The Oracle Speaks

Warren Buffett's annual letters to shareholders are legendary. We were treated to another one on Saturday morning. This year's letter and 10-K provided some interesting insights. Buffett, who is a fan of higher taxes on the rich, was surprisingly critical of government. He says government intervention in the financial crisis "will almost certainly bring on unwelcome aftereffects." He thinks inflation is a very likely outcome. He also predicts municipalities will soon be looking for federal bailouts of their own. The good news is that Buffett says "America's best days lie ahead."

Berkshire's book value per share fell 9.6% in 2008, its worse performance ever. Yet I think the biggest surprise is that the company did not do worse. Given the financial crisis and Berkshire's heavy exposure to the finance industry, I think the results were actually quite commendable. The company turned a profit and even troubled subsidiaries such as General Reinsurance showed marked improvement.

Still, Berkshire lost a lot of ground in 2008. Gross unrealized gains in equity securities fell $16.5 billion. Gross unrealized losses grew by $4.9 billion. There was a $25 billion decrease in the value of equity securities on the balance sheet. The company also wrote down $6.8 billion of derivatives on the income statement. It is important to understand, however, that the write down had no effect on cash flow. It is simply the result of the same mark-to-market accounting rule that is making our nation's banks look unprofitable. Even though it took a toll on Berkshire, Buffett says, "We endorse mark-to-market accounting." It would have been nice if he explained exactly why. Maybe he realizes that because of mark-to-market, Berkshire and other financial companies will report much larger earnings in future periods when market conditions improve.

I was very disappointed by the kinds of questions posed by shareholders at last year's meeting. Instead of asking good questions about the company's business operations, we got questions such as "What should I do with the rest of my life?" Apparently, Buffett was fed up with those questions, too. He says in his letter that at this year's meeting, he will "steer the discussion back to Berkshire's business." That is welcome news indeed.

Nationalization the "Atlas Shrugged" Way

I am posting this from Austin, Texas. I traveled here yesterday to participate in a panel discussion at the CFA Society of Austin. The panel was moderated by Vincent Catalano. Other panelists included former Fed governor Bob McTeer, David Abramson from BCA Research in Quebec, and Tim Hayes of NDR.

The discussion focused on the growing role of government in the private sector. The United States, which is supposed to be the model for free market capitalism, is taking a big step toward socialism. The budget put forth by our new president is a repudiation of the Reagan revolution. It seems our government is trying to outdo other governments in nationalizing some of our biggest companies. It's a good time to reread Atlas Shrugged by Ayn Rand.

So I guess it was fitting to awake this morning and find out that our government is about to hold a huge stake in Citigroup. If this is not evidence of nationalization, I don't know what is.

The latest GDP report was also disconcerting. The preliminary estimate for fourth quarter contraction was revised down to 6.2% from the 3.8% advance estimate. That's what I call a revision. This means the 8.1% unemployment rate projected for 2009 in President Obama's budget looks laughable. The employment situation will not improve until private sector investing improves. Don't hold your breath for that to happen now that Obama wants to raise taxes on the so-called rich. With higher taxes on the way, there is little chance the economy will revive enough to slow down the acceleration in the unemployment rate.

The Fat Tail

Last night I attended the book launch party for the
The Fat Tail, a new book co-authored by Ian Bremmer and Preston Keat. Bremmer is President and Keat is Director of Research at The Eurasia Group, a political risk research firm. Admittedly, I have known Bremmer for almost 10 years and my opinion may be biased, but I consider him to be the foremost expert on political risk. I have heard him deliver a number of speeches over the years. He is an excellent speaker who makes extremely cogent arguments.

The title of the book comes from the bell curve. In a normal distribution, there is a 67% probability that an outcome will fall within one standard deviation of the mean. Unlikely outcomes occur at the tails. In a distribution with fat tails, the probability of unlikely outcomes is higher. Bremmer and Keat are implying that investors often underestimate the probability that unlikely outcomes will occur. For example, they begin the book with the 1998 crisis in Russia and tell us how the leading experts assured investors that Russia would not default on its debt. Yet that's exactly what happened. The book is full of such examples.

Because I have just begun to read the book, I can't provide a complete analysis. So far, however, I find it interesting and timely. It also fits nicely with Bremmer's recent assertion that financial regulation and the U.S. Congress represent the greatest political risks of 2009.

More on the UAE

As my readers know, I traveled to Abu Dhabi and Dubai two weeks ago. I was invited by the CFA Institute to address investors at the Abu Dhabi Investment Authority (the world's largest sovereign wealth fund), Mubadala, and Hawkamah. Perhaps I am now more aware of events in that part of the world because of this trip. Maybe this is why I have noticed quite a bit of news about the United Arab Emirates since I returned home. For example, immediately following my return, Dubai made news by denying an Israeli athlete a visa to compete in a major tennis tournament. Soon after it made news again when it received a $10 billion bailout from the UAE central government. Dubai, which just a year ago was one of the world's greatest financial success stories, now seems plagued by poor decisions and economic turmoil.

Yet one of the best articles I have read in recent weeks was one written by Zvika Krieger in the Wall Street Journal. The title of his commentary says it all: "There's No Reason to Gloat Over Dubai's Fall." Mr. Krieger argues that the UAE is not perfect, but it is moving in the right direction. I agree. His op-ed inspired me to write a letter to the editor in support of his view.

Greenspan Was Right in 1996

Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.

Alan Greenspan, Dec. 5, 1996


On the day Alan Greenspan spoke those now famous words warning that stock prices might be too high, the Dow Jones Industrial Average closed at 6437.10. Yesterday, more than 12 years later, the Dow closed 16% higher at 7465.95, which comes out to about 1.2% on an annualized basis. Of course, the Dow peaked at more than 14,000 before falling back to current levels. If anything, this should cause investors to question the wisdom of long-term, buy-and-hold investing. That approach is akin to simply sticking your head in the sand and ignoring signs of trouble. A strategy of active asset allocation, i.e., taking money off the table after rallies and buying more after selloffs, produces much better results over the long term.

Dubai May Be Struggling, but Abu Dhabi Looks Strong

I'm back from Abu Dhabi and Dubai. I'm still a little jet-lagged, but I got a good night's sleep for the first time in a week. Here are some more thoughts about my trip.

The United Arab Emirates consists of seven emirates. The best known are Dubai and Abu Dhabi. When it comes to economic development, Dubai is considered the more aggressive one. Dubai embarked on a plan to quickly become the major financial center in the Middle East and one of the most important in the world. There was a tremendous amount of money spent on infrastructure. (Reminds me of the Obama stimulus plan.) Beautiful buildings and roads were planned and constructed. As I said in an earlier post, Dubai is at the cutting edge of architecture and construction.

While I was in the U.A.E., The New York Times published an article warning that the economic boom in Dubai has come to an end. (I thank Vitaliy Katsenelson and Todd Weintz for bringing this article to my attention.) I had already heard rumors of many of the things discussed in that article. Because I spent less than 24 hours in Dubai, I did not get a complete picture of the economy. I had to wonder, however, how there could possibly be enough demand to justify all of the construction going on. To my eyes, Dubai certainly seemed like a busy place. There was plenty of traffic on the streets and the Al Bustan Rotana Hotel where I stayed was busy enough, but I do not have a personal point of reference to make any comparisons.

I was told by some individuals that business activity is way down. Construction has apparently been suspended on some buildings. Most workers in Dubai--from laborers to executives--are from someplace else. One young finance executive told me he was concerned his company would be laying people off soon. A driver told me things were getting bad and many people were going back home or looking for jobs elsewhere. (Sounds a bit like the situation in the U.S.). Given a new law that imposes a heavy fine for disparaging the economy, I wondered if they were being cautious with their comments.

I spent about six days in Abu Dhabi and things there seemed perfectly fine. Abu Dhabi has been more conservative with its economic development plans. There is plenty of construction going on, but there are no obvious signs of overbuilding. People in Abu Dhabi appeared more confident about the local economy. Those in the finance industry were extremely concerned about the global economic slowdown, but not so much about the situation in Abu Dhabi.

