Gold Price Forecasts Oil Consolidation

Tom and Sherman McClellan have pointed out several times in their McClellan Market Report newsletter that the price of Oil trails the movement of Gold by about 11 months.  It’s an odd relationship that defies logical explanation but it does hold up pretty well over time, aside from event driven oil spikes such as the first Gulf War. 

Based on the price of Gold, the current view is that Oil should experience another near term spike higher before entering a long 8 month trading range.  The following chart is the current picture of gold which exploded out of a sideways triangle formation earlier in the year. 

Gold_today

I would guess that the Oil trading range will be remain between $66 and $56.  Tops will be marked by an RSI (14) reading of 65 – 70 and bottoms by an RSI reading of 35 – 40. 

Oil_vs_gold_123005

Avoid Low-Quality Investments

Everyone makes the mistake of taking "low quality trades."  Before you make your next trade or investment, make sure you’re not falling into the following trap highlighted by these excerpts from Trader’s U

Low-Quality Trades: Lots of Activity, Little to No Profit

Have you ever taken a trade or gotten into an investment that you knew was not that great as soon as you entered?

I’m sure that you recognize it – one of those trades or investments that didn’t quite meet all of your set-up and entry requirements, but you took it anyway. I call these "low-quality trades." These are the positions that even the most experienced professional finds on his trade blotter every once in a while. They are the "fodder" of the trading industry. I really like that word – fodder. Webster defines it this way:

fodder (n): inferior or readily available material used to supply a heavy demand

And that’s just what "low-quality trades" are. They are inferior to the high-quality trades that we all long to make each time we open a position. And they certainly are readily available – you can take a low-quality, coin-toss type of trade any time you like. But the key for traders and investors who find themselves taking low-quality trades is found in the last part of Webster’s definition – "used to supply heavy demand."

When you take a trade of dubious quality, what demand in your life is it supplying? Why are you taking a trade that doesn’t measure up?

Are you bored?
Do you need the action of trading, even at times when a high quality trade doesn’t exist?
Do you believe that success only comes from hard work or furious activity?
Are you frustrated by your last trade or trades, and trying to "take it out on the market?"
Are you trying to make up for losses that you took earlier in the day, month or quarter?
Does your broker need some new equipment for the family yacht?

Low-Quality Trades: Spyware for Your Brain

For many people, managing low-quality trades is the biggest drain they have on their profit potential. Why? Let’s look at the real costs associated with low quality trades.

As a reminder, low-quality trades are those that don’t quite meet your set-up and entry requirements. These are the trades where you "relax" your entry rules, and trade on a tip, or just because the market is in the middle of a big move and you don’t want to miss it.

These marginal trades tend to be more like coin flips. Here are just three ways they hurt us:

1. Spyware for your brain. Managing low-quality positions dilutes the attention and resources that you can apply toward finding and executing higher-quality trades. This "opportunity cost" of taking marginal trades can be quite high if it makes you miss some really good trades or investments. Managing low-quality trades eats up a large part of your brain’s processing power. Just like spyware. At the least, they’re a distraction. At worst, they command your complete attention and keep you from finding and executing more profitable opportunities.

2. Eaten alive by transaction costs. While low-quality trades chew up your mental energy, the transaction costs of these trades (slippage and commissions) eat up your account’s equity. Even if they’re 50/50 trades, they will consume your account little by little. Let’s look at an example…Say you make five low-quality stock trades per month, just to keep yourself from getting bored. With a $10 commission per side, and a $10 slippage getting in and getting out, you are spending an extra $200 per month, or $2,400 per year just on transaction costs! And if the frequency of your low-quality trades is worse, or your commissions and slippage are higher, this figure can balloon from there.

3. The physical and emotional cost. No one needs more stress in their life. But many of us add the stress of managing bad trades to our already taxed system. As we’ll discuss next week, many low-quality trades are born out of stressed states when we are more prone to let our guard down.

Trading and investing have plenty of challenges of their own – without adding the costs of taking low-quality trades that we really shouldn’t be in.

If you’re bearish (post Fed hikes)…

Since it seems the last Fed hike is quickly approaching, it’s worth taking a look at what happens to equities after a tightening cycle.  The conventional wisdom states that the market should act well after the last Fed hike, like it did after 1994.  However, several different analysis methods forecast a difficult 2006 for the equity markets. 

It’s often a bad idea to bet on conventional wisdom, as Bear Sterns strategies Francois "All-Star" Trahan points out in his November 19th report.  He points out that in the 1950s and 1960s, the market actually went down post a tightening cycle…

Currently, the most common belief among Wall Street pundits is that the equity market will soar ahead as soon as, if not slightly before, the end of the Fed tightening cycle — à la 1994-95. The thinking behind this theory is fairly simple: “Equities typically do well when the Fed is done raising rates.” We would have no issue with that statement if the analysis were limited to the 1980s/90s. Very true, in those two decades, stocks rallied strongly following the last rate hike of a tightening cycle. That said, the reason equities did well in those episodes is explained by the sharp decline in bond yields that typically followed the end of a tightening phase.

