The dip in prices last week was once again met with buying that now have positioned oil, gold and stocks for a run to recent highs. This setup is impressive now that the S&P has reclaimed the 1100 level and now attacking resistance at 1110/1120 which was the triple top from November/December. This has all been accomplished without the aid of Dollar weakness that can accelerate the bull trend on a turn down below 79.5.

Stocks were nearly unchanged for the week with prices in the major indexes off less than 1 percent. The above-mentioned S&P was down 5 points, which is a 0.4% loss in the broad based market barometer. The Dow was down 77 points, -0.7%, and the NASDAQ lost 6 points, -0.3%, for the week ending February 26th.

The “square root” recovery was not my original description but aptly summarizes market action over the past 18 months. As the name implies the recovery is that of a square root sign, which is a sharp initial recovery followed by leveling off later down the road. The V shaped recovery has stalled with prices moving sideways in most assets since the highs of December and January.

Stocks had led the way for the past year and look ready for another attack on the S&P 1150 then the original breakout of 1300 from August 2008. Since my research service, Resource Trader Alert, focuses on trading commodity futures, not stocks — not stocks — the question remains: how does that affect our futures plays?

The upside potential is magnified in natural resource assets, which were crushed in the previous economic decline. Prices in commodities have another 15% to regain half of the overall drop from 2008. Stocks have long ago rallied above that level and signal a continued recovery with resiliency short lived selling pressures.

A Commodity stock rally from the February 5th lows is leading the way: US Steel $42 to $54 (28%), Cleveland Cliffs $39 to $58 (49%), and the worlds largest Gold producer Barrick Gold $33 to $38 (15%).

One natural resource that is not exchange traded, Iron Ore, has made new yearly highs.  This from Bloomberg:

The cash price of iron ore delivered to China, the world’s biggest buyer, rose to the highest in more than a year on demand from the nations steelmakers.

The cost of 62 percent iron-content ore delivered to the port of Tianjin increased 1.4 percent to $133.10 a metric ton today, the highest in at least 14 months, according to The Steel Index. The so-called spot price has gained 9.8 percent in the past four weeks and has more than doubled from its 2009 low on March 27.

As mentioned last week, sometimes clues come from not what happens, but rather what does not. The comeback from the depths in February was a good sign for continued trend strength.

In fact the Dow gained 2.6% during the month, as the S&P 500 added 2.9% when our fighter looked knocked down. Gold also added $40 an ounce and crude over $6 a barrel for the month. This powerful resurgence was surprisingly against the headwind of a rising US dollar.

That all boils down to one thing – if our square root recovery holds true, we can expect stocks to track sideways for a while. And while that’s not great new for all of the folks who are betting hard against the market right now, it’s great news for traders like us… After all, a sideways track for the market gives us plenty of short-term opportunities to trade for maximum profit. You can bet that’s exactly what we’ll be doing as we approach the second quarter of 2010.

It all comes back to commodities,
Alan Knuckman
Penny Sleuth

March 4, 2010

What the “Square Root Recovery” Means for Commodities was originally featured in the Penny Sleuth.

Here’s an exclusive look at how my trading strategy picks winners 80% of the time…

The commodity options trading strategy employed by Resource Trader Alert is to purchase limited risk options or option spreads with solid reward to risk ratios. Equally important is buying enough time until expiration for our plan to move into profitability.

The option price is determined by a few main factors that we balance in order to purchase the best value for the money.

Simply stated, the more time you buy translates into more expensive option premiums – that’s because your window of opportunity is being extended. Additionally, the greater the price movement in the market raises relative costs because of the price volatility component. For example, something that hasn’t had recent significant dollar moves like Live Cattle versus faster moving Crude Oil has cheaper options.

Commodities contracts themselves typically have approximately a twenty to one leverage. For example, a Gold contract controls 100 ounces at $1100 an ounce representing a cash value of $111,000 for a deposit of only $7000. The financial gains and losses are therefore magnified with $1000 for each $1 movement in price. As you may expect, undisciplined outright futures without risk control have turned many large fortunes into small ones. That’s why we stick with limited risk options.

Commodity Options Trading Strategies: Beyond Time and Volatility — Delta Payoff

I’ve been asked by a few readers to go into a little more depth on my options philosophy, so let’s pull back the curtain…

Because of the underlying leverage in commodities, the additional leverage in the options can amplify and multiply returns from modest price movement. The selection of the In-the-Money versus the At-the-Money versus the Out- of the- Money options is based upon cost.

The higher the Delta, which is the percentage that the option price moves in comparison to the underlying asset, the more expensive the option premium. You get what you pay for, so another way to look at Delta is to see it as the approximate probability of the option being at the strike price at expiration.

