Thursday, December 20, 2007

Interest Rates v. Tax Rates

David Wessel wrote an excellent article in today's Wall Street Journal about the need to stimulate the economy. While everyone agrees that the economy is slowing and needs a boost, Wessel wonders if it is better for the Fed to continue cutting interest rates, or if a tax cut would be more effective. He pretty much rules out hope for a tax cut arguing that Congress is unlikely to agree to one.

That's too bad because the Fed cannot realistically cut rates anymore, and because tax cuts are indeed much more effective in stimulating economies. Even former Clinton-era Treasury Secretary Lawrence Summers is now pushing for tax cuts.

Why can't the Fed cut rates? Because inflation is rising. Since September, the Fed dropped both the discount rate and the fed funds rate by a hundred basis points each. Although it takes time for interest rate cuts to stimulate the economy, these recent cuts appear to be having little (if any) effect. They have, however, helped to trash the dollar. While U.S. exports have risen, which is certainly a good thing, so has the level of inflation. Higher inflation makes it very unlikely that the Fed will keep cutting rates.

Many economists are hoping that lower interest rates will soon revive the housing market. But the Fed's actions have not lowered mortgage rates. Furthermore, the housing market will remain in the doldrums for quite some time. There is simply too much inventory on the market. And no rational person would buy a house if he expects the price to keep falling--even if he could get a zero percent mortgage.

That brings us back to tax cuts, which of course are not popular with the liberal set. Liberals argue that tax cuts typically benefit only the wealthy. Yet if tax cuts must be implemented, liberals would rather see those in the lower income brackets get the cuts.

But how is that possible? After all, by definition tax cuts only benefit those who actually pay taxes. Because our income tax code is so progressive, those in the lower income brackets hardly pay any tax at all. How many Americans realize that the bottom 50% (by income) of our population pay only 3% of all individual income taxes? How could Congress possibly deliver a meaningful tax cut to this group? The only way to truly help those in lower income brackets is to implement policies that stimulate economic growth and create opportunities for all members of society.

For many working Americans, the tax burden is much too heavy. The combination of federal income taxes, state income taxes, property taxes, sales taxes, and all those other hidden taxes can easily eat up more than one-half of income. Property taxes, in particular, have literally gone through the roof in many parts of the country. If politicians really want to stimulate the housing market, the most effective way would be to immediately cut property taxes and limit how high they could go in the future.

Friday, December 14, 2007

Brain-Enhancing Drug Scandal

On the heels of Senator George Mitchell's report on the abuse of performance enhancing drugs in baseball, comes word that the phenomenon had been quite common outside the world of sports as well. New rumors have surfaced out of Sweden alleging that at least one-fourth of all Nobel laureates had at one time or another used brain-enhancing drugs to boost their intellectual capabilities. Critics claim their Nobel prizes were unearned and should be rescinded. One disgruntled scientist said, "These findings are truly unfair to all of us scientists with lower IQs who played by the rules. I think the world should immediately stop using whatever inventions those cheaters created!"

Tuesday, December 11, 2007

Ominous Warnings From the Fed

Today's Fed statement was filled with ominous warnings. It made references to slowing economic growth, the housing correction, softer business and consumer spending, strains in financial markets, elevated energy and commodity prices, inflation risks, and increased uncertainty. In other words, there is no good news to report.

Although the Fed cut the fed funds rate and the discount rate by a quarter point each, the market was strongly disappointed. Many investors were hoping for bolder action, perhaps a half-point cut in both rates. At the very least, investors were expecting more clarity from the statement. They exhibited their disappointment by selling stocks. Almost immediately, the Dow shed more than 200 points.

The Fed's comments make it clear that the probability of recession is much higher than many economists (including those at the Fed) had been forecasting. Yet with higher food prices, and with oil prices still flirting with the $90 per barrel level, the Fed knows it cannot focus solely on core inflation numbers anymore. The Fed knows that high food and energy prices will inevitably work their way into the core figures.

The Fed is truly between a rock and a hard place, officiating a game of tug-of-war between slowing growth and inflation. My view is that the Fed did the right thing by cutting the fed funds rate by just a quarter point. A steeper cut would have contributed to the dollar's weakness. However, I believe the Fed could have been a more aggressive with the discount rate. Given the slowing economy and the real potential for recession, there is no need to keep the discount rate a half-point above the fed funds rate.

Friday, December 07, 2007

Cruisn' For an Economic Bruisin'

Because I have been swamped, I haven't had an opportunity to post to my blog lately. I arrived home early this morning from the 12th Forbes Cruise for Investors, which went through the Panama Canal. A cruise, of course, is lots of fun. But it was also work for me and the other speakers. We started in Costa Rica on Nov. 30, went through the Canal, and stopped to visit St. Lucia. I disembarked in Antigua. The cruise is still proceeding on its was to Miami where it will end in a few days.

On my half of the cruise were Steve Forbes, Gary Shilling, Bob McTeer, Pete du Pont, and John Goodman. Rich Karlgaard served as the host. Gary, who has been right about the housing market all along, is still bearish on the economy and stocks. It was good to be around someone who is more bearish than myself. It made me feel like a good guy. The other speakers were more optimistic.

While on the ship, I learned about the Bush adminstration's plans to freeze certain subprime mortgage resets. Clearly, there are obvious moral hazard problems with doing something like this. It will be seen as a bailout of those who made imprudent decisions. Even so, I don't believe that even this measure will prevent housing prices from falling further. Freezing monthly payments may slow foreclosure rates modestly, but it won't solve the problem.

Given the continuing troubles in the housing market, I am posting below my comments from the December issue of the Forbes Growth Investor. This commentary was released to our subscribers several days ago:

It is not a pleasant topic, but the time has come to talk about recession. Although the probability of recession has obviously risen by a significant amount in recent months, most economists, including those at the Federal Reserve, are still betting the U.S. will be able to avoid one. Yet almost all economists, even those at the Fed, have lowered their projections for growth.

Minutes from the Fed’s Oct. 30-31 meeting reveal the new thinking. Most notably, the Fed is now projecting that economic growth will range from 1.6% to 2.6% for 2008, down from the 2.5% to 3% projection made just four months earlier. It is important to realize that the Fed is predicting anemic growth, but not recession. This, however, does not provide much comfort.

Not long ago, the so-called real estate experts claimed that housing prices never fall on a national basis. Those who said things were different this time were ridiculed. That argument is now settled. Not only have prices fallen; they are still plunging. The quarterly S&P/Case-Shiller U.S. National Home Price Index fell 1.7% sequentially in the third quarter, the biggest drop in its 21-year history. This index is down 4.5% year-over-year, and the rate of decrease has accelerated. This means that more than $11,000 of value has been erased from a home that was worth $250,000 a year ago. Of course, in some parts of the country, the story is much worse. In Tampa, you can now fetch just $222,250 for a house that was worth $250,000 a year ago.

Given losses of this magnitude, it is no surprise that foreclosures are up. Particularly hard hit have been homes financed with subprime adjustable-rate mortgages. The Fed estimates that monthly payments on more than two million such mortgages will be reset by the end of 2008. We will see many more foreclosures between now and then.

The real estate market is in a downward spiral. Falling property values contribute to foreclosures, and rising foreclosures contribute to falling property values. When a house is foreclosed, all the houses in that neighborhood lose value. In fact, Global Insight, an economic consultancy, recently estimated that property values will fall by $1.2 trillion in 2008. Foreclosures are being blamed for about half that amount.

In recent years, local governments have reaped a windfall in revenues by taxing all those inflated properties. That game will come to an end as homeowners demand that assessments be brought down to more realistic levels. Financial institutions are just starting to write down the values of their securitized subprime mortgage portfolios. Citigroup provides just one example of how devastating this can be for stockholders. The stock started the year at $55 per share. It is currently the biggest loser in the Dow Jones Industrial Average year-to-date.

Given the extent of the housing debacle, and a stock market that could potentially go much lower, why wouldn’t the economy go into recession? The Fed’s lowered growth projections are still too rosy. Perhaps the Fed is betting that the shrinking dollar will cause a huge boost in exports. We are certainly seeing some of that already. While it is true that a weak dollar can help prop up the economy in the short run, over the long run the U.S. is better off having a currency that everyone wants to hold. It's time for Treasury officials to do more than just give lip service to a strong dollar policy.

Monday, November 19, 2007

Shorting Starbucks Paid Off Big. Time to Cover?

Regular readers of this blog know that I have been bearish on Starbucks (SBUX) for quite some time. Here is what I said in August 2006:

Perhaps the latest Starbucks report is a harbinger of things to come. Starbucks reported disappointing growth and the stock took a big hit. Management blamed it on too much demand for blended drinks that take a long time to prepare. That's unique. Growth slowed because demand was too strong. With gasoline prices pushing north of $3 per gallon, I suspect the real story is that consumers are wondering how much sense it makes to pay $16 a gallon or more for coffee.

In October of that year I said:

Starbucks is another stock that appears overvalued. It is selling for 51 times expected earnings, almost 4 times sales, and 11 times book value. That seems like a lot to pay for what amounts to a chain of restaurants. Of course, Starbucks has tremendous growth prospects, but that doesn't warrant buying the stock at any price.

In May 2007 when gasoline prices broke above $3.20 per gallon, I said:

Companies like Starbucks and Whole Foods that sell overpriced and unnecessary goods might find that growth will slow. These two stocks have already fallen well off their highs. Chances are they will go lower still.

And in July 2007, after Starbucks announced a price increase that came out to nine cents per cup on average, I warned:

There seems to be little skepticism on Wall Street about Starbucks' recently announced price increase. The company admitted again that higher costs are pinching profits. It is struggling with higher dairy prices, higher fuel prices, and higher energy prices.

Well last week Starbucks announced earnings and the stock got hammered. Although the company continues to make good money, growth is slowing. Worse, store traffic actually fell. It seems that even Starbucks addicts are not able to cope with the latest price increase.

