Archive for June, 2008

I try to stay as far out of political journalism as possible, because everything seems to boil down to subjective oppinions which have little substance. This article on Bloomberg is a prime example:

Higher taxes for hedge-fund managers and oil companies will not cover anticipated Obama tax cuts for the poor and middle- class, universal health care and aid to the depressed residential real estate market, said Gross, a long-time Republican.

Democrats, historically speaking, are ones who emphasize budget surpluses…

Bill Clinton may have made several questionable calls in his presidency, but he was smart enough to surround himself with the people who knew fiscal policy. Barack Obama, if only because of his age alone, should not be someone who believes he can execute on every issue that faces the US, and as a result, will likely do the same as Clinton. There is already speculation that he will bring Bob Rubin back as Secretary of the Treasury, which in my oppion, would be a monumental upgrade over Hank Paulson.

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This is some market, but as Warren Buffet says, “when everyone gets scared, I get greedy.”

That is not to say that this downturn is over, but something tells me we will have a relief rally next week. Just a hunch, but it will be the end of a REALLY bad month (down 8.5%), it’s a short trading week before America’s holiday celebrating our independence, a light earnings week, and the market has responded to every bottom of this year with a rally.

That said, Bloomberg pointed out an interesting statistic today:

The Chicago Board Options Exchange Volatility Index, or VIX, rose 13 percent to 23.93 yesterday, leaving it 26 percent below the 2008 high. The Dow is poised for the worst June since the Great Depression after record oil prices and credit-market writedowns sent the average to its biggest drop in three weeks.

The VIX is a gage for the market’s volatility, and we have not had that much of it relative to prior short-term bottoms. I am not enough of a statistician to interpret what that means for today’s market but Cramer came out with a surprisingly good insight:

The negativity coming into today’s session is as thick as I can recall nearing most short-term bottoms. The issue is there is not enough fearout there. Despite the consensus, which obviously creates a need for lower prices before it is worth buying, there isn’t a big spike in the VIX, there isn’t a gap down, or a crescendo of selling. There isn’t even any volume. So while the bearishness is real thick, the selling isn’t. (Bloomberghad an excellent piece on this yesterday, noting how much lower the VIX was than at other bottoms.)

There sure is a lot of gloom and doom out there.

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Jim Kunstler


He’s an utterly cynical bastard, and I’ve never seen him this angry in a post. Brace yourself if you’ve never read his material before…

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There are several applications of the Law of Diminishing returns, most commonly used in reference to marginal production of labor (which I could not find a good chart of), but in this case we also have an example of optimal power use.

There are also practical applications of this law to the markets, and stocks themselves. Companies are first bought for their growth prospects, and inevitably they mature; Citi, GE, or any company in the Dow Jones Industrial Average.

Citi and GE are examples of companies which have simply grown to be too large (Citi has a balance sheet of $2.2 trillion, and GE has a market cap of $283 billion). Its not that they are not competitive in their respective industries, its only that they have limited upside due to lack of further growth (As you can see in the chart above, 1 share of GE is practically worth the same nominal amount after 5 years) . For example’s sake, lets say Berkshire Hathaway acquired a small cap materials company which doubled its returns one year after the acquisition; those profits would be negligible on Berkshire’s balance sheet.

This has been an inconvenience to investors in the United States for a while, as we are maturing as a nation. The addition of billions of dollars to our GDP amounts to a very small amount regarding the total (its been near 1%-2% per year), hence the diminishing returns. No wonder hedge funds/Investment banks are levered 25 to 1…25 times 2% turns into a good return, but it comes with consequences when abused, as we have seen.

Finally, the question; what does this mean for the future of the US? we have had some bad recessions including the tech bubble, but this one is being lead by financial instruments which got out of hand, and driven further by bad bets (This is not reminiscent of old fashioned value investing).

Perhaps this is why we have witnessed a shift to stocks which have natural growth prospects, ones which have exposure to demand driven markets: Rio Tinto, Vale, Southern Copper, Monsanto, Potash, US Steel, XTO, Apache, and Petrobras.

Materials and Energy are emerging as secular themes in global markets, and this may be the beginning of a trend which leaves the US in the dust as a global importer of raw materials…after all, we’re only a nation of 340 million people, where as China and India make up close to 3 billion combined (or half of the world).

