago Fed believes that the explosion of sub-prime lending is not related to loose monetary policy? They claim that "levels of spending on housing are largely explained by the wealth created by dramatic technological progress over the previous decade", an apparent reference to the tech bubble, but can't seem to connect the tech bubble to loose monetary policy either. Call me a cynic but I don't think the Chicago Fed will ever find an inflated asset that was caused by loose monetary policy.

Monday, September 11, 2006

Weekly Economic Calendar

Click on the title to get this week's economic calendar. Friday is the big day this week with several important reports, the most anticipated being CPI. Capacity Utilization and Industrial Production also come out Friday though and we think those reports actually have a greater capacity to move the market than CPI. Tomorrow we get the Trade report which we think is mostly irrelevant, Thursday brings export and import prices and retail sales. Data recently has pointed toward an economic slowdown and moderating inflation; we think that will continue this week.

Friday, September 08, 2006

More Forecasting Follies

Last month I wrote about the futility of economic forecasting. The post is here.

Now there's a new post about the same subject on TCS Daily:

The imprecision of economic forecasts isn't a comment on the forecasters' intelligence or work ethic. Rather, it demonstrates that the economy is too complex a system to be adequately captured by existing modeling techniques. The rational response to this realization is a combination of caution and humility.
Read the rest by clicking on the title of this post.

At AIM we invest such that we don't have to forecast the market or the economy. In fact, we will tell anyone who cares to listen that we cannot predict the future. Thankfully, a crystal ball is not required to be a good investor. Anyone who tells you that they can predict something as complex as the stock market or the economy is either lying or deluded.

Wednesday, September 06, 2006

Unit Labor Costs to Fuel Inflation?

The Labor Department released figures today on productivity and unit labor costs for the second quarter. Both were disapointing with productivity posting a 1.5% gain while unit labor costs were up 4.8%. Of course the two go together; lower productivity will naturally result in higher unit labor costs. Unit labor costs rose at a slower pace than the first quarter when they rose 9%, but that's small consolation for those hoping that inflation has peaked (that would include us). Of course, there's no guarantee that higher unit labor costs will result in higher inflation as companies could choose to book lower profits. However, it seems everyday that we read about some company or another raising prices. The most recent example is Caterpillar which announced yesterday that they will be raising prices in January.

In the Federal Reserve's Beige Book report (isn't that a perfect name for a report from a bunch of economists?) this afternoon there are hopeful signs:

Labor markets were mostly described as steady since the last report, with scattered labor shortages and associated upward wage pressures noted in a number of Districts, especially for workers with specialized skills. Widespread increases in the prices of energy and certain other commodities persisted since the last report, though most of these increases do not appear to have passed through to finished consumer goods.

The report also characterized the real estate markets much as we have:

Housing markets and home construction activity weakened throughout the nation, but commercial real estate and construction strengthened in most Districts....Commercial real estate markets were uniformly described as strong and, in most cases, increasingly so. Office markets showed noticeable signs of improvement in the Boston, New York, Philadelphia, Atlanta, Chicago, Minneapolis, Kansas City, Dallas and San Francisco Districts.

We have been arguing that a housing market slowdown will be at least partially offset by an increase in commercial construction. It's good to see some confirmation.

The market has responded negatively to the economic news today (or perhaps we were just due for a pullback after the August gains), but overall, we don't see much change. The Fed is still likely to sit on their hands at the September meeting.

Beige Book Report

Tuesday, September 05, 2006

Could China make Kim Jong Ill?

Ted Galen Carpenter of the Cato Institute has an op ed in the Wall Street Journal this morning that endorses the notion, long held here, that the key to North Korea is stored on China's key ring. Without Chinese support North Korea will fold like a cheap tent. China's concern is that if Kim Jong Il is taken down, there will be a flood of refugees into China. That's possible I suppose, but should be manageable if handled properly. Should we encourage China to depose the North Korean Pompadour? Sounds okay to me. Read the whole story by clicking on the title (subscription may be required).