Abu Dhabi also has one major advantage over Dubai. It has plenty of oil. While the plunge in oil prices has delivered a blow, this emirate can still generate tremendous cash flow from oil production. Yet those managing the Abu Dhabi economy understand the importance of diversification. Abu Dhabi appears to have struck just the right balance between relying on oil and seeking other sources of income. In fact, Abu Dhabi has the potential to become a major tourist spot. The Emirates Palace Hotel is right on the beach and has several swimming pools. The weather is almost always sunny. It is a perfect spot for a family vacation. The Sheikh Zayed Mosque is magnificent and open to the public for visits. Indeed, during my stay I noticed that Abu Dhabi was full of tourists, many of them German speaking. Abu Dhabi also has a world class golf course. The Abu Dhabi Golf Championship is on the European tour and offers $2 million in prize money.

There may be some friendly competition going on between Dubai and Abu Dhabi, yet at the end of the day, these emirates are a part of the same nation. If things get bad enough for Dubai, Abu Dhabi will likely come to its aid, especially if oil prices rise as global economies emerge from their collective recession.

Impressions of Dubai

I am back in Abu Dhabi after a short trip to Dubai. Before going there, I had heard a lot about all the construction going on in Dubai. Yet it was still a surprise to see it with my own eyes. With all the skyscrapers, Dubai reminded me a little of New York City except that everything is brand new and sparkling clean. There are so many buildings, and perhaps even more that are still under construction. It is hard to believe there is enough demand for all that space. In fact, I heard some projects have actually been stopped midway through. Given the global recession, it seems funding is drying up and some of the projects may not be completed at all. I've also been hearing that many foreign workers are losing their jobs. Some are returning home, others are trying to find jobs in Abu Dhabi where the economy is still good.

Nonetheless, Dubai is an architect's dream. Imagine having a client ask you to design the most outrageous building you could think of without regard to the expense. The Bourj al-Arab Hotel looks like a sailboat (dhow). Another building looks like a jet airplane. Some buildings are straight; others are curved. Some look like they could be fitted together like Lego pieces. The building that houses the indoor ski slope looks like it could tip over. They are really at the cutting edge of what can be done with construction.

While in Dubai, we made presentations to members of Hawkamah, the institute for corporate governance. This was also sponsored by Mudara at the Dubai International Financial Center. There was intense interest in our presentations and we were peppered with questions. There is keen interest in promoting good corporate governance practices in this part of world.

I finally got a chance to relax and catch up on some sleep. Unfortunately, I am returning home just as my body has adjusted to local time. I'm sure there will be more sleepless nights to come.

First Impressions of Abu Dhabi

As the Obama team gets ready to stimulate the U.S. economy, I flew off to Abu Dhabi to see how things are on the other side of the world. I will be giving a talk tomorrow to the Abu Dhabi Investment Authority (ADIA), then I'm off to Dubai.

So far I am very impressed. I flew over on Etihad Airways, the national airline company. It is a very long flight. Fortunately, I was in business class. Both the service and food were great and the time went by rather quickly. After clearing customs, we took a drive through the city. There is a lot of construction taking place and there are cranes everywhere. Although I hear the economy has taken a hit from the fall in oil prices, that is not readily noticeable.

I am staying at the Emirates Palace Hotel, which without a doubt is one of the finest hotels in the world. It really does look like a palace inside and out. The hotel is located right on the beach on the Persian Gulf. The architecture is beautiful. Everything is very geometric. The inside of the hotel has marble everywhere. I am going to catch up on some sleep, then it's off to dinner. There are several interesting restaurants in the hotel. More later.

January Roundup From Forbes Growth Investor

The following is from the February issue of the Forbes Growth Investor.

Despite staging a bit of a rally toward the end of 2008, stocks plunged again to kick off the start of a new year. According to data from Ibbotson Associates, last month’s selloff in large-cap stocks was the worst ever for a January. An old Wall Street adage says,“As goes January, so goes the year.” This is not an encouraging sign for investors who are long. Those who believe in adages and indicators should at least take some solace from the Super Bowl, since it pitted two teams from the old NFL against each other; a good omen for stocks.

Unfortunately, the news continues to be bad on the economic front. Most economists were expecting a large retreat in fourth quarter GDP. Yet the Advance estimate, a decline of 3.8%, was better than the consensus expectation. Investors seemed relieved at first. However, they quickly changed their minds once they realized that increased government spending, a $6.2 billion build in inventories, and an $80 billion decline in imports largely explained why the GDP report was not worse than it was. This was the first build in private inventories in at least two years. Companies were producing more than they could sell. During the current (first) quarter, however, businesses have been laying off workers at an accelerating rate so production should slow. As for international trade, it too is slowing appreciably. And it wasn’t just imports that declined. Exports were off $83 billion.

There is a real lack of demand on the part of consumers. Other than necessities, people are not buying anything. This is not simply due to a lack of available credit. There has been a real change in the mindset of American consumers. We are rapidly transforming from a nation of spenders into a nation of savers at precisely the wrong moment. No one wants to spend money—even those who are relatively well off and gainfully employed—when coworkers and neighbors are losing their jobs. Large numbers of clothing stores, electronics stores, and automobile dealerships are simply shutting down for good.

Lack of demand is also plaguing the housing market. New home sales have fallen off a cliff. Just a few years ago, home builders were selling 1.2 million new houses a year at an average price of almost $300,000 each. These days they are selling only one-fourth as many houses at an average price that is almost 20% less. At the current rate of sales, it will take 16 months to clear the inventory of new houses. It is inevitable that at least a few of the publicly traded home builders will not survive this crisis as independent entities.

Things are a little rosier for existing homes. Sales climbed 6.5% in December thanks largely to falling prices and growing interest in foreclosed properties. Inventory fell almost 12% in just one month. It is possible that we are finally approaching a bottom in existing home prices. I’m still calling for that to happen by late spring. While stable housing prices are key to restoring confidence in the economy, the days of thinking about residential housing as an asset class are probably gone for a long time. It is good to get rid of the speculation in this sector.

Dow 36,000 Is Nothing But A Book Title Now

The Dow Jones Industrial Average is currently at about the same level it was in early 1998. This means that, ignoring dividends, investors have earned nothing in 10 years.

In March 1999, immediately after the Dow broke above 10,000 for the first time, James Glassman and Kevin Hassett published their now infamous op-ed in the Wall Street Journal called Stock Prices Are Still Far Too Low. They argued that investors were overestimating the risks associated with investing in stocks. They argued that stocks were no more risky than a government bond.

Perhaps to demonstrate just how bullish they were on stocks, they also published a book that same year titled, Dow 36,000. They weren't trying to imply that the Dow should reach 36,000 some day. No, they were insisting that the Dow should be at 36,000 right now (i.e., in 1999).

Their point was that investors were wrong to think that stocks were risky simply because stocks were volatile. Because history showed that stocks outperformed bonds over the long term, the authors argued that stocks were really no more risky than bonds. In fact, they argued that the appropriate risk premium for stocks is zero.

This reminded me of a debate I had many years earlier about mortgages. My opponent at the time was arguing that the best mortgage is always the one with the lower interest rate. My point, however, is that cash flow must also be considered. A one-year interest free mortgage is clearly cheaper than a 30-year mortgage at 6%, yet there aren't many borrowers who have the kind of cash flow needed to service that one-year mortgage.

Likewise, stocks have outperformed bonds over the long term and may continue to do so in the future. But not all investors can stomach the volatility. Investors have cash flow needs. They can foresee some of those needs, but they can't foresee them all. This is why investment advisors never tell their clients to put all their money in stocks even though they believe stocks will do well over the long run.