This company is caught between a rock and a hard place. Does it raise prices to protect margins at the risk of lower volumes? Or does it hold the line, absorb higher costs, and watch margins shrink? Of course, if dairy or energy prices were to start falling, Starbucks would become a buy once again. But it's not yet time to start buying the stock. However, if you shorted Starbucks at much higher levels, you may want to start thinking about covering at least part of your position.

Wednesday, November 14, 2007

The Pro-Tax Buffett

The Pro-Tax Buffett is the title of the ninth chapter of my new book, Even Buffett Isn't Perfect, which is due for release in May 2008. Warren Buffett's Congressional testimony delivered today convinces me that the title of the chapter is apropros.

Buffett favors higher taxes on the so-called rich. He favors both higher income taxes and higher death taxes. Estate taxes take their biggest toll on those whose estates are not very liquid. This group includes small farmers, ranchers, and business owners. These individuals typically oppose the estate tax because it often means that heirs must kill the business to pay the tax. Yet many of the mega-rich including Buffett favor this tax. Perhaps it is because they feel a little guilty about being so rich. Perhaps it is because they are convinced that charities would suffer if there was no estate tax and no loophole available to escape it. Yet, as a number of conservative commentators have pointed out, even if there is no tax, anyone who feels strongly about leaving his money to the government is free to do so. However, they should not force others to do the same thing. Furthermore, if they really believe this tax is a good thing, they should not take advantage of loopholes to escape it.

Prior to the Bush tax reforms, estates that were valued above $675,000 were taxed. The federal tax rate reached as high as 60% on large estates. Under the current law, this non-taxable limitation escalates to $3.5 million by 2009. Estates above $3.5 million will be taxed at 45% in that year. In 2010 the estate tax will be completely repealed. There will be no estate tax in 2010. However, in 2011 it comes back with a vengeance, hitting estates worth more than $1 million.

Just imagine the kinds of discussions that are underway in law offices across the country as wealthy clients try to plan their futures. Pity the old and sick. Their heirs are praying they hang on until 2010, but they may also be hoping they kick the bucket before 2011.

Chances are good that Congress will once again tinker with estate taxes sometime in the near future. Most Americans would not object to an estate tax that was reasonable and fair. However, taxing estates above $1 million at rates approaching 50% hardly seems reasonable. Some have suggested a 15% tax on estates above $10 million. Liberals think this is inadequate. Conservatives think even this is too much. Regardless of which party controls Congress and who sits in the White House, we can only hope that our politicians reach some sort of reasonable compromise on this issue before too long.

Tuesday, November 13, 2007

Today's Rally May Be Short-Lived

The Dow rallied 320 points today. Most analysts are crediting the rally to Wal-Mart's better-than-expected earnings, and comments out of Goldman Sachs saying it won't be posting any significant writedowns. Other analysts are saying the market rallied simply because it was short-term oversold. In other words, stocks went up today because they had gone down in previous days.

I am happy to see today's rally in Wal-Mart because the stock is on my recommeded list in the Special Situation Survey. I'm also happy to see the nice rebound in Citigroup because I started buying it just a few days ago (see Can Citi Maintain the Dividend). Yet I remain cautious on stocks overall. We will be seeing more mortgage-related writedowns. Yestereday's announcement from E*Trade won't be the last. Furthermore, problems could soon arise with securitized credit card obligations.

Although oil prices backed off more than $3 per barrel today, they remain extraordinarily high. This means gasoline prices will be going up significantly from current levels--just in time for the holiday shopping season. With consumer spending likely to slow, the weak dollar may be the only thing keeping our economy out of recession.

I would use strong rallies like today's to hedge positions. The UltraShort ProShares ETFs are a good way to accomplish this.

Thursday, November 08, 2007

Can Citi Maintain the Dividend?

Citigroup's dividend yield keeps rising as the stock keeps falling. A month ago, the yield was about 4.5%. At last look, it had reached 6.8% as the stock fell below $32 per share. The initial sell-off in the stock had to do with news that the company would write-off an additional $8-11 billion in sub-prime CDOs. But the stock has continued to fall because many investors are betting that the dividend will have to be cut in order to shore up capital.

So far at least, the board has indicated that the dividend will be maintained. But suppose it is cut? Will that drive the stock price lower? It may, but I doubt it will go much lower. In fact, investors may view a dividend reduction as good news. It could signal the board's determination to get serious about the company's financial problems.

My view is that Citigroup has reached a low enough level to justify the risk of buying some shares. That's exactly what I just started doing. My investment will likely be dead money for a while, but taking a page from Warren Buffett's book, it should pay off handsomely in the years ahead.

Thursday, November 01, 2007

Fed Rate Cuts Imperil the Dollar

The Federal Reserve is on a mission. By slashing interest rates, you may get the impression the Fed is out to save the economy. Instead, it is trashing the dollar.

It now costs almost $1.45 to buy one euro. It costs $2.08 to buy a British pound. Gold is $800 per ounce, and oil, which is denominated in dollars, costs more than $95 per barrel. There seems little doubt that we will soon break the dreaded $100 mark. One hundred dollars is exactly the price Osama bin Laden suggested the West should be paying for a barrel of oil soon after he attacked America on Sept. 11, 2001.

Investors, however, are cheering as the Fed devalues our currency. The Dow rallied 138 points in response to the latest interest rate cuts. The Fed reduced the discount rate by a quarter point to 5%. At the same time, it reduced the fed funds rate by a quarter point to 4.5%. With oil and gold prices near record levels, you might think that reasonable people would expect stocks to be struggling a bit. Reason, however, seems to be in short supply on Wall Street.

The Fed justified its latest rate cut by saying that economic expansion is likely to slow in part due to the housing correction. Furthermore, it said core inflation readings have improved. Apparently, no one at the Fed drives a car, buys food, or heats his home.

Those who have mortgages that are about to adjust to higher levels might want to send the Fed a thank you card. The Fed has given them an opportunity to switch into fixed-rate loans. Unless significant penalties are involved, refinancing in this manner should payoff over the long term.

The Fed’s action came the same day the Department of Commerce released its advance estimate for third quarter GDP. Although the figure is subject to revision, growth was a much stronger-than-expected 3.9%. It is no surprise that exports contributed to this growth. They surged 16.2% because the weak dollar makes American goods cheap abroad.

With growth near 4% it seems odd that the Fed would risk inflation by cutting interest rates. Core inflation may be tame, but headline inflation is not. The Fed is obviously looking ahead, and apparently it does not like what it sees. It may be worried that the sub-prime mortgage mess has not fully settled. It may also be concerned that consumer spending will eventually take a hit. Consumers, however, are weathering the housing bust and high oil prices fairly well.

But consumers don’t buy crude oil. They buy gasoline and heating oil. Despite high crude prices, gasoline prices have remained well off their spring highs. But how much longer can that last? Either gasoline prices must rise, or oil prices must fall. Gasoline inventories may fall in coming weeks as refiners start producing more heating oil. And with Thanksgiving just around the corner, demand for gasoline is likely to rise. Don’t be surprised if gasoline prices surge 20 to 30 cents per gallon by the end of this month.

Wednesday, October 31, 2007

Top 100 Companies in Muslim World

It is not surprising that some of the biggest companies in the Muslim world are found in the oil and gas industries. After all, Islamic countries sit on about two-thirds of the world's proven oil reserves, and oil prices are at all-time nominal highs.

What is surprising, however, is the diversity of businesses represented. I recently interviewed Rafi-uddin Shikoh, editor of DinarStandard, an online publication that tracks business in the Muslim world. His website lists all kinds of interesting information including top brands and top scientifically productive countries.

You can watch this MoneyMasters interview starting tomorrow (Thursday) morning.

Monday, October 29, 2007

Here & Now Interview

Oil prices are going through the roof, yet stocks are rising, too. Contrary to popular opinion, one has little to do with the other. Nonetheless, it is common to hear reporters blame a sell-off in stocks on rising energy prices. They often say things like "Stocks fell today because oil went up $2 a barrel." The truth, however, is that the two are not negatively correlated over the long term.

Yet rising commodity prices are a cause for worry. The two commodities that get much of the attention are oil and gold. Both are near all-time highs. Both may be telling us to expect higher inflation.

So far, gasoline prices have not budged much. Given the recent surge in oil prices, this is a bit surprising. It probably won't last. Either gasoline prices will rise, or oil prices will fall.

To hear more about the recent rise in oil, listen to my recent interview on Here & Now, a radio program broadcast out of Boston.

Thursday, October 25, 2007

Ian Bremmer on MoneyMasters Discusses Political Risk

China has the world's fastest growing major economy. It surged 11.5% in the third quarter. But China's economy still pales in size compared to the U.S. Even though China's population is more than four times larger than America's, it's economy is only about one-fifth as large. In fact, with a gross domestic product of more than $13 trillion, the U.S. economy is about four times larger than Japan's, which has the world's second-largest economy. The U.S. accounts for about one-fourth of total world GDP.

This is why an economic slowdown in the U.S. could have dire consequences for the entire planet. California's economy alone accounts for about 13% of U.S. GDP. California, of course, is literally on fire. According to the latest accounts, the wildfires are finally under control, but the damage to the economy has yet to be fully assessed. About a million people have been displaced and approximately 3,000 homes have been destroyed or damaged. I doubt, however, that even the home builders thought this was a good way to get rid of excess inventory.

Most forecasts for U.S. growth are still positive, but they are shrinking. It is becoming increasingly difficult for economists to argue that the U.S. will avoid an economic recession. Investors are still hoping the Fed will come to the rescue. In fact, stocks rallied yesterday on rumors that the Fed was about to cut the discount rate once again. I'm not betting on it. And I'm not betting on a Halloween rate cut either. I continue to expect poor returns for U.S. equities for the near future. While investing abroad may seem riskier, investors should keep a healthy exposure to foreign stocks. The lower correlations should provide diversification benefits.

