Wednesday, August 27, 2008

Bill Gross: Inflation or deflation?

This is interesting.

Last month’s Bill Gross missive talked about an inflationary uptrend. Here’s what he wrote:

A trillion dollars of government deficit spending is potent medicine. Its potency regarding inflation will not be felt fully during the peak deficit period. Rather, inflation will accelerate during the subsequent recovery as the government bonds acquired during the recession are transformed once again into risk bearing assets and high levels of investment.

I covered this and commented on El-Erian’s latest book in an earlier post. I had concluded with these lines:

My 2 cents is that yields would probably come down in the next year in a deflation scare, before treasuries enter a decade long bear market. Even Hussman extended bond duration a few weeks back. PIMCO’s investment thesis, while right in the long run, could underperform this year.

Note that my conclusion was derived in part from reading Gary Shilling’s opinion, the GaveKal piece on monetary velocity posted by John Mauldin, and the simple fact that commodities peak late in a slowdown. Talking of commodity price driven inflation in a credit crunch with rising unemployment is problematic, global growth and a trillion dollar fiscal deficit notwithstanding.

Guess what? Maybe it’s due to crude cracking up, or some other data point, but Gross seems to have changed his view point. The 'deflationary threat' seems to be the new mantra.

From Bloomberg:

“Inflation is high. headline inflation at 5% is much higher than it should be. To suggest that the Fed or a central bank should raise interest rates in the face of a significant asset deflation, is certainly a wrong approach, to put it mildly. With housing prices going down, unemployment going perhaps as high as 7% 12 months down the road will be tantamount to raising interest rates in the mid 1930s which was a classical mistake the Fed reserve made at that time”

His investment outlook for August makes a similar argument. (As an aside, McCulley similarly talks about the menace of asset price deflation in an environment he calls the ‘paradox of deleveraging’.)

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Thursday, August 21, 2008

3G iPhone: Implications for the wireless ecosystem.

It's been a while since I posted anything tech related. The new 3G iPhone has been the rage since it's release a month back. Semiconductor Insights, TechOnline, Portelligent, and several others have done a great tear down analysis of the device. (You can catch the TechOnline breakdown here)

Apart from the evolution to 3G and the GPS, the hardware innovation is essentially incremental in nature. I thought it would be interesting to talk about the implications for the handset vendors and the chipset manufacturers. My personal opinion is that the iPhone is a good thing for the chip makers but probably a slight negative for the handset manufacturers.

With 19 chips inside, the iPhone will drive higher margin chips and accelerate Smartphone adoption. Check this link for a detailed picture. While there were no major surprises in terms of design wins, I did expect some of the discrete chips to be replaced by a single one.

Chips: Before the iPhone, the chip makers were in a race to the bottom. Cranking out lower cost chip solutions at the lowest possible price point seemed like a solid differentiating strategy (for the ultra-low-cost market). The smartphone uptick is good because it implies a rush for higher content, higher priced chips.

What do I mean? Most chip providers are essentially in a race against commoditization. With prices for chips and handsets eroding every year, they rely on newer features to maintain their margins. With the upsurge in demand for high-end features like GPS, the chip set vendors should be able to sell higher average selling price (ASPs) chips with fatter gross margins. They can further differentiate themselves on the basis of features like multi-mode solutions, power consumption, multimedia, mobile TV, HD video, GPS/bluetooth integration, etc.

Many carriers are now heavily subsidizing smartphones, which is spurring a strong demand for these devices. This should fuel high-volume shipments in these high end chips. Smart phone IC commoditization is at least a few years away for wireless chip makers. In the near future, expect to see additional features like HD video, mobile TV, and of course the natural evolution to a 4G air interface (LTE/Wimax).

Handsets: The first thing I realized when I heard that the iPhone would sell for $200 in the US was that the handset margins were headed down. The $199 price tag points towards handset price erosion for manufacturers like Nokia and Samsung. While carrier subsidies should offset some of the price declines, I remain skeptical about the bargaining power non-Apple vendors might have. The subsidies could also be quid pro quo in nature, like the Apple deal showed (Apple discontinued the unique revenue sharing model it had with AT&T in lieu of the price subsidy). Feature rich 3G phones have historically sold for high prices, and this would be difficult going forward.

Some of the components like memory are probably a couple of quarters away from their cyclical bottom, and it’s unlikely the semiconductor component pricing would decline like it has in the past. A higher silicon content with healthy component pricing points to a higher bill of materials, squeezing those handset margins. Note that some of these negatives are offset by higher volumes (regular demand elasticity).

In conclusion, I view the iPhone as a strong positive for the chip makers but probably a slight negative for the handset vendors.

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Tuesday, August 19, 2008

A 100 year storm?

The investing pantheon has been famously negative for more than a year now. Plenty of people have compared the current banking crisis to a 100 year storm. From a Prem Watsa interview. :

History shows that there are 100-year storms and 50-year ones. In 1929, a 100-year storm, only 10% survived the market crash and it was only those who were negative in 1925 and did something about it.

Q: Is this a 100-year or a 50-year market and what’s the difference?

“The 100-year is a Depression. The 50-year is what happened to Japan in 1989 to 2003. We don’t know yet.”

While it’s hard to appreciate the magnitude and severity of the current crisis, this interesting article from PIMCO's Emerging Markets watch drives home the point.

“It’s like deja vu all over again” as we see a classic Emerging Markets (EM) balance of payments crisis unfolding before our very eyes – but this time in the U.S.

Here's an eye-opening chart from the same:

In summary:

  • Average length of the banking crisis is 4 years.

  • Emerging markets have a higher fiscal cost, even though the output loss in developed economies is higher (I wonder why).

  • The average output loss of 24% in developed countries is HUGE.

  • While the average length of the crisis is about 4 years, the “lost years” due to GDP shrinkage could be a lot longer.

  • There is a wide difference between a banking crisis alone, and a banking AND currency crisis. An average output loss of 5.6% in a banking crisis alone is basically ~2 years of lost growth. That 30% output loss in a banking and currency crisis translates to a lost decade.

The article concludes by recommending Brazilian bonds, Singapore dollars and Chinese yuan. Recommends avoiding converging European currencies (particularly Hungary and Romania), US Dollar, and the long end of US treasuries.

Wait, there's more. Here’s what a recent NYTimes article on Dr. Doom Nouriel Roubini says:

After analyzing the markets that collapsed in the ’90s(the emerging market crises), Roubini set out to determine which country’s economy would be the next to succumb to the same pressures. His surprising answer: the United States’. “The United States,” Roubini remembers thinking, “looked like the biggest emerging market of all.”

It's rare to see such a strong chorus of negative pessimism. If this is indeed a classic “balance of payments” problem, then I’d reckon this crisis would be a long drawn out one.

The smart money seems to concur.

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Monday, August 4, 2008

Jeremy Grantham (GMO) Quarterly missive.

Jeremy Grantham’s quarterly missive ("Meltdown! The Global Competence Crisis”) makes for an interesting read. I think Grantham falls in the select group of market/ecnonomy prognosticators who are spot on from a long-term perspective. I had written earlier about his 7 year asset class return predictions. While things always change, the accuracy of his earlier 1998 predictions certainly strengthens his case.

Anyways, so his historical bearishness turned out to be optimistic, given the unraveling of the past few months.

His conclusion?

Due to a combination of spectacular mismanagement by the authorities that resulted in very excessive and dangerous speculation and very bad luck in the timing of commodity problems and over-rapid expansion of China, the fundamental global outlook is substantially worse than expected.