Stocks are not risk free, but from a long-term perspective, they are probably less risky today than they were when the Dow was at 14,000. Yet at 14,000, investors were happy to buy stocks--many using lots of margin. But now, most investors are simply too scared to buy. Who knows when (if ever) the Dow will hit 36,000, but it's a good bet that it will hit 10,000 again--perhaps sooner than we think.

Beware the U.S. Congress

There are plenty of conflicts and problems going on around the world, each vying for the attention of global investors. The war between Israel and the Palestinians is currently on the front burner. It's a conflict that threatens to pull in Iran, which continues in its race toward a nuclear weapon. The wars in Iraq and Afghanistan are still going on. Terror attacks in Mumbai threaten to break the shaky peace between Pakistan and India. And Russia is flexing its muscles by threatening former Soviet republics and restricting the flow of natural gas to Ukraine and Western Europe.

Given all these seemingly intractable problems, which poses the biggest risk for investors? According to Ian Bremmer of the Eurasia Group, the top risk of 2009 is financial regulation in the United States and the rising power of Congress.

Bremmer reminds us that following our last financial crisis, Congress gave us the Sarbanes-Oxley act. We are likely to get something much more onerous this time. The bottom line is that there will be considerably more regulation. Congress will try to regulate everything from the rating agencies to complex financial securities. It will also reform the regulatory agencies. The risk is that Congress may make things worse by delivering bad regulation or simply going overboard in a manner that prevents innovation.

Bremmer also worries that government is getting involved in the actual management of private enterprises. It already holds large stakes in publicly-traded companies, and there is talk of a car czar to oversee the automobile industry.

Finally, Bremmer is concerned that fiscal policies meant to spur the economy may fail. Infrastructure spending, for example, may end up doling dollars to favored pork barrel projects instead of targeting the most worthy programs.

The Eurasia Group is perhaps the best political risk consultancy in the world. It certainly is an ominous sign that this highly-respected firm thinks the U.S. Congress poses the greatest risk to investors in 2009.

Cut Property Taxes Now

According to the S&P/Case-Shiller 20-city Home Price Index, housing prices peaked in July 2006. They have fallen 23% through October 2008. With employment falling, housing prices will no doubt go lower in coming months.

If there is any good news in this, it is that the affordability index is improving. This index tries to give us some sense of how affordable the median priced house is for the median income family. In addition to housing prices, the affordability index considers mortgage rates, which have also come down largely due to government intervention.

Unfortunately, the affordability index ignores an increasingly important cost of home ownership: property taxes. Prospective home buyers in many parts of this country, especially the Northeast and Midwest, must pay close attention to this cost before signing on the bottom line. For many homeowners the monthly outlay for property taxes now rivals their monthly payment toward principal and interest.

This economic recession we are currently struggling through was largely brought on by the collapse of housing prices. The recession won't end until housing prices stabilize. Lower mortgage rates are certainly helpful, but reducing property taxes would go a long way to provide a much needed boost to the housing market. Obviously, the federal government has no role here. It is up to local municipalities to cut property taxes. Like the rest of us, they need to trim their budgets and live within their means. Otherwise, more neighborhoods will be plagued with vacant and foreclosed homes.

Class A Sleuth

A dozen years ago, when I was on the faculty at Boston College, I was teaching in the Master of Science in Finance program. One of my students was a quantitative analyst at a hedge fund. This guy was an excellent student who instinctively understood derivatives and their pricing models. He was an active member of the Boston Security Analysts Society and provided great encouragement as I toiled with the CFA exams.

I joined Forbes in 1997. Every now and then I spoke with this former student of mine. Eventually, he quit his job. He told me he had become disillusioned with the whole Wall Street game and was convinced there was a lot of fraud going on in the industry. He said he was going into business for himself investigating fraud in the securities industry. Without being specific, he said he was on to one of the biggest Ponzi schemes ever. He also told me about his frustrations dealing with the SEC.

Sounds kind of paranoid, doesn't it? I knew this guy wasn't crazy, but I had to wonder if he wasn't exaggerating a bit. Well, imagine my surprise when I read about him on the front page of the Wall Street Journal on Thursday morning. His name is Harry Markopolos and he has been mentioned on my blog before. It turns out the Ponzi scheme Harry was looking into was the one run by Bernie Madoff.

Thanks Harry for doing such a great service to your country. I wish the powers that be had paid more attention to what you had to say long ago.

Facebook Friend

One of the best things about Facebook is that it allows you to track down long lost friends. That's how I found Mark Stivers, the kid who lived three houses down from me when we were growing up. Mark is a multi-talented individual. It turns out he is also an excellent cartoonist. I suggested he draw this cartoon of Ron Gettelfinger, which fits in nicely with my Dec. 12 post. I hope to feature Mark's work from time to time in the Forbes Growth Investor.

The UAW has Priced Itself Out of the Auto Market

When the $14 billion bailout for the auto industry fell through last night, Senate Majority leader Harry Reid said, "I dread looking at Wall Street tomorrow. It's not going to be a pleasant sight."

Stocks opened lower as Reid predicted, but not nearly as much as his words suggested. And soon after the open, stocks began to rally. Some will say investors grew hopeful that the White House and Treasury Secretary Henry Paulson would step in and use TARP money to save the auto industry. However, I believe investors are simply pleased that Congress is taking a hard stand against bailout seekers. Bad companies should be allowed to fail. At least some of our politicians have finally gotten that message.

Ron Gettelfinger, president of the United Automobile Workers, gave a press conference this morning blaming Republicans for the failure of the bailout, but the conference only proved how defensive Gettelfinger has become. The U.S. auto industry is dying, yet the UAW refused to allow any wage concessions in 2009. The UAW doesn't seem to understand that it has priced its membership out of the market. While this union tries to "protect" its members, foreign manufacturers are grabbing market share and putting Americans to work throughout the South. It won't be long before out-of-work union members begin migrating south seeking employment at these non-union shops.

Initial Jobless Claims Get Worse

The Department of Labor reported today that initial jobless claims for the week ending December 6 hit 573,000 on a seasonally-adjusted basis. The news is certainly unsettling. Nonetheless, even though the number exceeded the consensus estimate by almost 50,000, the stock market gave the report a rather ho-hum reception.

Because the week-to-week initial claims figures can be volatile, economists prefer to focus on the four-week moving average. This average climbed to 540,500. It has risen six weeks in a row. During the previous recession (March to November 2001), the 4-week average climbed five weeks in a row before peaking at 489,250. I suspect, however, that this time we haven't yet hit the peak. The graph above plots the 4-week moving average ever since the 2001 recession began. As you can see, it has been rising sharply since late 2007, and so far shows no sign of leveling off. I really don't think it is alarmist to suggest that the unemployment rate could hit 8-9% by mid-2009.

Dismal Employment Numbers May Mark Bottom in Stocks

Today the Bureau of Labor Statistics released the employment figures for November. They weren't pretty. Nonfarm payrolls fell by a much bigger-than-expected 533,000. Even worse, the September and October figures were revised. October's job losses went from 240,000 to 320,000. September's went from 284,000 to 403,000.

The service sector alone lost 370,000 jobs in November. Losses were widespread from retail to automobile dealerships to leisure and hospitality. Health care was the only bright spot, gaining 34,000 jobs.

Surprisingly, the unemployment rate ticked up to just 6.7%. No doubt, this measure will rise considerably in coming months. I was criticized for suggesting it could surpass 8% by mid 2009. I sincerely hope I am wrong about that.

So far in 2008, the economy has lost an astounding 1.9 million jobs. It won't be easy to put all these people back to work on short notice. But that is exactly what President-elect Barack Obama hopes to do. Part of his economic stimulus plan is to increase infrastructure spending by $60 billion over 10 years. He estimates this will create about two million jobs--about the same number of jobs lost so far this year.

The American Society of Civil Engineers estimates that $1.6 trillion is needed just to bring all U.S. public works to good condition, so increasing spending on infrastructure is certainly a good idea. It is also inevitable. But $60 billion over 10 years is just a drop in the bucket. Despite so many other priorities right now, such as bailing out the the finance and auto industries, this figure is likely to rise.