For a more in depth discussion of some of the world's hot spots, watch Pricing Political Risk. It's a short interview with Ian Bremmer of the Eurasia Group, a leading political risk consultancy that caters to many of Wall Street's top investment banks and hedge funds.

Tuesday, October 16, 2007

Double Standards

China is extremely upset that the Dalai Lama will be awarded a Congressional Gold Medal. The White House is in favor of this award. It brushed aside China's objections. President Bush plans to attend the ceremony to honor one of the world's greatest spiritual leaders.

Turkey is extremely upset that the House Foreign Affairs Committee passed a resolution condemning the Armenian Genocide. The White House is almost as upset as the Turks. Before the vote, President Bush went on national television begging the committee not to vote on this non-binding resolution. Now that the resolution has passed, Bush is begging Speaker Nancy Pelosi to prevent it from reaching the floor of the House for a full vote.

Let me see if I've got this straight. The White House does not care how China feels, but it is bending over backwards to please Turkey. The White House is not arguing that the Armenians did not suffer a genocide. It just thinks that recognizing genocide is less important than hurting Turkey's feelings.

Armenians are being told that this is not a good time to vote on this measure. So when exactly is a good time? Armenians have been waiting for almost 100 years. Before the fall of Communism, they were told that Turkey was too important to upset because it bordered the Soviet Union. During the Clinton administration they were told that Turkey was too important to upset because it was a key ally that was friendly with Israel and supported our efforts in the Middle East. Now they are being told that Turkey is too important to upset because it borders Iraq.

To make its displeasure known, Turkey has threatened to invade Iraq and cut off U.S. supplies. Instead of reminding the Turks that we give them billions of dollars in foreign aid every year to buy their cooperation, the White House is begging Turkey for forgiveness. As for China, it couldn't care less.

Tuesday, October 09, 2007

A Shock to the Economic System

Today's release of the Fed's minutes from the Sept. 18 meeting gives us a better understanding of what the FOMC members were thinking when they decided to slash interest rates by 50 basis points.

For starters, the Fed "marked down" its estimate for fourth quarter GDP growth. It also "trimmed" its growth forecast for 2008. It raised its forecast for unemployment. And because business executives are growing cautious, the Fed now expects capital spending to be scaled back. Finally, the Fed trimmed expectations for both core and headline inflation.

All in all, the Fed was very concerned about the outlook for economic activity, and less concerned about inflation. The housing market deteriorated much faster and further than the Fed expected. The minutes said subprime mortgages are "essentially unavailable," that there is "little activity" in nonprime mortgages, and that borrowers of prime jumbo mortgages "faced higher rates and tighter lending standards."

But the Fed is not entirely ignoring inflation. It expressed concern about rising benefit costs and labor costs and said the weakening dollar had the potential to heighten inflation risks.

It appears that the Fed was hoping to shock the markets with a large one-time interest rate reduction. Given the strong rally in stocks ever since those cuts were made, it looks like the Fed succeeded. However, the remarks in the minutes of the Sept. 18 meeting also indicate that those who are expecting additional interest rate cuts are likely to be disappointed.

Friday, October 05, 2007

Can We Trust the Data?

Today's jobs report was certainly encouraging, but it raises an important question. Why does the government bother to release preliminary results if they are so unreliable?

The Bureau of Labor Statistics, which is responsible for tracking the data, said a month ago that August non-farm payrolls fell by 4,000. This spooked the markets. It convinced many economists that the economy was slowing much faster than they had anticipated. Most economists said the loss of jobs increased the probability of recession. It also put tremendous pressure on the Fed to cut interest rates. Because the jobs number was so weak, the Fed slashed both the fed funds rate and the discount rate by 50 basis points.

But today, the August figure was revised. It turns out that the economy did not lose 4,000 jobs after all. Instead, it actually created jobs. In fact, according to the most recent data, non-farm payrolls increased by 89,000 in August. Had the Fed known that, it may not have cut rates at all. In any case, it is now evident that the Fed went overboard.

Yet it must also be pointed out that even the 89,000 figure is not final. It will be revised one more time. We won't know until a month from now exactly how many jobs were created (or lost) in August.

In any case, today's data makes it much less likely that the Fed will lower rates again at its next meeting at the very end of this month. Given Chairman Bernanke's concerns about inflation, further rate cuts are highly unlikely.

Wednesday, September 19, 2007

The Fed Comes to Rescue After Saying It Won't

First of all, I apologize for not posting in a while and thank those of you who have noticed. The fact is that I've been incredibly busy. On top of everything else I normally do, I'm in the process of putting the finishing touches on a book I have been writing. That process is now near completion so I hope to be posting again on a regular basis relatively soon. However, yesterday's interest rate cuts by the Fed were so over the top, I had to make some comment.

Last Friday on Kudlow & Co. I predicted the Fed would cut the fed funds rate by 25 basis points and would leave the discount rate alone. Larry was calling for much bigger cuts in both. He was right. Yesterday, the Fed announced 50 basis point cuts in both interest rates.

My take on all this is that we can now officially change the name of the "Greenspan Put" to the "Bernanke Put." This aggressive action goes a long way in convincing investors that the Fed will always come to the rescue no matter how many times it says it won't. No one cares anymore that only about a month ago Bernanke warned that the Fed would not bail out investors when they make bad financial choices. He just proved that the Fed will do exactly that.

Furthermore, the Fed would not have taken such bold action unless it was absolutely convinced that the probability of recession has risen dramatically. It is interesting to note that not one member of the FOMC dissented. The decision to cut rates received unanimous support.

Today's disappointing housing numbers indicate that recession may be nearer than we thought. The CPI indicates that inflation is under control. But the CPI is likely to jump next month especially when energy prices are taken into account. Even though gasoline prices are well off their highs, oil prices keep setting new records. This divergence can't last. Either oil prices must come down or gasoline must rise. I'm betting that in the near term the latter is more likely. In any case, I'm sure at least a few hedge fund managers are buying gasoline and shorting oil.

While it was nice to see that the rate cuts caused a strong rally in stocks, you might want to take advantage of the opportunity to trim your long positions. I suspect we are going to give up all of the recent advance.

Monday, August 27, 2007

Rove + Gonzales = Trouble for Republicans

A professor once joked that the best way to turn a Democrat into a Republican was to let him graduate, get a job, and see how much he has to pay in taxes. Indeed, when I was in college, most of my classmates had Democratic leanings. I preferred to remain independent. But as time went on I noticed I had more in common with Republicans, and that is the way I usually voted.

Many years later I took a job in Massachusetts. Almost everyone in the state was a registered Democrat, so I decided to register as a Republican. I did so just in time to help elect William Weld, a Republican, governor. I have been a registered Republican ever since.

This is why it pains me to see the Republican party struggling so much in recent months. The Bush administration, in particular, is falling apart. A number of high-ranking officials have resigned. Karl Rove and Alberto Gonzales are only the most recent.

It is becoming more and more difficult for me to believe that the Republicans will be able to hold on to the White House in 2008. There does not appear to be a single Republican candidate who can energize the core of the party and at the same time attract a critical mass of Democrats.

The Democratic candidates have many flaws, yet their constituents appear quite satisfied with them. In my opinion, unless the Democrats completely blow it, this election belongs to them, which of course makes me all the more bearish on stocks. I believe a Democrat in the While House, along with a Democratic Congress, spells higher taxes. I expect stocks to go lower as more and more investors reach the same conclusion.

Friday, August 10, 2007

2% Growth is Bullish?

Brian Wesbury wrote an especially amusing op-ed in yesterday's Wall Street Journal. He argued that the business media are giving too much time to those who are bearish. Citing numerous surveys, he claimed that the vast majority of economists are bullish. Therefore, according to Wesbury, by giving bears and bulls an equal amount of time, viewers are getting the incorrect impression that economists are torn about economic growth.

I found this amusing for a couple of reasons. First, his definition of a bull is one who is forecasting at least 2% GDP growth. Not too long ago, 2% would have been considered bearish. In fact, I've been portrayed as the bear on a number of television debates because I was forecasting less than 3% growth.

Furthermore, he ignores the fact that almost all economists have been ratcheting down their forecasts. They may still be predicting growth, but they are getting less and less optimistic.

He also ignores the fact that it rarely pays for forecasters to disagree with the masses. They want to make sure their forecast is not too far off from the average forecast. This way, if they are wrong, they can simply shrug their shoulders and say, "Hey, that's what everybody was expecting."

As for me, I still think the probability of recession is rather low. I think 2% GDP growth is still a reasonable estimate. So why am I a bear? It is not because I expect a recession. It is because I expect stocks to go lower. Despite the recent sell-offs we've been seeing in the markets, I think there is still a ways to go before we hit bottom.

Saturday, August 04, 2007

Rising Volatility Means Stocks Can Go Lower

Given the sell-off in stocks we are now seeing, I decided to post my recent comments from the Forbes Growth Investor:

Volatility is back on Wall Street. There were 21 trading days in July. The range between the Dow’s high and low exceeded 100 points on 13 of those days. It exceeded 200 points on six days.

The CBOE Market Volatility Index is another way to monitor volatility. This index measures implied volatility from the prices traders are willing to pay for stock options. Implied volatility was rather low during the second half of 2006. It started rising in late February 2007, breaking through its 200-day moving average. It has now reached its highest levels since 2003. Traders love this kind of market. It gives them plenty of opportunity to make quick profits by jumping in and out of stocks. Long term buy-and-hold investors, however, may not pay much attention. They should. Rising volatility can sometimes signal a major turning point in the market. In 2003 it signaled the start of a bull market. Today, it may be telling us just the opposite.

