Hip Dysplasia

The investment and political worlds have, to borrow a phrase from The Lord of the Rings, “abandoned reason for madness”. This shouldn’t surprise anyone. Politics, like investing, is driven by emotion, not logic.

Still, watching investors make the same mistake time after time is like watching an old golden retriever of mine. Retrievers are great dogs, and usually smart. But as they get older, they get hip dysplasia. The ball and socket joints in their rear legs deteriorate, and it makes it hard for them to get around.

As a young dog, my retriever (Riven was his name) would chase a tennis ball all day. No side affects. As he got older, he slowed down. But it wasn’t really a problem until I moved into a two-story log house in Colorado. My bedroom was upstairs, and the steps weren’t carpeted. They were made out of varnished pine logs…which made them slippery. Riven found this out the hard way.

I woke up one morning to find him sleeping at the foot of my bed. When I got up to go downstairs for coffee, he followed a few steps behind. Then I heard his dog toenail scratch across the top step. I looked back to see him surfing down the stairs, front legs out in front of him like Superman, gaining on me quickly. I jumped the last few feet to get out of the way and turned around to see him crash, muzzle first, into the cabin wall.

It’s okay to laugh. It looked funny. But from then on, I stopped him from following me upstairs whenever I could. But dogs are loyal…and when Riven’s loyalty trumped his memory, he paid for it.

The Last Bull Market: What Used to Be Hip

I can’t help thinking about this story when I see investors piling into tech stocks. These pavlovian investors are asking for it. Those investments may have been hip at the top of the bubble…but, as history shows, it simply makes no sense to keep investing in the best-performing stocks of the previous bull market. Especially when there’s a much better way.

Let’s take oil as an example. There’s a good chance that in a post-Saddam Hussein Iraq, oil production is going to rise. Rising production will likely lead to lower global oil prices. Big American oil companies won’t do as well in a free Iraq as they’re doing right now. But oil-service companies could do better.

This is a simple, direct piece of geopolitical investment analysis. Yet most investors take it and do exactly the wrong thing. Thinking in old terms, investors conclude that if oil prices fall, this is good for the economy…and if it’s good for the economy, it’s good for the stock market…and if it’s good for the stock market, well then it must be time to buy tech stocks!!!

So, the poor saps run out and buy the most popular stocks from the last bull market – AOL, Lucent, and GE, to name a few.

The obvious problem with this strategy is that you’re exposed to all the risk of a falling market, while your upside is limited to whatever the broad market does. Put another way, if you choose to buy the biggest names because they’re “safe”, you take all the risk of owning an individual stock in today’s market – fraud, disappointing earnings, leadership in the negative sense – while limiting your profits to broad-market moves.

The Last Bull Market: Regroup and Charge!

Yet investors keep regrouping and charging right back into the biggest names in the market. For example, even though it’s down from a remarkable $1 trillion (in 2001), Fidelity still has over $700 billion in investor funds under management in its family of funds.

Watching investors in this bear market is a lot like watching my dog charge up the stairs after me, and then realizing he’s in trouble. If you’re investing in today’s market with yesterday’s techniques, there’s no easy way down.

Instead of doing the reflexively obvious thing – going long stocks – it makes much more sense to pick an investment that profits if you’re right, but minimizes your risk if you’re wrong. A simple goal. But a lot easier to achieve today with the emergence of “exchange traded funds” (ETFs), iShares, and HOLDrs.

I hesitate to say that ETFs are “the next big thing” – mainly because that would be tantamount to cursing them. Plus, you can buy these new vehicles exactly the same way you’d buy a stock, which means they’re not exactly revolutionary.

But the great advantage of ETFs is that you can invest in general geopolitical insight, like an observation about oil production in post-War Iraq, without exposing yourself to the collateral dangers you get in a mutual fund or a single stock. You can almost always find a liquid ETF to buy for any idea you have. The expenses are low compared to funds. You can use limit orders and stop orders. And, unlike a big Vanguard fun, you can trade intra-day, rather than being locked into the closing price.

The Last Bull Market: Investing in Specifics

With this next generation of investment vehicles, you have a lot more flexibility to invest in specific ideas. What’s more, if you’re inclined to trading rather than investing, you can buy put or a call option and make it even simpler. In fact, looking at our Iraq example, there are several different oil service indexes for which you can buy options. The Philadelphia Euro Style Oil Services Index (OSX), is but one example.

When I look for the best vehicle, I look for something that’s liquid and leveraged. For my money, there are two attractive options. The first is the Morgan Stanley Oil Services Index (MGO). This index gives you exposure to 28 oil service companies. And its chart shows that it’s more responsive to fluctuations in the price of crude.