The key question we would raise is whether equities can behave this way and rally strongly when the ten-year Treasury yields a mere 4.5%. In our opinion, the answer to that question is no! In that sense, we believe the 1950s/60s, or the last time long-term rates were range-bound at these levels, have more to offer as to what lies ahead for equities here than the 1980s/90s.Post_fed_trahan

The most important element of the equity equation near the end of a tightening cycle is the behavior of market multiples. In the 1980s/90s, a world marked by a secular decline in long-term rates, the forward multiple of the S&P 500 was largely influenced by gyrations in the long end of the yield curve. As such, the catalyst that fueled equities following the last rate hike of the Fed tightening cycle was a decline in bond yields.

Interestingly, things did not always unfold this way. Indeed, in the 1950s/60s, a world marked by low and range-bound long-term rates, the forward multiple of the S&P 500 was far more susceptible to changes in economic prospects than mild variations in long-term interest rates. In other words, multiples then correlated with and looked a lot like leading indicators of the economy. As such, the element that influenced equities in a post-tightening environment was not changes in long-term rates but rather changes in leading indicators of economic activity.

The performance of the equity market in a post-Fed environment will look very different in a 1950/60s world than in the 1980s/90s, which makes sense since the drivers of multiples are very different themselves. The chart above shows that the equity market suffered in the 12-month period preceding the last rate hike of early 1995 and did well thereafter.

This stands in contrast to the 1960s, where equities held their own during the tightening phase only to weaken later, typically when leading indicators were under pressure. A quick glance at market and, in particular, multiple behavior reveals that equities today appear to be behaving a lot more like they did in the 1950s/60s than in the 1980s/90s.

As such, investors should not expect to see the market surge ahead here when it becomes clear the Fed is done, in our view. Rather, the start of the next major move in equities should coincide with a turn in leading indicators, a development that typically occurs a few quarters past the last rate hike.

Similarly, the Bank Credit Analyst points out that a sideways market is much more common than a roaring bull market this far into the upturn.  From the December Bank Credit Analyst…

The stock market upturn began in late 2002, and since then, the trend in real equity prices has closely tracked the average of previous rallies.  The chart is based on the market cycles that followed the previous eight bear markets during the post-WWII period.  If the market was to keep following the historical average, it would imply that prices will make little progress during the next six months or so, before suffering a significant correction in the second half of 2006.  Only then, would a major new rally phase take hold. Past_upturns

Of course, no two cycles are ever the same, and historical averages are made up of diverse experiences.  In the past, the monetary cycle was often in a restrictive phase by the time that an equity bull market had moved into its fourth year, but that is not likely to be the case this time around.  Thus, there will not be any pressure on valuation from rising interest rates, and less risk of a major economic slowdown.  At the same time, corporate sector finances are in much better shape than normal. 

Finally, the four year stock market cycle could start to exert its influence beginning any moment.  The four year cycle has been extremely good at marking market bottom and it’s pointing to a bottom in the Fall of 2006.   

Four_year_cycle_120705

I’ve been bullish based on my belief that the Fed will soon be done with its rate hikes.  However, there’s compelling analysis to show the market doesn’t have to take off to the upside and could in fact stay in its two year trading range before making a more significant bottom next Autumn. 

OSX 2005 vs SOX 2000

I’ve been neutral to outright bearish on the oil stocks for almost six months now but a recent piece of research that suggests the OSX is due for a blow-off top has me rethinking my negative stance.   

I’ve been bearish because 1) sentiment was becoming over-exuberant about the prospects for higher oil prices ($100 oil target by Goldman Sachs); 2) rising stock prices have discounted much of the increase in the commodity, already (the OSX and Energy Sectors are by far the strongest industry groups for the past year); 3) despite the concerns about "peak oil," the oil and natural gas inventories are actually above 5 year averages; and 4) price has been overextended numerous times and the DeMark indicators have given numerous sell signals. 

The recent drop in the price of oil vs the corresponding rise in oil related stocks had me becoming even more bearish.  It seemed to me that the market had completely lost touch with the underlying commodity price and was trading solely on momentum. 

However, a piece from Tycoon Research has me revisiting my bearish thesis.  It’s a simple argument – the OSX is about to experience a blow-off move like the SOX did in 1999.  From hedge fund manager Teeka Tiwari comes the following analysis…

I’m buying options on the Philadelphia Oil Service Index, or OSX for short. As I’m sure many of you know, Oil Service stocks are the companies that provide all of the ancillary services 
to the major oil companies. They provide drilling rigs, helicopters, seismic surveys, well construction, etc …

The Big Oil companies are currently sitting on over $100 billion in cash, and must put it to work or risk having Congress take it away from them. Don’t think Congress can’t impose "windfall" taxes and price controls.  They did it in the ’70’s, and aren’t above making the same mistake twice if the political heat gets intense enough. 

Because of fear of collapsing oil prices, Big Oil companies have vastly UNDER INVESTED in finding and bringing on line new oil wells; but find more oil they must, or risk the wrath of Congress. 

It’s this massive pent up exploration spending that is going to drive the oil service stocks through the roof. 

Think about it logically. The OSX is trading at about the same level it was when it peaked back in 1997 and 2000.  Anyone remember what oil was trading for in 1997 and 2000? It was $26 and $36.50 respectively!  That’s a heck of a lot less than today’s price of 58 bucks.