Weekly Economic Calendar

Click on the title to look at this week's economic data calendar. Highlights are:

Wednesday we get a look at productivity and unit labor costs. If the US is going to avoid inflation, productivity must keep rising. The ISM reports it's services index as well.

Thursday brings the weekly jobless claims and Wholesale Trade numbers. We also get oil inventory numbers.

Friday's lone report is on consumer credit.

There are probably no market movers in this week's numbers although the unit labor costs numbers could prove interesting. The consensus is for a rise of 4% which seems quite high to us. That number should start to moderate as the economy slows, but so far there is no sign of it. Could this be the beginning of wage push 70s style inflation? We hope not....

Friday, September 01, 2006

Won't Get Fooled Again

There's nothing in the street
Looks any different to me
And the slogans are replaced, by-the-bye
And the party on the left
Is now the party on the right
And the beards have all grown longer overnight

From "Won't Get Fooled Again" by The Who

As most of you know by now, I consider myself a libertarian. I don't trust politicians of any party; I think they are all pretty much the same. Another thing I don't trust are government economic statistics. Our government naturally wants the economic stats to look good -- especially before an election. Here's an article at Mises Institute about how the government manipulates the inflation numbers. This article doesn't even delve into things like hedonic adjustments that further distort the numbers, but it will at least give you an idea of how they manipulate the numbers and why. Read the entire story by clicking on the title of this post.

Construction Spending Drops in July

The US Census Bureau reported today that construction spending dropped 1.2% in July from the June reading. However, spending was still 5.1% above last July so things aren't exactly falling apart. As we have stated many times, we believe construction spending will fall but with commerical building activity picking up, we don't think it will be a major drag on the economy. Here's an interesting question though -- why does the Census Bureau report construction spending? I guess they need something to do when they aren't doing census stuff every ten years.

Pending Home Sales Index Falls

Pending Home Sales Index Points To Easing Market

WASHINGTON (September 1, 2006) – Home sales should be leveling out in the months ahead at a lower pace, according to an index based on pending home sales, a leading indicator for the housing market published by the National Association of Realtors®.

The Pending Home Sales Index,* based on contracts signed in July, is down 7.0 percent to a level of 105.6 from a downwardly revised reading of 113.5 in June, and is 16.0 percent lower than July 2005.

This shouldn't be a surprise to anyone. It's been obvioius for some time now that the real estate market is slowing. We continue to believe that while real estate will slow down, it will not crater because mortgage rates are also falling and the economy continues to add jobs. We also note that while the declines seem severe, sales are falling from a very high level.

ISM Survey

Manufacturing Expanded in August, but at a Slower Pace Than July

WASHINGTON (AP) -- The nation's manufacturing sector expanded in August at a slower clip than in July amid rising commodity prices, a trade group said Friday.
The Institute for Supply Management, based in Tempe, Ariz., said its manufacturing index registered 54.5 in August, just below the 54.7 July reading. Analysts expected the index to be flat.

The ISM survey shows growth in manufacturing (and apparently increased productivity since manufacturing shed jobs last month) that was basically unchanged from July. Another report that supports the Fed view of a slowing economy. If the economic data continues to come in like this, the Fed is probably done raising rates.

Jobs Report

Employers Add 128,000 Jobs in August
WASHINGTON (AP) -- Hiring perked up in August as employers added 128,000 jobs, pulling the unemployment rate down to 4.7 percent and flashing a Labor Day weekend message of an economic expansion that still has staying power.

The jobs report was pretty much as expected. Job gains were in healthcare, food services, financial services, and mining. Losses were in retail and manufacturing. Surprisingly, construction added jobs in the month. Hourly earnings were up just 0.1% which bodes well for inflation.