Rising volatility means investors are getting nervous. They no longer feel confident about the market’s overall direction. Of course, much of the current volatility is being blamed on woes in the sub-prime mortgage market and on worries that those problems will spread to higher quality mortgages. Yet even today, there are those who seem to be completely discounting the deterioration in housing. They seem convinced that the housing market is about to bottom and that any further problems—if they do occur—will have only a minimal impact on consumer spending.

Economists will debate exactly how much investors should worry, but one thing is for
sure: This bull market is getting old. As a result, many investors are sitting on sizable gains. When they see stock prices gyrate excessively, they can’t help but think about taking profits. They probably should take some money off the table.

It’s likely that housing prices will continue to fall. In fact, the 10-city S&P Case/Shiller Home Price Index recently posted its biggest drop since 1991. Furthermore, oil is trading for more than $78 per barrel and some analysts predict it will hit $100 within a year. Yet so many otherwise meticulous market watchers are simply overlooking the price of this indispensable commodity. To them, the price of
oil does not matter—until, of course, when it does.

Despite seemingly strong GDP growth in the second quarter, stocks are likely to go lower. Those who are truly worried about further declines, but for tax purposes are reluctant to realize gains, should consider hedging their portfolios. One good way to do this is by buying one or more of the UltraShort ETFs. These move opposite in direction to the corresponding index, but by twice as much. For example, the DXD will rise 10% in value if the Dow falls 5%. The SDS provides a similar hedge against the S&P 500. Readers can learn more about these products at

Wednesday, August 01, 2007

Taking a Gamble on Hooper Holmes

Several years ago, my wife and I decided to buy some life insurance. The insurance company sent a couple of paramedics over to our house to do a basic medical exam and take samples of blood and urine. These paramedics were employed by a company called Hooper Holmes (HH). Unfortunately, the company hasn't been doing so well. It has no profits and revenues are falling. The stock has been falling, too. It has fallen steadily for about seven years and currently sells for $2.65 per share.

Despite all these problems, I recently started accumulating shares of the company. New management took over more than a year ago and I'm betting the worst is over. The gross profit margin is already showing signs of recovery and there is hope that the revenue decline will moderate. Furthermore, the company has no debt outstanding.

This is not a growth story. HH is not operating in a particularly complicated industry. In fact, it's a rather boring business. It's the kind of stuff Warren Buffett might appreciate. There is nothing high tech about it. It should be relatively easy for this kind of company to make some money. Most importantly, HH needs to get expenses under control and bring them down to a level that is appropriate for the reduced amount of revenue it is now generating. At the same time, it needs to find ways to stem the revenue decline.

The company will probably announce second quarter results in about a week or so. I'm not expecting anything spectacular. If it can simply break even and show that revenues are holding steady, that will be enough to attract some buyers.

Sunday, July 29, 2007

Ethanol Revisited

I recently read an excellent article in the May/June 2007 issue of Foreign Affairs, which is published by the Council on Foreign Relations. Professors C. Ford Runge and Benjamin Senauer argue in "How Biofuels Could Starve the Poor" that the push for corn-based ethanol is driving up global food prices.

High oil prices have prompted governments to subsidize the development of alternative fuels. Brazil uses sugar to produce ethanol. The U.S. has focused on corn-based ethanol. Although corn production is near record levels, an increasing portion is being dedicated to refine ethanol. This has depleted corn inventories. Furthermore, as farmers plant more and more corn, yields of other food crops are falling, pushing up their prices as well.

Ethanol is expensive to produce. Ironically, high crude oil prices are necessary for ethanol production to be profitable. The authors argue that if oil prices fell back to $30 per barrel (admittedly, not a very likely outcome), corn prices would have to fall to less than $2 per bushel for ethanol production to remain a profitable business. However, at $80 per barrel for oil, ethanol refiners could afford to pay more than $5 per bushel for corn and still make a good return. The tradeoff, of course, is more expensive food.

I commented on much of this back in April when I wrote Ethanol is Not the Solution. I argued that the most promising technology to address our transportation needs in the short term is the plug-in hybrid car. Since then several automobile manufacturers have announced plans to invest more money to research and develop this technology. The farm lobby may oppose these efforts, but success would not only significantly reduce our dependence on foreign oil, it would also bring food inflation under control.

Tuesday, July 24, 2007

Starbucks Raises Prices and Analysts Cheer

There seems to be little skepticism on Wall Street about Starbucks' recently announced price increase. The company admitted again that higher costs are pinching profits. It is struggling with higher dairy prices, higher fuel prices, and higher energy prices.

But consumers are also dealing with higher prices, leaving them with less and less income to spend on discretionary items like Starbucks coffee. So is the nine cents per cup price increase sufficient to preserve profit margins without depressing volumes? Or is it too much of an increase that will turn away some customers and make them wonder why they are paying so much for coffee? These are the questions Starbucks and analysts are grappling with.

Customers are getting squeezed by higher prices for all kinds of things. Food and energy prices in particular are taking a bite out of their incomes. I doubt even Starbucks believes that customers will finance their coffee purchases with stock market gains or home equity loans. The bottom line is that things don't look promising for Starbucks right now. We'll learn more about the company's financials on August 1. In the meantime, I'm sticking with my recommendation to short the stock.

Thursday, July 12, 2007

The Real Cost of Living

Wednesday night I argued on Kudlow & Co. on CNBC that inflation is problematic. I mentioned soaring gasoline and food prices. Larry Kudlow took me to task saying those volatile components are rightly excluded when measuring core inflation. He said the prices of other things like televisions and cell phones have been falling. He didn't care for my argument that consumers buy gasoline and food every week, but that they might buy a cell phone only once every two or three years. He said I was being silly.

After thinking about it for a while, I realized that even the costs of watching television or making a phone call have risen. Take television. Granted, quality has improved dramatically, but the cost of watching television has gone up tremendously. I purchased a color television set in 1987 for $299 and paid an additional $200 to have a rotational antenna installed on my house. That allowed me to capture stations from Baltimore to Philadelphia. There were no additional costs involved. I received all my programming for free.

These days you would have to buy a high-definition television set. I know prices for HDTVs are falling, but they still cost about $1,000 or more. You also have to subscribe to premium cable or satellite services that cost at least $60 per month. And even though you can now get hundreds of stations, it is still difficult to find much that is worth watching. So, economists may argue that the cost of a television has fallen if you factor in the vastly improved quality. Yet the fact is that the cost of watching television today is much higher than it was in the 1980s.

As for cell phones, they were certainly a rarity back in 1987. Those who wanted one installed in their car had to pay a fortune. These days cell phones are ubiquitous. Yet I can't say that I have noticed a decrease in the price of making a call. Even cell phone prices don't seem to have fallen much in recent years. Yes, the phones are getting cooler and cooler. They do offer lots of features I never thought I needed. But when you consider all those hidden fees and taxes, the cost of making a call just seems to go higher and higher.

There are many such examples. Technology has brought us lots of products we couldn't even have imagined just a couple of decades ago. And if these products come with added features with only a marginal increase in price, economists actually consider that a price decrease. Yet the cost of daily life keeps rising. Think of all the things you do on a regular basis. You spend money on housing and clothing. You have to eat and drive to work. You might watch television and listen to satellite radio. You might go out to dinner and a movie. You might take a vacation. Perhaps the quality of the things you buy on a regular basis has improved, but the costs of daily life are certainly not falling.

Wednesday, July 11, 2007

Life is Good Without a Car or Food

Is there or is there not an inflation problem in the U.S. economy? Anyone who buys gasoline knows inflation is rampant. Filling up the average sized gas tank costs about $50 these days. Just a few years ago you would have needed only about $30. Food prices are also way up. Even Starbucks is complaining that high dairy prices are pinching profit margins.

Yet Fed officials and most economists say inflation is not so bad because they prefer to focus on core inflation. In other words, they want to know how much prices are rising if we exclude gasoline and food. They believe gasoline and food prices are just too volatile to provide a meaningful measure of inflation, so they simply ignore them.

But investors are waking up to the fact that gasoline and food really matter. Consumers know these items are taking a bigger and bigger bite out of their paychecks. The effects are starting to show as consumer spending becomes strained. For example, Wal-Mart has been complaining for some time about higher gasoline prices weakening their customers' purchasing power. It turns out some of those customers are making up for this by resorting to the 5-finger discount. Wal-Mart is getting fed up with the increased levels of shoplifting activity it is seeing, so it announced plans to be more aggressive about prosecuting violators.

In the meantime the housing market continues to implode and foreclosures keep rising. Even S&P and Moody's have finally figured out that sub-prime mortgages are indeed risky. Housing prices are falling nationwide. Of course, the high-end of the market will probably fare well. But average prices are likely to fall enough to put some homeowners in a negative equity position.

As for jobs, so far so good. The economy is still creating jobs and the unemployment rate remains low. Nonetheless, incomes are not doing so hot. According to the Commerce Department, inflation-adjusted incomes actually fell in May. Of course, that's using overall inflation, which includes those volatile gasoline and food prices. Those of you who are lucky enough not to have to drive or eat, well it turns out you're doing pretty well!

Friday, June 29, 2007

More Worrying Signs of Market Weakness

Yesterday the Fed said it would hold the fed funds rate steady at 5.25%. This was widely expected. But market traders were placing bets on the wording of the statement. They said if the Fed took "elevated" out when referring to inflation, we would see a nice rally. The dreaded word is gone, yet the Dow finished slightly lower for the day.

The Blackstone Group was one of the most highly anticipated IPOs in recent times. It went public last Friday. The offering price was $31 per share. As commonly happens with an IPO, the stock opened much higher. It finished the first day of trading at $35. That's considered a success. But the stock has closed lower every day since. Just two days later, it was selling below the offering price. That's considered a miserable failure. Compare Blackstone to Google, which never sold below its offering price.

In recent periods, investors were reacting positively to all news. Good news was considered grounds for a rally. So was bad news. But now there seems to be more skepticism in the markets. Even on days when stocks initially rally, they later give up much of the gains. This bull market is losing its steam.