The Resource Trader Alert strategy is to buy options or option spreads that are one or two strike prices from current levels because they have a good payoff that will increase as the market moves further in our desired direction (and still, it’s a little more complicated than that – but I can’t give away all of my secrets!).

This tells us that there’s a 50/50 chance mathematically that prices are above 3200 at expiration (before the increase from our analysis edge.) At the same time the out-of-the-money 3700 option leg will gain little in comparison. With six months of time and a close to the market strike price we have selected a high probability play that has the nice return potential.

Commodity Options Trading Strategies: The All-Important Exit Strategy

Money management is a very important part of my trading plan. I can’t repeat enough that our plays are always limited risk with the maximum financial exposure limited to the total premium paid. That said, it’s never my intention to let an option expire worthless if and when the trades fail to develop as we intended.

The rule I follow is to monitor a position closely if it loses half of the premium from our entry price. With options, that means either the market has moved significantly the opposite direction or the time to expiration is approaching.

It’s a tough call to salvage the position, since I’ve seen plenty of options run from near worthless to highly profitable, but for some traders it is good discipline to sell out and recover premium for another day.

The ultimate trick is to avoid that scenario – that’s why so much detailed analysis goes into any options pick I make. I’d much rather spend time finding an excellent commodity trade than spend time trying to figure out how to salvage a mediocre one.

It all comes back to commodities,
Alan Knuckman

February 24, 2010

A Guide to Commodity Options Trading Strategies was originally featured in the Penny Sleuth.

European politicians are debating how to sell the idea of a bailout to their taxpaying, voting populations. This is an attempt to contain the damage from the last decade’s overspending of the Greek government. This government will default soon, unless we see a combination of sharp cuts in spending and a bailout from wealthier neighbors.

The stronger economies of Europe — the ones not driven by government spending and tourism — are in a pickle. If they let Greece default on its debt, the consequences for financial markets could be sharp and very painful. If they extend a lifeline to the Greek government, every other irresponsible government will line up for a bailout. At that point, everything may appear to be under control, but a few years down the road after a round of bailouts, the problem will emerge once again.

They will remain in place until the size of welfare states and banking systems fall in line with the productive capacities of the economies that support them.

The root of the problem is that the financial and, for lack of a better word, the “government spending” sectors of the global economy have grown too large. The sectors that produce valuable goods and services cannot afford to subsidize banking and government at their current sizes.

The resolution of this problem will take many years, and it will involve a combination of weak-to-flat global GDP growth and currency debasement. Banking and government finance much of their activity by being first in line to benefit from the inflation that’s constantly being created by central banks. This is a hidden tax on the productive economy.

At this point, it remains to be seen if German taxpayers will be generous enough to subsidize the lifestyles of Greek government employees.

German and French politicians may have voiced support for Greece, but, thus far, have not backed up words with concrete actions. Ultimately, the IMF may get involved in some fashion (which ultimately adds to the burden of U.S. taxpayers). In the meantime, this situation could get messier, and maintain pressure on the prices of risky assets like stocks.

The endgame of Keynesian policy is on display in Greece right now. The reputation of loose government spending as a serious policy will, by the end of 2010, be dealt some deserved blows.

These policies ultimately lead to bankruptcy, not prosperity. When responding to a criticism of the long-run costs of his prescriptions, John Maynard Keynes, (the economist so revered by fans of big government) quipped, “In the long run, we are all dead.” Well, he may be dead now, but plenty of people are still alive, and living with the consequences of his distorted view of reality. Production comes before consumption.

Hopefully, mainstream economists and politicians will have re-learned this simple truism by the time this rolling crisis has passed.

Regards,
Dan Amoss

February 18, 2010

Keynes’ Folly Hits Home in Greece was originally featured in the Penny Sleuth.

When a person (who qualifies for unemployment) loses his (or her, but it’s a pain to keep using two pronouns) job, his application for benefits is recorded under the weekly initial jobless claims.

If he is still out of work after a week (and who isn’t these days?), then when he collects benefits on week two, he is placed in the continuing claims category. In most recent years, the continuing claims benefit continued for 26 weeks.

I guess the supposition is that if you haven’t found a new job in half a year, you weren’t really looking anyway. The government isn’t going to put up with you being so “lazy”… so you would collect no more money.

But ever since the world collapse that has brought so many government benefits out of the woodwork (and just as many people to collect them), pressure has been applied to extend these benefits under emergency measures to continue supporting those who remain out of work longer term. Handily enough, they are called extended benefits and emergency benefits.

Now here’s the kicker: Even though we have been witnessing steady declines in the headline numbers of the new and continuing claims for unemployed, the emergency benefits portion of unemployment has been rising FASTER than the other two headline numbers have been falling.

