Patience is Paying Off

Last week the Dow fell 400 points and the NASDAQ fell 2%.
That’s 3 down weeks in a row. Out of the last 7 weeks, 5 weeks ended down.

I always go back to the trends because it’s too easy to lose sight of the forest for the trees. Individual weeks can be false signals. For example, I would argue that May 16th was an options expiration day and a short squeeze pushed up stocks that week. That’s just conjecture, of course, but it makes sense when you see that stocks had been moving up for 2 months prior. Also, note that that was the last time the Dow moved up.

Just as the last options expiration day may have pushed up stocks, it also may have been acting last week to push them down. This time, with stocks trending down, there was no short squeeze to drive traders to buy stocks to cover their positions.

Which is my way of saying things might be oversold in the short term. Don’t be surprised if the market rises up again next week in a mini dead cat bounce. But overall, the market will continue to move down.

Staying with the big picture story, go back to my previous chart showing global money racing away from the stock markets and into money markets. Now go back to the chart showing the Dow and the NASDAQ for the last 3 months. Hedge fund rules limit investors from cashing out in the last 45 days of the quarter. In this case, May 16th. Notice the sag in both markets that week.

The story I'm reading in the markets is that smart money hsa been leaving the markets for some time and in earnest in May when the Q2 exit deadline loomed. The market's downward drift was arrested by an options expiration week that squeezed shorts (traders had to buy up stocks to cover short positions). Also, I suspect that regular investors misinterpreted the pullback as an investment opportunity, further goosing up the market in the short term.

At this point, the NASDAQ and DOW diverged. I think this was caused by the financial heavy Dow.

If I had to guess, next week will be even worse as funds sell-off in order to lock in rapidly evaporating Q2 profits. Especially tech stocks.

I am focusing on the big picture. Foreclosures are accelerating, consumers are belt tightening, and companies are firing people. California unemployment shot up in May from 6.2% to 6.8%. Experts point to seasonal summertime workers like students, as if that explains the increase. First of all, schools don’t get out until late May. Secondly, there wasn’t the same problem last year in May. The jobs simply don’t exist.

I think the stock market will continue to get worse as mid-July comes. We get a look at corporate earnings and the GDP, and as we get forward guidance. And the Fed meets.

Against this background it only makes sense to hold short positions.
AGN is the only one crying out for an immediate decision – it expires in 4 weeks. It would be great to see a $50 price before then. But I noticed last week that AGN is finally tracking the Dow’s decline.
AN is also exciting. The fell below 412 – what I consider to be a resistance point, and on heavy volume. From Wednesday-Friday last week, 21M+ shares were traded compared with an average daily volume of 2.3M.

The Ultrafunds are also showing a lot of life

My preference is to unload the puts in the summer. I’ll stay in the ultrashorts a bit longer.

I want to buy Natural Gas and Coal stocks, and there was some pullback last week. I usually don’t want to buy this close to earnings, but I suspect some amazing earnings and guidance will be forthcoming. The only concern here is that some investors mistake a connection between oil and coal & NG.

Don't sell those puts

Great day to be short - and a lot of this is simply because it's options expiration Friday. There is no short squeeze in a market that has seen the Dow drop 1000 points in 1 month. Nothing to prop up prices.

Which means prices could rebound a bit in the next 2 weeks - and AGN puts expire in 4 weeks.

I think we sit tight and hope for another 5% drop in the stock prices underlying our puts.

MGM - I think the deep decline suggests further weakness. Sell the put when it hits $35? (a ~$3 investment and a $15 return)
AN - looks like another breakdown. It is also showing definite weakness

VMC - not getting low enough, fast enough

ZLC/HOG/NKE - what is up with these consumer stocks? Why won't they crash harder? Sadly, we need a 15% pullback on these in 3 months just to return to breakeven.

