Wednesday, March 23, 2011

March 21st 2011 Stock Market Recap with Coal Chart

Not much volatility nor volume today left the market right where it left off yesterday. This is a good sign for bulls and with some further consolidation we could easily see another 2-3% push higher.

For me I am keeping a highly pruned watchlist and monitoring it closely. On the NASDAQ if we see a decent move through 2700 I will definitely consider putting some cash to work on the long side.

Also tonight I have a chart of the Market Vectors Coal ETF, KOL. With some further consolidation it may be ready to make a break higher which would be good for coal stocks such as WLT, ACI, BTU, ARLP, ANR, ICO, and PCX.

Trend Table
Trend Nasdaq S&P 500 Russell 2000
Long-Term Up Up Up
Intermediate Down Down Down
Short-term Down Up Down

(+) Indicates an upward reclassification today
(-) Indicates a downward reclassification today
Lat Indicates a Lateral trend

*** I’m simply using the indices’ relations to their 200, 50 and 10-day moving averages to tell me the long, intermediate and short-term trends, respectively.

Jay Taylor: Turning Hard Times Into Good times


The Case for a Massive Price Deflation in the Midst of Quantitative Easing


click here for audio hour #1 hour #2 hour #3

Silver ETF Ready to Break to New Highs SLV is picking up buyers again

iShares Silver Trust (NYSE: SLV) — At the beginning of January, I cautioned, “Precious metals have led most other groups with SLV advancing almost 70% in four months. The uptrend line is now so steep that it will be difficult to maintain, and a penetration on profit-taking is to be expected.”

At that time, I recommended that traders who owned this exchange-traded fund (ETF) sell at least part of their position due to the “strong likelihood of a correction.”

SLV was at about $29 then, but instead of pulling back, it launched to a new high at over $36. Now at $35.30, it is picking up buyers again, and last year’s relationship of a bearish dollar versus bullish precious metals appears to be gaining momentum.

It is time to buy silver again with the expectation that it will break to a new high with a trading objective of $40-plus.

Trade of the Day - SLV Chart

Dollar Multi-year Flag/Pennant Pattern Ending?

Today technical analyst Chris Kimble suggests we keep an eye on the Dollar.

Chris comments: The action in the Dollar since 2008 has created a series of lower highs and higher lows, resulting in a large flag/pennant pattern.

Of late investors are attempting to break the bottom of this pattern, by pushing prices below a 3-year support line.

It would be natural for the Dollar to rally some from here, testing the underside of the new resistance line.

Watch the price action on an underside test. Should it happen, it will be key to the next big move in the dollar.

CAUGHT ON TAPE: Former SEIU Official Reveals Secret Plan To Destroy JP Morgan, Crash The Stock Market, And Redistribute Wealth In America

A former official of one of the country's most-powerful unions, SEIU, has a secret plan to "destabilize" the country.

The plan is designed to destroy JP Morgan, nuke the stock market, and weaken Wall Street's grip on power, thus creating the conditions necessary for a redistribution of wealth and a change in government.

The former SEIU official, Stephen Lerner, spoke in a closed session at a Pace University forum last weekend.

The Blaze procured what appears to be a tape of Lerner's remarks. Many Americans will undoubtely sympathize with and support them. Still, the "destabilization" plan is startling in its specificity, especially coming so close on the heels of the financial crisis.

Lerner said that unions and community organizations are, for all intents and purposes, dead. The only way to achieve their goals, therefore--the redistribution of wealth and the return of "$17 trillion" stolen from the middle class by Wall Street--is to "destabilize the country."

Lerner's plan is to organize a mass, coordinated "strike" on mortgage, student loan, and local government debt payments--thus bringing the banks to the edge of insolvency and forcing them to renegotiate the terms of the loans. This destabilization and turmoil, Lerner hopes, will also crash the stock market, isolating the banking class and allowing for a transfer of power.

Lerner's plan starts by attacking JP Morgan Chase in early May, with demonstrations on Wall Street, protests at the annual shareholder meeting, and then calls for a coordinated mortgage strike.

Lerner also says explicitly that, although the attack will benefit labor unions, it cannot be seen as being organized by them. It must therefore be run by community organizations.

Lerner was ousted from SEIU last November, reportedly for spending millions of the union's dollars trying to pursue a plan like the one he details here. It is not clear what, if any, power and influence he currently wields. His main message--that Wall Street won the financial crisis, that inequality in this country is hitting record levels, and that there appears to be no other way to stop the trend--will almost certainly resonate.

A transcript of Lerner's full reported remarks is below, courtesy of The Blaze. We have heard the tape, but we have not independently verified that the voice is Lerner's. You can listen to the tape here.

Here are the key remarks:

Unions are almost dead. We cannot survive doing what we do but the simple fact of the matter is community organizations are almost dead also. And if you think about what we need to do it may give us some direction which is essentially what the folks that are in charge - the big banks and everything - what they want is stability.

There are actually extraordinary things we could do right now to start to destabilize the folks that are in power and start to rebuild a movement.

For example, 10% of homeowners are underwater right their home they are paying more for it then its worth 10% of those people are in strategic default, meaning they are refusing to pay but they are staying in their home that's totally spontaneous they figured out it takes a year to kick me out of my home because foreclosure is backed up

If you could double that number you would you could put banks at the edge of insolvency again.

Students have a trillion dollar debt

We have an entire economy that is built on debt and banks so the question would be what would happen if we organized homeowners in mass to do a mortgage strike if we get half a million people to agree it would literally cause a new finical crisis for the banks not for us we would be doing quite well we wouldn't be paying anything...

We have to think much more creatively. The key thing... What does the other side fear the most - they fear disruption. They fear uncertainty. Every article about Europe says in they rioted in Greece the markets went down

The folks that control this country care about one thing how the stock market goes what the bond market does how the bonuses goes. We have a very simple strategy:

  • How do we bring down the stock market
  • How do we bring down their bonuses
  • How do we interfere with there ability to be rich...

So a bunch of us around the country think who would be a really good company to hate we decided that would be JP Morgan Chase and so we are going to roll out over the next couple of months what would hopefully be an exciting campaign about JP Morgan Chase that is really about challenge the power of Wall Street.

