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Wednesday, June 29, 2011

Oil and Vinegar dont mix neither should Oil and Politics

Last week the International Energy Agency(IEA) planned to release 6o million barrels of oil from emergency reserves including 30 million barrels from the US Strategic Petroleum Reserve. The official party line is that the conflict in Libya has removed around 140 million barrels of oil from the market and this could result in tightness of supply and poses a threat to the recovery. The market reaction was to send crude prices plummeting mainly because the announcement was unexpected. Of course we live in a shoot first ask questions later market so the plunge was to be expected.

Looking at the situation realistically I have to question if there were ulterior motives or agendas in action here. In the year 2010, the IEA reported that the world consumed 88 million barrels of oil a day. The much talked about release of 60 million barrels equates to about 2/3 of a day’s supply for the world, or hardy enough to cause the dramatic price drop we experienced.  As soon as I heard this news my first thought was this was a politically motivated move and I still believe that it is. My suspicions were heightened to this as Timmy “Turbo Tax” Geithner began making the rounds stating that the release was not political almost like a Jedi mind trick. I can almost picture Timmy on TV saying “These are not the barrels you are looking for..”

So what is the going on here? There is no way to know for sure but in the current environment both politicians and governments around the world are deceiving their populations or at the very least trying to cover up unpleasant situations. Recent examples are “the subprime crisis is contained” or the “Fukishima reactors are contained”. For the moment I remain like Missouri “Show me” that it is not true.

If the Obama Administration was behind pressuring the IEA to take this action then maybe this was the first shot across the bow of implementing a stimulus package a kin to “QE 3”. Energy and oil in particular runs our society so a drop in crude prices translates in to relief for the consumer and businesses alike. At a time when the leading economic indicators have been rolling over and unemployment remains stubbornly high a drop in energy prices could cause a rise in the President’s sagging poll numbers.

Maybe it was orchestrated because things are not as they seem. The Saudis were going to raise their production quotas to compensate for the Libyan disruption, but maybe they can’t ramp up production. Even with all the Saudi public pledges to increase supply their production is down from the peak in 2008 over 20%.

The House of Saud has been spending billions to keep their population placated during this “Arab Spring” and as a result have put less money back into oil well maintenance and exploration. Since the Saudis are spending less on their oil production capacity it is possible that they cannot ramp up. The reality is that the Saudis are comfortable with higher oil prices as it affords them the ability to keep spending and retain power. Ironically it is not in America’s best interests to drive oil down past $80 as that could cause a destabilization in the region and much larger disruptions should the House of Saud implode. Moreover, as a result of this release the market may interpret the situation as a real problem point and recognize that capacity cannot be increased if really needed during a true emergency.

If the release of the oil was politically motivated then it was also short sighted. To start with the Strategic Oil Reserve is just that “Strategic”. The intent of the reserve which has only been tapped 2 prior times was to prevent oil shocks like what occurred during the oil embargo of 1973. This decision in my mind was not strategic in nature as we are and were not in a situation that threatened our economy because supply was unavailable, but instead because we had to pay more than people liked; but when you pulled in to your local gas station you were able to fill up no problem. Using this supply to cushion the price of oil provides a short term benefit at the expense of longer term security.

The release comes with some potential unintended consequences relating to oil prices going forward. The world demand for oil has been rising and is projected to continue to rise up to 89 million barrels a day this year. In the face of this rise we are lowering prices to stimulate even more potential demand, which seems misguided at best. The fall in the price of oil also has an impact on those who drill for oil and stop drilling the less economic wells resulting in further supply constriction and higher prices again. Additionally, as I understand it some of the wells that get capped due to the low prices are not restarted as the oil that was being pumped is now not recoverable. Moreover, the oil from the reserve that was used to drive the price down will have to be replaced potentially causing further upward pressure on the price.

The ramifications of this decision to release the oil has many implications, but from an investing stand point to me it just confirms that energy and oil in particular are in secular up trends.  Even during a period of worldwide economic weakness demand for energy is still growing.

Looking at the energy sector the chart of the S & P bullish percentage indicator has plummeted and created a double bottom in the low 30’s, and has begun rising. The time to purchase energy related investments has been when the S & P bullish percentage is in the low 30s or lower. Last June the indicator bottomed in the mid 20's. Over the past couple years the indicator has bottomed out in February and then again in June like a seasonality situation. Additionally, if the EU can kick the can down the road and the Euro can stabilize here the environment would favor energy companies whose products are priced in dollars would command higher prices.

At this time there are many companies to choose from in the energy sector sporting good statistics and dividends. In the oil patch Chevron (NYSE: CVX) yielding 3.2% looks attractive as does Total (NYSE : TOT) yielding 4.8% and Conoco Phillips (NYSE : COP) yielding 3.7%.

The oil sector is not alone as some of the coal stocks look attractive at this time such as Arch Coal (NYSE ACI) yielding 1.8% and Peabody Energy (NYSE :BTU) yeilding .6%.

Most investors don’t want to hear this and I am not going to delve in to this at the moment but the uranium sector also is getting to the point where those with a longer term view could build positions. Most of the Uranium stocks have gotten absolutely crushed, but they have also stopped going down and reacting to news. The reality is that Nuclear power is going to be with us and for every government like Germany that wants to step away there are others moving forward with plans to build out. In my opinion Uranium is a sector you should educate yourself about now and then look to build positions for the eventual next rise.

I guess the point is I do not know if the release of the oil from the Strategic Reserve was truly political although I suspect that politics was a factor. Regardless of what the reason was the reality of the situation is that as an investor you can take advantage of these down drafts to establish positions at better prices and add to existing positions. The same applies to other sectors as well for example given that none of the factors driving precious metals has been addressed or solved when the market hands you a correction it is time to add or buy in. In any sector where you can identify a “disconnect” a potential great investment opportunity awaits you.

Disclosure: Not long any of the stocks mentioned yet...Potentially adding all right after July 4th Holiday.

Wednesday, June 22, 2011

Microsoft – Everyone loves to hate this stock (MSFT)

Back in the Halycon days of the tech bubble there were 4 Wall Street darlings that made investors a fortune. In the beginning there was Dell (NASDAQ : DELL), Cisco (NASDAQ : CSCO), Intel (NASDAQ :INTC) and Microsoft (NASDAQ : MSFT) who were commonly referred to as the “Four Horsemen”. Everyone used to love these stocks and they were found in countless portfolios that is until the “Tech Wreck” of the early 2000’s. A quote from an article I read during that period stuck in my mind, “It used to be that no one ever got fired for buying IBM (NYSE : IBM), but now no one gets fired for buying Microsoft”.