The market initially responded to the employment figures just as one might expect. It sold off. Yet by the end of the day, stocks were up. The Dow finished higher by 259 points. I don't think investors are wrong to bid up stocks right now. The recession, which started a year ago, is already growing long in the tooth; and when employment numbers get this bad, it often marks a bottom in stocks. I continue to expect a strong rally in 2009.

How Low Can It Go?

No, I'm not talking about the stock market. I'm talking about crude oil and gasoline.

Back when oil prices were still well over $100 per barrel, I wrote in Forbes magazine that they were likely to fall. I thought the global slowdown and the rapid change in driving habits would bring oil down to about $70. Of course, we've already fallen well below that mark. Crude is now selling for less than $50. Gasoline prices have also plunged. According to the AAA Fuel Gauge Report, the national average retail price for regular unleaded gasoline is currently $1.93 per gallon.

It would be nice if prices were falling because the world had discovered a lot more oil. Unfortunately, prices are falling because demand is being destroyed. Much of the demand destruction is due to the global economic slowdown. In particular, people are driving less in the U.S. They are also driving more efficient cars. U.S. auto manufacturers are struggling in part because no one wants to buy a gas guzzler anymore. The Honda Civic is suddenly chic.

Other countries are being impacted as well. Europe and much of Asia are in recession. Although demand is still growing in China, it is growing at lower-than-expected rates.

So how low can oil go? It all depends on the severity of the global recession. It also depends on how serious we remain about alternative energy. Plug-in hybrids and all-electric vehicles seemed to make economic sense when oil was at $140 per barrel and $5 gasoline was within sight. But how many drivers would be willing to give up their internal combustion engines if gasoline is expected to remain below $2 per gallon?

Not long ago, no one seriously thought we'd see $40 crude oil again. However, now it appears that we'll see $30 very soon.

This Recession Will Last Longer Than Average

Most sensible economists agree the U.S. economy is in recession. Yet the fact remains that no recession has been officially declared.

The textbook definition of recession is two successive quarters of contraction. After posting very strong growth during the second and third quarters of 2007, GDP fell 0.2% during the fourth quarter of that year. However, it rebounded to 0.9% growth in the first quarter of 2008. The tax rebate checks, billed as an economic stimulus plan, boosted second quarter 2008 GDP to 2.8%. GDP fell 0.3% in the third quarter. So if the economy contracts during the fourth quarter, which it certainly will, we will have satisfied the textbook definition of recession.

The more relevant definition, however, is the one stated by the National Bureau of Economic Research. This is the entity that has the authority to declare official recessions in the U.S. According to the NBER, "a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales." By this definition, it appears that a case could be made that we have been in recession for almost a year.

The NBER takes its time in declaring recessions. According to the NBER, the last recession began in March 2001 and ended in November of that year. But the NBER did not declare the start of the recession until November, when the recession was already over. Furthermore, it did not declare the end of the recession until July 2003. That's almost two years after the recession had already ended.

Employment is one of the many factors the NBER studies when trying to determine if the economy is in recession. In December 2006, the unemployment rate stood at 4.6%. One year later, it had climbed to 5.0%. After dipping a bit in January and February of 2008, it resumed its upward drift. The unemployment rate for October hit 6.5%, 150 basis points higher than it was just 10 months earlier. The last time the unemployment rate visited this level was in April 1994.

Given layoffs like the one announced yesterday by Citigroup, there is no doubt unemployment will jump to much higher levels. Some economists hope the unemployment rate will peak around 7%. I think this forecast is much too optimistic. In June 1992, the unemployment rate hit 7.8%. In November and December of 1982 it peaked at 10.8%. Furthermore, it is not unusual for the unemployment rate to continue rising for some time even after a recession has ended. This is because employers are wary about hiring until they are convinced that better times lie ahead. At this time, I am expecting the unemployment rate to rise to somewhere between 8-9% by June 2009.

I believe the current (undeclared) recession began in January 2008. I am optimistic that it will end around June 2009. If I have the starting and ending points right, this recession will have lasted 18 months in duration. That is about the average length of all recessions recorded in the U.S. since 1854, but it is 10 months longer than the average since 1945. In fact, 18 months would set a post-WWII recession record.

Of course, if businesses become more aggressive with layoffs, retail sales continue to fall, and housing prices fail to stabilize by next spring, this recession could last considerably longer than 18 months. That would be a dire outcome indeed.

Tax-Related Selling Will Keep Market Volatile Until 2009

The following is from a Special Report sent to subscribers of the Forbes Special Situation Survey.

In our Oct. 7 Special Report we discussed the unprecedented level of volatility plaguing the markets. Things have gotten much worse since. Both the intra-day and inter-day swings on the Dow and other major indexes are simply mind boggling. There have been a number of days when the Dow opened up or down several hundred points only to finish in the opposite direction.

We believe this volatility will continue through the end of the year. We believe much of it is due to tax-related trading. Earlier this year, many investors sold stocks for hefty capital gains. They then invested that money back into the market. Now they are sitting on large capital losses. These investors will sell shares in order to realize those losses to offset their earlier gains in order to minimize their tax bill. This activity puts downward pressure on stocks.

Other investors have already realized large capital losses. Because the IRS limits investors to only $3,000 per year in net capital losses, these investors have an incentive to sell into rallies in order to realize whatever gains they can to offset their large losses. This activity keeps the market from going higher than it otherwise would.

Of course, on top of all this, hedge funds and mutual funds are selling in order to meet redemptions. Investors who want their money back from hedge funds by yearend must notify them by Nov. 15. If large numbers of investors do so, selling pressure could increase between now and the end of the year. Mutual funds are also selling heavily. Many investors who have seen the value of their mutual fund holdings collapse will be doubly shocked when they realize they will owe capital gains taxes on shares the mutual fund managers sold at a profit.

Given the extreme sell-off in stocks this year, subscribers should keep a watchful eye on their tax situation. Make sure you realize net losses of $3,000 ($1,500 if married and filing separately). If you realize more than that, you will have to carry forward the losses into the next tax year. That’s not a bad thing, but it is not as valuable as taking them now.

Once all this tax-loss selling is completed, the market will stabilize. We expect volatility to subside once January rolls around. Furthermore, even though the economy will exhibit tremendous weakness for at least another six months or so, the stock market is likely to rally long before the economy improves. A strong rally after a bad year is not unusual. A 50% rally in the Dow from current levels would bring us back to only about 12,750. A 25% rally translates into a 10,625 Dow. This is a level that looks quite achievable by the end of 2009.

Give (Small) Businesses a Chance to Flourish

I gave a talk yesterday at William Paterson University in Wayne, NJ about the economy and stock markets. Many of the participants were small business owners and were very concerned about how the dismal economic climate will affect small businesses in particular.

Small business is the backbone of the U.S. economy. It accounts for about half of all private sector employment, but it also accounts for most of the job growth. At least it did during the last decade. These days, of course, there is no job growth. The economy has shed almost 1.2 million jobs over the past 10 months--more than half a million in the last two months alone.

While the failure rate for new businesses is high, the fact is that owning your own business is one of the best ways to achieve economic prosperity. The new Obama administration should consider ways to make it easier for individuals to start and run businesses. One good idea is to exempt all new businesses from taxes for the first five years. Let them build up some steam before you slow them down. Besides, they will employ more people as they grow and the government will get its due from payroll taxes.

Everyone Should Pay Their Fair Share of Taxes, But Not a Penny More

I just returned from the Fourteenth Forbes Cruise for Investors. We left New York City on Oct. 29 and toured the Caribbean. I got off in Angtigua on Nov. 4, but the cruise is still in progress. I arrived at JFK airport around 11 p.m. on the 4th and entered the baggage claim area just as CNN declared Barack Obama the winner of our presidential election. The place erupted in cheers.

