The Danger of Short-Term Predictions

A couple of weeks ago I wrote a post entitled "So Many Words, So Little To Say" expressing some frustration with an article written by Tony Crescenzi of TheStreet.Com. In his article, Tony started off by stating, "There is a scenario that has a low but reasonable chance of occurring next week that could result in a very large rebound in share prices and risk assets next week and the week after, say 500 points or so in the Dow." I took issue with that and a few other comments that he made.

So, it's been a couple of weeks now. Let's see how Tony's call panned out. Tony wrote his article in the afternoon on June 10th. The close that day for the DJIA was 12,289. Since he said the rebound could come within two weeks, let's check in two weeks later on June 24th. The close that day for the DJIA was 11,807. Ooops. That's actually pretty amazing since it is a 482 point DECLINE! So net-net, Tony was only off by 982 points! Now that is impressive. That would be hard to do even if you were trying.

As I wrote in my first critique of Tony's article:

I know that it isn't easy writing in a public forum and opening yourself up to criticism, but idle speculation about possible big moves in the market that might or might not happen over a ridiculously short time period if certain other things do or don't occur really doesn't add a lot of value. This type of article could just as easily have been written about the possibility of a 500 point drop in the market if the things Tony discusses don't come to fruition.

Looks like Tony should have written about the possibility of that 500 point decline instead. What are the lessons we can take from this?

• The majority of the investment opinion articles out there are basically useless and do more to confuse people than enlighten them. Of course, none of us think our own articles are garbage!
  
• Nobody knows where the market is going in the very short-term. If they did, they ought to be placing huge bets in the futures market and unblinkingly staring at their quote monitors -- not writing articles about it for Cramer.
• Don't be fooled by someone's credentials. Some of the worst investors that I know have terrific credentials.
• Be careful what you write. Someone might be reading it (my wife/co-editor reminds me of this with each of my posts).
  

Finally, as I wrote in the earlier post:

Although calling for a 500 point move isn't terribly bold in the current environment, Tony will get a ton of credit (and perhaps press) if it happens. If it doesn't happen, who will remember?

Well, I will.

The author is short sensationalism, silly short-term predictions, and poor short-term memories.

When The "Expert" Needs An Expert

How comfortable would you feel with your plumber if he had to call another plumber to fix his own running toilet? How about a CPA who hired another accountant to do her taxes? What if your pediatrician didn't feel competent enough to examine his own child?

These are the questions that immediately came to mind today when I read that Wachovia has just hired Goldman Sachs to "perform analytics on our loans to evaluate various alternatives." I think Saturday Night Live's Seth and Amy can probably sum it up best. "Really?! Wachovia. Really?"

I wonder how the good folks at Wachovia are responding today to customers walking into their branches around the country.

"You'd like to open a savings account? Um, can you hold on a minute while I call the teller over at Bank of America to find out what our rates are?"

"Yes, we can offer auto loans, but would you mind running over to Vinnie's Used Cars and Bait Emporium to see what size loan we can offer you?"

"A personal loan? Well, let me see if I can get in touch with the CEO who I think plays golf with one of the senior bankers over at Morgan. I'm pretty sure that guy has a gardener who knows a personal trainer who thinks he heard some rumor about whether we're still offering those."

"A mortgage? No, we don't do those anymore."

This is just sad. I'm embarrassed for Wachovia and its employees. If you're a large bank with a large securities and investment banking division and you don't feel qualified to evaluate your own balance sheet or market your own portfolio, isn't it pretty much time to just hang it up and go into the dog grooming business? No offense to dog groomers.

The only thing cushioning my pain is that I've been short Wachovia these past few months. I was thinking it might be time to cover. Now I'm not so sure.

The author is short Wachovia and long dog groomers and emporiums.

Energy, Inflation, and Speeding Tickets

By now, it's probably safe to assume that everyone knows that oil and gasoline prices have been rising sharply and are near record levels. Even the recently discovered uncontacted tribe in Peru can be seen in this photo trying to shoot down a plane for its fuel.

Reuters

One of the surprises in the current cycle has been that rising energy prices haven't yet shown up in broader measures of inflation. The most recent Consumer Price Index (CPI) figure registered a year-over-year increase of 4.2%, but core CPI (excluding food and energy) came in at a relatively modest 2.3% increase. The bulls highlight this discrepancy and claim that it points to an overblown fear of inflation. They also point to the lack of flow through from the rising Producer Price Index (PPI) to the CPI as evidence that rising energy prices, in particular, are not impacting the price of goods and services more broadly.

According to the Bureau of Labor Statistics website, food makes up about 13.8% of the CPI, and energy accounts for 9.7%, for a total of 23.5%. In making the case for core inflation, economists point to the volatility of food and energy prices. Everyone can agree that food and energy prices are more volatile than many other goods and services, but I'm rather sympathetic to those who claim that we shouldn't ignore them. First off, they account for nearly one quarter of overall CPI. Second, we're talking about food and energy! Along with housing, these things are not exactly discretionary.

Now, let's look at the 9.7% weighting of energy in the CPI. We're definitely not as energy dependent as we were during the last energy crisis, which is certainly a positive. However, oil is used in a huge variety of ways and can be found in everything from plastic, lipstick, and disposable diapers to Captain Kirk's hair, tires, panty hose, lotion, Vaseline, and artificial limbs. And, of course, the manufacture of most products requires the use of energy, most of which is derived by the burning of fossil fuels. So although energy itself may only account for 9.7% of the goods and services measured by the CPI, the importance and impact of energy is certainly greater.