Much has changed since the early 2000’s and today it seems most people have given up on these companies and some actually hate them. The Four Horsemen have been put out to pasture and are considered “uncool” to own.

 Dell fell out of favor facing stiff completion, losing both market share and profitability. For a period of time Hewlett Packard (NYSE : HPQ) appeared to be having Dell’s lunch, but now all the PC manufacturers are facing stiff competition and a slowing of the upgrade cycle.

 Cisco lost its way and ventured off in to the wilderness with things like the “Flip” video camera and allowed their highly profitable core businesses deteriorate. Cisco still makes many of the components that allow the internet to function but their lack of focus has allowed competitors like JDS Uniphase (NASDAQ : JDSU) and Juniper Networks(NASDAQ : JNPR) to set up shop in their backyard.

Intel has mainly lost in the perception department particularly at the Goldman boys trading desk. Intel continues to perform and crush estimates but the Goldman gang has a thing for them so their ratings are consistently negative. Yes Intel was slow to get to the tablet party but their very high margin server business is more than adequate to make up for the fact that they are playing catch up in the mobile arena. After all much of what makes or brakes the viability of the tablet is the “cloud” and the internet that makes it possible, much of which is driven by Intel’s high end servers. As the tablet, mobile internet device, and general internet innovations markets grow so does the demand for Intel’s high margin chips. Of course the Goldman boys believe that lower margin tablets will make more money, well I guess that will remain to be seen. I liken it to the profit margins on LCD and Plasma TVs which were high initially but as more models and competition emerged the costs came down but so did the margins. As Warren Buffet might say Intel has a pretty wide moat in many areas and while there are skirmishes on the periphery they have the means, innovation and the war chest to maintain their edge. I have covered Intel in the past and do have a position in the company.

Today the “Four Horsemen” are very different companies from those early days and many people still try to view then from the lens of when they were high growth companies, instead of the mature companies they have grown to be. Today things are different not only for these companies but for investors themselves. The economy and market are such that we have slipped back to 1999 levels and while back then we were all partying today people are looking for some level of safety.

I like many others learned at a relatively early age about the “miracle of compounding” which is by far less sexy than cashing in on the next Google (NASDAQ :GOOG) or Apple (NASDAQ : AAPL), but also very lucrative. Compounding will not make for exciting cocktail hour chatter but it does allow one to grow their assets in a slower but generally less risky manner. Sure it is great to hit the home run and get rich quick, however, for every investor that does just that there are thousands that get nowhere.

With the choppiness of the markets and interest rates on safe debt instruments not even keeping pace with inflation, what is an investor to do? I might suggest using the compounding method as an alternative to what one might call low yielding fixed income investments. Buying a stock is essentially a bet on future cash flow and earnings, but buying a dividend paying stock gives you the benefit of getting paid to wait for the earnings to grow and provide you with capital gains as well. Many investors today look only at yield because they believe that they can get their money back or higher income quicker. In theory it sounds good to want a high rate of dividend but in the average investors lust for the cash they over look factors which make the investment more risky than they think.

When I evaluate a compounding stock I look for many factors but a super high dividend is not a driving factor for me. I look for companies that are in good financial shape in that have a commanding presence in their industry. Next I want to see that the company is not over leveraged as this can lead to many problems which are often times resolved by cutting the dividend. Additionally, if a company is borrowing to pay the dividend that is a huge negative. This type of situation is indicative of a management is currently unwilling to address problems in the business but will more than likely be forced to in the future. Once the situation is forced a decline in share price and probably a reduction of dividend will be the end result along with many distressed shareholders.

I like to look at companies whose payout ratio is less than 60% as this indicates that the company can cover the dividend and continue to invest in itself as necessary. Ideally, one should want a lower payout as 60% would be an upper range and a lower pay out just gives the company more breathing room to increase dividends and keep itself healthy or withstand market turmoil better.

It is also important to look for companies that have a long track record of paying dividends as it demonstrates management’s commitment to shareholders. I like to look for companies that have a minimum history of 10 years of payouts since that shows the company’s management was able to continue the dividend through a full circle of business cycles. As I said I like a 10 year minimum but I will make exceptions on a case by case basis as investing is as much art as science.

In addition to the track record I want to see a company raise the dividend by a fair percentage on a regular basis for a couple reasons. First, if a company is growing and performing they should give back to the share holders. Moreover, if the company is increasing dividend payments, not form debt financing, it clearly demonstrates that the company is executing well as dividends don’t lie. While earnings can be manipulated the company either has the cash for the dividend or they don’t it is that simple period. Secondly, I want to see the company raise dividends as it is a form of compensation for risk of holding equities in general and as the dividend is raised you either get more out in the form of cash per share or increase your position by larger increments through dividend reinvestment. When a company is continually increasing dividends and you choose the reinvestment method the compounding is doubled as the number of shares you own grows as well as the amount that the shares pay to be reinvested grows. Once again it is not as cool as bragging to everyone that you own a piece of Facebook, and you may not grow rich overnight on Mr. Zuckerberg’s coat tails but you can grow your wealth over time.

You must also remember that time is your friend in the increasing dividend scenario. If you invest in a company that currently has a reasonable dividend in the 3% area at say $10 a share your payout is .30 per share. If the same company grows earnings and raises the dividend but now it has a price of $20 per share and the dividend is still 3% then you have both a capital gain but your yield is 6% or .60 per share since your cost basis is $10. You can clearly see from this example why it is important to find companies that increase their dividends. One should acquire shares and hold since in time when you are ready for the income stream your yield will be far greater and as long as the dividends are still increasing incrementally so will your income.

The last of the Four Horsemen Microsoft is one of the larger cap stocks on the market and has an equally large band of detractors. Mr. Softie as some people call it is one of the most unliked and unappreciated stocks out there. Since Bill Gates left the helm to Steven Ballmer it seems that Microsoft has fallen in to the negative press hell no matter how much cash the company throws off. Wall Street analysts generally tend to shun Microsoft as I believe they dislike Ballmer and find him to be uncharismatic. In many respects Ballmer is an albatross around Microsoft’s neck. I believe that the perception about Mr. Ballmer is suppressing the price of Microsoft and creating great value for long term dividend appreciating investors.

In the past it was threat of litigation whether from the US Justice Department or the EU that hung like the Sword of Damocles restraining Microsoft’s share price. It looks today as if those things are a thing of the past at least for now, since the EU seems to be targeting Google with various issues like street view and other government entities appear to have jumped off the Microsoft bus on to the Google bus.

Microsoft is a strong large cap with a household name and while there is tremendous completion in the software segment the company is still doing very well depite the fact that much trash is talked about it. The company trades at a PE below 10 which is cheap for it on a historical basis. Additionally, Microsoft has strong margins on its products although they did contract by 1% but considering they are still over 40% this does not seem like a pressing issue. Even with the slight decline in margins the company was able to grow earnings just over 22%.

