The Big Picture | Psychology/Sentiment

Confessions of a Short Seller

Saturday, May 17, 2008 | 09:43 AM

in Psychology/Sentiment | Short Selling | Trading | Valuation

Nice Interview with my pal Doug Kass, the "anti-Cramer" in this week's Barron's, called "
Confessions of a Short Seller."

Doug runs a short only fund, Seabreeze Partners. He discusses a few key datapoints from the interview:

• As of April 30, flagship Seabreeze Partners Short fund was up 16.5% (vs 5.6% loss for the SPX)

• Since inception (January 2005) the fund is up 40.7%, versus a 15% gain for the S&P

• The amount of trading dollars that are in dedicated short pools are tiny: About $5.4 billion (Knowledge@Wharton). That's one-seventh the size of Fidelity's Magellan Fund.

• The $5.4B dedicated short hedge funds are a sliver of the nearly $2 trillion of hedge-fund assets.

• Over the past two decades, 58% of the issues on the New York Stock Exchange have advanced, while 42% have declined -- every year.

Here's an excerpt from the Interview:

What makes short selling so difficult to do effectively over a long period?

The objectives of a long buyer and a short seller are similar. Both want to produce uncommon returns by taking common risk -- typically by developing a variant view. Many believe short selling is a mug's game, but I don't, and thus far our results at Seabreeze have supported our opinion. But it is essential to maintain a disciplined short-selling strategy because, remember, risk and reward are asymmetric in selling stocks short. An investor can make only 100% if correct -- that is, if the stock sold short goes to zero. But you can lose an infinite amount if you're wrong as the stock keeps appreciating. And there is a gravitational pull of stocks higher over longer periods of time. So we use a very conservative approach to shorting.

Explain it, please.

First, we're diversified across company and industry lines. No individual security exceeds 2.5% of our partnership's assets and no industry sector exceeds 20% of the assets. We'll have 35 to 40 holdings at any given time. Second, "Wee Willie" Keeler, a .341 lifetime hitter who played in the early part of the 20th century, liked to say he "tried to hit 'em where they ain't." We try to do the same by being creative in our stock-selection process.

In what ways are you creative?

We strenuously avoid stocks whose short interest is high relative to the float, or companies whose shares have large short positions relative to their average daily trading volumes. Many short sellers have made the mistake of shorting valuation and have blown up during short squeezes. Avoiding them allows us to sleep at night and allows time for our negative fundamental catalysts to develop.

We also mitigate risk by avoiding leverage [borrowing to enhance the size of a position]. Historically, short sellers have taken concentrated positions, often in companies with small to medium capitalizations, and then used -- and abused -- leverage. That's a recipe for disaster, particularly when they select investments with too many shorts. The average market capitalization of our holdings is more than $10 billion. Shorting large-caps is another way to control risk.

Interesting stuff . . .

Source:
Confessions of a Short Seller
Interview With Douglas A. Kass, President, Seabreeze Partners Management
LAWRENCE C. STRAUSS
Barron's May 19, 2008
http://online.barrons.com/article/SB121097996687000019.html

Only 5% of Wall Street Recommendations Are "SELLS"

Friday, May 16, 2008 | 09:00 AM

in Investing | Psychology/Sentiment | Valuation

Here's a fascinating data point:

Only 5% of the fundamental research of the brokerage firms is a sell. That's up from 2% in the 1990s. Despite having paid $1.4 billion to settle the analyst/banking scandals of the 1990s and early 2000s, Wall Street is still disproportionately afraid of the word "Sell."

That's rather low, when you consider how many stocks underperform their respective indices each year.

There's a small sign of a potential change in this attitude: Merrill Lynch: "Starting in June, Merrill will require that its analysts assign “underperform” ratings to 1 out of every 5 stocks they cover. About 12 percent fall into that category now."

NYT excerpt:

"The bank [Merrill] analyzed stock performance over a decade and determined that from 1997 through 2007, on average, 37 percent of stocks in the MSCI world index and 40 percent of stocks in the Standard and Poor’s 500-stock index declined each year. The bank covers about 75 percent of the stocks in those indexes.

Under its new system, analysts cannot assign “buy” ratings to more than 70 percent of stocks they cover, “neutral” to more than 30 percent and “underperform” to less than 20 percent. (An underperform rating suggests the analyst believes the stock will either fall within 12 months or will rise less than competing companies with higher ratings.)

But some in the financial industry say it may be too late for research departments at Merrill or other investment banks to reclaim the credibility and prestige they lost after the technology stock bust. Hedge funds, which account for up to 75 percent of trading on some markets, conduct much of their own research and often pay twice the going rate on the Street for analysts. Many banks, by contrast, have cut research budgets." (emphasis added)

40% of the SPX? wow, that's higher than I would have guessed.

It would be a interesting to see a longer data run -- more than the 1997-2007 period, as it contained the bubble and crash period.

Also, I'd be curious to see how many stocks underperform, in terms of their marketcap as well as their trade weighted volume percentage on the NYSE and the Nasdaq.

