DJI tops 10,000 (for how long?)

The DOT COM run was interesting but it really does pale in comparison to the past 18 months. All major indexes have recovered ground since the financial meltdown with the Dow Jones Industrials crossing the “psychological” 10K mark for the first time in about a year. While still 30% off its historical high in 2007, the major index is certainly showing resilience form its recent low earlier this year under 7,000.

Most economists suggest that the recession is easing and the market has these positive sentiments baked into the numbers already. Is it too much to ask for continued growth in the market? Probably.

The weakening dollar has not produced the export gains hoped for. Further, money policy will ultimately tighten next year while the federal debt figures put tremendous inflationary pressure on the system.

I’m not counting on any further upward momentum. However, I’m still holding most of my equities and remain fully vested. I’m watching DOW but continue to like the company’s near term prospects. I’m also watching ARLP which doesn’t appear to be boosted much since the current Administration won’t get on the clean coal bandwagon. But the rest of the Johnson stash appears solid for a longer term: FRO, VFC, SFL, MCGC, CHKE, etc.

So how does one make money in a flat (albeit choppy) market? Back to basics are my strategy and I’m expecting 15% annually in a flat to down market while maintaining opportunities for a rising market if I’m wrong.

First, watch the fundamentals and dollar cost average into strong equities. This move alone, should have returned all the losses from last year and then some if you can control your nerves. Take MCGC as an example, I was buying this stock at $14 a while back. It then proceeded to nose dive to 75 cents. Reading the companies corporate reports would have shown a healthy, albeit strained, balance sheet. I accumulated the shares up to about $2.00 ultimately increasing my position by a multiple of four. With a cost basis under $2.00 at that point, I’m happy to say the stock appears on its way over the $5.00 mark in the next few months. A similar story can be found with Dow Chemical where a nervous market put so much pressure on the stock price that it was hard not to throw excessive cash at the shares when it was under $10. Keep a watchful eye on the fundamentals and opportunities will always surface.

Second, it’s time to break out the old covered call trick. For any new readers, this involves the sale of a Call Option on a holding you think is done rising for a while or you want to start divesting a bit. For example, DOW has had a good run recently is probably due for a breather. If you can trade options in your account, a possible play might look like this:

• Suppose you own 1,000 shares of DOW and the current price is trading at $27.00 and you wouldn’t mind getting out of the stock at $29.00 in the next month if possible
• DOW provides Call Options for a $29.00 strike price that expire on 11/20/09 for about $1.00
• You could sell short 10 contracts of NZAKC for about $1.00 per share (i.e. – your broker will let you sell contracts against your shares for $100 per hundred shares which would pay you $1,000 on your $27,000 in stock)
• If the stock rises to $29.00 before 11/20/09 you get to keep the $1,000 but you have to sell the stock at $29.00 for an additional $2,000 profit on your current holdings (that’s more than 10% profit on your current position if you are exercised)
• If the stock does not rise to $29.00 you simply keep the $1,000 return and continue holding your stock for future gains

Some people can’t stomach the thought of fixing a price on their stock holdings in a bullish market but the secret to investing is profitable trades not wishful thinking.

Third, and finally, I always keep an eye open for various arbitrage or market fluctuations that look profitable in the short term. I’ve had only a few losers in my years of trading these opportunities and find down markets to be more fruitful than up markets. Regardless, I just wrapped my CYCL trade with a 10% return in about 90 days. I don’t have any ripe fruit at the moment, but I am monitoring a little pharma trade on a company with ticker TRMS. They are being bought by a Korean firm for $3.60 in cash. Nothing appears in the way but the deal was only announced two weeks ago and I expect a little profit taking in the meantime. If the stock drops under $3.30 I’ll probably grab a few shares hoping for a December close at $3.60. Such an opportunity would yield about 8% in approximately 60 days regardless of the broader market direction. Not too shabby…

I’m expecting a dull holiday retail season but still like the prospects for VFC and CHKE since retail will ultimately recover faster than other sectors when cash starts to move around some more. In the meantime, I may run to Target and buy a shirt or two to keep those license dollars flowing to CHKE. After all, Christmas is approaching ;)

No, I Didn’t Disappear

Oh what glorious days a big fat rebound brings! Everyone makes money in an up market, and the gloom and doom folk shrink a bit, and all the ads for “safe” investments come out of the woodwork.

