Andy Sutton's Extemporania

Weekly Commentaries and Occasional Observations

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December’s Centsible Investor is Available

by TwoCentsEditor

Published on: 12/15/2010

Categories: Centsible Investor Info., Economics, Financial Markets

Tags: andy sutton, Centsible Investor, investment, portfolio, stocks

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This month’s Centsible Investor is now available. For more information or to subscribe, Click Here

A quick status update on the Original Model Portfolio: Currently, the dividend-producing segment has a total return of 13.30% including dividends. This while the major indexes are off around 20% during the same time period.

Overall, the model portfolio with its newly added segments is up 11.47% with the Precious Metals leading the way, up 17.32% with only half the monies in the segment deployed at this time. Our precious metals purchases are up a whopping 36% in less than a year’s time. The speculative segment is up 8.15%, and we only began adding to this slice a few months ago. The fixed income slice is up 5.00% with the first additions coming just 11 months ago.

The 11%+ return is a bit deceiving since the portfolio is barely 50% invested at this time. The balance of the value is sitting in cash waiting for opportunities as we identify and present them.

On November 2nd we dispatched to our subscriber base regarding our in-house econometric interest rate model. The model had just issued a rather strong signal on the 10-year Treasury note. In the month and a half since that dispatch, the 10-year note has plunged with yields rising 96 bps to 3.49%. This month’s keynote article focuses on interest rates, the model, and the implications of a higher cost of borrowing for the USGovt.

This month’s energy report further dissects the situation with regards to imports, exports, US production and the systematic gap between what we’re consuming and what is being brought to market. We also follow up on some breaking news regarding the Marcellus shales in the eastern US.

Each month our precious metals report will now contain pertinent news and events in the rare earth space as well as analysis of additional REO companies moving forward. Our first REO play has done very well in the month since it was added and we’re expecting big things from this little known, but heavy hitter moving forward.

In the market report we discuss prevailing conditions from both a technical and fundamental perspective and analyze our model portfolio slice by slice. We’ve got some big winners and we’re going to cut one loose to lock in some nice profits.

Is the Wall Street Party Over?

by TwoCentsEditor

Published on: 09/20/2010

Categories: Current Events, Financial Markets

Tags: Economics, economy, finance, investment, money, stocks, Wall Street

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NY Times

Inside the great investment houses on Wall Street, business has taken a surprising turn — downward.

Even after taxpayer bailouts restored bankers’ profits and pay, the great Wall Street money machine is decelerating. Big financial institutions, including commercial banks, are still making a lot of money. But given unease in the financial markets and the economy, brokerages and investment banks are not making nearly as much as their executives, employees and investors had hoped.

After an unusually sharp slowdown in trading this summer, analysts are rethinking their profit forecasts for 2010.

The activities at the heart of what Wall Street does — selling and trading stocks and bonds, and advising on mergers — are running at levels well below where they were at this point last year, said Meredith Whitney, a bank analyst who was among the first to warn of the subprime mortgage disaster and its impact on big banks.

Worldwide, the number of stock offerings is down 15 percent from this time last year, while bond issuance is off 25 percent, according to Capital IQ, a research firm. Based on these trends, Ms. Whitney predicts that annual revenue from Wall Street’s main businesses will drop 25 percent, to around $42 billion in 2010, from $56 billion last year.

While the numbers will not be known until after the third quarter ends and financial companies begin reporting earnings in October, the pace of trading this summer was slow even by normal summer standards. Trading in shares listed on the New York Stock Exchange was down by 11 percent in July from 2009 levels, and August volume was off nearly 30 percent.

“What’s happened in the third quarter is that after a very slow summer, people expected things to come back,” said Ms. Whitney. “But they haven’t, and the inactivity is really squeezing everyone.”

The downward slide on Wall Street parallels a similar shift in the broader economy, which has slowed considerably since showing signs of a nascent recovery this spring. And if banks come under pressure, all but the safest borrowers may struggle to get loans.

With less than two weeks to go in the third quarter, companies will be hard-pressed to fulfill earlier, more optimistic expectations.

“It’s like the marathon: if you’re five miles behind, you can’t make that up in the last 10 minutes of the race,” said David H. Ellison, president of FBR Fund Advisers, a money management firm that specializes in financial companies. Many banks are barely scraping by in traditional Wall Street business.

As a result, executives, portfolio managers and analysts say that even the mighty Goldman Sachs, which posted a profit every day for the first three months of the year, is unlikely to deliver the kind of profit growth that investors have come to expect.