Stock traders seem to like the report with the Dow up about 80 points as of this writing. The bond market is essentially unchanged. This report further reinforces the idea that the Fed has gotten it right. The economy is slowing but not falling off a cliff into recession. We think that is probably right, but further weakness would be a cause for concern.

Thursday, August 31, 2006

Economic Stats for the Day

Several economic statistics were released today. Most continue to point toward an economic slowdown and moderating inflation.

Personal income increased $60.2 billion, or 0.5 percent, and disposable personal income (DPI)
increased $63.9 billion, or 0.7 percent, in July, according to the Bureau of Economic Analysis.
Personal consumption expenditures (PCE) increased $78.7 billion, or 0.8 percent. In June, personal
income increased $60.0 billion, or 0.6 percent, DPI increased $47.8 billion, or 0.5 percent, and PCE
increased $36.6 billion, or 0.4 percent, based on revised estimates.

Personal Income and Expenditures were in line with market expectations. The inflation numbers in the report were also in line with expectations.

U.S. factory orders fall 0.6% in July
WASHINGTON (MarketWatch) - Demand for U.S.-made factory goods fell 0.6% in July on a large drop in orders for transportation goods, the Commerce Department said Thursday. Excluding the 10.1% decline in transportation orders, factory orders rose 1.1% in July, the government said. The 0.6% decline was slightly stronger than the 0.9% drop expected by economists surveyed by MarketWatch. Shipments of factory goods were unchanged in July. Factory inventories increased 0.6%, the ninth increase in the past 10 months. The inventory-to-shipments ratio rose to 1.17 from 1.16.

The ex-transportation number +1.1% was pretty good. Transportation orders (aircraft mainly) are very volatile so excluding that portion gives a better idea of activity.

U.S. Aug. Chicago PMI 57.1, close to expectations
WASHINGTON (MarketWatch) - Business activity in the Chicago region decelerated slightly, but continued to expand at a moderate pace, according to NAPM-Chicago. The Chicago purchasing managers index fell to 57.1% in August from 57.9% in July, the private group said Thursday. The decline was in line with economists' expectations, according to a survey conducted by MarketWatch. Readings over 50 indicate growth in the region. Economists use the Chicago index to gauge the August national business index to be released on Friday by the Institute for Supply Management. Economists expect the Aug. ISM factory index to hold steady at 54.7%.

The Chicago PMI was about as expected and indicates further expansion. The national ISM survey will be out tomorrow.

Overall the reports out this week have all been Fed friendly. Tomorrow we get the employment report but unless it's way out of line, don't expect much market movement in this pre-holiday week.

More Mutual Fund Scandal

NASD Charges American Funds Distributors, Inc. with Arranging $100 Million in Directed Brokerage Commissions for Top Sellers of American Funds

Washington, D.C. -- NASD has charged American Funds Distributors, Inc. (AFD) with violating NASD's Anti-Reciprocal Rule by directing approximately $100 million in brokerage commissions over a three-year period to about 50 brokerage firms that were the top sellers of American Funds. The payments were made to reward the firms for past sales and to encourage future sales of American Funds' 29 mutual funds.

AFD is the principal underwriter and distributor of American Funds, the third largest mutual fund family in the U.S. with more than $450 billion in assets and approximately 25 million shareholder accounts. The commissions were payments for executing trades for the American Funds' portfolio that were directed to the brokerage firms as additional compensation for past sales of American Funds, and to ensure that American Funds would continue to receive preferential treatment at those firms.

I wonder if the commissions charged by these brokers was competitive. We know that fund companies routinely pay higher commissions to brokers in exchange for research; it seems likely that they would be willing to pay higher commissions for sales of the funds too.

Our sole source of revenue is the fee paid by our clients. We don't have any conflicts of interest. If we buy a fund, it's because it's the best fund available.

Wednesday, August 30, 2006

Option Expensing - I told you so.....

