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).

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

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.

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.

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.

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.

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.

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.

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

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.

Recently, there has been more than idle talk about converting most of these loans to equity stakes, which do NOT need to be paid back. Furthermore, future disbursements would like be made by buying equity stakes in the firms rather than making loans. Sound the same? Not quite. Here are some reasons why:

1) In the event of bankruptcy, creditors are paid off before shareholders from any proceeds of liquidation. Given the vaporization of BSC and LEH, this is definitely worth mentioning. Historically, shareholders are left holding the bag in a true bankruptcy and subsequent liquidation.

2) Even if the firms remain solvent, there is significantly more risk in holding equity than debt. The taxpayer’s investment would be subject to all the risks generally associated with holding stocks. Taking a look at the performance of banking stocks during 2008 gives a pretty good idea of what I am talking about here.

3) Current shareholders are negatively impacted by dilution if more shares are created out of thin air for the government to purchase. And even if the shares are bought in the open market, the mere size of the stake could have a rather deleterious affect on existing shareholders should that stake need to be sold en masse.

4) By taking an equity interest, the government is consummating an incestuous relationship with the banking industry. Nationalization is the term typical used in this type of situation, but the term has become taboo in the mainstream media in recent weeks.

5) Also, bear in mind that the banks don’t really need this money at all. They have been printing their own currency for years now via unregulated, non-transparent OTC derivatives. Now that some of their bets have gone bad, the taxpayers have been forced to ‘legitimize’ this activity by the infusion of trillions of less-funny-money (dollars).

Sea changes can be either dramatic or subtle. The recent direction in terms of supporting the financial system sounds subtle enough, but with dramatic results.

Desensitization

Increases in consumer confidence during the past two months are indicative of desensitization. Consumers are becoming acclimated to weak economic conditions, poor stock market returns, and the continued accumulation of job losses. This desensitization has been emphasized by the mainstream media; particularly in the past few months. The take-home message of articles and news reports has shifted to ‘be happy things aren’t getting worse’ and people are doing just that. Bargain hunters have been lured into many areas including housing, stocks, and even retail products. Meanwhile, important fundamentals like GDP, unemployment, foreclosures, and household net worth go largely unmentioned and underanalyzed.

Where are Consumers Spending Their Money?

What is telling, however, are the reports coming out of some individual sectors in the consumer landscape. Traditional economics breaks goods and services down into two major categories: staples and discretionary. This division follows the old-school definition of needs vs. wants. However, today, the lines have been blurred quite a bit and goods that would have easily been considered discretionary even 10 years ago are now regarded as staples.

The following NAICS category charts were selected because they represent areas that are extreme examples in the staple—discretionary continuum. And for comparative purposes, the total US Retail Sales chart is included at the end of the series.

The situation with grocery stores is a primary example of how aggregate consumption numbers are reported, which will be explained in greater detail later in the article. Just reading the chart, Americans spent less at grocery stores from the middle of 2008 through the beginning of 2009, which is when we called the bottom in terms of consumer prices. Did people eat less or just spend less on what they purchased? In all likelihood it is the latter, given that grocery store shopping is one of the most basic of spending types. For the sake of thoroughness, included below is the same chart for big-box/warehouse type stores just in case everyone abandoned their local grocery store for lower prices at BJ’s and Sam’s Club.

You’ll notice quickly that the rate of growth in warehouse club spending has been declining steadily since the beginning of the decade. Spending has also flattened considerably in the past 6 months. Clearly Americans didn’t take their unspent grocery store dollars and run to the warehouse clubs, so our initial conclusion is intact.

Gasoline station spending fell off a cliff from July through December, indicative of falling gas prices and people cutting back on the purchases of accoutrements such as drinks and sandwiches. In a similar fashion to grocery store sales, there has been a recent increase in spending at gas stations reflected by the price of gas jumping from near $1.50/gallon to around $2.00/gallon nationally.