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This is a particularly interesting issue if we consider the long-term future of refiners. I, for one, am a buyer of peak oil. It seems as though no one can verify the amount of oil the Saudis claim to have (maybe this is why their relief efforts have provided NO RELIEF in crude futures market), and the only new discoveries in recent years have come off shore in deep waters, which by definition are harder to come by because of their deep locations.

Petrobras seems to discover these types of oil fields all the time; there was the monumental oilfield back in november (which will cost them an estimated 240 billion dollars to retrieve), and one in the Campos Basin more recently. Despite these discoveries, crude has shrugged off this data, and continued its seemingly unstoppable ascent.

There have been many theses as to why Oil is going up, so lets briefly depict the most viable ones, without subjectivity….yet. These will be cookie-cutter, CNBC talking head explanations (or recaps for the least common denominator…ha!) Full Disclosure: I cannot stand Maria Bartiromo.

Back to the fundamentals…

  • Supply & Demand issues: India and China have displayed booming economies, despite a stagnant US, and appear to be able to cover our decreased demand on their own.
  • Weak Dollar: There isn’t much for the background on this one…the Federal Funds Target is still at 2%, primarily to bail out banks with bad paper. Many analysts speculate that Bernanke will raise rates by 25 bps at August’s FOMC meeting. Bottom Line: when the greenback decreases in value, a dollar denominated commodity will increase in value (because we need more dollars to buy the same quantity).
  • SPECULATORS & Hedging Strategies: In order to hedge a depreciating dollar, investors (mutual funds, pension funds, hedge funds) have gone long oil because of the former two points.

Now that the framework is in place, we can finally delve into the probability of a sustainable pull back in oil.

Lets face it: the true driving factor of the oil run has been a booming economy in China, exacerbated by the fact that their Government has subsidized prices at the pump to the point which they have felt only an 18% increase year to date (compared to our outlandish 50%-60% change).

The only sign of a pullback occurred last Thursday, when China announced a decrease in their gasoline subsidy, resulting in an increase of 17%-18% for gasoline. This is an example of curbing demand. However what if there were an event which caused a natural decrease in demand…like a recession, or even a correction? This is an interesting prospect considering that the Beijing Olympics will end in August, and the potential mark of an end to their renaissance…could this be the chief reason driving Royal Bank of Scotland’s call for a global crash in 3 months?

Forgetting China for a moment, we can extrapolate a more certain outcome. I know we have never really had a strong dollar, only strong dollar policyat best. However Ben Bernanke was smart enough to figure out we had a Financial Crisis at hand, and that wasn’t so obvious to many. When we relieve ourselves of that wretched “core-inflation” statistic (or ex-food and energy), it is quite clear that average household income is being eaten alive. If Ben Bernanke is half the Fed Chairman he has been hyped up to be recently, he will increase rates rather aggressively in the coming months. This will result in a stronger dollar and should (key word) result in a noticeable pullback in oil…

If either of these outcomes seem remotely plausible, then you may be thinking of a way to play a fall in oil prices. One of the more obvious routes is by going long refiners. Two come to mind, primarily because they have been smoked YTD: Valero (-38% YTD) and Tesoro (-57% YTD).

Note: Tesoro is down by a greater amount for good reason. Their refineries are constructed to handle the more accessible “light sweet crude” which will be more scarce going forward. They have experienced far greater losses due to poor hedges. Valero has a competitive advantage, in that they have the capability to refine both the muck which Venezuela sends us, and the lower grade which Brazil will be sending the US for years to come.

Both companies have been victims to pinched margins.  They buy crude (spot or future) and sell it for the fixed price at the pump. As the article says, they will continue to lose money until one input corrects; crude needs to drop, or gas prices need to rise. The fundamentals seem to point to one of these happening, at least for a little while.

Therfore on an intermediate basis,  Valero should be a great trade (its around 42.80 as I write this). My price target is $52.oo, but would begin to scale out around $48.oo. I think it could go as high as $55.oo, but that may be a reach. If all goes to plan, this is a near 25% return on a 3-4 month time frame. Normally, I would talk about fundamentals/option strategies, but this post is already too long.

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