Some other excerpts:

  • The Fed, the ECB and other financial authorities failed and have lost their credibility.
  • We run a serious risk of a meltdown in confidence in leadership totally unlike anything we have seen since World War II.
  • China is exporting inflation (by under pricing currency).
  • The recycling of oil country surpluses could be destabilizing.
  • There’s a transfer of income from consumers to miners and farmers.
  • Underweigt on emerging markets from overweight. Sees a global slowdown, and export-dependent developing countries with massive over investments are ripe for a shakeout.
  • The probability for longer and deeper overruns below fair value and the chance of a “meltdown” has gone up.
  • Poor prospects for commodities and emerging markets for the next couple of years. Attractive from a long term perspective.
  • In the U.K., house prices could easily decline 50% from the peak. If prices go all the way back to trend, then the U.K. financial system will need some serious bailouts and the global ripples will be substantial. (He calls this a near certainty)

Hmm... Certainly food for thought!

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Saturday, August 2, 2008

GMO asset class return forecasts.

In an earlier post, I had written about GMO’s 7 year asset class return predictions. Well, they have updated their charts, and here’s how the predictions look now:

The decline since March has made the long term returns look even more favorable. (There’s something to be said about not trying to time the exact market bottom and holding on for the long term! )

For those questioning the accuracy/relevance of their numbers, here’s how their 1998 forecasted numbers stacked up. While the absolute numbers might change, the rankings for the asset class returns were spot on.


  • Seems like a good time to invest in international small cap, especially small cap value (DISVX?)

  • Inflation-indexed bonds are expected to underperform US govt bond.

  • US quality stocks and timber look attractive.

  • The long range forecast on emerging markets and international equity has also gone up since March, partly due to the severe declines we’ve seen since then.

I was intrigued by the definition of “US Quality”. Here’s what the description reads: GMO U.S. Quality Strategy begins with a universe represented by large capitalization stocks in the U.S. market. Using proprietary quantitative models, the strategy screens an issuer's quality based on several factors, including, but not limited to, expected earnings volatility (as measured by the volatility of profitability), profits (return on equity), and operational and financial leverage (fixed operating costs and total outstanding debt, each in relation to equity). Further, the strategy seeks out stocks it believes are undervalued within this defined universe.

The top holdings in their "US Quality" asset class are:

Exxon Mobil Corp. 6.9%
Microsoft Corp. 6.8%
Wal-Mart Stores Inc. 6.8%
Johnson & Johnson 6.7%
Pfizer Inc. 6.3%
Coca-Cola Co. 6.3%
Chevron Corp. 6.2%
PepsiCo Inc. 5.0%
UnitedHealth Group Inc. 3.6%
Procter & Gamble Co. 3.4%
Merck & Co. Inc. 3.4%
QUALCOMM Inc. 2.7%
Oracle Corp. 2.3%
Cisco Systems Inc. 2.3%
Home Depot Inc. 1.9%

I would have guessed that the “predictability in earnings” would imply a heavier weight towards consumer staples, health care, pharma and other non-cyclical sectors. Turns out to be true, except I was a little surprised to see Oracle and Cisco.

Going forward, it’s going to become increasingly important to evaluate stocks from an inflation-pass through perspective. Any company which can pass on inflationary cost increases to its consumers is going to see a multiple expansion going forward (think Walmart, Proctor and Gamble). One name which has intrigued me thanks to Buffett is Kraft, but I need to do my homework on that one first.

In my next post, I’ll discuss Grantham’s quarterly missive.

Disclosure : Long Qualcomm, Microsoft, DISVX.

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Thursday, July 24, 2008

Did the financials make a bottom?

It’s always good to hear experts commenting on business cycles, economy, markets and commodities. Most unfortunately tend to be wedded to their ideas.

If a known talking head changes his or her viewpoint, it especially pays to listen to their arguments. A cheerful Nouriel Roubini talking about 1500 on the S&P 500 would jolly well crush the shorts (naked or otherwise). In a similar vein, Jim Rogers talking up $60 a barrel oil would probably have oil executives jumping off rooftops, not to mention becoming a brand new target for the Middle East hit men.

Anyways, Michael Kahn, Barron's excellent technical analyst, and a skeptical bear, had written earlier about finding no bottom in the financial sector. A week later, he’s changed his opinion, thanks in part to this excellent chart.

That sure looked like a capitulation bottom. While he is still talking of a long healing period, and a possible retest of the lows, at least one bear seems to have retracted his earlier opinion.

Yup. You heard that right. The bottom for financials is in.

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Wednesday, July 23, 2008

The Qualcomm Nokia deal.

The media is abuzz with the settlement between Nokia and Qualcomm, the two telecom giants. They've had a long running acrimony over royalties on wireless patents. This deal is obviously big for Qualcomm because it validates their patent licensing business model. A 15 year deal covering the gamut of 3G and 4G technologies should remove any litigation uncertainty from both the stock names. Reduction in litigation expenses are obviously a bonus for both sides, and should boost margins and income in possibly difficult economic times ahead.

While much will be written about the pros and cons of this deal as more details emerge, commentary from this article caught my eye.

Why Qualcomm could be the big winner here:

“This is a huge win for Qualcomm,” said analyst David Marchesani, of Quality Growth Management in Rancho Santa Fe. Marchesani said the length of the deal and the number of technologies covered were noteworthy.
“You don't have to wonder whether they're going to have to go through all the same stuff again in three, four or five years,” he said. “This resolves a lot of uncertainties. And the market hates uncertainties.”

Reasons which favor Nokia:

Comments from a Nokia executive suggest that the company will pay less than the 5 percent royalty Qualcomm typically charges manufacturers. “We are happy to have a rate structure that will not slow down growth and innovation in the industry,” Nokia Chief Financial Officer Rick Simonson said. “We're not going to disclose the rate structure, but I will say 'mission accomplished.' ”

“We got a deal that was financially beneficial to Nokia,” he said. “It was worth it.”

It'll be interesting to see how the two stocks react tomorrow. Both are up after hours.

Full Disclosure: Opinions expressed are my own and do not represent any official view. Long QCOM.

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Thursday, July 3, 2008

India: The bear case

BusinessWeek is out with a great article on the grim prospects for Indian equities and the economy over the next year.

To summarize:

  • 10% of India's GDP would be spent on fuel subsidies, fertilizer subsidies and stupid farmer loan-waiver programs. That's a recipe for inflation.
  • There's been ZERO reforms over the past four years (!!).
  • There's a risk that global investors who had set up base in India might leave.
  • Communists in the ruling coalition are against globalization and industrialization.
  • Elections will handicap the administration from acting decisively.
  • Growth is hitting systemic choke points.
Chetan Parikh sums it up nicely: "We will lose years".

I kind of disagree that things were different six months back. Most of these signs were still there; only the perception has changed.

I'd commented in November 2007 that the the Indian market was going through a speculative blow off. Technically it was a classic top. Breadth had declined, and the majority of the advance in equities had been led by a few names. Markets churned around 20,000 on the index, broke through a few times, failed, and rolled over.

I'd also written about the emerging markets hoopla back in September 2007. Here's what I wrote about India (you can check the article for my view on the Chinese bubble) :

Emerging markets: one doesn't see the point of investing in emerging markets, with their high PEs. We need risk premium dammit!

Today, you can invest in the US(and Europe) with their reasonable PE ratios. There needs to be a risk adjustment in valuations, regardless of their "growth fundamentals". Let’s not forget, the Communist Party of India is still in alliance at the center. The possibility of them screwing things up is just very very high. This is very similar to how multinationals got banned from India in the 1970s, relegating India to the ‘Hindu rate of growth’. The recent posturing on the nuclear deal is a good example of their potential nuisance. India needs nuclear power if they have to maintain their growth rates. If CPI succeeds, the growth prospects of an infrastructure constrained, energy constrained, and corruption constrained India would surely need to be revised down.

The risks in India are under appreciated. A repricing of risk in the Indian subcontinent is due.

Also, in a little known and often overlooked event, IMF downgraded the historical growth contributions of both India and China by as much as 40% back in January 2008.

To conclude, while I really liked the article, I disagree with the assertion that things have changed in six months. The signs have been there all along for every one to see. If anything, this could be an indicator that all the negative domestic news has finally been priced into the market.

Full Disclosure: None

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Monday, June 30, 2008

Bill Gross and Mohamed El-Erian : The PIMCO maestros.