Keith Horowitz, a bank analyst at Citigroup, said he expected Goldman Sachs to earn $7.8 billion in 2010, a 35 percent decline from the $12.1 billion it made last year.

The drop in trading translates into lower commissions for brokerage firms, as well as a weaker environment for underwriting initial public offerings and other stock issues, traditionally a highly lucrative niche.

Banks are also scaling back on making bets with their own money — known as proprietary trading — another huge profit source in recent years that will soon be forbidden under terms of the financial reform legislation passed by Congress this summer.

Indeed, analysts have finally started to bring their forecasts in line with the new reality. On Sept. 12, Mr. Horowitz reduced his estimates for third-quarter profits at Goldman and Morgan Stanley.

Mr. Horowitz had predicted Goldman would make $1.75 billion in the third quarter, or $3 a share; he now expects Goldman’s profit to total $1.34 billion, or $2.30 a share. For Morgan Stanley, his revision was even steeper, with earnings expectations revised downward to $140 million, or 10 cents a share, from $726 million, or 53 cents a share.

Mr. Horowitz’s estimates are considerably lower than the consensus among analysts who track the two companies. If the other analysts revise their estimates closer to his, they would put pressure on the shares.

One of the rare bright spots for Wall Street recently has been the issuance of junk bonds, as ultra-low interest rates encourage investors to seek out riskier debt that carries a higher yield. But that will not be enough to offset the weakness elsewhere, said one top Wall Street executive who insisted on anonymity because he was not authorized to speak publicly for his company, and because final numbers would not be tallied until the end of the month.

To make matters worse, he said, many Wall Street firms increased their work forces in the first half of the year, before the mood shifted and worries of a double-dip recession arose. If activity remains anemic, firms could soon begin cutting jobs again.

“I think the summer was horrible for everyone, and no one expected it to be as bad as it was,” he said. “It’s coming back a little bit in September but nowhere near enough to make up for what happened in July and August.”

The profit picture is brighter for diversified companies like JPMorgan Chase and Bank of America, which have larger commercial and retail banking operations in addition to their Wall Street units, but some analysts say earnings expectations for them could come down as well.

“Estimates still seem a little high, and the revenue story for all the banks is not a good one,” said Ed Najarian, who tracks the banking sector for ISI, a New York research firm.

With interest rates plunging, banks are making less off their interest-earning assets like government bonds and other ultra-safe securities. At the same time, demand for new loans remains weak.

One wild card will be the credit card portfolios at major banks like JPMorgan, Bank of America and Citigroup. As delinquencies ease, Mr. Najarian said, credit losses are likely to decline. That trend helped earnings at JPMorgan in the second quarter, and could be crucial again in the third quarter.

Ms. Whitney says the gloomy short-term predictions foreshadow a series of lean years in the broader financial services industry.

Indeed, she said the Street faced a “resizing” not seen since the cutbacks that followed the bursting of the dot-com bubble a decade ago.

“We expect compensation to be down dramatically this year,” she wrote in a recent report. She predicts the American banking industry will lay off 40,000 to 80,000 employees, or as many as 1 in 10 of its workers.

That may be extreme, but Ms. Whitney argues that the boom years are not coming back anytime soon. As both consumers and companies cut back on debt, and financial reform rules put the brakes on profitable niches like derivatives and proprietary trading, the engines of earnings growth for the last decade will continue to sputter.

A Bit of ‘Must-Have’ Market Information

by TwoCentsEditor

Published on: 09/16/2010

Categories: Centsible Investor Info., Current Events, Economics, Financial Markets

Tags: andy sutton, bonds, Centsible Investor, Economics, finance, gold, investment, investment newsletter, justin bieber, lady gaga, money, silver, stock market

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September’s issue of ‘The Centsible Investor’ is available.

A quick status update on the Original Model Portfolio: Currently, the dividend-producing segment has a total return of 13.59% including dividends. This while the major indexes are off around 25% during the same time period. Our Precious Metals purchases in the Model Portfolio are up 21% in just 10 months.

This month’s keynote article focuses on the financial markets and the Ides of Autumn that have wreaked havoc for 8 of the past 13 years. We also enumerate and detail the bullish and bearish factors facing equity markets right now and provide updated Elliott charts. If you want to know where markets are headed, this is the publication you need. Click Here for more information.