Microsft has year over year sales growth of roughly 7% and over 5 years of 10%.  The company also has diversified out of just the operating system and office niche in to cell phones and game consoles. In fact Microsoft dislodged Sony (NYSE :SNE) from the top spot of console makers. Additionally, there was much made about the threat from open source operating systems to Microsoft’s dominance. While Open source has gained in popularity with the techno crowd its wide open architecture and lack of consistent flavor has made it not quite as palatable to the mass computer using public and Microsoft appears to have fended off that threat. The argument for open source software dominating the market reminds me of those who argue for Lacrosse. I have had people tell me that lacrosse is getting so popular that it was going to replace baseball as the US’s national pastime to which I would respond “uh huh ok”.

Microsoft does pay a dividend and currently yields 2.6% which is not bad, but they have paid the dividend consistently since Q4 2004. Microsoft doesn’t meet the 10 year payment criteria but based on its strong balance sheet I am willing to look beyond that metric. Management appears to me to be committed to the dividend as they have increased it 17% last year and 12.5% over 5 years. Moreover, Microsoft sports a low 23% payout ratio which leaves more than ample room for dividend growth as well as reinvesting in the company or further accretive acquisitions. I am aware that Microsoft spent $8.5 billion on Skype and there are questions as to how the acquisition will benefit or fit within their product mix, but even if it was a mistake based upon the amount Microsoft earns it could be made up for in short order and their cash available is north of $40 billion so there is plenty cushion there as well.

It is my belief that Microsoft will continue to meet the challenges it faces and have strong earnings for many years to come as they branch further in to other related areas of their business. I also believe that the current dislike of such a strong company is unwarranted but gives investors with a longer time horizon the ability to pick up a world class company with a dividend and strong balance sheet for a very good price. Moreover, as the company grows that 2.6% dividend your yield will grow as you wait for Mr. Market to recognize the value of Microsoft. Additionally, I feel that if one is patient you will be able to pick up shares somewhere in the low 20’s not because there is a problem with the company, but instead because I believe there will be a short lived market pullback after June 30 when QE2 ceases. I believe that Microsoft will continue to do well proving the naysayers wrong and eventually once the stock breaks the downtrend by moving past $25.50 on strong volume a move to the $36 area would not be unexpected. Remember as Warren Buffet has said “you want to buy when others are fearful and sell when others are greedy.” You always stand the best chance to make money by buying assets that others hate since if everyone hates it, who is left to sell(assuming you have done your homework)? If there is no one left to sell then the path of least resistance is up.

Friday, June 17, 2011

Today's Nickel is really a Dollar with all the debasement deducted.

I always find that it is helpful to look at multiple time frames to validate a short term trend. So I have put together a couple charts below of the US Dollar as represented by the DXY index. It is my belief that the Dollar is even weaker than what these charts reflect as it is benefiting from the turmoil in Europe. The DXY is far from perfect as an index as roughly 50% of the measurement is the Dollar vs the Euro, where as there are other currecnies around the world that are doing substancially better than the Euro, take the Swis Franc for instance. While other currencies are represented in the DXY their proportions are small and don't have as much of an impact as the Euro. Well the DXY is still the index that most traders refer to so we need to be coginzant of what is going on there as when it falls equities and Precious metals tend to do well vs a rise tends to impact those markets. The coorelation between the DXY and the Precious Metals and Equity markets are not cast in stone in fact there were periods in the last decade where all items rose in tandem confounding many.

Below is the DXY chart represented on a minute tick basis over the last 12 hour period. I have drawn in the trendlines  so you can see that while the DXY has managed to get above the 50 day moving average which is now acting as support at 74.77 rally attempts have been capped by the down trend line

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The down trend line for the dollar is also appearent on a 6 month chart using bars that each represent 1 days trading. Currently the DXY has poked its head above the down trend line and has subsequently played cat and mouse with it.

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Here is the DXY in terms of a longer 3 year view and you can see the support level lines on the bottom of the chart that must hold to prevent large decline in the DXY. Moreover note the down trendline from the Dollar's last peak in June of 2010. Additionally, you can see the up trend rally which culminated in June 2010 is a different breed of rally then what we are wittnesing today in the DXY. Today's supposed dollar rally appears to both lack conviction and be in much more compressed time frame. 
Click image to enlarge
This last chart is just to give you a grand sense of the Dollar's condition as in most posts regarding the dollar the focus is on the here and now which is where we make our money, but it is good to have perspective of history as well. The chart below is a 30 year chart of the dollar. 

If I had the data I would display for you a chart of the Dollar that extends back to 1913 when the FED was founded and you would be able to see the debasement of the Dollar over that multigenerational period. Since 1913 the Dollar has lost 95% of its purchasing power. Isn't one of the FED's mandates price stability?  In the price stability department I would have to say the FED has failed completely.

Looking at the 30 year chart one could make an argument that the period we are in now is very similar to the period between the first peak in the dollar and the second one. Can see that argument and understand the logic behind it if you are only looking at this from a pattern perspective. To me the difference is the economic and fiscal backdrop was completely different at the last two peaks and the current situation is much more tenuous given the debt, deficit and the lack of will on the part of our leaders to make the hard choices.


Click image to enlarge

So could the Dollar rally and create another peak like the prior one in 2002? I guess it is possible but with out an economy that is truly growing and producing jobs and standing on its own without stimulus or FED intervention I believe that it is unlikely. We have yet to address all the missallocations of capital and all the excessive public and private debt and until we as a nation start on the path back to fiscal sanity I don't believe we will see a sustainable rally in the dollar. We don't have to solve all our problems over night but we do have to get back our credibility in the finacial markets and all the QE , stimulus and half baked spending tax plans are not going to do it, instead the sooner we bite the bullet and start doing the right things the sooner America can wake up from this nightmare. Unfortunately I just don't see this happening until after the 2012 elections at the eariliest, nor do I believe that Joe "three letters - J-O-B-S" Biden can control the debt ceiling situation, instead we face a rocky period.  Winston Churchill once quipped, "You can always count on Americans to do the right thing - after they've tried everything else."  I believe Churchill was correct in his observation and it still holds true today. For these reasons, I am personally using any dips in Precious Metals to average in because I believe that in the not to distant future the Dollar will be lower and Precious Metals higher.

 



We don't have a 14.2 trillion-dollar debt because we haven't taxed enough; we have a 14.2 trillion-dollar debt because we spend too much
Ronald Reagan - Updated!

Wednesday, June 15, 2011

Benny and the Debts...