Bill Gross is again out with a no holds barred punch at the administration and the current state of affairs. He predicts a trillion dollar deficit for the next administration, and a severe inflationary uptrend.

I had linked to his earlier excellent missive and CNBC appearance here. There’s also a discussion where I speculated that a mean reversion in the price-earnings multiple to ~12 could be the fat tail PIMCO is watching out for.

It’s good to see wide media coverage for both Bill Gross and Mohamed El-Erian. I'm generally a fan of fixed-income strategists. While Gross has a nice straightforward way of assessing things, El-Erian's measured tone makes him really interesting to watch or read.

I’m currently reading El-Erian’s "When Markets Collide", and it’s been a gripping read so far. His analysis on the current situation is really thought provoking. I think this is shaping up to be one of the must read books of the year, especially to understand the current situation and the shape of things to come. (Think Taleb’s Black Swan in 2007). You can read the reviews from this Amazon link to pique your interest:

You can also read the introduction to the book from PIMCO’s website.

An excerpt from the introduction follows:

A series of inconsistencies and anomalies, which will be detailed throughout the book, acted as early signals of the growing tension between what participants or actors on the global finance stage were pressing for and what could be reasonably and safely accommodated by the existing systems in order to minimize the risk of turmoil.

Market participants first become aware of transformations through what is commonly known as “noise.” This noise comes initially from the sudden emergence of anomalies to long-standing relationships that participants take for granted. Noise can matter in so far as it contains signals of fundamental changes that, as yet, are not captured by conventional monitoring tools.

For what seemed an eternity for investors (many of whom feel that a week is a long time), the U.S. bond market provided signals about the economy that conflicted with those coming out of the other most liquid market in the world, the U.S. equity market.

This inconsistency was accompanied by a rather peculiar situation among Fed watchers, that group of economists and analysts on Wall Street who make their living from predicting the course of the most influential interest rate in the world—the fed funds rate. In the middle of 2006, with the rate at 51⁄4 percent, the vast majority of Fed watchers fell into two distinct and opposite camps. One confidently predicted rate hikes—to 6 percent; the other equally confidently predicted cuts—to 4 percent. I remember noting several times that I could not recall such divergence in sign and size among such credible market observers.

Hmm.. Don’t we have a similar situation right now? Market strategists and economists seem divided between whether interest rates are headed up (read PIMCO's missive) or down(eg. Gary Shilling). There's even a divergence between countries cutting or raising interest rates. Is this signal telling us something? The current divergence could be hinting at the shape of things to come over the next year or so. It's all about observing signals in the noise.

My 2 cents is that yields would probably come down in the next year in a deflation scare, before treasuries enter a decade long bear market. Even Hussman extended bond duration a few weeks back. PIMCO’s investment thesis, while right in the long run, could underperform this year.

Full Disclosure: None

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The 2008 European Bear Parade

Over the past two weeks, the commentary from Europe has gotten decidedly bearish. And none of them are talking of a run of the mill bear market. The most cheerful of the lot is forecasting a 30% global equity markets correction; the others are warning of a once-in-a-century doomsday scenario. So without further ado, here’s the European bear market parade:

The parade really started with RBS coming out with a warning about a full-fledged global stock market crash. With a call for the worst bear market in the last century, Bob Janjuah warned us that "a very nasty period" was soon to be upon us.

Next up was Morgan Stanley strategist Teun Draaisma, the guy who called the market top in July 2007. His advise was to bugger off and go goose hunting. With a call for a 10% downside over the next 6-9 months, that certainly sounded appealing. He's also called this the best shorting period since 2002(with some short screen ideas). His thoughts on the evolution of a bear market can be found here.

Barclays chimed in with this: "We're in a nasty environment," said Tim Bond, the bank's chief equity strategist. "There is an inflation shock underway. This is going to be very negative for financial assets. We are going into tortoise mood and are retreating into our shell. Investors will do well if they can preserve their wealth." I found their recommendations on yield curve steepening, shorting Asian bonds and Indian currency interesting.

The ever cheerful pair of James Montier and Albert Edwards at Societe Generale called for a decline of over 70% in the indices. “The US is leading the way, diving into deep recession as a collapse in consumer confidence induces The Great Unwind. This asset-backed economic Ponzi scheme will finally crash to earth as debt revulsion leaves interest rates impotent.” Other forecasts include oil at $60 and US 10 year bond yields at 2% There’s an interesting inflation versus deflation debate shaping up between the various market strategists.

Not to be left out, Fortis warned of a complete collapse of the US financial markets within a few days to weeks. "The situation in the US is much worse than we thought. There is starting to be a complete meltdown in the US. "

So there you have it, the great 2008 European Bear parade. It certainly seems like the unseasonal weather, massive asset write downs, and an economic slowdown has made the European strategists a moody lot. While US commentators like Louise Yamada, Grantham, Paul Desmonds and Hussman have cautioned on the stock markets, it's hard to beat the gloom and doom coming from Europe. It almost seems like a race to be out with the most bearish forecasts.

Their cheerful disposition is infectious indeed.

Full Disclosure: No positions. Wishing I was short Investment Banks back in July 2007.

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Thursday, June 26, 2008

In-Flight announcement - State of Economy (Parody)

(From an email)

Ladies and Gentlemen:

This is your Captain Ben Bernanke speaking. Welcome to the now-bankrupt U.S.A. Air, flight number 1929, non-stop service to Depressionville.

After reaching a cruising altitude of 5.25 %, we’ll steadily drop down to 2.0 % and hold it there for a long time before crash landing at Depressionville.

For your safety, please bundle-up Treasury Bills and stay in dollar. Federal law prohibits speculating in commodities.

Our in-flight entertainment will feature two Market Watch films, “2 Dollar Gas,” starring Rex Nutting as comedian, and “Bull Run,” starring Mark Hulbert.

In the unlikely event we loose cabin pressure, there will be a ten dollar surcharge to use the Oxygen mask.

After reaching the cruising altitude, we will be serving you complimentary doses of Prozak and Maylox.

If there is anything we can do to reduce your inflation pain, please do not hesitate to contact one of our flight attendants to receive a low CPI number.

Thank you for choosing U.S.A. air for your final destination, sit back and rest in peace.

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Did the IMF blow the emerging markets bubble?

Sometime in late 2007, a ‘new paradigm’ seemed to have emerged; that of fast-growing developing markets to trade at a premium to the developed world. I was in India in December 2007, and was often befuddled at some of the articles and conversations I came across. Indeed, brokerage houses pompously proclaimed the dawn of a new era in emerging markets. Investors, it seemed, would pay up for the faster growth, disregarding country risk, currency risk, inflation risk, home bias, etc. Truly, a ‘structural change’ seemed to have occurred.

Fast forward six months, and it’s a completely different cup of tea. A lot of ink has been spilled on the under performance in the emerging markets YTD. Some reasons discussed include:

-Increased risk aversion (flight to quality).
-Credit crunch induced liquidation of assets.
-Commodity inflation induced price shocks.
-Reversion to the mean in valuations.
-Reversion to the mean in profit margins.
-Decline in cost competitiveness due to commodity inflation, local currency appreciation and increasing labor costs.
-Debunking of the decoupling theory.
-Uncapitalistic regulatory and price control regimes.
-Political upheaval due to upcoming elections in India.
-*Insert favorite reason here*

Well, how about a new one?

In January 2008, IMF came out with a now forgotten report titled “Global Growth Estimates Trimmed After PPP Revisions”. The report trimmed the annual global growth estimates between 2002-2007 by 0.5% each year, definitely not a ‘rounding error’! More importantly, the contribution to the global output from China went down from 15.8% to 10.9%, and India's contribution was revised from 6.4% to 4.6%: a downward revision of almost 30%!!

Here's an interesting chart from the IMF report:

Quite interestingly, countries whose contributions held steady seem to have outperformed those who faced downward revisions.