Dow Stumbles to Worst August Since 2001

by TwoCentsEditor

Published on: 08/31/2010

Categories: Current Events, Economics

Tags: bonds, business, finance, investment, money, stock market crash, stocks

Comments: No Comments

Stocks limped to their worst August since 2001, battered by a wave of discouraging data that cast doubt on the faltering economic recovery.

Investors now enter September, a month that has been historically challenging for the stock market, against a backdrop of broad uncertainty, including slow growth and deflation fears.

The Dow Jones Industrial Average battled to a stalemate on Tuesday, rising 4.99 points, or 0.05%, to finish at 10014.72. The blue-chip index’s 4.3% drop for the month was the worst since a dismal May, and the measure’s first down August in five years. The Dow had rallied 7.1% in July.

Small-capitalization stocks have taken a big hit this month. Above, a trader on the floor of the New York Stock Exchange Aug. 31.
More

* September Slump Superstitions

August is typically a positive month for stocks, whereas September declines tend to come as companies begin issuing warnings ahead of third-quarter results and mutual-fund managers get back to work after the typically light volume in the summer.

The Standard & Poor’s 500-stock index fell 4.7% for August, while the Nasdaq shed 6.2%. Small-capitalization stocks, a leading indicator of the economy, took an even bigger hit. The Russell 2000 index of small-cap stocks posted its worst August in 12 years, falling 7.5%.

Other barometers of economic activity are flashing warning signals, too. Technology stocks were the weakest performers on Tuesday, taking a hit after technology-research firm Gartner cut estimates for computer sales, reinforcing growing concern about the outlook for the sector.

Intel and Cisco Systems were big decliners, and joined Hewlett-Packard as the month’s worst performers among Dow components, each falling 13% or more in August. The Philadelphia Stock Exchange’s Semiconductor Index fell 11.8% during the month. “The average retail investor is definitely fearful right now,” said Paul Brigandi, senior vice president of trading at Direxion Funds.

Crude-oil prices also fell, dropping 3.7% to bring the month’s fall to 8.9%. Gold edged closer to all-time highs, capping a 5.6% gain for the month.

Stocks made gains early in the day after housing, manufacturing and consumer-confidence data came out slightly better-than-expected. But those gains vanished after minutes of the August Federal Reserve meeting showed policymakers disagreeing over how to support the faltering economic recovery.
Market Data Center

Paul Vigna explains why stocks managed to finish in the green after trading lower earlier and falling below the 10,000 level.

The yen continued to gain on every major currency but the Swiss franc, defying the Japanese policy makers’ efforts, while the safe-haven Swiss currency approached parity with the dollar for the first time in over two years. The euro edged up against the dollar.

Hurricane Hunter

by TwoCentsEditor

Published on: 09/25/2009

Categories: Financial Markets, My Two Cents

Tags: capital, finance, Hindenburg Omen, investing, investment, money, nyse, stocks

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As global stock markets navigate through the eye of the ongoing financial hurricane, it becomes increasingly important for investors still impacted by these markets to be able to gauge when the storm’s fury will reassert itself and plan accordingly. By all measures, there are a healthy number of individual investors still in the stock markets in one way or another who are hoping to recover everything lost in 2008. The good news is they’ve gotten a nice chunk back. If they’ve been proactive as we’ve advocated, then they’re ahead of the game. However, it is important to note that we are operating within the context of a bear market rally; and this bear market still has a lot of teeth left. I am writing this article now, before the DJIA cracks 10,000, because once it does no one will be listening and the opportunity will have been lost.

The Hindenburg Omen

Once it has been established that we are in fact looking for a top, the next order of business is to try to get a handle on when that top might occur. This week we’ll take a look at once such indicator; the Hindenburg Omen. Before we even start it must be said that this indicator is not a be all end all and should only be used in conjunction with other technical indicators, a broad understanding of the macroeconomic environment, and a healthy dose of common sense. It is merely a tool. It is not a magic wand. Such things do not exist.

Essentially, the Hindenburg Omen is an indicator of underlying divergence in the movement of the issues traded on the New York Stock Exchange (NYSE). It is stock market sonar, meant to scan underneath apparently placid waters, searching out turbulence beneath the surface. Merely looking at the daily progression of the price of the major market indexes will not glean any light whatsoever on the actual internal condition of the markets. Examples of such divergence generally happen around major tops, which is what the Omen has been rather good at sniffing out. In the past 25 years there has not been a major market crash event without a confirmed Hindenburg Omen. However, to be fair, it must also be said that every Hindenburg Omen has not resulted in a market crash during this same period of time.