And so what we are looking at is the first week in May can we get enough people together starting now to really have an week of action in New York I don't want to give any details because I don't know if there are any police agents in the room.

The goal would be that we will roll out of New York the first week of May. We will connect three ideas

  • that we are not broke there is plenty of money
  • they have the money - we need to get it back
  • and that they are using Bloomberg and other people in government as the vehicle to try and destroy us


And so we need to take on those folks at the same time. And that we will start here we are going to look at a week of civil disobedience - direct action all over the city. Then roll into the JP Morgan shareholder meeting which they moved out of New York because I guess they were afraid because of Columbus.

There is going to be a ten state mobilization to try and shut down that meeting and then looking at bank shareholder meetings around the country and try and create some moments like Madison except where we are on offense instead of defense

Where we have brave and heroic battles challenging the power of the giant corporations. We hope to inspire a much bigger movement about redistributing wealth and power in the country and that labor can’t do itself that community groups can’t do themselves but maybe we can work something new and different that can be brave enough and daring and nimble enough to do that kind of thing.

FULL TRANSCRIPT FROM THE BLAZE

SPEAKER: Stephen Lerner. Speaker at the Left Forum 2011 "Towards a Politics of Solidarity" Pace University March 19, 2011

Speaker Bio: Stephen Lerner is the architect of the SEIU's groundbreaking Justice for Janitors campaign. He led the union's banking and finance campaign and has partnered with unions and groups in Europe, South American and elsewhere in campaigns to hold financial institutions accountable. As director of the union's private equity project, he launched a long campaign to expose the over-leveraged feeding frenzy of private equity firms during the boom years that led to the ensuing economic disaster.

TRANSCRIPT:

It feels to me after a long time of being on defense that something is starting to turn in the world and we just have to decide if we are on defense or offense

Maybe there is a different way to look at some of theses questions it’s hard for me to think about any part of organizing without thinking what just happened with this economic crisis and what it means

I don't know how to have a discussion about labor and community if we don't first say what do we need to do at this time in history what is the strategy that gives us some chance of winning because I spent my life time as a union organizer justice for janitors a lot of things

It seems we are at a moment where the world is going to get much much worse or much much better

Unions are almost dead we cannot survive doing what we do but the simple fact of the matter is community organizations are almost dead also and if you think about what we need to do it may give us some direction which is essentially what the folks that are in charge - the big banks and everything - what they want is stability

Every time there is a crisis in the world they say, well, the markets are stable.

What's changed in America is the economy doing well has nothing to do with the rest of us

They figured out that they don't need us to be rich they can do very well in a global market without us so what does this have to do with community and labor organizing more.

We need to figure out in a much more through direct action more concrete way how we are really trying to disrupt and create uncertainty for capital for how corporations operate

The thing about a boom and bust economy is it is actually incredibly fragile.

There are actually extraordinary things we could do right now to start to destabilize the folks that are in power and start to rebuild a movement.

For example, 10% of homeowners are underwater right their home they are paying more for it then its worth 10% of those people are in strategic default, meaning they are refusing to pay but they are staying in their home that's totally spontaneous they figured out it takes a year to kick me out of my home because foreclosure is backed up

If you could double that number you would you could put banks at the edge of insolvency again.

Students have a trillion dollar debt

We have an entire economy that is built on debt and banks so the question would be what would happen if we organized homeowners in mass to do a mortgage strike if we get half a million people to agree it would literally cause a new finical crisis for the banks not for us we would be doing quite well we wouldn't be paying anything.

Government is being strangled by debt

The four things we could do that could really upset wall street

One is if city and state and other government entities demanded to renegotiate their debt
and you might say why would the banks ever do it - because city and counties could say we won’t do business with you in the future if you won’t renegotiate the debt now

So we could leverage the power we have of government and say two things we won’t do business with you JP Morgan Chase anymore unless you do two things: you reduce the price of our interest and second you rewrite the mortgages for everybody in the communities

We could make them do that

The second thing is there is a whole question in Europe about students’ rates in debt structure. What would happen if students said we are not going to pay. It’s a trillion dollars. Think about republicans screaming about debt a trillion dollars in student debt

There is a third thing we can think about what if public employee unions instead of just being on the defensive put on the collective bargaining table when they negotiate they say we demand as a condition of negotiation that the government renegotiate - it’s crazy that you’re paying too much interest to your buddies the bankers it’s a strike issue - we will strike unless you force the banks to renegotiate/

Then if you add on top of that if we really thought about moving the kind of disruption in Madison but moving that to Wall Street and moving that to other cities around the country

We basically said you stole seventeen trillion dollars - you've improvised us and we are going to make it impossible for you to operate

Labor can’t lead this right now so if labor can’t lead but we are a critical part of it we do have money we have millions of members who are furious

But I don't think this kind of movement can happen unless community groups and other activists take the lead.

If we really believe that we are in a transformative stage of what's happening in capitalism

Then we need to confront this in a serious way and develop really ability to put a boot in the wheel then we have to think not about labor and community alliances we have to think about how together we are building something that really has the capacity to disrupt how the system operates

We need to think about a whole new way of thinking about this not as a partnership but building something new.

We have to think much more creatively. The key thing... What does the other side fear the most - they fear disruption. They fear uncertainty. Every article about Europe says in they rioted in Greece the markets went down

The folks that control this country care about one thing how the stock market goes what the bond market does how the bonuses goes. We have a very simple strategy:

  • How do we bring down the stock market
  • How do we bring down their bonuses
  • How do we interfere with there ability to be rich


And that means we have to politically isolate them, economically isolate them and disrupt them

It’s not all theory i’ll do a pitch.

So a bunch of us around the country think who would be a really good company to hate we decided that would be JP Morgan Chase and so we are going to roll out over the next couple of months what would hopefully be an exciting campaign about JP Morgan Chase that is really about challenge the power of Wall Street.

And so what we are looking at is the first week in May can we get enough people together starting now to really have an week of action in New York I don't want to give any details because I don't know if there are any police agents in the room.