I would avoid anything that is popular, especially adds for gold and loan modifications. Although the ads for cars are probably a pretty good deal if you are in the market and not subject to the almost 10% sales tax in Los Angeles.

But on to some good stuff. Can I give you any advice that might add a couple of points to your savings return? Possibly.

Let’s start with interest rates. Short term rates are probably going to stay low since near term economic performance does not appear very strong. While the economy isn’t getting weaker, you can always tell a sketchy situation by “less bad” news being considered good news. On the other hand, I don’t think we can avoid long term interest rate hikes and an inflation spike in the next 3 to 5 years. The government can’t spend like a college teen with a virgin credit card and not pay the price down the road. If you have any long term debt (mortgage, car loan, etc), now is the time to refi and prepare for the worst in a few years.

As for the market, I was forecasting 9000 on 12/31/09 and I’m still standing by my story. That means we’ll be fairly flat for the next several months but probably in the form of moderate volatility. Here are a few events that could increase volatility: 
- Obama-care
- China backing away from treasuries
- Iran / Iraq (not necessarily with each other) political issues 
- N Korean hostility (could the ill Jong-il get nuke happy on his death-bed?)
- Bernanke replacement (it couldn’t be much worse, right?)
- California default (no really, maybe in 2010, ala NYC)

There are probably others, but these are currently on the brain. As for equity opportunities, I’m bailing on all my holdings related to consumer banking. (this includes XLF) The new credit card regulations combined with pending additional legislation are going to put a big crimp in the consumer credit profit machine. I expect increased fees and rates, but the short term could get very choppy. Advanta just closed down their entire credit card division. I expect poor earnings in this sector which will pressure firms such as B of A and Chase.

I’ve stopped accumulating DOW. With a 120% increase in share price combined with some modest dividends, I’m happy with an exit over 20. The company will benefit form any increase in construction so I’m not necessarily selling yet, but if I see opportunities I will begin to distribute shares as it nears 30.

I still really like MCGC and expect it to double from the current position. If you price-averaged into a sub $2 position you are sitting pretty at this point. The firm just released their management bonus structure and it doesn’t kick in until $5 per share. They appear to have solved their near-term cash issues and they do make money easily.

There are two small M & A plays worth looking at. One is ENPT which is a family business going private. There’s not much to be made here, but the delist price is $2.50 and it is trading at $2.40. The shareholder vote for the delist is in Aug and would take effect almost immediately after approval. I expect approval and delist in weeks. 4% isn’t a huge return but not bad when annualized. The only risk is not getting an adequate poll from the shareholders.

The next M & A play is a bit more typical and exciting. CYCL is a cellular provider being purchased by AT&T. The offer is at $8.50 and the current price is $7.40. The acquisition was announced last year and most opportunistic traders don’t have a stomach for delays in closing. In reality, this deal is probably in the bag. The total is less than $1B which is a smallish transaction for the big T. The delay to a Q3 close is due to the FCC and DOJ not providing approval promptly. But I don’t think the delay has anything to do with anti-competitive concerns. CYCL is too small a fish, even in Puerto Rico where a combination with AT&T would hold 40% market share. The delays are most likely due to the administrative turnover from Obama’s team. Most of this teams are still operating with skeletal staff since he can’t seem to put his full administration in order. I expect an approval and a jump to $8.40 the day after approval. I would expect more news in late Aug or Sep.

I’m quite bullish with my old SFL. I think the improvement in credit markets combined with a stable oil price will show us some nice numbers from our Scandinavian friends. I’m also bullish with ARLP who is really going to hit a homerun if anything looking like a clean coal power plant comes to life in the US. (dozens are on the floor for approval)

At some point retail will be in vogue and when it does I’m looking at my favorite CHKE and the all powerful VFC to plow the way. Both are near highs for the year.

More to come, so stay tuned…

FASB is back!!!

I’m not sure why our federal government waited until $10 Trillion in wealth was wiped out before acting, but it is finally done. The silly mark-to-market rules have been eased and age-tested accounting rules are being allowed to prevail once again. Expect financial institutions to begin altering their balance sheets accordingly which will probably mean large paper gains. I don’t expect the gains to recover the paper losses of the old FASB rules but it will certainly make it easier for balance sheets to stabilize.

