Monday, October 27, 2008

Lower Gasoline Prices Won't Pay the Mortgage

In my previous post I said, "Lower oil prices and more efficient cars will leave consumers with more cash to spend on other things." While this is certainly a move in the right direction, I don't want to leave the impression that we're talking about a lot of money here.

Assuming the average driver rolled up about 12,000 miles per year and got 20 miles per gallon, he would need to purchase 600 gallons of gasoline per year. At $3.50 per gallon, he would spend $2,100 per year for gasoline.

But now gasoline costs about $1 per gallon less than it did a month ago. Furthermore, drivers are also driving less and more of them are shifting to fuel efficient cars. So let's assume our average driver now drives only 10,800 per year and gets 28 miles per gallon. At $2.50 per gallon, he spends $964 per year for gasoline.

While that might look like a big saving, it comes out to less than $100 per month. Yes, it does leave consumers with more cash, but not enough to make a mortgage payment.

Saturday, October 25, 2008

Lower Oil Prices and Tax Cuts Will Boost the Economy

The financial crisis, economic turmoil, and the stock market sell-off have investors in the doldrums. One bright spot, however, is the recent plunge in oil prices. While this is a welcome development, it is not entirely unexpected. In recent years, easy monetary policy brought us the tech stock bubble, the housing bubble, and the commodities bubble.

High oil prices were largely the result of a weak dollar. They had less to do with strong demand or too little supply. Perhaps it took longer than it should have, but high oil prices finally caused the demand destruction we have been expecting. In reality, this destruction has been going on for months, but it become noticeable only recently. For example, the Department of Transportation just documented a decline of 15 billion fewer miles driven in August 2008 than in August 2007. But it's already late October. No doubt, demand has continued to fall during the last two months as well. Furthermore, as I explained more than a month ago in Forbes magazine, "with global economies slowing, the dollar strengthening and U.S. demand declining, even the threat of hurricanes can't keep oil's price up."

OPEC has long been saying there is plenty of supply. Now it is worried there is too much. Cooler heads at OPEC never wanted to see prices go as high as they did because they feared high prices would cause a global recession—something that is clearly bad for their business. Now they are just as worried that prices will plunge to levels not seen in years. This is why OPEC just announced a 1.5 million barrel per day production cut.

But just as OPEC was unable to keep prices from spiking, it is likely to find that it can't prevent prices from falling. Some OPEC nations with weak economies were already exceeding their quotas, trying to sell as much oil as they could at ridiculously high prices. On paper, these nations are entirely in favor of a production cut. However, in practice, they will find it much harder to stick to their promises.

Some economists fear that lower oil prices will cause Americans to return to their profligate ways—putting conservation aside and buying up SUVs and pick-up trucks once again. This won't happen. Every automobile company has invested millions—if not billions—retooling their factories to produce more fuel-efficient vehicles. No one is in favor of going back to old ways.

Lower oil prices and more efficient cars will leave consumers with more cash to spend on other things. This could do as much good as a meaningful tax cut, helping to revive the economy. Combine lower oil prices with a real tax cut and the economy is likely to boom. But if OPEC manages to push oil prices back up to recent highs, the U.S. and the entire world will have an extremely difficult time shaking off this recession.

Friday, October 24, 2008

Nouriel Roubini is a Star

I've been out of the office for several days. I spent a couple of enjoyable days in Blacksburg, VA, home of VA Tech University and one of my all-time favorite places. The view of the mountains as I flew into Roanoke airport was phenomenal. I went to Blackburg to give a talk about my book, Even Buffett Isn't Perfect. I was hoping to attract 100 people. About 300 showed up. In times like these, everyone is seeking Buffett's wisdom.

The Blue Ridge mountains provided much needed relief from these troubled markets. Readers of my blog know I had been bearish for quite some time. In fact, in June 2007, I even wrote a piece in Forbes magazine called Here Comes the Bear arguing that stocks were likely to sell off. Yet in all honesty, what we've seen has far exceeded my expectations. I never thought we would have this kind of selling.

One man who did is Nouriel Roubini. More than a year ago, when most economists were still very bullish on the economy, Roubini was calmly and clearly explaining why we were about to have a serious recession. When he warned about subprime mortgages and collapsing home prices and how this would cause systemic problems, he was often ridiculed. I'm sure his critics wish they could take back their words.

Roubini remains very bearish. In fact, he has been warning about widespread financial panic, arguing that fundamentals don't matter because everyone is selling. Take a look at his blog RGE Monitor. It is definitely worth a close read.

On Wednesday, Oct. 29, we are hosting the Forbes Family Business Forum. We were hoping to sign up Roubini as a speaker. Unfortunately, he wasn't available saying he had to teach class. No doubt his students at New York University appreciate his dedication.

Roubini may be right about his views. It is extremely difficult to predict when the economy, let alone the markets, will turn. I have long believed this mess would end when housing prices stabilized, which I still expect to happen by spring 2009. However, I'm now beginning to wonder if stable housing prices are enough. Despite my concerns, I have been buying stocks anyway. I know stock prices could go much lower in the short term, yet I am comfortable buying at these levels. I feel confident that the world will avoid a great depression and that the investments I make today will appreciate over time.

Wednesday, October 15, 2008

One Step Forward, Two Steps Back

Today's market action was extremely disappointing. On Monday, Oct. 13, the S&P 500 rallied 11.6%. That had many investors hoping the sell-off was finally over. Unfortunately, the market wasn't able to sustain Monday's gains. It gave up 0.5% yesterday. Today it plunged 9%.

