Model Portfolio timbo56:SSOF1

I cannot say that this is a fearless forecast, but I'm calling a bottom. At around 10:40 EDT today the DJIA hit 9,738.30. Call me foolish, I think this is a bottom, cast in panic. It is panic that makes market bottoms, and we have had plenty of it. Although things seem absolutely terrible right now, what with major European banks pitching into the mud, following their American brethren, the elements for recovery have already been set in place. I for one (call me foolish) believe that the financial rescue plan will work. I think it is an intelligent, sensible means to address the meltdown we have been seeing. I think that Paulson will get it working fast, and it will do a world of good for the credit markets. And other than the problems in the credit markets and the housing market, not too much is wrong with us. I think we saw the bottom today.

Posted by Timothy at 01:45 PM | Permalink | Comments (0) | TrackBacks (0)

Well, it happens sometimes. There are the long term trends, and then there are occasionally violent pullbacks from those long term trends. We are now in the midst of a violent short term pull back. I remain confident that the long term trends will reassert themselves. These pullbacks are very difficult to predict, and one must generally just try to ride them out, although it is not easy, and I do worry that my investors may be getting quite impatient and distressed.

But let us take a look at what the long term trends are, and what the implications of those long term trends are. Here are the really important trends that I see, over the next 10 years:

1. Economic growth in China, India, Vietnam, Brazil and Eastern Europe.
2. Population growth in Saudi Arabia and many other oil exporting countries.
3. Gradual topping out of the world's petroleum production.
4. Reduction of U.S. trade deficit.

None of these long term trends has changed. There is a fifth trend that has changed dramatically in the last 2 years and that is a gradual decline in U.S. production of natural gas. We have now figured out how to harvest natural gas from shale deposits far more efficiently than before. This has made a huge difference to our natural gas current production and future prognosis. Could the same thing happen with petroleum? It seems unlikely.

Because the long term trends have not changed, I'm not changing my investment philosophy. I know it has been difficult. But these short term violent pull backs are very unpredictable. And they run along an unpredictable course.

I also feel that the demand for natural gas will increase, as it is substituted for expensive petroleum in a number of different areas. Also, at the current prices I would certainly not presume that production will increase. Harvesting natural gas from shale is expensive, and these prices will not support the sort of strong and dedicated effort that has caused production to rise dramatically. The rate of increase from the Barnett Shale, underneath Ft. Worth Texas, will slow. Other shales are not as good sources as the Barnett Shale is. And conventional gas production is declining. So I think the low prices will effect both the supply side and the demand side of the natural gas equation.

With respect to petroleum, give me a break. Inventories are still quite low, and they have fallen over the last year. At these prices demand will return, not only in the US, but in the areas where demand has been growing so quickly. If inventories were above the levels of last year I could see the price decline that we have seen. I don't know what tomorrow's inventory readings will show, but it just seems that there is not really that much petroleum and product in storage and this will over time, tend to support prices.

And with gold, the growing wealth of China is going to eventually cause prices to rise. We are starting the buildup to Chinese Lunar New Year. Eventually that will have an effect. I hope it is soon.

Investors' perception of the steel industry will never cease to amaze me. The level of negativity is just astounding. Nobody believes in steel. But steel production is necessary to support the production of fossil fuels and to support an American industrial resurgence that must happen if we are to reduce the trade deficit that must be reduced.

So call me stubborn, and I do regret the losses in this very, very difficult quarter. But the long term trends are on our side, and they are powerful and will make a difference.

Tim

Posted by Timothy at 10:01 PM | Permalink | Comments (0) | TrackBacks (0)

Wow! The August natural gas (“gas”) contract has fallen from a little over $13 per Million BTU to 10.57 at market close today, about a 20% drop in less than two weeks. Is it going to stay down, or pop back up? In favor of staying down there is increasing production from the U.S. deepwater, reduced demand from industries that supply house building materials, electricity from new windmill farms reducing the need for gas generated electricity and a build of 104 Billion Cubic Feet in the week ending July 11, 2008 (“the last week”).

Even taking these factors into account, however, I believe that we will see a price recovery. If the low pressure wave in the Caribbean turns into a hurricane, we will see an extraordinarily fast recovery. But even if it does not, there are many factors that point to higher natural gas prices.

First, it is important to recognize that because the readings for the government storage survey take place at 9 AM on Friday, the last week was far more affected by consumption on July 4 then July 11. And July 4 is a national holiday in which many businesses are closed and consumption of natural gas tends to be far lower than on a normal weekday. Some may be comparing the build for last week, which was the 28th week of the year, with the typical build for the 28th week of the year. But July 4 generally falls in the 27th week of the year, so this comparison is erroneous. Compared with the typical 27th week, the last week was not a particularly large build at all, being just 6 billion cubic feet above the 5-year average of 98 billion. And the week-to-week change is an inherently noisy statistic, so one week’s figure should not drive big price changes.

Between May 29 and July 3 of this year gas storage went from being 66 billion cubic feet below the 5-year-average storage to 120 billion cubic feet below the 5 year average, despite the spot price of natural gas being above $12 per million BTU for the entire period. The weather was a little warmer than usual, but taking the nation as a whole, it was not tremendously warmer. And gas at above $12 per million BTU creates a far more powerful incentive to avoid gas usage than does the current price of $10.54.

Let us imagine that I had a knob that I could turn to change the spot price of gas, and I was trying to handle that knob so that this country would end up with at least 3.2 trillion cubic feet of gas at the autumn peak, an amount generally considered adequate to get through the winter. After viewing last week’s storage figures, I would have nudged the knob a little in the “lower-price” direction and then continued to watch to see what effect the change would have and what sort of weather we would have. But the market has swung the knob a huge amount and I just do not think that it was justified. Moreover there are long term reasons to be bullish on gas.

Just as deepwater gas is being exploited; all other gas production is declining. So it is a contest between the deepwater expanding production and all other production declining to see whether production will increase or decline. Petroleum production, however, is down from last year, and this could be an indication that gas production is, too. It also seems likely that Canadian gas production is starting to decline, based on declining reserves.

Also, wind power still produces a very small percentage of U.S. electricity production. Changes must be made to the electric grid in order for wind power to become a more significant producer. This will take time. Also, although production of house building materials, such as bricks, is way down, production of goods for export is up, and some of this production is bound to use gas.

More importantly, there is a huge, growing consumption driver for natural gas, and that is tar sands production in Alberta. In a conventional mine, where the tar sands are scooped up and dumped into hot, soapy water, gas is used to heat the hot, soapy water. In steam assisted gravity drainage (SAGD) gas heats the boilers to create the steam that is pumped into the earth to heat and soften the bitumen. In either case, gas is combined with the bitumen to provide hydrogen when the bitumen is cracked into smaller molecules. With the high price of petroleum, a tremendous amount of development money has been directed toward the Alberta tar sands, meaning ever more gas consumption.

