All-Source Investing

“The September 11 story, therefore, should be an object lesson in the perils of failing to share information promptly and efficiently between (and within) organizations, and in the need to ensure that intelligence analysis is conducted on a truly ‘all-source’ basis by experts permitted to access all relevant information – no matter where in the intelligence community it happens to reside.”

– U.S. Senate Select Committee on Intelligence Report, “September 11 and the Imperative of Reform in the U.S. Intelligence Community”; Additional Views of Senator Richard C. Shelby

The capture of al Qaeda thug and John Belushi look-a-like Khalid Sheik Mohammed was a huge achievement for the U.S. intelligence community. With luck, President Bush may soon be able to put a big red “X” across the face of bin Laden on the most wanted list he keeps in his Oval Office Desk.

While we appear to have some momentum in “huntin’ down” al Qaeda’s network, it would be a mistake to think the U.S. Intelligence Community is operating well. It isn’t. And remarkably, the problems facing intelligence community are quite similar to the problems facing investors.

First, take an example from the intelligence world. Prior to 9/11, the CIA had intelligence showing that two of the eventual hijackers, Khalid al-Mihdhar and Nawaf al-Hazmi, were living in San Diego under their own names.

All- Source Investing: TIPOFF

Under internal rules, the CIA is required to provide a “watch list” of suspected terrorists to a system called “TIPOFF”. (TIPOFF is a searchable database shared by consular or Immigration and Naturalization Service officials checking Visa applications.) The CIA did not put al-Mihdar’s and al-Hazmi’s names on TIPOFF list. Both men left and reentered the country freely, completely unmolested by the INS. In fact, in a March 2000 internal memo, the CIA noted the presence of both men in the country – but added this remark: “Action Required: None, FYI”.

The intelligence community made many such errors leading up to 9/11. Significantly, there was a common reason behind most of their mistakes: the complete collection of source intelligence information never seemed to get into the hands of someone capable of making probable connections. Of course, there’s no guarantee those connections would have been made. But under the current regime – where analysts simply aren’t getting the full intelligence picture – the intelligence community is almost doomed to fail.

Intelligence analysis, like investment analysis, is not a matter of spotting the obvious. If it were that easy, there would be no terrorists, and we’d never buy bad stocks. Instead, good intelligence or investment analysis means reaching probable conclusions based on a variety of sources of data. A good investor analyzes all the data he has to detect patterns or signals telling him what to expect…and naturally, how to prepare.

It’s an inexact science. You won’t always be right. But there are three keys to doing it well: using all the sources at your disposal, recognizing informational patterns, and constantly re-evaluating what you know as the context changes.

All-Source Investing: Dow 3100

Let’s take an investment example. Last week, Michael O’Higgins, author of the famous ‘Dogs of the Dow’ strategy, gave an interview in the Miami Herald. In the interview, he said that in the best-case scenario, the Dow would probably fall another 25% to around 6,000. Then he added this cheerful note: “When you say it can’t be like 1929 through 1931 [when stocks lost 89% of their value], you’re right. It could be worse.”

O’Higgins’ worst-case scenario is Dow 3,100. Since that’s a forecast I’ve made in the past, I thought I’d use it to illustrate the “all-source” method of investing.

Under the “all-source” method, you start with historic stock valuations and examine the patterns of previous boom- bust cycles – just as O’Higgins did, looking back at the aftermath of ’29. This provides the historical context.

Then you move to the present, analyzing background “noise”…which, in practice, means looking at current stock market and economic news. Using the sources I have in the Strategic Group, I’ve reached a stark assessment: the economic fundamentals in the United States are bad and getting worse, which is obviously bad for stock prices.

When your general forecast is bearish, the natural question to ask is, “Who has the most to lose?” This is not always the best question, of course. Even in bear markets, there are some exceptions. And in those cases, your question is equally simple, “Who has the most to gain?”

But in this case, O’Higgins dire Dow forecast happens to correspond with mine: namely, that the leaders of the past bull market are never the leaders of a new bull market. The next bull market won’t be led by Cisco, Microsoft, Dell, Intel, and Oracle. It’s likely to be a totally different asset class (my guess is hard assets).

But investors prefer chasing old losers – like finally getting the cheerleader from high school…but at your 20th reunion, when she’s forty pounds heavier and her anatomy no longer defies the laws of gravity. A better strategy is to avoid the old leaders and mercilessly profit from their demise. The obvious question that follows is: “How?”

All-Source Investing: Shorting

Of course, you could buy puts on the Dow 30. But I’ve gone one step further. I’ve picked ten particular Dow stocks – the ones with the highest dividends – and “shorted” all of them by buying puts. I picked the dividend payers because if the dividend of the average Dow stock goes up (as it must and has historically done before stocks trade at reasonable values), the current top-10 dividend payers are going to loose their present appeal. They’ll soon have plenty of competition. Paying a fat dividend won’t be enough to make them attractive, especially amid such dismal business conditions.