This action will also help ease the credit markets a little. While some assets will sit on the books at questionable levels, good assets will find an easier rode to market. Confidence still has to recover further, but this latest move might signal the finality of the bear.

Certain firms will certainly have some issues recovering from last years beating but the healthy ones will, indeed, recover.

Here are a few issues I like and probably worth a look:

ARLP	Coal producer: coal will be the winner in the clean energy arguments
VFC	Retail: as the largest apparel company and a strong balance sheet, they will probably move higher early
CHKE	Retail: same story, different approach as VFC
AINV	Financial: as the credit markets loosen, this stock will recover quickly
MCGC	Financial: same story as AINV
DOW	Chemicals: while they will have some effort digesting Rohm, these guys are profitable on a scale even Bill Gates would admire. I’m looking for a 50% rise in the next 12 months
FRO	Transportation/Energy: my long time favorite firm is still making money and this management team knows how to play their markets well
SFL	Transportation/Finance: as the market eases, the reality of billions in built in sales will send this issue back into the 20’s

If you want a stable 4% – 6% return, play on VFIIX (Vangaurd GNMA). I would not keep CD’s and the dollar play is probably got less risk/reward benefit.

Of course, the broad approach to riding the banking sector back to health is still XLF. And the grand-daddy of diversification is still the old SPY (spiders).

Are They Liars or Just Stupid?

Last fall, Sec Paulson ran into the capital building with three pages of scribble claiming that Armageddon was upon us if Congress didn’t permit a $700B bailout by the weekend. I know that most of Congress doesn’t read their own legislation (they’re either lazy or can’t read, I’m not sure which), but three pages doesn’t seem like a lengthy consumption. So who’s more at fault, Paulson for playing Chicken Little or Congress for believing it?

OK, switch gears… A lender has the prerogative to set whatever terms they want. How many terms could possibly be crammed into three pages? Given that it probably took an entire paragraph to spell out seven hundred billion zero million zero thousand and no cents, I’m guessing there weren’t requirements to receive TARP funds (certainly not a credit check by the looks of things). So now we have Barney Frank, among others, crying that AIG has carried on with business as usual. WHAT DID THEY EXPECT?!

Let us not forget that AIG made over $21B in profits for 2006. Whatever employment deals and bonuses AIG has with their employees obviously works under usual circumstances. OK, fine, we aren’t in usual circumstances, but if the lender isn’t going to specify restrictions what is a company to do but consider paying 0.1% of revenue in bonuses? Reality check… $170M is 1/1000th of AIG’s revenue. Don’t get me wrong, $170M is a large some of cash, and it certainly was poor judgment not to curtail bonuses under such circumstances. But what business does Congress have complaining about AIG operating procedures if they didn’t specify their expectations with the loan? I’m pretty sure AMEX isn’t going to call me if I buy a gold plated hammer for $5,000 whether I can afford it or not as long as I have room on my credit card.

I’m really getting tired of the whining from Congress when they are the ones how lent the money in the first place. If they don’t do their due diligence then shame on them. Of course, that really ends up being shame on us for voting these jokers into office. Keep in mind that Barney Frank is the same guy that needled lenders into loosening credit standards because “everyone deserves” home ownership regardless of their ability to pay the mortgage. Then Paulson and Bush needled FASB into mark to market rules that totally fabricated trillions in write-downs on performing assets. Finally, Pres Obama figures that if the federal checkbook has any checks left there must be cash to cover it. Our US Treasury has borrowed over $3 Trillion so far this year, more than the last 10 years combined.

And our government is now complaining that our biggest lender is wondering if we have our financial house in order. Who can blame China’s Wen for his remarks? For years we’ve been complaining about China’s spending habits and our glass house is looking awfully fragile to be throwing stones. Meanwhile Bernanke is on 60 minutes and Obama is on the Tonight Show. STOP THE WORLD, I WANT OFF!

The recession is a drag but cycles do happen. While we all hold some blame for the original cycle, our government has turned a burning ember into a four alarm fire. And all the fire trucks have pulled up with tanks full of ethanol.

I can’t even start on state financial complaints because I can’t believe what my home state of California is doing. When it sinks in, I’ll comment. I just keep thinking I’m going to wake up from this nightmare.