Last June, the number of continuing claims topped out at 6.9 million. Since then, they have retraced by 30% to just above 4.5 million. Under the extended benefits plan, we have a somewhat better showing, where the numbers have fallen from 520,000 to 260,000. So that’s basically cut in half. Unfortunately, as mentioned above, the number of people who are now living on EMERGENCY benefits has ballooned. From last June, when there were 2.6 million on the emergency rolls, the number has MORE THAN DOUBLED to 5.6 million. It’s also worthy of note that this is the highest number to date.

In other words, this figure is actively growing and, even worse, showing no signs of abating.

When the numbers are released, the drop in unemployment is simply an accounting quirk, whereby aid recipients are moved from the headline numbers to the emergency category. And you can tell from the figures I’ve given you that the fall in the continuing claims category is actually exceeded by the number of enrollees on the emergency rolls.

The grand total of non-working citizens has jumped 30% in the last nine months, from 8 million to 10.2 million. When we look at the Non-Farm Payroll numbers next month, they will purport to tell us how many jobs have been created. Last month it was a huge positive surprise. But it is awfully hard to believe we are creating jobs while the unemployment figures are swelling beyond belief.

I think it must be kind of like all the money given to the banks to lend to us “little people,” which never seems to reach us. Here are jobs, created for the “everyman,” but meanwhile, he sits unemployed each week, bringing him closer to the end of his benefits — and the end of his rope.

What does this mean as we look forward?

Simply this… if we do not have another leg of recessionary activity ahead, I do not know how it will be averted. Common economic theory maintains that monetary stimulation is the only means whereby an economy can be revived.

The United States has massively stimulated its economy. So has Europe. So has China.

Government spending is a real and present danger. And while many of the governments have halted various stimulus programs and are already hinting at removing excess liquidity, perhaps later this year or early in the next, at this point in time I cannot see how. Be wary about the economic numbers you’re fed.

Until next time,
Bill Jenkins

February 10, 2010

What Unemployment Numbers Really Mean for Your Investments was originally featured in the Penny Sleuth.

But one thing I’d like to stress in today’s Sleuth, with the Volatility Index ($VIX) around 25, is that I believe we’re still at a reasonable level of volatility – and if anything, last week’s correction was long due.

The sell off was the worst since March 2009 with a 5% drop in the last three days of the weak week. Put in perspective, though, 15 Month S&P highs were made Monday January 19th – only a few trading days ago.

My focus lies on the recently humbled physical commodity markets that were down 6.5% as the raw materials sector retreated on Chinese concerns. Their coordinated announcement of slowing growth from the official 10% latest quarter GDP jump is designed to temper inflationary pressures – but contrary to some published obituaries the Red Dragon is still very much alive.

Last week has definitely gotten our attention but remember we have seen this action repeatedly before. For the last 10 months, every time the market looks like it will turn down it has responded with a rally to new relative highs.  Take a look:

One component in pricing for the options that my Resource Trader Alert readers invest in is volatility. For our purposes it helps us determine simply to buy an outright option if price are cheap or to purchase a spread if expensive (in relative terms). An increase in volatility is an increase in price movement – and don’t forget we need the markets to move in order to make money on our positions.

Stocks had slowed in the last couple of weeks and the $VIX, which measures the S&P 100 stocks, was solidly below 20 and as low as 16 January 11th. No fear, no movement as you saw quiet market conditions with tighter daily trading ranges while the market searched for a catalyst for prices.

Earnings have begun once again feeding the beast with its necessary diet of market information to digest. Banks have been permitted to make back some money from interest rates held low by the Fed. They had to make some money the old fashioned way:  they Earned it with the risk free policies of the Central Bank allowing them to replenish their dwindled cash coffers.

Is This Just a Pullback, Jack?

After any turnaround (in any market), traders look for price support. The logic is to start small with not making new lows for an hour, then a day, then the week. For example, the highly traded e-mini S&P 500 futures declined to 1089 in today’s session but not below Friday’s lows at 1086 and reversed to move higher on the day.

As a group commodities have done much the same with Gold and Oil closing higher after testing last weeks lows. Crude actually made a lower low at 73.97 Monday for the March contract but closed higher on the day which is a positive technical sign with that reversal on lower volume than Friday.

Another clue can be taken from the action in Treasuries, which benefited from the stock uncertainty last week. 30-Year Bond futures are off by nearly half a basis point as some fear has subsided in the short term. The next round of market volatility will tell us a lot about the market’s future direction.

It may be cliché, but my nearly 20 years of experience makes me most afraid when others are not and gives me a sense of calm when the public is frantic and unhinged.