Also, the price of gas is now less than half that of petroleum, on an energy content basis (a barrel of petroleum has about 5.8 million BTU). So for any activity where there is a choice, there is now an enormous incentive to use gas to get petroleum or to use gas instead of a petroleum product. I know that in many cities where natural gas is available, some people still have heating oil furnaces. There is now a huge incentive to switch over to gas, and it would not take long to recoup the investment in a gas furnace. Some may choose to use small electric heaters to heat whichever room is occupied. These heaters are cheap and very easy to use. In today’s electricity production environment it is quite likely that much of the electricity generated to power these heaters will come from gas. We will not see much effect from this until late fall, but there are, no doubt, industrial users of petroleum products that now have a huge incentive to shift to natural gas or electricity, where we would see the difference immediately.

Finally, hurricane season has just begun. Just because we have not seen any major gas production damaging hurricanes in the last two years does not mean we won’t have one this year. Also, despite the last two years of relatively light hurricane activity, I still feel that the 2005 season was a harbinger of things to come, and that hurricane activity in general will become more of a problem in the future, as Caribbean and Gulf of Mexico waters get hotter in the summer and take longer to cool down in the fall.

There are a number of ways to make money from an increase in gas prices. There is an ETF, having the ticker symbol UNG, which tracks the price of gas. Also, energy producer XTO Energy, Inc. (XTO) is known for producing a high proportion of gas in its hydrocarbon mix and tends to be affected by changes in gas prices more than other energy producers. I would rate both of these a buy.

Posted by Timothy at 10:20 AM | Permalink | Comments (0) | TrackBacks (0)

This market plunge makes me optimistic. “Why???,” you may ask. Because I feel that Ben Bernanke will finally learn his lesson, which is, “Don’t talk tough on inflation.” Every single time that Bernanke has talked tough on inflation, the market has tanked. On June 10th, Bernanke stated that, "The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation … ." He followed this up with, "Although activity during the current quarter is likely to be weak, the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so … ." Yes, the possibility that the economy had entered a substantial downturn had diminished. But the “tough inflation” talk brought that possibility right back. The very act of making the statement about the possibility having diminished resurrected the possibility of a “substantial downturn.” The S&P 500 index has dropped by 7.79% since June 10. This reduces the Fed’s ability to staunch inflation without sending the economy into an even worse tailspin. The stock market is a leading indicator, one that is causal and not simply indicative or reactive.

This is far from the first time. On June 6, 2006 the stock market tanked after some tough on inflation talk by Bernanke. And earlier, on May 2, 2006 Bernanke had made some comments to Maria Bartiromo that she announced on her news show, and which also clobbered the stock market.

OK. Now we are in a bear market for real. We are down more than 20% from the October 2007 high. Is there any chance at all that we could stop the inflation tough talk? It has been incredibly destructive. This is an economy that has already been battered raw by the sub prime crisis, the resultant fallout in financial institutions and high petroleum prices. Is there any chance that we could enter into a period of benign neglect from the Fed Chief’s statements. He can still raise interest rates. But comments that have phrases like “strongly resist” in them frighten people. They introduce uncertainty that is destructive to people’s ability to make positive decisions and commitments.

But now I’m hopeful that the stock market, this collective mouthpiece of so many, which is nothing if not 100% sincere, will have finally taught Mr. Bernanke that he could just be a little milder in his statements. Could he not simply have said something on the order of, “It looks like there might have been some mild erosion of price stability expectations and it is probably nothing, but don’t worry, if it ever became a serious concern we would take action that I feel certain would be very effective.” This is a market that needs reassurance.

Well, my gut feel is that this has happened enough times so that the stock market has now tamed Ben Bernanke, at least a little. If he does it again, his term really should not be renewed. But I would hate to see him replaced because at least now he has some experience, and some new Fed Chief would not. And it seems that being Fed Chief is a job where there is just no substitute for actually doing it for awhile to get the hang of it.

Posted by Timothy at 03:56 PM | Permalink | Comments (0) | TrackBacks (0)

Reach for the Sky – Manitowoc Co. Inc. (MTW)

Yes, construction spending in the United States is down. And now Western Europe appears to be following suit. So Manitowoc (MTW), which gets more than 80% of its revenue from cranes, should not prosper. Except for that the United States and the European Community do not make up the whole world. There will be continuing demand for cranes in the Middle East, China, India, Latin America and Eastern Europe. And with Manitowoc down by almost half since last December, this stock looks like a bargain.

But there is another reason to buy a crane builder. With petroleum prices high and likely to go higher, the world will become more vertical. It was the automobile and the relatively low price of petroleum that allowed American cities to spread out in the first place, from 1950 through about 2005, with a thriving central city giving way to thriving suburbs and then exurbs popping up at the edges. Now the process is working in reverse, with the focus back on the center and housing in the form of multi-story buildings becoming increasingly prevalent. Cranes will be required to build the housing of the future.

Besides constructing housing, going “back to the future” will require new mass transit and commercial structures. This country, and even this world, has an immense amount of construction to do over the next 40 years as we transition from a world of relatively plentiful petroleum to a world with petroleum production that is only a fraction of what it is today.

Mass transit must work on a hub-and-spokes system. The mass transit trunk lines must be where there is a large volume of traffic, which is into and out of a central hub. So if a person wishes to go from point A in the outskirts to point B, also in the outskirts, he will likely take a train into the hub and another out of the hub to point B, as opposed to driving directly to B. Accordingly, if you live near the hub it is much easier to easily reach more places.

If one looks at how urban development in the U.S. looked in 1890, even small cities and towns had multi level structures downtown near the train station. This is the pattern of the future, and it will be built with cranes.

Terex (TEX) gets a big portion of its revenue from sales of aerial work platforms, also handy for multi-story construction, as well as making cranes. Terex has also gone down a lot since last year, and is a bargain, today.

Manitowoc has a trailing PE of 9.37, with Terex coming in at 7.23. These figures show that there is a very strong degree of skepticism on Wall Street regarding these stocks. Perhaps some view them as unexciting rust belt relics who have had their moment of excitement for the decade. But as I see it, the fundamentals are only getting stronger. At some point even a skeptical and inattentive Wall Street will have to take notice, because the money flowing in is just too good to ignore.

Both Manitowoc and Terex make and sell products other than cranes. Manitowoc also builds and sells ships and food service equipment (and has been in the news with a recently accepted bid to acquire British food service equipment maker Enodis). Terex builds and sells a wide range of construction and mining equipment. To me, it’s all good. Some might say that high tech companies are the companies of the future, but I say it is also those companies that will help us construct the fuel efficient cities of the future, namely Manitowoc and Terex.

I own Terex stock, myself, but no Manitowoc. I own both of these two stocks in my mFolio portfolio, however.

Posted by Timothy at 01:12 PM | Permalink | Comments (0) | TrackBacks (0)

Ahhhh, the business cycle, etched so very deep into the collective mind of Wall Street. The business cycle, so very important, so very fundamental, that there is even a category of stocks known as "cyclicals." And conventional wisdom states, "Don’t get caught with a cyclical when the business cycle goes south! Cyclical stocks do terribly in the trough of the business cycle. So if you see even a hint that the down side of the cycle is coming, get out, get out. Run for the hills. It’s gonna be baaaad. Oh so very, very baaaaaad."