Source:
Merrill Tries to Temper the Pollyannas in Its Ranks
JENNY ANDERSON and VIKAS BAJAJ
NYT, May 15, 2008
http://www.nytimes.com/2008/05/15/business/15place.html

Policy Shift: Can the Fed Identify & Pop Asset Bubbles?

Thursday, May 15, 2008 | 06:45 AM

in Commodities | Federal Reserve | Markets | Psychology/Sentiment | Trading

Interesting discussion in the FT Wednesday about a potential major shift in Fed philosophy: Maybe its a bad idea for Central Banks to passively wait for bubbles to pop.

I am not sure if the Fed will shift away from the Greenspan doctrine: "Inflate Bubbles & Clean Up he Mes After." Will the change be to something less disruptive, or will they throttle the growth side of the equation? That's the risk.

Perhaps one idea worth exploring might be not to not blow these bubbles in the first place.

Here's an excerpt from the FT:

"The US Federal Reserve is reconsidering the way it deals with asset price bubbles in the wake of the housing and credit bust, in a move that could see the central bank using regulation - or even interest rates - to fight unjustified increases.

Top officials are re-examining the Alan Greenspan doctrine that central banks should not try to tackle asset bubbles and should focus on mitigating the fallout when they burst.

They are open to the possibility that the Fed may have to adopt a different strategy in future. However, they have not reached any conclusions and could end up reaffirming their traditional hands-off stance . . .

The Fed has long stood out among central banks as the least willing to embrace the idea that it should "lean against the wind" when asset prices are rising rapidly. Former chairman Mr Greenspan famously argued that it was in practice impossible to identify bubbles before they burst, and attempts to prick them by raising rates were likely to do more harm than good."

Greenspan has claimed its impossible to identify bubbles in real time; Ben Bernanke has been more contemplative on the subject. He's said its "difficult" to know for sure when we are n a bubble.

Chairman, let me suggest a few data points worth considering:

• Standard Price Deviations: Is the asset class trading 2 to 3 standard deviations away from its traditional price metrics?

• Inventory: Is there a huge inventory build? Bubbles create the incentive to produce a whole lot more, be it Miami condos or dot com companies.

• Fundamentals: Has something shifted in the fundamental supply/demand equation that is impacting pricers, or is it pure speculation?

• Regulatory Changes: Has the government altered some part of the equation that might have changed the game somewhat?

There are others, but these are a good beginning.

Note that the inventory metric is why I have doubted commodities are a bubble; also I have long claimed that we did not have a national Housing bubble, but instead had a lending & credit bubble -- a subtle but important distinction.

By the same metrics, I agree with I agree Stuart Hoffman, chief economist of PNC Financial, who notes that the enormous volume of new condos in Miami in inventory are just that proof of a local bubble (I agree).

UPDATE: May 16, 2008 5:42am

WSJ:

First came the tech-stock bubble. Then there were bubbles in housing and credit. Chinese stocks took off like a rocket. Now, as prices soar on every material from oil to corn, some suggest there's a bubble in commodities.

But how and why do bubbles form? Economists traditionally haven't offered much insight. From World War II till the mid-1990s, there weren't many U.S. investing manias for them to look at. The study of bubbles was left to economic historians sifting through musty records of 17th-century Dutch tulip-bulb prices and the like.

The dot-com boom began to change that. "You were seeing live, in action, the unfolding of lots of examples of valuations disconnecting from fundamentals," says Princeton economist Harrison Hong. Now, the study of financial bubbles is hot.

Marketwatch:

Fed should deflate some bubbles, Mishkin says

The Federal Reserve should try to aggressively deflate some types of asset bubbles before they can harm the economy, Fed Gov. Frederic Mishkin said Thursday.

But raising interest rates isn't the way to prick a bubble, he said. And some types of bubbles, such as the dot-com bubble of the late 1990s, probably shouldn't be pricked at all, he said.

On the other hand, the housing bubble of this decade was the type of bubble that should have been targeted with closer supervision and tighter regulation to prevent widespread economic damage, Mishkin said.

The Fed should watch for bubbles that are associated with a fast expansion of credit, he said, because these bubbles have the potential to inflate bank balance sheets on the way up and destroy them on the way down.

Sources:
Fed looks at ways to fight asset bubbles
Krishna Guha
FT, Tuesday May 13 2008 18:05
http://us.ft.com/ftgateway/superpage.ft?news_id=fto051320081916203957

Bernanke's Bubble Laboratory
Princeton Protégés of Fed Chief Study the Economics of Manias
JUSTIN LAHART
WSJ, May 16, 2008; Page A1
http://online.wsj.com/article/SB121089412378097011.html

Fed should deflate some bubbles, Mishkin says
Monetary policy ineffective, but supervision can break harmful feedback loops
Rex Nutting
MarketWatch, 7:04 p.m. EDT May 15, 2008
http://tinyurl.com/4wk673

The NonGuidebook Version of What to Do (and Not Do) in NYC

Wednesday, May 14, 2008 | 10:00 AM

in Consumer Spending | Currency | Psychology/Sentiment

Its that time of year: New York City is flooded with tourists. Thanks to the weak American Peso, the place is just thick with 'em.