Hindenburg Omen Criteria

There are 5 criteria that must be observed on a particular day in order for a Hindenburg Omen to be registered. They are:

• 52-week Highs and Lows must both be greater than 2.2% of the issues traded on NYSE.

• The lower of the Highs/Lows must be greater than 75.

• The 10-Week NYSE Moving Average must be increasing

• The McClellan Oscillator must be negative.

• The 52-week Highs cannot be more than twice the number of 52-week Lows, but the number of Lows can be more than twice that of the Highs.

• An optional condition for the Hindenburg Omen, which has been found to be extremely beneficial in honing the accuracy of the indicator, is a confirmation within 36 trading days of the initial observation. So in order to have a confirmed HO, two observations need to be made within 36 trading days of each other.

NYSE 10-Week MA

Let’s take a look at the Hindenburg Omens of the past 25 years. It is important to note that the indicator is not exclusively prescient. It will sometimes trigger prior to a crash event, sometimes it is coincident with the beginning of the crash event (the market top), and sometimes it comes slightly after the crash has begun.

Historical Occurrences

In the past 25 years, there have been 27 confirmed Hindenburg Omens and 191 individual occurrences of the Omen. Thus, the rate of occurrence was around 3%. Here’s the breakdown of what happened after those 27 confirmed Hindenburg Omens:

DJIA decline of 15% or more: 8 times or 30%

DJIA decline of 10-14.9%: 3 times or 11%

DJIA decline of 5-9.9%: 10 times or 37%

DJIA decline less than 5%: 6 times or 22%

Of the last group, 2 of the declines were less than 2% and therefore considered ‘failures’ in terms of the predictive value of the signal. Looking at it a different way, there is a near 78% chance that a confirmed Hindenburg Omen will result in a 5% or greater decline in the DJIA. In the context of the current position of the DJIA, we would have a 78% chance of at least a 480 point drop if we had a confirmed HO. Fortunately, as of this time we do not, and in fact do not have even an unconfirmed observation.

Below is the chart of data for the Confirmed Hindenburg Omens shown.

Hindenburg Omens Since 1990

Incidentally, there is no relationship at all between the number of observations and the magnitude of the resultant decline (Correlation between series: -0.01)

Date of First Signal	Number of Observations	Drop in DJIA – %
6/6/2008	6	47.3%
10/16/2007	9	16.3%
6/13/2007	8	7.1%
4/7/2006	9	7.0%
9/21/2005	5	2.2%
4/13/2004	5	5.4%
6/20/2002	5	23.9%
6/20/2001	2	25.5%
3/12/2001	4	11.4%
9/15/2000	9	12.4%
7/26/2000	3	9.0%
1/24/2000	6	16.4%
6/15/1999	2	6.7%
7/2/1998	1	19.7%
2/22/1998	2	0.2%
12/11/1997	11	5.8%
6/12/1996	3	8.8%
10/09/1995	6	1.7%
9/19/1994	7	8.2%
1/25/1994	14	9.6%
11/03/1993	3	2.1%
12/02/1991	9	3.5%
6/27/1990	17	16.3%

Where do We Stand Currently?

Based on 9/24/2009 closing numbers, this is where the various requirements for a Hindenburg Omen stand:

52-Week Highs: 157 (4.97%) – Met

52-Week Lows: 3 (.10%) – Not met

Lower Greater than 75? – Not met

52-Week Highs < 2X greater than 52-Week Lows – Not met

10-Week MA: Rising – Met

McClellan Oscillator: -112.34 – Met

The above analysis indicates that while some requirements have already been met, that the level of bearish divergence necessary to generate the required number of 52-week lows still doesn’t exist. Keep in mind that these numbers change daily and therefore, must be watched continuously.

Worth Noting

Two failures of a confirmed Hindenburg Omen to predict a more significant drop in the DJIA during the past 25 years were accompanied by significant liquidity injections by the Federal Reserve to stave off the decline. Chalk these up to either coincidence or overt market manipulation. These injections were $155 and $148 Billion and occurred in 2004 and 2005 respectively. Just three years later, multiple trillions were required and were still not enough to keep a 50% crash at bay. This alone should reinforce the notion of a hyperbolic growth in debt, leverage, and systemic risk.