And what could be more cyclical than steel. Sure, when the good times role, we need steel, out of which to build cars and beautiful office towers. But when the business cycle turns south, we don’t need very much steel anymore. And then, per conventional wisdom, there is a competitive frenzy between the steel companies and they start going under and fools who have been crazy enough to invest in steel lose all there money. And that’s baaad. Oh, so very baad.

Perhaps it is this type of thinking that has caused analysts to rate AK Steel (AKS) at a collective 3.2, where 1 is a strong buy, 5 is a strong sell and the average stock is ranked at about a 2.4. AK steel has had a rating of about a 3.2 during its entire climb from a little over 2, to 72. Well, the analysts sure missed the boat on that one. You would have thought that one of them would have had the guts to issue a buy recommendation. But for the most part, not a one of them did. And this has been a fabulously lucrative stock for those who bought, despite the disapproval of the analysts.

And perhaps it is that sort of business cycle thinking that in the last few days has slammed AKS from a high of 70.54 on Monday, June 30 all the way down to a closing price of 52.79, today, July 3rd. Yes, that is a drop of 25% in a little less than four short days. The new orders information released by the Census Bureau showed a very small drop in steel orders from April to May and the auto makers announced dismal sales figures and wham, did AK steel ever get hit hard. And why not? If this the beginning of a trough in the business cycle for steel, which will represent a harrowing descent for the steel companies, it makes perfect sense.

I am convinced, however, that structural changes in the world economy will continue to boost the fortunes of AK Steel. Sure, it could go down further in this crazy, skittish environment. But, hey, although its course over the next month or two is unpredictable, eventually the fundamentals of the situations will translate to an increased stock price. And what are these structural changes? Well, I discussed four of them in my Marketscope article of April 2005. Now I can think of at least 10:

1. Fossil fuels are being depleted: This is a structural change that will not be reversed. The greater the depletion of fossil fuels the deeper we will have to go to get them out. The greater the complexity of the extraction process, the more steel typically will have to be used. Rather than just drilling down a mile or two and pumping it out, we must drill down a mile or two in a first well, and then drill a bunch of wells around it to inject water or gas or steam to get that oil out. And we must drill more wells, deeper, into smaller pockets of oil and gas. This all takes more and more steel.

2. The huge U.S. trade deficit is not sustainable. We must start to make progress at closing this massive deficit, which is running at about $2,500 per American per year. To do this the dollar must fall. Perhaps not today, or tomorrow, but eventually. As it falls, American steel producers become more competitive with foreign producers. We should also note that the domestic steel industry’s nightmare days came at a time when the dollar was worth about 20% more than the Euro. Those dark days are not coming back.

3. The high price of petroleum means that it costs more to ship steel from overseas. As the United States is a net steel importer, this benefits domestic steel producers because it drives up the price of competing imported steel.

4. The high price of petroleum means that petroleum exporting countries are going on a building spree, using a great deal of steel. The Saudis are planning huge new cities. The steel for these cities comes from all over, and it drives up the international price.

5. The high price of natural gas is making alternative means of electricity production increasingly feasible. That means steel supports for windmills and steel structure for solar facilities (a square mile of pivoting mirrors translates to a lot of steel structure).

6. The high price of petroleum creates an advantage for railroads over trucks. This means the railroads will expand their rail network, which is made of steel.

7. The Chinese government used to encourage steel exports, now they discourage them, to keep the steel in China.

8. The agricultural boom means more spending on agricultural structures, made of steel.

9. The high price of gold, silver, copper and other metals means that more steel will be needed for mining equipment, mine structural supports and processing facilities.

10. Our continuing efforts to fight pollution mean that we will use more steel for sewage treatment facilities and pollution control equipment.

So that is ten structural changes that will cause steel to continue to prosper. U.S. Steel (X) is good also, but AK Steel, with its 3.2 analyst rating and its recent 25% price plunge, is the underdog that I love. It may take another two months for it to bottom out, or it may have hit bottom already. There is just no telling with the investor psychology. But I foresee, that this stock has some more strength and will be moving back up, before too long.

Disclosure: I own AK Steel, myself, and I also own some in my mFolio portfolio.

Posted by Timothy at 12:39 AM | Permalink | Comments (0) | TrackBacks (0)

Gandalf Vs. The Barolrog; Napolean Vs. The Duke of Wellington; Rome Vs. Carthage; Sponge Bob Vs. Squidward; Fisher Vs. Spassky; Dempsey Vs. Firpo; Genoa Vs. Venice; Jefferson Vs. Adams; Ming Vs. Manchu; Scott Vs. Amundsen; Yankees Vs. Red Sox; Grant Vs. Lee; Potter Vs. Voldemort; OSU Vs. UofO; Charles XII Vs. Peter the Great; Wright Vs. Le Corbusier; Bryan Vs. Darrow; Alexander the Great Vs. Darius III; Jud Vs. Curly; Turgenev Vs. Dostoyevsky; Trotsky Vs. Stalin; Carranza Vs. Zapata; Girondist Vs. Jacobite; Tokugawa Ieyasu Vs. Hideyoshi; Guelph Vs. Ghibelline; Moses Vs. Pharaoh; Thailand Vs. Burma; Ali Vs. Abu Bakr; Ibo Vs. Yoruba; Atreides Vs. Harkonnen; The Foundation Vs. The Mule; David Vs. Saul; Rama Vs. Ravana; Leo X Vs. Martin Luther; Ferdinand II Vs. Jan Hus; Hamilton Vs. Burr; George III Vs. George Washington; Frodo Vs. Sauron; Nathaniel Vs. Simon Lovelace; Elizabeth Bennett V. Lady Catherine de Bourgh; Capablanca V. Alekhine; Mufasa Vs. Scar; Byzantine Empire Vs. Ottoman Empire; Snow White Vs. The Wicked Queen; Peronist Vs. Anti-Peronist; DeFarge Vs. Darnay; Javert Vs. Valjean; Churchill Vs. Hitler; Cromwell Vs. Stuart; Bourbon Vs. Guise; Montague Vs. Capulet; Pompey Vs. Caesar; Latkas Vs. Hamantashan; Montgomery Vs. Rommel; York Vs. Lancaster; Hatfield Vs. McCoy; Eyre Vs. Scatcherd; Eragon Vs. Galbatorix; Lilliput Vs. Blefescu; Engineer Pete Vs. Steve Barker; Jett Rink Vs. Bick Benedict; OSU Vs. UofM; Nimitz Vs. Yamamoto; Nelson Vs. Villeneuve; Angra Mainyu Vs. Spenta Mainyu; Cortez Vs. Moctezuma; Achilles Vs. Peter Wiggins; Hector Vs. Ajax; UCLA Vs. USC; William Vs. Harold Godwinson; Iconoclast Vs. Iconodoule; Hinayana Vs. Mahayana;

And now for the greatest epic struggle of them all: The Federal Reserve Board Vs. Inflation

Sadly, the result is a foregone conclusion: Inflation will win. More sadly still: there will be a lot of collateral damage on the way.