The goal would be that we will roll out of New York the first week of May. We will connect three ideas

  • that we are not broke there is plenty of money
  • they have the money - we need to get it back
  • and that they are using Bloomberg and other people in government as the vehicle to try and destroy us


And so we need to take on those folks at the same time

and that we will start here we are going to look at a week of civil disobedience - direct action all over the city
then roll into the JP Morgan shareholder meeting which they moved out of New York because I guess they were afraid because of Columbus.

There is going to be a ten state mobilization it try and shut down that meeting and then looking at bank shareholder meetings around the country and try and create some moments like Madison except where we are on offense instead of defense

Where we have brave and heroic battles challenging the power of the giant corporations. We hope to inspire a much bigger movement about redistributing wealth and power in the country and that labor can’t do itself that community groups can’t do themselves but maybe we can work something new and different that can be brave enough and daring and nimble enough to do that kind of thing.

Listen to the tape here >

BEWARE OF THE COMING MARGIN COMPRESSION

Stocks are allegedly cheap now, at 15.7 times 2010 earnings. And they are cheap by historical standards. Only 10 years ago, their price/earnings ratios were double today’s; they are even cheaper if you compare their forward (2011) earnings yield of 7.3% to the 10-year Treasury yield of 3.40%. They are cheap, cheap, cheap!

Or so we’ve been told.

Unfortunately, the cheapness argument falls on its face once we realize that pretax profit margins are hovering close to an all-time high of 13.3% (the all-time high was 13.9% in 2007), almost 58% above their average of 8.4% since 1980. Once profit margins revert to their historical mean, the “E” in the P/E equation will decline. If the market made no price change in response, its P/E would rise from 15.7 to 24.9 times trailing earnings.

Many disagree that profit-margin reversion will take place. Here are their most common arguments, and some food for thought on why this supposed common sense doesn’t translate to sensible logic.

Who said that margins have to revert to a mean; why can’t they just remain high?

“Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.” – Jeremy Grantham

Profit margins revert to the mean not because they pay tribute to mean-reversion gods, but because the free market works. As the economy expands, companies start earning above-average profits. The competition reacts to fat margins like bees sensing sugar water. They want some, so they fly in and start cutting into these above-average margins.

What about the billions of dollars U.S. companies poured into technology – weren’t they supposed to make their operations more efficient and bring higher profit margins?

Those billions of dollars did not go to waste; companies are more productive now than ever before. Efficiency gains stemming from productivity were a source of competitive advantage and higher margins when access to proprietary technology was a competitive advantage. For example, Wal-Mart’s rise in the retail industry was achieved through a very efficient inventory-management and distribution system that passed cost savings to consumers and drove less-efficient competitors out of business.

Today, however, that same – or even better – technology is available off-the-shelf to retailers like Dollar Tree and Family Dollar, whose outlets are about the same size as a couple of Wal-Mart restrooms put together. Oracle or SAP will gladly sell state-of-the-art distribution/inventory software systems to any company able to spell its name correctly on a check. Increased productivity didn’t and won’t bring permanently higher margins to corporate America – the consumer is the primary beneficiary of lower prices. If profit margins didn’t respond as they do, Wal-Mart’s net margins would be 25% today, not 3.5%.

Over the past 70 years, growth in corporate earnings and GDP haven’t differed significantly. On the other hand, there has been a permanent benefit from increased operating efficiency: It lets companies hold less inventory and adjust more quickly and precisely to changes in demand. This has led to less volatile GDP.

Shouldn’t average profit margins be higher now, as the U.S. economy has transitioned from an industrial (low-margin) economy to a service (higher-margin) economy?

It is not as much of a change as we might think. In 1980, services represented about 51.3% of GDP. After 30 years and a lot of changes like outsourcing, services have increased to 65.3% of GDP. If we assume that the service sector has double the margins of the industrial sector (a fairly conservative assumption), increases in the service sector should have boosted overall corporate margins by about 40 to 80 basis points above their 30-year average – to between 8.8% and 9.2%, but still far below today’s 13.3% margin. Thus, if we adjust corporate margins to reflect the transformation toward a service economy, corporate profit margins are still 45% above their long-term mean.

Shouldn’t globalization allow U.S. companies to increase margins?

A larger portion of U.S. companies’ profits is coming from overseas than ever before. However, globalization is a double-edged sword – U.S. companies are expanding and will continue to expand overseas and capitalize on new opportunities. But as the world flattens, they also face new competition at home and abroad. For example, Motorola – a company that used to represent American might in the telecommunications arena – has been marginalized in the U.S. and around the world by companies whose names we didn’t recognize 15 years ago – Finland’s Nokia and South Korea’s Samsung. (It’s very interesting how much the smartphone industry has changed in three years: Apple, a company I did not even mention in my 2008 article, has transformed the industry. Motorola, which was almost dead then, is coming back to life. Nokia is becoming irrelevant very quickly, and LG and HTC are important players.)

Although Wal-Mart is rapidly expanding overseas, it will soon face a new breed of competition. U.K. retail giant Tesco recently entered the American market (Cisco Systems has been successful in Asia, but its home turf has been attacked by the Chinese company Huawei.) U.S. companies may get a larger portion of their earnings from overseas (the weak dollar will help), but they’ll have to fight to defend home turf.

International expansion doesn’t guarantee fatter margins; quite the opposite: We are facing competition from countries such as Korea and China that may be more concerned with increasing market share, even at the expense of short-term profitability.

Higher oil prices are here to stay, so maybe multiyear higher margins in the energy sector are here to stay as well.

This would be the case if energy companies sold their products to customers in another galaxy where somebody else bore all the costs of high-energy prices. Petroleum products are consumed by corporations and individuals. The benefits of higher profit margins to the energy sector are achieved at the expense of lower margins for companies that consume their products – which is the rest of the corporate world, to varying degrees.

Today’s stock valuations are a lot higher than it appears if you normalize earnings to lower profit margins. And while it’s hard to tell when earnings will embark on a fateful journey to their historic mean, competitive forces will make that happen sooner than later. Earnings will either decline or grow at much slower pace than GDP.