Tuesday, June 19, 2007

Speculating on a Microsoft and Yahoo! Deal

Google (GOOG), one of my favorite overvalued stocks, is a great company. It dominates internet search and makes a bundle selling ads. Microsoft (MSFT) and Yahoo! (YHOO) haven't been able to compete. Will they finally team up to beat Google?

This is pure speculation, but there is reason to believe that Microsoft and Yahoo! will be cooperating more closely in the near future. Yesterday, Yahoo! announced that CEO Terry Semel is resigning. He is being replaced by founder Jerry Yang. But the most interesting part of the management shake-up is that CFO Susan Decker is being promoted to president. The media is already speculating that one day soon Decker will be named Yahoo!'s CEO.

Decker's promotion is key to a Microsoft deal. I say this because Decker was recently appointed to Berkshire Hathaway's board of directors. Warren Buffett's board also includes Microsoft founder Bill Gates. This arrangement will give Decker and Gates plenty of opportunity to get to know one another much better. They will primarily be discussing Berkshire business at Berkshire board meetings, but you can bet they will also have lots of time to strategize about how Microsoft and Yahoo! can work together to battle Google.

Monday, June 18, 2007

Enlightened Leadership Should Encourage Guidance

Here we go again. The latest attack on quarterly earnings guidance comes from the Aspen Institute, a non-profit organization that according to its website is "dedicated to fostering enlightened leadership and open-minded dialogue." Promoting the elimination of guidance, however, is anything but enlightened. So in the hope of fostering some dialogue, here is my argument against eliminating guidance.

There is a widespread misconception that earnings guidance is bad because it causes investors and corporate executives to focus on short-term results rather than the long term. While no one doubts that running a corporation with the long term in mind is the better approach, it is wrong to believe that guidance is the problem. Investors certainly do focus on quarterly earnings numbers, but not because corporations give out guidance. They focus on quarterly results for only one reason--the SEC requires corporations to report results on a quarterly basis. It is because of this SEC requirement that investors form quarterly expectations. If the SEC told corporations to report results on a monthly basis, investors would form monthly expectations. This has nothing to do with guidance. Eliminating guidance will in no way stop investors from forming expectations.

Guidance is valuable information. After all, who knows better what a corporation is likely to earn, a bunch of Wall Street analysts or the corporation's own management? If guidance is not provided, analysts' earnings estimates will simply become more inaccurate. Earnings surprises would become bigger. By the way, there are at least two academic studies in circulation that prove this point. And in an era in which regulators are trying to promote more disclosure, how much sense does it really make to tell corporations to stop providing guidance?

The truth is that those who want to end guidance are upset about the volatility that occurs when corporations miss the earnings estimate by just a penny or two. They believe the ensuing sell-off is unjustified. They are probably right about this. However, instead of grabbing the opportunity to buy more shares at a lower price, as any self-respecting long-term investor should do, they want to eliminate volatility by eliminating guidance.

Furthermore, if they would really like to see a greater focus on the long term, perhaps they should petition the SEC to eliminate quarterly reporting altogether. There was a time when corporations had to report results just once a year. However, many corporations reported quarterly results long before a change in the law required them to do so. They did this for one simple reason: their investors demanded the information. This is exactly why corporations provide guidance. If investors want quarterly guidance, should we not be encouraging corporations to provide it?

Tuesday, June 12, 2007

Interest Rate Sell Off

Stocks are selling off as the yield on the 10-year note climbs. At last look, it's standing at 5.26%. Just a couple of months ago, it was down around 4.5%. My expectation that interest rates would rise was one reason I cited for my bearishness on stocks in the June 18 issue of Forbes magazine.

Many economists have been betting that the Fed would cut short-term interest rates. I've been saying that what the Fed does is largely irrelevant. The yield on the 10-year note is much more important. I believe the Fed was hoping that the 10-year yield would rise so it would not have to raise short-term rates anymore. Now that it has, the Fed can breathe more easily.

The Fed's next opportunity to change rates comes on June 28. Now that the yield curve is cooperating with its wishes, my guess is that the Fed will take no action. The higher 10-year yield will keep a lid on inflation by keeping the economy from overheating. The bigger risk right now is too much of an economic slowdown.

Wednesday, June 06, 2007

Here Comes the Bear

The June 18 issue of Forbes magazine contains my column explaining why I am bearish on stocks. Although Google is one stock I panned, it just keeps going up. I firmly believe that the growth rate assumptions built into Google's valuation are unsustainable. After all, if Google's growth doesn't slow, it will eventually own all the assets in the world. When a high growth firm realizes that growth is slowing, it often starts acquiring other high growth companies. That often ends in trouble. Google seems to be going down this path.

The two other stocks I panned, Starbucks and Whole Foods, are already showing signs of weakness. I've been bearish on Starbucks for a while--largely because of rising gasoline prices. I just don't see how anyone but the very rich can afford to buy $5 lattes on a daily basis.

Giving Thanks to the Military

I'm spending the week in Carlisle, PA at a National Security Seminar at the U.S. Army War College. Civilian guests such as myself have been put into small seminar groups that consist primarily of military officers from all the various branches. The groups also include a small number of officers from select foreign nations. We've been debating all kinds of issues from the war in Iraq to the economy. The experience has been absolutely outstanding. I would say that the most surprising--and pleasant--thing I have discovered is the tremendous degree of independent thought and diversity of opinion that exists in the military. While I have always held in high esteem those who serve our country through military service, my respect for them has grown tremendously. It is extremely comforting to know that our military ranks are filled with so many intelligent individuals. Knowing how much these people sacrifice for our country, I can't help but feel a little ashamed that I have never served in the same way.

Friday, June 01, 2007

All News is Good News

The market is in one of its euphoric phases where all news is good news. Gasoline prices set all-time highs and stocks rally. Oil prices go higher and stocks rally. The housing market shows signs of falling apart and stocks rally. GDP growth all but disappears and stocks rally. The yield on the 10-year note closes in on 5% and stocks rally.

In fact, other than a fairly robust jobs market, there really isn't a lot of good news out there. Yet investors keep pushing stock prices higher. As I explain in the new issue of the Forbes Growth Investor, demand for shares is strong thanks to private equity firms, M&A activity, and share buybacks. And in my column in the June 18 issue of Forbes magazine, I explain why I'm bearish on the market. I also pan some stocks that I think could get hurt when consumer spending slows.

Tuesday, May 22, 2007

Gasoline Above $3.20 Per Gallon

According to the AAA, the national average price for a gallon of gasoline broke through $3.20 per gallon. This is an all-time high even on an inflation-adjusted basis.

I have been interviewed on MSNBC at least a half dozen times in recent weeks about rising gasoline prices. I have to admit, I am surprised by the extent of this increase. I thought we might see about $3.10 or so, then slide back down. The fact that we're still going up tells me that drivers don't yet feel the pain. Demand for gasoline is actually rising despite the higher prices. Prices will keep rising until drivers start making adjustments. For example, if they are convinced that high prices are here to stay, they will consider buying more fuel-efficient cars. But as long they are willing to drive SUVs, and long as demand for gasoline goes up, that tells me prices are not too high.

What about supply? Some say refiners need to produce more gasoline. Perhaps they could have done a better job maintaining refineries and making the seasonal switch to summer blends, but they are not likely to invest in more capacity. If you were a refiner would you be keen to invest $2 billion or so and several years building a new refinery when you know you will have to battle regulators and environmentalists? Furthermore, you see that our government is promoting and subsidizing alternative fuels such as ethanol. After investing all that time and money to build a new refinery, you might find there is too much gasoline on the market and not enough demand. Before you know it, gasoline prices may go much lower and your investment will provide no payback.

In the short term, our best hope for more supply is imports. As a result, we will become dependent on foreign gasoline as well as foreign oil. The alternative is to get serious about cutting demand. The best way to do this is to put a high floor on gasoline prices. However, just about all politicians are looking to do the opposite. They want to find ways to decrease price rather than increase it.

Nonetheless, it looks like consumers will have to adjust to higher prices whether they like it or not. The long-predicted effect on consumer spending may finally materialize. Companies like Starbucks and Whole Foods that sell overpriced and unnecessary goods might find that growth will slow. These two stocks have already fallen well off their highs. Chances are they will go lower still.

Monday, May 07, 2007

The Bearish Case

Last week on Kudlow & Co. on CNBC, I explained why I am bearish on the markets. It boils down to three things: 1) Slowing earnings growth, 2) Rising interest rates, and 3) Higher taxes.

There is no question that earnings are strong. Corporations have been doing great. Those that do a significant amount of business abroad have been doing particularly well. Some of this is due to strong foreign economies, but much of it is due to a weak U.S. dollar that keeps weakening on a regular basis. More importantly, however, corporate earnings growth is actually slowing. Furthermore, the growth in net earnings is significantly less than the growth in earnings per share. This is because of all the share buybacks going on. Corporations know investors focus on EPS. They also know they can easily boost EPS by buying back shares. I will interview S&P's Howard Silverblatt about earnings tomorrow. This MoneyMasters interview will be posted on on May 17.

Interest rates are a bit more interesting. I actually think there is a better chance the Fed will lower rates than raise them. But as we've learned in recent years, what the Fed does has little influence on the longer end of the yield curve. GDP growth has slowed considerably, and the most recent employment figures were disappointing. Results like these should make the Fed feel more comfortable about lowering interest rates. However, I continue to worry about rising energy prices. Gasoline prices are near an all-time record. Although I expect them to back off a little from this level, they certainly aren't going to plummet. Eventually they will feed inflation causing the yield on the 10-year note to rise. Furthermore, I also believe credit spreads will widen.

Finally, there are taxes. I often laugh when I hear liberals rail against the Bush tax cuts. I really haven't noticed any tax cuts. When you factor in my state and property taxes, and the fact that I can't deduct these on my federal form because of the AMT, my taxes have risen quite a bit. And now that the Democrats control Congress, it's pretty much a sure bet that taxes will not be going lower. Even if the Republicans manage to hold onto the White House, the best we can hope for is a veto of any tax increase. Don't hold your breath for a cut.