If you look at the table above, India (INP) and China (FXI), two countries where the contribution percentages went down sharply, have underperformed in 2008. On the other hand, Japan (EWJ) and Brazil (EWZ), where contributions were (marginally) revised upwards, have held up rather well.

Is this merely a coincidence? While I don’t know the answer to the above question, it's certainly a good one to ask.

Parting thoughts: what are the possible implications of this 30% downward revision on the current commodity super cycle boom? A case maybe of going too far too fast?

Ticker symbols discussed: SPY, FXI, EWJ, EWZ, INP

Full Disclosure: None

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Monday, June 23, 2008

Weekend reading update..

Yet another update on my weekend reading. Last week, we had RBS issue a global stock and credit crash alert. Morgan Stanley chimed in with a warning on a “catastrophic event”.

I’ve read quite a few bearish European commentators talking of a sideways/upwards movement for the markets till early July, and downhill from then on till October. Here’s a few more links to whet your appetites!

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Thursday, June 19, 2008

Quotabale quotes on market direction.

It's always interesting to know what the smart money is saying. These have been culled from my readings over the last 7-10 days. Warning: Most of the commentators sounded bearish to me!

  • Rob Arnott: Stocks are likely to move lower in the next six months and will be in hibernation for years. For the long-term investor, stocks will offer single-digit returns over the next 10 to 20 years, though individual years could be far better or worse.

  • Michael Kahn: Technical analysis can be compared to a court of law where there is not one definitive proof that the trend has changed but a preponderance of evidence to say so. No bell has rung, but there is also no denying what is happening before our eyes. And until the evidence starts to pile up on the other side of the battle, we must act as if this is a bear market.

  • Jeff Saut (paraphrasing Ken Dupre): The market is cheap at a 16x P/E multiple (vs. 19 P/E a year ago) on depressed financial earnings, and there is a lot of cash on the sidelines. To me, this suggests a slow, rising, more volatile market. I am also a seasonal man and believe there are always bargains to be found in September/October, so having some cash today, or raising some this summer in rallies, should be useful this fall.

  • Prieur du Plessis: I would like to stress again that the emphasis at this juncture should be on the return of capital rather than the return on capital.

  • Nassim Taleb: “America is the greatest financial risk you can think of.”

    “Governments and policy makers don’t understand the world in which we live, so if somebody is going to destroy the world, it is the Bank of England saving Northern Rock. The biggest danger to human society comes from civil servants in an environment like this. In their attempt to control the ecology, they don’t understand that the link between action and consequences can be more vicious. Civil servants say they need to make forecasts, but it’s totally irresponsible to make people rely on you without telling them you’re incompetent.”

  • Larry McMillan: We have no buy signals from our indicators. However, we do have oversold conditions. Thus a short-lived and potentially powerful rally could spring up at any time. We think any such rallies should be sold.We think that this new down leg is strong enough that it will have to be resolved with a typical capitulation low -- involving a spike peak in $VIX and put-call ratio buy signals near the top of their charts. By the time all that happens, it would not be surprising to see $SPX in the neighborhood of the March lows. If so, it will be interesting to see whether or not a "retest" holds.

  • Eoin Treacy (Fullermoney): US government bonds in long-term bear market. Yields took 22-years to fall from their accelerated peak and may yet take as long again before they reach the highs of this secular move.
    This is a long-term cycle, and it will not be the same as the last bond bear market, but it will give context to almost every other asset class over the coming decades.

  • John Hussman: The prospect of 10-year total returns of just 4% in Treasury bonds is not particularly compelling on an investment basis, so the primary driver of bond returns will be speculation about economic weakness and a ‘flight to safety’ from credit concerns.

    Presently, deteriorating stock market internals suggest fresh skittishness among investors, which coupled with still-rich valuations (on the basis of normalized earnings) often results in particularly negative outcomes for stocks.

  • Richard Russell: The implications of the Lowry’s statement is clear enough. If there is no case of Lowry’s Buying Power making new lows many weeks after an important market bottom – then the fact that Lowry’s Buying Power is now making new lows indicates that the stock market has NOT yet put in an important bottom. In other words, we have not yet seen a bottom so far in 2008. If this is true, then the major averages and many, if not most, stocks are fated to break to new lows.

  • Brett Steenbarger: From housing to the dollar, banking to commodities, national debt to soaring Medicare and Social Security obligations: it's difficult to see the period since 2002 as anything other than one of profligacy and utter fiscal mismanagement. I am not a bear by nature, but when you consider the average debt of the average household and the concentration of household assets in housing, it's difficult to see happy retirements for many baby boomers.

  • David Rosenberg: The euphoria in the equity market has been breathtaking in the past few months. Are we believers that this is sustainable? The answer is no.

  • Gary Shilling: We think the unemployment would be going to 7.2% in the second quarter of next year, which we think would be the bottom of the recession. Brushing it aside is Fed's assertion that inflation is a concern not economic growth, but we don't agree with him. We are looking for the biggest decline in consumer spending of any recession since the 1930s.
    To make a bold prediction, I think towards the end of the year we'd be back to worrying about deflation and not inflation. We are long the Dollar against the Euro currency.

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Sunday, June 15, 2008

Weekend reading

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Saturday, June 14, 2008

On bond yields, treasuries and inflation

We’ve had Bill Gross coming out with a no holds barred scathing commentary on the US understating CPI. Other commentators have chimed in with a view that treasuries could be the most overvalued asset class in the world. (back in March)

I had an interesting email exchange which takes the opposite point of view(You should click the post link to view the emails). Here’s the email :

I have been a big proponent of the long-term US Treasury STRIPS. For the first ten years of their existence, 02/28/85-02/28/95, they were a far superior investment compared to S&P 500. Their total compounded annual return for the 10-year period was 15.3% compared to 14.14% for the S&P 500. Their beta was only 0.36 compared to the S&P 500.

1995 also happens to be the time when stock market investments were heavily pushed by 401-Ks based on their 3, 5, and 10-year returns. Were STRIPS, with superior returns and lower risk, offered as a choice in any 401-K programs?

The UST STRIPS have also been a far superior investment to the S&P 500 during the last ten years. The UST STRIP bought for $1,000 on 02/28/85, when first available, would be worth more than $9,000 today. We know that inflation has only been up by a factor of 2. Even for the conspiracy theorists it has not been more than a factor of 3.

Here was the reply:

Going long STRIPS in mid 80s, and staying long through the period of "the great moderation" was obviously a great strategy in hindsight. Gary Shilling was a famous advocate of the "Long Bond" through these 20 odd years.. (You can check his chapter from John Mauldin's "Just one Thing" for a quick review)

Going long bonds/STRIPS at the ridiculously low yields you have today is plan hara kiri. We might be in for a 10+ year bear market in STRIPS. If the US is understating true inflation, why would you be advocating a long STRIPS strategy now?

Buying treasuries at historic low levels is a crap shoot at best – sure rates might go lower, we might get a Japanese style deflation. But even in the unlikely case that happens, your upside is limited while the risk of being wrong is high, and the opportunity cost higher. CPI showed inflation at over 7% annualized! Kind of sucks to be losing money as treasury yields rise to a negative real returns.

Counter reply :
It was in February 28, 1985, when UST STRIPS began (the Treasury dept started to deal with them directly). The inflation had peaked five years ago and the headline inflation rate had come down to 3.52%! For the next ten years the long-term UST STRIPS out-performed the S&P 500 with a beta of only 0.36.

$1,000 invested in long USTs in Sep 1981 and then converted into STRIPS in Feb 1985 would be worth $20,000 TODAY and I expect that to be $25,000 by 2010. That is good enough for me. The Yield on the 10-Year will go below 2% and long-term UST STRIPS would out-perform. Inflation is in the process of peaking and will collapse 12-15 months into the recession.

Hmm. Certainly food for thought! I think there is a strong case to be made for a second half treasury rally.

I also highly recommend checking out John Mauldin’s Just One Thing for this and other similar interesting ideas.