In the previous post, I talked about the possibility that the new rules about options expensing would result in more opportunities for clever CFOs to manipulate earnings. It seems I was wrong; companies actually manipulated earnings in anticipation of option expensing:

In preparing for adopting the new rule and to lower future stock-option expense amounts reported in the income statement, some companies accelerated the vesting of employee stock options, typically those that were out of the money or "underwater." We identify 900 companies with a median market capitalization of $251 million employing this strategy. This is an increase of 151 companies with a median market capitalization of $276 million over those identified in our January 2006 report. We estimate over $8 billion of future stock-option expense has entirely vanished from future income-statement recognition as a consequence of stock-option-vesting acceleration.

In our view, for companies granting a similar dollar value of options and/or restricted stock in 2006 compared to historical amounts, there is a greater likelihood that option-vesting acceleration was used as a means to temporarily benefit reported earnings.

That's from a Bear Stearns study as reported in Barron's. Click on the title to read the entire article.

Does anyone really believe that companies won't find a way to manipulate option grants and expenses to benefit future earnings?

Option Expensing

Incentive stock options have been in the news again with the "backdating" scandal. The issue is whether various companies' executives manipulated option grants by backdating them to a time when their stock price was near a low and therefore guaranteeing themselves a profit. I haven't followed this scandal that closely because frankly, I don't see that it's a big deal. Shareholders were told the quantity and price of the option grants and if they had a problem with it, they could sell the stock. Furthermore, if the executive had something to do with the subsequent rise in the stock price, maybe he/she should be compensated through a bonus scheme. Giving the bonus in the form of a backdated option merely makes the bonus taxable as a capital gain rather than regular income. And I never have a problem with anyone paying less in taxes.

My greatest concern about options has been the accounting treatment that now requires all options to be expensed through the income statement. This change was supposed to make more obvious the true cost of the options that were being granted to top executives and was pushed by the class warriors who are concerned about CEO pay. It all smacks of envy to me, but nevertheless, the FASB (Financial Accounting Standards Board) caved in to the political pressure and decreed that all options must be expensed. Here's my problem with it; there is no way to accurately value the option at the time it is granted and forcing expensing just provides unethical executives another way to manipulate reported earnings. Furthermore, the "cost" of the options are already reflected in the balance sheet. If the options are exercised, existing shareholders will be diluted. The real problem was that investors were just too lazy to actually look at the balance sheet and all the footnotes.

Now, because of expensing, several questions arise:

1. What if the value placed on the option at the time of grant is wrong (as it is likely to be)? Will companies be forced to restate earnings from previous quarters or will there be adjustments in future quarters? Doesn't that make evaluating the company even harder than it was before expensing?
2. If the "cost" of the option is reflected in the income statement and through changes in the number shares outstanding, aren't the costs overstated?
3. What if the options are never exercised because the stock price declines? Will the companies add back the "expense" in a later quarter?
4. Since the "cost" of incentive options involves no outlay of cash, why should current earnings be penalized? Isn't it more like a future liability and therefore more properly reflected on the balance sheet?

The Wall Street Journal has an OpEd today about a group of economists and others who are pressing to end the expensing of options. The group includes Nobel Prize winners Milton Friedman and Harry Markowitz. Click on the title to read the entire story. Here's an LA Times article about the group. And here's a press release from UC Berkeley, where the position paper was published.

2Q GDP Revised Higher

WASHINGTON (AP) -- The economy grew at a 2.9 percent annual rate in the spring -- better than first estimated but nowhere near the brisk pace logged in the winter, another sign of slowing business growth. Inflation marched higher.

There's no surprise in this report. Inflation numbers were revised very slightly lower, exports revised up, inventories revised higher. Corporate profits were up 3.2% quarter to quarter but up 20.5% over the last year. This supports the Fed's view that the economy is slowing but not falling into recession. 3% growth, if inflation moderates, is exactly what the Fed wants. We'll have to wait for more data before we can determine if this continues or growth slows even more. Click on the title to read the whole story.