Companies that don’t have a sustainable competitive advantage will not be able to keep their competition at bay, and will face margin compression, along with lower earnings growth or declining earnings. Look at your portfolio: Can the companies whose margins are hitting all-time highs sustain them?

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email, click here or read his articles here. .

P.S.

Robust (above-average) earnings growth from the depth of a recession creates a false appearance, usually reflected in forward earnings estimates, that earnings can and will grow at a faster rate than the economy for a long period of time – but they don’t (see chart below, the growth of $1 of earnings and GDP from 1950 to 2010). For earnings to grow at much higher rate than the economy (GDP) for a long time, profit margins have to keep expanding, and as I’ve discussed in the past, capitalism (i.e. competition) doesn’t allow that to happen.

The Seven Immutable Laws of Investing, by John Mauldin

I am in London this morning, just a few miles (in theory) from the writer of this week’s Outside the Box. James Montier, now with GMO, is one of my favorite analysts. I read everything he writes, and my only complaint is that he does not write enough. Today he offers us his thoughts on what he calls the “7 Immutable Laws of Investing.”

Co-hosting Squawk Box for two hours this morning with Geoff and Steve was fun. They took the time to have some thoughtful conversations on a wide variety of topics, as well as have some fun. Malta, Milan, and Zug/Zurich, and then back home. Book launch party in a few hours, so let’s just jump into James’s work.

Your wondering what time it is analyst,

John Mauldin, Editor
Outside the Box

The Seven Immutable Laws of Investing

by James Montier

In my previous missive I concluded that investors should stay true to the principles that have always guided (and should always guide) sensible investment, but I left readers hanging as to what I believe those principles might actually be. So, now, for the moment of truth, I present a set of principles that together form what I call The Seven Immutable Laws of Investing.

They are as follows:

  1. Always insist on a margin of safety
  2. This time is never different
  3. Be patient and wait for the fat pitch
  4. Be contrarian
  5. Risk is the permanent loss of capital, never a number
  6. Be leery of leverage
  7. Never invest in something you don’t understand

So let’s briefly examine each of them, and highlight any areas where investors’ current behavior violates one (or more) of the laws.

1. Always Insist on a Margin of Safety

Valuation is the closest thing to the law of gravity that we have in finance. It is the primary determinant of long-term returns. However, the objective of investment (in general) is not to buy at fair value, but to purchase with a margin of safety. This reflects that any estimate of fair value is just that: an estimate, not a precise figure, so the margin of safety provides a much-needed cushion against errors and misfortunes.

When investors violate Law 1 by investing with no margin of safety, they risk the prospect of the permanent impairment of capital. I’ve been waiting a decade to use Exhibit 1. It shows the performance of a $100 investment split equally among a list of stocks that Fortune Magazine put together in August 2000.

For the article, they used this lead: “Admit it, you still have nightmares about the ones that got away. The Microsofts, the Ciscos, the Intels. They're the top holdings in your ultimate ‘coulda, woulda, shoulda’ portfolio. Oh, what might have been, you tell yourself, had you ignored all the naysayers back in 1990 and plopped a modest $5,000 into, say, both Dell and EMC and then closed your eyes for the next ten years. That's $8.4 million you didn't make.

“Now, hold on a minute. This is no time for mea culpas. Okay, so you didn't buy the fastest growers of the past decade. Get over it. This is a new era – a new millennium, in fact – and the time for licking old wounds has passed. Indeed, the importance of stocks like Dell and EMC is no longer their potential as investments (which, though still lofty, is unlikely to compare with the previous decade's run). It's in their ability to teach us some valuable lessons about investing from here on out.”

Rather than sticking with these “has been” stocks, Fortune put together a list of ten stocks that they described as “Ten Stocks to Last the Decade” – a buy and forget portfolio. Well, had you bought the portfolio, you almost certainly would wish that you could forget about it. The ten stocks were Nokia, Nortel, Enron, Oracle, Broadcom, Viacom, Univision, Schwab, Morgan Stanley, and Genentech. The average P/E at purchase for this basket was well into triple figures. If you had invested $100 in an equally weighted portfolio of these stocks, 10 years later you would have had just $30 left! That, dear reader, is the permanent impairment of capital, which can result when you invest with no margin of safety.

Exhibit 1: Fortune Magazine’s Ten Stocks to Last the Decade

Exhibit 1

The securities identified above represent a selection of securities identified by GMO and are for informational purposes only. These specific securities are selected for presentation by GMO based on their underlying characteristics and are not selected solely on the basis of their investment performance. These securities are not necessarily representative of the securities purchased, sold or reco mmended for advisory clients, and it should not be assumed that the investment in the securities identified will be profitable. Source: Bloomberg, Datastream, GMO As of 6/30/10

Today it appears that no asset class offers a margin of safety. Cast your eyes over GMO’s current 7-Year Asset Class Forecast (Exhibit 2). On our data, nothing is even at fair value, so from an absolute perspective all asset classes are expensive! U.S. large cap equities are offering you a close to zero real return for the pleasure of parking your money in them. Small cap valuations indicate an even worse return. Even emerging market and high quality stocks don’t look cheap on an absolute basis; they are simply the best relative places to hide.

These projections are reinforced for equities when we investigate the number of stocks able to pass a deep value screen designed by Ben Graham. In order to pass this screen, stocks are required to have an earnings yield of twice the AAA bond yield, a dividend yield of at least two-thirds of the AAA bond yield, and total debt less then two-thirds of the tangible book value. I’ve added one extra criterion, which is that the stocks passing must have a Graham and Dodd P/E of less than 16.5x. As a cursory glance at Exhibit 3 reveals, there are very few deep value opportunities in global markets currently.

Bonds or cash often offer reasonable opportunities when equities look expensive but, thanks to the Fed’s policy of manipulated asset prices, these look expensive too.