That’s a pretty straight forward argument and the charts and fundamentals back up the idea.  The following is a weekly chart of the SOX from 1995 to the latter half of 1999.  In 1999, the SOX had already made a strong move out of a four year base and had blown past several DeMark sell signals, as the chart below shows.

Sox_vs_osx_112699

Source: Bloomberg

Similarly, the OSX has already made a strong move out of a multi-year base blowing past its share of DeMark sell signals, too.

Sox_vs_osx_2_112605

Even after a strong run, the SOX managed to stage a huge blow-off into 2000.  After moving steadily higher in the latter part of 1999, the SOX formed a small base and exploded higher in 2000 until it hit the top of the tech bubble in March 2000. 

Sox_vs_osx_3_112605

The key to staying long in a momentum trade like this is having the patience to ride out the volatile sideways consolidations.  As long as the market doesn’t make a lower low, the potential for a blow off run exists.  The two charts below show the consolidation areas marked in green boxes.

Sox_blow_off

Osx_blow_off

Besides being an anagram (eerie!?!), the OSX and SOX industry dynamics are actually remarkably similar.  Both are highly cyclical industries.  Both industries experience wild swings in earnings because of the high fixed costs and cyclicality of the business.  Both industries often trade on "peak earnings" (what the companies will earn at the top of the cycle) multiples.  And both industries are subject to wild swings in the stock prices because investors often times confuse the rising cycle with a "new era of growth".

And, like the OSX, the SOX looked expensive when it started its move higher but only became more expensive as the blow off progressed.  The SOX started its run when the industry traded around 40x earnings and didn’t peak until it traded at well over 70x earnings, as the chart below shows.

Semi_earnings

Source: Baseline

Similarly, the OSX currently trades around 32x earnings, which is still at the low end of the historical range.  If the market becomes over exuberant, I could easily see the OSX trading at 50x – 70x earnings. 

Oil_driller_earnings

So while I hesitate to buy stocks high in hopes of selling them higher, I also realize that I have been wrong about energy stocks in the past six months because I didn’t "see" the other side of the trade.  A blow-off top is a very valid scenario that makes me more reluctant to be short the stocks and even contemplating switching to a long posture. 

Multiple Compression Could Turn Into Multiple Expansion With Lower Commodity Prices

Following a solid spring, a combination of macroeconomic and industry specific factors began to be manifested retail.  These have been well cataloged and include higher transportation and energy costs, the economic impact of the fall hurricane season, rising interest rates and concerns about increasing inflation and a slower economy.  This is a pretty depressing litany of factors outside our control, but most are not altogether new…

– Paul R. Charron, Chairman and CEO, Liz Claiborne

Liz Claiborne isn’t alone in feeling the effects of high transportation, energy, and interest costs.  I would argue that the entire market is being compressed by these factors.  By compressed, I’m referring to a phenomenon called "earnings multiple compression." 

As a matter of background, investors are usually willing to pay a certain multiple of earnings (referred to as the Price/Earnings (P/E) multiple) for a stock based on its growth and quality characteristics.  Investors will pay a higher multiple for strong companies with consistent, sustainable earnings growth (for example, Ebay trading at 38x earnings) while investors will pay a much lower multiple for highly cyclical companies (for example, homebuilder Toll Brothers trading at 7x earnings).   

That implies that there are two key variables to figuring out what investors will pay for a stock – the earnings themselves, and the multiple of those earnings.  Typically, when stocks move significantly higher, it’s not just the higher earnings that investors are taking into account – they are also willing to pay a higher multiple for those earnings.  Investors are inferring that the earnings growth is sustainable and are willing to pay a higher multiple for that growth.  Similarly, when a stock collapses because of poor earnings, investors are not only factoring in the lower earnings estimates, they are also paying a lower multiple for those earnings. 

The same phenomenon applies to the overall market.  When investors are confident of future earnings growth, they are willing to pay a higher multiple for all stocks.  The huge market run up in the late 1990s was mainly the result of "earnings multiple expansion."  Earnings growth was generally in line with historical averages but investors felt confident that the growth would go on forever and began paying a higher multiple of earnings for that growth.  The chart below shows the multiple expansion and subsequent compression on the S&P 500.  The top half of the chart shows the S&P 500 price along with the earnings per share of all the S&P 500 companies.  The bottom half of the chart shows the earnings multiple of the S&P 500 stocks.  Currently the forward price to earnings multiple of the S&P 500 is 15.6x, which is at the bottom of the range. You can see that it has been as high as 27x in the late 1990s. 

Spx_pe_102505

Source: Baseline

You can also see on the top half of the chart that the earnings per share growth (EPS is marked by the dotted line) has been strong in the past three years.  In 2006, the S&P 500 companies are expected to earn over $80 per share.  That’s up from about $50 per share in 2003.  So in the past three years, earnings have grown by about 60% but the S&P 500 is only up 35%.  Investors are clearly not willing to pay a high multiple for the earnings of the S&P 500 companies. 

You can also see this phenomenon by looking at a long term price chart of the S&P 500.  The rally from 1996 to 2000 broke out above the long term trend channel that the market had carved out from the early 1980s.  While prices often break above or below long term trend channels, the fact that the S&P 500 stayed above the price channel so long is truly amazing.   The multiple expansion of the late 1990s caused an aberration on the price charts. 