But I’ll let the cat out of the bag: I also picked them because there’s a way to buy all ten top Dow dividend payers in one single stock. Better yet, there’s a way to short them, or buy puts on them all at once.

The vehicle I’ve picked is an exchange traded fund (ETF) composed of an equal weighting of the Dow’s top 10 dividend payers. It was a happy coincidence that some of the components were also on my list of “toxic” stocks to avoid, or stocks I’ve shorted and bought puts on in my trading service, Strategic Trader Alert. Prominent names include J.P. Morgan, SBC Communications, and General Electric. If you’re bearish, or just realistic, it’s a nice combination of tired old tech, financial, and blue-chip leadership from the last bull market. They all have a lot to lose from a falling Dow.

Will this play be a huge success? As with any strategy, there’s no guarantee. I’ll keep you posted.

But remember that “all-source” investing means not confining yourself to pure balance-sheet analysis, or analyzing only economic conditions, or exclusively trying to figure out how changes in global politics affect investment values. You cannot adopt any one of these strategies well without adopting all of them – or in other words, looking at the more complete picture all of them together can give you.

In the end, there’s still no guarantee that your analysis of the available source information (no matter how complete your sources) will be accurate. Even the best data is useless in the hands of a poor analyst.

However, in the hands of an analyst with a sound knowledge of economic and financial history, access to real-time market data, and a specific “tool-bag” of investments designed to maximize your gain and minimize your risk, your chances of surviving the coming crash are a whole lot better than blindly believing in any single approach.


Dan Denning,
for the Daily Reckoning
March 10, 2003

P.S. The Intelligence community has its flaws. But it’s not usually with the people on the front lines. I got a note from a family friend last week. He’s in Afghanistan, as Captain of a Special Forces Unit.

He had this to say: “Will be leaving in a few hours, as I have been asked to participate in an extended visit of the local countryside to familiarize myself with the local flora and fauna, and so will not be able to respond for some time.”

I hope that some of that fauna happens to be about 6’5, bearded, and marching in front of an M-16.

Even if we do get bin Laden, the next month is more likely to be dominated by Iraq. And in our “all-source” context, this is a good time to ask, “Who has the most to gain from a free Iraq?”


“Payrolls plunge by 308,000 in February,” says a Reuters report. “Hundreds of companies may slash pensions,” adds CNN. “Pilots’ retirement threatened by airline losses,” notes the Washington Post.

The U.S. economy “may be slipping back in recession,” declares another article.

“Chronic budget deficits forecast,” continues the Washington Post…

Let’s see…

Record trade deficits…record federal deficits…

Stocks still preposterously high, while profits and capital investment lag…

And even though consumers are furiously refinancing in order to take advantage of the lowest rates since the ’50s, consumer spending is dropping as saving rates rise…

Where does this lead?

For the last 3 years, we have been pointing East…as in the Far East…as in the Land of the Rising Sun. If that is where this leads, Daily Reckoning readers have cause for concern, but no reason to put a gun to their heads.

Japan’s unemployment rate just reached 5.5% – its highest level since WWII. But in the U.S., 5.8% of working stiffs are not working, which is not so bad.

And the Nikkei just made the news, too – falling to 8,144 last Friday, its lowest level since 1983, wiping out 20 years of gains. If the U.S. were to continue following the Japanese example – with a lag of 10 years – Wall Street’s Dow will sink to 3,355 by March of 2013. (In our typical cheery way, dear reader, we give you something to look forward to…)

Still, no collections are being taken in church destined to feed the poor in Japan. By all accounts, the Japanese are still living well – even after 13 years of on-again, off- again recession, a bear market, and deflation. If only we should be so lucky! But after writing a book on the subject, we have come to believe that the U.S. will not follow Japan after all, for two reasons. First, Japan entered its slump in a very good economic position; its people had a thick cushion of savings on which to fall. And then, Japan had no geo-political ambitions.

All the many circumstances which were so favorable for America at the end of the 20th century seemed to have turned against her at the beginning of the 21st. Her people are deep in debt; many are nearing retirement – with little resources set aside. Her currency is weakening. And she is beginning expensive military campaigns…at a time when she must rely upon foreigners to lend her money. How will she manage? She must almost certainly betray her creditors by destroying the dollar. But how? When?

We will have to wait to find out…



Eric Fry, reporting from New York…

– Something vaguely resembling springtime arrived in New York City over the weekend. For what seemed like the first time since August, the mercury inched above 40 degrees. The chilly conditions on Wall Street also thawed a bit at week’s end. On Friday, for what seemed like the first time since August, the Dow converted a steep 100-point decline into a respectable, 66-point advance.