On the back of this exchange, here’s an interview with Mr. Long Bond himself (Gary Shilling). He seems to agree with this point of view.

(Note: I haven’t checked the authenticity of the exact numbers, but the general trend is indeed right)

Disclosure: None

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Wednesday, June 11, 2008

Nice chart.

Came across this interesting chart:

It seems Trichet’s comments caused a rally at the backend of the European curve. In my opinion, this could be implying a slowdown in the European economy, with lower yields going forward.

A flat yield curve in Europe, along with the negative news we've been hearing on the European names, could be implying a tough second half for the European banks.

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Monday, June 2, 2008

Revisiting the indicator review theme

Would you buy this chart?

Your opinion on this chart could very well determine your opinion on the market. The chart is the US Treasury ten year note yield.
  • If you think this breakout is sustainable and a long term one, then that's bad news for stocks . If this looks overbought on an intermediate term basis (and due for a correction), then that’s definitely a positive.

  • I personally think the ‘rising yields, rising inflation’ theme is a multi-year one. However, if things get rough for the remainder of the year, , the yields could very well go down and retest their March lows. (People could be underestimating the deflationary impact of declining home prices and any decline in monetary velocity)

  • The Fed has cut by more than 300 basis points over the past year. Yet, the change in the mortgage yields y-o-y is a paltry 40 basis points. The cuts are obviously not having their intended effect on the mortgage mess .

Here’s a look at the S&P500 chart:

  • The index briefly did a head fake by breaking out above the 200 day moving average, but quickly reversed direction and has now successfully tested the 50 day moving average, twice.

  • If we close below 1375 then of course all bullish bets are off.

  • The fact that this support has held, and looks to be forming a double bottom (notice the second retest is at a higher low), might imply a sideways-upwards pattern for the equity markets for the next 4-5 weeks.
I’ve also talked about the carry trade(dollar-Yen) as a proxy for investor risk appetites.
  • The carry trade is dead. Long live the carry-trade!

  • Yen is flirting with the 105 level, inspite of the 5% decline in the equity markets. Risk appetites and the ‘carry-trade’ is still very much alive.

  • The indicator review theme has consistently been the ‘reversion to the 200 day moving average’ one. Given that premise, we could very well see Yen close above 107 before the current upturn from March is in serious trouble.

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Tuesday, May 27, 2008


Been caught up in work. Huge deadline first week of June. Blogging shall be sporadic in the meantime.

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Thursday, May 22, 2008

Bill Gross on Inflation.

Bill Gross came out with a pretty scathing article today, questioning the low inflation numbers used in the US. He made a clarion call to fellow Americans to get off the couch and shape up – physically, intellectually, and institutionally His arguments made a lot of sense, and I suggest reading the whole article.

Gross was also on CNBC:

His bottomline: Invest in BRICs and countries which are more transparent about their inflation numbers, with authentic real growth and inflation rates.

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Wednesday, May 21, 2008

Short oil because of excessive speculation?

It’s weird how normal $100 plus oil suddenly seems. Oil has gone parabolic, and this chart from Bespoke Investments seems to suggest that things could be getting toppy.

Speculators are not very popular right now. Futures trading in many commodities across the world has been banned. Numerous experts have spoken out that most of crude’s price today is due to "speculation" and a "strong inflow of funds". Indeed, I came across this interesting article where an analyst was commenting on the rampant speculation in the oil space:

Fadel Gheit, an oil analyst at Oppenheimer, said record-breaking prices are a result of pure speculation by hedge funds and commodities traders, not a result of negative market fundamentals, adding that there is no real supply shortage.

"But rumors and speculation have taken over the market," said Gheit. "For example, even if the oil company is shut down, which Russia would not allow, they could maintain their current export volume, because they are limited only by capacity, not by production. And Russia has plenty more oil waiting to be exported."

Before you run off to double your short positions, check the date. The article was published way back on August 2004. The path of least resistance has been consistently up these past few years (even with a 40%+ price correction like we had in 2006). That price action needs to be respected. While oil may very well go down in the event of a global recession, it could also double in between.

Speculators play an important role in price discovery, and just because speculation is rife doesn’t mean that prices are unstable and headed down. Speculators are trend followers, not trend creators. Judging by what the strategists are saying, we may end the year up. (Goldman Sachs is now forecasting a second half price of $141 and a super spike price of $200). Marketwatch has this article with Outstanding Investments predicting $140 oil.

Trying to time the change in a multi-year trend line is risky, especially one that's hitting a new 52 week high seemingly every week.

Full Disclosure: No positions

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Tuesday, May 20, 2008

Interesting Dollar Yen commentary.

Argues that we may actually break the dollar yen downtrend, at least on a short term basis.

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Monday, May 19, 2008

Quotable quotes: the Market direction edition

Which way do you feel like lurching, Mr. Market?

I guess this week can be wrapped up as the 200 day MA week! Everyone was talking about the significance of a breakout above that level on the S&P500 and the Dow.

-We are at a point where the YTD losses are being erased. That could feed in some “extra cash” and keep us going sideways/up for the next few weeks.
-All that emerging markets money which went into commodities could very well rotate into stocks.
-We've had some solid action, with the S&P closing at or near it's intra-day high.
-Can we have a rally if the energy prices go down, dragging the energy and materials sector with them? Can we sustain this rally if the commodity prices/sector continue going up?
-I’m looking out for a Yen breakout and a ten year yield breakout. I think we could be seeing 4% yields on the ten year and a 107 on the Yen before we are through with this rally. (I’ve talked about a reversion to the 200 day MA in my posts earlier). (You can also check out an earlier market direction post)
-I feel the risk-reward situation is for a 5% upside, and a 15% downside.

Well, why listen to me? Let’s catch up on what the strategists are saying on the market direction in this marathon edition:

  • Teun Draaisma : We think the bear market rally is at or near its end. We do not recommend investors to be short yet, and our index target implies 0% downside on a 12-month view. If we were to go 5% higher from here, the risk-reward to short equities would be good.

  • Rick Santelli: It’s a question of realistic expectations. Realistic is that the darkest impact of the credit crisis and the industries in the construction and the housing sector may be behind us. But it's the rate of change.. it’s kind of how much of the path we have going forward. The truth is somewhere in between. Having a bottom is one thing. Having a parade that we are going to the moon is the other end. :)

  • Michael Kahn: The good news is that last week's stock market slide was halted right at the rising March trend line. The better news is that the Russell 2000 has finally broken free from its 2008 trading range. The rally is still on the ugly side with market breadth lagging behind price action and volume still fading.

    Another bit of ugly comes from the NYSE advance-decline line, which has not yet moved above its 2008 range. Market breadth has not confirmed the rally, at least not with any degree of confidence.

    Based on the evidence, we do have a rising trend but one that does not have solid technical underpinnings to sustain it. That means short-term investors can follow along as long as they never take an eye off the long-term chart. It is still a bear market rally.

  • Mark Hulbert : The average equity exposure of the market-beating newsletters over the past 20 years is only seven percentage points greater than for the market-lagging newsletters. In March, the comparable difference was 21 percentage points. This lessening of the bullish plurality is not an outright bearish omen, in my opinion. But it does point to the bullish case not being as strong as it was two months ago.

    To be bearish right now, you have to bet that the market timers who have lagged the market over many years are now, uncharacteristically, going to be more on target with their forecasts than the timers whose market timing calls over the years have added value.

  • Jim Rogers :US stock market is still too high as far as I'm concerned! Some stocks went down a lot, but the overall average is down, what, 6%? I'm surprised the market is not down more! The recession is going to be a lot worse than what we've had in a long time. I may be wrong, won't be the first time I am wrong. But it won't be the first time the stock market is wrong either! Zinc and nickel are down 50%. I've started looking at metals again. India and China are still there! Dollar might rally for the rest of the year!