There are lots of standard guides you might find helpful to use (i.e., NYC Guide for Tourists), but they are primarily designed for that gullible visitor, the double decker riding, Hawaiian shirt wearing, one born every minute visitor -- the Rube.

That's not you. You are much hipper than that. You want to be in the know, plugged in, well connected. Well, ya came to the right place. I'm going to give you the straight dope, the inside info that the guidebooks don't tell you about. This is real insider trading, "Blue Horse Shoe Loves Anacot Steel" type stuff that people go to jail for. Not you or me, but people. Some people. Mostly tourists.

Anyway, instead of relying on a Fodors or Let's Go NYC, consider these suggestions from a born and bred Nu Yawkah (I even got dah aksent dat gos wit da place). A Brooklyn born guy who works in finance and has worked in NYC most of his Adult life, this guy knows a thing or two about Gotham.

These suggestions will help make your stay in the city enjoyable and safe. It well help you get the most out of your visit here. As an added bonus, I get to keep all of you birkenstocked, rucksack wearing, slow walking, camera snapping touristas out from underfoot of us locals.

Enjoy.

~~~

A New Yorker's Guide for Tourists: 20 Ways to Make Your Stay in New York City More Enjoyable

1. DO NOT DRESS ALIKE. This is for your safety, as well as for the benefit of the typical New Yorker's highly refined aesthetic sense. At all costs, avoid wearing identical matching outfits. Worse than looking like hicks from the sticks, you will look like a group of out-of-towners begging to be mugged.

I don't mean literally mugged by a criminal element, but rather, robbed by unscrupulous taxi drivers and retail merchants alike. They will spot you as a rube, and be all too happy take advantage of your apparent naivete to lighten your wallets.

You might as well carry a sign that says "Rob Me!" -- and they will.

The corollary to this is to avoid festooning every item of clothing you have on with "New York, NYC, or Yankees" logos -- No one is THAT big of a fan -- for the same reason as above.

~~~

2. BATHROOMS: Here's the thing: There just aren't many public bathrooms in NYC.

Why? Its a long story, which I don't have time to go into, but there just aren't that many. Plan accordingly.

Your best bets are as follows:

Department stores
Starbucks
Barnes & Noble/Borders Bookstores
Restaurants
Hotels

The nicest public toilet in the city is Bryant Park at 42nd Street between 5/6. Sometimes there is a wait.

For those of you who have real, um, reallygottagonow issues, its best that you plan ahead. Get a copy of Where to Go: A Guide to Manhattan's Toilets. Thats right, the NYC toilet situation is so absurd that someone wrote a book about it.

On the plus side, the Rainbow Room and the Grand Havana Club have some of the nicest bathrooms I've ever been in -- floor to ceiling windows, right next to the urinals!

~~~

3. Tipping: The city has a service-based economy, and tipping is encouraged/demanded/insisted upon.

Some basic suggestions: 15% of the bill for "Fair" service, 20% for "Good" service. This applies to waiters, waiteresses, bartenders, cab drivers, call girls, etc. Note that you can easily ballpark 15% by doubling the tax (~16%). Chamber maids should get $5 per day.

Leaving a 5-10% tip is considered a complaint -- but stiffing (leaving nothing) is not perceived as a complaint, but as a sign of cheapness/cluelessness.

Note that for large parties (6 or more) some restaurants automatically add the tip to the bill, so double check that bill (don't double tip).

~~~

4. See a LIVE TV Show: This requires some advanced planning, usually 6 months to a year ahead of time. I suggest Late Show with David Letterman, The Daily Show, The Colbert Report, Late Night with Conan O'Brien, and Saturday Night Live (email SNL TIckets).

If you did not plan in advance for this year, no worries: Just diary this for next December or January to order tickets for Summer 2009.

Imagine where the US Dollar will be then -- we'll practically be paying you to come here!

~~~

5. Do a bunch of local New York things: Hang out in Central Park, Explore Brooklyn, wear black, enjoy the free WiFi in Bryant Park (use the bathroom there -- nice). Attend a lecture at the 92nd ST Y, go to Chinatown in Queens. Buy junk at a street fair, and eat street meat (don't ask). Have a cigar at the Grand Havana Room (members only). Catch an author speak at a Barnes & Noble (use the bathroom while you are there).

Spend a weekend at Fire Island or the Hamptons (make arrangements first). Go to a designer sample sale. Do the NYT crossword puzzle on mass transit. Jog around the reservoir in Central Park. Go to a Woody Allen retrospective. See the Mets at Shea.

The ultimate New Yorker activity? Buy the Sunday NY Times late Saturday night; skim it, then lounge around early Sunday morning, with the paper -- and a pot of strong coffee -- in bed Sunday morning. Heavenly!