Spx_102705_long_term

Currently, investors aren’t willing to pay a high multiple for the earnings because of the factors listed so succinctly by Liz Claiborne’s Chairman.  Investors have low confidence that the earnings growth is sustainable because of the high commodity and input prices.  These costs can be viewed through the lens of the CRB index, which measures a broad basket of commodities.    The chart below shows the CRB index in the third panel of the chart.  You can see that since the CRB broke to new highs, the S&P 500 multiple has remained relatively flat. 

Spx_crb_102505

Source: Baseline

Typically, the higher CRB index would imply higher rates of inflation.  And that would normally translate to higher interest rates.  However, that has not occurred during the past three years.  Interest rates remain at relatively low levels, as the chart below shows.  The ten year yields have just now started to creep up to the top of the range. In addition, the inflation adjusted 10 year TIPS have just now begun moving higher.  That’s part of the "conundrum" that Greenspan kept talking about.  There’s clearly inflation in commodity prices but interest rates haven’t reflected it.  This presents a potential problem – if interest rates start moving higher on top of the high commodity prices, the earnings multiple of the S&P 500 could be compressed even further down.    

Spx_tbonds_102505

Source: Baseline

However, if the opposite happens, that is, commodity prices stabilize and begin moving down, then the interest rates will probably remain a moot point.  Currently, I’m watching two key commodities for signs that commodity prices will move lower.  The first, crude oil, is being watched by everyone.  The second, steel scrap, is a bit further off the radar. 

Spx_commodity_102505

Source: Baseline

If these commodity prices begin declining, the "earnings multiple compression" currently affecting the market could turn into "earnings multiple expansion."  Right now, the market is trending at the bottom end of the long term price channel.  I believe the market could easily move back to the middle of the long term price trend.  That would imply a move to 1,500 or 1,600 on the S&P 500.  I believe that a "earnings multiple expansion" led by a move lower in commodity prices could spur such a move higher in the S&P.

Why Investors Should Use Technical Analysis

Yesterday, a heated discussion of technical analysis broke out on the Realmoney.com chat board with some participants declaring they don’t “believe” in technical analysis.  It’s the same discussion that breaks out about once a month on Realmoney.com and it’s often repeated on other fundamentally oriented sites like Fool.com. 

But saying you don’t “believe” in technical analysis in investing is like saying you don’t “believe” in hammers in carpentry.   It’s a completely nonsensical statement that is borne out of hubris and complacency.   Technical analysis is simply an investing tool and using it competently can only increase your investing success.

Just like learning to use any tool, the quality of the end result will depend on the skill and aptitude of the user (the first time I used a hammer, I broke my dad’s finger as he was pointing out where not to hit.)  Does using any tool preclude making mistakes?  Of course not.    Does it preclude two competent technicians from reaching completely different conclusions?  Certainly not.  Just like two fundamental analysts can come to different conclusions about the value of a stock based on the exact same financial data, two technicians can come to different conclusions about the direction of the market.  Of course, no one ever questions whether "fundamental analysis" as a practice is valid or not…they just question the competency of the analyst. 

Numerous practitioners of technical analysis make it seem needlessly complex and arcane (myself included).  However, understanding simple concepts such as the Trader Vic 1-2-3 reversal and how to draw a trend channel is not complicated.  Simple technical tools can save you hours of time searching for new investment ideas and thousands of investing dollars in timing entries and exits.  Despite what academics and fundamental analysts will have you believe, prices move in trends and understanding those trends with technical analysis will help your investing results.

 

I use technical analysis in several ways.  First, I use it to find stocks to buy.  I screen for oversold stocks based on their weekly charts.  I like buying oversold stocks because I want to buy high quality companies whose stocks have already gone down.  Arne Aslin from Realmoney.com had a great quote that I have taped to my monitor — "There are only two types of companies – ones that have problems and ones that are going to have problems."  I’m looking for companies that have problems where the bad news is already known and discounted in the market.  If a stock is nearing oversold levels, valuation is at the low end of its historical range and the company is already starting to make improvements, I have a good idea that the bad news has been discounted.  Then all I need to find is a good catalyst such as new management or a new product that can re-ignite the stock. 

The other technical screen I use is to find stocks coming out of long-term bases.  I want stocks that have been going sideways for several quarters or even years through good and bad earnings.  This ensures that the stock is in "strong hands" – investors that understand the story and won’t flip the stock as soon as it moves up or down a $1.  Once a stock is in "strong hands" it can start moving up rapidly once the positive fundamentals start appealing to the greater investing public.  The best example of stocks coming out of long term bases happened in 1994.  Numerous large cap stocks just launched higher out of two and three year sideways ranges as the chart of KO shows.

Ko_monthly

Second, I use technical analysis to time the purchase and sale of stocks.  Once I find a stock to buy, I want to buy it down, ideally as it hits trendline support and/or potential reversal points such as a weekly DeMark Sequential (TM) buy signal.  When selling, I want to sell as the stock is rising into resistance or hitting the top of a trend channel.  Selling into strength and buying into weakness is the only way I know beating the market and generating incremental positive alpha. 