The other is an Oil Service “HOLDR” (a specific type of ETF) traded on the Amex, which gives you exposure to the ten biggest oil service stocks in the industry. And it gives you leverage and liquidity in your call options. Once you’ve got it narrowed down to this vehicle, then it’s just a matter of selecting the best option.

As a trader, this my preferred method for speculating on the direction of the indexes. I usually look for either near-term, in-the-money call options if I’m bullish or long-term, out-of-the-money put options if I’m bearish.


Dan Denning
For The Daily Reckoning
February 27, 2003


The Rue Vivienne is a street in Paris which runs from the Bourse up towards Pigalle – that is, from the stock market to the red light district…or from one group of whose virtues are for sale to another whose virtues are both more affordable and more enjoyable. It is to this street that you must go if you want to buy gold coins. But the street’s coin vendors greet you as if you were applying for a bail bond. You stand in front of a small window in a tawdry stall of shop…like a ghetto liquor store…and count your change carefully.

Buying gold is not as easy as buying stocks. Taking advantage of last week’s trip to America, and a $25 per- ounce drop in the gold price, your editor decided to load up. But a call to one coin company went un-answered. Another informed us that Krugerrands were in short supply and could not be immediately delivered.

Your editor left America disappointed and empty handed. But his faith in gold was confirmed. No shortage of shares in Amazon.com nor GE has ever occurred. Nor has any lone biped with money in his pocket ever had any problem buying them.

If the shortage in Krugerrands persists, the South Africans will mint more of them. But they will not be able to create them out of thin air “at virtually no cost” (as Fed governor Ben Bernanke described dollar creation at the Bureau of Printing and Engraving). At current prices, each one-ounce coin costs about $364 and contains about $354 of gold. Plus, there is the actual cost of minting and distributing the coin.

Most investors and financial analysts are amazed that anyone would want to buy gold at all.

“It’s mainly war talk that is driving gold higher,” explains a report in the Detroit Free Press. Gold is thought to be the duct tape and plastic sheeting of the investment world – the last resort of the paranoid, the hysterical and the delusional.

Will the price of gold collapse after the ‘quick and easy’ war is over? We do not know. But yesterday the Bush administration asked for $95 billion to fund the war effort. This pushes the federal deficit to well over $1 billion per day. And there is the U.S. trade deficit, too – more than $1 billion per day. Where will all the money come from? Not from Krugerrands. Most likely, the Fed will create it…at virtually no cost to itself, but huge cost to dollar-based investors.

On September 10, 2001, an ounce of gold could be bought for $271.50 per ounce. The central banks of the world – the very same banks whom people believe to be capable of seeing into the future and improving it – were selling tons of it at this price. By February 2003, gold was selling for $100 more.

Even central bankers must have noticed. Seventy-five percent of their reserves are in dollars – and losing value – while the gold they sold rises. How long will it be before we spot Bernanke, Duisenberg and Hayami on the Rue Vivienne?

We will see.



Eric Fry, reporting from New York…

– Another sloppy day on Wall Street. Stocks sloshed around most of the day before running amuck in the afternoon. The Dow slipped 102 points to 7,807 and the Nadsaq dropped 25 to 1,303. Meanwhile, the safe-havens attracted safety- seekers once again. Gold gained $1.70 to $354.10 an ounce and oil gushed $1.69 to new 12-year high of $37.75 a barrel.

– Meanwhile, government bonds continued their incredible ascent, as the yield on the 10-year Treasury note dropped all the way to 3.77% from 3.82% on Tuesday. It’s hard to believe that bonds could sustain a strong rally in the face of soaring oil prices, imminent war and rising government deficits. But when have the financial markets ever been rational? Perhaps bonds are simply the latest bubble to come floating out of Alan Greenspan’s macroeconomic bubble bath.

– Tuesday afternoon, Hewlett Packard proudly trumpeted quarterly earnings that exceeded Wall Street expectations. Unfortunately, investors didn’t buy the hype, as the stock tumbled more than 15% yesterday. HP “beat the number” all right, but not the right number. Revenues fell well short of expectations, and that was the number that mattered most to investors.

– Helwlett’s quarter was not without notable achievements, however – foremost among them was the company’s groundbreaking contribution to the Wall Street lexicon of deceptive euphemisms for earnings. Hewlett’s contribution: “non-GAAP earnings.”