  • Jeffrey Saut: Isn’t it amazing how fear has morphed into greed in a mere seven weeks, for now the cry on the “Street of Dreams” is about the new bull market that has emerged! We, on the other hand, have turned cautious. Our caution centers on the belief that our economic problems are NOT all behind us, the Dow Theory “sell signal” of November 21, 2007, the double-top chart configuration of the SPX at 1560-1570, and the 20-month moving average (MMA) (aka “The Snake”) that has often represented the demarcation line of bull and bear markets.

  • Bill King: For obvious reasons, permabulls, street paper pimps and their stooges in the financial media mitigate the fact that financial firms are raising and must continue to raise enormous amounts of capital and overemphasize purported good news.
    The big sucker rally that we warned almost always follows March (1907, 1929, 1980), and sometimes April (1987) crises as well as soft Q1s in recession years (1990, 1991, 2000, 2001, 2002) is now occurring. And after such sucker rallies, an autumn debacle is a very high probability.

  • David Kotak, Cumberland: We are fully invested worldwide in equities using exchange-traded funds. We will hold these strategies as long as we see the expansion of the Fed’s tools applied for the purpose of restoring the financial system to more normal functionality. When and if we see the Fed reaching a level of cessation of expansion of the tools, we will be proactive in reallocating assets.

    For now this activity is very bullish for equities, and it supports our notion that the US slowdown will be shallower and shorter than it would otherwise have been, had the Fed not become aggressively proactive last December and continued that pro-activity to present.

  • Wilbur Ross : At best we are in a period of stagflation. In the worst case a combination of inflation and a poor economy, largely due to the consumer. Consumer is tapped out and sort of fatigued. I don’t see multiples expanding.

  • George Soros : I think this is a fairly difficult bear market really. I could be wrong, but this is it. I think this is a bear market.

  • Lawrence McMillan: This has been a very strong week, and -- for now -- the danger to the bullish case has passed. $SPX twice tested the trend line, bottoming at 1384 and 1386 last Friday and Monday, respectively. That held, tentatively at first, and more strongly now that $SPX has risen above the 1420 level -- an area that had inhibited advances five separate times this month. Clearly, our observation last week that the trend line was the most important thing about the $SPX charge, was true. In summary, all systems are bullish, and that is evident by the trends in these indicators: the rising bullish trend on the $SPX chart, and the (declining) bullish trends on $VIX and the equity-only put-call ratios.

    Moreover, breadth is overbought, and thus conducive to the bullish case as well. We see no danger to the uptrend until at least two of these reverse direction -- something that doesn't seem too likely at the moment. Equity-only put-call ratios have remained on buy signals since shortly after the March bottom.

  • Anthony Bolton (Fidelity Special Situations) : The recent snap-back in share prices could be short-lived as stock markets face renewed weakness. Equity markets might not hit lows until early next year. The equity market’s slide that began last August might mark the beginning of a prolonged bear market and that the recent rise in equity prices is a “bear market rally”.

  • John Catsimatdis: The dollar is being devalued 30-40% The Dow is still at 12000 something. Yes, it has a lot to rise.

  • Ron Baron: Dow Jones was 11700 on 2000. It’s now 12500. So market has gone up about 1-2% for the past 8-9 years, so yes there is a lot of opportunity in our opinion.

  • John Hussman : With the U.S. stock market still relatively overbought in an unfavorable Market Climate, there is continued risk of substantial and possibly abrupt stock price weakness. As I've noted frequently, I rarely have much of an opinion on near-term direction except when conditions are either overbought in an unfavorable Climate or oversold in a favorable one. We observed some initial weakness late last week, but we remain braced for more significant trouble.
    At the same time, we have to recognize that the rebound through early last week brought market internals not far from the point that would begin to feed purely speculative “trend chasing.”

  • Clark Yingst, chief market strategist at Joseph Gunnar & Co: A lot of the lack of volume is accounted for by the deleveraging of the hedge funds. Requirement of more collateral is a reason for this. Near term Dow resistance level is at 13200. The market is anticipating a better US economy 6-9 months further out. We don’t necessarily agree with that. But we are taking the market action at face value, trying to capitalize on that. We are more inclined to view individual stocks as short term trading vehicles rather than investment vehicles, thinking that if that scenario does not unfold later this year, the market could have a serious retracement.

  • Jeremy Grantham : Sit on the sidelines, unless you're one of those nimble, quick-on-the-button traders who can move money around really fast and leap in and out at the right times. That's a good way to make money if it's your skill set. But for ordinary dudes with a seven-year [time] horizon like us, you've got to pick the long-term fundamental events and stick to them. The toughest thing to do is to stay out of the market, load up on cash and fret about all the money you're not making. But that's probably the best advice. Let the other suckers take all the risk.

  • Alec Young(Standard & Poor's): We are bullish but a little more cautious. We think the market continues to move up through the year. We priced in a weak economy and high oil. We still have enough macroeconomic headwinds eg. analyst revising earnings estimates downwards, that we believe the direction is going to be more two steps up, one step back.

  • Robert Pavlik, of Oaktree Asset Mgmt: I’m very positive on the stock market. I think the market has all the ingredients right now for it to move higher as the year goes on. We are faced right now with a lack of confidence. As we approach the 200 day MA we have an interesting chart pattern developing. It’s an ascending triangle, which is a very positive pattern for going forward. We just need one catalyst to get us over the flat line going up and the market goes up from there.

  • Barton Biggs: Sophisticates are bearish and pessimistic. I am bullish and I believe we have seen the worst. Tech is a major place to be. A great trade would be long financials and IBanks, and short Materials and energy sector.

  • Bill Strazzullo, Bell Curve Trading: The response to the sell-off has been extraordinary. Traders are buying because they have a backstop in the Fed. & Govt. The price for this liquidity is a weak dollar. Does the risk-reward make sense, with all the major issues and challenges? We had looked towards the move towards 1450 on April 10th, and this is where we get off the train.

  • Jordan Kotick (Barclays Capital): Markets around the world are breaking to new all-time highs, led by Brazil. Brazil still has a lot of upside.

  • Stephen Pope(Cantor Fitzgerald Europe): I don't think people can actually afford to sell in May and disappear because there's too much money sitting in the wings that needs to find a home

  • (From Quantifiableedge): Dr. Brett Steenbarger tracks the 10-day moving average over the 200-day moving average of the CBOE total put/call ratio. That reading dropped below 0.85 for the first time since October – also not a good time to be long.

  • Liz Ann Sonders: The current bear market for the dollar is the longest since at least 1967.The current period ranks second in terms of declines, down 41% (July 2001 peak to April 2008 trough), behind the 48% decline seen from February 1985 to December 1987. Entering a new bull market for the dollar would bode well for equities, as the average performance of the S&P 500 during dollar bull markets (averaging 1,708 calendar days) is 86% versus only 16% for dollar bear markets.

    I've often noted the perfect inverse correlation historically between core inflation (excluding food and energy) and market valuation. However, historically, sustainably high food and energy prices have eventually filtered into core inflation. If we get a commodity price reprieve, it should lower core inflation expectations—which could lead to equity valuation expansion.

  • VixandMore: Strong bear signal from VIX:VXV ratio lowest level to date on Thursday, previous low was 12/21/07. At the very least, the bulls should consider some downside protection in the current market environment. I suspect the bears are preparing to pounce very soon…

  • Check out that short interest!

  • Michael McCarty(Meridian Equity Partners) (on the low VIX): This measure broke through a trend established in early 2007 and now appears to be headed lower. The move down is real, and that for investors represents a sea shift, much like in sailing from a headwind to a tailwind. The movement in pricing of risk is now beneficial to stock prices.

Drop me a line if you liked this.

Full Disclosure : No positions

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Saturday, May 17, 2008

What I'm reading

  1. RGE Monitor has an excellent review of commodity price histories. Basically argues that this has been a boom in mineral prices, and not really agricultural related. An interesting trade would be going long the currencies of the major mineral exporters

  2. RGE Monitor: US dollar weakness now and afterwards.
    When inflation becomes the main concern instead of recession, interest rate will be raised and regardless of America’s economic performance, the US Dollar will climb back up.