 

Finally, I use technical analysis to provide an "early signal" of a problem stock.  If a stock is supposed to be going up because it has beaten earnings and is in a strong group but is instead lingering or going down, there’s usually something wrong with the fundamental story.  Technical analysis is a great way to "double check" your investment thesis and make sure that somebody, somewhere doesn’t know something you don’t.  This doesn’t mean I sell a stock every time it squiggles under a trendline, but I do sit up and take notice and make sure the reasons I bought the stock are still valid. 

I think these are simple technical concepts that can be added to any investors tool box.  They don’t require you to become a chart reading master and they don’t require huge leaps of faith that moon cycles and ocean tides affect investor behavior.  All the techniques require is an open mind and the "belief" that some tools are worth learning how to use. 

Riding the Bullish Shareholder Rights Trend

It’s trendy to talk about oversized capital gains available in flipping condos and the mind-numbing trading ranges in equity markets.  However, I believe it’s time for some sector rotation out of real estate and back into equities.  Today’s stock market environment is very conductive to making value-based equity investments.  It’s truly a great stock pickers market that should continue to have its fair share of good, steady returns. 

Ironically, this more somber environment is making the steady gains in equities fly under the radar of the mainstream investor.  In the late 1990s, stocks received all the attention when CEOs, declaring they could post 100% growth year over year in the New Economy, came on CNBC to hawk their wares.  The excitement of new technologies combined with ample liquidity and gun-slinging, overly-promotional executives, created an environment that caught the attention of everyone from hairdressers to Harvard MBAs. 

Unlike the 1990s, stocks today are driven by cautious, conservative management teams that dare not give earnings guidance out of line with reality.  Boards of Directors are finally re-asserting their duty to act in the shareholder’s best interest.  And equity buyout firms are sharpening their pencils and putting their huge capital bases to work in buying solid but undervalued companies.  While none of this is as exciting at 100% pie-in-the-sky growth, it’s what good equity returns are built on.

Here are five trends which make me bullish on equity prices for the next several years:

1.  Boards of Directors are back on the equity investor’s side, not in the CEOs pocket.

Nothing characterized the greed and excess of the late 1990s technology industry more than Charles Wang’s $650 million pay out in restricted stock and options at Computer Associates (CA).  He set the standard for convincing a clueless Board of Directors into giving him an absurd compensation package.  The payout was so rich that the company had to take a special one-time charge to pay for his salary.  As we know now, the company’s strong performance was largely based on aggressive accounting and the stock, which topped in the $80s in 2000, plunged to under $10 by 2002.  Not only did the Board miss the questionable accounting practices but it also rewarded the CEO with one of the most outlandish payments in the history of public companies.  The company is still recovering from the mismanagement of the last five years.   

It turns out, of course, that CEOs who had accumulated large option stockpiles may have been motivated to artificially inflate stock prices and then cash out.   Who knew CEOs could be so greedy? 

Now, for the first time in decades, Board members understand the downside of blindly listening to the CEOs spiel and rewarding him based on his annual presentation to the Directors.  Boards of Directors are now vigilant about accounting issues as well as excessive compensation for fear of being sued or having to pay damages out of their own pockets

In addition, the steep prison sentences for Dennis Kozlowski at Tyco and the Rigas’ at Adelphia highlight the fact that there’s now a steep downside to fraud.  The risk to reward for Boards to let irrational or illegal decisions slide has clearly moved back in favor of shareholders. 

2.  Dissenting Board of Directors Have a New Voice and its not Mickey Mouse.  Investors should thank Roy Disney. 

Until Roy Disney and Stanley Gold took their fight against Michael Eisner to the shareholders, dissident Board of Directors didn’t have much recourse except "retiring" or going along with the rest of the Board.   The fact that Disney and Gold won their fight with Eisner, as powerful and entrenched CEO as you will ever find, gave testament to the power of dissident Board members who have the backing of shareholders.

In 2003, seventy-one year old Roy Disney and cranky value manager Stanley Gold seemed like a weak match for Michael Eisner, whom the two disgruntled Board members had actually hired in the mid-1980s to resurrect the company from extinction.  Eisner had done a masterful job steering the company back to entertainment dominance, culminating with huge success of The Lion King in 1994.  The turnaround earned Eisner huge options grants and the trust and confidence of the Board of Directors. 

Success bred complacency, however.  And after being able to do no wrong, Eisner could do no right.  Disney lost its big screen dominance to Pixar and Dreamworks because of weak talent and poor scripts, the company lost its dominance of the amusement park market to Universal because of chronic under-investment in new infrastructure, and the company made a huge and expensive gamble to buy ABC… and lost.  By, 2002, ABC was the worst rated TV network.  To make things worse, the Board wasn’t about to make any changes.  Despite a negative 10% shareholder return for the 1998 – 2000 time period, Eisner received $699.1 million in stock options and was number two on the list of executives who gave shareholders the least for their pay, according to Business Week.

But after Disney and Gold took the fight to Eisner, something magical happened.  In 2004, California Public Employees’ Retirement System (CalPERS) announced that it wouldn’t back Eisner’s reelection bid.  And while Michael Eisner squeaked by to win reelection, the voice of the shareholders and dissident Board members had been heard.  Eisner and the Board decided to make changes before changes were made for them, with Eisner announcing his retirement as CEO and the Board becoming much more shareholder friendly. 