This from Bloomberg:

Traders are piling into bets that the biggest sell-off in U.S. shares since March will increase stock market volatility, pushing call options on the VIX Index to the highest level in 19 months.

The VIX jumped 55 percent to 27.31 in the last three sessions, the biggest surge since February 2007, as demand rose for options to protect equities from losses. Futures show traders are betting it will remain above 25 for six months after averaging 20.29 over its two-decade history.

The VIX had its biggest annual drop ever in 2009, falling 46 percent, as the smallest stock-market swings in two years reduced the value of equity derivatives. The gauge is still down 66 percent from a record 80.86 in November 2008.

These emotional inputs have been successfully interpreted and managed within my readers’ disciplined RTA trading plan through ups and downs. Risk is always quantified and controlled with our strategies and that does not change as volatility increases, but opportunities do. We’re going to take advantage of those opportunities going into 2010.

It all comes back to commodities,
Alan Knuckman

January 29, 2010

Don’t Panic from the Pullback… Profit from It! was originally featured in the Penny Sleuth.

The jobs of providing economic forecasts/commentary versus trading advice are two completely different roles. One is to predict what the market will do and the other is to profit from how things develop.

At Resource Trader Alert, my premium commodities trading advisory, the focus is on executing high reward versus risk investment strategies to make money. A solid trading plan is developed for each option position with potential entry and exit points determined prior to getting into the market. This money management discipline is designed to eliminate or at least diminish the emotional components of the constant noise in the marketplace.

Opinions: Everyone Has ‘Em – But They Do Not Make Money

You cannot let what you think the market should do impact a well thought out trading plan. At RTA we trade technically what we see in the charts – and sometimes that goes against what we think should happen. The trading methodology of Identify, Execute, and Manage to Maximize outweighs the larger macro viewpoint for the future.

For example, back in mid 2009 we were one of the first to mention the Bond Bubble and profit handsomely from the decline in Treasury prices. The combination of 2008’s safety position unwinding and increased debt sales put the pressure on prices for our trade. The following sharp decline in Bonds from 121 to 112 in June gave us nice profits of $2,200 to add to the RTA track record.

For a trader there is little consolation in being right without the financial payoff.

What Does the Market Tell Us About Interest Rates?

Interest Rates are set to rise currently — there is very little doubt about that with the current Fed target between zero and .25. Short term rates are determined by government monetary policy and remain near historical lows — prices actually went negative because of panic buying in the 2008 collapse – which leaves rates nowhere to go but up. The question is not if rates will go back up, but rather over what time frame they will go back up.

All of this movement and the timing is important to commodity investors because without rising interest rates the dollar continues to fall – and a falling dollar is bullish for our overall commodity portfolio.

To estimate the timing of interest rate moves I always turn to Eurodollar (not to be confused with Euro Currency) futures. Short-term trading instrument prices move in the opposite direction of the interest rates for Eurodollars.

For example the current price of the March Eurodollar of .9973 reflects a rate of .27%. Subtract the price from par at 100 to get that current interest rate. So the market is telling us that rates should remain close to the Fed’s target range for the next few months.

Here’s a look at the last 15 years in the Eurodollar:

Looking past this chart and into the futures market, the deferred months of June (.9955) and September (.9923) for the Eurodollar show a moderate increase in rates has been priced in. These indicate a rate of .45% by June and .77% by September.

But the recent upward Eurodollar price action of nearly 25 points since last Friday’s Unemployment Report has decreased the likelihood of Fed Action any time soon.

Back to Bullish on the Long End of the Curve

Eurodollars, Bonds and notes are not driven by Fed targets but rather supply and demand. With the current fragile state of the economy and no sign of a job recovery it’s nearly impossible to raise rates anytime soon. Keeping mortgages appealing is also necessary for the distressed housing segment.

Ten-year note rates had recently jumped to multi month highs and now sit against the significant 4% yield barrier. This is a solid resistance that should not be violated without the green growth of economic recovery. Not just yet anyways, these are future concerns that will be later trading opportunities.

All of this combined makes our recent Bond trade look very attractive.

Plus, another added bonus is the hedge potential we have from another stock downturn or political/ economic crisis that would create flight to quality and boost bond prices. The outside markets of oil and metals are giving signals that the dollar is under pressure with renewed rallies. It is very difficult for the dollar to fall in an increasing interest rate environment and vice versa.

While the selling of Treasuries may very well be the “Trade of the Decade” all of our information adds up to a buy in the very short term, relatively speaking, with minimal financial risk. Look at this trade as a 100-yard dash for the next couple of months within the larger marathon run of rising interest rates.

