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.
Monday, March 26, 2007
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."
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.
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.
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.
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.
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%.
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.
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.
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