  3. The Future of Dollar "The situation facing the USD is not irreversible. Although macroeconomic indicators are weak and there is much uncertainty, the USA shows more strength and microeconomic dynamism than many countries. It remains one of the most competitive economies in the world and there are no signals that this is about to change. The USD can take back its strength if the US authorities are prepared to implement the needed reforms. Given the position of the current administration, we will have to wait for the next one to sort this out."

  4. Thinkthoughts with a megatrends prediction.

  5. Microsoft trying to break the Google hegemony:

    Today, when a Web surfer is looking for a car, he might type "Chevrolet" into Google and then click on an ad alongside the search results. Google gets all the money for that click, even though other marketing efforts, both online and off, probably helped persuade that person to conduct the search. Ideally, an advertiser would know about all the ads that a potential customer sees before he makes a purchase. "They're trying to say that Google's getting too much credit, and there's probably a lot of truth to that"

  6. Things are not looking pretty in China.

  7. Jeffrey Sachs on how to save the world.

  8. Top 10 tech trends. I noticed that location based services were a notable omission.
  9. Retail moats: Fact or facade?

  10. Analysis of the recent spinoff of Dr. Pepper-Snapple (NYSE:DPS).

  11. RGE Monitor: The willingness of Asian countries to impose export restrictions on food and commodities to secure domestic supplies and proposals to form a rice cartel have been widely criticized. Creating an OPEC-like cartel could exacerbate global food price increases, create price distortions for farmers and deeply impact the poor consumers at home and abroad. While undermining the Doha trade talks, the food crisis also highlights the need to improve agriculture investment and yields as urban population and incomes rise.

  12. The Absolute Return Letter's May edition is titled Food for Thought. Basically argues that the current food price inflation is mainly driven by US ethanol policy and massive investment inflows into the commodity asset class. Also talks about falling agricultural productivity and the impending water shortages.

    Most investors seem to believe that headline inflation will gradually come back to core inflation levels over the next year or so. Few investors seem to
    think the unthinkable — that core inflation will gradually rise to headline levels.

    Even fewer seem to realise that if oil prices and agricultural prices continue to run amok, the Asian miracle story, upon which so many investors have pinned their hopes for the next few years, may, in fact, turn into a nightmare. The reason is simple enough. Asian countries are large importers of both oil and food staples. Very large!

    My food for thought: What's the impact of commodity inflation on Asian currencies and growth estimates? Indian rupee has declined over 10% in a two week period on the back of food price inflation. What about the current growth rate estimates? The BRICs are a 14 trillion economy on a Purchasing Power Parity basis, but only one-third that on a nominal comparision. I just fear that the PPP-based estimates might be overstating the case.

    Because of where the BRICs are on the utility curve and the inefficiencies in the system, a 5% rise in commodity prices has a much serious impact on the regional economies than in the developed world. I'll also point out to the fact that Indian elections are due next year, and money supply growth is running at a 30%+ rate; definitely not promising indicators on the shape of things to come.

Full Disclosure: No positions

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Wednesday, May 14, 2008

Memory vendors investment thesis: timely call.

Here’s an interesting video which shows the advantages of a Solid State Drive over a Hard Disk.

The article I had written earlier about the impending upturn in the memory sector turned out to be quite timely (Here’s the Seeking Alpha version).

  • Citigroup upgraded Sandisk on Tuesday. SanDisk Corporation (NASDAQ:SNDK) is Citi's mid-cap top pick on contract pricing and EPS revision catalysts.
  • Trade radar posted a summary on the industry coverage. It talked about the Citigroup upgrade, reports by the DRAM Exchange, the Korea Times, and the
  • Applied Materials, Inc. (NASDAQ:AMAT) on their conference call talked about a sharp slowdown in DRAM and NAND flash spending. (A sure sign of price stabilization.) The memory vendors, Micron Technology, Inc. (NYSE:MU), SanDisk Corporation (NASDAQ:SNDK) and Qimonda AG (NYSE:QI) rallied on the news.
  • [EDIT]: There was a Sandisk upgrade from Needham as well.

One consequence of any stabilization in memory pricing would be a minor erosion in the margins of companies like Hewlett-Packard Company (NYSE:HPQ) and Apple Inc. (NASDAQ:AAPL). These guys have been helped thus far by a favorable commodity pricing environment, which might be tough to repeat going forward.

While this rally may turn out to be short lived, and we may very well retest the January -March bottom, the consensus is slowly but surely turning around to the fact that the worst in the memory sector is probably behind us.

Full Disclosure: No positions.

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Tuesday, May 13, 2008

Quotable quotes : The Warren Buffett edition.

I got held up in posting the quotable quotes for the week. Well, we had the investing Woodstock in Omaha Nebraska. When Warren speaks, you don't need to hear what anyone else is saying! Make a note, remember it, and file it away for posterity.

These are quotes by both Buffett and Munger from the Berkshire shareh0lder meeting and the Wesco shareholder meeting. While this event was heavily covered, I still wanted to put together what I think are truly 'words of wisdom' or interesting observations.

  • (Book reco) I'll read the Intelligent Investor, chapters 8 and 20 I recommend
  • (On hiring managers)I would look for a person with a passion for the job, doing more than their share, good communicators.
  • The two most important things one can learn are: 1. How to value a business and 2. How to overcome influence from market fluctuations. (On what you should learn from Business School)
  • Go to work for organization you admire or an individual you admire. Which also means most MBAs I meet would be self employed.
  • I went to work for Ben Graham. I never asked my salary.
  • You’ll do better if you have a passion for something in which you have an aptitude. If Warren had gone into ballet, no one would have heard of him.
  • I avoided all classes that had public speaking, I got physically ill if I had to speak. I signed up for Dale Carnegie course. Gave them check for $100, then I went home and stopped payment on check. I was in Omaha, took $100 cash to Wally Kean, I took that Carnegie course, and then I went to University of Omaha to start teaching – knowing I had to get in front of people. Ability to communicate in writing and speaking – it is under taught – and enormously important. If you can communicate well, you have an enormous advantage. Force yourself into situations where you have to develop those abilities. At Dale Carnegie – they made us stand on tables. I may have gone too far. You are doing something very worthwhile if you are helping introverted people get outside of themselves.
  • It’s the nature of things that most small businesses will never be big businesses. It is the nature of things that most big businesses fall into mediocrity or worse. Most players have to die.
  • (Advice to 12 year old) I’d read a daily newspaper. You want to learn about the world around you. Bill Gates quit at letter P in World Book Encyclopedia. Just sop it up, and find what is most interesting to you. The more you learn, the more you want to learn. It is fun.
  • I wouldn’t be in currencies with a small amount of money.
  • I think it is stupid to use up hydrocarbons of the world so quickly. Stupid when there are few and limited alternatives. What should we have done? We should have brought all the oil over from Middle East and put it in our ground. Are we doing it now? No. Government policy is behind in rationality. If we have prosperous civilization, we must use the sun.
  • Accounting people really failed us. Accounting standards ought to be dealt with like engineering standards.
  • The great problem of mankind is that the genie is out of the bottle on nuclear weapons.
  • We live in a dangerous world. Getting more dangerous as we go along. In Cuba Missile Crisis it was probably a 50/50 odds, we were lucky. It won’t go away. You would hope we have an administration which will try to figure out how to minimize the risk. It should be paramount to eliminate deaths on a large scale.
  • When I get classes in universities I ask them to buy one classmate to own for rest of life. They pick the person who not with highest IQ, but who are most effective, the ones you want to be around. These people are easy to work with, generous, on time, not claiming credit, helping others. There are things that turn other people on, and turning other people off. Those are good habits to develop.
  • Your children will live in a better country than you, even if a few idiots run it in the meantime.
  • I think you have to start with the idea that a lot of the current troubles are richly deserved.
  • We may not save very much because we don’t need to. We are a very rich country, and we may not need to save as much as other countries trying to reach their potential.
  • If we had banned the phrase, “this is a financial innovation which will diversify risk", we would have been far better off.
  • Most important job you have is to be the teacher to your children. You are the big great thing to them, you don’t get the rewind button, you don’t get to do it twice, teach by what you do not what you say. By the time they get formal school they would have learned more from you than school.
  • If you look at effective individual – why do people want to be around them? You should copy those qualities… I would look for what I admire and emulated, and try not to let things distasteful be copied.
  • Capitalism without failure is like Christianity without hell.
  • Inflation is bad for civilization but great for capitalists.