Posted by Timothy at 02:45 AM | Permalink | Comments (0) | TrackBacks (0)

Peak Oilers 135, CERA 80

I remember taking a pleasant mountain hike, and when I got to the mountain peak noticing a strange fellow there with a small bottle of olive oil, who was pouring a little out onto the ground. “What are you doing?” I asked him. “In the holy book of the Braphulthustrins it states, ‘you shall anoint the mountain peaks’” he replied, “I am following the teachings of my religion.” That was my first encounter with a Peak Oiler.

But if you think the Peak Oilers are a little strange, the Cambridge Economic Research Associates (CERA) is stranger still. And even more strange is the continuing credence given to this strange group by all sorts of folks, from the U.S. Government, to the news media. To me, CERA long ago completely annihilated any shred of credibility they may have been thought to have had. Their study deriding the peak oil theory, published November 14, 2006, was ridiculous. While roundly abusing Peak Oilers for their illogic, CERA bounded off into fantasy land itself, counting 704 billion barrels of shale oil in its projection of total global resources. This oil is in solid rock. We don’t know of any efficient way to get it out, and there is real doubt that we ever will. Also, CERA completely accepted the figure of 662 billion barrels in the OPEC Middle East, although at the time it was already clear that this figure was (and still is) entirely bogus. What is wrong with them???? In the one-and-a-half years since the report’s publication, its near-in predictions, at least, have been shown to be entirely wrong.

More recently, on November 30, 2007, CERA predicted that the 2008 WTI oil price would trade in the $70 to $90 per barrel range in 2008. At that time, I was predicting a $100 to $120 per barrel range for the year. Well, we were both wrong, but I was less wrong than they were, and I don’t have a big research budget and staff to help me out. Moreover, the report blamed the “high prices” at the time as being the result of market psychology, rather than fundamentals. But even at the prices of today, U.S. stockpiles are lower than a year ago and lower than average for this time of year. This shows that it is fundamentals that have driven the price up.

There was also an article in today’s New York Times by Jad Mouawad and some compatriot, asking why the price is so high. Can there be any question? Isn’t the answer obvious? Demand growth in China had been driving the price up, but now Russian supply growth has stalled out and Russian demand growth has switched into high gear, together with Middle Eastern demand growth. It is a prescription for higher prices and the prescription is working. At the beginning of the year I did not realize that Russian supply growth would stall out and I did not realize the extent to which Russian demand would grow. And I don’t have a big research staff. I’m sure that if I did I would have nailed it, not, because predictions are difficult. But with a big research budget, and an array of minions, one would have thought that at least CERA would have come a little closer. And one would hope that the New York Times, with the array of resources at its disposal, would be able to offer a more cogent analysis.

Posted by Timothy at 03:45 PM | Permalink | Comments (0) | TrackBacks (0)

The exchange traded fund (ETF) world has blossomed with the introduction of designer exchange traded funds (ETFs) that apportion their holdings according to some statistical process other than mere market cap. There are ETFs from Wisdom Tree that apportion their holdings according to total dividend payments. Along similar lines the SPDR Dividend ETF (SDY) invests in the 50 highest-yielding companies in the S&P Composite 1500 that have consistently raised their payouts for at least 25 years. On the other hand, the PowerShares FTSE RAFI US 1000 (PRF) evaluates the 1,000 biggest U.S. companies on the basis of average sales and cash flow over the previous five years, total dividends distributed over the previous five years and latest book value (assets minus liabilities) and apportions its holdings according to a formula based on these factors.

There is a basic philosophical problem with all of these funds. Apportioning according to market cap mimics and therefore accepts the actual distribution of money in the market. This distribution, just like the price of every stock, is that which those with the most money invested have made it. Those with the most money invested, unsurprisingly, have typically hired the best minds, with the most time and the best training to make the investment decisions that have resulted in the relative market caps of the various stocks. Using a statistical guide for the distribution of money into stocks suggests that this process has been inefficient.

The designer ETFs take a subset of the information that has been analyzed by the investors who have set the distribution of market caps, in an ever changing dynamic process. They then take this subset of available information and apply a rigid formula to it. And they appear to believe that this distribution, based on a subset of information and devoid of an ongoing application of human judgment can beat a process based on the full set of information and constantly informed and updated by skilled human judgment.

I don’t buy it.

Now I do swear to you, the reader, that when I began to write this journal entry I had not checked the performance of SDY or PRF. I picked them at random from a short list of designer ETFs. I have just checked performance and over the past two years they have both been beaten by the S&P 500 index. PRF was beaten by about 5%, whereas SDY was absolutely clobbered by roughly 20%. I did not take out the management fees of SDY or PRF, but also did not add in the dividends one would receive if holding the S&P 500. Clearly this is a quick analysis based on only two randomly selected designer ETFs. Nevertheless it tends to bear out my point. You can’t outsmart the market by basing your distribution of money between stocks on a rigid computer analysis of part of the data. It just does not make sense.

Now we all know that in March of 2000 the largest of the large cap stocks were overvalued. Since that time an S&P 500 index in which each stock was equally weighted has far outperformed the actual S&P 500 index in which each stock is weighted according to its market cap. But the designers of the designer index funds are not the only ones who have noticed this phenomenon. There is every possibility that the current market caps in the S&P 500 have been strongly influenced by this past overvaluation. Perhaps the market has actually overreacted. It is possible that the present valuations actually undervalue the largest large cap stocks. But let us theorize that there actually is some attribute of investor psychology which causes the largest large cap stocks to be consistently overvalued. If this were to be the case, surely a better way of addressing this issue would be to apply a secondary weighting to the market cap weighting, which would cause the largest large cap stocks to be weighted slightly lower than they would be in a straight market cap rating. I’m not recommending it, except for as a more sensible alternative to ranking by dividend payments or any other subset of the available financial information.

Market cap is a function of democracy, except for resulting from a process in which each dollar, rather than each eligible person, gets a vote. So Winston Churchill’s famous aphorism about democracy, that it is absolutely the worst system of government, “except for all the rest,” holds true in this context.

Posted by Timothy at 05:10 PM | Permalink | Comments (0) | TrackBacks (0)

Were you born yesterday? Because if you were, I have a really great story for you. Its at:

Plan Would Lift Saudi Oil Output

You see the Saudis are going to raise their oil output by 500,000 barrels a day, next month. Yes, according to Jad Mouawad of the New York Times Saudi officials have briefed “analysts” and “oil traders” of their plans. Ahhh, but Ibrahim al-Muhanna, of the Saudi petroleum ministry declined to comment on the reports. Hmmmm, now that is a trifle curious. Why would the Saudi petroleum ministry refuse to confirm the good news? After all, this is what the world has been crying, dare we say, “begging” for. So if the Saudis were really going to do this, would there be a need for secrecy?? It is a little hard to imagine, given that they would win accolades all around. And who doesn’t like accolades? So why would Mr. al Muhanna refuse to confirm the good news? Maybe because it is not true? After all, you can spread all sorts of false reports, but if you have never gone on record with the supposed information, it will be pretty hard for people to blame you after the fact. Especially if Mr. Mouawad never tells us who his sources are.