Stocks in the News

I saw some interesting news that seemed worth pointing out

ETFC - They have drooped in light of the recent Financial sector concerns. I missed the chance to make a few pennies on June $4 covered calls, but I think next week, after Friday's options expiration, the stock should lift and give us a good opportunity.
Meanwhile, they announced good news about trading volume
http://uk.reuters.com/article/rbssFinancialServicesAndRealEstateNews/idUKN1844941220080618
"Average daily trading volume, a key indicator in the on-line brokerage industry, increased 10 percent from a year earlier while its retail customer assets were up 3.9 percent month over month."
They have more money in the bank and customers are doing a lot more trading and adding to ETFC's revenues.
It's a sign of a solid turnaround plan in motion.
I think that ETFC could shoort to $5 if they can show a return to the core business - meaning zero exposure to the mortgage debacle.

AN - More good news for our puts. Yesterday saw shares tumble in the car industry. Carmax, the nation's largest used car seller, reported a 54% drop in profits and missed earnings by 40%. http://uk.reuters.com/article/ousiv/idUKN1847736220080619
AN is the nation's largest new car dealership and they can't be doing any better. In fact, I think they are doing much worse - their biggest product line is SUVs and they aren't selling.
I previously mentioned that I thought US car sales would fall from 16M to 14M - looks like that's even optimistic. "A survey of dealers...suggested the seasonally adjusted, annualized rate of sales was running near 13 million vehicles in the first half of the month, down from 15.2 million in the first quarter and near 14.4 million in April and May"
Also, put volume has dramatically accelerated on AN.
The combination of more interest in puts and the stock price nearing $12 helps our puts. At the moment, $12 is the resistance point. I think we drop below that soon.

MGM - Down a bit more. I think $40 is their resistance point, but I also think the worst has yet to come for Vegas. But how far down can MGM drop?
I'm thinking $35 is the low. Throughout 2005 & 2006 they bounced around between $34 and $45. Business levels are already returning to 2006 levels.
Business wise, cash is tight. Operating income was running at $450M per quarter until last quarter when it fell to $340M. Then they have to pay ~$160M servicing their $13B debt. They are cash flow positive but it has fallen from $280M a quarter to $180M per quarter.

Outside of weakness as a hotel, a business conference destination and a gambler's mecca, MGM is exposed in the real estate market. Called the City Center and located next to Monte Carlo and Bellagio, it will open in August 2009 with 4,800 hotel rooms and 2650 condos. Talk about bad timing - Vegas is already starting to see surplus hotel rooms and massive oversupply of condos. Meanwhile, construction prices have pushed up development costs from $4B to $9B and counting. The stock price has yet to bake in the impact of lower condo prices (at least $100K lower per condo, or $2B shortfall).
Long term, this is probably a brilliant move. Short term, it will probably force MGM to go deeper into debt and sell off pieces of its empire. I believe that, once folks look beyond the gamblers revenue shortfalls and start asking questions about the City Center, the stock will take another beating.

ZLC - Unbelievably strong, but I have faith in their doom. Blue collar workers are struggling to put gas in their trucks - they aren't buying jewelry. In fact, look at the news on Blue Nile, a major competitor. http://www.forbes.com/markets/economy/2008/06/18/blue-nile-closer-markets-equity-cx_lal_0618markets41.html
"Traffic on Blue Nile's U.S. Web site decreased by 29% in May from the year prior period"
Even Tiffany saw only 6% growth in the US.
It's just a matter of time and we have 6 months.

VMC - From the 80s down to the 60s. VMC is raising $650M to payoff some debt (a bridge loan).

http://www.forbes.com/afxnewslimited/feeds/afx/2008/06/18/afx5127269.html

It's a great idea to borrow money in a low interest environment, and this will improve their financials somewhat.
But that doesn't chang ethe fact that business sucks today and is getting worse every month. Revenue and profits are down after they acquired Florida Rock. Ooops. And their materials costs are rising rapidly as oil costs rise.
I suspect they drop to $60 next month if they show a negative quarter.