Tuesday, August 29, 2006

Bill Gross Likes Bonds!

Bill Gross, who manages the biggest bond portfolio on the planet, has a new commentary at PIMCO's website. Amazingly, Mr. Gross likes bonds and doesn't like stocks. Wow, a bond manager that likes bonds. Um, call me underwhelmed by Mr. Gross' pessimistic view of our economy and society.

Well, as I acknowledged at the start of this Outlook, some of us never have had it so good, but the demographic season is changing and a rebalancing, more equitable distribution of our rather meager stockpile of nuts lies ahead.

Gosh Bill, should I put some money in your fund to protect myself????? Geez, talk about self serving. Click on the title to read the rest of this depressing rant.

Fed Funds Folly

The Federal Reserve targets the Federal Funds rate in its efforts to control growth and inflation in the US economy. I have no idea why they think this will be successful as every effort at central economic planning in the history of the world has failed. How can a group of bankers and economists possibly expect to devine the demand for and proper supply of money in an economy as diverse as the US? I guess when your only tool is a hammer......Anyway, economist Paul Hoffmeister has an article in National Review Online about the futility of Fed Funds Targeting.

The evidence suggests that the recent fed funds targeting experiment has wholly failed in effectively restraining money-supply growth in relation to money demand. Attention should instead be focused on calling for the Fed to directly intervene in the open market by selling bonds to drain enough liquidity so as to cause gold to fall back to a non-inflationary level of $400 an ounce.

Click on the title to read the entire article.

Prudential to Settle on Market Timing

Prudential Financial may be close to settling charges concerning market timing of mutual funds.

NEW YORK (Reuters) - Prudential Financial Inc. (NYSE:PRU - news) may be close to a settlement with authorities that would resolve market timing investigations as early as Monday, Bloomberg News reported on Friday.

As part of the settlement expected to be announced on Monday, Prudential will pay about $600 million, according to a report on the Wall Street Journal Web site citing unnamed sources.

Under the agreement, Prudential, the second-largest life insurer in the United States, will avoid criminal prosecution the Bloomberg story said, sourcing it to people familiar with the probes.

Just another example of brokers looking out for their own interests. Click on the title to read the entire article.

Ameriprise Again

A subsidiary of Ameriprise Financial, Securities America, was hit with a $22 million arbitration award yesterday.

A securities-industry arbitration panel has awarded $22 million to a group of Exxon Mobil Corp. retirees who accused brokerage firm Securities America Inc. of improperly steering them into high-risk investments between 1996 and mid-2003.

The three-member panel of the National Association of Securities Dealers, the brokerage industry's self-policing organization, made the award Monday against Securities America, a subsidiary of Ameriprise Financial Inc.

The $22 million award includes some $11.6 million in compensatory damages, $3.5 million in punitive damages and $4.7 million in attorneys' fees, and is said by experts to be one of the largest of its kind ever levied against a brokerage firm.

Ameriprise markets itself as the broker to the boomer generation. Apparently, boomer refers to what happens to your portfolio if you decide to trust them with your retirement. Click on the title to read the entire article.

Monday, August 28, 2006

Pump and Dump

The internet has made communication simple and cheap. Unfortunately, that applies to the scammers too. This story from the Economist is about a new way to pull off an old scam - the pump and dump. The scammer buys stock in a thinly traded small company and then sends out mass emails encouraging others to buy the stock (the pump). When it rises, the scammer dumps his shares. I get these emails all the time and delete them without reading them. I suggest you do the same. Click on the title to read the whole story.

Barron's on Housing

Barron's cover article (click on the title to read the whole story) this weekend was about the homebuilders. They make the case that while housing is pretty bad right now, the stocks are very cheap and may present an opportunity. We don't have an opinion about the group as a whole, although we are investigating a few individual names that are trading at steep discounts to book value. For those who want to play the whole sector, Barclay's now has an IShare for the group. The symbol is ITB and the top ten holdings are:

Pulte Home (PHM)
Centex (CTX)
Lennar (LEN)
DR Horton (DHI)
Toll Brothers (TOL)
KB Home (KBH)
Ryland Group (RYL)
Mertiage (MTH)
Standard Pacific (SPF)

Full disclosure: AIM does not own any of these stocks, but we have one client who owns ITB.