Mr. Mouawad also lets us know that as part of a “huge expansion program” expected to bring its production capacity to 12.5 million barrels a day by 2009, Saudi Aramco “is planning to start soon an oil field, called Khursaniyah, with a daily production rate of 500,000 barrels per day.” This “could” be made public at an energy meeting scheduled by King Abdullah.

If Mr. Mouawad had taken five minutes to do a simple Google search he would have found the following articles, indicating that Khursaniyah has already been started, more than a month ago, but has just not reached 500,000 barrels per day, yet.

RIGZONE - Saudi Aramco Starts Up Khursaniyah
Apr 22, 2008 ... RIGZONE News - leading source for the latest news and information for the oil and gas industry.
Saudi Aramco Starts Up Khursaniya - 27k - Cached - Similar pages - Note this

Upstreamonline - Aramco 'opens Khursaniyah taps'
Saudi Arabia has kicked off production at its 500000-barrels-per-day Khursaniyah oilfeld, Abdullah Jumah, head of state oil company Saudi Aramco said. ...
Aramco 'opens Khursaniyah taps' - 42k - Cached - Similar pages - Note this

Aramco to miss Khursaniyah deadline
Mar 7, 2008 ... Boost in production to 500000 barrels a day unlikely to be achieved until later in the year....
Aramco To Miss Khuraniyah Deadline - 25k -

Also,….can we please get real for a second. No one ever just flips a switch and starts a field producing 500,000 barrels a day. That is not how it works. Do you imagine that they have all the wells drilled, a huge array of pumps all in place, King Abdullah flips a switch, and they all start pumping at once, filling the pipelines? That would be crazy. Production from an oil field gradually builds over time, as it is increasingly developed. There is never a simple step function from 0 to 500,000 barrels per day.

Mr. Mouawad does note that “Some investors doubt that Saudi Arabia has the capacity to increase its production beyond current levels.” That is the only point in the article that he recognizes, without naming the name “Matthew Simmons” that at least one very smart and very insightful petroleum analyst, who has spent a lot of time and effort studying this issue, does indeed, refuse to believe that “Saudi Arabia has the capacity to increase its production …. .” And why???? For one thing they are working awfully hard to produce at their current levels. For another, the “water cut” at their premier field, named “Ghawar” is up to 30%. This is a real problem. As the Khursaniyah field comes on stream, it is likely to be partially replacing a decline in production at Ghawar.

What has really happened here??? This is my theory. There is indeed a lot of pressure on the Saudi’s to do something to alleviate the high petroleum prices. There is a rising public sentiment, looking to find someone to blame, and OPEC is ever convenient. But if truth be known, I don’t think they can increase their production. I think they would love to produce more oil and sell it at $135 a barrel. But they can’t. Because of the intense ruckus, however, they have decided to pretend to do something, just to see if that mollifies the crazy westerners. So they float a rumor, and host an oil summit. They say they would really like to see the price come down a bit. This part might be true, because they tried to keep prices high in the early 1980’s and it really backfired. So now they might truly be somewhat worried that this latest price increase will lay the seeds of a future price decline. Then again, they are raking it in now, so I don’t think they are too terribly upset. Whether they are, or not, I really doubt that there is a thing they can do about it. Just sit back, enjoy, and host a summit, just to let people know that they are concerned. Float a rumor that they are increasing production, but not go on record so that in two months when people ask, “where was that increased production?” they can say, “we never said we were increasing production.”

Posted by Timothy at 08:30 AM | Permalink | Comments (0) | TrackBacks (0)

I just read a Fortune magazine article about Ken Heebner, the manager of GGM Focus fund, who has beaten the market by a huge margin over the past 10 years. The article is an object lesson in why we need Marketocracy. Heebner graduated from Amherst, an extremely prestigious college, and Harvard Business School. Nevertheless it took him 11 years of hard effort to get to the point where he had the chance, as a mutual fund manager, to show what he could do. He had just been fired as an assistant fund manager, for criticizing the head of the firm after having a few too many martinis over lunch. But he had developed enough of a reputation at that job to entice another mutual fund company to hire him. Lucky thing for him and all the people who have made big bucks investing with him.

What is wrong with this picture?? There is this brilliant guy, turns out to be a fabulous fund manager, but it takes him 11 years after graduating from the best business school to get to show his stuff as a fund manager. The point is that you can't tell who is going to be good at it till you give people a chance to actually do it. There were lots of other grads from Harvard Business School, how were we supposed to know that this one was the one who was going to be great as a fund manager?? And the skills that it takes to get that first crack at it in the "real world" are not the ones that it takes to do well after you get that first chance. Sure, there is some overlap. But it is far from a perfect match. Ken Heebner was not all that good at patiently accepting leadership that seemed questionable to him. He, perhaps, did not make the best impression on an interview. Those are the skills needed to get the first chance. His penetrating insight and admirable intellect got him the chance eventually, but it took awhile. Perhaps if Marketocracy had been around back then, it would have taken him a lot less time.

Posted by Timothy at 08:19 AM | Permalink | Comments (0) | TrackBacks (0)

Arthur Schopenhauer (1788 - 1860) stated, "All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident."

How very true this is. When I told folks back in 2001 that the price of petroleum was going to rise, they ridiculed the idea, then many violently opposed the notion, now people take it as self-evident that this was bound to happen.

But that is just an example, and not my central point here. Why do people do this?? I think it is to avoid mental dissonance. When something new is first proposed to be true, (e.g. Einsteinian physics, the Big Bang Theory, Evolution) it is likely to conflict with present beliefs. That causes conflict inside the minds of those who hear the new message. They don't like it. People have a strong distaste for mental conflict. That bears repeating, people have a strong distaste for mental conflict. I think that is what the Thirty Years War was all about.

What does this have to do with Marketocracy??? Marketocracy causes mental conflict. To those who believe that all actively managed funds are a bunch of hooey, it is just one more managed fund with a lot of big claims, that are all going to turn out to be nothing. For those who have their money socked away at Fidelity, it is just not going to make sense that people who are not with a big-name, well-established, long-history, big-money, blue-blood, ivy-league mutual fund organization could possibly do better than those who are. For those who work at Fidelity, it might well be infuriating that anybody who is not at a big-name, well-established, long-history, big-money organization and who does not have blue-blood and did not graduate from an ivy-league school could possibly think that he or she could pick stocks better than those who do and did.

But the Marketocracy performance is starting to all add up.

So get ready to start saying that it was self-evident all along, all you big-name, well-established, long-history, big-money types. Yeahhhhhhh, I mean you. Hey, what are you doing reading this anyway, if you are so confident it is all a bunch of hooey.

Timothy Siegel

Posted by Timothy at 09:07 PM | Permalink | Comments (0) | TrackBacks (0)

Is mutual fund performance persistent? This is a much debated question, with many journal authors stating that it may be. Of course, Marketocracy, with its lack of other guides depends entirely on persistence of performance for its market edge. Accordingly, Marketocracy is an experiment that should be followed by the academic community, as it would appear to bear out the notion that performance for managers at least, is indeed persistent. If performance were not persistent, the entire Marketocracy model would fail, and the statistics would appear to indicate that it has worked pretty well these last three years.