In the meantime, I’ll keep buying fundamentally sound stock issues that demonstrate good value. I still like Dow Chemical even though the stock is up almost 20% in the last week. Avoid bank deposits if you can. The rates are dismal. For safe cash returns try buying VFIIX to get some federally backed Ginnie Mae’s (GNMA). Brace yourself though, while the markets jumped a bit last week there’s still some dark clouds on the horizon. I’m not a depression doomsayer but we are technically still in a bear market.

Have a nice day…

The Sage Says We Fell Off A Cliff

Well, I certainly made a costly mistake and didn’t see the spring meltdown coming. I was certain that “healthy” financial firms wouldn’t see their stock prices fall to a small percentage of their net worth. Of course, I also didn’t see $3.3 Trillion in borrowing from the US government in my lifetime. Needless to say, the markets are not impressed with the direction of new President is taking us. And while he discounts the markets as simply pole taking, the real world US citizen is watching their savings shrivel.

Mr. Buffett says the US economy fell off a cliff but better times are to come. I’m actually a little more optimistic, go figure. I’m very disturbed by the governmental borrowing and wasteful spending. Unfortunately, I see an inflation hit in the coming years because of this, so prepare your finances for inflation risks. On the silver lining, however, I see a valuation opportunity that seems to be only mildly mentioned on various financial sites.

Let’s take one of my favorite large banks, Wells Fargo, for example. This company is currently trading at half of the balances sheet net worth. In other words, if I had $45 Billion lying around, I could buy Wells Fargo, sell all the assets, settle all the debts, and have $90 Billion left over. Such a move would be a handsome 100% profit for my trouble. There are two gotchas in this scenario. First, balance sheets rarely show the whole picture. Historically, however, the picture is not always bleak. Corporations are not allowed to determine income based on cash flow. If a company purchases a desk for an office it can’t write off the purchase amount against incomes. It is only allowed to write off approximately 20% of the purchase price each year. Interestingly, the desk will probably stay in service far beyond five years, so year six will show a balance sheet entry of zero for the desk when the desk still has some value remaining. In this example, the balance sheet is undervalued. However, sometimes companies don’t write off assets at all and carry them on the balance sheet for an amount that is actually higher than the asset could ever fetch from a fire sale situation. For example, Circuit City never achieved anything close to parity when it liquidated its inventory. Thus, we have an example of an overvalued balance sheet. When you take the good with the bad, you have to assume that balance sheets are at least somewhat “balanced”. (especially since the CEO and Board are now on the hook for lawsuits if they cook the books)

But there is still a missing element here. President Bush (W), enacted a lame provision with the best of intentions. (famous last words) FASB, the governing body for accounting rules, was instructed to create a mark to market provision. I’ve talked about this provision before, but the short version is this. If Countrywide has an average of 40% losses on their loans because they made bad loans they are required to write down their balance sheet to the amount they could actually sell the loans for, say 50%. If Wells Fargo had not made any bad loans and had a average loss of 1% on their loans, the new rules require that they, too, write down their loans to what Countrywide could get. In other words, Wells Fargo has to assume that their loans are as toxic as those of Countrywide even if the loans Wells Fargo holds are being serviced regularly. Wells Fargo recently wrote off $4 Billion and is considering another $28 Billion. But they aren’t selling the loans!!! In other words, this bank prefers to hang on to the loans and service them which means they earn approximately 4% after servicing costs on the loans. The write offs would only be realized if one of two things happened. First, Wells Fargo sells the loans. (good luck) Second, Wells Fargo experiences a huge increase in loan defaults. Now when I say huge, I don’t mean relative to past default levels. Unlike the press, I don’t consider a jump from 2% to 3% a huge increase. It is large relative to the figure but not relative to the lender’s portfolio. Nobody, short of the “bomb shelter wackos”, is suggesting that broad portfolios such as Wells Fargo is going to experience losses on their loans of anything over 3%. So their losses aren’t real!!! In contrast, when they earn interest on their loans, the interest income is cash in hand and very real. Real income, paper loss = stock hammered and opportunity.