I feel like starting this missive with the best opening line of a book ever written, “it was the best of times and it was the worst of times”. This is the message that one can take away looking at the landscape of our economy and world these days. For everything that is going well there appears on the scene something to suggest that things are not well. Surely, if you are the average Joe times could be better, of course, if you are of the “Bankster” class times have never been better. We are living in tumultuous times dear reader I did not have to tell you that as you are living it every day too.

On a daily basis one sees and hears different pieces of information that shapes your and countless other investors opinions. The media in particular does a great job of trying to only accentuate the positive therefore when negatives appear on the scene everyone has the ability to act like Cpt. Renault in the film “Casablanca” when he is informed that there is gambling going on in Rick’s CafĂ© American. Everyone fakes a gasp and says, “I am shocked, shocked I say, to find out that there is gambling taking place here”.
I think that we as Americans are a very optimistic people and try always to look on the bright side , which many would agree is part of what gave rise to the original  American can do spirit that built the country. The problem right now is multifold and part of the issue in my opinion is that American’s have not been leveled with for so long that the political class fears and rightly so that if they did the ire of the American people would run them out of town on a rail rather than allow them to truly do what is needed to right the ship. Americans in the past have risen to any occasion and made sacrifices for the public and world good without hesitation when they both understood the problem at hand and collectively decided to address it.

Today’s problems are so large and complex that even if the government and politicians were honest with the people as to size and scope I am not sure that any of us mere mortals could wrap our minds completely around the issues. We talk about budget deficits in the Trillions of Dollars but I would venture to guess that most people cannot even fathom what a Trillion dollars really is or the estimated $100 Trillion if you include the “unfunded liabilities” of Uncle Sam. Of course if you want to see a person’s eyes not only glaze over but pop out of their heads try and inform them that the OTC derivatives market has a notional value which has continually grown and is approaching a Quadrillion Dollars. To most people numbers like a trillion seem like monopoly money which in essence is what the currency is being turned in to at this rate. To help visualize $1 trillion, if you took the $14T  deficit and created stacks of $1 bills the resulting pile would extend approximately 882,000 miles or roughly 3.6 round trips from the earth to the moon.
Today the big news is that there is rioting in the streets of Greece as the people there are protesting the perceived draconian austerity measures. Suddenly the markets have decided that based on an issue that has been brewing for over a year it was time to melt down and send the Euro off the deep end there by floating the Dollar. So mind you the Dollar has responded and has shot straight up from just below 75 on the DXY in parabolic fashion to 75.65. Although even as the Euro lost ground against the Dollar the “almighty” buck surrendered some of its strength to the “Swissie”. Ultimately I see the EU debt situation as bullish for gold and silver since it sends yet another vote of lack of confidence in debased paper currencies and that the debts will have to be repudiated or inflated away. Deflationists argue that repudiation of debt is deflationary and that may be but what is driving the precious metals is a loss of faith in the value of currency and the ability of governments worldwide to manage the economy. If you don’t trust the debt or the government issuer why would you want to hold the currency that debt is denominated in? This is what will ultimately undo the dollar in my opinion.

Today ‘s news comes to us from Greece, but baring another EU event possibly involving Spain which would be like a 9.0 on the Richter scale vs Greece will be the US debt ceiling debate. The debt ceiling debate appears to me as a lose-lose situation.  If the congress approves the debt limit without real cuts and a real plan the markets will perceive that as there is no will to fix the US’s fiscal house. Of course the media is out in full force snagging sound bites from the likes of Mr. Intelligentsia Joe “three letter word J-O-B-S” Biden, who is prognosticating that a deal will be reached in time. I don’t know about you dear reader, but this is all suspect to me and harkens back to pronouncements of the sub-prime debt crisis being “contained”.

It seems to me from reading the various articles coming out on an hourly basis that at least the politicians are talking, but they appear to be miles apart on substantive issues and are coming at the problem from opposite sides talking at each other but not to each other. We are asking many of the same people who got us in to this mess in the first place to figure a way out, of course they never saw it coming so expectations had better be low. Alex De Tocqueville, a French Political thinker in the 1800’s, recognized that we would ultimately reach this point in his famous quote, “The American Republic will endure until the day Congress discovers that it can bribe the public with the public's money.” We are at the cross roads now and Congress is out of money so the republic teeters on the razors edge.
Neither Democrats nor Republicans have demonstrated a real ability to compromise on the issues that keep them apart, although I do wish they would. One positive note is that the Republicans may have decided to suspend subsidies for corn based ethanol which should have been done a long time ago and would have reduced the fire under corn prices and other corn dependent commodities. The point is while it is  a good start it is hardly a core issue but is being touted as some sort of major victory in getting to a deal, which it is not.
 It looks like that best that we can hope for is some sort of compromise that is a “Wimpy” solution, in the words of the famous Popeye character, “I’ll gladly pay you Tuesday for a hamburger today”. The discussions revolve around maintaining spending in exchange for spending cuts at a later date like after Nov 2012. One must recognize that the spending cuts will never come even if they put penalty clauses in the bill as there will always be some way around it like an emergency that puts off the cuts yet again. It also appears that the solution is to cure the debt issue by more debt now and less later, which will only make matters worse. Of course it would be helpful if anyone really knew what was being discussed but I guess like everything else that passes for commonsense these days we will have to pass the debt limit resolution to find out what is in it, a la Nancy Pelosi.

The bottom line is that if the debt ceiling gets raised without real and tangible cuts it will just be an affirmation that the US views itself exempt from the laws of economics and the net result will be very dollar bearish.  Of course the flip side is that if they do pass a debt limit extension and there are cuts that are viewed as either unrealistic or to shallow the signal is also sent that the US government is not serious about fixing their fiscal house.
It appears that aside from a couple media photo ops, both sides are so far apart and neither will sacrifice their sacred cows so any compromise reached will be convoluted and market reaction most likely will be negative. If no agreement is reached then I believe that the markets will not take kindly to a US defacto default on the debt and it would make future borrowing by Uncle Sam more difficult and by far more expensive while throwing the markets in to turmoil. Furthermore, it would cause a rise in interest rates right at a time when trillions in short term government debt needs to be rolled over thereby exacerbating the deficit problem by increasing funding costs.