Most participants on the investment cruise were resigned to an Obama victory, but they worried about what this would mean for the economy. Of course, Obama has threatened to raise taxes on the so-called rich. Depending on the day, his definition of rich seems to include anyone who makes $200,000 per year or so. I know in some parts of this country this sounds like a good sum of money, but I do not know anyone in the New York City area who makes this amount of money who considers himself rich--especially if he is supporting a family. With the top 1% of income earners already paying 40% of all the federal income taxes, it seems the "rich" already pay way too much tax.

More than one-third of Americans pay no federal income tax at all. Some are honest hard-working people who simply do not make enough money to pay taxes. But others either refuse to work or work in the underground economy. Many grocers, landscapers, painters, waiters, musicians, etc. deal only in cash. Are all these cash-based businesses declaring their income and paying their fair share of taxes? Some experts estimate that the illegal drug trade alone has a global value of $400 billion--all of it tax free. Instead of trying to squeeze more money out of the rich, Obama should first make sure that everyone pays his fair share.

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.

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.

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.

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.

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.

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.

Blame the Feds, Not Wall Street

Given the unprecedented financial crisis and the government's proposed $700 billion so-called bailout, I have to say I am a little sick of hearing how greedy Wall Street bankers are to blame for getting us into this mess. I agree some of them do bear some responsibility. I also agree that many CEOs are grossly overpaid. (So are many professional athletes for that matter.) Yet the fact is that the government bears at least some of the blame for the current crisis.

Many years ago (circa 1993), I listened to a lecture delivered by a then prominent Federal Reserve governor. He argued that banks had to be pressured to lend money to those who were otherwise not creditworthy. The government in its wisdom had decided that home ownership was a good thing and wanted to see more of it. It is often argued that neighborhoods are safer, cleaner, and better kept when a large number of people own (rather than rent) the homes in which they live. The government wanted to promote home ownership so it pressured lenders to make mortgages available to those who did not qualify under traditional standards.

The New York Times (not known for espousing a conservative point of view) published a prescient article in 1999 (that's before George W. took office) exposing all this. Steven Holmes wrote, "Fannie Mae...has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people..." The article then went on to predict the current crisis. It warned, "In moving, even tentatively, into this new area of lending, Fannie Mas is taking on significantly more risk, wihch may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980s."

I thank Cesar Chekijian for bringing this article to my attention. Click below to read the article's full content.

Fannie Mae Eases Credit To Aid Mortgage Lending

The Perils of Long-Term Investing

The following commentary is extracted from a special report sent to subscribers of the Forbes Special Situation Survey.

Lehman Brothers was selling for more than $85 per share in early 2007. American International Group (AIG) was around $70. Both companies were thought to be among the bluest of the blue chips. So much so, that Dow Jones even added AIG to its prestigious Industrial Average in April 2004. Yet over the course of just a few short months, both Lehman and AIG have been decimated. Lehman is now a penny stock seeking bankruptcy protection. AIG is scrambling to stay alive.

Yet Lehman and AIG are not the only “great” long-term investments that have since collapsed. For years, General Motors, Ford, Fannie Mae, and Freddie Mac were included in almost all long-term oriented portfolios. Fannie Mae, for example, generated a 25% annualized return for the 20 years ending in 2000—and that does not include dividends. Unfortunately, those who bought the stock back then and are still holding it, are now sitting on a loss. As impossible as it is to believe, Fannie Mae is worth less today than it was even 30 years ago!

Warren Buffett is clearly one of the greatest investors of all time. He is famous for avoiding risk and for having a long-term buy-and-hold orientation. Like Buffett, many investment professionals are also convinced that buy-and-hold is the best way to go. Yet recent events should make all investors question this advice. Buying, after all, is just half the story. Successful investing also requires selling. And despite his reputation, even Buffett engages in short-term trades from time to time. PetroChina and Pier 1 Imports provide just two recent examples.

There is no doubt that a buy-and-hold approach can be profitable. After all, those who buy and rarely sell minimize trading costs. They also minimize taxes because, if they do not sell, they do not realize their gains. However, I have seen too many investors get burned by holding onto a stock too long simply because they wanted to avoid paying taxes. Recent events should convince even the most diehard buy-and-holders that sometimes there is fate worse than taxes. (But, of course, not worse than death.)

It is extremely important to keep an eye on intrinsic value. If a stock is no longer undervalued, it makes little sense to keep holding it. In hindsight, I have gotten out of many positions much too soon. However, I would rather move on to a stock I believe is undervalued than take the risk of holding on to one that is becoming overvalued.

Whether Or Not the Facts Change

While preparing for an MSNBC interview recently about the presidential candidates' energy plans, I was struck by how similar they are. They are both in favor of reducing carbon emissions, they both want more wind and solar power, they both favor clean coal technologies, they both like cap-and-trade systems to reduce greenhouse gases, and they both want to see more nuclear power. Of course, they differ on degree and implementation on some of these issues. John McCain would rely on market forces and incentives. Barack Obama prefers more government mandates.

Until very recently, one critical difference was where they stood on offshore drilling. Obama was opposed to it. McCain is in favor. Obama stressed that oil companies already hold leases to 68 million acres of land and 40 million acres offshore. He said he would force them to drill in these areas or lose their rights to do so. However, McCain thinks it is better to let oil companies drill where the oil actually is. He has called for lifting federal restrictions on drilling in the Outer Continental Shelf.

But now Obama has changed his tune. Last weekend, he indicated a willingness to compromise on offshore drilling. Some have criticized him for changing his mind. I applaud him. Obama is moving from idealism to reality on this and other key issues. Even the Wall Street Journal applauded Obama this morning for backpedaling on his threatened tax increases. Apparently his advisors have told him that tax increases (even if they are intended to hit only the rich) can indeed slow the economy. That's not a particularly good idea when unemployment is rising and recession is a real possibility.

John Maynard Keynes once said, "When the facts change, I change my mind." Facts haven't changed, but it is encouraging to see that Senator Obama shows a willingness to change his mind as he becomes more familiar with the facts.

McCain or Obama: Who is Better for Taxes?

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

The stock market was open for trading last month, but as a former track & field athlete, I have to admit that the Olympics monopolized my attention. Usain Bolt was magnificent, as was the entire contingent of Jamaican sprinters. With a population of just 2.8 million, this small island country managed to win 11 medals on the track—six of them gold.

During the commercials, however, I did notice that stocks were rallying. In fact, the S&P 500 gained 1.22% in August. This is better than it did every month so far this year except for April. At least some of August’s rally was due to the 3.3% preliminary GDP figure for the second quarter, which was announced on August 28. This number was much better than expected and significantly better than the 1.9% advance figure reported a month earlier. Because the preliminary figure is based on more complete data, investors can have more confidence in it. Although overall growth was certainly robust, it came primarily from importing fewer goods and services and exporting more. It turns out the weak dollar is having a much bigger impact on international trade than almost anyone expected. I hope Barack Obama is listening.

Personal consumption expenditures were also very strong in the second quarter. Unfortunately, this is not likely to be repeated during the third quarter because the tax rebate checks have been fully disbursed. Some economists are already calling for another stimulus package. You can put me in that camp. However, tax rebates won’t do the trick. Their impact is just temporary. Tax cuts are the way to go if you really want to boost the economy in a long-lasting manner.

Speaking of taxes, here is something to ponder. Is it possible that taxes could actually go higher in a McCain administration than in an Obama one? That certainly does not sound logical. After all, Obama has been threatening to raise taxes while McCain has been calling for tax cuts. Yet a Congress controlled by Democrats is not likely to help a president McCain reduce taxes. Instead, under McCain, Congress could very well let the Bush tax cuts expire, in effect, giving us a significant tax increase. However, with Obama in the White House, Congress will almost certainly deliver a package of tax hikes. Yet this option could be less onerous than an outright expiration of the Bush tax cuts. “You’re next stop: The Twilight Zone!”