Shareholders have Roy Disney to thank for the increase in Board member activism in the past year. 

Roy Disney’s victory has lead to the ouster of other high profile CEOs who had the Board under their control.  Carly Firorina mangled Hewlett Packard’s chances of turning around with the purchase of Compaq, but it wasn’t until Disney won his battle that HP’s Board gained some clout.  No executive could be more powerful and entrenched than AIG’s Herb Greenberg.  Despite the numerous scandals, I don’t believe he would have been ousted had it not been for the new power of Boards of Directors.  And recently, despite having the backing of the Board, Morgan Stanley’s Philip Purcell decided to ‘retire’ after it was clear that shareholders were voting against his tenure.   

Board members are becoming more active and are becoming more accountable to shareholders.  In my mind, that means more and steadier returns for equity investors.

3.  Hedge Funds, which are Having Trouble Making Money by Trading, are Instead Taking Controlling Interests in Turnaround Situations to Force Change

Master trader, investor and now business operator, Eddie Lampert, started the trend of hedge funds buying a controlling interest in a corporation with the expectation of taking a Board seat and turning around the operations.  Lampert’s ESL bought a controlling interest in Kmart while the company was in bankruptcy and turned it into a retailer to be reckoned with.  In the process, he earned himself a $1 billion last year. 

Of course, no good hedge fund manager wants to be left behind.  Pembridge Capital Management, a New York-based activist hedge fund, has given notice to Topps that it intends to nominate its own slate of directors at the company’s 2005 annual meeting. 

ValueAct Capital Partners, a hedge fund that no management team wants to see on their top investor list, recently announced it is prepared to buy Acxiom, a chronically underperforming company which provides customer information to businesses. 

And Highfields Capital, a $6.5 billion money manager best known for its activist role at Enron, recently offered to acquire Circuit City for $17 a share in cash.

We would be remiss to omit Kirk Kerkorian’s hedge fund, Tracinda Corp., which announced an offer to purchase up to 28 million shares of General Motors at $31 apiece when the stock was trading at $28.  The fund now owns over 5% of the company. 

4.  Don’t Call it a Comeback – the Leverage Buyout Fund Never Really Went Away, it Just Became a Team Player. 

The downside of low interest rates is that it forces investors to accept higher risks in search of better yields.  The upside is that low interest rates mean lower costs of doing business for leveraged buyout funds.  And that spells more buyouts of weak or underperforming companies.  One of the new trends in LBOs is teaming up with other investors to make a big bet. 

Last year, a group of seven private equity firms bought SunGard Data Systems Inc., a software manufacturer specializing in financial programs. At nearly $11 billion, it was the second largest LBO ever.  In 2004, Kohlberg Kravis Roberts, Bain and Vornado Realty Trust teamed up to buy Toys-R-US in a $6.6 billion deal.   

These mega deals come on top of the steady stream of "smaller" deals such as Apollo Management’s buyout of and distributor Metals USA for about $700 million and last week’s $1.2 billion offer from Thomas H. Lee Partners to buy Callaway Golf.  Even weak companies in the technology industry are finally being bought as Hellman & Friedman’s buyout of DoubleClick for $1.1 billion shows.    These deals create a great environment for value investors because they essentially create a "bottom" for stock prices at which an LBO is a no-brainer.

4.  Industries with Overcapacity are Finally Being Consolidated

One of the enduring problems facing equity investors in the 21st century is the overcapacity in almost every industry, new and old. From fiber optic cable to telecom services to drugs, retail, and autos, it seems there’s too much capacity to build and sell everything.  Overcapacity is a debilitating problem because it causes severe price pressure and keeps investors from earning a decent return on their investment. 

However, management teams and Board of Directors have finally realized they have the power to do something about the overcapacity problem – buy weaker firms to acquire customers and shut down the excess capacity. 

Federated’s purchase of May department stores is a classic example of this strategy finally beginning to take root.  The $17 Billion buyout will allow Federated to close competing stores and allow the department store retailers some room to breathe. 

Similarly, the huge overcapacity in the telecom industry finally seems to be shrinking with the acquisitions of AT&T and MCI.   These companies were classic examples of what happens in overcapitalized industries with too much capacity to begin with.    With Verizon and SBC taking these ailing telecom giants out of their misery, capacity can be rationalized and customers can be transitioned into higher profit businesses such as wireless. 

Finally, the on-line financial services business seems to be consolidating as well with the purchase of Ameritrade by TD Waterhouse.  The financial industry is a perfect candidate for consolidation – while customer acquisition costs have increased exponentially, customer profitability has declined with lower and lower commission rates.  The only way to survive and earn a return on investment in this industry is through economies of scale, which will only come through continued acquisitions. 

5.  Selling Bad Businesses to China

In the late 1980s and early 1990s, the greatest market worry was that Japan was beating the US in every industry – electronics, technology and automotive.  Nothing represented that worry more than when Mitsubishi took a controlling stake in Rockefeller Center in the late 1980s.  Of course, it turns out that the Japanese bought at the top of the market and the Rockefeller’s knew what they were doing the whole time.  By the mid 1990s Mitsubishi took Rockefeller Center into bankruptcy because of the crushing debt burden it had taken on to buy the building.  In 1996, it sold the building to Goldman Sachs – to a group that included, yes, you guessed it, David Rockefeller.   