~~~

6. iPod walking guides

Continue reading "The NonGuidebook Version of What to Do (and Not Do) in NYC"

Positive Thinking vs Skepticism in the Markets

Wednesday, May 14, 2008 | 06:25 AM

in Credit | Investing | Markets | Psychology/Sentiment

Today we have an an interesting guest commentary from Jack McHugh.

I found it thought provoking, and thought you would too. Call it The Power of Positive Thinking, Market Edition.

"It makes sense to approach life with a positive frame of mind. Positive thinking lightens the load at work, makes the goals in life feel easier to achieve, and allows both friends & family to more often enjoy your company. Even family pets know the difference between a smile and a scowl.

But when it comes to investing, I've always tried to be a little more demanding, even skeptical. As a result, some may mistake the tone or subject matter of these commentaries as more properly belonging to a sourpuss of the Doubting Thomas school of economic thought than to one who looks forward to each and every day. I humbly disagree, and as evidence I offer up more than just my usually sunny disposition: I always maintain net long positions in my personal portfolio (hedged to various degrees, yes, but always net long).

These scribblings are mostly about risk management, and as such, I will always be on the lookout for the next problem, the dangers which may not be clear and present, and the events which can otherwise harm the returns of investors -- especially those trusting souls who believe in things like the "Greenspan/Bernanke put". I subscribe to the adage: "Be trustworthy to all and optimistic in all your dealings, excepting those of a financial nature."

The trusting and the skeptical have been doing battle all year, and the stark contrast offered by the market action on Friday and today are only the latest examples. That AIG has sprung a second and massive leak of red ink in as many quarters (which prompted its former Chairman to claim the company is "in crisis" -- see below) was the news that sat so poorly with Mr. Market on Friday. Today looked like it would fare little better when Fed Ex announced yet another shortfall over the weekend and MBIA served up another loss this morning (also below). Market participants would have none of it, and after an opening dip, they powered stocks higher almost all day. Not even a prediction from one of their heroes, Jamie Dimon, that the "recession is just starting" could deter the optimists, nor could a pronouncement from the Carlyle Group that "enormous bank losses" still have yet to be recognized (see below). The rally came, saw, and conquered because of the final quartet of news items you see posted below. HSBC reported lower write-downs than had been feared, Apple announced it was running out of I-Phones, and it was revealed that HPQ has an amorous interest in EDS. It also helped that some retailers posted better than expected results, causing many to think a recession won't visit these shores (see these charts).

These " it's all about the future" thoughts are nicely summed up by the following quotation:

Continue reading "Positive Thinking vs Skepticism in the Markets"

WSJ: Fed's Stern Says U.S. Recession likely

Tuesday, May 13, 2008 | 07:30 PM

in Credit | Federal Reserve | Psychology/Sentiment

Q: Do you think we’re going to avoid a recession?

A: No.

But there are recessions and then there recessions. The previous two were short, and the most recent one was not only short but shallow. I think that’s what really matters to people. The average resident doesn’t distinguish between whether the economy is growing half a percent or one and a half percent. That’s not their interest. It’s more, how does this feel? Are conditions generally improving noticeably or aren’t they?

>

Wow, that's a pretty explicit admission from Gary Stern, president of the Federal Reserve Bank of Minneapolis. Stern is the co-author of “Too Big To Fail: The Hazards of Bank Bailouts.”

Stern suggested in an interview that the U."S. economy may face “subdued” performance for the next two quarters, with output that’s barely positive or barely negative."

You know, kinda like the last 2 quarters of 0.6% GDP.

I disagree with his assessment of the current environment being "similar to the early 1990s when “headwinds,” a phrase then Federal Reserve Chairman Alan Greenspan used to refer to the lenders’ reluctance to lend, weighed on the economy."

The rest of the interview can be found on the WSJ's Real Time Economic: Stern: Credit ‘Headwinds’ to Weigh on Economy Beyond 2008

Source:
Stern: Credit ‘Headwinds’ to Weigh on Economy Beyond 2008
Real Time Economics, May 13, 2008, 3:23 pm
http://blogs.wsj.com/economics/2008/05/13/stern-credit-headwinds-to-weigh-on-economy-beyond-2008/?mod=WSJBlog#comments

Markets: As Good With Elections As They Are With The Economy

Tuesday, May 13, 2008 | 02:30 PM

in Markets | Politics | Psychology/Sentiment

>

"What you're doing is collecting bits and pieces of information and aggregating it so we can watch it and understand what people know. People picked this up and called it the 'wisdom of crowds' and other things, but a lot of that is just hype."

-California Institute of Technology economist Charles Plott
>

Interesting piece in the WSJ on prediction markets and politics, Traders' Calls Just as Bad On Elections. (I may have mentioned something about this in the past).

"John McCain's presidential campaign is doomed -- at least, if you still believe what political futures markets indicate. At the Irish electronic exchange Intrade, on which people bet on election outcomes and other events, the futures market suggests Mr. McCain has a 38% chance of becoming the 44th president. In the Iowa Electronic Markets, set up at the University of Iowa, Mr. McCain's Republican Party gets a 41% chance of winning the popular vote for the White House.