Exhibit 2: GMO 7-Year Asset Class Return Forecasts* as of January 31, 2011

Exhibit 2

* The chart represents real return forecasts1 for several asset classes. These forecasts are forward-looking statements based upon the reasonable beliefs of GMO and are not a guarantee of future performance. Actual results may differ materially from the forecasts above. 1 Long-term inflation assumption: 2.5% per year. Source: GMO

Exhibit 3: % of Stocks Passing Graham’s Deep Value Screen

Exhibit 3

* With additional criterion that stocks have a Graham and Dodd P/E of less than 16.5x. Source: GMO As of 3/29/10

In order to assess the margin of safety on bonds, we need a valuation framework. I’ve always thought that, in essence, bond valuation is a rather simple process (at least at one level). I generally view bonds as having three components: the real yield, expected inflation, and an inflation risk premium.

The real yield can either be measured in the market via inflation-linked bonds, or an estimate of equilibrium (or normal) real yield can be used. The TIPS market currently offers a real yield of 1% for 10-year paper. Rather than use this, I’ve chosen to impose a “normal” real yield of around 1.5%.

To gauge expected inflation we can use surveys. For instance, the First Quarter 2011 Survey of Professional Forecasters2 shows an expected inflation rate of just below 2.5% annually over the next decade. Other surveys show little variation.

The use of surveys of forecasts might seem a little at odds with my previously expressed disdain for forecasts. But because history has taught me that the economists will be wrong on their inflation estimates, I insist on including the final element of the bond valuation: the inflation (or term) risk premium. Estimates of this risk premium range, but I suggest it should be between 50-100 bps. Given the uncertainty surrounding the use and impact of quantitative easing, I would further suggest a figure closer to the upper range of that band currently.

Adding these inputs together gives a “fair value” of somewhere between 4.5-5%. The current 3.5% yield on U.S. 10- year bonds falls a long way short of offering investors even a minimal margin of safety.

Of course, the bond bulls and economic pessimists will retort that the market is just waking up to the impending reality that the U.S. is set to follow Japan’s experience and spend a decade or two mired in a deflationary swamp. They may be correct, but we can assess the probability that the market is placing on this scenario.

In constructing a simple scenario valuation, let’s assume three possible states of the world (a gross simplification, but convenient). In the “normal” state of the world, bond yields sit close to their fair value at, say, 5%. Under a “Japanese” outcome, the yield would drop to 1%, and in a situation where the Fed loses control and inflation returns, yields rise to 7.5% (roughly speaking, a 5% inflation rate).

If we adopt an agnostic approach and say that we know nothing, then we could assign a 50% probability to the normal outcome, and 25% to each of the tails. This scenario would generate an expected yield of very close to 4.5%. We can tinker around with the probabilities in order to generate something close to the market’s current pricing. In essence, this reveals that the market is implying a 50% probability that the U.S. turns into Japan.

This seems an extremely lopsided implied probability. There are certainly similarities between the U.S. and Japan (e.g., zombie banks), but there are marked differences as well (e.g., the speed and scale of policy response, demographics). A 50% probability seems excessively confident to me.

Exhibit 4: Bond Scenario Valuation

Exhibit 4

Source: GMO

Our concerns about the overvaluation of bonds have implications for both our portfolios and for relative valuation. Obviously, you won’t find much fixed income exposure in our current asset allocation portfolios given the valuation case laid out above.

One of the “arguments” for owning equities that we regularly encounter is the idea that one should hold equities because bonds are so unattractive. I’ve described this as the ugly stepsisters’ problem because it is akin to being presented with two ugly stepsisters and being forced to date one of them. Not a choice many would relish. Personally, I’d rather wait for Cinderella to come along.

Of course, the argument to buy stocks because bonds are appalling is really just a version of the so-called Fed Model. This approach is flawed at just about every turn. It fails at the level of theoretical soundness as it compares real assets with nominal assets. It fails empirically as it simply doesn’t work when attempting to predict long-run returns (never an appealing trait in a model). Moreover, proponents of the Fed Model often fail to remember that a relative valuation approach is a spread position. That is to say that if the Model says equities are cheap relative to bonds, it doesn’t imply that one should buy equities outright, but rather that one should short bonds and go long equities. So the Model could well be saying that bonds are expensive rather than that equities are cheap! The Fed Model doesn’t work and should remain on the ash heap.

Exhibit 5: What Relationship Between Bonds and Equities?

Exhibit 5

Source: GMO As of 1/12/11

Relative valuation holds little appeal to me and even less so when I consider that neither bonds nor equities are even vaguely stable assets. In general, when valuing an asset you want a stable anchor by which to assess the scale of the investment opportunities. For instance, one of the reasons that the Graham and Dodd P/E (current price over 10-year average earnings) works well as a valuation indicator is the slow, stable growth of 10-year earnings. In contrast, the bond market was happy to extrapolate the briefest peak of inflation to over 30 years in the early 1980s, and similarly was willing to extrapolate the deflationary risks of 2009 for over 10 years. Using such an unstable asset as the basis of any valuation seems foolhardy.

I’d rather consider the absolute merits of each investment independently. Unfortunately, as noted above, this currently reveals an unpleasant truth: nothing offers a good margin of safety.

In fact, if we look at the slope of the risk return line (i.e., the 7-year forecasts measured against their volatility), we can see that investors are being paid a paltry return for taking on risk. Admittedly, Mr. Market is not yet as manic as he was in 2007 when we faced an inverted risk return trade-off – investors were willing to pay for the pleasure of holding risk – but at this rate, I believe it won’t be long before we are once again facing such a perverse situation. Albeit this time it is officially-sponsored madness!

Exhibit 6: The Slope of the Risk Return Line

Exhibit 6

Source: GMO As of February 2011

This dearth of assets offering a margin of safety raises a conundrum for the asset allocation professional: what does one do in a world where nothing is cheap? Personally, I’d seek to raise cash. This is obvious not for its thoroughly uninspiring near-zero yield, but because it acts as dry powder – a store of value to deploy when the opportunity set offered by Mr. Market once again becomes more appealing. And this is likely, as long as the emotional pendulum of investors oscillates between the depths of despair and irrational exuberance as it always has done. Of course, the timing of these swings remains as nebulous as ever.

2. This Time Is Never Different

Sir John Templeton defined “this time is different” as the four most dangerous words in investment. Whenever you hear talk of a new era, you should behave as Circe instructed Ulysses to when he and his crew approached the Sirens: have a friend tie you to a mast.