Stocks also may have responded to the latest S&P/Case-Shiller figures on housing prices. As I discussed in last month’s issue, a bottoming out process is underway. Housing prices are still falling at an accelerating rate, but the rate of acceleration is beginning to stabilize. Because the Case-Shiller figures are delayed by almost two months, we could actually learn in October that August was not so bad. Furthermore, we have already seen an uptick in mortgage applications. Yet despite marginally better news in the housing market, Fannie Mae and Freddie Mac continue to get crushed. There is even talk that these mortgage giants will be restructured and equity investors will be wiped out completely. However, if these government sponsored entities survive, those who have the guts to buy now could eventually find themselves sitting on huge gains. While this is a distinct possibility, it is a much better bet that an American relay team will drop the baton in the next major track meet.

The Worst May Soon Be Over

The latest (June) S&P/Case-Shiller figures provide a little (and I emphasize little) comfort that housing prices are bottoming out. With year-over-year prices down a record 15.92% on average in 20 major markets, that may sound like an odd thing to say. But that decline is only a little worse than the previous month's figure. In fact, if you look at the rate of change of the rate of change of the rate of change (what a mathematician would call the third derivative), things have been improving since February.

By no means does this imply that price drops are a thing of the past. On the contrary, housing prices will likely keep falling for another 12-18 months. However, the evidence suggests that the rate of decrease is about to slow. In fact, there is a good chance that the year-over-year decline in prices for July (to be reported at the end of September) will be less than it was for June.

Because almost all of the problems in the financial sector have been related to falling real estate prices, a stabilization of prices is critical for the health of our financial institutions. And because real estate prices will keep falling on an absolute basis for many more months, banks will continue writing down assets. Yet it is encouraging to see that the worst may soon be over for both the housing and finance industries.

Added VLO to FGI and SSS

In my June 2 posting, "Avoiding Oil Related Stocks", I said I was in the bubble camp when it came to oil prices. This is why we had no energy stocks in the Forbes Growth Investor and only one in the Special Situation Survey.

Now that oil prices are starting to ease, we decided it was a good time to add an energy stock to both newsletters. That may seem a bit nonsensical, but the stock we added is a refiner. High oil prices have squeezed margins at refiners. With oil prices falling, margins should expand once again. As a result, we decided to add Valero Energy (VLO) to both newsletters. In fact, in today's earnings release, Valero said gasoline margins (aka the crack spread) fell to $6.60 per barrel in the second quarter of 2008. They were at $28.95 per barrel a year ago. This explains why the stock price has been cut by more than half during the same time.

Of course, the crack spread won't expand if gasoline prices fall as rapidly as oil prices. While we certainly expect gasoline prices to ease, we think they will hold up better than oil because they didn't climb as much as oil to begin with.

While we expect VLO's profit margins to improve, we think the bigger risk over the near term has to do with volumes. Gasoline demand is falling sharply as drivers respond to high prices by cutting back, car pooling, and switching to more efficient vehicles. That's a risk we are willing to take. Low price multiples and a recent dividend increase make this stock extremely attractive.

Supervalu Gets Clobbered

Shares of Supervalu (SVU) took a big hit last week. This is a stock on our recommended list in the Forbes Special Situation Survey. It is also a stock I own personally. The sell-off had nothing to do with any specific news related to the company. Instead, investors sold the stock in reaction to disappointing results from Safeway (SWY) and the Great Atlantic & Pacific Tea Co. (GAP). Safeway beat earnings by a penny, but missed its revenue target. A&P missed earnings by seven cents per share. On the other hand, Kroger (KR) reported strong results a month ago and the stock rallied in response.

Tight economic times are taking a toll on supermarkets. Food price inflation is prompting shoppers to seek out bargains. They are trading down from name brands to store brands. This may depress revenues, but it should also boost earnings since store brands are more profitable. However, revenues are getting a bit of a boost from consumers who are trying to save money by preparing meals at home instead of eating out in restaurants as often.

Our view is that Supervalu has been unfairly punished for Safeway's and A&P's shortfalls. The stock was already undervalued even before the sell-off. Supervalu will announce fiscal first quarter results on Tuesday, July 22. Those who want to play it safe should wait until then. Those who prefer to take some risk, should buy on Monday.

Housing Market is Still Struggling, But Positive Signs Are Beginning to Emerge

With rising energy prices, falling nonfarm payrolls, a plunge in consumer confidence, and a host of other negative indicators, economists have plenty to worry about. Their biggest concern, however, continues to be the housing market. Yet there is finally a little hope that the worst may be over.

According to the S&P/Case-Shiller indices, housing prices are still falling. Furthermore, they are still falling at an accelerating rate. This is the bad news. However, for the second month in a row, the rate of acceleration has declined. While this is not a reason to start celebrating yet, it is a necessary sign before the crisis finally ends. And because there is a two-month delay in the numbers, things may actually be a little better than the available data suggest. Right now, economists are studying April's numbers. The figures for May won't come out until the end of July.

Another encouraging sign is the recent week-over-week increase in mortgage applications for both refinancings and home purchases. While total applications were down almost 23% from a year ago, applications for home purchases were up 2.8% from the prior week.

Some parts of the country are also seeing interest from foreign investors who are backed with stronger currencies; and vulture investors are getting interested in purchasing condos in bulk in places like Miami. The Fed is hoping for more such signs that the worst for housing is over. Because inflation is becoming a concern, the Fed is itching to start raising interest rates. It will not do so, however, until it is believes the housing debacle is nearing an end.

Discussion of Economy on CNBC

There is tremendous debate these days about oil prices. Some say given tight supplies and strong demand, $140 per barrel is fully justified. Others say there is a bubble in the oil markets. I am in the bubble camp.

I don't question that supply is tight and demand is strong. I also agree that there is much less slack than there used to be. Nonetheless, the intraday volatility tells me there is much more going on than simple supply and demand considerations. Federal Reserve policy must take some of the blame for rocketing oil prices. The Fed's policies have significantly weakened the dollar, causing investors to seek ways to hedge the Fed's actions. Oil is suddenly viewed as an investable asset. This is true for a number of other commodities as well. I recently argued in the Forbes Growth Investor that the stock market will not rally until the Fed and Treasury Department get serious about defending the dollar. I discussed this and other matters in a July 3 interview on CNBC with Peter Klein of Fifth Third Asset Management and John Ryding of RDQ Ecnomics (formerly of Bear Stearns). The segment was hosted by Michelle Caruso-Cabrera of CNBC. Steve Liesman of CNBC also took part.

Tempting Warren Buffett

I did an interview this afternoon with WBBM News Radio 780 in Chicago. The hosts, Kris Kridel and Sherman Kaplan, wanted to discuss Berkshire Hathaway. The stock is down about 15% year to date—not the kind of performance one would ordinarily expect from a company run by Warren Buffett.

Berkshire, of course, if heavily invested in the insurance business. Although it owns more than 70 subsidiary companies, many of the non-insurance companies, such as Fruit of the Loom and Jordan’s Furniture, are rather small. Most are dwarfed by the likes of GEICO and General Re.

Buffett warned at this year’s shareholders’ meeting that the insurance business would be quite difficult this year. Berkshire just can’t command the kinds of premiums it did in the recent past. Buffett also warned that Berkshire stock will not generate the kinds of returns it did in the past.

Berkshire also owns more than 40 publicly-traded stocks, but just four stocks account for more than half the value of this portfolio. This group, referred to as the Big Four, consists of Coca-Cola, American Express, Wells Fargo, and Procter & Gamble. Each of these stocks is down more than 15% year to date.

Given Berkshire’s heavy exposure to the finance industry, it is rather impressive that the stock is down only 15%. Compared to the likes of AIG, Citigroup, and the investment banks, Berkshire is doing quite well.