So why do stocks keep going up? Investor sentiment has a lot to do with it. That's really all that matters in the short run. Add to that hedge funds using lots of leverage, private equity firms buying public companies, the new merger wave, and all those share repurchases. The demand for stocks is greater than the supply. This may go on for a while, but it won't last over the long term.

Friday, April 27, 2007

Investment Newsletter Performance

Subscribers to my investment newsletters sometimes ask exactly how well our recommendations are doing. They don't have to take my word for it because our performance is regularly monitored by the Hulbert Financial Digest, which also tracks the performance of almost 200 other investment newsletters. According to Hulbert, the Forbes Special Situation Survey (SSS) returned 26.5% (excluding dividends) over the year ending March 31, making it the third-best performing investment newsletter during that period. In comparison, the Dow Jones Industrial Average gained just 11.2%. What’s more, if you compare us to newsletters that focus only on domestic equities like we do, we are actually No. 1.

Furthermore, SSS has been consistent over the long term. Ever since Hulbert began tracking us in January 2002, we have produced an annualized return of 14.6%. The annualized return on the Dow during the same time is only 4.1%. It is true that a handful of newsletters managed to beat us, but at least some of them relied on the use of margin, short selling, or derivatives. Their performance is not necessarily due to good stock picking. It can be explained at least in part by market timing and the use of leverage. In contrast, SSS does not assume that subscribers buy stocks on margin or employ other kinds of strategies. Our returns are solely the result of stock-picking ability.

The Forbes Growth Investor (FGI), which relies on a quantitative, momentum-based model also did well, significantly outperforming the market averages since Hulbert began tracking it. It has produced an annualized return of 9.0% since January 2002. Because this newsletter has a diversified recommended list of 50 stocks, it tends to be less volatile than SSS.

We credit these outstanding results to our disciplined screening process. Most importantly, for SSS, we rely on our proprietary discounted cash flow (DCF) model. We are sometimes told that our model is not realistic. This is absolutely true. Indeed, our model is overly conservative. For example, if we believe a company can realistically grow revenues by 10% each year, we might model only 5% growth. If we believe the operating profit margin is likely to be around 15%, we might model only 10%. We do this because we are not trying to determine what a stock is actually worth. Instead, we are trying to determine what it is worth at a minimum. In other words, our methodology is designed to find reasons not to recommend a stock. However, if despite all our conservative assumptions we derive a minimum intrinsic value that is greater than the stock’s market price, that stock becomes a candidate for recommendation.

It is interesting to note that Warren Buffett, perhaps the greatest investor of all time, also relies on a DCF methodology to determine a company’s intrinsic value. He points out, however, that two analysts using this methodology will rarely derive the same intrinsic value. This is because DCF analysis is as much art as it is science. It is prone to error because it requires making assumptions about the future. It is precisely for this reason that we try to make our assumptions as conservative as possible.

DCF analysis does not always work. For example, during the dotcom boom of the late 1990s stocks that DCF analysis flagged as overvalued continued to go up. This was because of overly optimistic investor sentiment. Barring such unusual periods, we believe a conservative DCF approach is the best way to pick undervalued stocks over the long term.

For FGI, we rely on a proprietary quantitative model. This product is more short-term oriented and puts a lot of weight on price and earnings momentum.

Thursday, April 19, 2007

China vs. India

This is the final day of the Forbes cruise. We are actually pulling into Hong Kong at the moment. I see a lot of mountains and many beautiful tall buildings. I will spend one more night on the ship then fly back to New York tomorrow afternoon.

Jim Michaels, former Editor of Forbes magazine, moderated a spirited discussion yesterday about the merits of investing in China and India. John Dessauer, who travels to China frequently, was not keen on investing there. He thinks there is insufficient transparency. He would not even recommend buying ADRs of Chinese companies. He prefers to invest in large U.S. conglomerates such as Citigroup and Wal-Mart that are conducting business in China. But Arjuna Mahendran was willing to pick a few Chinese stocks. He particularly favors oil company CNOOC. Warren Buffett also likes Chinese oil, but he prefers PetroChina.

Despite all the excitement over China, Jim Michaels thinks India offers better opportunities for investors. He said the Chinese are focused on manufacturing low-cost items, but the Indians are specializing in high-skilled services.

Wednesday, April 18, 2007

Bulls on Board

Forbes magazine Publisher Rich Karlgaard started off the 11th Forbes Cruise for Investors this morning with an excellent presentation. He said Americans seem to hate a good economy, but that’s a good thing for investors because it keeps expectations low. He pointed out that there is a correlation between one’s view of the economy and one’s view of President Bush. He also talked about the media and how it tends to lean left and focus on the negative. He even made some predictions about real estate. He said the gap between real estate prices on the coasts and prices in the interior is greater than it has ever been. He believes that baby boomers will increasingly retire to interior regions of the country. He favors college towns in low tax, non-union states.

John Dessauer spoke next. He was extremely bullish about the stock market. He sees stocks going much higher primarily because of corporate earnings growth. He says stock price appreciation has lagged earnings growth rates. Therefore, he believes it will require a strong rally in stocks to straighten things out. According to Dessauer, those who warn about slowing earnings growth are simply wrong.

In addition to the presentations, the cruise has been wonderful. As usual, the food is great. However, the seas have been extremely rough the last couple of days. Running on a tread mill was all but impossible. I finally had to give up after half a mile. In fact, most people look drunk simply walking around on board trying to keep their balance.

Cho Was Purely Evil

Now we know his name. Cho Seung-Hui is the Virginia Tech student who in just a flash of time killed 32 innocent people, injured 14 others, and disrupted the lives of tens of thousands. He was a loner who talked to no one and had no friends. Today he is world famous and will never be forgotten by the loved ones of those he killed. By the time the media is through, we will know all his deepest and darkest secrets. And we will hear all the experts theorize about what went wrong and how an immigrant Korean child could grow up to become one of the greatest evil doers in American history.

Just a couple of days ago I briefly wrote about my favorable impression of Koreans. I have no doubt that Koreans all over the world are absolutely shocked by Cho’s crimes. I am sure many are now feeling shame and trying to understand how one of their own could have done so much evil. This is nonsense. Cho was not one of their own. He was not one of anyone’s own. The fact that he was of Korean descent is about as relevant as his height or his weight or the color of his hair. This guy was pure evil. And as we know, evil comes in all colors, lives in all countries, and practices all religions.

Tuesday, April 17, 2007

Investing Like Buffett

The 11th Forbes Cruise for Investors continues. Today we heard from Marilyn Cohen, a fixed-income specialist who also writes a regular column in Forbes magazine. We also heard from Arjuna Mahendran, Chief Strategist Asia Pacific at Credit Suisse. Both made excellent presentations. I also gave a presentation, which focused on my research on Warren Buffett. For the past several months I have been writing a book about Buffett. While there are a number of books already in publication, they are all “love” stories. I believe my book is the most objective one by far. While I criticize Buffett for advocating certain views that I believe hurt investors, I also conclude that he is clearly the greatest investor of all time. My respect for him has grown immensely since I began this project. If all goes according to plan, the book will on the market by next spring.

Horror in Blacksburg

I’m on the high seas cruising from Osaka to Hong Kong. I woke up Tuesday morning at 5:00 am our time (which was 5:00 pm Monday in New York) and turned on the television to find out how the stock market had done. Instead, I was horrified to hear news of what was being called “The Virginia Tech Massacre.” I was stunned. I spent five years of my life studying at Virginia Tech where I earned two graduate degrees. Blacksburg is one of my favorite places in the whole world. I absolutely love it. I also considered it one the safest places to live. I couldn’t believe this kind of horrible tragedy could occur in such a wonderful place. I extend my deepest sympathies to the families and loved ones of all the innocent victims of this terrible crime.

Sunday, April 15, 2007

Polite Societies

I'm in Osaka, Japan. I just boarded the Crystal Symphony for the second half of the 11th Forbes Cruise for Investors. I arrived Saturday evening, which of course, was Saturday morning in New York. I'm still jet-lagged.

I haven't been in Asia long, but I have made a number of observations. Let me start with the flight. I took Korean Airlines from New York to Seoul then changed planes for Osaka. The service was outstanding. The stewards and stewardesses were wonderful. The food was as good as anything you would expect to find in a fine restaurant. I had steak for lunch and an arrangement of seafood wrapped in phyllo dough for dinner. I had a second codfish dinner on the flight from Seoul to Osaka. Both planes were Boeing 747s. Since I flew business class, there was plenty of leg room. The seats reclined to an almost horizontal position, making it much easier to get some sleep.

Getting from Kansai International Airport in Osaka to the Westin Hotel was easier than I expected. The airport is not near the city and I heard cab fare runs around $200. So I took a bus to the New Hankyu Hotel and a taxi from there to the Westin. That cost about $25 in total. The Westin was very nice, but there was no wireless Internet access and no wired access in the rooms. The next morning I had a delicious traditional Japanese breakfast. I'm not exactly sure what I ate, but I do know there was a lot of seafood involved. In any case, I really liked it. I've had plenty of sushi back home, but this was the first time I ate a real Japanese breakfast. By the way, the tea was excellent. It was much better than what I've had in typical Japanese restaurants in American.

After breakfast, I returned to my room and read The Daily Yomiuri, an English-language newspaper. One story really caught my attention. It turns out that "more than 400 Osaka municipal government workers lied about their academic backgrounds when they applied for posts designed for workers who had only graduated from high school or middle school." That’s right; these people actually denied having graduated from college! I've heard plenty of cases of people embellishing their resumes in order to secure better jobs than they were qualified for, but these workers had done exactly the opposite. They had purposely downplayed their qualifications. Either finding a job in Osaka is very difficult, or this is a society that suffers from an extreme case of humility.