Today, the same is occurring, except instead of trophy real estate, the US is selling its low margin, low value businesses to the Chinese.  Lenovo’s take over of IBM’s desktop PC business for $1.7 billion highlights this trend.  For the $1.7 billion, Lenovo received 5 percent of the worldwide PC market – a tough and unprofitable position which is at the mercy of industry leaders Dell and HP. 

Similarly, Maytag recently received an offer from Chinese Appliance Maker, Haier, a month after Maytag agreed to be acquired by an investor group that wanted to take the company private.  With its unfunded pension obligations and high debt load, Maytag is in need of serious repair.  While the brand name might be worth something to a low-cost, Chinese manufacturing company, US investors will say good riddance to the chronically mismanaged and underperforming company which has consistently lost market share to Whirlpool, General Electric and LG. 

Apocalypse, Ashmocalypse

To borrow a line from Sports Illustrated, this week’s sign that the Apocalypse is upon us is Morgan Stanley’s Steven Roach changing his long held belief that a collapsing dollar will signal the upcoming financial Apocalypse of the United States because the Fed will raise rates and choke our slowing economy into recession.  From Mr. Roach…

"Given my concerns over the US current account deficit, I have long in the bearish camp with respect to the US bond market outlook.  A rethinking is now in order.  The likelihood of a China-led slowing of Asia has prompted me to change my view.  I now suspect bond yields will stay low for the foreseeable future, and I wouldn’t rule out the possibility that they might even drift lower. "

Contrarian that I am, I want to believe that Steven Roach is the highest profile bond bear who has finally turned tail.  That would, of course, mean that higher rates will be upon us.  However, I don’t think that’s the case and I think lower long term rates could be in offing.  Plenty of investors are still betting on higher rates and it will take a while to unwind these bets and move sentiment to the bullish side. 

The reason I believe Mr Roach is correct in flipping sides is that four percent long term rates aren’t out of the ordinary.  One of my favorite analysts, Steve Sjuggerud at Investment University, made a great case for this last August and his analysis was right on the money – here’s an excerpt –

"There are three things that everyone believes…

Interest rates are at historic lows.
Interest rates are headed up.
Interest rates can’t go much lower.
Today, I’ll show you why all of these beliefs are wrong.

1. Everyone Believes Interest Rates Are at Historic Lows
I put together a chart of U.S. and British interest rates going back to 1720. These are long-term interest rates. You can clearly see that the average long-term interest rate, going back to 1720, has been about 4.7%.

Over the last 200 years in the U.S., long-term interest rates have been below 6%. Only during the last few decades (and for a brief moment during the founding of our nation) have interest rates been higher than 6%.

U.S. interest rates are not at their historic lows. They are in line with their historic average, around 4.5%.

In your own life experience, interest rates are as low as you’ve seen them. But that is only a few decades of hundreds of years of interest rates. Everyone else believes that interest rates are at historic lows. Now you know better.

2. Everyone Believes That Interest Rates Are Headed Up

All you hear on the news is how the Fed is going to raise interest rates. And that, of course, will most likely happen. But what interest rate is it going to raise?

This is where people get confused… Short-term interest rates are at an extreme – the Fed lowered short-term rates so banks can get money at 1%. But long-term rates, like mortgage rates, are much higher, around 6%.

Here’s where the confusion comes in… short-term rates are headed higher… they could go to 2%, for example. But long-term rates may be headed lower… mortgage rates could go to 5%, for example.

Generally, this doesn’t happen… generally, long-term interest rates and short-term interest rates move in the same direction. But the Fed lowered short-term rates to an extreme low, and has to raise them back to "normal." Meanwhile, long-term rates could easily go either way… they’re not under the control of the Fed.

3. Nobody Believes That Interest Rates Can Go Lower

Now, this is a ridiculous assumption! Let me give one simple example:

We’ve only had one other major stock market bubble in a developed country in our generation… and that was Japan’s stock market peak on Dec. 29, 1989. At the time of Japan’s stock market peak, long-term interest rates in Japan were around 6%. As the bubble has burst over the last 15 years, long-term interest rates in Japan actually dipped below 1%!

I created a chart for you today to compare interest rates in Japan and the U.S. I lined up the peak in Japanese stock market with the peak in the U.S. stock market. The similarity so far is uncanny…

Long-term interest rates in the U.S. were at 6% at our stock market peak, too. And today they’re closer to 4.5% in the U.S. – almost exactly where they were four and a half years after Japan’s stock market peak.

I’m not saying what happened in Japan will happen here. I just find it interesting that we have only one other stock market bust in a developed country in our generation for comparison. And in that country, long-term interest rates dipped below 1%!

The point is, YES, interest rates can go much lower."

This doesn’t change the problems faced from an inverting yield curve.  The Fed could still push the US into a recession by continuing to raise interest rates in the face of lower long bond yields.