Obviously, jewelry is far at the other end of the staple-discretion continuum, and is a good indicator of purely discretionary spending. It is pretty apparent, at least from this graphic, that this type of discretionary spending (in total dollars) is contracting rapidly, now at a year over year rate of around -22%. Massive discounting by many national and regional jewelers have certainly contributed to fewer total dollars spent as well.

Above, we notice the same tail in total retail sales starting at the beginning of 2009. This change in total retail sales correlates well with our data on consumer level inflation and brings the mainstream’s assertion of the re-emergence of the consumer into question.

Inflation Returns to Consumer Prices

In early January, a number of our in-house statistical indicators turned positive in terms of the spillover of monetary inflation into consumer prices and we discussed this issue in detail in 2/20/2009’s article “The Turning of the Tide?”:

“If we have indeed witnessed the inflection point where the trillions of dollars parked in investment and commercial banks are finally being let out to play, then our wealth and purchasing power are about to come under serious attack. Obviously the risk in putting such an assertion to paper is that if we return to the previous trend of falling prices even for a brief time, the entire construct will be discredited rather than the possibility that the timing was a bit off being acknowledged. There are some factors that would help us to confirm or deny that such an inflection point has taken place……”

Since those indicators went positive, we have received affirmation of our observations from PPI/CPI, the GDP Price Index or GDP Deflator, nominal retail sales, and import prices. It is the retail sales portion that applies here, and the key lies in how that report is interpreted. It absolutely must be remembered that almost all of these aggregate spending metrics report in total Dollars, NOT units. Nor are these numbers adjusted for ‘inflation’. They are adjusted for seasonal factors that are at the discretion of the reporting agency, but that is it. What this means is that increases in consumer prices (especially in staple goods since people are less likely to cut back) will be interpreted as economic growth when retail sales are reported because people are spending more money. Conversely, when prices fall like they did from July through December of 2008, the interpretation will be economic contraction.

So the question needs to be asked: Did people actually buy fewer goods and services (an actual retrenchment) over the past 6 months or did they just pay less for some of the things they purchased thereby causing retail sales to drop?

The answer is more difficult to find than one might imagine.

We know from the Advance GDP report on Wednesday of this week that personal income in the US dropped by an estimated $59 billion (2.0% annualized) as job losses put more and more Americans on the unemployment rolls. The rate of decay in personal income grew from $42.9 Billion or 1.4% annualized in Q4 2008.

The report also gleaned that personal outlays increased .7% in Q1 2009 after falling 9.5% in Q4 2008. Looking for example at the CPI for that period, we find that using the old CPI methodology that consumer prices increased 1.18% for Q1 2009. By extension then, if consumers would have purchased the exact same quantity of goods as they did previously, they would have spent 1.18% more yet they only spent .7% indicating that less goods/services were purchased. A terribly small cutback for sure, but certainly not the growth trumpeted by the mainstream media.

For comparative purposes let’s apply the same analysis to Q4 2008. Using the same CPI methodology as the previous paragraph, consumer prices dropped 2.93% in Q4 2008. So if consumers had bought the same quantity of goods/services, they would have spent 2.93% less. Yet consumers spent 9.5% less indicating a significant cutback.

One conclusion we can draw from this cursory analysis is that while consumers spent more in Q1 2008, they didn’t really buy more. Still, in the face of rising unemployment, falling housing prices, and general economic malaise, consumers are still trying hard to hold onto yesteryear after a very brief period of belt-tightening.

In our ‘Spin Cycle’ podcast, we are currently doing a 7-part series in which we depict the factors affecting the US economy as sides of a Rubik’s Cube – independent, yet interrelated. Episodes include Interest Rates, Economic Growth, Debt/Monetary Growth, Energy, Demographics, Geopolitics, and the State of the Consumer. To listen, visit www.my2centsonline.com/radioshow.php