HOG - They slipped 4% yesterday in sympathy with the auto stocks. We've done the due diligence: auto/vehicle imports and exports are down, GM/Carmax reports extremely soft car sales, and financing is tighter. And the working man is cash strapped. Analysts expect only a 6% drop in sales, which seems optimistic: new car sales look to be down 20%.
I see them drooping to the low 30s by next month's earnings release.

NKE - Uggh, this isn't working out. I expected a drop in clothing sales and I was right: US consumer spending on clothes drooped $3B in Q1 this year. Apparently, NKE is immune. Tiger Woods is out for the rest o fthe season, and that may dent sales, but I doubt it really matters. NKE is riding on the Olympics and the gains from international sales being translated into the dollar. The dollar advantage ends in a few months, so that works in our favor. But we really need to see a consume spending pullback, and soon.

AGN - Word is getting out - cosmetic surgery is drooping. (Sorry - couldn't resist)
Not only was this issue featured on the Daily Show, it is starting to make the rounds in the investors corners.
http://biz.yahoo.com/ibd/080613/health.html?.v=1
The article nicely sums up my investment thesis. AGN is all about cosmetic surgery. Almost 40% of their business is botox and breast implants. And they are slowing (despite recent company assurances that all would be fine). AGN is going to weather any downturn because they do have a strong business in eye care (pink eye and glaucoma products), but I think th ebotox projections are optimistic. In any case, a forward P/E of 24 seems a bit lofty, especially given current expected growth of 18% for 2008 and 2009.
I hope to see $50 and we're out.

TRID - It actually traded below $4, almost their cash value. Which means that it could do it again. I am puzzled here. All facts point to a strong market. There are no facts (yet) showing competition, but neither are there any pointers indicating that TRID has effectively gained some new product wins.

Buying DUG

400 shares @ 27.27

MGM Puts still looking good

Four issues are driving down MGM's profits. Three are known, 1 I uncovered.

http://www.marketwatch.com/news/story/airfare-hikes-capacity-cuts-start/story.aspx?guid=%7BF6045F48%2DC0C8%2D44ED%2D9CEB%2DFAF1E60E4D24%7D&siteid=yhoof

1. Fewer people are travelling to Vegas.
"there are predictions that total capacity could be down by double-digits percentages or more by autumn, following declines of 3% and 6% in the first and second quarters, respectively"

2. They are gambling less when they do go
"April gambling revenues were down 5% statewide to $1 billion, with a 1.3% drop on the Strip"
If that continues, Strip casinos will lose 15% gambling revenues for the year.

3. Hotels room rates are dropping
"average daily room rates (ADRs) on the Strip in the second quarter were 13% (down) over the same period in 2007, with weekdays off 10% and weekends down 17%. "
An MGM spokesman "noted that when the company reported its first quarter earnings, it said that occupancy was flat with rates down slightly. 'This will likely continue through the end of the year...'"

And now the 4th issue
4. Surging electricity costs
According to the EPA, the average large Vegas Casino uses 100m kwh per year or ~$9M annually per hotel. MGM in Vegas has the Mirage, MGM, Bellagio, Circus Circus, Excalibur, Luxor, Mandalay Bay, New York New York, Monte Carlo, and Treasure Island. That's 10 casinos with an annual electrical bill of ~$90M. Add other casinos in Reno, Detroit and elsewhere and we can round up to $100M.

Electricity costs are up 15% in Vegas since last year (they went up June 1st 2007). MGM is looking at an extra $15M in annual costs or ~$4M this quarter. That's ~2% drop in EPS.

Revenues falling 6%, costs going up. Last year, MGM reported $360M in profits fo rthe quarter. I'll be surprised if they beat $200M.

I'm hoping that they see a big miss and the stock drops <$40. That's when I'll unload the puts.

Investing in the Oil Bubble

While oil is making all the headlines, the real action is coal and natural gas.

I will post a separate review of coal and NG later, although my previous posts include my target stocks for these sectors.

It's worth taking a big picture look at energy consumption. I will explore the myth of Peak Oil and show why today's oil prices are just an ordinary bubble, and then where to invest.