All in all this is quite a pickle we have ourselves in. No matter whose plan you look at the cuts called for are too small without having some inflation and a most importantly a growing economy. The Ryan plan looks to cut $4 Trillion over 10 years or $400 billion per year where as the Obama plan is looking at $333 Billion or $4 T over 12 years. This sounds great but if interest rates rise then much of the supposed savings will be chewed up by increased borrowing costs. Moreover, once the CBO scores the passed plan we are likely to find out that it doesn’t live up the reported figure, just like the supposed $38 billion in savings which the CBO scored out as a fraction of that amount. The bottom line is we need to make very deep and painful cuts and raise taxes on all citizens, even those who make very low incomes need to pay something. Save your hate mail I am not talking about taxing the poor to death, but everyone created this mess and it will require everyone to get out of it. Moreover, if one does not have any skin in the game it is easy to vote for increased deficits or taxes because you simply don’t care as it does not impact you since you do not pay, that is how we get systems so out of whack. To quote Alexis de Tocqueville, “in other words, a democratic government is the only one in which those who vote for a tax can escape the obligation to pay it.

This debt limit debate comes with the backdrop of an economy that appears to be weakening and has other factors hindering it like today’s report of the largest 1 month gain in inflation since 2008. The talking heads paraded out on CNBC still discuss things like the economy is healing when the Leading Economic Indicators are trending down and unemployment creeps up remaining stubbornly high. In my opinion the view that the economy is in recovery is not based in reality and nothing more than whistling past the graveyard, reminding me of the “green shoots” and 2nd half recovery mantra that never materialized.
The markets have been struggling with a spate of poor economic news and the knowledge that QE2 or Quantatitive Easing 2 ends on June 20th. The reality is that the economy has been on FED life support for many months and now the support is being removed. I don’t know if “B52 Ben” actually believes that the economy won’t act just like an individual who is on life support and then has it removed or he just needs an excuse to come riding in on his white horse with some form of monetary rescue. The current state of the economy is not unlike economies of the past that required support and would fail under their own weight. I have written many times of the French Assignat and how each time the French economy of the late 1700’s would stumble they would print more until that no longer worked.

Just like the French of the Assignat period we must face the same lesson and if QE by that name or any other stops then things could get real hairy, with the markets tanking, higher unemployment and another round of confidence lost. The stakes are high as misplaying this hand by both Congress and the FED could easily lead to the recognition that neither Congress nor the FED has control over the economy or a solution to what ails it.
The net result is that one may see a spike up in the dollar not because it is worth more but because assets are being liquidated and that causes an artificial demand for dollars as they transition to other areas. As this spike occurs would be an optimal time to either purchase high quality stocks at low prices or take advantage of what will likely be a sharp but short drop in precious metals.  Ultimately when the Dollar and other currencies are debased you will be glad to have precious metals.

You need to think of precious metals like you do home insurance. You buy home insurance not because you want or think your house will burn down, but because if it does you are able to rebuild. One needs to view precious metals in the same way but you are insuring your financial house not your physical dwelling. I have heard since I began buying the metals back in 2001 that it is overvalued and what a horrible investment it is etc.. None of this deterred me as I believe in monetary history extending beyond the 40 years or so of Keynesian economics and based upon what I see happening precious metals will not find their value against paper money but instead paper money will continue to debase against the metals. Until I see serious efforts to stem the debt creation and a move back toward fiscal sanity I will continue to hold and add to my precious metals positions.  Dear reader to leave you with a positive parting note I will reiterate yet another Tocqueville quotation that gives me hope for our country going forward. The greatness of America lies not in being more enlightened than any other nation, but rather in her ability to repair her faults.  Let us hope that we put aside the partisan bickering, insane policies and can get the repairs done as quickly as possible!

Hi Ho Dollar!?

With all that is going on the Dollar has had mini parabolic move on the DXY today but is still trying to break above the short term down trend line seen in the chart below. I am not sure if it can do much more than what we are seeing here today as the stochastics and Williams %r are showing overbought conditions and the feel of the situation is as if the DXY had reached stall speed. Of course the market has been know to make fools of us all!

Click Image to enlarge

The longer term down trendline still waits above at 77.50
Click image to enlarge

Monday, June 13, 2011

I think the Dollar Emperor has little to no clothes.

We keep hearing all about how the US Dollar is going to rally and it seems to get every chance possible, yet it consistently stymies the bulls. Yes, the Dollar is the best looking horse in the glue factory but lets face facts it is still a deeply flawed currency. Realistically on a day when S & P comes out again and downgrades Greece to a point where default is close to a lock investors are not piling in to the Dollar. Something has changed in the market psyche since in the past an event like this would have caused a dramatic rise in the Dollar, instead we have the chart below:

The DXY built a reverse head and shoulders for most of the day only to come up to the neckline where a breakout should have been a given under the circumstances. Instead just before the 2pm hour the rug was pulled out from underneath that market and the Dollar dropped like a stone. I know there are many out there calling for a bull run in the dollar but I am not one of them. I guess it could rally up to resistance around 77.5 on the DXY but I don't see the catalyst for that to happen.

In the meantime I am beginning to sense that the Precious Metals sector which is in a seasonally weak period of the year at present has so much negativity towards it that it is just waiting for an opening to spring to life. Over the past couple weeks I monitored the articles about the precious metals and with out a doubt the sentiment was easily 2 bearish PM articles for every bullish one.This is not what tops are made of but bottoms.Moreover, even with the declines gold has endured the yellow metal appears to be in more of a trading range from $1510 or so to $1535 or so and there have been no earth shattering spikes up or down during this period. Tops in the precious metals sector are rarely made with a nice rounding pattern like the one in the chart below but instead with an exhaustion spike.

Medtronic not as shocking but still concerning none the less...

As a result of some insight from readers of my prior article I have gone back and refined the search criteria within the Maude database acquiring more refined numbers,providing different results. I scanned the MAUDE database for only defective items that resulted in patient death, granted there may be other ways to classify product problems but this is the most straight forward. Doing it this way removes all the people that may have died as a result of blunt force trauma or some other non device related complication instead of a failure of an implanted device, this still does not guarantee 100% accurate results but it is the data available.

When you are dealing with a field that involves life and death you need to make sure that your defect rate is as low as humanly possible as this is a zero tolerance industry. That is to say if Honda or GM put out cars where they suddenly failed, even if it was only a few per year there would be huge public outcry and I would think those companies might not survive problems like that year after year. One would argue that a moving vehicle could cause harm a lot of people at one time where as the medical device only kills one person. While in many cases that is true but what if a medical device fails when the patient is on the job as a bus driver or even just driving a vehicle on crowded streets. I also understand that Medtronic may be larger in some markets than its competitors but the number of devices made by all manufacturers is still significant and you can see below their numbers as well. So the bottom line is here are the numbers I ran going back to 2005:

Number of deaths as a result of defective device:

Boston Scientific:
1/1/2005 to  05-31/2011 : 0

Guidant:
1/1/2005 – 05/31/2011 :0

Abbot:
1 - Reported device failure related fatality in 2008 none any other year

St Jude:
2 - Device failure related fatalities in 2007 none any other year

Medtronic:
2005 : 1,
2006:0,
2007: 6,
2008: 35,
2009: 247,
2010: 173,
and 1/1/2011 -5/31/2011 : 83

Now it is true that these numbers are not as shocking as the original ones in the article(still shocking none the less by comparison), but ask yourself, are these numbers acceptable? Why do the numbers run so high for Medtronic vs other competitors in the segment? Maybe I am comparing apples to oranges because the companies don't all compete head to

head in the exact same space..