Main Street Under Pressure

Since last summer there have been fairly regular stories even in the mainstream press about banks cutting limits on credit cards. It would seem as though the bankers had decided that the age of consumerism had gone too far. Ironically, these actions happened concurrently with the largest giveaways in the history of mankind. In the past 9 months the United States, #1 on the world financial stage, has committed an entire year of economic output to stem the ongoing crisis. How do banks respond? By cutting credit card limits. It is like giving a small child sweets until the kid is in a frothing sugar-frenzy, then locking up the candy dish. The analogies are nearly limitless, but the point is obvious. While the banks screamed for the elixir of easy Fed credit, they slammed the door on Main Street. For their part, consumers at some levels have cut back on their spending, which is a good thing. The unfortunate reality is this: Even the most prudent and responsible consumer will have a bad month. There will be a string of unexpected expenses, and that individual might need to carry a balance for a while to get things straightened out. Job losses will cause exactly this type of situation and now in many cases the credit is not there.

Another unintended consequence is that when credit lines are cut, utilization goes up and suddenly the most frugal appear to be on a spending bender. Take the person who has $25,000 in total credit from a number of different sources. Say on average the individual uses $5000/month for regular expenses, but never carries a balance. Now let’s assume that their lines are cut in half. Their utilization just doubled from 20% to 40%. Their new application for a small business loan might now be rejected because they’re judged to be a bad credit risk due to the 40% utilization. More unintended consequences.

Another amazing development has been the continuation and acceleration of foreclosure activity despite all the political rhetoric over the past 15 months from both sides of the aisle in terms of ‘helping’ homeowners. According to RealtyTRAC, foreclosure activity, which includes default notices, repossessions, and auction sale notices, increased 6% from January 2009. This same measure increased nearly 30% from February 2008. So despite trillions of dollars pledged to Fannie, Freddie, Bobby, Lulu, and anyone else with a leaky balance sheet to supposedly assist homeowners, not only is foreclosure activity not abating, it is increasing.

Runaway government spending

As most are acutely aware this tax day, their contribution to the team effort of bailing out the economy will not be near enough. Not only will their continued (and increasing) participation be needed, but that of their children, and grandchildren will be required as well. While I could sit here and tally up the various tabs, totals, and sums, it would be pointless. The public is mind-numb from hearing these staggering figures. It is very difficult to even fathom a billion let alone a trillion. However, this reality has dawned on an increasing number of people over the past few months and they are understandably perturbed. We have hopefully learned a valuable lesson, and that is that liberty is akin to a seedling. It is planted, but then must be watered, fed, and protected from the harsh environment in which it lives. While Americans were out collectively living it up over the past umpteen years, that harsh environment has wreaked havoc on our seedling. The bad news is that we’ve got a lot of work to do. Hopefully the sheer magnitude of our task doesn’t discourage us from doing it.

Big Bank Profits = Bubble Watch

After 6 quarters of dire forecasts, failures, predictions of failure, and uncounted bailouts, big banks are suddenly earning money again. Interestingly enough, most of these newfound profits are coming from the investment banking sides of their businesses. Translated, that means they’re back to their old tricks again and it is back to business as usual. Secure in the knowledge that their backs are securely covered by ‘We the People’ and without fear of extinction, the winners of the 2008 financial crisis have been refreshed, revived, and are back at it. Since our economy and monetary system are still compromised by the same structural imbalances that existed before the crisis, it is again time to go on “Bubble Watch”. The ingredients are there: very cheap money from the Fed and existing dislocations in many markets. The only thing missing is you. And this little fact could cause quite a problem. Americans, quickly growing weary of the accelerating boom-bust cycles, and still punch drunk from the last beating are not likely to be as willing to participate in the next bubble.

One of last fall’s pieces focused on the causes of the Great Depression and tried to dispel the myth that the market crash of 1929 was somehow solely responsible for the mess that followed. We pointed to a nagging reality from 1929 and that was the proportion of Americans living in poverty. More than half were living below a minimum subsistence level, which at the time was $750/year. Essentially one half of the population was unable to support further economic growth. That was one of the underlying structural imbalances. The crash and subsequent misguided government responses were the triggers that caused the Depression.