So, will we ultimately see these higher prices flow through to other goods and services? It seems likely. Plenty of transportation business are levying fuel surcharges, which is the obvious place to expect it first. Other service providers who rely on transportation seem to be jumping on board. Anecdotally, my wife just raised her rates for her interior design business in part due to higher gasoline costs. Her handyman just did the same. And, according to today's USA Today:

The surging price of gasoline has come to this: a "fuel surcharge" on your next speeding ticket.

Drivers caught speeding in this north Atlanta suburb soon will have to pay an extra $12 — to cover $4-a-gallon gas costs for the police officers who stop them.

The City Council passed the fee hike, effective July 1, to offset fuel prices that have eaten up nearly 60% of the police department's 2008 fuel budget, Police Chief Ken Ball says.

He expects the fee increase, which applies to all moving violations and can be rescinded if gas prices fall below $3 a gallon, to generate $19,500 to $26,000 a year for the town of 7,700.

Ball says he was seeking ways to maintain patrols despite record high gas prices. "I was hearing that Delta (Air Lines), pizza deliverers, florists were adding fuel charges to their services, and I thought, why not police departments?" he says.

By my math, a $12 surcharge on $4/gallon gasoline works out to 3 gallons of gas per speeder. If we assume 20 mpg (highway), it seems each speeder should be entitled to a 60 mile chase.

Whether higher energy prices flow through may not even matter as far as equity returns are concerned. To the degree that sellers don't pass along their higher costs, their margins, earnings, and valuation will suffer. If they do pass them along in this current environment, we run the risk of seeing a sharper decline in consumption as an over-stretched consumer is forced to retrench even further. Neither case bodes particularly well for equities.

As for strategy, I still believe that we are in the middle innings of this commodity bull market and plan to continue holding a core position while exploiting significant short-term moves. I remain overweight commodities and energy, but I wouldn't be at all surprised to see a pullback near-term given the rhetoric over new Saudi production, "crack downs" on oil speculators, and near-term reduced oil demand -- at least from the industrialized world. (For the record, I do not believe that this new oil from the Saudis or restrictions on speculators will solve the problem of high oil prices.) Retrenchments are part of a healthy bull market. Should such a pullback occur, I will be a buyer yet again.

The author is long artificial limbs and uncontacted Peruvian tribes and short Pollyannas.

So Many Words, So Little To Say

Like many portfolio managers, I spend a good part of each day just keeping up with the news flow on the companies that I own, the stocks on my watch list, the markets, the latest Bollywood gossip, and the global economy. Most of the "news" out there is nothing more than noise, and sifting through the garbage can be time consuming.

One of the "news" outlets that I gave up on years ago is CNBC. When I saw how they turned from somewhat serious reporting to out-and-out stock pumping during the tech bubble, I lost my lunch. When they started to rewrite history during the market collapse and claim that they had done a terrific job of being balanced, I lost my wife's lunch. It was a nice reminder that there really isn't much worth watching on TV. My wife and I canceled our cable.

I'm also not a big fan of TV Jim Cramer and TheStreet.com although I do enjoy the writing of contributor Doug Kass. I'll save a more detailed review of Jim and TheStreet for another time, but let's just say that I've done fairly well fading (doing the opposite of) a number of his recommendations. One of my main complaints about Cramer is very similar to one of my major complaints about Wall Street analysts, strategists, and economists -- there is an ever-present pressure to have a strong opinion about a stock, the market, or the economy, but no one can know everything about everything (unless she's married to me). It's great for generating commissions but not so great for investment performance.

With that out of the way, let's turn to an article just highlighted on TheStreet.com. The article is written by Tony Crescenzi and is entitled "Big Rally Possible." Normally, a junk title like that would be enough to keep me away, but it's a slow news day. Now, I don't know anything about Mr. Crescenzi, so I checked out his bio. He's a chief bond strategist, so that's one knock against him. He did write a couple of books I'm not familiar with, but so did Madonna, so...I'm not really sure what to make of that. Most importantly, Tony Crescenzi is a name straight out of "The Sopranos", so I'm going to change my locks and avoid making direct eye contact with anyone for a few days. Let's look at what he wrote:

There is a scenario that has a low but reasonable chance of occurring next week that could result in a very large rebound in share prices and risk assets next week and the week after, say 500 points or so in the Dow.

If the G-8 delivers a communiqué strong enough to reinforce the recent message on the dollar, and if OPEC's meeting with consumers results in more oil production, the combination could boost the value of the dollar, jolt the commodities markets, and thus bring a huge sigh of relief to investors. U.S. Treasury Secretary Paulson has resisted opportunities like this before, particularly following the April 11 G-7 meeting, which produced a communiqué that French Finance Minister Lagarde said was on par in importance with the 1985 Plaza Accord. Any effort to boost the dollar would be welcome worldwide, given the recent surge in commodity prices. Massive intervention would cap it off.

Ok. Trying to be tactful. Let's start with the first sentence. "There is a scenario that has a low but reasonable chance of occurring next week that..." What doesn't have a low but reasonable chance of occurring next week?! Oil could hit $150, we could attack Iran, gold might retake $1,000, the Pillsbury Doughboy could go on the Atkins Diet, Lehman could collapse, the Fed might raise interest rates (just kidding), I could be killed in a tragic dirigible accident. The list is endless.