This analogy doesn’t apply to all institutions. Some banks have stricter debt requirements. For example, one of my old favorites (may my portfolio rest in pieces) is MCG Capital. They, however, cannot allow their assets to drop to less than 200% of their debt. Because FASB requires the write down of their assets regardless of servicing record, the adjustment has a negative effect on their ability to maintain their own debt. In this example, they can be forced to sell off assets at a highly reduced rate which further pressures their capital position, which increases the supply of companies selling assets, which further pressures the asset price, which further reduces their capital position, etc, etc.

The cycle is spasmodic and can only be stopped by letting the FASB rules return to their previous reasonable state. Oh yeah, the government could simply buy all the banks at fire sale prices and then unwind the fabric of the US economy while increasing the size of government forever. Did I mention I was optimistic?

Portfolio Time

With the market ripe with opportunity I've had to reallocate my portfolio some to balance the risk reward situation. True, the market in general will come back strong and financials will lead the pack at some point. However, there are some opportunities beyond the arbitrage and dividend plays I've mentioned thus far. 

I will be setting many of my new positions into companies that appear to be valuable given the current market turmoil. There are many, but three jump out at me:

Alliance Resource Partners (ARLP) is in the coal business. Unlike the typical oil-energy plays which will probably make money as oil increases, coal has two benefits. Coal prices will follow oil up on sympathy alone. Since coal is cleaner (believe it or not) to burn in power plants and more power plants are coming online in 2009 based on coal, the bias is towards coal domestically. Assuming no more coal mine disasters, Alliance is positioned well to benefit from increased coal demand. At the same time, the company is well funded and while the stock isn't a bargain at current commodity prices, they pay shareholders over 8% in dividends while waiting for the stock to rise. Not too bad.

 I've always been partial to utility companies because they have so little competition and rarely lose customers. But most are priced in accordance with their dividends and don't offer much appreciation benefit. With the market turmoil, a few equities have unearthed some opportunities. One such firm, is Great Plans Energy (GXP). This utility is based in Missouri and services about 500,000 customers. Recent margins have been a little higher than historical levels but the market turmoil has knocked the stock price into levels not seen since the '80s. The firm isn't without its burdens, but the income levels are very attractive for the current price and again, an 8% dividend will help steady the way of rocky market fluctuations.

Now my favorite is a little Michigan chemical company called aptly named Dow (DOW). You may have heard of them. Dow is fairly well diversified and since it has operations in 35 countries it isn't a bad dollar hedge either. Under normal market conditions, the stock would be priced in accordance with their value but currently shares are trading well under the value of the balance sheet. The market turmoil beat up this fortune 500 player and Kuwait recently bailed on a commitment to form up a new partnership and help pay for a large acquisition of Rohm and Haas (ROH). Now the story gets interesting. The acquisition was supposed to be a $78 cash play which would lead one to jump on Rohm shares and wait out Dow shares until after the acquisition. Indeed, Berkshire Hathaway committed $3B into the play which already puts a nice shine on Dow to begin with. But the Rohm purchase may be on the rocks despite sentiment in the last couple of days. Dow has some cash, to be sure, but $15B is a lot of cash to put up for a company that generates less than $1B in cash on a good year. Market turmoil has sent Dow's credit rating under A- which means that financing the deal is probably a show stopper. 

So here's my logic. If the merger happens, I'm cool with the results because Mr. Buffett blessed the deal with his own cash and at current levels, but stock is bound to outperform the market. If the merger doesn't happen, the stock will bounce up since Dow still makes a fortune and their cash levels remain intact for other opportunities. Either way, this stock is going higher soon. Oh yeah, and if you buy now they'll throw in a set of steak knives. Oops, I misspoke. You'll have to buy the knives yourself with the 10% dividend they're currently paying.

OK, recap on the Dow thing since this one was a little wordy. You give your broker about 16 bucks for one billionth of Dow Chemical. Off the bat, you just bought $21 worth of balance sheet across 35 countries. You wait for the stock to get back over $40 where it belongs (and was less than 12 months ago). While you wait, Dow pays you $0.42 per quarter. Savvy? 

