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.

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.

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.

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.

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.