Because I have discussed the latest notion of a new era in my recent “In Defense of the ‘Old Always,’” I won’t dwell on it here. I will point out, though, that when assessing the “this time is different” story, it is important to take the widest perspective possible. For instance, if one had looked at the last 30 years, one would have concluded that house prices had never fallen in the U.S. However, a wider perspective, drawing on both the long-run data for the U.S. and the experience of other markets where house prices had soared relative to income, would have revealed that the U.S. wasn’t any different from the rest of the world, and that a house price fall was a serious risk.

3. Be Patient and Wait for the Fat Pitch

Patience is integral to any value-based approach on many levels. As Ben Graham wrote, “Undervaluations caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inflated prices caused by over-enthusiasm or artificial stimulants.” (And there can be little doubt that Mr. Market’s love affair with equities is based on anything other than artificial stimulants!)
However, patience is in rare supply. As Keynes noted long ago, “Compared with their predecessors, modern investors concentrate too much on annual, quarterly, or even monthly valuations of what they hold, and on capital appreciation… and too little on immediate yield … and intrinsic worth.” If we replace Keynes’s “quarterly” and “monthly” with “daily” and “minute-by-minute,” then we have today’s world.

Patience is also required when investors are faced with an unappealing opportunity set. Many investors seem to suffer from an “action bias” – a desire to do something. However, when there is nothing to do, the best plan is usually to do nothing. Stand at the plate and wait for the fat pitch.

4. Be Contrarian

Keynes also said that “The central principle of investment is to go contrary to the general opinion, on the grounds that if everyone agreed about its merit, the investment is inevitably too dear and therefore unattractive.”

Adhering to a value approach will tend to lead you to be a contrarian naturally, as you will be buying when others are selling and assets are cheap, and selling when others are buying and assets are expensive.

Humans are prone to herd because it is always warmer and safer in the middle of the herd. Indeed, our brains are wired to make us social animals. We feel the pain of social exclusion in the same parts of the brain where we feel real physical pain. So being a contrarian is a little bit like having your arm broken on a regular basis.

Currently, there is an overwhelming consensus in favor of equities and against cash (see Exhibit 7). Perhaps this is just a “rational” response to Fed policies that actively encourage gross speculation.

William McChesney Martin, Jr. observed long ago that it is usually the central bank’s role to “take away the punch bowl just when the party starts getting interesting.” The actions of today’s Fed are surely more akin to spiking the punch and encouraging investors to view the markets through beer goggles. I can’t believe that valuation-indifferent speculation will end in anything but tears and a massive hangover for those who insist on returning again and again to the punch bowl.

5. Risk Is the Permanent Loss of Capital, Never a Number

I have written on this subject many times.4 In essence, and regrettably, the obsession with the quantification of risk (beta, standard deviation, VaR) has replaced a more fundamental, intuitive, and important approach to the subject. Risk clearly isn’t a number. It is a multifaceted concept, and it is foolhardy to try to reduce it to a single figure.

To my mind, the permanent impairment of capital can arise from three sources: 1) valuation risk – you pay too much for an asset; 2) fundamental risk – there are underlying problems with the asset that you are buying (aka value traps); and 3) financing risk – leverage.

By concentrating on these aspects of risk, I suspect that investors would be considerably better served in avoiding the permanent impairment of their capital.

6. Be Leery of Leverage

Leverage is a dangerous beast. It can’t ever turn a bad investment good, but it can turn a good investment bad. Simply piling leverage onto an investment with a small return doesn’t transform it into a good idea. Leverage has a darker side from a value perspective as well: it has the potential to turn a good investment into a bad one! Leverage can limit your staying power and transform a temporary impairment (i.e., price volatility) into a permanent impairment of capital.

Exhibit 7: BoAML Fund Manager Survey (Equities and Cash)

Exhibit 7

While on the subject of leverage, I should note the way in which so-called financial innovation is more often than not just thinly veiled leverage. As J.K. Galbraith put it, “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.” Anyone with familiarity of the junk bond debacle of the late 80s/early 90s couldn’t have helped but see the striking parallels with the mortgage alchemy of recent years! Whenever you see a financial product or strategy with its foundations in leverage, your first reaction should be skepticism, not delight.

7. Never Invest in Something You Don’t Understand

This seems to be just good old, plain common sense. If something seems too good to be true, it probably is. The financial industry has perfected the art of turning the simple into the complex, and in doing so managed to extract fees for itself! If you can’t see through the investment concept and get to the heart of the process, then you probably shouldn’t be investing in it.

Conclusion

I hope these seven immutable laws help you to avoid some of the worst mistakes, which, when made, tend to lead investors down the path of the permanent impairment of capital. Right now, I believe the laws argue for caution: the absence of attractively priced assets with good margins of safety should lead investors to raise cash. However, currently it appears as if investors are following Chuck Prince’s game plan that “as long as the music is playing, you’ve got to get up and dance.”

Disclaimer

Market Cap as a % of Nominal GDP

Natural Gas Now Viewed as Safer Bet

Natural gas may be having its day, as its rival energy sources come under a cloud.

The serious problems at the nuclear power plant in Japan have raised new doubts about the safety of nuclear energy. New exploration has yet to resume in the Gulf of Mexico after last year’s blowout of a BP oil well. And coal plants have been under a shadow because of their contribution to global warming.

Meanwhile, natural gas has overcome two of its biggest hurdles — volatile prices and questionable supplies. In large part because of new discoveries in the United States and abroad that have significantly increased known reserves, natural gas prices have been relatively low in the last two years.

It is far too early to say for sure whether the calamitous events in Japan may roll back the global nuclear revival and lead to a surge in natural gas demand. It is also too early to say whether officials in charge of nuclear policy are just paying lip service to the public’s safety concerns in the wake of the unfolding disaster.

Still, with the global demand for energy expected to grow by double digits in coming decades, analysts are anticipating a new boom in gas consumption. Given the growing concerns about nuclear power and the constraints on carbon emissions, one bank, Société Générale, called natural gas the fuel of “no choice.”