Perhaps the one thing that strikes me most about the Koreans and Japanese is how incredibly polite they are. I realize my perception may be skewed. After all, I was primarily exposed to people working in service industries. They are required to treat customers nicely. But the workers here seem to be in a league of their own. Of course, we are all aware of what happened to all those manufacturing jobs that used to be found in the U.S. If customer service jobs could be outsourced as easily, I'm not sure what kind of work would be left in America.

Wednesday, April 11, 2007

Ethanol Is Not The Solution

With crude oil and gasoline prices at high levels, it makes sense to look for alternatives. President Bush seems convinced that ethanol is the best solution to our energy problems. Ethanol certainly has a lot going for it. Most importantly, it is relatively easy to manufacture automobile engines that can run on high ethanol-content fuel.

But like gasoline, ethanol comes with its own share of problems. For example, it isn't as efficient as gasoline. As a result, it takes more ethanol than gasoline to drive the same number of miles. Also, growing demand for ethanol is pushing up food prices all over the world. This is because today's ethanol is made from sugar or corn. Both products are widely used in all kinds of foods. President Bush says we should make ethanol from switch grass, but that's not so easy.

So in the end, will we be trading our dependence on expensive gasoline for even more expensive ethanol? In order to protect U.S. farmers, our government taxes ethanol imports, but can the U.S. even make enough ethanol to meet its expected needs? And what will happen when those tariffs are eventually reduced or eliminated? Instead of being dependent on the Organization of Petroleum Exporting Countries (OPEC), will we become dependent on a new Organization of Ethanol Exporting Countries (OEEC)?

I'm not saying we should not use any ethanol. Ethanol certainly will help reduce our reliance on oil and gasoline. That's a good thing. But I am saying that ethanol by itself is not the answer. What we really need are technologies that allow us to drive more miles at a lower cost. One way to achieve that is with more fuel-efficient cars. Don't get me wrong. I am not in favor of government mandates that dictate how many miles per gallon cars must get. Rather, I prefer market forces. Let gasoline rise to $4 or $5 per gallon and we will quickly see new solutions. In my opinion, the best solution in the near term is the plug-in hybrid vehicle. Since most people drive less than 50 miles a day, a car that can go that far on electricity before having to switch over to gasoline will significantly reduce our appetite for foreign oil.

Of course, a more immediate solution is to drive smarter. The last time gasoline prices topped $3 per gallon, demand actually fell. That's because people took matters into their own hands. Many who own gas guzzling SUVs also own more fuel-efficient passenger cars. They parked the SUV and drove the car. Some started car-pooling. Others began using public transportation. Those who couldn't do these things began planning better to minimize the number of miles driven.

Unfortunately, when people respond in this manner and demand falls, gasoline prices also fall. After a while, people notice the lower prices and revert to their old ways. Demand rises again and so do prices. We end up in a vicious cycle. If we really want to get serious about energy conservation, perhaps it is time to consider a floor on gasoline prices. This is a solution many economists favor, but you certainly won't find any politicians talking about it.

Thursday, April 05, 2007

Forbes Investors Roundtable Discussion

Last week we hosted a Roundtable discussion with a few notable investment experts at our headquarters at Forbes. Participants included Barbara Marcin, Mike Holland, Joe Battipaglia, and Nikhil Hutheesing. Our discussion began with an overview of the economy and stock market. Barbara, Mike, and Nikhil were all bullish. Joe and I were bearish. Each of the participants also presented some of their best investment ideas for the year. The full report is available only to subscribers of the Forbes Growth Investor and Special Situation Survey investment newsletters.

Monday, March 26, 2007

Largest Supply of New Homes Since 1995

Just a few days ago, I heard an analyst defend the home building industry. He said home builders were cutting back on construction in order to reduce inventories. He seemed certain business would soon pick up.

Not soon enough according to today's report from the Department of Commerce. It turns out that on a seasonally-adjusted and annualized basis, only an estimated 848,000 new homes were sold in February. That's down 3.9% from the revised January estimate, which is itself down 5.9% from the initial January estimate reported a month ago. At this rate, we could conceivably see today's figure eventually revised to less than 800,000.

Regardless of any future revisions, it is clear that problems persist in housing. While home builders may be reducing inventories, they are also selling fewer homes, which means supply is actually rising. In fact, according to the latest report, there is now an 8.1 months' supply of new homes on the market. That's the highest amount of supply since December 1995.

Amazingly, prices are holding up. In fact, February's median price of $250,000 was up 2.8% from January. But prices should be taken with a grain of salt. Home builders are making all kinds of concessions to move houses. They are throwing in every conceivable upgrade to hold the line on price.

What does this mean for the economy? I think the Fed will worry more about slowing growth than rising inflation. In my view, today's report raises the odds of a Fed rate cut by year-end.

Saturday, March 24, 2007

American Superconductor May Soon Turn the Corner

In the interest of full disclosure, let me first say that I am an American Superconductor (AMSC) shareholder and have been on and off since the late 1990s. The stock has been one of my favorites—and most profitable—even though the company has yet to make any money. But now I am starting to believe that profitability is just around the corner.

AMSC has three segments: Wires, SuperMachines, and Power Electronics. Power Electronics, the largest by far, recently turned profitable on an operating basis. However, profits in this segment are dwarfed by operating losses in the other two segments. This is because management is pouring a ton of money into R&D. It is no longer manufacturing its first-generation high temperature superconducting wires. Instead, it has moved on to making second generation (344 and 348) wires, which will provide superior performance and eventually incur much lower manufacturing costs.

Another promising area is ship-propulsion systems. AMSC has been working on a 36.5 megawatt superconducting motor for the U.S. Navy. Superconducting motors deliver the same power as conventional motors, but are much smaller and lighter. They are quieter, too. That is particularly important in military applications.

The company's January acquisition of Windtec is one the primary reasons I am turning more optimistic about future profitability. Windtec is an Austrian company that designs wind turbine systems that rely on AMSC's PowerModule systems. The acquisition makes strategic sense and already appears to be paying off in the form of major orders from Sinovel Wind Corp. of Beijing. Windtec is also receiving orders from South Korea.

Warning—this is an extremely risky and volatile stock. It has already run up about 50% so far this year. And the company is still burning cash. This means management may decide to take advantage of the recent rally by issuing more shares, which would likely push the price back down. Nonetheless, I think there is a good chance the company may break even in fiscal 2008, which begins next month.

You can view a MoneyMasters interview I conducted with CEO Greg Yurek back in December. It's called "Powering the Future."

Wednesday, March 21, 2007

Chances of a Rate Cut Are Better Than you Think

With the Fed wrapping up its two-day meeting, investors are betting on the outcome. Conventional wisdom is calling for no change in interest rates. Indeed, CBOT futures are pricing in a 98% probability that the Fed will stand pat and just a 2% probability that it will cuts rates by a quarter point.

I believe chances for a rate reduction are higher than the numbers indicate. I am convinced the Fed is seriously concerned about the housing market. Fed officials are fully aware that higher rates at the longer-end of the yield curve could accelerate the pace of mortgage defaults and foreclosures. The sub-prime market has already been hit. If troubles spread to the alt-A and prime markets, the economy would easily be thrown into recession.

So is the Fed willing to risk a little inflation in order to prevent a housing meltdown? Inflation is currently running a bit higher than the Fed's so-called comfort zone. That's why many investors believe the Fed won't cut. But inflation is still quite low by historical standards. As a result, the Fed can feel comfortable about cutting rates at this time. A rate cut, however, would scare the markets and could result in a significant sell-off because it would send the message that recession is a likely possibility.

Of course, like most investors, I'm betting against a rate cut. Nonetheless, I won't be surprised if it happens today.

Tuesday, March 20, 2007

Housing Still Hasn't Bottomed

Housing starts for February came in at a better-than-expected 1.525 million. Several commentators jumped on this as evidence that the housing market has bottomed and that the economy is strong. They shouldn't celebrate.

Although the figure was 9% better than January's 1.399 million estimate, the 90% confidence interval is ±10.2 percentage points. In other words, there is a good chance housing starts did not rise at all. Furthermore, February's figure is 28.5% lower than it was a year earlier.

Housing is not out of the woods. The bust in the sub-prime mortgage market will continue, especially if the yield on the 10-year note starts to rise. This will force more homeowners into default as their monthly payments rise. The prime market, however, should be fine; unless the economy slows further and the unemployment rate begins to rise. At this time, I don't expect current problems in housing to cause a recession. Yet there is little doubt that economic growth will be more anemic than many economists had previously expected.

Sunday, March 18, 2007

Less Guidance Means More Risk

Earnings guidance is a topic that is near and dear to my heart. I have written a number of articles that criticize efforts to ban guidance. The first two, In Defense of Earnings Guidance and Is Buffett Hazardous to Your Wealth?, were published in 2003. The third, Gimme Guidance, was co-authored with Mike Ozanian and published in 2006.

Guidance is in the news again because the U.S. Chamber of Commerce recently came out with a report encouraging companies to put an end to the practice. Even Warren Buffett, perhaps the most successful investor of all-time, opposes guidance.

There are a number of objections to guidance. However, the one that gets the most play is that guidance encourages executives to focus on the short term rather than the long term. As a result, managers worry more about managing earnings than they do about managing the business. For example, it is argued that managers who provide guidance are more likely to reduce R&D spending in order to "meet the number." Doing something like this will boost short-term profits at the expense of long-term profits. Everyone, include myself, agrees this is a bad idea.

The problem with the argument is that it falsely assumes that "short-termism" is caused by guidance. It isn't. The fact is that investors will form expectations whether guidance is provided or not. They currently form quarterly expectations simply because the SEC requires corporations to report earnings every quarter. If the SEC required monthly reports, investors would form monthly expectations.