Something began occurring in 2008 as you can see from the figures. Sure the numbers fell back in 2010 from 2009 levels but they are still way higher than the rest and the current number of 83 extrapolates out to somewhere close to 200 which is again an increase.

Is it a result of the management culture I do not know the answer to that but clearly, Huston we some sort of problem. I am aware that people do die of complications all the time but the numbers indicate a problem to me since these are specifically related to product defects.

If the issues stem from manufacturing or design problems for the failed devices than you could argue that the management culture is at fault for not addressing the issues and allowing them to continue. Moreover, it is not like the management would not be alerted to problems of this nature as I said before it is a life and death industry and if they are not aware  than that is a different but unacceptable issue as well. I don’t know the answer as to the high numbers or management knowledge and without being an insider it would be difficult to ascertain.

What I do know that the stock looks like a short to me from a chart perspective and as investors know many times company problems are baked in to share prices ahead of time and reflected in the charts. Maybe it is not this issue a at all that is driving the shares but something else or even just the market not giving a vote of confidence to management.

If it was life or death for you would you be leery of having a Medtronic device implanted in your body? Look I like and have invested in Medtronic in the past but this issue is worrisome and I believe it needs to be addressed before I would go long again in the meantime the charts an market will do the talking.

Wednesday, June 8, 2011

Medtronic Is Shocking Under The Hood

Many conservative portfolios have dividend paying stocks as a bedrock of their assets and one stock Medtronic (NYSE : MDT), has been a good investment over the years. For those of you who are unfamiliar with Medtronic they are a medical devices maker and compete against other companies like:  St Jude (NYSE :STJ), Abbot Labs (NYSE :ABT), Boston Scientific (NYSE : BSX) and Guidant (acquired by BSX). In the past Medtronic has been a portfolio and hedge fund favorite because it delivered a 10.3% annual growth rate over the past 10 years, however, over the past 12 months the growth rate has gone negative 2.7%. So what’s an investor to do with Medtronic?

I am sure that if Medtronic was honest with itself about the past couple quarters and particularly this last earnings report it would have to admit that it could use one of its own devices to regulate itself or at least a new CEO. Wedbush Securities analyst Phillip Nalbone commented about the incoming CEO that takes over on June 13th ,Mr. Omar Ishrak, who is an outsider to the company. Nalbone’s logic is that Medtronic is so committed to turning things around that for the first time in 25 years they recruited from outside of their “comfort zone”. Of course looking at Medtronic’s past leaders the outgoing CEO Bill Hawkins came from Novasote back in 2002 so I guess he was no longer an outsider.

Can Mr. Ishrak turn things around at Medronic? I guess the answer to that question is we will have to see. Issues may have arisen in the company due to the corporate culture, which may have contributed to the less than stellar management decisions. People at Medtronic may not have questioned and went along with the decisions made, because they were comfortable under the guidance of an insider. Bringing in someone alien to the corporate culture can be the needed catalyst for change or it can also have a negative effect as there could be significant resistance. The bottom line is we will not know if Mr. Ishrak can turn the USS Medtronic away from the iceberg or if there will be a mutiny. I will say though that given the amount of time that the deterioration has taken place along with market factors working against Medtronic, Mr Ishrak is going to have his hands full.

Over the last quarter Medtronic’s earnings report was shall we say less than stellar. The last 12 months annualized growth rate for the company was a negative 2.7%. The flipside is that Medtronic competes in the medical devices space which is highly competitive and in the current health care environment you can expect pricing pressure on the items that Medtronic produces. Granted they manufacture a great many things that are life saving and were not even around a scant couple years ago like continuous glucose monitoring , drug coated stents and kyphoplasty, so it is not like they are a one trick pony. Additionally, Medtronics is continually developing new products as their R & D budget is on the order of $1.5 Billion per year, and for that kind of coin you should be able to come up with a gizmo or two per year. One has to keep in mind that Medtronic’s space is fiercely competitive and market share is there for them to lose. Moreover, the declines in revenue in the past report are related to one of Medtroinc’s highly profitable device called an implantable cardioverter defibrillator (ICD) and sales have been off due to an investigation by the DOJ, which ended up impacting earnings.

Normally I would be optimistic about a company like Medtronic that has a low forward PE ratio and all the key metrics like debt to equity and current ratio well within safe limits. Medtronic has an almost 20% and 28.5% profit and operating margin respectively and carries a beta less than the market at .96. All of his sounds good, but I have not even gotten o the dividend yet. The dividend is currently at 2.3% which is better than money markets but will probably fail to impress those seeking high yields even with a 31% payout ratio and the fact that the dividend has increased on the order of 80% over the past 5 years. Of course there is no guarantee that Medtronic can keep increasing the dividend at the rate of the last few years but if I had to guess they will do everything to keep it going.

 Medtronic has been trying to offset its lackluster performance by engaging in share buybacks which have recently risen to retiring 2.3% of the outstanding shares per year. The share buybacks are good for equity holders as they allow for earnings to be spread over fewer shares boosting returns, but it is also a way in which poor performance can be masked. Additionally, with earnings impacted now and going forward I believe it will be challenging for Medtronic to keep all the aforementioned items in check, the numbers will deteriorate.

So my problem is not with whether Medtronic can execute a turnaround from a corporate culture perspective, but I believe there are more serious issues lurking under the hood which will cause Medtronic much larger problems going forward.

All the device manufacturers that sell their products in the USA are tracked by the FDA with regards to the performance of their devices once they are implanted or used. One can track this information for themselves by using the following link to check on any company and the history of various products, just click here.  The report is the Manufacturer and User Facility Device Experience or MAUDE report for short.

 I ran a scan on Medtronic and some of its competitors (ABT, STJ, BSX and Guidant) using the basic parameter of all devices in which the report result was death, meaning the patient died as a complication of the device used or at least that is the designation reported. The result was that from the available reporting period of 1/1/2011 to 4/30/2011 Medtronic outpaced all the other companies with reports of fatalities related to their products by at least 3 to 1. You can see for yourself below the raw number totals.