Then again, six months ago, the Iowa markets gave Barack Obama less than a 30% chance of winning the Democratic nomination. Academic studies suggest these markets are more reliable than opinion polls, but that might be giving the markets too much credit.

Intrade futures had John Kerry beating President Bush well into the evening of Election Day 2004. They also said there was a good chance Mr. Obama would top Hillary Clinton in January's New Hampshire primary, which she won."

The article details many of my favorite quibbles: thinly traded, plagued by bad information, skewed participation, bubbles, head-fakes and manipulation.

What did it reflect when all those people bought all those Hillary Clinton and Rudy Giuliani presidential futures when each was a front runner? Somehow, the phrase "Wisdom of Crowds" just doesn't seem to capture the full essence of that . . .

Previously:
Iowa and Prediction Markets, January 24, 2004 http://bigpicture.typepad.com/comments/2004/01/iowa_and_predec.html

Why Prediction Markets Fail January 11, 2008 http://bigpicture.typepad.com/comments/2008/01/prediction-mark.html

Misunderstanding Prediction Market Failures February 14, 2007 http://bigpicture.typepad.com/comments/2007/02/misunderstandin.html

Source:
Traders' Calls Just as Bad On Elections
MARK GONGLOFF
WSJ, May 13, 2008; Page C1
http://online.wsj.com/article/SB121063385437486555.html

Inflation Ex-Inflation Ex-Inflation

Tuesday, May 13, 2008 | 06:55 AM

in Data Analysis | Inflation | Psychology/Sentiment

I stumbled across a data point yesterday that was quite fascinating: The percentage of food and health care in the Consumer Price Index.

It turns out that Inflation may be even worse that I previously thought.

According to Mark Faber (via Bill Fleckenstein), food and health care are significantly under-weighted in the CPI. That's based on the actual consumption of food and health care by real (as opposed to theoretically modeled) people.

Faber notes that:

"In the U.S. counts food as only 8% of the CPI index. Whereas, it counts for about 10% in the United Kingdom, about 15% in the rest of Europe and more than 18% in Japan."

~~I have yet to validate it that percentage, but if it turns out to be true,~~ we have Inflation (as reported) on top of the misleading hedonic/substitution adjustments (ex-inflation) on a disproportionate spending pie (ex-inflation X 2). UPDATE: Food at home is 7.66% of the CPI according to the BLS (Thanks, Mike)

Hence, doubly understated Inflation. Unless you go Core, which is the original Inflation Ex-Inflation.

Now here's where things get really interesting. Fleck points out that if you consider the proportion of U.S. household spending on food by income quintile, all but the top 20% of earners spend at least 20% of their paychecks on food.

Hence, what the weighting versus the reality are very different. This means that for 80% of the country's populace, the CPI weightings are dramatically understates what the average American is experiencing in terms of their inflation versus the official CPI measure.

This goes a long way to explaining the difference between the official inflation data and the generally poor consumer sentiment data.

CPI data is Wednesday, with a consensus of 0.3%.

NYT Interactive Inflation Chart

Previously:
Is Inflation Really Understated? (No!) May 08, 2008 http://bigpicture.typepad.com/comments/2008/05/inflation-infla.html

Inflation Abounds April 29, 2008
http://bigpicture.typepad.com/comments/2008/04/inflation-aboun.html

Is the Fed Causing a Global Food Crisis? April 25, 2008
http://bigpicture.typepad.com/comments/2008/04/is-the-fed-caus.html

Source:
Why all roads lead to inflation
Bill Fleckenstein
Contrarian Chronicles
MSN Money, 5/12/2008 12:01 AM ET
http://articles.moneycentral.msn.com/Investing/ContrarianChronicles/WhyAllRoadsLeadToInflation.aspx

Cognitive Surplus, Part II

Sunday, May 11, 2008 | 07:00 PM

in Psychology/Sentiment | Video

A few weeks ago, we discussed the Clay Shirky's concept of cognitive surplus.

Here's the original video of that discussion:

Quote of the Day: On a Great Danger Approaching

Friday, May 09, 2008 | 03:00 PM

in Psychology/Sentiment

Today's quote is from a clever commenter in our W/H discussion last week:

"With the enemy's approach to Moscow, the Moscovites' view of their situation did not grow more serious but on the contrary became even more frivolous, as always happens with people who see a great danger approaching.

At the approach of danger there are always two voices that speak with equal power in the human soul: one very reasonably tells a man to consider the nature of the danger and the means of escaping it; the other, still more reasonably, says that it is too depressing and painful to think of the danger, since it is not in man's power to foresee everything and avert the general course of events, and it is therefore better to disregard what is painful till it comes, and to think about what is pleasant."

--Leo Tolstoy, "War and Peace"

Oil Bubble?

Friday, May 09, 2008 | 10:51 AM

My friend Paul points to this report by Factset, titled: An oil bubble to rival the internet boom.