Guidance plays a valuable role because it ensures that investor expectations don't get out of hand. I have theorized about this in the past and said that without guidance, the disparity between actual earnings and the consensus estimate will only be larger than it already is. Now there is empirical evidence that supports this theory. Baruch Lev of NYU and his co-authors, Joel Houston and Jennifer Tucker of Florida, have a very interesting paper in circulation called "To Guide or Not to Guide?" They find that earnings estimates do indeed become less accurate when companies stop providing guidance. What's worse, they find absolutely no evidence that those companies that end guidance increase the focus on the long term. Companies that end guidance do not increase R&D spending, they do not increase capital expenditures, and they do not provide investors with any additional information.

A second study in circulation by Shuping Chen, Dawn Matsumoto, and Shiva Rajogopal of the University of Washington called "Is Silence Golden?" finds that eliminating guidance destroys shareholder wealth. When companies announce an end to guidance, they suffer a statistically significant decline in stock returns.

There really is only one thing that can be said for sure about ending guidance. Less guidance results in less information. And all investors know that less information creates greater uncertainty, which means more risk. It seems odd in the post-dotcom era when regulators are trying to encourage more disclosure, that some of the most vocal corporate critics of the past are now telling corporations to keep mum.

Monday, March 12, 2007

24 Hours a Day

An energy analyst recently said that demand for gasoline will rise because of daylight savings time (DST). She believes people are happy to have an extra hour to drive.

Of course, they don't have an extra hour to drive or do anything else for that matter. Despite DST, there are still only 24 hours in a day. What she apparently means is that the additional hour of daylight in the evening (at the cost of an hour of daylight in the morning) will somehow convince people to drive their cars more.

I don't buy this argument. Neither do I buy the argument that DST saves energy. Even if it did, how much energy could it possibly save? People will run their refrigerators and computers just as much as they did before. They will still heat or cool their homes, vacuum their houses, and blow-dry their hair. Perhaps they might use a little less lighting in the evening, but compared to everything else, light bulbs don't use that much energy.

It was dark this morning when my alarm went off. As a result, I had to turn on the lights. I didn't have to do that last week. I might have my lights on for an hour less in the evenings, but I'm making up for it in the mornings. I don't believe DST makes a meaningful dent in energy consumption; and I certainly don't believe it has any impact on gasoline demand.

Wednesday, March 07, 2007

Why Are Gasoline Prices Rising?

I'm often asked to comment on energy prices. MSNBC asked me today why gasoline prices are rising again. First, since oil prices are up about 20% from their early January lows, it isn't surprising to see gasoline prices up about the same amount after a bit of a lag. Second, because gasoline is a refined product, refinery problems add to its cost. For example, we recently had a couple of refinery fires. Also, many refineries are down for routine maintenance. In addition, refineries are now switching to more expensive summer blends that produce less smog.

People often wonder why gasoline prices vary so much from state to state. Many New Yorkers, for example, make a point of filling up in New Jersey whenever they can. Price differences have to do with state and local taxes that are added on top of federal taxes. California has the highest gasoline prices in the country. It also has the highest taxes. In addition, California demands a much cleaner burning fuel than is required by federal laws. It is simply more expensive to produce "California" gasoline.

I'm also often asked why gasoline prices go up faster than they come down. I'm not convinced they do, but economists have studied this issue of sticky prices for many goods. When input prices go up, manufacturers often raise prices for finished goods in order to protect profit margins. But when input prices fall, they aren't as quick to reduce finished goods prices. This may be partly due to a belief that the drop in input prices will prove to be temporary. It may also be due to a desire to enjoy fat profit margins for a while. Yet, I haven't seen any evidence that gasoline prices are any stickier than the prices of other consumer goods. On the contrary, it appears that gasoline prices are extremely responsive to a change in oil prices. The correlation coefficient between gasoline and oil prices is well over 90%.

Friday, March 02, 2007

Commentary from Forbes Growth Investor

I released the March issue of the Forbes Growth Investor yesterday to my subscribers. Here is the front-page commentary:

For many months, market watchers had been wondering what had happened to the risk premium. Investors seemed to have no fear of risk. Volatility had all but disappeared. But all that changed on Feb. 27. For reasons that are not completely clear, investors decided in mass they didn't like risk anymore. They sold stocks like crazy and bought bonds. Down volume on the New York Stock Exchange was 100 times larger than up volume. The system that tracks the Dow fell behind because trading volume was too much for it to handle. When it finally caught up, investors were shocked to see the Dow down by more than 500 points. Stocks did manage to gain some of that back by the end of the trading day, but the Dow still closed 416 points lower. As for bonds, the credit risk premium expanded as the yield on the 10-year Treasury note plummeted to 4.5%. Just two weeks earlier, it had been above 4.8%.

When stocks fall this much in a single day, inquiring minds want to know why. The media hunt for pundits and put them on the spot. What was the catalyst? If I were superstitious I would say it had something to do with the fact that I had lunch that day with Robert Shiller, author of "Irrational Exuberance," the book that correctly called a market top in 2000. But there are other explanations. Some blamed the selloff in New York on the selloff in China that immediately preceded it. Others said stocks fell because former Fed Chairman Alan Greenspan suggested a day or two earlier that a recession was possible by the end of the year. Still others blamed the selling on a disappointing durable goods report that came out that same morning. And at least one reporter said traders were telling him the plunge was in response to a failed attempt by the Taliban to assassinate Vice President Richard Cheney. (I am sure, however, that these traders were not suggesting a successful attempt would have caused a rally.)

Investors were understandably anxious the following morning. Yet stocks stabilized and even inched a little higher at the open even though the Commerce Department said it was revising down its fourth quarter GDP growth estimate to 2.2% from 3.5%. Investors even shrugged off evidence of further weakening in housing as January new home sales plummeted 20% year-over-year and 16% from the prior month. Stocks gained steam when Fed Chairman Ben Bernanke began his testimony to Congress. He expressed strong concern about entitlement programs and deficits, yet investors focused more on statements relating to interest rates. Bernanke said economic growth should remain at moderate levels, which was interpreted to mean that further rate hikes are unlikely. Many traders were disappointed, however, that by the time the markets closed, the Dow had managed to get back only 52 points of the previous day’s loss.

Where do stocks go from here? The signs are troubling. I said in our December issue that rising volatility would be a negative indicator. The CBOE market volatility index, commonly referred to as the VIX, has suddenly reached levels not seen since last July. Oil prices are another concern. After falling back to $50 per barrel, they are now comfortably above $60. And although some say former fed chairmen should keep their opinions to themselves, it is not good news that Alan Greenspan is talking openly about a possible recession. All these factors are making at least a few institutional investors nervous. Individual investors should exercise caution as well.

Tuesday, February 27, 2007

Start of Something Big?

Robert Shiller published his book, "Irrational Exuberance" in March 2000. The book argued that stocks were overvalued. For those who may have forgotten, March 2000 is also the same exact month that the Nasdaq Composite peaked.

Today, the Dow lost over 400 points. The Nasdaq lost almost a 100. Maybe it is just coincidence, but today I also interviewed Shiller for my MoneyMasters video program. The Dow was down about 140 points when I left my office to go to our studio. After the interview, we went out for lunch. Sam Masucci, CEO of MacroMarkets, joined us. Fortunately, I wasn't aware the sell-off was getting worse; otherwise I might have had indigestion.

Why did the market fall so much today? The simple answer is that there were more sellers than buyers. No one knows for certain why. Perhaps it was the big sell-off in China. Perhaps it was the disappointing durable goods report that came out this morning. Perhaps it was Alan Greenspan's comments about a possible recession by year-end. Or perhaps, investors suddenly decided there really was no good reason for stocks to have rallied in the first place.

Earnings growth is slowing, oil prices are above $60, the housing market is struggling, and the Fed is unlikely to cut rates. Unlikely, that is, unless things get so bad that a rate cut becomes necessary to boost the economy regardless of what that means for inflation.

Although the second edition of "Irrational Exuberance" focuses on overvaluation in the housing market, Shiller told me he still thinks stocks are too expensive. I don't feel comfortable betting against him. My interview with Shiller will be posted on March 8.

Thursday, February 22, 2007

Housing Has Not Bottomed

Last Sunday I did a hit on MSNBC with Alex Witt about the housing market. This was partly prompted by remarks by Fed Chairman Ben Bernanke and former Fed Chairman Alan Greenspan that the housing market has bottomed.

My view is quite different. Just about every metric indicates a continuing deterioration. Whether you look at year-over-year sales, building permits, housing starts, orders, or cancellations, things are getting worse with no real evidence of a bottoming.

Let's look at some recent reports by major home builders. Toll Brothers (TOL), which caters to luxury home buyers, reported net income of $54.3 million for fiscal Q1. That's down from $163.9 million in the year earlier period. Much of the decline was due to writing down the book value of land the company owns. Yet even if write-downs were ignored, net income would have been only about $118 million. Signed contracts were down 34%. The company delivered fewer units and signed fewer contracts in every geographic region it serves. It also has significantly less backlog than it did a year ago.

Other home builders such as KB Homes (KBH) and Hovnanian Enterprises (HOV) are reporting similar problems. Indeed the entire housing market seems to be weakening by almost every conceivable measure. Even home prices are showing signs of trouble. Nationwide median prices haven't really fallen, but they have stopped going up. While there are pockets of falling prices all over the country, it seems like it's now just a matter of time before prices start falling in all geographic regions.

Optimists insist the worst is over. But pessimists appear to be more realistic at this time. Those who follow the housing market closely are betting on a continuing decline. Forbes columnist Gary Shilling remains extremely pessimistic. I plan to interview Robert Shiller of Yale University and MacroMarkets on Feb. 27 about his views on the housing market. Shiller recently announced a new home price index he is launching with Standard & Poor's and Fiserv. This index will track actual transaction prices for single-family homes only. I will ask Shiller about this and other issues in our interview, which we plan to post on MoneyMasters on March 8.