So what specifically might happen according to Tony? The Dow could rally "500 points or so." Well...sure. First of all, that would be about a 4% increase. Given the recent volatility in the markets, I don't know that anyone would be shocked by a 4% move either way "next week and the week after." The market fell by 400 points this past Friday alone. It's not like calling for another Black Monday when the Dow lost 22.6% of its value in one day.

What's going to cause this big rally? Apparently, IF the U.S. and G-8 get super serious about the dollar with strong words and massive intervention and IF OPEC starts pumping a lot more oil, then commodity prices would get whacked and money would flow into the U.S. market.

Could it happen? Sure. But the very opposite is at least as likely to happen. Paulson and Bernanke are already starting to talk tough about the dollar, but I have a hard time believing that they're going to raise interest rates or intervene in the currency market to support the dollar given the weakness in our economy and financial markets. Raising rates certainly won't help the economy recover, and the Fed has shown this to be of primary importance. A higher dollar would also harm U.S. exports, which have been one of the few GDP bright spots. So, until proven otherwise, this is just talk. Words are their only weapon since they don't have the cojones to raise rates. Once the market figures this out, I would expect the dollar decline to resume.

As for OPEC suddenly pumping more oil, I've addressed this in prior posts. Does anyone seriously think that there is one OPEC country sitting on idle production with oil prices this high and climbing? No way. First of all, these guys remember $10 oil in the mid '90s. They're going to make hay with current prices. Second, high oil prices are ultimately bad for OPEC as they encourage lower demand and the development of alternatives, and OPEC is well aware of this. If OPEC had the power to drive oil prices lower, they would -- not to $20, but back towards $100 seems reasonable. The only way they could do this is by further opening the spigots. I think the fact that oil prices continue to climb well beyond a level that OPEC is comfortable with points to the likelihood that the spigots are already open. OPEC is fairly powerless right now to combat rising oil prices (how ironic) and is not likely sitting on idle capacity. In fact, it's possible that some countries are producing at rates that are too high for the long-term well-being of their oil fields.

Of course, anything can happen in the short-term. So, should the market rally in the next week or so because of a dollar-led commodity price collapse, I'll be more than happy to take the opposite side of both of those trades and further short the dollar and add to commodities.

As for Tony's article and for others like it, they just don't serve a useful purpose. I know that it isn't easy writing in a public forum and opening yourself up to criticism, but idle speculation about possible big moves in the market that might or might not happen over a ridiculously short time period if certain other things do or don't occur really doesn't add a lot of value. This type of article could just as easily have been written about the possibility of a 500 point drop in the market if the things Tony discusses don't come to fruition.

Before I go, let's consider Tony's employer. Tony works for Miller Tabak + Co., LLC, which according to their website, is "a twenty-four year old institutional trading firm specializing in the discrete handling of stock purchases and sales, portfolio rebalancings and listed options." He works for a trading firm, and he's out with an article that (at least implicitly) encourages short-term trades. Coincidence? Perhaps. Either way, there appears to be a strong negative correlation between the number of articles/posts someone writes and the quality of opinions expressed in said posts (present author excluded, of course). Tony appears to be a prolific writer.

Finally, people seem to be more disposed towards remembering correct predictions/recommendations than the predictions that don't work out. The fact that Joe Battipaglia still has a career as a Chief Investment Officer following his disastrous pronouncements during the tech bubble and collapse is testament to this. Although calling for a 500 point move isn't terribly bold in the current environment, Tony will get a ton of credit (and perhaps press) if it happens. If it doesn't happen, who will remember? There is no downside. From an "investment" perspective, his minor investment in a few paragraphs of words has tremendous upside and no downside. Tony may be wrong, but he ain't stupid.

The author is short the G-8, Battipaglia, and the dollar and long OPEC, Bollywood, lunch, and cojones.

Employment Report Disaster

A loss of 49,000 jobs. If only it were so benign. Today, we add to the heaping pile of rotting economic indicators the latest monthly employment report from the Bureau of (lack of) Labor Statistics. At least this time the headlines don't appear to be shading the report, but they're not fully capturing just how ugly it is.

Let's start with the nonfarm payroll numbers. This showed a loss of 49,000 jobs in the month. Nothing too surprising in the breakdown -- construction and manufacturing down, service-providing up modestly, professional and business services down, education and health services continued their strong steady climb, and our "less is more" Republican-led government continues to grow. The only somewhat surprising number was that leisure and hospitality employment continued to grow despite an obviously stressful time for the consumer.

Now let's turn to the unemployment rate, which is the number we'll be hearing about in the news today. Its one month increase of .5% is the highest monthly jump in over 20 years! In layman's terms, that's bad. How did this happen? Double-whammy. The number of employed persons fell by 285,000 last month while the number of unemployed rose by 861,000! There are now 8.5 million people counted as unemployed, a level 30% higher than a year ago. And, yet, we're not in a recession?

What's also interesting is that the increase in the unemployment rate hit everyone. Men, women, teens, hermaphrodites, loan originators, and people of every color. Teens in particular took a hard hit with their rate climbing from 15.4% to 18.7%. Good luck getting your teens out of the house this summer. Even the professions that they're overqualified for (like investment banker, mortgage broker, home appraiser) aren't hiring.