It all comes back to commodities,
Alan Knuckman

January 18, 2010

The Facts About Forecasts was originally featured in the Penny Sleuth.

Birinyi compiled all of the 2010 strategist forecasts and calculated the following averages: a yearend S&P 500 target of 1,222, $76 in S&P 500 earnings, and 3.1% GDP growth. The deviation from these averages was not wide. These numbers might be plausible if this were a typical rebound from an inventory-led recession. But this is not what we’re experiencing.

Just consider today’s weak nonfarm payroll report. Government number crunchers estimate that the economy lost 85,000 jobs in December. Of course, this figure is highly massaged by seasonal adjustments and the “birth/death model,” which assumed that new businesses created 59,000 new jobs in December. Without the birth/death adjustment, the headline would have been 144,000 jobs lost.

The civilian labor force participation rate fell to a new low — 64.6% — as more discouraged workers give up looking for jobs. If these workers were considered by the statisticians to be looking for jobs, the headline unemployment rate would jump several percentage points.

To gauge the accurate health of the labor market, check the tax withholding figures. These figures are still down significantly year-over-year.

Job creation needs to turn highly positive quickly to justify the valuation of the stock market. The employment picture is also vital to the health of the credit markets and the banking system. The popular obsession over how long the Federal Reserve is going to hold short-term rates at zero distracts many investors from the destructive influence that high unemployment will have on credit quality.

The Fed’s extremely loose policies have sparked investors to take on more credit risk in the secondary markets. This has pushed up the prices of junk bonds and junk stocks, lowering yields. But if the labor markets don’t rebound dramatically from here, we’ll see accelerating credit losses on everything from mortgages to credit cards. Those who piled into junky credits due to zero interest rate policy will flee out of them due to rising defaults.

We’re in uncharted waters when we combine stubborn labor market weakness with heavy private sector debt loads. Credit losses are likely to surprise the market on the upside in 2010. This is especially dangerous for a banking system that’s marking its own assets at “mark-to-myth” levels.

Through several examples, it’s clear that the Treasury Department’s unofficial policy for dealing with underwater real estate loans is “extend and pretend.” This means that as long as underwater borrowers are making monthly payments, most bank examiners will look the other way and allow banks to mark loans at artificially high values. Bank regulators are also likely to look the other way if banks roll over maturing loans that are underwater on a mark-to-market appraisal basis.

But this isn’t cause for celebration. Instead, this mass denial of reality will only make the ultimate credit losses even larger. But this seems to be the policy, because it’s politically expedient and painless (for now).

Just like we saw in post-1990 Japan, “extend and pretend” will commit huge amounts of scarce capital in the banking system to defend bubble-era loans. Instead of extracting this capital out of bankrupt situations to be reinvested into new loans, we’re prolonging a misallocation of capital. By defending and maintaining old underwater loans at unreasonably high marks, most banks won’t have much room on their balance sheets for new lending. This one consequence of “extend and pretend”: continued tightness in lending for small businesses, which are the biggest job creators.

A Correction in China Looms

It’s likely that the growth we saw in emerging markets in 2009 will decelerate. China’s infrastructure-heavy stimulus package put Chinese people to work and boosted commodity imports from resource-rich countries like Brazil and Australia.

But this stimulus package is leading to excess capacity in real estate and many heavy industries like steel. It’s also gone hand-in-hand with mind-boggling growth in bank lending. Rapid growth in bank lending always leads to trouble.

So the People’s Bank of China (PBOC) is just now tiptoeing towards a tightening policy. The PBOC seems worried about the real estate bubble that’s now becoming more obvious in major Chinese cities. Earlier this week, the PBOC sold three-month bills at a higher (rather than lower) interest rate for the first time in 19 weeks. This is a clear signal to the heavily state-influenced banking sector that it should tighten its loose lending policies. Much of this lending went to finance large infrastructure projects deemed by (often corrupt) communist bureaucrats — not the free market — to be necessary.

This kind of activity can go on for much longer than logic would dictate, but eventually, misallocated resources become too obvious to ignore. Just as the U.S. housing bubble continued a few years beyond when it became obvious (say, in 2005), so can the excesses in the Chinese economy.

The potential catalysts for a correction in China are many, but the most likely would be continued escalation of trade protectionism. This protectionist trend could offer several attractive short ideas in 2010. For example, on Dec. 30, The U.S. International Trade Commission ruled that growth in imports of Chinese-made drill pipe and casing materially injured the U.S. steel industry. The commission imposed 10%-15% tariffs on imports of Chinese steel pipes, with the possibility of further tariffs in the coming months. The Chinese government is allegedly subsidizing its steel industry. This is probably true, but China will likely respond with its own protectionist measures anyway.