Timothy Siegel

Posted by Timothy at 06:23 PM | Permalink | Comments (0) | TrackBacks (0)

A box without hinges, key or lid,
Yet golden treasure inside is hid.

The Hobbit, J.R.R. Tolkien

The above riddle is one of a wonderful set of riddles that Bilbo Baggins and Gollum trade back and forth in the fifth chapter of The Hobbit.

But now our entire society faces another sort of riddle.

What interest rate is low enough to foster an incipient recovery?
Yet high enough to bolster the dollar and prevent inflation?

Answer: There is none.

Not every puzzle has a solution.

Ben Bernanke's talk has managed to push up the dollar, a little, for now. But export growth and import substitution are some of the main strengths of our otherwise beleaguered economy right now. If the dollar goes up by much, these strengths will go away, too. Also, the U.S. has negative real interest rates right now. So are the U.S. bills, notes and bonds really a good investment? It's hard to see it. Also, if the Fed is going to raise interest rates, what is that going to do to housing? How is the housing market ever going to recover, if interest rates start to go up?

I'm not going to try to predict currency rates in the short term. This month and next month, anything can happen. But there is a long term trend for the dollar, and it's not up. Nothing the Fed can do or say can stop that, because it is based on the fundamental fact that the U.S. has a huge trade deficit that must be corrected. It might take 40 years to do it, but eventually this country will have balanced trade. And only a weaker dollar is going to get us there.

Posted by Timothy at 07:54 AM | Permalink | Comments (0) | TrackBacks (0)

Well, I have now chucked my model of petroleum price increases, starting at $60/barrel on January 1, 2006 and increasing at $20 per year. It held true for awhile, and I successfully used it as a guide to get in at the troughs and out at the local maxima, but it must now be superseded by a new model having faster price increases. I am thinking of something on the order of $40 per year.

Along these lines, someone please explain to me why the price is down so much from a week ago. First, it seems to me that the Energy Information Agency's (EIA's) explanation for last week's plunge in inventories, that there was fog on the Houston Ship Channel, was disingenuous. I found this article offered by Indian Reuters. it seems peculiar that they should note this in India, but not in the U.S. edition:
http://in.reuters.com/article/oilRpt/idINN2929207020080529">href="http://in.reuters.com/article/oilRpt/idINN2929207020080529">http://in.reuters.com/article/oilRpt/idINN2929207020080529
.

" HOUSTON, May 29 (Reuters) - The Louisiana Offshore Oil Port (LOOP) said on Thursday some crude oil tankers canceled scheduled deliveries last week, but the only U.S. deep-water oil port operated normally.

Delays in Gulf Coast tanker movements was cited by the U.S. Energy Information Administration when it reported an 8.8-million-barrel drop in U.S. crude oil inventories on Thursday.

"We had a light week last week," said LOOP spokeswoman Barb Hestermann. "They don't happen very often, but they do happen."

The LOOP can offload over 900,000 barrels per day (bpd) in crude oil from tankers and takes 500,000 barrels of crude via pipeline from the offshore Mars platform.

The EIA report of tanker delays left the U.S. Coast Guard and shipping sources scratching their heads after repeated calls from reporters asking if they knew of any problems in the major waterways supplying Gulf Coast refineries.

"I've received several calls and I haven't been able to find anything in the New Orleans sector," said Lt. Stephen Nutting of the Coast Guard's New Orleans office.

Sources along the Houston Ship Channel said operations have been normal for several weeks.

Hestermann said she couldn't provide information about the number of tankers that canceled deliveries or the amount of crude they were scheduled to deliver.

The LOOP continued to make deliveries to Gulf Coast refineries via pipeline throughout the week, Hestermann said.

No major weather problems were seen along the Gulf last week nor were there reports of fog halting traffic along Gulf Coast waterways."

So...was it all a big lie?? Just to reassure a skittish public???

With respect to today's figures, which can be found at

http://www.eia.doe.gov/pub/oil_gas/petroleum/data_publications/weekly_petroleum_status_report/curren
t/txt/table1.txt
and which does not seem to copy over very well, what I typically do is take the change in the total figure and subtract out the propane/propylene component which always moves in a very tight annual pattern. Doing this shows that looking at petroleum and its range of products we are down a little from last week and about 2.5 percent from last year. Even with these high prices causing people to use less fuel, we are still seeing declining inventories. And it certainly looks as though the answer is not fog on the ship channel. This is still the energy consumption light second quarter, so I fail to see anything whatsoever petroleum price bearish about the figures. Do serious traders go by the press reports and fail to review the easily accessible government figures?? It is a little hard to believe.

In any event, for my funds I am going to buy the petroleum price ETF USO and may also buy some Schlumberger (SLB) and Smith International (SII). After all, if some hurricanes hit, watch out for that petroleum price, it is going to be launched into orbit.

Posted by Timothy at 08:21 PM | Permalink | Comments (0) | TrackBacks (0)

Q: When the percentage of households that own their home goes down, what goes up? A: The percentage that rent.

Avalon Bay Communities (AVB) builds and runs apartment communities. Accordingly, it is in the one part of the housing market that is healthy. As fewer can own, due to the tightened lending standards, more must rent. Also, some, but not all, of AVB's communities are urban. This is a huge advantage as the nation will slowly de-suburbanize and re-urbanize in response to increasingly tight fuel supplies. Human habitation will gradually become more concentrated, benefiting purveyors of urban rentals. Also, AVB qualifies as an REIT, and has a yield of 3.57%. For those who want a safe and high yielding investment, well you are doing better than 5 year T-notes with this one. And if inflation rises, AVB may well be able to increase its rents and its dividends, unlike a 5 year T-note purchased today which pays out the same set amount, regardless of changes in the inflation rate.

Looking at the chart, as REITS in general got hit, AVB has declined from a high of close to $150, in February of 2007, to about $100 now, even as interest rates have fallen. This is a great example of a stock that has been pulled down because it has been "tarred by the same brush" even though unlike other REITs it is in the right place at the right time, rather than being in the wrong place at the wrong time.

One way in which AVB came to my attention is that it is just about finished building a downtown apartment complex in Bellevue, WA, where I live and work. If this development says anything about the market savvy of their team, then it is a very positive statement. The development is timed perfectly to profit from booming downtown Bellevue. AVB has played its cards exactly right, at least on this occasion.

On the downside AVB does have some far flung suburban developments out there. Well, nothing is perfect, and these will still benefit from the trend towards renting. After all, people need a place to live, and with the high vacancy rate of for-sale housing, and low rate of housing construction, rentals will benefit.

Posted by Timothy at 07:58 AM | Permalink | Comments (0) | TrackBacks (0)

Let's imagine that we lived in a society where in order to compete in professional golf, one had to have majored in golf at a prestigious golf college and needed to have done fairly well there. In such a system the professional golfers would be pretty good. But we have a different system to determine who gets to play in professional golf tournaments. It's called, "play golf." It is a better system, because although the system where one majors in golf would be a good system producing good golf players, who had all taken in courses called "golf swing 202" and participated in seminars with names like "sand trap strategies," the system where everyone just plays golf and the best player gets to move up to a higher level is a better system.