Well, if you've made it this far you're in for a real treat -- the birth/death model. If you're not familiar with this, go back and read my post on April's employment report. Incredibly, this latest employment report includes an assumed 217,000 jobs created! If you back that out, then this month's nonfarm payroll figure would be registering a loss of 266,000 jobs! This birth/death model is assuming that 42,000 CONSTRUCTION jobs were added last month. That's just insane. Foreclosures are skyrocketing, builders are struggling, home sales are plummeting, prices are collapsing, but 42,000 construction jobs were added. I hope the folks at the BLS are at least a little embarrassed about putting out such a number. Just as ridiculous, the model assumes that 77,000 new leisure and hospitality jobs were created. Apparently, the 2 million additional unemployed people we have this year are all spending their last dimes at the beach resort getting cucumber mud facials in the spa. Come on. Even Starbucks is retrenching, and people are addicted to coffee.

So what does all of this mean for investors? Bernanke and other Fed member have been recently trying to talk up the dollar and have been hinting that the rate cuts are behind us. Given the data we've seen of late and the continued weakness in the economy, I can't imagine the Fed is suddenly going to develop a spine and actually start fighting inflation and the falling dollar by raising rates any time soon. They wouldn't have cut rates so far and so fast if this was their real concern (If you want to see a real Central Bank, check out the ECB). Bernanke always appears calm and collected in public, as he should, but I've got to believe he's spending a lot of time in his office mumbling to himself, violently brushing nonexistent bugs off of his pants, and dreaming of the day he can charge ridiculously high speaking fees to tell everyone that it wasn't his fault.

This report should put a nice headwind in front of the recent dollar mini-rally which also might provide a further boost for gold and commodities. It certainly isn't stock market positive as even further interest rate cuts would have limited, if any, positive impact, but it is clearly supportive of bonds. (The markets just opened, and not surprisingly, this is the initial reaction.). Of course, this all holds true only until the next bit of bogus manipulated data comes out and the traders and spinners tee it up all over again.

In the meantime, it will be interesting to see how the bulls try and spin this one. I imagine it will go something like this:

Well, the loss of jobs wasn't as bad as expected so that's outstanding and super bullish. Besides, that's old data. The month of May was over, like a whole week ago. The market looks forward, and I'm sure June will look even better. Heck, I just replaced two of my overpaid cabana boys with 4 illegals. That's a doubling of employment! The fact that the unemployment rate climbed a touch is simply testament to the fact that we Americans are a hard-working lot, and more of us are eager to get back into the labor force and do our part for the economy. As for the birth/death model you mention, I've never heard of that, but I can assure you it's bullish for tech stocks.

Disclosure: The author is short perma-bulls, the birth/death model, and cabana boys.

New Home Sales - Revising Their Way Higher

Yet another housing data point to digest. This time it’s the monthly New Home Sales report from the Census Bureau. It looks like all of the headlines concerning the release are touting a 3.3% rise in new home sales from last month (to an annualized rate of 526,000), and a number of articles are once again implying that, again, this may again be yet the latest sign again that the end of the real estate downturn again is here – once again.

Most of the articles I've seen either ignore or glance over the fact that last month's figure was revised down from an annualized rate of 526,000 to 509,000. So, if last month's figure hadn't been revised lower, this month's figure would have been dead flat with last month. Depending on your level of optimism or pessimism, that's either 0% growth or a 0% decline, but it's definitely less than 3.3% growth. It is, however, a nice easy way to manufacture growth. Personally, I'm thinking of revising my April intelligence lower by 10% to boost my self-esteem this month.

To be fair, the report itself isn't completely terrible. The months-of-supply figure (how long it would take to sell the new homes currently for sale given the current rate of sales) fell modestly from an absurdly high 11.1 months to a ridiculously elevated 10.6 months. That's the right direction, but only time will tell if it's the beginning of a trend. It does illustrate what needs to happen to get back to equilibrium -- builders need to build fewer houses relative to the level of sales. You can track all of the home price data, builder optimism surveys, permit numbers, and sales info you like, but residential housing isn’t going to bottom out until the months-of-supply (inventory) figures for both new and existing homes get a lot closer to normal levels.

As an aside, those who are clamoring for a return to normalcy (which I think includes everyone) should be embracing the fall in housing prices. The lower prices will make housing once again affordable to more people and thus lead to the higher demand that the housing market needs. Moves by Congress to offer "aid" and to "support" the housing market at best will forestall the correction in prices that must ultimately occur to get back to equilibrium.

Despite having strong contrarian sympathies, I currently remain modestly short the real estate sector -- primarily through exposure to two ETFs (long SRS and short XHB). I suspect the real estate shakeout will take longer to occur than many think. Furthermore, it's very unlikely that we'll experience another real estate boom for quite some time.

The home builder industry is likely to emerge a bit smaller and more consolidated with rather unspectacular growth and margin opportunities. Even once they bottom, I imagine that there will be more fertile pastures elsewhere - probably in fertile pastures (I like agriculture.). That’s not to say that there may not be some intriguing deep value plays at some point, but at the current time, my strategy with the housing sector is fairly straightforward -- short substantial advances, cover on the declines, and some day finish staining my deck.

Oils Well That Ends Well

It looks like our overpaid Congressfolk are at it again - flexing and preening for the American public. This time the House has approved a law that would allow us to sue OPEC for high oil prices. They'll debate and pontificate about limiting frivolous lawsuits and excessive malpractice awards but then turn around and pass a law like this? It makes me pine for the glorious days of the Truman-era "Do-Nothing Congress". Good times.