– Hewlett’s press release states: “Non-GAAP(1) (formerly reported as pro forma) operating profit totaled $1.1 billion, up 25% sequentially…Non-GAAP diluted earnings per share (EPS) for the quarter was 29 cents, compared to 24 cents in the fourth quarter, up 21% sequentially…”

– Move over, “pro forma”…”non-GAAP” is the new kid in town! The term, translated loosely, means “non-earnings earnings”. For those of you who do not read accounting textbooks for pleasure, GAAP stands for Generally Accepted Accounting Principles. And GAAP earnings are the only ones that qualify as the real deal. GAAP earnings, for example, are the ones that appear in a company’s annual report.

– Of what possible use to common shareholders is a calculation of non-GAAP earnings? Couldn’t non-GAAP earnings be just about anything, including non-earnings? Are shareholders really clamoring to know non-GAAP earnings? Wouldn’t that be like standing in a long line at the grocery store to buy “non-fish” fish? To be sure, supermarkets would try to sell non-fish fish all day long, if they could find buyers for the stuff…and that is exactly what companies like Hewlett Packard are still trying to do.

– The issue is not merely a semantic one. Hewlett’s audacious “earnings” report shows quite clearly that the game-playing continues on Wall Street. Even now, in the putatively “clean” post-Enron era, many U.S. corporations find it difficult to shake their proclivity to deceive. What’s more, S&P 500 companies have been reporting non- earnings earnings for so long, that very little of the real stuff remains.

– “David Bianco of UBS Warburg reports…that from 1991 through 2000 GAAP earnings accounted for 84% of operating earnings,” Barron’s relates. “Put another way, one-sixth of companies’ bottom lines came from things that GAAP does not deem ‘real’ earnings. Then came the write-off derby and profit recession of 2001-2002, when only a little more than half of operating earnings – the kind that analysts try to forecast – counted as GAAP earnings.

– “Only eight S&P 500 companies reported ‘pro forma’ earnings that equaled GAAP earnings for each of the last 12 quarters, and 85 of the companies never once had the earnings measures they emphasized in their press releases conform to GAAP.

– “The coming rules and the related effects on corporate reporting practices could shave as much as 10% off the published earnings forecasts for S&P 500 companies, Bianco figures. Going a step further, Bianco estimates that ‘poor quality earnings’ in the form of unearned pension income, employee-stock option costs and off-balance sheet transactions might make up $10 of the expected $52 per share in S&P 500 earnings projected for 2003.”

– In other words, honest earnings – let’s call them “earnings earnings” – for the S&P 500 are probably closer to $42 than $52, which would make the S&P 500’s “real” P/E closer to 20 times earnings than 16 times earnings, neither of which would qualify as a bargain.

– Anyone for some non-bargain bargains?


Back in Paris…

*** Greenspan does not seem to want another term. Deficits DO matter, he told Congress last week…and taxes shouldn’t be cut – thus contradicting the Bush bunch and ensuring his retirement.

Alan is not alone in his thoughts. “It’s bad enough for tax-cutters that Greenspan came out against them,” says Dan Denning, from whom we’ll hear more below, “but now the man behind the Bush tax plan, Glenn Hubbard, is leaving government and heading back to academia. As of Friday, Hubbard will no longer run the President’s Council of Economic Advisors.

“I don’t know if this means the tax plan is headed for defeat…but the twin deficits (trade and Federal) aren’t just theoretical economic issues anymore. They’re starting to end careers in Washington. Maybe deficits aren’t all bad after all….”

*** Greenspan’s reputation is roughly the inverse of the gold price. When gold was at an epic low – in the late-’90s – every word about the Fed chairman was flattery. But now we are three years into a bear market…with rising unemployment and bankuptcies. Why didn’t Greenspan puncture the bubble when he had the chance, people wonder? Gold gleams, while Greenspan’s reputation rusts.

“Why didn’t I retire when I was still on top of the world?” Greenspan must wonder to himself. He could have followed the (rare) example of Roman emperor Diocletian, who voluntarily resigned at the peak of Rome’s power…and subsequently enjoyed a quiet life growing cabbages.

*** What will America be like in the post-bubble world? Many times, have we looked at Japan for an example. But the Japanese had huge savings…and were net creditors to the rest of the world. In the years following the collapse of the Tokyo stock market, the yen actually rose in value, and the Japanese continued to live well.

Maybe Argentina is a better example. Last year, the Argentine economy fell 10%. The peso lost 70% of its value. And consumer prices rose 40%. Half the population lives in poverty, say press reports. Crime is rising. But it is not all bad news. You can buy a $300,000 apartment in Buenos Aires for less than $100,000, reports my friend Lief Simon, who is currently looking for bargains south of the Rio Plata. And trendy restaurants offer all-you-can-eat specials for less than $10.