There are, of course, very important differences between golf and portfolio management. A golf game can be played in a few hours, but to really get meaningful results in portfolio management takes years. A real golf game can be played without entrusting anyone to big assets, but a real portfolio management game cannot. Accordingly, the portfolio management "competition," to be open to everyone, must be virtual. And one must be patient and wait at least years to get meaningful results. But just as the skills to do well in golf college would not precisely match the skills needed to be a play golf well (although there would likely be a strong positive correlation), so the skills needed to get a Stanford or Wharton MBA likely do not perfectly match those needed to successfully manage a portfolio (although, again, there is likely a strong positive correlation). As long as that correlation is not perfect, there is benefit to be had in opening up the process to all comers. It is a process that takes some patience, but we are seeing some real benefit now, with the MOFQX significantly outperforming its peer group of funds. It's because Ken Kam has found a better way of picking the pickers. The investment community would do well to take a good look at the Marketocracy model, because it is the wave of the future.

Posted by Timothy at 06:43 AM | Permalink | Comments (0) | TrackBacks (0)

I believe that over the next 40 years we are going to see a continuing upward climb of petroleum prices. Over the next 10 years I believe that petroleum prices are going to rise by enough to force U.S. consumption of petroleum down from about 20 million barrels a day, now, to about 12.5 million barrels a day in 2018.

I think world production (including natural gas plant liquids) over that time period will fall from about 85 million barrels per day, now, to about 75 million barrels per day in 2018. We are likely to see increased production in Angola, Brazil, Kazakhstan and Iraq, but falling production just about everywhere else, including Saudi Arabia, Kuwait and the United Arab Emirates. Certainly, the United States and China will see lower production 10 years from now, with deep water petroleum having peaked at that point and onshore and shallow water production much lower. Russia, I think, will be about the same or a little lower. North Sea production (UK and Norway) will be way down.

So, if we accept the view that we will have about 10 million barrels per day less to divide among the nations of the world, how will this be divided? I certainly see China as taking a much, much larger share, tying the U.S. at 12.5 million barrels per day. Rapid economic growth and a burgeoning car industry will help China to consume more, even as we are consuming less. If we accept this view, at that point the average Chinese person will consume about 1/4 of the petroleum that an average U.S. person does. Western European consumption will fall, but Eastern European consumption is likely to rise a bit. Middle Eastern consumption is likely to rise a lot. As the price rises the petroleum exporters have more money to spend, and they will spend a portion of the money on more automobiles for their growing populations.

So, again accepting the analysis up to this point, how high does the price have to go to push U.S. consumption down by 7.5 million barrels a day over a ten year period. Well, the good news is that some of the choices consumers are making now will effortlessly follow through to the future. The more fuel efficient mix of cars sold now will effortlessly reduce our future consumption. But we are talking about a huge decrease in consumption, and new big SUVs, while being sold in greatly reduced numbers, are still being sold. Even if the average new car sold today consumed half the fuel of the new car sold 2 years ago, this would still not be enough, because it takes more than 10 years for the entire fleet of cars to be replaced and the number of cars may start growing again. I have to reach the conclusion that petroleum ten years from now will cost about $300/barrel, in current dollars. This would likely result in gasoline prices of about $9/gallon at the local gas station, again in current dollars.

The changes we are going to have to make will be far reaching and will effect every part of society and every aspect of our lives. Product packaging will change, with less plastic being used. Import substitution will reduce the amount of fuel spent bringing goods from abroad. Air travel will see a continuing decline. If we are smart we will start now to build a set of high speed train lines. A much higher percentage of goods will be shipped by train. (I note that currently there is a huge problem with the train line congestion).

So, how can we as investors benefit from this trend? I worry about the oil exploration and development companies because of the possibility of a windfall profits tax. But the oil service companies should not be adversely affected, and may be good deals, now. Railroads are clearly a great deal. Steel producers are huge beneficiaries on several fronts, and they are still relatively cheap (even after their incredible run up in price). Gold miners will be helped by the stoking of inflation by the increasing petroleum price, but hurt because they are major consumers of diesel fuel. And the opportunities to make money shorting stocks are obvious and numerous. I've written before about the fate of the Las Vegas casinos not being particularly bright right now. It's not the business downturn that is going to hurt them, but high air fares and declining disposable income.

Every change brings opportunity, for those who see it coming.

Posted by Timothy at 09:44 AM | Permalink | Comments (0) | TrackBacks (0)

In the sense that every object is unique, rareness is quite common. At first it might not seem as if every object is unique, but if we were to measure the surfaces of any object down to the nanometer lever, we would certainly find differences between any given object and every other object in the world. There is a black coffee mug on my desk, apparently the same as the others in its set. But if we were to measure that mug at the nanometer level no doubt the surfaces would undulate differently and have differing microscopic dimples in the glaze. So it is not enough that an object be rare, it is necessary, in order for that rareness to give value to the object, for the object to be rare in a way that makes a difference to an owner.

There are two ways that the differentiating characteristics of an object can boost its value. Either they must yield a utilitarian advantage, or they must be famous. A nuclear power plant is valuable because once it is built electricity can be generated from it using a much less costly stream of fuel than for other power plants that consume fuel. The Mona Lisa is valuable because it is distinct in a famous manner. Let us note that it is so famous that one can just say or write, “The Mona Lisa” without further qualification and virtually every reader more than 10 years old will immediately know what is meant. That is remarkable fame. One might suggest that it is not the fame of the Mona Lisa that makes it valuable, but its beauty. I disagree, because replicas have been created which only an art expert could tell from the original, but they have no value at all, despite being approximately as beautiful. It is fame or utility that makes a rare object valuable.

But for rare objects, there is a real problem of lack of divisibility and fungibility. The Mona Lisa cannot be broken up into pieces without greatly reducing its value. Although it would be silly to discuss the fungibility of a unique object, the class of objects known as “art objects” do have fungibility (a degree of uniformity of value) but hardly any. Each must be valued separately, with no sure way of determining relative values other than holding contemporaneous auctions.

The alert reader will already have gathered that this posting is leading up to the advantages of the precious metals, which are both rare, famous, divisible and fungible, quite a powerful combination for having and keeping value. A quantity of gold can be divided up as much as we might wish. It has complete uniformity of value. Every ounce of gold in the world is worth as much as every other ounce of gold in the world (with the exception of gold formed into a valuable object or existing in a place where there are import restriction on gold). The value is easily determined by just referring to the gold market. Gold is famous. It has been and is the main symbol of wealth in every society I know of. Accordingly, it is no wonder that gold has been used as money for all of recorded history. Technology marches on, but I seriously doubt that the alchemists’ quest of turning lead into gold will ever be achieved.