“At the end of the day, when you look at the risk-reward equation, natural gas comes out as a winner,” said Lawrence J. Goldstein, an economist at the Energy Policy Research Foundation. “It’s a technical knockout.”

Financial markets have already started to price in this new interest in gas. Since the disaster in Japan, uranium prices have dropped by 30 percent, while natural gas prices in Europe and the United States have risen by about 10 percent. Officials from several countries, including China, Germany, Finland and South Africa, said they would review their nuclear strategies.

Utilities are also reconsidering natural gas as a potential source of stable power, a function historically filled by coal and nuclear energy. Utility chiefs have been wary of price fluctuations of natural gas, particularly in the last two decades.

But that may be about to change, according to John Rowe, chairman of Exelon, the biggest nuclear utility in the United States. He argued that building a nuclear power plant would be prohibitively expensive, while new rules limiting carbon emissions by the Environmental Protection Agency would require costly investments to scrub emissions from coal-powered plants. This means that utilities will increasingly switch to natural gas.

“Natural gas is queen,” Mr. Rowe told a panel at the American Enterprise Institute in Washington this month.

That view was endorsed by a report to be released on Tuesday by the Bipartisan Policy Center and the American Clean Skies Foundation, which predicts that natural gas consumption will increase because of an abundance of new supplies, some of them in the United States, that are likely to keep prices relatively low.

Global natural gas production rose by 44 percent in the two decades from 1990 and 2010, while gas reserves grew by 67 percent. After peaking at $13.58 per thousand cubic feet in 2008, gas prices in the United States averaged $4.38 last year. What is more, natural gas emits about half as much carbon dioxide as coal when it is burned to produce one kilowatt hour of electricity.

The immediate market for natural gas will likely be Japan, which is looking to raise its fuel imports after a fifth of its nuclear power capacity was shut down, including the troubled Fukushima Daiichi plant. And Tokyo Electric Power says that the rolling blackouts in the country will continue at least into next winter.

Japan already imports a third of global liquefied natural gas shipments and its import terminals, mostly in the south, were not damaged by the earthquake. Nuclear power and coal each accounts for a quarter of Japan’s power generation, while natural gas accounts for 30 percent, according to analysts with the Raymond James financial company.

“It could be that the Honshu earthquake is the catalyst which fundamentally reshapes our approach to global energy,” Bernstein Research analysts wrote last week.

Many oil companies have anticipated this shift. At Royal Dutch Shell, natural gas production overtook its oil output in recent years. Exxon Mobil bought XTO Energy last year to raise its presence in the growing domestic shale gas market. It has also developed significant resources in Qatar, which holds the third-largest reserves of natural gas in the world, after Russia and Iran.

Huge new projects dedicated to liquefied natural gas — in which gas is frozen, compressed in liquid form for easier shipment, then returned to a gas state at import terminals — have been mushrooming around the world.

In Papua-New Guinea, Exxon is leading a $15 billion project to build and develop an LNG plant to supply Asian customers. Chevron recently began engineering work on the $40 billion Gorgon gas project in Australia, along with Shell and Exxon. Russia, for its part, is planning to develop huge new fields in the Arctic.

Natural gas is not without problems. To unlock methane from hard shale rocks in the United States, energy companies use hydraulic fracturing, a method that has been criticized on the grounds of polluting water sources, including rivers and underground aquifers.

But energy policy must balance out these hazards with the concerns about nuclear power, as well as the still unresolved problem of what to do with spent nuclear fuel that remains radioactive for hundreds of years.

“Nuclear power has suddenly found itself going from being (arguably) part of the solution for future green energy to a now dangerous relic of the cold war era,” Deutsche Bank said in a report last week.

In the United States, where no new reactor has been built since the Three Mile Island accident in 1979, the attitude toward nuclear power has been ambivalent. Last year, the president asked the Energy Department to provide some financial backing for nuclear operations, including two reactors planned for Georgia.

But in the aftermath of the Japanese disaster, the administration ordered a comprehensive review of safety at nuclear plants.

At the same time, the industry has found it nearly impossible to develop and finance new plants. In December, for example, Exelon dropped its application to build a plant in Victoria County, Tex., in the face of opposition.

Utilities have also faced a challenge in renewing their existing operating licenses. The Pilgrim Nuclear Power Station, in Plymouth, Mass., has been waiting for a new license for five years because of litigation and court delays. State officials in Vermont have been battling to shut down Entergy’s Vermont Yankee plant, which began operations in 1972.

There are 104 nuclear reactors in the United States, which contribute 23 percent of the nation’s electrical power. Twenty reactors have applications pending with federal regulators to extend the plants’ operating lives by as much as two decades, according to Bloomberg News.

“We are likely to do to nuclear licensing what we did to offshore permitting,” Mr. Goldstein, of the energy policy foundation, said. “We will delay and stall.”

Important Index Levels To Watch – Support and Resistance

Today is a good day to take a look at general market conditions to see why we are sitting in a generally neutral position. With the help of the major market indicies, we can see that there is a clear line in the sand drawn at the next support and resistance levels. (We will be discussing these in detail on this week’s DHUnplugged Podcast)

S&P 500

The move of the 20-Day moving average below the 50-day shows that there is momentum to the downside. Not a good sign. 1,300 is still resistance with 1,304 the point of both the 20- and the 50-day SMA. The short-term trend will change to a bullish level if the S&P 500 can close over 1,309/1,310. Above 1,331 will be a strong uptrend confirmation.

There have been larger than normal swings and ranges in March – the largest in some time. It is also showing a bearish volume trend. Monday, 3/21/11 is a good example of this as there was a big pop, with lackluster volume.

(Click to enlarge)

Russell 2000

The small cap index has been holding up better than expected through this recent market correction. Perhaps the sellers are looking to unload their most liquid names first as they would like access to cash and are unwilling to attack those stocks that may see great volatility with large sell tickets.

The 780 level has become an important point of support. Below 770 is a pre-cursor for another leg down, if it can break through. The 20-day SMA is flattening and now the index is above the 20- and 50-day SMAs. The pop above these levels were on low volume on 3/21/11.