The interference of governments into free trade — in the form of both subsidies and tariffs — is not good for the future of globalization. Many of today’s big transnational corporations are built on the assumption of unending globalization. These big corporations are establishing closer ties to politicians around the globe, and many are seeking to game the system or pursue government subsidies rather than serve their customers.

Regards,
Dan Amoss

January 15, 2010

Why We’re Still Headed for a Correction at Home and in China was originally featured in the Penny Sleuth.

The most reliable way for investors to lose money is to buy assets that have been inflated by a bubble. Considering the lofty prices investors are paying for highly cyclical trucking stocks, many must believe that they cannot lose — especially in today’s echo stock market bubble environment engineered by the Federal Reserve and Treasury Dept.

Many stocks exhibit bubble characteristics, having rallied far ahead of evidence that earnings have really recovered. In typical economic recoveries, rallies often occur on scant evidence that fundamentals have turned. But we are dealing with a hangover from a giant credit binge.

This hangover will return after the effects of the stimulus wear off, and it will correct many of the capital spending mistakes made during the credit bubble. Some of those mistakes are obvious, including supply gluts in residential and commercial real estate. But mistakes were also made in asset classes you might not expect, like building too much capacity in the trucking industry.

If businesses react to misleading price signals, they can easily make capital spending errors. Credit bubbles cause misleading price signals. These signals are unhealthy because they act to pull future demand into the present.

This artificially boosted demand sends the signal to businesses to add capacity. Then, once the growth in credit slows, or even reverses, demand can fall far below supply. The industries that were most aggressive during the boom are left with excess capacity. Even the best businesses within each industry suffer from the investment enthusiasm of their peers, which winds up suppressing prices and profits.

Governments, central banks, the banking system, and borrowers worked together to inflate the biggest credit bubble in history. The bubble was so large that most of its fallout cannot be stopped — only delayed. Governments are running huge stimulus programs, which eases and delays the adjustment process. This temporarily restores some of the earlier boom conditions. But sooner or later, prices adjust until supply and demand fall into balance.

Inventories Are Critical for the Trucking Business

As the global economy adjusts to post-credit bubble reality, it remains to be seen how much inventory of physical goods is sustainable. The desire to hold inventory is critical for the trucking industry. Lower demand for inventory and lower final consumer demand translate into less frequent deliveries from 18-wheeler trucks. Inventory is in a constant state of flux, and reflects businesses’ estimates of their customers’ demand.

Most mainstream economists expect inventory replenishment to boost GDP growth in the coming quarters as government stimulus spending wanes. But I have my doubts. Those expecting an inventory replenishment cycle are operating under the assumption that 2006–2007 inventory levels were sustainable.

How much inventory do businesses really need?

This is something that each business must decide for itself. But with hindsight, we know that retailers in particular held far too much inventory heading into the 2008 collapse in retail sales. Inventory planning has its tradeoffs: Too much inventory leads to weak profit margins and returns on capital, while too little inventory leads to missed sales opportunities. The recent buying behavior of many retailers reveals that most are willing to sacrifice sales in order to protect profit margins and are not expecting a quick recovery to peak sales levels.

This nasty recession has forced every business involved with physical trade — from manufacturers to distributors to retailers — to reassess how much inventory is appropriate to hold. The inventory-to-sales ratio provides a rule of thumb. This ratio has historically trended downward as more businesses adopt just-in-time inventory management. But during the 2008 crisis, this ratio spiked as sales dropped much faster than inventories.

According to the U.S. Census Bureau, the economywide inventory-to-sales ratio was 1.3 at the end of October 2009, down from an early 2009 peak of 1.45. This ratio is now back to the 2004–2007 average of 1.3, so unless final demand picks up dramatically, the widely anticipated inventory rebuilding cycle will be tame.

With many businesses still shell-shocked from the crisis, it’s unlikely that we’ll see a rush to preemptively build more speculative inventories. Yet the trucking stocks have already priced in a robust recovery in freight volumes and pricing.

While I think that trucking is the industry with the most downside right now, a similar situation is likely to continue for a number of other industries, including bulk shippers and companies that operate in similar transportation niches. Stay away from these issues until further notice.

[Ed. Note: Some small-cap trucking names worth watching for a downside play include Quality Distribution (NASDAQ: QLTY), YRC Worldwide (NASDAQ: YRC), and Arkansas Best (NASDAQ: ABFS).]

Regards,
Dan Amoss, CFA

December 22, 2009

Why Inventory Numbers Point to a Tame Recovery for Trucking Stocks was originally featured in the Penny Sleuth.

From time to time a substantial story rolls along that, while outside of my normal purview of our direct options, may still have an indirect impact on currency plays — and the Master FX Options Trader portfolio.

