Monthly Archives: June 2010

the stock market and the unemployment rate

June 18, 2010 By in Constructing a Portfolio, Current Market Thoughts, Portfolio management, Stock ideas, Strategy Tags: , , , , , , , , , , , , 1 Comment

Can the US have a robust economic recovery without a fall in the unemployment rate?  Probably not.   GDP growth can be seen as the product of changes in two factors:  the number of workers and productivity.  Without an increase in the workforce, the country’s economic engine is operating on only half its cylinders.

Can the US stock market maintain a substantial advance without a decline in the unemployment rate?  Certainly, it would be easier for US stocks to go up if the domestic economy is booming.  But that may not be entirely necessary.  Several reasons:

1.  Only about half of the profits generated by publicly trade firms come from the domestic economy.  The health of Europe (currently being invigorated by the collapse of the euro) and of emerging markets are also important.

2.  Even the domestic portion of S&P profits doesn’t mirror the structure of the US economy closely.  Some of the weakest economic sectors, like housing, commercial real estate or autos, have virtually no representation in the market.  In addition, only the strongest firms are able to qualify for listing.  So normally the performance of the domestic arms of publicly traded companies is far ahead of that of the overall economy.

3.  (the real reason for this post)  I think it may be important to distinguish between businesses that produce necessities and those that benefit from discretionary spending.  Yes, this is a fuzzy distinction.  Producers of pure commodities like energy may be one thing.  But even staples producers have both value and premium brands, that consumers trade up and down between as economic circumstances dictate. 

Still, there may be an important difference between the profit potential of companies that depend on having more people having jobs and those that benefit from already-employed people having more money to spend.  I think the second group has much greater potential than the first.  How so?

As their operating performance is improving, I’ve been noticing more and more companies who had reduced working hours, or wages/bonuses, or benefits like a 401k match, restoring them.  The latest two examples have come this week:

a.  Fedex, which also remarked in its May quarter earnings conference call on the “undue pessimism” of investors that’s not supported by the strengthening world economy, stated that it is reinstituting pay raises and is restoring half of its suspended 401k match.  Personnel expense for this global company in the fiscal year just ended was something over $14 billion.  My (admittedly rough) guess is that raises and 401k together will amount to an extra $100 million paid to US employees in the coming 12 months.

b.  Wynn Resorts is restoring wages and working hours for most of its employees in Las Vegas to pre-recession levels, at a cost of about $7.7 million yearly.  At the same time, in order to be able to do this (WYNN is cash flow positive but still unprofitable in Las Vegas) the company is laying off 261 workers. 

This may represent the 2010 economic recovery dynamic in a nutshell:  businesses not hiring anyone new, and maybe even laying some people off, but paying existing workers signficantly more than they are earning now. 

The relevant investment question is what these better off workers will spend this extra money on.  Of course, they’ll probably save a larger portion than they would have before the recession.  But they’re certainly not going to spend it all on basics.  There’s already evidence that some WalMart customers are trading up to Kohls, Target or Macy’s (although others are apparently trading down to the dollar stores).  Maybe they’ll take a step further and trade up to mall stores.  My guess is that people will splurge on smartphones, TVs and vacations. 

In any event, however, the 90%+ of Americans who are working will likely be spending signficantly more in the year ahead than Wall Street now expects.  So the portion of the S&P that depends on strong domestic consumer demand will probably do well. 

If we add all this up, the 50% of the market that’s non-US has good prospects.  Let’s say half of the remainder (probably too low) stands to benefit from spending by those now emplopyed.  That would imply that at most a quarter of the market’s capitalization is going to exhibit earnings weakness.  In my experience, the “good” proportion is high enough to be able to drag the “bad” part of the market along with it on an upward journey.  Were the proportions reversed, the “good” stocks would be relative performers, but would likely be mired in a Japan-like swamp.

one caveat

This story will take some time to play out.  It may be another year, or longer, before consumer demand gains enough momentum for companies to begin to look toward the long-term unemployed as a source of workers.  Chronic unemployment at a high level may not be politically acceptable (arguably it should not be acceptable).  I have no idea when or how efforts might be made to redistribute economic energy from the 90% to the 10%–or what effects any attempts to do so might have on stocks.  Something to be on the alert for, though.

thoughts on BP

June 16, 2010 By in Current Market Thoughts, Recent Market Action, Stock ideas Tags: , , , , , , , , Leave a comment

The market for BP’s stock is made or broken in the UK, where the majority of its shareholders reside.  The London Stock Exchange itself is chock full of mature, slow-growing, dividend paying companies with exposure to a wide variety of different geographical areas outside the domestic arena.  There isn’t much tech and not much growth retailing.  In other words, BP is much more a mainstream stock for UK investors than it is for the US.