August Centsible Investor Available

by TwoCentsEditor

Published on: 08/15/2009

Categories: Centsible Investor Info., Financial Markets

Tags: business, finance, investing, investment, investment newsletters, money, stocks

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August 2009 Issue Highlights

This month’s Keynote article deals with the US Bond market, the future of interest rates, and potential impact that the oversupply of Treasury bonds will likely have on the equity markets. We also update our powerful proprietary indicator, which has been front-running major turns in the 10-year yield market for nearly the past 3 years.

In the Energy and Precious Metals reports, we analyze the many mixed signals in precious metals, and take a much closer look at the supply-side of the energy markets. Our contention is that mainstream economists and analysts alike are making a critical error when assessing these dynamics. You need to be aware of these misconceptions.

Model Portfolio Recap: 15 of 20 active components are currently in positive territory. 9 of our current components are up over 25% and 4 are up over 50%. The Portfolio has a total return of 3.44% since 11/2007. The fact that we’re able to talk about gains when one looks at the performance of the major indexes during this period is quite remarkable. If you agree, please please consider subscribing.

For subscription information, please Click Here

Basic Financial Analysis – Part III

by TwoCentsEditor

Published on: 07/10/2009

Categories: Economics, Financial Markets, My Two Cents

Tags: asset, bonds, business, Economics, economy, finance, inflation, investing, investment, money, personal finance, portfolio, Portfolio management, S&P500, stock market, stocks, xlp, xly

Comments: 1 Comment

Before we begin, it must be understood that there are many perceptions of value. In fact, if you took 10 investment professionals polled them individually; you’d likely get several very different definitions of value. If you put them together and forced them to come to a consensus, you would do well not holding your breath waiting for an answer. While there is no one right definition – especially in the investing world, what we are looking to do is select a metric or some group of metrics that applies to our particular situation. Again, investing should not be approached with a ‘one size fits all’ mentality. It must also be said that this list is not a comprehensive one, but rather a sampling of some of the methodologies available for ascertaining value.

The Mainstream’s Darling – P/E

If you turn on your television, perhaps the most popular measurement of ‘value’ is the price/earnings or P/E ratio. While P/Es are mentioned frequently, rarely does anyone stop to really think about what it represents. Simply put, the P/E ratio is the price of a share of stock divided by the earnings per share. In essence, it is how many dollars you will pay in share price for each dollar of earnings. I will be honest; I rarely use P/E as a decision tool simply because I don’t believe it is applicable in most situations. An average investor is not buying earnings. Sure, earnings may help drive the share price in the future, but they just as easily might not. News events about a company can drive price as much if not more than earnings, so perhaps a Price/News ratio would be appropriate too? And really, why would anyone ever want to pay more than a dollar for a dollar’s worth of earnings anyway? By definition then, a P/E of greater than 1.0 would mean the stock is expensive. The argument will also be used that one is not simply buying the earnings, but a claim on the assets of the corporation. While this is theoretically true, you can’t drive down to your local Home Depot and take a truckload of lumber out of the store without paying just because you’re a shareholder!

So there are many conceptual problems with the idea of P/E ratios yet once the P/E of the DOW goes below a certain point, we’re supposed to buy because stocks are now ‘cheap’. This to me is drawing some parallels that are eerily similar to herd mentality. All this should not be construed as an indictment of the P/E ratio, but rather to point out its limited relevance in terms of determining ‘value’.

Another frequently used, but less popular metric is the Price/Book ratio or P/B. Simply put this is dollars paid in share price for each dollar of book value. This is more of a liquidation metric, however, than an actual investing metric. Now there are some obvious instances where once might sniff out a bargain. Our example in the prior week’s issue of food companies is a bit lacking, but let’s use the example of a natural resource company. If for example, the company has proven resources in its properties and the P/B is .75, we might, in the absence of extenuating circumstances conclude that this is a bargain and that the stock is currently undervalued.

Some Situational Metrics – Cash Flow Generating Securities

One of my personal favorites is calculating the Net Present Value/Breakeven point for a stock that pays a stable dividend stream. This metric actually has relevance because the dividend is a cash payment that comes directly to the investor as a consequence of owning the shares. In the short-term, dividends are a known quantity. Obviously the metric only applies in the case where a dividend is paid. In the case where an investor is focusing on dividend investing for income purposes or simply for generating the maximum cash from their investing capital, these are important considerations.