The difficulty with the bubble moniker is determining exactly how much of the price is being driven by purely speculative factors. With Crude, a variety of forces are driving prices: A combination of both fundamentals (increasing demand, constrained supply, pipeline problems), technicals (Trend, money flow, etc.), along with the geopolitics of two Middle East wars -- as well as some speculation.

Additionally, we have seen the general perception of commodities shift, where they are now seen as a more legitimate asset class for portfolio managers, along with Equities, Fixed Income, REITs, cash, etc. than it has been previously.

Even If I disagree with the bubble thesis, I love any report festooned with lovely charts, and this one is no different:

Source:
An oil bubble to rival the internet boom (PDF)
FactSet, 3 May 2008
http://www.factset.com/websitefiles/PDFs/outlook/english/03-05-2008english.pdf

What's Next for Crude Oil ?

Friday, May 09, 2008 | 06:39 AM

in Commodities | Contrary Indicators | Energy | Psychology/Sentiment | Technical Analysis

>
"The commodity looks like it has legs, which is trader talk for its going higher. While I do not make a habit of forecasting commodity prices, $110, and then $125 are our next two targets.

I got your core inflation right here . . ."

>

That was our March 3rd quote on energy prices.

As Bloomberg reported this morning, Crude was $125; As I write this, CNBC is flashing that Crude is over $126 a barrel.

We have been Bullish on Oil and energy stocks for a long time. Our first recommendation of Crude Oil was back in 2003, when the price broke out over $32 per barrel. I picked Energy as my favorite sector for the Business Week forecasts for 2004 -- something that more than a few people ridiculed at the time.

In 2004, we observed our target of Oil = $50 a Barrel was hit. I also explained why at $40-50 there was no “terror” premium (comments picked up by WSJ, Barrons, and Slate).

Early on, we recognized that it was Chinese Oil Demand underlying the increase in cost. We also looked at why Refining Capacity was a problem. We have examined Global Crude Oil Demand & Gasoline, we looked at Oil: Inflation adjusted.

We looked at whether Oil Jitters Gotten Overblown?. That answer was no. We also looked at the question: Do Higher Oil Prices Lead to Recessions? Turns out the answer is yes. Large Hedge Funds who had been ignoring our bullish energy advice did so at their own peril.

So where does that leave us in 2008?

Well, we have political considerations with the US presidential elections, upcoming Summer Olympics in China, an ongoing war or 3 in the Middle East, and of course, a weak dollar (which is now in a counter-trend rally).

Let me offer one last way to think about Energy: Its relative strength versus precious metals.

As the dollar has strengthened, precious metals have gone south. Yet Crude oil has continued upwards, implying that this is more than a mere currency story.

Dennis Gartman writes:

"All things being equal, if one were to hear that crude would be $2/barrel higher and then were asked how much stronger gold would be, one would answer, swiftly and with confidence, "Oh, at least $5-$10/ounce." Wrong!! Gold's down $6/oz, sending the gold/crude ratio to new lows for the past several years. At the current levels, it now takes 7.06 barrels of crude to "buy" one ounce of gold. 15;1 is rather more "normal."

Have a look at this ratio in a 3 year chart:

graph via Stockcharts

I'll see if I can find produce a longer term chart of the ratio above -- it might be revealing.

~~~

Its funny, but I got a lot of grief over an $86 forecast several years ago -- but $125 was pretty easily accepted. That implies a major change in psychology is taking place.

More on this in the coming weeks . . .

Sources:
The Gartman Letter
Dennis Gartman,
Thursday, May 8, 2008
http://thegartmanletter.com/

Crude Oil Rises to Record Near $125 a Barrel on Supply Concern
Grant Smith and Christian Schmollinger
Bloomberg, May 9, 2008
http://www.bloomberg.com/apps/news?pid=20601087&sid=auqhuZnpEFFE&

Is Inflation Really Understated? (No!)

Thursday, May 08, 2008 | 11:20 AM

in Financial Press | Inflation | Psychology/Sentiment

Yesterday, I wrote: "David Leonhardt's NYT columns are oftentimes insightful and illuminating. Unfortunately, today's column is not one of those times . . ." I promised readers (and David) an explanation. Consider this it.

First off, I interpreted Leonhardt's column as really two distinct issues -- one psychological, one statistical. He got the first one right, but muffed the second.

The psychological concepts of recency effect and salience were dead on. Gasoline is the only consumer product that has 6 foot tall prices on street corners and highways. We see gas prices more readily than we do many other items. So the visibility -- Salience -- is very high. Additionally, drivers tank up every week or more. You cannot help but see and feel the prices more acutely than other items.

The same is true for food prices. You see supermarket prices more readily than many other items, shop for them more regularly. When a restaurant menu has to use stickers to update new menu prices -- they change too rapidly too print new menus each time -- you notice it.

The Psychology of inflation is a genuine factor in how people feel. On these issues, the column correctly described the angst behind frequent purchases.

Perhaps it is a matter of emphasis, but I thought the column's tone and content failed to adequately address other realities of price changes in the US.

Let's look at these explicitly. Consider the following realities:

- Education, Health Care, Housing, Insurance, Property Taxes are not as visible as food or energy. However, they have all risen tremendously in price;

- David mentions that Prices were flat in the 1980 -- but that followed a huge spike in the preceding decade, the inflationary 1970s. That points to the impact of the Fed more than anything else. In the 1970s -- and the early 2000s -- the Fed dropped rates, allowing more inflation than is comfortable.

- Prices do not necessarily rise smoothly; they seem to sawtooth, rise abruptly, stay the same for a period, rise abruptly again. When this huge run in commodities ends -- as all bull markets eventually do -- would it surprise you to see prices flat for 2 decades?

- Even with the recent pullback in Housing, prices remain significantly elevated; By many traditional metrics (i.e., median incomes to median home prices) Houses are cheaper than they were in 2005/06, but much more expensive than prior years.

- Owner's Equivalent Rent (OER) -- the BLS method of accounting for housing expenses -- is flawed, but not quite in the way the column suggested. First off, it fails to account for increases in utility costs, property tax increases, and rising maintenance expenses. Additionally, while OER understated inflation when housing prices were rising -- due to the falling rental market -- it may not be overstating them on the way down. Why? The excess inventory of homes for sales have become rental units, and in many markets is depressing rental prices. (UPDATE: See Tim Duy: Misunderstanding the CPI for more on this).

- Core Absurdity: The idea of eliminating "Volatility" by ignoring prices in food and energy is ridiculous. If one wants to smooth the data or pull out price fluctuations, you should use a moving average. For example, as Oil ran from $20 to $120, the concentration on the Core didn't reduce volatility, it instead eliminated a huge source of Inflation.

- The same is true for the doubling and tripling of food prices over recent years.

- Speaking of food, the BLS concept of Substitution is more nonsense. When Steak goes up in price, and consumers choose chop meat instead, that does not mean there was no inflation -- it means you have been price out of steak. (No mention of that in the column)

- Also omitted: Hedonics -- quality adjustments -- which have claimed that falling prices are deflationary. See our prior discussion: Technology Adoption Lifecycle as to why they are not (go to #3).

- If hedonic quality improvement is anti-inflationary, what about corresponding drops in quality? The low, low price retailers sell cheap clothing, but subjectively speaking, the quality has been decreasing rapidly. Where's the Hedonic adjustment for that?

- Sometimes, skepticism is deserved. Each of the major BLS changes in CPI data have resulted in a significant shift downwards in price reporting:

Courtesy of San Diego Union Tribune

>

Lastly, as to the conspiracy theories, I have my own take on it: The government doesn't respect you enough to lie. They actually put out all of the official statistics reach month for anyone with the time and interest to plow through them. All of these data runs, adjustments, changes to CPI, historical data -- its all online, waiting for you to review it, and be mollified or outraged.

Most people don't bother . . .

Sources:

Seeing Inflation Only in the Prices That Go Up
DAVID LEONHARDT
NYT, May 7, 2008
http://www.nytimes.com/2008/05/07/business/07leonhardt.html

The Fed's inflation gauge isn't realistic, critics say
Dean Calbreath
San Diego UNION-TRIBUNE, April 17, 2008 http://www.signonsandiego.com/news/business/20080417-9999-1n17inflate.html

Previously:
GDP, Inflation & Recession
http://bigpicture.typepad.com/comments/2008/04/gdp-inflation-r.html

Is the Fed Causing a Global Food Crisis?
http://bigpicture.typepad.com/comments/2008/04/is-the-fed-caus.html

Inflating Our Way Into Recession
http://bigpicture.typepad.com/comments/2008/02/inflating-our-w.html

Disconnect

Tuesday, May 06, 2008 | 07:04 AM

in Credit | Finance | Markets | Psychology/Sentiment

Today, we are going to go to Bill King, a long time observer of the stock markets. Bill writes the daily “Independent View of the News”, for institutional clients (you can contact him here).