Britain is thinking cricket, the US is thinking something else. Despite its penchant for listing fly-by-night companies rising from the ruins of the old USSR and its harboring of the worst US financial malefactors, the UK’s expectation for its corporations, including BP, is that they will go beyond the letter of the law to do what is fair and honorable.   The US, on the other hand, seems quite concerned that BP will pay out all its cash as dividends and then present an empty shell to the bankruptcy court.

UK investors, both individual and institutional, are much more dividend oriented than their US counterparts–which shouldn’t come as much of a shock if you accept my description above of what the London market has on offer.  What this means, though, is that the US government suggestion that BP either refrain from paying a dividend or place it in escrow is a far more serious threat to the stock than an American might think.

There’s a lot of bond in the big oils.  That’s what a veteran oil analyst told me when I began to follow the industry in the late Seventies. It wasn’t true during the oil shocks of that period, nor has it been the case during the recent upward spikes in the price of crude.  But I think it is so again today.  As a result, the dividend is one of any oil equity’s main attractions.

Investors will look not only at the current payout (a sky-high 10.7% in BP’s case), but also at the prospects for growth in earnings and cash flow, and at the percentage of profits (very high for BP) now being distributed  to shareholders.  On most of these measures, BP looks sub-par.  And the yield itself, because it is so far above the norm for the big integrateds–around 4%–should be read as an indication by the market that the payout will be cut.

BP looks very cheap, on a price to book (less than 1) or price earnings (below 5) basis.  As a foreign firm, BP does not make the extensive disclosure of the value of its reserves that the SEC requires of US listed companies (BP trades in the US as an American Depository Receipt–basically a bank IOU backed by shares of BP held in its vaults).  So price to book is probably the best measure of value.  However…

The stock has become a political football. President Obama has been stung by his negative standing in polls of voters who put him in office to be an agent of change, only to find him wilting before a political establishment they perceive as thoroughly corrupt and want him to fix.  He has decided (mistakenly, I think) to show he is “tough enough” by kicking around a foreign oil company–which doesn’t address the real issue, but risks offending almost no domestic interest.  Unluckily for it, BP is his target.

The current oil spill is not BP’s only recent misstep. The firm had a disastrous joint venture in Russia, for example.  It experiencing a major refinery fire in Texas that cost 15 lives.  The US Chemical Safety Board attributed this worst industrial accident in the country in fifteen years to overzealous cost-cutting.  In the case of the oil spill, press reports again suggest that BP was cutting safety corners to get drilling back on schedule.

Good wells are always better than anyone expects; bad wells are always worse than anyone thinks. A pearl of wisdom from a long-time petroleum executive I dealt with years ago.  I’ve found it to be true not only in the oil business but a good rule for companies and stocks in general.  Whether some companies are just plain unlucky, whether some management flaw is deeply imbedded in a corporate culture or whether some mistaken way of doing things is broadcast throughout a company by the top brass is irrelevant to an investor.  The bottom line for me is that when things go bad, they tend to proceed far beyond what one would typically believe possible.

Several brokerage house oil analysts have come out in recent days to say that the market has severely overreacted to the bad oil spill news and that BP is very cheap.  The stock has lost almost $100 billion in market value since the oil leak news first became public and has underperformed both XOM and CVX by more than 40% over that span.  BP trades at a discount to book value, XOM at 2x book and CVX at 1.5X.  This may be lay-up for value investors.  As a growth investor, the stock still scares me.

movie box office futures approved for trading: implications

June 15, 2010 By in Entertainment, Industry Analysis Tags: , , , , , , Leave a comment

Monday the Commodity Futures Trading Commission approved the first of what you’d expect will be a steady flow of futures contracts related to movie box office.  The initial contract will cover the opening weekend box office for Takers, a Sony crime movie slated to be released in the US in August.