Total Fatalities as a result of Medical devices by company for 1/1/2011 – 4/30/2011:

Guidant – 41

Boston Scientific – 91

St. Jude – 96

Abbot Labs – 793

Medtronic - 2899

I have been trying to figure out what causes the discrepancy but it seems that this number is disproportionately high for Medtronic. At first I thought maybe it was a market cap factor that they were just plain bigger than the others and that would explain it, however, Abbot is double the size and the others are only ½ to ¼ the size of Medtronic. Even on a size basis the numbers of deaths are way out of line since by that logic Abbot should have a number greater than Medtronic yet it is 1/3 of the size. If I had to conjecture it would seem to me that the problems with management have run very deep at Medtronic and they allowed it to affect the manufacturing and or quality process.

As I stated before the numbers above are only for the period of 1/1/2011- 4/310/2011 but what is more disturbing is to look at the full year totals from 2010 which I will list below:

Number of Fatalities reported 1/1/2010 – 12/31/2010:

Guidant – 126

Boston Scientific – 566

Abbot Labs – 322

Medtronic 2373

Even last year Medtronic was the leader in a category that a company surely does not want to be crowned king. Just looking at this year’s numbers versus this year’s, Guidant and Boston Scientific appear to be tracking roughly in line with the past. If the first four months of MAUDE reporting numbers are extrapolated this year than Abbot Labs should run somewhere in the neighborhood of 2000 fatalities which is bad enough but it is very troubling that Medtronic  looks to be poised to log in somewhere in 8- 9,000 fatality range.

 What I find amazing is that the FDA who is responsible for the MAUDE report has this information and can see the numbers, how come there has not been a peep from them at least not yet? Probably because no one with a platform from which to disseminate the information has done so until now. At some point the staggering numbers of deaths related to Medtronic devices is going to catch up with the company through continued market share loss because of perceptions of a lack of quality. Additionally, it should only be a matter of time before the FDA is motivated to at least inquire regarding the dramatic numbers revealed in the MAUDE report. Any exacerbation of the problems for Medtronic will lead to further declines in share price especially if they are found to be producing substandard products that kill patients will also kill earnings.

Looking at the chart for Medtronic one can clearly see that the latest quarterly results had an impact on the company and shares have sunk from the low $40’s to the high $30’s. On the daily chart Medtronic has violated an upward trend line that dates back to September 2010. The trend line is not quite yet broken on the weekly chart but given the downward bias of the market and Medtronic being in the position of having to turn things around quickly I would guess that trend line will fall as well.  To me the charts are starting to confirm the fundamentals and things not yet known by the public like this troubling MAUDE report.

For these reasons stated I am looking to short Medtronic on any bounce up to the $40 range as I believe the trend line it violated will keep a lid on the stock and it is likeier to decline than keep ascending as bad news and slow rates of management change will take their toll. My initial downside target is $34 which is roughly an 11% move from its current trade at $38.70. I would suggest using puts with at least a 6 month time horizon for a couple reasons: 1) you need to give time for the decline to build and 2) if you short the stock you will be required to pay the dividend which would impact your return.

Disclosure : Short MDT via puts




Wednesday, June 1, 2011

The New Lexicon: "Financial Repression", Good For The Government Bad For Your Wallet..No Surprise There!


As a person living in today’s world we have to keep expanding our lexicon of terms since there appears to be a new one created every single day. Some of the terms are manufactured out of “Political Correctness” while others are a result of obfuscating what is really going on like Quantatative easing, which is in its simplest form money printing. A topic that has been getting increasing play in the media most notably due to high profile people like Mohamed A. El-Erian and Bill Gorss of Pimco Investments fame bringing the topic to the fore is “financial repression”. To most Americans myself included when we hear the word repression images of Idi Amin or Kim Jong Il come to mind as they use true repression to enrich themselves and control their populations, but “financial repression” is a completely different animal.

The idea of financial repression is not new and in fact in the post World War II period it has been used quite extensively by developed and developing countries Even the US itself engaged in a form of financial repression to deal with the large scale deficits left from WWII. The concept was given a name in 1973 by then Stanford economists Edward Shaw and Ronald McKinnon, although they were using it to describe the financial systems of emerging markets. During the Ronald Reagan era the practice of direct government intervention in the markets along the lines of financial repression was supplanted by more invisible hand type machinations of the “plunge protection team” and the FOMC. The financial environment had changed and the debts in the US while still large had fallen to a much smaller percentage of GDP making repression fall out of favor with the power crowd.

Today we as a nation find ourselves in a unique point in history and the rules of old don’t apply exactly as they used to as evidenced by the massive dislocations and intervention in all markets. In the recent past I had read the book “This Time is Different” by Carmen Reinhart and Kenneth Rogoff which documents 800 years of financial mishaps and their aftermaths, that occurred as a result of one form or another of financial mismanagement. The book is a very detailed analysis of the world from a monetary perspective and if you have the time I might suggest that you pick up a copy and read it; surely you will find that Mark Twain was correct when he said “History does not repeat but it sure does rhyme”. Reinhart who coauthored the book also co-wrote a “working paper” this year for the NBER (National Bureau of Economic Research) with M. Belen Sbrancia that carries the inauspicious title “The Liquidation of Government Debt”, but details the mechanics of “financial repression” and the history of debt booms and the busts.

Without going in to the long and drawn out history like the paper, let’s stipulate that the US is in the midst of one of these historic debt busts. The paper outlines five methods by which historically the debt to GDP ratio, a critical economic health measure, can be brought in to line making the debt more manageable.

The first method is for an economy to grow its way out by having a strong business environment where GDP grows faster than debt accumulation. Unfortunately ,the growth scenario does not appear to be in the cards as an economy needs some sort of paradigm shift that will generate economic growth on a large scale, think about the introduction of the automobile or the internet creating whole new industries and jobs.

The second method is utilization of fiscal methods like austerity measures being imposed upon Greece and Portugal. The issue with austerity measures is that they do not work for longer periods of time and given the size of our debt we are not talking about a “weekend at Bernie’s” to resolve this matter.

The third method is defaulting and or restructuring on the public and or private debt. Given the political rhetoric regarding outright defaulting or even restructuring our debt this option seems unlikely under current circumstances. Of course if more time passes before the US can get is house in order it is possible that views towards default or restructuring may change. It is not like it is without precedent that countries have defaulted and continued onward after the default or restructuring; modern day examples are Argentina and Iceland. In fact history is replete with examples of countries defaulting or restructuring debt including the US, UK, and France to name a few. At the moment however, it seems that default or restructuring would be a path not taken for better or worse.

The fourth situation that could have meaningful affect on reducing the debt to GDP level is a surprise sudden burst of inflation. Of course we all know that “B52 Ben” is deathly afraid of deflation and has been busy pulling all the magic levers to push inflation in to the system. I personally believe that inflation is baked in to the cake at this point and we have been fortunate enough to export it to the developing world, but at some point it will come back home to roost. That said, it is not part of the FED’s mandate to create a huge inflation quite to contrary it would not bode well for price stability.