Even More Signs You Should Double Check Your Investment Thesis on a Stock

And the next installment of even more signs you should double check the investment thesis of your stock investment:

  1. Companies with stock symbols that spell out a funny or clever word.  "There’s a fine line between clever and stupid" and most of the four letter stock symbols that spell a word cross that line.  A stock symbol that spells out a word is usually related to a "gimmicky" company which sports any one or all of the following – 1) a high valuation 2) a high but unsustainable growth rate 3) a promotional management team and/or 4) a high number of inexperienced investors.   For instance, symbol "WOOF" belongs to VCA Antech, a veterinary clinic company.  It’s a very clever symbol and the stock has done very well despite negative same store sales in its clinics for the past two years.   The stock could continue to do well but I won’t touch it because of the symbol – I think it shows a lack of good judgement on the part of management and/or their advisors.  Other violators currently include "TINY", which belongs to nanotech investment company Harris & Harris, "RAIL" from FreightCar America, "CARS" from Capital Automotive REIT and "SWIM" from pool maker Anthony & Sylvan. 
  2. The stock is cheap but has no catalyst.  If you catch yourself saying “I don’t see a catalyst to get the stock higher but it’s so cheap, there’s little downside,” then sell the stock.  Markets are made to find equilibrium of buyers and sellers.  If there aren’t any buyers at current levels because there’s no catalyst then the stock will go down to find a price where there are buyers.  Another problem with buying stocks with no catalyst is that you never know if to sell – the stock could go down and just get cheaper and cheaper.  Then what do you do – do you buy at book value, 1/2 of book value, 1/4 of book value?  Buying stocks where there’s a potential catalyst (new CEO, new strategy, new products) gives you a defined decision point – if the company doesn’t execute as you expected then you know to sell. 
  3. Every analyst on the Street has a buy recommendation on the stock except for one or two independent research firms.  This is more of a 1990s rule before Elliott Spitzer put the clamp on Wall Street research but it still works in some cases.   Most recently it worked with Pfizer (PFE) which had almost all Buys or Strong buys in 2004.  You can almost guarantee that stocks with ten buy ratings and no holds are fully valued – that won’t preclude them from going higher but generally, the risks far outweigh the rewards in these circumstances.  Likewise, it’s easy to dismiss contrary opinions from no-name research houses when you have Goldman Sachs and Merrill Lynch supporting your position.  However, having too many bulge bracket research houses pushing a stock is cold comfort to me.  It means everyone knows the story and has probably already invested. 

  4. The senior executives are under the age of 30.  If a CEO is under 30, he or she probably started the business in their early 20s.  That usually doesn’t give someone enough experience to see the pitfalls and traps most fast growth businesses fall into.  I don’t want to be invested when they invariably step into one of the traps. In general, America loves youth.  But in business, there’s no replacement for honesty and experience. 

More signs that you should double check the investment thesis of your stock

Part Deux of my signs that I need to double check my investment thesis on a stock:

  1. Any company that tells you China presents the next opportunity for revenue growth.  Beware the lure of Chinese math – "If we just sell one gizmo to 1% of the Chinese population, we’ll make billions."  The latest example of this is Federal Signal (FSS).  The problem isn’t the size of the opportunity – the problem is the difficulty of competing in a communist-run economy against local companies that are much more savy and well connected.  In addition, once you get into the country-side, the majority of the 1 billion people make less than $100 a year.  There were scores and scores of companies that fell into the trap of ‘Chinese math’ in the 1990s including Gillette (one razor for every China man) among numerous other household product companies.  If you made $100 a year, how many $5 razors would you own?  Probably 0.  Not that I don’t think a company shouldn’t try to enter the Chinese market…it should.  But as an investor or a manager, I just wouldn’t bank on all future growth coming from this closed, communist country. The only company that this rule didn’t work on is Qualcom. 

  2. Any company that’s in the cross hairs of the incomparable Herb Greenberg.  Whether you love him or hate him, you have to know what he’s saying about a company in which you are invested.  I have never known him to get facts wrong.  He spots problems.  Whether or not the management team can fix the problem is a completely different issue.  The only thing I think he’s been wrong about is timing – and that’s why I use technical analysis.
  3. The company is approaching or just breaking the $100 mln, $600 mln or $5 billion revenue barrier.  In my experience, each of these milestones presents unique operational challenges for companies.  It’s a step-change in operational complexity to go from small to mid and from mid to large sized business.   And unfortunately,  the management team that brought the company to its current step doesn’t have the skills to take it to the next step without stumbling.   
  4. The company is a “roll up”.  Any company that takes a small fragmented “mom and pop” industry, buys up a couple of the companies and plans on growing by doing more of the same, is doomed to failure.  I have never seen a roll-up concept do anything but crash and burn once the industry growth slows down.  The "mom and pops" are selling their companies to the "roll-up" because they know their company isn’t worth the high price the "roll up" is paying.  In other words, if you own the "roll-up" parent company stock, the "mom and pops" are selling to you at the top. 
  5. A Wall Street analyst who covers the company, joins the company as its investor relations person.   You would think that this would be a good sign but its not.  Usually analysts who follow growth companies join the company because they think the stock is dramatically undervalued and the company isn’t doing a good job explaining the "story" to the Street.  However, the stock is usually "undervalued" because the Street knows something the analyst doesn’t.  The analyst has just bought into managements story and usually doesn’t have a good appreciation of the risks involved.  This rule has worked well with Hollywood Entertainment, Scient among many others.