Monday's rally and today's sell-off are indicative of the kind of volatility we've been experiencing lately. To measure volatility, market traders often focus on the VIX, which is hovering near all-time highs. A simpler way to measure volatility is to look at the daily percentage changes in a major index like the S&P 500. For example, during the first six months of 2008, there were 17 days on which the S&P 500 Index changed in value by more than 2%. The biggest change during that period occurred on March 18 when the S&P 500 rallied 4.24%.

Since then, however, volatility has skyrocketed. From July 1 to Oct. 15, there were 22 days when the change in the S&P 500 exceeded 2%. In the last month alone, the change in the Index exceeded 4% on 11 days.

Monday's almost 1,000 point rally in the Dow was nice, but it would have been better to see the Dow rally 100 points a day for 10 days. Investors have no confidence in stocks right now. They need to be convinced that rallies can be sustained.

While it is true that Even Buffett Isn't Perfect, he is clearly one of the greatest, and it is encouraging to see him putting money to work at this time. Buffett has complained for several years that he couldn't find anything worth buying. By pouring $8 billion into Goldman Sachs and General Electric, and making a couple of other key investments, he has obviously changed his tune.

Friday, October 10, 2008

The Smartest CEO

It is said that the stock market is a forecasting mechanism. Let's pray it is a bad one. Otherwise, we may be in for a deep depression. The sell-off we have been witnessing is simply unbelievable. Investors, especially institutional investors, are selling everything—the good, the bad, and they ugly.

In December 2007, when I still held a bearish view of the economy and stock market, a colleague and I met with the CEO of a small biotechnology company. The purpose of the meeting was to discuss his finances and a proper asset allocation. Because of my bearish outlook, I made what I thought was an extremely conservative recommendation, suggesting he keep much of his money in cash (i.e., short-term Treasuries, CDs, and municipals) for the time being and put only about 50% in stocks.

He thanked me for my advice, but said he had an even more bearish view. He said he was convinced that leverage was going to come back to haunt us. He said he was worried about counter-party risk and did not trust the investment banks. He said he was using some cash to buy gold coins and he was shorting as many financial stocks as he could-the investment banks in particular.

When we left his office, I was in shock. I was bearish myself and had spoken with a number of bearish investors, but I had never met anyone who was so full of doom and gloom. I knew this CEO was a smart man, but I hoped he was wrong. Unfortunately, he wasn't.

If he maintained his short positions, he is no doubt a very wealthy man today. For the sake of the economy and all long-term investors, let's hope the selling is finally done. At this point, it's hard to imagine stocks going any lower.

Thursday, October 02, 2008

A $700 Billion Investment, Not Bailout

The following commentary is from the October issue of the Forbes Growth Investor.

The biggest stock market sell-off occurred on October 17, 1987. The Dow Jones Industrial Average plunged 508 points or 22.6% on what has come to be known as Black Monday. Yet, on average, stocks have shown a tendency to do worse in September than in any other month and what happened this past September was nothing less than ugly. Despite a strong rally on the last day, all major market indexes took a nosedive.

September’s sell-off came in reaction to the expanding economic crisis, which has seen one major financial institution after another either go out of business or get gobbled up at fire-sale prices. Lehman Brothers, for example, filed for bankruptcy protection. One of the oldest investment banks on Wall Street was selling for $85 per share less than two years ago, but could find no buyers in its time of need. The remaining investment banks on Wall Street, Goldman Sachs and Morgan Stanley, have since decided to move to Bank Street.

While investment and commercial banks went under, our elected officials twiddled their thumbs. Eventually, they raised investors’ hopes by finally agreeing to vote on Secretary Hank Paulson’s unpopular $700 billion rescue package. Then they quickly dashed those hopes by voting it down. Ironically, more Democrats than Republicans voted in favor of the bill, which was being pushed by the Bush administration. It remains to be seen if Republicans will pay a political price for refusing to go along. No doubt their constituents are extremely angry about the so-called bailout, yet they will be even angrier when they lose their jobs and watch their retirement savings shrink.

Those who voted against the bill say they are protecting taxpayers. How much truth is there to this statement? After all, one-third of Americans do not pay any federal income tax at all. The bulk of the taxes are actually paid by a rather small portion of the population. Most of the ones I know are in favor of the bill. Are the politicians listening to what real taxpayers have to say?

Furthermore, it is completely wrong to assume that the rescue plan will cost the quoted $700 billion. In fact, the government stands to make money on the deal. Because of mark-to-market accounting rules, financial institutions must pretend there is little if any value to these “toxic” securities. Yet once housing prices stabilize, a market for these securities will reemerge. The government is in an enviable position. It can borrow money at low Treasury rates and use that cheap money to purchase securities it will later sell—perhaps at higher prices. Even if it ends up losing money on the deal, those losses will be nowhere near $700 billion.

Warren Buffett, widely acknowledged as the world’s greatest investor, thinks Mr. Paulson’s rescue plan is a good idea. Buffett decided to take advantage of the current financial turmoil by purchasing $5 billion worth of Goldman Sachs preferred stock. He also got warrants to buy $5 billion of common stock at $115 per share. He cut a similar deal with General Electric. This kind of private investment in public equity (PIPE) is Buffett’s modus operandi. He said his decisions to invest in Goldman and GE were predicated on the assumption that the government would approve the rescue package.

There is still hope that government officials will overcome political gridlock and get their act together by week’s end. Expect a big rally once they do—or at least a smaller sell-off than we would otherwise see.