Energy consumption is growing overall but rocketing up in Asia.

Growth in global trade has led to massive increases in manufacturing, itself a major driver of energy consumption. In addition, getting richer means millions more people are joining the ranks of the middle class. Inevitably they aspire to the same living standards as enjoyed in the developed world : refrigerators, TVs, air conditioners, computers and so on. And of course, cars.

In the chart of global energy consumption, you'll see that the 5 year growth in energy demand is mild in the developed world (less than 5%). A lot of this growth comes from computers and the internet: according to the EPA, US data centers now consume 1.5% of total US energy consumption. Asia – the world's largest energy consumer - has seen energy consumption grow 38%. Big growth off a big base. The point being that developed world energy consumption has largely stabilized but that of Asia has a long way to go.

When it comes to electricity, multiple sources exist: coal, nuclear, wind, hydro, solar, natural gas and so on. When it comes to transportation, however, the only solution today is oil (forget ethanol for the moment).

Oil is a challenge for two reasons. First, there is no substitute (at least today). Second, global economies depend on hauling raw materials and finished goods.
INVESTMENT OPPORTUNITIES:
SHORT: Shippers (UPS, FEDEX), Truckers (pick any), planes (United or USairways), CCL
LONG: Railroads (CSX, KSU is my favorite), Boeing/PCP in 6 months (once Boeing begins shipping their fuel efficient planes), TIE, ZOLT (now that prices have fallen, expect more usage of lightweight, strong materials)

WHY OIL PRICES ARE SO HIGH: THE MYTH OF PEAK OIL
OPEC was formed 34 years ago with a mission: to manipulate prices by managing supply. They didn't do a very good job: oil stayed around $20~$30 for years. But the emergence of strong, new demand in Asia meant that the end of years of oversupply. One side effect of forcing production below capacity is that OPEC never invested in boosting capaccity - so now that they want to sell more oil at $135 a barrel, they can't!

Ever noticed that, every 20 years or so, when oil prices surge, we hear that oil won’t last more than 40 years. Then 20 years pass and, again, prices spike, and again we are told: oil won’t last more than 40 years. Sounds like the same crap peddled by real estate agents during the housing bubble: "prices ar ehigh and will stay high because they aren’t building land anymore."
It's hype to distract from massive specualtion.

Like diamonds, prices are high because a cartel has restricted supply. Unlike diamonds, it takes time to get new supply to the market.

KNOW YOUR HISTORY
Lets review the history of supply, demand, and price controls.
1974 OPEC is formed.
1979-81 prices surge due to Iranian revolution and impact on oil supplies
1982-1985 Prices begin falling. Saudi Arabia cuts production to stabilize oil prices, but it doesn't work – too much member cheating. By 1994, oil prices had fallen to the lowest level since OPEC was formed in 1973.
1995 A new cycle emerges. Demand surges from India and China. Supply also surges from former Soviet states.
1998 Prices soften further amid oversupply and slackening Asian demand (the Asian economic crisis). OPEC again tries to enforce production cuts in order to raise prices. On Jan 1st 1998, OPEC oil production stood at 27.5 million barrels per day, OPEC removes 4.2 Million bpd from production. It works: prices began to rise.

Note that at ~$25/barrel, there was minimal infrastructure investment to increase production AND there was plenty of spare capacity.

2000 OPEC reversed production cuts and added 3.7M bpd
2001 Chaos in the oil markets. A weakening US economy, 9/11, and more Russian supply all combine to undermine OPEC attempts to drive up prices. OPEC and Russia cut production a staggering 5.5M bpd. That is nearly 15% of combined supply taken off the market.
2002 Supply exceeded demand by 6M bpd.

2003 Oversupply stopped being a problem: falling to only 2M bpd.
* Surging demand from a strong global economy that now includes rapid India and China growth
* Shrinking supply Iraq (2M bpd), Venezuela (1M bpd), Mexico and Iran.