Weekly Economic Calendar

It's another jobs week with non farm payrolls released on Friday. Here's the rest of the calendar:


Consumer Confidence for August (Last Reading)106.5 (Consensus)102.0

GDP Revision for 2Q (Initial Reading)2.5% (Consensus)3.1%
Chain Weighted Price Index for 2Q (Initial Reading)3.3% (Consensus)3.3%

Initial Jobless Claims for week of Aug 26 (Last Week)313000 (Consensus)315000
Personal Income for Jul (June)0.6% (Consensus)0.5%
Consumer Spending for Jul (June)0.4% (Consensus)0.8%
Factory Orders for Jul (June)1.2% (Consensus)-1.0%
Chicago PMI for Aug (July)57.9 (Consensus)57.0

Non Farm Payrolls for Aug (July)+113000 (Consensus)+140000
Unemployment Rate for Aug (July)4.8% (Consensus)4.7%
Michigan Sentiment for Aug (July)84.7 (Consensus)79.1
Construction Spending for Jul (June)+0.3% (Consensus)-0.1%

The releases that have the potential to move the market are probably Consumer spending and non farm payrolls. The GDP revision could have an impact if it is way out of line with expectations, but usually the consensus is pretty close on revisions.

Monday, August 21, 2006

Sarbanes Oxley

Hank Greenberg has an op-ed in the Wall Street Journal today that should be required reading for every politician in Washington.

"Three words describe the prevailing sentiment in today's business environment -- private is beautiful. Increasingly, major U.S. corporations are removing themselves from the public equities markets and going private.

Why? To a large degree, because the cost of government regulations has become unbearable. HCA, the largest hospital operator, recently announced a record $21 billion deal to take itself private. Among reasons cited by the company's founder, Thomas Frist, for departing the NYSE: the untenable cost of complying with Sarbanes-Oxley. The recent trend of major companies going (or planning to go) private -- Hertz, Toys "R" Us, Kinder Morgan, Albertson's, Univision -- is not coincidental. And that's only half the tale. While corporations are retreating from our public capital marketplace, exchanges in the rest of the world are thriving at our expense. Of the 25 largest IPOs worldwide in 2005, only one took place in the U.S. Most went to London or Hong Kong. Even Australia weighed in with three."

The costs of compliance with the various and sundry regulations, such as Sarbanes Oxley, enacted after Enron/Worldcom, etc. is so great that companies are increasingly choosing to abandon the public market. While this may be good for shareholders in the short term (reduce the supply of stock and theoretically the price should rise), it is not good for the economy in the long term. The current regulatory environment discourages risk taking and limits the availability of capital to enterpeneurs. These entrepeneurs are increasingly going abroad, where the regulatory environment is more forgiving, to raise capital. With our economy increasingly focused on services, we cannot afford to discourage companies from partaking of those services.

Read the rest....

Friday, August 18, 2006

Time for Insurance Stocks?

Living in South Florida this time of year means thinking about hurricanes; so far this year I haven't had to think about much. We've had a couple of tropical storms come near us, but nothing even close to last year. Of course, I knew we wouldn't have any storms this year; my wife spent a small fortune on hurricane supplies at the beginning of the summer and that usually ensures a quiet season.