The fifth method which is described in the paper and is effectively a “trial balloon” for what is more than likely coming down the pike is a cocktail of 1 part financial repression and 1 part steady inflation(in the 3 - 5% range). If you read the paper you will note that the authors specify that options 4 and 5 are only viable for domestic currency debts of which our debts are since they’re denominated in US dollars. Moreover, the authors note that all the methods have occurred at one point or another throughout history, but they do send up a flare for options 4 and 5.

So what is financial repression? Financial repression is a method by which markets are controlled to create a dynamic that forces the debt to GDP ratio back in line. Financial repression is essentially a slow motion restructuring and taxation method that reduces the debt over a longer period of time.
The US and much of the world engaged in various forms of financial repression from the conclusion of WWII in 1945 until “the peace dividend” of the 1980’s. The components necessary to implement financial repression are outlined in the working paper and I will try to break them out below.

Part of financial repression is to cap interest rates on debt especially government debt but there is the ability to impact private debt as well. In the US there is regulation know as “Regulation Q” by which the government can prohibit banks from paying interest on demand deposits or setting a limit to what can be paid on savings deposits. Additionally, the FED can continue to set short term rates and banks would have to follow. This “capping” of the rates effectively gives the government borrowing ability at a much reduced rate so the net effect is that the saver and the banks are forced to continue subsidizing government spending. In essence what we see going on today with rates will continue and savers and retirees will continue to be punished so the government can keep borrowing at a reduced cost.

One might think logically that if the interest rates are capped at artificially low rates who in their right mind would be out there buying the bonds that “Turbo Timmy” and the US treasury wants to peddle? There will be a market for the bonds because the second part of financial repression is to create and maintain a captive domestic audience for the bonds. In other words the government will force by law the purchase of these mispriced junk assets to keep the money flowing. The government will make use of laws and regulations that will both force certain entities to have to buy the bonds as well as implement capital controls or tax measures to cajole people for tax reasons to buy the instruments. The government can force institutions like banks, insurance companies, and pension funds via high reserve requirements, “prudential” rules or other tax levies to have a certain percentage of their assets invested in these securities there by creating demand. This also ties in to the idea of the government confiscating your IRA or 401K that I have written about on my own blog here. What is to stop the government from saying that all 401k’s and IRA’s have to have a percentage of their assets in these securities, which is a defacto confiscation of your own money. Additionally, fees could be levied on financial or equity transactions driving up the cost to you and lowering the return and used to direct investors to preferred government instruments. Lastly, the report notes a prohibition on gold transactions almost as if they want to make sure that everyone goes down with the ship by removing all life rafts.

So the scenario presented is one of artificially suppressed rates, forced investment in to the rate bearing instruments and the icing on the cake will be a surprise burst and then steady dosage of inflation. Of course this scenario could work assuming the knuckleheads in Washington don’t continue to increase spending and out strip the intent of this “repression”.

A “financial repression” that caps rates and forces investment in to non performing government assets I am sure will not be the only tact taken especially given this administration’s and the Democrats penchant for raising taxes. I can foresee a slow to no growth economy with increasing inflation and continued mal-investment in to unproductive government assets. This plan while it will probably reduce the debt to GDP ratio over time the inefficient use of capital will cause us a decade or two of essentially stagnation. The only thing that would change this scenario and what I hold out hope for is some new disruptive type technology that causes a huge boom. I don’t know what sector the technology will come from, but even in the great depression there were technologies that spurred booms coming out of that period.

Given that the trial balloons have been sent up indicating that we will be entering a period of low and capped interest rates, capital controls and other impacts on investment vehicles and choices what is one to do? For starters I don’t think I would be buying government debt at this point if I could avoid it. Second, given the fact that a likely outcome is “doses” of inflation going forward it seems that you still want to follow the basic guidelines of buying equities of companies that are growing their dividends able to retain pricing power and are less impacted by inflation. The additional money pumping that will be required to get the sustained dosage of inflation will keep the “risk” trade going therefore growth stocks especially in technology and emerging markets like Asia should also do well.

There are those who feel that they would do just fine by investing in the safety of TIPS or treasury inflation protected securities. The flaw in this logic is that the government has continually changed the way that inflation is measured by hedonic indexing and ignoring the “core rate”. These TIP debt instruments while getting a raise in rates when the CPI goes up will be marked to a measurement designed to suit the government and remain below the true inflation rate. In essence while you would be getting a raise you are actually losing since they don’t keep pace with real world prices. The government jiggers the inflation numbers for a number of reasons, one of which is to limit the amount that it has to spend for various programs to give COLA (Cost Of Living Adjustments) as well as other expenses impacted by the inflation rate.

In my opinion, you still want to have exposure to the precious metals and their shares. I know the paper mentions prohibiting transactions in gold (silver too I am sure), however, I do not believe that the government is going to confiscate your gold or silver. If the confiscation scenario does worry you and you wish to take the excess out of your “doomsday” stash one can look at quite a few funds that hold physical metals most of which are outside the US borders. Moreover, even under FDR when gold was confiscated the shares of mining companies did very well in the midst of the great depression, Homestake Mining (now part of Barrick Gold (NYSE: ABX) went up some 600%. Once again though with the money pumping that will accompany the capped low rates you have a situation where inflation and capped rates work together to create a perfect environment for the metals. The metals tend to thrive in a “risk on” money printing environment and if real rates are negative after inflation there is no carry cost associated with the metals so they tend to run.

Another Idea is to buy what some have called virtual banks or Mortgage REITS. These banks borrow from the government at low rates (which will be capped) on the short end and then purchase government guaranteed mortgages on the long end, essentially making the vig. At the present time many of these virtual banks are paying in excess of 13% and if rates are held in check these REITs will continue to payout. Presumably when the government caps rates they will do it near today’s historically low rates, but I guess they could force them lower. Additionally, REITS do not fall in to the category of entities that would be required to purchase government securities unlike a bank or pension fund.

Yes, inflation will have an impact and at some point that will be a drag on the REITs but in a world where yields are capped, options are few and income investors are desperate for yield they will be willing to pay more and accept yields that are still well above the caps especially on the short end. In other words rather than chasing yield toward the long end of the treasuries they can buy a mortgage REIT paying a better rate which is also highly liquid, what’s not to like. If you take a look there are probably about 10 companies that play in this space but I favor Annaly Capital Management (NYSE: NLY) and Chimera Investment Corp (NYSE: CIM) which pay 13.7% and 14.4% respectively. As always you should do your own due diligence before investing any money.

Disclosure: I am long Annaly (NLY) but do not currently have a position in Chimera (CIM).