So the mainstream investment community is foolish to ignore that great potential of gold as the world economy and total world wealth, especially when measured in U.S. dollars, is growing so rapidly. The general dismissal of precious metals as an investment option also opens up the alluring possibility that should the mainstream financial community ever decide that the precious metals could be a good investment, after all, the price will really take off. During the last gold rally, lasting from the beginning of last quarter of 2007 until close to the end of the first quarter of 2008, some mainstream analysts started to say things like, "If you want to invest 5% of your assets in gold, go ahead." Because of their extreme unpopularity as an investment option, precious metals have an immense potential for appreciation. If pension funds were ever to start investing in precious metals, which I certainly believe they should do, then watch out. That would be a gold rally to end all gold rallies.

This scenario is not too far fetched. As gold becomes the best investment one could have made over the past 10 years (it may already be) it will start to gain some credibility as an investment. If it becomes the best 20 year investment, that is credibility. To Wall Street, twenty years means "forever."

Posted by Timothy at 08:28 PM | Permalink | Comments (0) | TrackBacks (0)

I see no contradiction between the concept that the stock market is efficient and the idea that a person could outsmart the market on a long term basis, although I think that many other observers do see a contradiction there. I believe that market efficiency is largely a matter of perspective. Let us take the perspective of "Joe Investor." Joe investor has an IRA of $200,000 and he would like to get the maximum return on this budding nest egg. He has above average intelligence and is quite interested in the stock market. He reads a few different publications on this subject and is considering using the advice given in these publications to make investment decisions. He has some of his money invested in individual stocks and another portion in mutual funds. From Joe's perspective, unfortunately, the market is efficient, for the following reasons:

1. With respect to stocks:
a. Anything he reads will have been read by hundreds of thousands of other investors.
b. Whatever the article writer has gotten right will have had its value diluted by a movement of the stock in the recommended direction.
c. Whatever the article writer has gotten wrong will mislead Joe.
d. The mutual fund managers, capital managers and big-money investors who are trading in Joe’s stocks will have much deeper and more complete knowledge of the issuing companies, and their business environments, than Joe has.

2. With respect to mutual funds: Any mutual fund that has performed well enough, long enough, to really show that it is being managed with skill, and has not just been the beneficiary of good luck, will either:
a. Have so much money to manage that it will have a very difficult time meeting previous performance levels, achieved while managing much less money; or
b. Be closed to new money, so that Joe will not be able to invest in that fund.
Moreover, there is no way to tell, for most funds, when there is an actual change in management.

So, for Joe Investor, the market is efficient. He might as well, indeed, invest in a passive instrument, such as an index fund.

Does this mean that it is not possible to beat the market on a regular basis? Of course it does not. Joe is working on the assumption that standard sources of information, interpreted in a straightforward manner (i.e. accepting the advice they give) can work. Nothing, of course, is that simple. In order to beat the market one must disagree with the current, most widely accepted (by the big money players, that is) market wisdom. One must free him or her self from commonly accepted images of industries and question every societal bias. One must be broadly informed, think independently, and have very strong analytic skills that one trusts as a guide.

Take, for example, my bet on the steel industry in 2003, when it had the worst imaginable image as a rust belt, sunset industry. I challenged that image, by asking why the domestic steel industry had that image. The conclusion I reached was that it was at least in part due to a dollar that had been very strong in the eighties (Reagan era supply side economics) briefly dipped in the early nineties, but then came roaring back and given an extra boost by the Asian currency crises of 1998. No wonder the domestic steel industry had suffered such a string of painful reversals. The strong dollar, the low price of fuel and comparatively low wages abroad had encouraged a flood of imports. But the dollar had already begun to fall at that point and any thinking person had to realize that the trade deficit of that time was unsustainable (although it continued to grow, even after that). Moreover, the increasing price of fuel would make it more expensive to import steel from distant countries. Now the domestic steel industry is doing great. The price of stock of AK Steel has risen from a low of about 2 and 1/2 in 2003 to 65 today (it was recently over 70 before dropping back a bit).

By questioning the accepted wisdom (and industry image) of the time, that the domestic steel industry was a rust belt, sunset industry, and by looking at the bigger international and historical picture behind that image, I was able to make a lot of money, both virtually and actually. What stunned me, and continues to puzzle me, was the power of that imagery in the minds of people that I would talk to, who simply could not accept the idea that the domestic steel industry would stage a comeback. The poor image, of course, made the deal so much sweeter, because it made it possible to purchase shares at what, in retrospect, was a ridiculously low price.

So for someone who examines the broad historical trends, who understands that just because things are a certain way right now does not mean that it is normal for things to be that way, who challenges industry images and looks deeper for the underlying causes of growth or decline, and who enjoys doing this and is good at it, the market is not efficient at all. It veers crazily in one direction, sending stocks of companies with no earnings up to dizzying heights one year, only for them to come crashing down and out of business the next. That is not efficient. Right now the stock prices of companies that own Las Vegas casinos are at high levels that makes no sense whatsoever. After all, their earnings were down with $100/barrel petroleum in the first quarter, what will $130/barrel-and-up petroleum do to them this quarter and next? Also, there is a crazy lack of recognition for the growing tidal wave of inflation that will sweep over our society, changing everything. There was an article in the New York Times business section yesterday advising how to manage one's bond portfolio with the threat of inflation in the air. I know how a bond portfolio should be managed: LIQUIDATE.

I would never say that beating the market is easy. The market is not logical, but rather a chaotic, illogical beast. But if one is patient and insightful, those reckless swings can become very profitable.

Posted by Timothy at 01:54 PM | Permalink | Comments (0) | TrackBacks (0)

This conversation will take place at different times in different industries. But gradually more and more U.S. importers will have this conversation:

Mr. Smith: Mr. Chan if you do not shave another 5% off, we will just have to take our business elsewhere.

Mr. Chan: OK. Good luck with that.

Mr. Smith: Perhaps you did not here me aright. I SAID, we will have to TAKE OUR BUSINESS ELSEWHERE.

Mr. Chan: OK. Good luck with that.

Mr. Smith: But don't you know that you need our business. We sell in the United States of America, the world's richest market. From the Texas Oil Billionaires, to the swanky shops of New York City, to the inestimable wealth of Silicon Valley and even Redmond, Washington, home of Microsoft. That is a market you cannot pass up. You need to sell through us, into the world's biggest, the world's baddest, the world's richest market.

Mr. Chan: Actually, right now the United States accounts for 12% of our sales, and we don't make any money off of it because you drove such a hard bargain last year at this time. We're in business to make money. If you want to go elsewhere, go.

Mr. Smith: That is impossible. You are bluffing.

Mr. Chan: No, 40% of our sales are in China, another 20% are in the rest of Asia, then 20% in Europe, and finally 7% in the Americas outside of the U.S. and 1% in Africa and Oceania. Those sales are growing, so if we lost 12 % of our least profitable sales, it would only mean a temporary disruption. And we would actually be more profitable.

Mr. Smith: Well, OK. You don't have to lower another 5%.

Mr. Chan: Actually, we are going to have to raise our price by 5%.

Mr. Smith: Oh well. I guess that's life.

Posted by Timothy at 10:33 PM | Permalink |