HAPPY NEW YEAR... now pay attention

This is no time to be sidelined from the market. And don't try to time an entry. Dollar cost average in so you don't get stuck on the wrong side of the volatility. But Jerry... you always seem bullish, what's different now? (I don't talk to myself often, but sometimes I get lonely)

Here are some very important facts to consider:

1. The high for the Dow Industrials was 14,000 in late 2007. 
   
2. The market gave up 6,500 points through late 2008, approx 46%.
3. Since the lows in late November, the market has recovered 1,500 points, approx 20%!!!
4. "Typical" volatility (as measured by VIX) is under 20 for most cycles.
5. Volatility in November was over 80, but is now under 40!!!
6. Short selling is down across the board (only a few poor performers are exceptions, like GM, go figure).

Summary: a fall in volatility suggests a move toward fundamental investing. A fall in short selling suggests a tendency toward normal equity trading where investors buy and hold companies that represent a good value rather than jumping in and out or flipping positions to ride waves. This summary doesn't mean that the market will be back to 14,000 this year but it does mean two things. First, shorts have to purchase equities to cover positions. A reduction in volatility usually signals a reduction in selling across both long and short positions. Therefore, when the shorts cover while the longs are buying, the stocks move up rapidly and without warning. Thus, you can't time it, so you better be in when the spikes occur. Second, there are trillions on the sidelines waiting to buy into a good position. At a minimum, this usually suggests an end to freefalling prices. Again, when the big pension funds start buying you don't want to be sitting in a money market account. 

Should you get back into the same positions you held before the crash? NO!!! As a rule, I like conservative investors to buy whole market indexes such as SPY or DIA. However, I think the prudent investor will actually look more toward value and income. Eventually a whole market position will cover your losses and then some. But down markets are the time to be opportunistic and make back more than you lost plus the opportunity loss. I think it was Ben Graham that said you don't have to make back your losses the same way you lost them. 

The mark to market FASB rules that hammered the financial segment balance sheets will do the exact reverse as the markets recover. Did you know that your mortgage is probably for sale at something like 60% - 80% of its book value? Would you buy back your mortgage at 60% of the balance you owe if you could? This inversion of value doesn't happen often but it means that financial firms that have the capital to survive the next 6 months will make more with their balance sheet than other segments. 

Let's look at an example: Big Mortgage Bank (BMB) has $100 million in mortgages issued that expect returns in the 6% range (some low risk at around 5%, others higher risk around 8%. BMB's balance sheet of mortgages are now only worth $80 million per FASB but BMB isn't going to sell these loans so the book value is largely unimportant for this example. But BMB is cash healthy and decides to purchase the mortgages of the Risky Business Bank (RBB) across town. RBB over extended their position and a run on the bank caused it to fold (sounds like IndyMac, huh?). Let's say RBB had $100 million in mortgages, too. But BMB has now purchased the mortgages of RBB for $80 million. Since BMB originated the first $100 million in loans their cost was actually $100 million. But the second tranche of loans was purchased, not originated. So now they have another $100 million in loans earning 6% but they only paid $80 million so over 20 years of servicing these loans they will make 7.5% instead of the lower 6%. The same business, doing nothing but keeping an eye open for opportunities will make 25% more profit because the business has a healthy cash position. Sears, or United Airlines won't have the same opportunity. So financials will be a great play. 

So how do you know which financials are healthier? Darwin has taken care of this for us. Only the healthy are surviving, so a purchase of all the surviving players will give you much of the upside without having to research their balance sheets. While the S & P fell over 45% from the highs in late 2007, the financial sector fell over 70%. The market will return smaller than the original so don't expect a 70% recovery soon (or 230% gain). However, the earnings potential is still there for the survivors so expect the financial sector to gain more than the broader markets. XLF is a ticker for the Financial Select Sector of the S & P. It's up 35% since November. Expect more of this.

What else? Income. Some companies are very geared toward benefiting the shareholder. This sort of management team is exactly what the small investor wants. I've always been a Frontline (FRO) fan and expect a dividend of at least 20% in 2009. Their more financial cousin, Ship Finance (SFL), will probably return a similar amount. These shipping companies can be volatile since much of their cargo involves oil. If you prefer a retail play which many believe are the first segment to gain out of a recession, check out Cherokee (CHKE). They don't actually make anything, but you can't leave a Target or major retailer without seeing Cherokee related products in your face. Wouldn't you like to have a company with 20 employees that earned $50 million every year? They get a piece of every shirt and jacket their licensee's sell. Oh yeah, they pay about 11% in dividends, too.  

Happy investing...