2007 OPEC has lost control. Price controls are no longer a matter of turning the faucet on or off. Lack of investment means that OPEC is operating almost at full capacity.

Venezuela and Iran followed similar paths in managing the oil revenue. Oil drives 65% of Iran’s government budget but they allocate only $4B per year to infrastructure improvements. Same with Venezuela. The result - they want to pump more but can not.

In 2007, oversupply was less than 1M bpd. That’s tight enough to where a slight disruption in supply matters. Israel fights Lebanon - oil prices spike. Nigerian oil pipeline disruptions - oil prices spike. But the real endemic problem is Russia: in May 2008 they reported that oil production slipped 0.7%.

Russia's problems are partly the Iran disease (underfunding oil infrastructure) and partly government intervention i nthe oil markets. In its rush to secure oil reserves and kick out the Western oil companies, Russia's oil development is slow.

The point is simple. Oil is alimited resource and we will run out of it. But today's oil price surge is not about a long term shortage. It is purely about supply mismanagement. And, arguably, demand mismanagement in the form of sloppy fuel standards for cars and planes.

OPEC wants high oil prices but not this high. They like $80 but not $135. The threat of permanently high oil prices is driving a lot of investment away from oil and into alternative energies. That’s a permanent and long-term threat to OPEC. Secondly, expensive oil is pushing weakening economies into a deeper slowdown, which always reduces demand. US fuel consumption has already started to decline. But, as usual, OPEC has overshot the mark in its efforts to manage prices and risks killing the golden goose.

Turning up more supply is an obvious step, and it will be taken. But another course of action is breaking the back of oil speculators who are taking advantage of short term supply disruptions.

The first step is a strong dollar. The Fed is all talk. But notice that, following the recent trip to the Middle East by Treasury Secretary Paulson, we see a firming of the dollar. Whereas Gulf countries were talking about moving away from the dollar, I bet they are now buying it. And we hear more discussion about making speculation technically harder and more expensive by raising the margin limits. Apparently, it is pretty cheap for Wall Street to trade oil commodities.

At the same time, expect China to raise the yuan. This will have a knock-on effect of raising global inflation somewhat (latest trade figures show that Chinese exports to the US are already seeing price inflation of 2.3%) A strong yuan reduces the value of Chinese dollar holdings, but it more critically reduces Chinese inflation from food and commodity imports. They subsidize oil, and a stronger Yuan will help.

INVESTMENT OPPORTUNITY:
DUG (oil short), get out of overseas stocks, buy dollars or sell the Yen. Buy Yuan.

On top of a slight OPEC oil supply increase, we will see slowing demand. One can play what-if games. What if US demand slows 1% (drops 210K bpd)? What if Global demand doesn’t grow 2M bpd but only 1M bpd.

It doesn't matter. Once there are signs that scarcity is not an immediate issue, expect speculators to leave and for prices to return to $100.

Prices could go even lower. Oil at $130 is a massive windfall – it is the only thing keeping Russian, Venezuela and Iranian governments in power. And they want to sell as much as they can. The pressure to pump more oil is going to drive demand for equipment and services to find and extract oil.

It will take years to hit serious oversupply. As long as oil is >$50, expect to see massive ongoing investment in oil extraction and production. Additionally, since 80% of world reserves are in the hands of State governments, public companies like Exxon will be looking offshore. Not in the Gulf of Mexico that is 200ft deep but 5 miles deep. So oil rigs and deep submersibles are a hot play for a while.

The bottlenecks in the supply chain are in drilling (wells, oil rigs), drilling equipment, and shipping. Secondly, there aren’t enough refineries. With extraction, distinguish between land based (aka known reserves) and offshore (aka unknown). Land based is about drilling new wells. Offshore is about oil rigs and exploration. And shipping in tankers

INVESTMENT OPPORTUNITY: MDR, FLR, ATW, DO, TTI, IO, NOV, FWLT, FLS, GNK, DSX

There are a few more I could throw out, but that's a good start.