Before getting to the new OPEC law, let's look in at today's Senate Judiciary hearing which is questioning oil executives about the rise in oil prices. Here's my favorite quote so far, and it comes from Senator Patrick Leahy, D-VT: "Normal supply and demand says prices should be around $55 to $60 a barrel."

Where does he come up with that? This guy must be pretty flexible to reach around and pull those numbers out of his ... assistant. Seriously, Mr. Leahy is incredibly arrogant to think that he knows what the "real" price of oil should be and to think that the market has it so incredibly wrong. I'm sure he also knows the "real" price of health care, ethanol, interest rates, rice, wheat, housing bailouts, etc. Ah, to be blessed with the intelligence of Mr. Leahy!

Back to this whole suing OPEC farce. This is a joke on many different levels. Let's start with the fact that one of the biggest gasoline bottlenecks we face comes from a lack of refinery capacity, and Congress certainly isn't doing anything to address that. Even if OPEC could immediately double its production, it would be irrelevant since there isn't enough global refining capacity to turn it into gasoline. Similarly, if my income suddenly doubled, it wouldn't be relevant since my wife couldn't spend it fast ... bad example.

Second, if anyone thinks that OPEC isn't pumping pretty much full-out at these oil prices, they're probably crazy enough to be running for office. When I say "full-out", I'm talking about maximum rates without damaging the oil fields, but I wouldn't be surprised if some countries were producing above such levels. Furthermore, it wasn't that long ago when OPEC was faced with $10/barrel oil. We certainly weren't rushing to subsidize them at those levels or accusing them of overproducing.

I won't get into the details of Peak Oil in this article, but there has only been one truly major oil discovery (offshore Brazil) since the mid-1970's. This includes OPEC countries where we think the oil just bubbles out of the ground. They've been picked over. The easy oil has been discovered. There is plenty of other oil still out there, but it's expensive to find and develop. It's buried deep below the ocean, in oil shale deposits, in tar sand deposits, and in hostile regions like the Arctic. It will take a high oil price to make this exploration and development economically viable, so trying to constrain oil prices isn't going to be encouraging the development of additional supply.

Then there are those (presumably including the members of the House who voted for this bill) who believe that oil prices at these levels are based largely on speculation by Wall Street types. I imagine this is a minor factor, but you can blame the Fed for this being a factor at all. Given the debasement of the dollar, who can blame anyone for preferring to own real hard assets (like oil) instead of dollars? Also, if these prices are being driven largely by speculators, why has the price of oil continued to make new highs in the days following the announcement that the government would stop adding to our Strategic Petroleum Reserves? The price is hitting new highs because there is no longer a supply cushion, and developing countries like China and India have a voracious appetite for oil.

Next, we have the Europeans who are paying between $6-7 a gallon for their gasoline. We don't hear them whining. I imagine their legislators are spending their time on less economically destructive endeavors like watching Dr. Who, going on fox hunts, and rioting at soccer matches.

I also have a bit of a logic issue with this new law. If you've been bitten by a snake and you're not happy about that, why would you turn around and poke the snake with a stick? If we really do think that OPEC has idle production capacity, why are we antagonizing them? Shouldn't we be making nice? We're not really in a position of power. Are we going to threaten to stop buying their oil? Stop laughing -- that was rhetorical. I think we're all familiar with the quote, "You attract more flies with honey than by poking them with a stick."

Here's the point that I believe is most interesting. If you were to ask every one of our congresspeople if they are pro-environment, every one would say yes. Most are also concerned with global warming and actively want to address it. Many also want to spend our tax dollars on helping to develop alternative energy sources. If they are really so concerned with the environment and the energy crisis, then why in the world would they want to do anything to limit the price of oil and gas? The single biggest driver of the development of alternative energy sources is higher oil and gas prices. For example, high oil and gas prices are making solar and wind power more economically viable. No one knows what the leading energy sources will be in 50 years, but with oil and gas prices as high as they are, the incentive is there for private industry to solve this problem. We don't need folks like Mr. Leahy spending our tax dollars as they see best, and we definitely don't need to be suing OPEC.

As for strategy, I've been bullish on energy for quite a while and remain so. Having said that, I continue to lighten on price spikes and rebalance as necessary. I continue to like a number of names including PBR, ESV, and NOV. Briefly, Petrobras was added following their discovery of the huge offshore Tupi field. The cost of developing their deep offshore finds will be tremendous, but PBR has a very good chance of becoming one of the leading oil producers in time as production ramps significantly over the coming decade, and there is, of course, hope of future large discoveries. As for Ensco, they are one of the largest offshore drilling contractors. They have one of the lowest fleet ages, a growing deep water capability, and one of the most attractive valuations in the space. With talk of Petrobras trying to lock up as many deep-water rigs as possible, the future looks bright for ESV and its peers. National Oilwell Varco has its hands in every aspect of the design, construction, and service of most of the systems and components used in oil and gas drilling and production. This includes the construction of rigs which is likely to benefit from increased drilling, particularly offshore.