Buffett is sitting on a boatload of cash. Many observers have been wondering when he will put some of that money to work. We know he likes to buy when others are selling. Given, the extent of the sell-offs witnessed lately, perhaps Buffett is getting at least a little tempted. But is he willing to invest in the financial stocks that have gotten killed? With Citigroup, Fannie Mae, Freddie Mac, AIG, Lehman Brothers, Merrill Lynch, and a host of others, there is a lot to choose from. Unless Buffett is completely bearish on the future of America, chances are he is thinking hard about buying one of these companies.

Inflation Ahead

According to the Hulbert Financial Digest, which tracks the performance of almost 200 investment newsletters, the Forbes Special Situation Survey is the best-performing letter year to date. Hulbert has us up 28.1% through the end of May.

Obviously, we are extremely pleased with this result. However, stocks have weakened considerably in June. Indeed, one of our holdings, Coventry Health Care (CVH), took a big hit last week when management warned that earnings would fall well short of expectations. Yet CVH will report strong revenue growth for the year, and 2008 earnings will likely exceed $3.50 per share. With a forward multiple of just nine times earnings, the stock is extremely attractive. Assuming management does not unload any more surprises, CVH should stage a bit of a rebound in the near term

Of course, macroeconomic factors continue to cast a pall over the entire market. Consumer confidence fell to a 16-year low and housing prices are still falling at an accelerating rate. It is at least a little encouraging, however, to see that the rate of change of the rate of change in housing prices is finally slowing down. Nonetheless, housing prices will probably keep falling on an absolute basis throughout 2008 and possibly into 2009.

Energy prices are another major concern. The extremely high price of gasoline is one major reason why shares of General Motors have plummeted to levels not seen in three decades. But crude oil prices are not just high; they are also remarkably volatile. Intra-day swings of 2% or more now occur on a regular basis.

As for the Fed, its most recent statement mentioned rising inflationary expectations and an uncertain outlook. The FOMC chose to hold interest rates steady at 2%, but it now has a clear upward bias. One member, Richard Fisher, voted against the decision to keep rates steady. He believes the time has come to start increasing interest rates. This comes as no surprise to Fed watchers since Mr. Fisher has dissented on every decision since being appointed to the FOMC in January. He may be a party pooper, but it looks as if he is also the only FOMC member who is ahead of the curve.

Making the Rounds in Boston

I have been in Boston the past few days. No, I did not come here to root for the Celtics. I came to give a couple of talks about my book and to attend a Forbes conference.

On Wednesday morning I spoke at the UMass Club in downtown Boston, which boasts a wonderful view. On Wednesday evening, I spoke at the Armenian Library and Museum of America in Watertown. I ran into several old friends at both venues.

On Thursday afternoon I tried to drive into the City to attend the Forbes Leadership Networks Forum. Unfortunately, I got caught up in the Celtics parade. Although the parade was officially over, the police still had not opened several key streets and I could not get to the Four Seasons Hotel where the event was taking place. I had to give up and try again a few hours later. I finally made it to the Four Seasons toward the end of the program.

When I finally got settled, I noticed that oil prices had fallen more than $4 per barrel because the Chinese said they were going to ease gasoline subsidies. It's about time they did this. By keeping gasoline artificially cheap, they have been encouraging consumption. Higher fuel prices in China should take the heat off of demand. Now if we can get the dollar to strengthen a bit, oil prices should fall back down to a level that is more in line with supply and demand considerations. I expect that level is about $80 per barrel.

The Pro-American Ahmadinejad?

There has been much debate lately about high oil prices. Some say they are fully justified simply because of the forces of supply and demand. Others say they are in a bubble. Well, I came across a rather bizarre story on Bloomberg.com. It appears that President Mahmoud Ahmadinejad of Iran believes in the bubble theory. He says there is plenty of oil available and the price rise is unjustified. He blames it on efforts by some to weaken the U.S. dollar. He also called for greater use of nuclear energy, which he called "clean and cheap."

Ahmadinejad suddenly sounds like an American. In defending the U.S. dollar, he is doing a better job than our own Treasury Secretary. And by urging greater use of nuclear energy, he is encouraging us to stop relying on OPEC. Ahmadinejad is not particularly popular in Iran. Perhaps he has aspirations for a political career in America? You can read the Bloomberg story by clicking here.

The Leon Charney Report

Although I have been interviewed dozens of times on television and radio, I always enjoy appearing on the Leon Charney Report. Charney is an extremely successful investor. He also served as an advisor to Jimmy Carter during the Camp David Accords. He hosts one of the most intelligent talk shows on television. There are no sound bites on this program. No screaming, no yelling, no cutting people off. Instead, Charney takes the time to conduct interesting conversations with interesting people. I have had the honor to appear on his show four or five times. In my most recent appearance on May 18, Charney interviewed me about my new book, Even Buffett Isn't Perfect. I thank him for the plug. You can watch this May 18 interview at the Leon Charney Report website.

Avoiding Oil-Related Stocks

Today, we released the June issue of the Forbes Growth Investor. The 50 stocks on our recommended list are up 2.11% year-to-date. In comparison, all the major indexes are down more than 4% during the same period. We have been seeing quite a bit of strength in the technology sector. For example, Sohu.com (SOHU) surged 83% during the three months it spent on our recommended list.

Our Special Situation Survey investment newsletter takes a more concentrated approach. We typically have only about 15 stocks on the recommended list in this newsletter. One of our best picks this year was Trinity Industries. The stocks in this newsletter are up 26% year-to-date, making it one of the best-performing investment newsletters so far this year as well as over the past five years.

Interestingly, neither newsletter has benefited from the surge in oil prices. There are no oil-related stocks on the recommended list of the Forbes Growth Investor. Currently, there is only one in the Special Situation Survey, but it hasn’t done particularly well. In general, energy is an area I have been avoiding. In fact, as far as oil goes, I am in the bubble camp. Supply and demand factors certainly explain a good part of the rise in crude oil prices, but I believe Federal Reserve policies that have weakened the dollar also carry some blame. U.S. demand for gasoline is actually falling. Gasoline is subsidized in many other countries, but their governments are finding it increasingly difficult to continue this practice. Oil prices could plunge as subsidies are lifted and as the dollar strengthens.

Fed Minutes Forecast Recession

Yesterday's release of the minutes from the Federal Open Market Committee's April 29-30 meeting shook the markets. In particular, investors were put off by forecasts for slower economic growth and indications that no more rate cuts are in store. Just about the only good news that could be found in the minutes were references to stronger exports and slowing core inflation. At the same time, however, the Fed raised concerns about elevated overall inflation and rising expectations for future inflation. Committee members also expressed concern about slowing economies abroad, especially in Japan, the U.K., the euro zone, Canada, and Mexico.

The Fed actually expects U.S. GDP to contract during the first half of 2008, which of course is almost over. This is one way to say recession. The Fed remains hopeful, however, that the American economy will strengthen during the second half due to "accommodative monetary policy and fiscal stimulus." The former refers to the significant interest rate cuts that the Fed has already delivered. The latter refers to the tax rebate checks. Despite this expectation for a stronger second half, Fed economists reduced their projections for GDP growth for the full year. Their projections now range from just 0% to 1.5%, down significantly from the 1.0% to 2.2% range delivered just three months earlier.

Rebate checks are not likely to provide much stimulus. This money will probably be used to pay down debt or fill the family car's gas tank a few times. Real fiscal stimulus requires tax cuts. Unfortunately, there is no hope of that happening in the current political climate.

The minutes also said that "most members viewed the decision to reduce interest rates at this meeting as a close call." They don't want to cut rates again unless things really go to hell in a handbasket. The Fed said, it is "unlikely to be appropriate to ease policy in response to information suggesting that the economy was slowing further or even contracting slightly in the near term."

Two FOMC members actually voted against the latest cut. Richard Fisher warned that rate cuts were hampering economic activity by reducing the value of the dollar and contributing to the rise in import and commodity prices.