An example is on order. Let’s say that an investor purchases 100 shares of a stock trading at $10/share that pays a $1/share annual dividend. The dividend yield on his investment is 10%. The P/Div ratio is 10. This means that the investor paid $10 for every dollar in dividends. Now the nice thing about dividends is that they are cash streams and we can use some common time value of money calculations to make determinations as to whether or not to invest. Let’s use the 100 shares as an example and do a net present value calculation with the following assumptions:

• Our time horizon is 25 years

• Dividends over the 25 years will average the current $1/year

• The Cost of Capital (COC or inflation) will be 6%/year for the duration of the exercise

Most popular spreadsheet programs contain the NPV function where you can set your COC and the value of the individual cash flows if you desire to perform this analysis for yourself.

The Net Present Value of this situation is $262.58, giving a positive indication or a ‘buy’ signal. This alone should not be used to make a buy determination, but should be used as a tool to validate or invalidate individual investment opportunities that arose from our analyses in parts I and II.

The Time to Cover or Breakeven point of this hypothetical investment is Year 15. What this means is that after 15 years, the dividends (after accounting for the deterioration in value due to inflation) will cover the cost of the initial investment. Whatever the investment itself is worth at that time is added value. So even if our stock is still at $10/share, it is paid for, we’re in the clear, making dividends for another 10 years before we need the funds, and can sell the stock at any time thereafter for a pure profit. And since inflation has already been figured in, we’re talking about real gains. We can easily modify the analysis to accommodate hypothetical taxation circumstances as well.

Another important point may also be made from the above analysis. Considering that we’re getting $1/year in dividends, in nominal terms, the Time to Cover/Breakeven would be 10 years. Inflation at a rate of 6% per annum increased the breakeven point by 50% or 5 years. While 6% doesn’t seem like that much, this example illustrates exactly how much of a burden on wealth it represents. If anyone really wants to see why clipping bond coupons isn’t such a hot idea, run this analysis on the 30-year Treasury Bond and it will become immediately obvious.

Moving forward, when looking at dividend paying investments, we are looking for lower P/Div ratios (higher yields), and consequently lower Time to Cover/Breakeven points. While looking at the yield gives some good insight, using the NPV and breakeven analysis allows us to quantify the deleterious effects of inflation over time. The yield alone doesn’t give us that ability since it is a snapshot in time and changes as the price of the underlying security changes. It is important to note that in this study, we are NOT valuing the firm. We are valuing the cash streams that the firm pays to shareholders and discounting them to the present.

The risks to the above analysis are obviously many. 25 years is a long period of time, and things can change dramatically. Firms can go out of business or eliminate dividend payments thereby rendering the above effort worthless. Also, the major types of risk such as market, currency, political, and systemic cannot be accounted for over such a long period of time. This is one of the reasons why it is never a good idea to buy today and walk away. Successful investing is a journey, not a destination. As soon as you think you’ve got it all figured out, that is when you’ll get bitten. Vigilance is the name of the game. Another obvious takeaway here is that we’re dealing with long term investing, not trading. Such studies are a moot point for the short-term trader since their focus is on a different goal. Realize I am not trying to be impertinent towards traders, but simply pointing out the difference between their objectives and those of long-term investing.

Non Cash Flow Generating Securities

For firms that do not pay dividends, the investor is limited to just one way to make money directly (other than writing options) from owning the stock and that is appreciation. In this situation, choosing appropriate themes becomes even more important because say for example, you selected a firm that pays no dividend and is in a market niche that relies heavily on discretionary consumer spending. When the economy entered into recession in late 2007, you would have had very little in the way of flexibility since there is in effect no longer anything supporting the price of your stock. You’re not being paid dividends while you wait out the business cycle. So you can either write covered calls and ride out the storm or just pull up stakes and get out of town. Below are charts of the XLY (Consumer Discretionary Sector) and the XLP (Consumer Staples Sector).

XLY

XLP

Let’s compare these two distinctly different themes.

From peak to trough, the loss for XLY was approximately 58% while the loss for XLP was 29%. For sure, 29% is not anything to write home about, but it does serve to illustrate the importance of picking the proper themes.