As much as I like the fundamentals of these firms, I am not adding to them at these levels, given the recent run in oil and oil-related stocks. Sentiment has turned very bullish for this entire space over the past couple of months, and the space is due for some consolidation. Should the oil complex continue to move up near term, I would anticipate taking some profits or initiating a short-term hedge. I have, however, recently added a new position in Petrochina (PTR) at levels not too far below the current price and would look to add further on pullbacks.

As for our government, it they want to sue someone over price gouging, maybe they should go after Starbucks. The price of my Venti mocha works out to about $1,075 per barrel. Keep that in mind the next time you're filling up your tank.

Agricultural Smackdown - South Asian Style

“Food is an important part of a balanced diet.” Fran Lebowitz

There was an interesting article in yesterday’s New York Times discussing the developing spat/misunderstanding between the U.S. and India about responsibility for the rise in food prices. The whole to-do started a couple of weeks ago with some comments by Condoleezza Rice and was exacerbated by President Bush a couple of days later (shocking).

I’ve looked over a number of articles discussing this issue and, as usual, most of them just pick and choose which quotes to offer or simply paraphrase what Rice and Bush (hereafter referred to as Brice) said. To paraphrase the paraphrasing, a good portion of the commentary has gone something like, “Brice blames rising food prices exclusively on the irresponsible growth in India and China and their lack of willingness to continue starving for the benefit of the West. To address this travesty, the U.S. is now developing a secret program to sterilize all of the women in both countries to ensure a continued orgy of steak, ale, Oreos, and Hummers for the best, brightest, sexiest, most shaved, and most smiled-upon people ever to grace the face of the planet – Americans.”

Let’s actually take a look at exactly what our beloved leaders said. First off, Rice was offered the following question at a recent Peace Corps Conference:

Many of us are in countries where the predominant source of food is grain, rice, et cetera. And I’m wondering about your thoughts about the US government’s thoughts about the skyrocketing prices of grain worldwide?

Her reply

We obviously have to look at places where production seems to be declining and declining to the point that people are actually putting export caps on the amount of food. Now, some of that is not so much declining production as apparently improvement in the diets of people, for instance, in China and India, and then pressures to keep food inside the country. So, that’s another element that we have to look at.

Now let’s look at exactly what Bush said a few days later.

Worldwide there is increasing demand. There turns out to be prosperity in developing world, which is good. It's going to be good for you because you'll be selling products in the countries, you know, big countries perhaps, and it's hard to sell products into countries that aren't prosperous. In other words, the more prosperous the world is, the more opportunity there is.

It also, however, increases demand. So, for example, just as an interesting thought for you, there are 350 million people in India who are classified as middle class. That's bigger than America. Their middle class is larger than our entire population. And when you start getting wealth, you start demanding better nutrition and better food, and so demand is high, and that causes the price to go up.

So…………they’re basically saying that declining production, trade restrictions, and the increasing demand for more and better food from a wealthier developing world are contributing to the rise in food prices. Sounds like a no-brainer to me. The problem with it, apparently, is simply that Brice didn’t explicitly state that these were SOME of the factors impacting food prices rather than ALL of the factors.
Because of this, we’ve seen an outpouring of hostility and disbelief from a portion of the developing world, most notably India, which is screaming that the U.S. is the real culprit behind rising food prices. Here’s an example from the NYT article,

…Pradeep S. Mehta, secretary general of the center for international trade, economics and the environment of CUTS International, an independent research institute based here, said that if Americans slimmed down to the weight of middle-class Indians, “many hungry people in sub-Saharan Africa would find food on their plates.”

He added, archly, that the money spent in the United States on liposuction to get rid of fat from excess consumption could be funneled to feed famine victims.

Explaining the food price increases, Indian politicians and academics cite consumption in the United States; the West’s diversion of arable land into the production of ethanol and other biofuels; agricultural subsidies and trade barriers from Washington and the European Union; and finally the decline in the exchange rate of the dollar.

Mr. Mehta just gave me my newest million dollar idea. Let’s re-package all of that cellulite into 8 ounce plastic containers and market it in the developing world as a high-calorie snack called YoGurth! Everybody wins!

Ok. Now let’s look at who has the upper hand in this argument. I’ve thought short and soft about this, and the winner is………..well, it’s a tie. We can debate the relative importance of each factor, but most of the points that both sides are making are valid.

• As wealth in India and China increases, demand for more and better food increases. This higher demand is one factor leading to rising food prices.

• The average American has enough fat to live off of for two entire years (note: this statistic has not been scientifically proven and was pulled from the author’s nether-region in the interest of editorial expeditiousness).

• Export barriers and tariffs may temporarily limit price increases internally, but they exacerbate global supply problems, lead to higher prices globally, and will likely result in lower domestic supply.

• Americans are the largest per-capita consumers of many things: oil, food, liposuction, therapy, fatuous TV programming, lust, gluttony, greed, sloth, wrath, etc.

• Some farm land has indeed been converted from food production to feed the ethically-bankrupt subsidized beast of ethanol.

What are the key points from all of this?
• The economies of China and India are growing quickly. It’s reasonable to expect them to want to improve their diets. Given that they’re moving from the starvation level to one of mere malnutrition, we Americans should take care not to speak too indelicately with our mouths so full.

• We’re never going to out-run the Indians and Chinese if they ever invade us. It’s in our own best interest to fatten them up.

• It’s hard to get the full story from the press. They write with the short attention span of the average American in mind and therefore feel the need…………….what were we talking about?

• YoGurth – Saturate Your Diet with the Taste of America!