– The one-day wonder was not enough to lift the blue-chip index into the black for the week, but it was a welcome moral victory, just the same. For the week, the Dow slipped 151 points to 7,740, while the Nasdaq slumped nearly 3% to 1,350. The Dow still remains squarely within the trading range of 7,600 to 8,100 that has bracketed the index since late January. What’s next for the blue chips? North of 8,100 or south of 7,600?

– Notwithstanding the worrisome “fuschia alert” signaled by the Paris office of the Daily Reckoning, the New York office continues to expect the Dow to head north of 8,100, before resuming its epic bear market…At least, that is our guess. (If it fails to rally, however, we are fairly certain that it will fall.)

– There is, to be sure, absolutely no reason why stocks ought to rally anytime soon, except that everyone seems to expect a continuing decline. However, stacking up against this touchy-feely contrarian rationale for a rally are innumerable negative factors – a dismal job market, sluggish retail sales, soaring oil prices and a looming war in Iraq, to name a few.

– “Last week brought fresh evidence of how down the economy is,” writes Alan Abelson in today’s Barron’s. “The Institute of Supply Management began [last] week with a discouraging report…Particularly ominous was that new orders fell off a cliff last month and so did hiring…The unemployment report for February was, to put it mildly, an unmitigated disaster: 308,000 jobs were lost…And to judge by the recent surge in weekly claims for unemployment and other disturbing soundings, this seems destined to remain very much a jobless recovery – and we’re starting to wonder about the recovery part.”

– Mr. Market has fallen on hard times, no question about it. His downward spiral since March of 2000 resembles the first half-hour of an “‘E’ True Hollywood Story” – a schmaltzy, formulaic, made-for-TV biography. The show’s first half-hour is when the rock star/celebrity with a mega-hit record gets all the drugs and girls he could possibly want. But then, his career hits the skids and he hits “rock bottom”…even contemplating suicide.

– (During the second half hour, the down-and-out former rock star goes through rehab and gets his life “back together”. Finally, at the age of 50, he’s happier than ever, making cameo appearances on “Will and Grace” and playing small clubs with his new band.)

– Unfortunately, Mr. Market is still stuck in the first half hour of his “True Hollywood Story”. He has not yet gotten his life back together, and he’s still in the down- and-out, suicidal phase. Will he EVER make it into the second half-hour?

– During the late 1990s, Mr. Market certainly achieved rock-star status. He possessed a strikingly handsome profile and he tossed money around like confetti. Who wouldn’t love a guy like that? But then his star crested. Just three years after becoming the talk of the town, he hit rock bottom. All of his former Wall Street groupies and hangers-on have scattered, denying they had ever befriended him. And all of his former strategist-buddies now say they never really liked the man that much.

– We’re all saddened to see Mr. Market fall to such a low estate, and we’re pulling for him. Unfortunately, the road to redemption is paved with repentance. And there is little sign that investors have turned away from their former sins.

– From the looks of things, most investors have not yet repented of paying bull market valuations for stocks. They continue to view 30 times earnings as a “reasonable” valuation, instead of a damnable excess.

– In other words, investors must acknowledge the error of their former ways in order to clear the path for a new bull market. A little more weeping and gnashing of teeth – not to mention donning of sackcloth and ashes – might be necessary before redemption will arrive on Wall Street.


Back in Paris…

*** The price of April gold dropped $6 on Friday. This is good news for those of us who are buying…but it is puzzling. How could the price of gold fall when the dollar fell too? And how could stocks manage to climb – however modestly – in the face of so much bad news and so many risks (not to mention our own Fuschia Alert signal)? You don’t think anyone would be fool enough to try to manipulate the markets, do you? We don’t know, but the last thing the Bush Administration would want, on the eve of its war against Iraq, would be crashing stocks and soaring gold.

*** Today is the 3rd anniversary of the Nasdaq’s peak. Will it fall a 4th year? Maybe…bear markets usually continue until they have erased ALL the previous bull market’s profits in excess of the very long-term trend. The occasion passed without much fanfare in the office, but we will raise a glass to the New Era later on tonight.

*** What a strange war! The papers report that Iraq is actively destroying its weapons. We have never understood the administration’s war aims, but shooting a fellow who has put his gun down just doesn’t seem very sporting, even if he still have a knife in his boot. Alas, the lure to empire is probably irresistible.

*** “I was went to the Salon d’Agriculture,” replied Edward this morning.

The question was, “What did you do this weekend?” And the answer conveyed the necessary information, but without the customary grammar.

Edward, 9, has spent his entire educational career in French schools. His French is not bad, but his use of the Mother Tongue is sometimes alarming, and usually mixed with French words.

Your editor wishes his French were as good as his English. The task seems impossible; native French speakers cringe every time he opens his mouth. But Edward gave him an idea: he will not try to speak French better; instead, he will speak English worse!

So, until he write again…tomorrow…

The Daily Reckoning