This morning, he wryly observes:

"Despite the braying about the credit crisis being over, the economy about to rebound and stocks entering a new bull market, the fundamentals not only remain crappy, they are worsening.

Months ago, Goldman’s CFO said there was a historic disconnect between the stock market and the credit market. But that’s not the entire story. There is also a historic disconnect between L’Affaire Bear and the credit markets and the economy.

Because the US financial system did not implode when Bear was rescued, people assume all is well in the credit markets and financial system. This is a gross miscalculation. The Fed proved this last Friday when it expanded its record credit-creation gimmicks and loosed collateral standards to a new all-time low.

Bloomberg: The Federal Reserve said the proportion of U.S. banks making it tougher for companies and consumers to borrow approached a record in the past three months as the credit crunch deepened. A net 70 percent of banks increased loan rates over their cost of funds for commercial and industrial borrowing, according to the central bank's quarterly survey of senior loan officers released today in Washington. That compares with 45 percent in the January survey, the Fed said.

As we stated several missives ago, there is no way the US economy, which has never been more dependent on debt to generate GDP, can flourish without an enormous amount of debt creation. If debt is now being curtailed or rationed, there can be only one direction for the US economy.

Morgan Stanley economist Richard Brenner: DISCONNECT - The economic fallout begins: Financial turmoil peaked six weeks ago, but the economic downturn is only beginning. It’s still a recession, in our view, and that’s no longer in the price. Indeed, reflecting higher energy quotes and slipping growth abroad, we see weaker US growth over the next few quarters than we did a month ago

The Times of London: After the crunch, a crisis in banking confidence Credit risk – that of borrowers not repaying loans – was cited as the next-biggest risk after liquidity. Consumer indebtedness was also a worry. A senior banker in an American bank said: “Consumers are in worse shape than most observers appreciate … their failure rate will look like a tsunami to those lollygagging on the financial beaches.”

Bill adds a pretty astute trading call each day: Example:

Today – Traders will play for a Turnaround Tuesday to the upside. But S&Ps must hold 1400; oil and commodity must behave and FNM (-.64 exp) cannot issue a disturbing report…There is no economic news or impact events to worry about.

Great stuff -- thanks Bill.

Sources:
The King Report
M. Ramsey King Securities, Inc.
Bill King
Tuesday May 6, 2008 – Issue 3869
http://www.mramseyking.com/index.html

Fed Survey Shows More U.S. Banks Tighten Loan Terms
Scott Lanman
Bloomberg, May 5 2008
http://www.bloomberg.com/apps/news?pid=20601087&sid=a45nIbT1eKLo&

After the crunch, a crisis in banking confidence
Patrick Hosking
Times Online, May 6, 2008
http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article3876856.ece

Raiding the 401(k)

Monday, May 05, 2008 | 05:30 PM

in Economy | Investing | Markets | Psychology/Sentiment

Wow, I found this shocking:

"Borrowing from retirement plans is surging.

At the end of last year, 18% of workers had loans outstanding from their plans, up from 11% in 2006, according to a survey of 2,011 full-time employees released in February by the Transamerica Center for Retirement Studies, a nonprofit corporation funded by Aegon NV's Transamerica Life Insurance Co.

With home prices falling nationwide, the loans may be a sign that cash-strapped consumers are raiding their nest eggs to stay afloat, no longer able to tap their houses for cash and up against their credit-card limits . . .

Last year, 52% of workers with annual incomes of $50,000 to $100,000 said they planned to rely primarily on 401(k) plans and IRAs to pay for living expenses in retirement, up from 46% in 2006, according to the Transamerica survey. The percentage counting on Social Security also increased, to 19% from 13%, while those counting on a company-funded pension plan dropped to 11% from 18%."

Sounds bullish to me . . .

Source:
Raiding the 401(k) Nest Egg
JENNIFER LEVITZ
WSJ, May 5, 2008; Page R1
http://online.wsj.com/article/SB120994246231866045.html

Huge Project in the Works!

Sunday, May 04, 2008 | 04:15 PM

in Corporate Management | M&A | Politics | Psychology/Sentiment

I have been out of pocket a lot this week at meetings -- I just inked the deal on a huge new project. Details will be forthcoming soon, but I am very jazzed about it.

Hint: It involves Bear Stearns . . .

Barron's Panic Euphoria Model

Thursday, May 01, 2008 | 07:30 PM

in Markets | Psychology/Sentiment

We have previously looked at the Smith Barney Panic / Euphoria gauge that runs in Barron's each week, wondering about its make up. A commenter asked earlier today about this, so I pulled an old chart along with the latest version.

What was the basis of the supposed deep panic in May 2005:

May 15 2005

Here we are in May 2008, and we are now racing thru neutral and heading towards Euporhia.

April 28, 2008

Any thoughts on this? What say ye?

Previously:
The Storm Before the Rally? (May 2005)
http://online.barrons.com/article/SB111602789595333463.html

AAii Sentiment Data

Thursday, May 01, 2008 | 12:06 PM

in Psychology/Sentiment

Peter Boockvar writes:

A measure of stock market sentiment out today is at levels similar to last October when the major indices hit record highs.

The American Assoc of Individual Investors weekly data today has Bulls at 53.3% and Bears at 26.3%. The high in Oct was 54.7% in the Bulls and 25.4% in the Bears.

The caveat with this # is that individual investors are very fickle and thus this data is all over the place week to week and is much more volatile than the weekly Investors Intelligence data.

I don't track this survey regularly -- I prefer either trade based measures (Put/call ratio, fund manager cash on hand), but I also do not dismiss surveys totally.

Anyone have any long term experience with this survey series?

Jittery

Wednesday, April 30, 2008 | 04:15 PM

in Federal Reserve | Psychology/Sentiment

Amusing:

Bear Markets Seduce Investors

Tuesday, April 29, 2008 | 07:22 AM

in Markets | Psychology/Sentiment | Technical Analysis |