Earnings Growth

However, there is one quantitative metric that is very useful in determining the success of a firm’s operations in the absence of dividends, and that is earnings growth. I prefer using earnings growth to sales growth or margin growth simply because earnings are at the bottom of the income statement and represent the impact of the entire operation including all of its cost centers on the bottom line. Companies that are able to consistently grow their earnings even during troughs in the business cycle are obvious candidates for any investor’s portfolio. While it remains true that the investor isn’t paid those earnings, companies that make money and grow their earnings are generally looked on favorably by the market, and as such are positioned to do well, all else being equal. One spinoff of this methodology is the PEG ratio or price/earnings/growth, which is stated below:

P/E Ratio

——————– = PEG Ratio

EPS Growth

The PEG ratio gives some degree of relevancy to the P/E ratio because it factors in growth. Obviously, the lower the PEG ratio, the ‘cheaper’ the stock is because in essence, you’re paying less for growth. Or, put another way, you’re paying less for the likelihood that the stock will go up in the future all other things being equal.

When valuing firms that don’t pay cash streams to the shareholder, it also becomes important to focus on intangibles because many times, they are what will drive the share price, rather than solid fundamentals such as earnings growth. There is an old market saying that goes as follows: “The market can be wrong far longer than you can remain solvent betting against it”. If you have the luxury of a long time horizon and no immediate need for your cash, you can afford to buy into the themes you feel will do well in the long term, monitor them, and wait for the market to sort it all out.

This is one of the main reasons I prefer dividend-paying investments. First of all, from an analysis standpoint, they provide something quantitative to analyze. Secondly, if you’re a long-term investor and the market hasn’t gotten on board with you yet, you are being paid (in some cases very handsomely) to wait. Thirdly, if you come to a decision where you’d like to retire and need some income, you already have it coming in. You’re not forced to sell into a potentially bad market to find income.

Next time we’ll take a look at risk, diversification, and portfolio construction now that we’ve been able to select our themes, come up with some portfolio candidates, and use various metrics to make some value judgments regarding those candidates.

For investors who are concerned about battling inflation, and operating within our new economic paradigm of spiraling debt and taxation, we are hosing a complimentary seminar on July 28th in Bethlehem, Pennsylvania. For anyone who would like more details, information, or registration instructions, please visit www.sutton-associates.net/seminar_reserve.php

Throttling the Recovery?

by TwoCentsEditor

Published on: 06/05/2009

Categories: Current Events, Economics

Comments: No Comments

06/05/2009

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

A compressing timeline – less time for proactivity

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

10-2year T-Bond Spread

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

No Green Shoots for Consumers?

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

M1 Monetary Base

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

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

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

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

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

Mortgage bond yields continue to rise

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

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

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

Fed MBS Holdings

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

One possible answer – The $100 Trillion consumption gap?

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

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

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

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

Hedging Your Bets

by TwoCentsEditor

Published on: 05/15/2009

Categories: Current Events, Economics, Financial Markets, My Two Cents

Comments: No Comments

05/15/2009

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

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

Flight to Cash and Equivalents

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

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

Going Short the Market

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

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

The following is the flip side of shorting the market.

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

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

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

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

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

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

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

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

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

Trading Day	Dow Jones Performance (%)	DXD Performance (%)	Dow Jones Price	DXD Price
1	-2%	+4%	9800.00	$104.00
2	+2%	-4%	9996.00	$99.84
3	-3%	+6%	9696.12	$105.83
4	-2%	+4%	9502.20	$110.06
5	-5%	+10%	9027.09	$121.07
6	+4%	-8%	9388.17	$111.38
7	+3%	-6%	9669.82	$104.70
8	-4%	+8%	9283.03	$113.08
9	-5%	+10%	8818.88	$124.39
10	+4%	-8%	9171.64	$114.44

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

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

Trading Day	Dow Jones Performance (%)	DOG Performance (%)	Dow Jones Price	DOG Price
1	-2%	+2%	9800.00	$102.00
2	+2%	-2%	9996.00	$99.96
3	-3%	+3%	9696.12	$102.96
4	-2%	+2%	9502.20	$105.05
5	-5%	+5%	9027.09	$110.27
6	+4%	-4%	9388.17	$105.86
7	+3%	-3%	9669.82	$102.68
8	-4%	+4%	9283.03	$106.79
9	-5%	+5%	8818.88	$112.13
10	+4%	-4%	9171.64	$107.64

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

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

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

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

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

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

Using Options to Hedge Portfolios

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

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

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

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

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

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

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

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

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

Centsible Investor Announcement

by TwoCentsEditor

Published on: 05/12/2009

Categories: Current Events, Financial Markets

Comments: No Comments

Dear Current and Interested Subscribers,

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

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

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

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

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

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

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

Best Regards,
Sutton & Associates, LLC

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

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