Such is the case with the United Arab Emirates, Abu Dhabi, Dubai, and its state-owned conglomerate, Dubai World.

If you heard all the Dubai news over the Thanksgiving weekend and saw the palpable fear on some commentators’ faces, but wondered what it all meant, I’m here today to set things straight.

Let’s begin with just a summary of the region and how it works.

The UAE, United Arab Emirates, is a confederation of seven states (called emirates). The two most well known are Abu Dhabi and Dubai.

The capital of the seven emirates is Abu Dhabi; it is the wealthiest and second-largest city in the group. It also lays claim to the sixth-largest oil reserve in the world. Just to prohibit some confusion, Abu Dhabi is the name of both the capital city and the state it is in, something like New York, New York.

In some respects, Abu Dhabi is like an older, wiser, more fiscally conservative brother to Dubai, which has been rather profligate in its assumption of debt and flamboyant in its projection the state’s image. Being a sort of Las Vegas and Disneyland of the region, it has built a gorgeous skyline, and as its oil revenues have dwindled, they have turned their attention to the money to be made in tourism. But attracting tourists to the desert is a difficult proposition. It takes glitz. It takes glamour. And apparently it takes around $60 billion in borrowed money.

The borrowing, however, was not done by the state of Dubai directly, and is not owed directly by them to any creditors. Instead, Dubai has a state-owned but “independent” company called Dubai World. My guess is that the more problems that stem out of the company, the more “independent” it will become. At any rate, this company has been the driving engine and catalyst for much of the growth seen in the region.

I do not know how much they have spent already. I don’t know how much they have borrowed and repaid up to this point. But that, as they say, is, water under the bridge. What matters is that they have requested a payment hiatus on $60 billion in loans.

The emirate of Dubai has said it is washing its hands of the whole thing. They are not offering a bailout, and they are not guaranteeing the company. This, of course, troubled investors and depositors in Dubai’s banks. Fearing a run on the “company store,” the central bank of the UAE stepped up to the plate and guaranteed all deposits in regional banks. In other words, no reason for the public to be afraid (and frankly, the markets liked that, too).

But what they didn’t say may be just as important — because the speech from the Dubai “Fed” did not offer help to the troubled Dubai World conglomerate. Essentially, since it guaranteed the public’s deposits but didn’t fork over public money to bail the troubled company out, they took the taxpayer right off the hook. If this is truly how it unfolds, then hooray for Abu Dhabi. The U.S. Fed could take some lessons. But the play is not quite over yet. If the UAE is not going to be on the hook for Dubai World’s excesses, who is? Who actually lent all this money out in the first place?

Actually, it looks as though the United Kingdom could be the hardest hit. Half of that debt is owed to banks based there. Some $13 billion of that money is on loan from the Royal Bank of Scotland and Standard Chartered; another $17 billion is from HSBC, whose stock fell from $62 down to $58 on the news.

Since the United Kingdom is still struggling to get any kind of recovery started, the news weighed heavily on its currency — at least initially. More bad debt on the books is not exactly what it needed at this point. Since the United Kingdom has already been issued a warning by Fitch about its sovereign debt rating, it certainly does not want an increase in borrowing costs for their gilts. This only adds to that burden.

But the world of finance has some pretty big bullies in it. I would think it highly likely that Abu Dhabi would be the subject of great external pressure if the situation remains wobbly. And this pressure could lead them to the conclusion that Dubai World is “to big to fail.”

That would relieve the pressure from the Eurozone (which has exposure by way of Germany) and U.K. banks. Beyond all doubt the West has financed itself up to its eyeballs, and one on this side of the world is willing to tack on a little more. RGE’s Nouriel Roubini is already predicting that the cost of U.S. bailout debt will rise from 40% to 80% of GDP. Not much room to borrow there.

And certainly Europe won’t be volunteering much help, because it’s having troubles of its own. It was recently announced that the cost of financing Greece’s debt has grown equal to that of Turkey’s debt… at one time considered a far more risky proposition. Should those individual countries continue to add to the red side of Europe’s ledger, some of the other larger states will need to jump in and bail them out. In the past, I’ve talked about the PIGS of the Eurozone: Portugal, Ireland, Greece and Spain. Add them to the increasing troubles in Lavia, Lithuania, Estonia, Belgium and Hungary, where foreign debt now exceeds 100% of GDP, and the “camel’s back” grows increasingly weaker.