Last year was a terrible year for storms and naturally the public expected this year to be similar. Al Gore and the global warming crowd cite last year as evidence that climate change is causing more severe weather. I don't have any expertise in climate research, but I do watch the local weather every day. I can't figure out how people can believe that climatologists have figured out what the weather will be in 50 years when they can't tell me what it will be next week. I also happen to think humans are rather insignificant in the face of Mother Nature. I don't know if the hurricane season will produce a major storm this year; there's still a long way to go in the season and I'm furiously knocking on wood right now. But I do think the odds of a major storm are less this year because of the extreme activity last year. Here's some evidence that maybe Mother Nature is still on the ball:

"Hurricanes require warm sea surface temperatures (SSTs), and last year the tropical Atlantic sea surface temperatures were running well above normal. Global warming was the explanation given by most 'experts' the media interviewed. And since global warming will only get worse, those SSTs were expected to just keep on increasing.

But now those same regions that had anomalously warm SSTs last year are -- gasp! -- near normal.....

This is not the only surprisingly cool SST story. A new scientific article now accepted for publication in Geophysical Research Letters shows that the globally averaged upper ocean cooled dramatically between 2003 and 2005, effectively erasing 20% of the warming that occurred over the previous 48 years!

The rapidity of this observed temperature change is beyond what computerized climate models can explain. This is perplexing for modelers, who tend to believe that their models contain all of the important physics of the problem."

Read the rest via TCS

So why, you might ask, is this post on an investment advisor's blog? Well, maybe it's time to consider the insurance sector. Since I don't buy that many individual stocks, I looked for an ETF that invests in insurance stocks. Our friends at Barclay's have one:

Dow Jones U.S. Insurance Index Fund (IAK)

The iShares Dow Jones U.S. Insurance Index Fund seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the Dow Jones U.S. Select Insurance Index.

This fund has 44% in property/casualty stocks, P/E of about 15, expense ratio of 0.48%. The only drawback is that 23% of the fund is in one stock, AIG.

Powershares has an insurance portfolio as well:

Symbol is PIC, P/E of about 12, expense ratio of 0.60%. It doesn't break down the portfolio into property/casualty insurers, but it is more diversified; the largest position is LNC (Lincoln National) at 5.43%. The Powershares portfolio is also one of the new fundamental indexes that is intended to outperform the more traditional capitalization weighted indexes.

Alhambra has not taken a position in either of these funds -- yet. We may or may not; it's just something we are considering at the moment. If we actually start buying, we'll let our blog readers know.

Friday, August 11, 2006

WSJ Economic Forecasting Survey

The Wall Street Journal conducts polls of economists on a monthly basis. These polls give us an idea what the consensus is about future economic data. Do they provide any useful information? If forecasting accuracy is the measuring stick, then I think they come up a little short.

The graphs above show the average GDP growth forecasts of the survey vs the actual GDP growth results and the average forecast for future GDP growth. As you can see, the forecasts and results appear to be almost random. Should we care what they are forecating in the future?

Here's another example from the CPI (inflation) forecasts:

Again, it doesn't appear that the average forecasts provide us with any useful information. The consensus on these things almost always turns out to be wrong and yet the market moves, sometimes violently, when these numbers are reported to be above or below consensus. Why?

The more interesting information in these surveys, in my opinion, is in the extremes. What is the highest and lowest forecasts for these various data points?

The highest estimate of Q3 GDP growth in the survey is 4.2%. The lowest estimate is 1.5%. The likelihood that the number falls somewhere between those two numbers is probably pretty high. Based on past results, it seems unlikely that the number will fall near the average. So, the trick it seems to me is to try and determine which extreme is more likely and which would be a greater surprise. Why? Because that's what would produce the greatest move in the market. So, what would be the greatest surprise right now?

The Fed is expecting, and I believe that market participants are expecting, the economy to slow. The Fed's hope is that slower growth will produce lower inflation and mitigate the need for further rate hikes. Based on recent market action, it appears that market participants are worried that the Fed has been too successful in their campaign to slow the economy. They are worried about recession. Since the market is already worried about that, it is being discounted. Therefore, the biggest market moving event would be if growth came in near the highest forecast rather than the lowest.