• The fertilizer stocks are still looking good. Still a buyer of POT, AGU, and MOS.

Death, Taxes, and A Ridiculous Employment Report

I’m finally getting around to reviewing the latest monthly employment report. I would have tackled it sooner, but I don’t type well when I’m rolling on the floor laughing and coffee is coming out of my nose. Now that my sides have stopped hurting and my nose isn’t burning, let’s take a look at the report.

To recap, the market was looking for a loss of 80,000 jobs in April, and the “official” number came in much better at a loss of only 20,000. The media pretty much universally applauded the report with headlines such as:

“US Stocks Rally on Jobs Report” – International Herald Tribune

“Jobs: Glimmer of Good News in April” – BusinessWeek

“Fur Seal Caught Trying to Have Sex With Penguin” – FoxNews

“Stocks Seeing Strong Gains On Employment Report” – RTT News

“Job Loss Far Below Expectations” – TheStreet.com

This employment report reminded me of the recent Google and Intel quarterly earnings reports. If you keep bringing down the estimates prior to the report to a level that’s easy to beat, you look like a hero when your report is just bad instead of apocalyptic. The purported loss of 20,000 jobs should look very suspect to anyone willing to pop an extra Ritalin, take a few minutes, and look beyond the headlines (this rules out most portfolio managers, government employees, and the breathing).

To really understand the employment numbers we have to look at what the Bureau of Labor Statistics (BLS) calls its Birth/Death model. According to the BLS,

There is an unavoidable lag between an establishment opening for business and its appearing on the sample frame and being available for sampling. Because new firm births generate a portion of employment growth each month, non-sampling methods must be used to estimate this growth.

What’s going on here? Basically, the BLS samples businesses and government agencies for its employment report. These sampled entities account for about 1/3 of all nonfarm payroll jobs. The BLS should be able to accurately measure the change in employment for those firms that remain in the sample from one month to the next. After coming in late for work on one of his 27 annual non-holiday work days, catching up on the latest Hollywood gossip online, and taking a lunch break that would make even the Italians blush, your average government employee can still probably muster up the simple arithmetic needed for this calculation. The picture is a little fuzzier for those firms that die (go out of business) since some of them may be too busy hocking their nail guns and backhoes at the local pawn shop to respond to the survey, and others will have already fired everyone, including whoever was responsible for reporting their data to the BLS. The final factor is the birth of new firms. This one isn’t directly measurable in any given month since it takes about 7 months before a newly spawned firm is available for sampling.

So, the BLS created a statistical model to estimate the net employment effect of the recently deceased and the newly hatched. Unfortunately, their model doesn’t appear to be very effective at times when a significant change in trend is occurring. This is hardly surprising. They’re no better than any other government agency, circus monkey, Federal Reserve chairman, or economist at knowing when a recession is underway (no offense to the monkey), so we shouldn’t expect their model to accurately account for this. So there’s a lag between what the birth/death model calculates and what’s happening in the real world at significant turning points in economic activity. When we’re headed into a recession, the model is spitting out fairy tale numbers based on much more robust historical comparisons while real jobs are disappearing. When the economy is turning up and creating more jobs, the model is finally reflecting the preceding deterioration and predicting fewer birthed businesses. Interestingly, they used to admit to this shortcoming on their website but no longer do.

With that background let’s turn to the most recent employment data. According to the bullish BLS report, the economy only lost 20,000 jobs last month. Virtually everyone in the media focused on this figure (including the experts dropped off at CNBC daycare). What they should have been discussing (had they been aware of it) is that this figure includes 267,000 jobs assumed to have been created by the birth/death model! Unless Obama infiltrated the BLS with his cronies who secretly adjusted the numbers for his 7 new states, this number is ridiculous. Ignoring those assumed jobs, the economy would have registered a loss of 287,000 jobs. Can you imagine how the market would have reacted to that headline?!

So, GDP is flat-lining, the financial and retail industries are suffering, manufacturing remains a basket case, and housing is in freefall, but somehow this model assumes that new businesses created 267,000 jobs last month. It stretches the limits of one’s imagination. Where exactly is this job growth? Not everyone can be a repo man, auctioneer, or Wal-Mart greeter. The model tells us that 72,000 jobs were added in the “Professional & Business Services” category. Maybe all of those ex-Realtors and mortgage brokers have reinvented themselves as credit repair specialists. 83,000 jobs were supposedly created in “Leisure and Hospitality”. I guess it’s possible if they’re counting all the new stay-at-home Dads. 8,000 new “Financial” jobs were supposedly created despite the carnage in banking. Maybe they recategorized all of the lawyers now lining up to sue the banks?

I saved the best category for last. The model assumes that 45,000 jobs were created in April in the construction industry. The construction industry! Seriously, why are we paying these folks? Why do we have or need a BLS if this is the quality of their work? How do they explain this? We all know that the construction firms are going out of business and laying people off. Residential building is screeching to a halt and commercial is now being impacted as well. I suppose all of those people who were fired from their construction jobs turned right around and started their own construction businesses to take advantage of all the business the firm that fired them didn’t have. Before hocking his nail gun I think our pawn shop friend used it to put the last nail in the coffin of common sense.

Here’s another point I love. The actual full release of the employment report runs to 28 pages. Guess how many of those pages make mention of the 267,000 birth boost? Zero. There is a reference to the existence of the birth/death model in the “Frequently Asked Questions” and the “Reliability of the Estimates” sections, but if you want to actually find the number you have to go to a separate web page (http://www.bls.gov/web/cesbd.htm).