815 is a key level to confirm the start of a short-term rally. 830 will become a confirmation point as it will both confirm the move and break above 827 resistance.

(Click to enlarge)

NASDAQ

There has been some very loose and very wild action in the NASDAQ index. 2,600 is hard support. There was a recent attempt to fill-the-gap of a few days ago. Buyers have been there on dips as can be seen by the long wicks on this daily chart. Notice that the chart shows a great deal of gaps. Not a healthy sign.

The index is down from its recent peak by about 8%. 2,730 will confirm the initial return of a rally and will also take care of most of the March gaps. 2,782 will confirm the longer-term trend.

JPMorgan: "The Likelihood That The Portuguese Government Will Fall This Week Looks High"

There has been a lot of speculation about just what the JPMorgan note that claims the Portuguese government can fall as soon as tomorrow, says. The speculation can now end. "The likelihood that the Portuguese government will fall this week looks high. This suggests that the sovereign will likely access the EFSF in the near term, despite the current government's efforts to avoid this outcome." Incidentally if JPM is right, the market better have priced in the next insolvent domino to drop in Europe, although judging by where the EURUSD is these days, the market decided to take a long hard sabbatical about 2 weeks ago.

From JPM:

Portuguese government could fall tomorrow: EFSF access increasingly likely

Faced with increasing market pressure, the Portuguese government a couple of weeks ago announced a new set of fiscal measures aimed at achieving its ambitious plan to push the deficit to 2% of GDP by 2013. The new plan included additional tightening measures worth 0.8%-pts of GDP for 2011, and detailed spending cuts and revenue-boosting measures worth a total of 2.5%-pts of GDP for 2012 and 1.2%-pts of GDP in 2013. The plan was spelled out more clearly yesterday, when the finance ministry published its latest update of the Stability and Growth Program (see table below). According to the program, the government will achieve a rapid deficit reduction thanks to front-loaded tightening, which will push down the primary balance by 3.4%-pts of GDP this year and 2.4%-pts next year. Partly in response to the new measures, the government lowered its growth projections, and now sees GDP contracting 0.9% this year and growing at a modest rate over the following two years.

The announcement of the new measures received the blessing of the EC, the ECB and the European Council, but was not welcomed by the main opposition party in Portugal, the centre-right Social Democrats, which have blamed the government for acting without informing them in time. This poses a clear challenge as the current Socialist government led by prime minister José Sócrates is a minority government.

It looks like the Portuguese parliament will vote on the new fiscal plan tomorrow. Prime minister Sócrates has already announced that, if the plan is rejected, he will resign, something that will lead to a general election. The prime minister has been attempting to find a compromise with the opposition, saying that the current plan could be discussed and amended as needed, but the opposition does not seem to buy into this. The head of the Social Democrats Passos Coelho, who enjoys a lead in opinion polls, has been critical of the measures, despite mentioning that he fully supports Portugal's deficit-reduction targets. This seems to suggest that his party would likely implement an equally austere plan, but in a new government structure.

The likelihood that the Portuguese government will fall this week looks high. This suggests that the sovereign will likely access the EFSF in the near term, despite the current government's efforts to avoid this outcome.

Wall Street slips after 3-day run; volume at 2011 low


(Reuters) - Wall Street snapped a three-day winning streak on Tuesday, even as investors adjusted to the insecurity created by events in Japan, the Middle East and North Africa.

The CBOE Volatility Index fell 1.9 percent to 20.21, leaving it not far from its level before the crisis in Japan sparked a huge spike in the VIX, suggesting investors have become acclimated to Japan's biggest-ever earthquake and the toppling of governments across the Arab world.

The VIX has tumbled 31.6 percent in the last four days.

"There is a palpable difference in the kind of intensity that someone like myself feels being on the trading floor," said Gordon Charlop, managing director at Rosenblatt Securities in New York.

Volume was the lowest of the year, with 6.52 billion shares traded on the New York Stock Exchange, the American Stock Exchange and Nasdaq, pointing to a lack of conviction. Average daily volume is 8.09 billion shares.

Fighting in Libya and unrest in Yemen have contributed to rising oil prices, which has dragged on equities. April U.S. crude futures rose $1.67 to settle at $104 a barrel while Brent added 74 cents to settle at $115.70.

"Those that are still bullish are trying to buy on dips and took advantage of the prices from the middle of last week. But as far as upward momentum, I don't think it's there anymore," said Terry Morris, senior equity manager at National Penn Investors Trust Company in Reading, Pennsylvania.

"So it's a wait-and-see attitude and not a lot of commitment from either side at this point."

According to a recent report from EPFR Global, fund flows "took a marked turn toward the defensive in mid-March," following the crisis in Japan, with greater flows to funds oriented in consumer goods, telecom and health care.

The Dow Jones industrial average .DJI shed 17.90 points, or 0.15 percent, to 12,018.63. The Standard & Poor's 500 Index .SPX dropped 4.61 points, or 0.36 percent, to 1,293.77. The Nasdaq Composite Index .IXIC fell 8.22 points, or 0.31 percent, to 2,683.87.

European Central Bank President Jean-Claude Trichet and other ECB policymakers have reiterated they are ready to act quickly to guard against inflation, despite the impact of Japan's disasters.

Walgreen Co (WAG.N: Quote, Profile, Research, Stock Buzz) was the S&P 500's biggest percentage loser, falling 6.6 percent to $39.21 after it reported its quarterly results.

One of the S&P's top percentage gainers was Netflix Inc (NFLX.O: Quote, Profile, Research, Stock Buzz), which rose 4 percent to $$221.39 after Credit Suisse upgraded the stock to "outperform.

After the closing bell, Adobe Systems Inc (ADBE.O: Quote, Profile, Research, Stock Buzz) climbed 1.4 percent to $33.33 and Jabil Circuit Inc (JBL.N: Quote, Profile, Research, Stock Buzz) jumped 10.5 percent to $20.91. Both companies reported quarterly results after the regular stock trading session ended.

Declining stocks outnumbered advancing ones on the New York Stock Exchange by 1,703 to 1,262, while on the Nasdaq, decliners beat advancers by 1,540 to 1,052.