So there we have it. According to the Fed, although we can expect much slower economic growth than we previously anticipated, we can no longer count on further interest rate reductions. There certainly wasn't much in the report to be optimistic about. Of course, that explains the big sell-off in stocks that took place soon after the minutes were released.

Because I recently completed a book on Warren Buffett, and because Buffett is touring Europe right now, I've been asked a number of times why he is there. In particular, Fox Business asked me today if it made sense for Buffett to be trying to purchase European companies at a time when the dollar is so weak relative to the euro.

The first thing to keep in mind about Warren Buffett is that he does not actively seek companies to buy. Instead, he waits for good companies to contact him. He is in Europe just to make it clear that he is available and ready to buy if they are ready to sell.

Second, Buffett's European tour is not a bet on the dollar. He is still bearish on the dollar for the long term because he believes U.S. economic policy is geared to make the dollar weaker, but he also says he has absolutely no idea what the dollar will do in the short term. Just two weeks ago, he told shareholders he would like to diversify Berkshire's revenue stream. He wants more revenues from foreign economies. And because he has so much money to invest, he is focusing on Europe. He prefers to buy very large established family businesses.

Stuart Varney had a difficult time with my name, but he managed to pull it off at the end. Click here to view.

Broadcom Co-Founders Snagged for Backdating Options

According to the SEC, Broadcom founders Henry Nicholas III and Henry Samueli and two other executives were involved in a scheme to backdate employee stock options. Backdating, which may have been more widespread than we know, didn't come to light until just a few years ago.

When a corporation grants stock options to an employee, it is supposed to be honest about the grant date. Backdating refers to the practice of selecting a date from the past when the stock price was at a lower and more favorable level for the employee. This is one way to recruit or retain valued employees. If the options are already in the money, the employee is less likely to leave.

About two years ago I had a conversation with former SEC chairman Harvey Pitt about this issue. Interestingly, he said the practice itself may not necessarily be illegal as long as it is fully disclosed. Microsoft, for example, routinely backdated options, but it also disclosed doing so in its SEC filings. Pitt, however, said that failing to disclose is outright fraud.

Apparently a number of other high profile companies, most notably Apple, have also engaged backdating options. However, some commentators have said the SEC is reluctant to go after Steve Jobs, Apple's founder, savior, and CEO. But these latest charges against the Broadcom executives indicate that the SEC considers backdating a serious offense. We may hear about more such cases in the future.

A Stronger Dollar and Falling Demand Should Cause Gas Prices to Retreat

According to the AAA's Daily Fuel Gauge Report, the national average price of gasoline just hit a record $3.72 per gallon, up 35 cents per gallon in just one month. Many consumers now believe the $4.00 mark will be broken very soon.

I am absolutely convinced that the run-up in oil and gasoline prices has more to do with the weak U.S. dollar than it does with supply and demand considerations. To a large extent, Federal Reserve policy decimated the dollar and caused inflation in dollar-denominated commodities. The Fed felt a need to aggressively loosen monetary policy because of the U.S. financial crisis and the slowing economy. However, it went way overboard by slashing the target fed funds rate from 5.25% in September all down to 2% where it stands today. Although the dollar had been weakening against the euro since 2002, the Fed's recent actions contributed to the dollar sell-off and the rush toward oil and other commodities.

This is not to say, however, that supply and demand played no part. Most oil producers are running close to full output and there isn't as much slack in the system as there was in the past. Furthermore, several oil-producing nations have serious problems. In Nigeria, it seems there is a new attack on production facilities almost everyday. Iraq, which has among the largest proven reserves in the world, is still mired in conflict and isn't producing anywhere near its full capability. And Venezuela has hampered its production by nationalizing assets and driving out foreign companies.

As for demand, it continues to climb in China and India. However, demand is actually falling in the U.S. We are currently consuming close to a million barrels of gasoline a day less than we were during last summer's peak. While demand is likely to climb as a new summer season dawns, it is unlikely to rise as much as it usually does if prices remain at elevated levels.

Now that it appears the Fed is through (or almost through) cutting interest rates, there is hope that the dollar will soon start to strengthen. With a stronger dollar and waning U.S. demand for gasoline, it is hard to believe that prices won't ease off a bit from current levels.

In Omaha at the Warren and Charlie Show

I’m posting this from Omaha. I arrived here yesterday for the Berkshire Hathaway shareholders’ meeting. My trip was exhausting. I got up and 3 a.m. and headed for LaGuardia Airport. I made a connection in Chicago, but due to bad weather sat on the runway for almost three hours. I finally arrived in Omaha, rented a car, and raced to Borsheim’s Fine Jewelry, a Berkshire subsidiary. I went there to do an interview about my new book, Even Buffett Isn't Perfect, with Liz Claman of the Fox Business Network. I was starving and had a splitting headache. Except for some water, I had not eaten anything all day. Fortunately, the interview went very well.

After the interview, I headed off to my hotel in Bellevue, which is about 15 miles south of Omaha. Because 30,000 Berkshire shareholders came to Omaha for the meeting, there were no more rooms available in the city. I checked into my hotel and immediately fell asleep for several hours. As soon as I awoke, I headed back to Borsheim’s for a reception. The place was packed. As I walked past displays of $20,000 watches and other kinds of expensive trinkets, I could not help but notice the diversity of people, all of whom were Berkshire shareholders. They were young, they were old, and they were from all over the world.

The actual meeting began this morning at the Qwest Center. There was a large exhibit hall with many of Berkshire’s subsidiary companies showing off their wares. Shareholders could buy everything from See’s Candies to Fruit of the Loom underwear at discounted prices. Soon, the real show began. Susan Lucci, star of the soap opera “All My Children,” took the stage and announced that Warren Buffett decided to leave the company. She said she had just been appointed the new CEO of Berkshire Hathaway and that her first decision would be to initiate a dividend payment. Suddenly, Buffett came on stage and put a stop to that. This was all in keeping with his great sense of humor.

For several hours, shareholders bombarded Buffett and Munger with questions. Many of the questions had little to do with Berkshire’s business operations. Young people asked what they should do with their lives, a teacher asked what she should teach her students, and one man wanted to know if Buffett had accepted Jesus Christ as his Lord and Savior. Others asked about nuclear proliferation and mass transit policies. One man made a plea that Buffett read the U.S. Constitution and then call Roger Pilon of the Cato Institute. It quickly became evident that for many people in the audience, Buffett and Munger were more like cult figures than great businessmen. All of these people were clearly smart to invest in Berkshire stock. Nonetheless, some were quite wacky.

Although most people in the audience revere Buffett and Munger, not everyone was enamored with the dynamic duo. Several indigenous Americans complained that PacificCorp, which is owned by MidAmerican Energy Holdings, another Berkshire subsidiary, was damaging waterways with its damns. They wanted to know what Buffett intended to do about it. They also complained that they weren’t treated very nicely at last year’s meeting. Buffett was polite, but tossed these questions to David Sokol, chairman of MidAmerican, who gave some very diplomatic answers that did not quite seem to satisfy the questioners.

I was surprised that no one asked about Joe Brandon, General Re’s former CEO who suddenly resigned just a couple of weeks ago. Buffett has frequently praised Brandon in his annual letters to shareholders. The rumor is that Brandon resigned because federal prosecutors pressured Buffett to let him go. These authorities seem to believe Brandon was closely associated with some of the fraudulent schemes involving General Re and American International Group. Four people, included General Re’s former CEO, Ron Ferguson, were recently convicted for these schemes. Brandon, however, has not even been charged with any wrongdoing. Yet his reputation has been tarnished. It would have been nice if Buffett had shed some light on Brandon’s departure.

All in all, while I am glad I attended the event, I can’t say it was particularly instructive. It certainly was fun to meet and mingle with many of Buffett’s fans and to see all of Berkshire’s products on display in one place. However, I am convinced that one can learn a whole lot more by studying Berkshire’s annual reports than by attending its shareholders’ meetings.