But I digress. Back to Dubai… and Dubai World. CMA Datavision, a credit market tracking company, puts the chance at a full default of Dubai World at just under 36%. And while that would be bad for banks, it could have real effects in the commercial real estate market. Dubai World has some of the world’s premier properties under its control, including the world’s largest skyscraper and a series of man-made islands that resemble a palm tree and a world globe. Such things do not come cheaply. And they only have a limited application in terms of profitability. But if they go belly up, and are allowed to fail, that could make the sound of the “other shoe dropping” in the real estate venue. And considering that Abu Dhabi just gave Dubai a $10 billion bailout back in February, they may not be so anxious until some other pressure is applied.

Of course, the $60 billion of debt that Dubai has racked up is just a drop in the bucket compared to the TRILLIONS (that’s with a “T”) that have already flooded the market from other stimulating economies. David Buik, an analyst at London-based BGP Partners, figures the trouble in the UAE won’t amount to more than just an “unfortunate public relations exercise by Dubai.” We shall see how this unfolds and whether or not the ripples dissipate or turn into bigger waves.

And we’ll keep that in the back of our minds as we explore the news elsewhere around the globe.

Until next time,
Bill Jenkins

December 3, 2009

Understanding Dubai’s Debt Problem was originally featured in the Penny Sleuth.

Rising living standards in emerging markets is a powerful investment trend. There are many reasons to expect this trend to continue. But central bankers and politicians all around the world, who think of ways to “improve” every possible situation with their enlightened meddling, are acting in a way that promotes future crises.

The most powerful, influential meddling right now is happening in the currency markets. By flooding the system with liquidity, and promises of much more liquidity, central banks have fueled the 2009 rally in “risk” assets.

The Federal Reserve’s zero interest rate policy has been the most important factor in financial markets for months. This policy is acting as an accelerant for money supply growth in many emerging economies. As Jim Grant says, the U.S. is the world’s reserve currency, so the Federal Reserve is the world’s central bank.

The U.S. dollar carry trade is prompting “hot money” to flow into countries like Australia — those with upward-trending currencies and short-term rates above zero. The Fed’s outlook for inflation focuses myopically on outdated, industrial-era statistics like the “output gap,” while its loose monetary policy fuels dangerous, unproductive bubbles.

The promises of limitless free money from central banks also embolden the big spenders in government, who are ramping up the GDP figures (but destroying real capital) at unprecedented rates. Without the belief that “quantitative easing” is available to finance deficits, big spenders in government might think twice about having to pay higher interest rates to borrow from the bond market.

The policies of central banks are also aggravating dangerous imbalances in the global economy. Countries that traditionally rely on exports are upset. With President Obama embarking on his first official visit to China next week, the issue of the dollar/renminbi peg is at the forefront of concern.

As the U.S. dollar index weakens, so does the exchange rate of the Chinese renminbi versus floating currencies like the euro and the Japanese yen. This translates into an effective price cut for American and Chinese exporters, without the typical hit to profit margins. European and Japanese exporters are suffering from what they consider to be an unfair playing field.

Debasing the value of a currency is an old-fashioned way for politicians and central banks to subsidize politically powerful exporters. Cheap currency policies are widely popular among the bureaucrats and central planners that populate the halls of academia and policymaking. But over long periods of time, the quality, efficiency, and productivity of an export sector will determine its success — not whether it’s located in a nation with a weak currency.

Like doping in sports, a weak currency gives exporters a price advantage against its competitors. But once too many countries get involved in this “mercantilist” type of policy, it transforms into an ugly race to the bottom. In the end, the average citizen is impoverished by diluted purchasing power.

Policies that actively weaken currencies are not good for the health of the middle class. Our “bail out bank shareholders and bondholders at any cost” policy is a hidden long-term threat to the health of the U.S. middle class. And the stimulus spending and inflation created by the Chinese Communist Party is a threat to the emerging Chinese middle class. This wasteful spending doesn’t appear to have a cost right now, but those costs will become obvious in time.

An August 2009 report from asset manager Pivot Capital Management has gained notoriety in the press lately. The report, China’s Investment Boom: The Great Leap Into the Unknown, captures the bear case for China.

Some of the themes outlined in his report will relate to Strategic Short Report’s future short ideas. In preview, Chinese central planners are blowing massive bubbles in asset-heavy industries like steel and cement. The ultimate returns on capital invested in these sectors will be nonexistent or negative. You can download the PDF version of Pivot Capital’s report at this link.

It remains to be seen whether positive global trends like advances in technology and education and the post-Soviet era trend toward freer markets and stronger property rights will overcome negative trends like the “white elephant” projects that will inevitably result from stimulus spending.

There certainly will be winners and losers in China’s capital spending bubble, and we’ll be targeting the losers.

Regards,
Dan Amoss

November 24, 2009

How to Profit from the Coming Currency Crisis was originally featured in the Penny Sleuth.