The CFTC approved the contract on a split 3-2 vote, despite very strong opposition from the film industry.  The movie makers argued, to no avail, that the contracts were frivolous, could easily be manipulated and served no hedging purpose and were not in the  public interest.  Hollywood does have another arrow left in its quiver, however.  It is lobbying heavily in Washington to have Congress outlaw trading in movie-related futures as part of the financial reform legislation wending its way through Congress.  The Senate has already okayed a ban; the House has not.

I have two observations:

1.  The contracts might be fun–sort of like internet betting on presidential candidates–but I don’t see how they serve any national interest.  I was surprised to learn from the Wall Street Journal,  however, that serving the public interest is no longer a relevant issue in commodities trading.  That requirement was removed from the laws governing commodities trading in 2000, presumably by the same laissez faire “geniuses” who repealed the Glass-Steagall Act, opening the doors to proprietary trading by commercial banks, and   default “swaps” and other toxic derivative instruments.  Who were those people?

2.  I think the movie industry has a legitimate concern about the potential for attempts by contract holders to try to influence opening weekend box office.  I can’t imagine that the industry is too worried about positive viral campaigns on the internet.  But, given the falloff in DVD sales over the past couple of years, coupled with how soon after release box office revenues have begun to tail off, a negative social networking or other internet campaign has the potential to be very damaging.

That’s what Hollywood is saying, anyway.  I don’t think that’s the issue uppermost in film companies’ minds, though.

Only about one in eight movies makes a profit.  That’s partly because movie making is a high risk profession.  But it’s also because Hollywood follows a series of complex, arcane accounting and operating procedures that have the effect of separating outside investors from their money in the most efficient manner possible.  These investors seem to me much like the limited partners in oil and gas or real estate tax shelters.  They get the ego satisfaction of rubbing shoulders with industry bigwigs, and the ability to  name drop at social gatherings, but little else.

That’s because, until now, outsiders have only been able to exchange their money for a share of (usually non-existent) profits, not the revenue participations that all the insiders have.  With the advent of commodity contracts based on revenues, outsiders have an alternative to accepting the bad deal they have been getting from the studios.  I think it’s the potential loss of this hedge fund “dumb money” that really has Hollywood upset.

BIS: a currency collapse is a good sign, not a bad one

June 14, 2010 By in Basic Concepts, currency effects, Current Market Thoughts, Recent Market Action, Stock ideas, Strategy Tags: , , , , , , , , , , , , , , 1 Comment

In its latest quarterly review, published this morning, the Bank for International Settlements (the organization that comes up with international bank capital adequacy rules) presents results of research into currency collapses that is of particular importance to stock market investors.

the bottom line

The research studies a large number (79) of past currency collapses, mostly in developing countries.  There’s a complicated definition of what constitutes a collapse, but it’s basically meant a drop of 22% or more in the value of a country’s currency in a short period of time.

Collapses are associated with a permanent loss in real GDP of 6%–not a good thing.  –also something you’d expect to see.

What’s interesting about the study, though, is that it finds the output loss begins three years before the currency drop.  Therefore, although the currency decline is correlated with the output loss, the currency movement doesn’t cause it.

In fact, quite the opposite.  The currency collapse appears to mark the beginning of a period of accelerating economic growth that would likely not have occurred in the absence of the currency decline.  The better economic performance continues for several years, and ends up offsetting about two-thirds of the economic loss.

In other words, the currency decline, although frightening, is the first sign of economic healing, not the harbinger of further economic doom.  (Note, again, there’s no claim to have established causation.  The only assertion is that the better economic performance comes after the currency debacle.)

think:  the euro

The fall in the euro vs. the US dollar has been 21%+ over the past half year or so.  For my money, this counts as a currency collapse.

We know in theory that currency decline has three effects:

–it acts like a drop in interest rates as a stimulus to economic growth,

–it redistributes economic energy toward exporters and import-competing industries.  It channels growth away from importers and foreign manufacturers.  And,

–it increases the value to locals of foreign hard-currency assets.

Said a different way, a stock market investor should look for companies that have hard-currency revenues and weak-currency costs.

My experience with European stocks has been that recognition of the new currency facts of life lag the actual currency movements by a couple of months.

What does the BIS study add to these theoretical musings?  The fact that in 79 past instances, this is the way things have turned out.