There is useful information in these surveys, it's just not what the WSJ is reporting. The averages are useless except to determine what is least likely. The extremes provide more useful, actionable information.

Thursday, August 10, 2006

Fed Policy and Commodity Prices

In an article for NRO, Thomas Nugent claims that the Federal Reserve uses a price rule to determine the course of the Federal Funds rate. This means that, as Nugent puts it "the Fed will supposedly track the price of a basket of commodities as a benchmark for inflation, and when the price of this benchmark moves above a certain level, the Fed will raise the fed funds rate (the price of money) until commodity prices move back within the target range."

He then goes on to claim that he did a study once upon a time that proved the Fed was indeed doing exactly this.

"In 1989, in an article for Laffer Associates (“The Price Rule Vindicated”), I tracked the implementation of the price rule relative to a proxy for the Fed’s benchmark, the Dow Jones Spot Commodity index, from 1982 through 1989. My conclusion was indeed that the Fed was conducting monetary policy using a price rule."

I think maybe Mr. Nugent needs to update his data because commodity prices have been anything but stable over the last several years. The Fed may have been using a price rule back in the 80s, but sometime over the last decade or so, it has been abandoned in favor of the Chairman Knows Best rule. Unfortunately, that rule seems a bit more flexible.

You can read the rest of Mr. Nugent's ode to central banks article here.

Abusive Mutual Fund Sales Practices

One of the reasons I decided to open Alhambra is that I was fed up with being associated with the brokerage industry. The brokerage industry has a long history of abusing their clients, usually in ways the average investor doesn't even understand. I know many fine individuals in the brokerage industry, but as a whole, it seems to be run by people that are ethically challenged to say the least. Here's another example:

"Regulators took a series of new steps in their efforts against abusive mutual-fund sales practices, as they wind down a crackdown on brokerage firms that allegedly collect special payments to promote favored funds.

Yesterday, the National Association of Securities Dealers said it fined four broker-dealers affiliated with ING America Insurance Holdings Inc., a unit of ING Groep NV, $7 million for taking brokerage commissions from mutual-fund complexes in return for preferential treatment of their funds."

To put this in terms everyone can understand, these firms demanded and received kickbacks, in addition to the regular commisssions they collected, to promote particular mutual funds. The kickbacks were either in the form of brokerage commissions paid by the mutual funds or direct cash payments. The effect was to raise the expense ratios of the funds to the detriment of fund shareholders. The brokerage firms had reason to push these funds on unsuspecting clients regardless of whether they were appropriate or the best funds available. These brokerage firms put their interests ahead of their clients.

Lest you think this is just one small brokerage firms doing this, consider this:

"The penalty was part of a series of actions NASD has taken in recent years to end directed brokerage. In April, it fined American General Securities Inc., a unit of American International Group Inc., $1.1 million, for allegedly engaging in the practice.

Other sanctioned firms include Ameriprise Financial Inc., then known as American Express Financial Advisors; Lord Abbett Distributor LLC; AllianceBernstein Investment Research & Management Inc.; Wells Fargo & Co. affiliate Wells Fargo Investments; and SunAmerica Securities Inc., another subsidiary of AIG that is now called AIG Financial Advisors.

A 2003 action against Morgan Stanley by the NASD and the Securities and Exchange Commission was one of the higher-profile cases in the broader campaign. The firm paid $50 million to resolve the actions by the two agencies."

"It was pretty widespread, in this particular area, but most of the firms, if not all, have gotten this message," said James Shorris, head of enforcement at the NASD. "We're not opening new investigations into directed brokerage, at least not at the rate that we were a few years ago."

Mr. Shorris added that directed brokerage and market-timing cases -- in which firms traded in and out of mutual funds rapidly, letting them benefit from market-moving news and arbitrage when most shareholders didn't -- "seem to be winding down." Still, he said, "the mutual-fund area is still giving rise to other kinds of cases."

Read the entire story...