Furthermore, we all know that the employment figures are often significantly revised. The birth/death figures are no different. So, why does anyone pay attention to these releases, and why does the market move on this “news”? First of all, most participants don’t take the time to delve into the details of these reports. As I mentioned, the BLS doesn’t even provide the birth/death figures in its 28-page release. Second, even if you know these numbers are inaccurate at best, if you think that the rest of the market is going to pay attention and trade off of them then you need to be interested in them, too. In this case, if Trader Timmy is going to jump off a bridge, you’d better at least go and dangle your toes off the edge.

As for the BLS statistical methodology, I’m not one to rush to judgment. In the interest of fairness, I decided to use their random sampling methodology on the BLS itself. The results were as expected. I just came up with the B and the S.

.....Stuck In The Media With You

"U.S. Stocks Slip on Crude Oil, Fall Hard" - TheStreet.com
"Stocks Fall on Gushing Price of Oil" - Chicago Tribune
"Stocks Decline as Oil Prices Creep Higher" - Associated Press
"Stocks Skid on Record Oil Prices" - Seattle Times
"Stocks Sink as Oil Soars" - Business Week
"Oil at $123 Hits Wall St." - Reuters
"Stocks Retreat as Oil Prices Creep Higher" - Forbes

This is just a sampling of the headlines I saw concerning Wednesday's stock market decline. I've always been amused at how the press seems to think they can precisely explain just why the market goes up or down on a daily basis. Did oil prices rise Wednesday? Yep, by about 1.45%. Did the stock market fall? Yep, by about -1.80%. Isn't it logical to assume that the higher oil price led to the stock market decline?

To help answer that question, let's look at the stock and oil action from Tuesday (the prior day). Oil prices rallied nearly 1.5%, which just happens to be about the same percentage increase that the price of oil rallied on Wednesday. So let's check to see how much the stock market fell on Tuesday. What's this? It looks like the S&P 500 was actually UP 0.75% on Tuesday. Well, how about that? Oil prices spiked, but the stock market went up.

So, how is it that the press knows that Wednesday's oil price increase led to the stock market decline if a similar increase the day before was met by a rising stock market? The simple answer is that the press doesn't have a clue. Of course, when terrorists destroy the World Trade Center we can be pretty sure why the stock market falls. However, on the vast majority of days there are far too many variables at play to really KNOW why the stock market rose or fell.

Did some people sell stocks yesterday only because of the rising price of oil? There are many thousands of participants in the market each day. Someone out there sold solely because of the rise in oil prices. Someone else out there probably sold because the entrails of the squirrel they ran over that morning looked a bit suspicious, but we'll leave that for another article. Most market participants don't focus solely on one factor. In all my years in the investment business (including as an energy analyst), I've never had a conversation go as follows:

Ken: Hey, Doe. Anything looking interesting to you in the market these days?

Portfolio Manger Doe: Hi, Ken. Look, I've got to make this quick. Did you see that oil prices are rising 1.5% today! I've got to dump my stocks.

Ken: Ummmmmm.....ok. But we've been making new highs in the oil market pretty regularly for a while now. What's got you so lathered up today?

Doe: Don't you see it? This is a bearish increase in oil! It's time to blow stocks out, man. I've already liquidated my 401k and invested it in used drill bits.

Ken: So, you must've been selling yesterday as well given that nice jump we saw in the oil price.

Doe: Yesterday? No way. Are you crazy? I was buying. That was a bullish increase in oil!

If oil rises by the same percentage on two consecutive days, but the stock market rises on one and falls on the next, clearly the market isn't just focused on oil prices. What about Cisco's outlook, renewed financial contagion fear, profit-taking, the Miley Cyrus scandal, rising interest rates, exchange rate expectations, the productivity and pending home sales data, the weakness overnight in Asian markets, valuation concerns, etc.? Furthermore, there are large institutional investors who trade based on technical criteria. Maybe some large quant funds exacerbated yesterday's selling with a large sell order based on some technical threshold being violated. Perhaps Buffett and Munger had a spat and Munger started a rumor that Buffett really preferred Diet Pepsi Vanilla to Cherry Coke. Maybe Grandma had to sell off her IRA to pay her mortgage, health insurance, and grocery bill.

Oil prices are just one piece of the puzzle. All we really know is that when the stock market rises, demand for equities exceeds supply that day, and the reverse is true when it falls. It's fine to say that the stock market fell and oil prices rose, but we really don't know the extent to which the oil price rise (or any other factor) CAUSED the decline in the stock market.

(As an aside, let's not forget that the energy sector is a beneficiary of rising oil prices, and the energy sector is a growing part of the S&P 500 and a key reason that overall corporate earnings haven't completely imploded.)

Also, am I the only one amazed at how the press as a whole comes to the same conclusion as to what drove the market? All of these different people sitting in Seattle, Chicago, New York, and London all come to the same conclusion. I couldn't find one headline attributing yesterday's fall to anything other than the rise in oil. Are they all using the same source? Are they just wiring their stories in from the same hash house in Amsterdam? Are they the product of inbreeding?

I've got to run. I've got a hot tip on a used drill bit.

Disclosure: The author is not long used drill bits and does not condone the reading of entrails.