Note: These are Charlie Munger quotes from Wesco’s shareholder meeting.

  • People are used to laying money aside and investing in standard fashion, and becoming quite comfortable. It is easy to forget that this isn’t guaranteed.
  • The reason my generation did so well was kind of a fluke, and won’t necessarily continue. There will be lots of chicanery in future. Many claim alpha – but really they are just taking an earthquake risk.
  • Envy effects corporate compensation. People want to be paid like movie stars rather than archbishops.
  • (On Berkshiree) There is a lot to be said that people in power make money with shareholders, not off them.
  • We do not need the smartest people in science and math in computer driven strategies. This is not a plus for the wider civilization.
  • We normally avoid [discussing the general investment climate] like the plague. Most assets are priced to a level where it is hard to get excited. It is hard to get 4% yield on a nice apartment, and it doesn’t include replacing the carpets. Bonds of strong corporations are 4% yield. Corporate equities are paying 2% pa, growing 4% per year. Such a world isn’t the one that made all of you able to come to the meeting. Last generation has been in hog heaven – some bumps, but it had easiest time getting ahead. In the eighteen years that preceded hog heaven, the purchasing power of Yale’s endowment went down 60%. They were getting real investment return of 0%, negative. It is not at all impossible that brilliant investors like Yale get bad results in the future.
  • The only duty of corporate executive is to widen the moat.
  • (On CDS) There is no reason in America to have vast bets on $100m bond issue to which no one is party. It creates needless complexity and very perverse incentives. They say “it’s a free market”. The correct adjective is insane.
  • (On war on terror) Terror is a hell of a problem. People are vastly overconfident in the solution. They are probably making an error.
  • I would avoid funds that have 100% turnover per year. It is a ridiculous way for an ordinary index fund to behave.
  • Berkshire would have been a mess if it had ever stopped learning. Only reason we’ve been able to keep a shred of decency in our record is that we have been hell bent to keep learning.
  • We tend not to sell operating businesses. That is a lifestyle choice.

Full Disclosure: No positions.

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Sunday, May 11, 2008

Shorting share buybacks: great comments.

Boy, taking the opposite side of a well accepted notion does upset quite a few people!

The shorting share buybacks blog entry attracted a fair amount of comments on Seeking Alpha. In case you missed out, the Seeking Alpha article can be found by clicking here.

I shall be posting a summary and addendum of my thoughts on the subject early next week.

Thanks for the excellent exchange.

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Friday, May 9, 2008

Contrarian pick: Buy flash memory vendors because of elasticity.

The investment thesis in flash memory vendors consists of the following:

  • Memory prices are in the dumps.
  • The creation of newer markets due to price erosion.
  • Increased demand due to higher memory capacities and new markets, more than offsetting any price per bit declines.
  • Memory vendors currently trade at rock bottom valuations.
  • Most existing players are looking to divest or merge. The survivors should be great investment candidates.
  • The trend towards mobility and computing convergence will drive growth towards newer markets and higher capacities.

Moore's law has been a constant guiding light over the last 30 to 40 years in the semiconductor industry. Gordon Moore made this observation thirty years ago, and it has held true ever since. This basically predicts the shrinking of transistors, thus doubling performance every 18 months, with reduced costs and area. The reduced cost and added functionality facilitates their use in a wider array of markets and applications.

As the average selling price (ASP) continues to plummet, elasticity dictates that newer markets and applications would be discovered, which would simulate sales growth. Andy Kessler discovered the same phenomena with EPROMs in the 1980s. Really, nothing has changed in terms of demand supply curves. Elasticity is the guiding investment principle in this sector.

Right now, as memory prices collapse and vendors bleed red, people are scared from investing in companies like Micron Technology, Inc. (NYSE:MU) and SanDisk Corporation(NASDAQ:SNDK). A slump in demand, coupled with an oversupply, has forced vendors to sell memory chips below cost. Many have predicted an impending shakeout with the smaller players either exiting or being bought out. Most chip companies like Intel Corporation(NASDAQ:INTC), Advanced Micro Devices, Inc. (NYSE:AMD), Infineon Technologies AG (NYSE:IFX) and STMicroelectronics N.V. (NYSE:STM) have spun off or merged their 'undesirable' memory divisions, or are in the process of doing so. The memory sector has been left for dead, which is exactly the best time to get in from a contrarian perspective. A similar shakeout took place in the mid 1980s, when Intel exited the DRAM sector. That turned out to be a good time to invest.

The number one use of flash right now is in Apple Inc.’s(NASDAQ:AAPL) iPods. Just contemplating the possible markets where memories could be widely used gets me excited.

  • Think of the growth in feature rich cell phone markets. Multiply that growth with the increasing memory capacities for each of those cell phones. You get the picture.
  • The introduction of the high memory capacity iPhones by Apple Inc.’s(NASDAQ:AAPL) should drive other phone providers to beef up the memory capacity in their phones, thus accelerating the trend towards higher capacity phones.
  • While everyone is anticipating a faster 3G rollout because of the iPhone, fewer analysts are anticipating the growth in memory usage. Broadband and wireless just gets wider coverage than the commoditized memory sector.
  • In 2007, 271 million PCs (laptops+desktops) were sold. In contrast, a mind boggling 1.15 billion cell phones were sold last year (and growing fast). As these become more feature rich and pack in higher capacity chips, the memory vendors who survive the current shakeout are in for a bonanza.
  • Solid state drives in laptops are on the cusp of mass adoption. Five years from now, most of us would be toting around flash enabled SSD drives. Flash memories would be faster, less noisy, more power efficient and increasingly a preferred usage choice for even high capacity drives.

Check out the graph below. While I agree with the growth projections, I’d just like to add that it probably underestimates the cannibalization of MP3 player growth rates due to integrated phones with music capabilities (like iPhones), and underestimates the erosion in USB Drives due to online storage and cloud computing applications.

Here would be the top three names to play the memory sector:

  • Sandisk(SNDK): A strong patent portfolio in flash, good management, a visionary CEO in the form of Eli Harari, and an innovative marketing and design strategy makes this a buy. Should come out very strongly through the current downturn.
  • Micron(MU): One of the strongest patent powerhouses in the world. It’s resilience to past downturns and current scale makes it a buy.
  • Samsung: A low cost structure due to geographical location and scale gives it a serious competitive advantage. Should survive any shakeout and continue to do well in an economic upturn. This is not a pure memory sector play, as it has several product lines.
  • Bonus: iShares MSCI South Korea Index Fund (NYSE:EWY) would be a diversified way to gain exposure to Samsung (14% of the ETF). Moreover, valuations for Korea are attractive, as suggested by Warren Buffett recently.

Caveat: There is a potential threat from newer memory technologies (FeRAM, MRAM, phase change RAM), but their commercial deployment and proven success is still many years away.

In short:

  • We are truly on the cusp of a phenomenal growth cycle in memory chip usage.
  • The best part is that people absolutely hate the sector right now.
  • This makes it a classic contrarian pick.
  • The current carnage would scare away incumbent semiconductor players toying with the idea of an entry.
  • Demand-supply elasticity tells us that the memory sector should scale beautifully over the next few years.

To conclude, buying the discounted memory chip vendors close to the bottom of the economic cycle sounds like an excellent investment proposition.

What say you?

Stocks mentioned: MU, EWY, SNDK, AAPL, INTC, AMD, IFX, STM

Full Disclosure: No positions.

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