How much different are we really today? Sure, the poverty line has been adjusted upwards in nominal terms, but fundamentally, how many Americans are below it now? Perhaps the most important variable that has changed in the past 70 years is the reliance we have on credit as a society. How many of us would be living below the poverty line, unable to participate in the economy were it not for VISA, Mastercard, and equity lines of credit? The recent spikes in unemployment will only exacerbate the situation, causing further reliance on credit for subsistence; credit which is shrinking by many measures.

In conclusion, it is particularly disheartening that nearly all of the political focus spanning the last two administrations has been about getting credit flowing again, with only token talk of job creation and fostering legitimate economic growth. The actions have been no better. The vast majority of bailout and stimulus dollars have gone to the financial system to encourage lending and borrowing rather than to the real economy. Our fiat monetary system’s reliance on debt for its growth is the elephant standing in the room each time a press conference or media event is held. It is the elephant nobody in charge wants to talk about. It is the question nobody in media wants to ask. And, at the end of the day, I would imagine that is why so many people came out on Wednesday and will continue to do so. They aren’t interested in parties. They just want to talk about elephants.

I have talked on my weekly radio shows for some time now about two potential rallies in this bear market. I am not looking at technical indicators to make that statement, but rather two potential occurrences that could trigger rallies within this mega-bear market. It has been my opinion that policymakers would use these occurrences to either touch off or maintain the current bear market rally. As it turned out, the markets provided their own bottom of sorts in terms of selling exhaustion and a wave of euphoria about economic prospects from Washington. Now we get to our possibilities – and the rhetoric and symbolic changes are already taking place.

1) The Uptick Rule – The uptick rule, put in place to prevent predatory short-selling was for some still unknown reason removed in the summer of 2007 – just a few months before the peak in the DOW and S&P500. The SEC claimed that the uptick rule in the age of instant (and in their opinion, perfect) information was irrelevant. This incredibly foolish move paved the way for institutions and hedge funds to cannibalize each other from November 2007 through the present. The net result of this cannibalization was an unprecedented and historic consolidation in the financial sector.

It seems the SEC has finally found its common sense and there have been hearings about re-instituting the uptick rule. This serves to send the signal to opportunistic banks and hedge funds that the coast is clear to start buying assets at fire sale prices, which will lead to further consolidation. Even mere talk of bringing back the uptick rule will impact investing decisions. Keep in mind that this arena is not one occupied by Ma and Pa Podunk, but rather multi-billion dollar hedge funds and banks.

2) Revisions of the Mark to Market Rule – This is the equivalent of allowing financial institutions to play ‘Alice in Wonderland’ with regard to the value of otherwise worthless derivative securities and non-performing mortgage tranches. While the arguments for mark to model are plentiful, and in some cases legitimate, the bottom line is that an asset is only worth what someone is willing to pay you. Following the current logic, homeowners should be able to pretend that their homes are worth 40% more than the market price and behave accordingly. See another bubble possibility here?

We will present a much more in-depth analysis of the ramifications of the uptick rule and the changes recently made to ‘mark to market’ accounting in this month’s edition of The Centsible Investor. For more information, please click here.

There is no need for any of this political grandstanding. The US Government owns a near 80% stake in the failed insurance company and as such could simply retract the bonsuses through a shareholder action. There is no need for hand-wringing, negotiations, or incessant hearings on Capitol Hill.

Secondly, the chief of AIG insisted that “when you owe someone money, you pay it back” referring to the fact that these bonsuses were contractual agreements. However, the Congress has had no problem suggesting that bankruptcy judges modify subprime residential mortgages (which are also contracts), so the small matter of the $165 million shouldn’t be an issue from a contractual standpoint.

Perhaps most importantly, the AIG bonus situation is non-issue in comparative terms and is meant to absorb the public’s outrage while the vast majority of TARP and other Fed disbursements go unaccounted for. By my calculation, the $165 million is exactly .61% of the money that has been spent in the people’s name so far (that we know about) in dealing with the financial crisis.

The hystrionics of both political parties are a nice piece of acting, but should further establish that they are much more interested in protecting the status quo than the US taxpayer.