Liquidity Zombies

Because of all the conflicting signals this market is throwing off lately, I have few very firm convictions about what is going to unfold over the next several months.

Since there is nothing to do as I see it, I'm not doing anything, with a couple of small exceptions I'll explain later. I remain fairly defensive. This leaves me very vulnerable to a sustained upward push in the market.

The dollar pessimism appears to have reached an apogee for the medium term, and I believe that the path of least resistance is now up for the dollar. Although my long-term view on the dollar is very bearish, I am now net long the dollar, but not by much. My US cash position is hedged with positions in the Swiss franc (FXF), the yen (FXY), and gold (GLD).

I retain several unsexy long positions in Berkshire Hathaway B-shares (BRKB), which has proven a surprising winner as a haven of liquidity in a liquidity-starved world, Johnson & Johnson (JNJ), and the Toronto-listed former Saskatchewan Wheat Pool, now called Viterra (VT.TO).

The fact that I am neutrally positioned does not mean I don't have expectations about what is likely to unfold, though. It just means that I don't currently see a way to exploit these expectations profitably.

For example, here is what I expect and am watching for . . .

I believe that the market is currently in a long-term topping process that is nearly complete. The sharp up days smack to me of short-covering, and are exactly what you would expect from counter-trend rallies. We've moved into a long-term trading range between bull (S&P above 1550) and bear (S&P below 1400) markets.


(yahoo.com)
Where we break out from here should determine the direction for another year or so. My guess is that the direction will be down, but since I'm not forced to act on that sentiment, I choose not to do so. I'm no perma-bear. If we go up, we go up.

And when my money's all gone
I'm on the telephone
Hollering "Hey hey mama
Can your daddy come home?"
Johnny Horton, "Honky Tonk Man"

Unfortunately for the cause of real global growth, the threat of further US dollar flagellation by holders in Asia and the Middle East means that "Mama" (the Fed) has to think twice about using her money (liquidity) to bring Daddy (the broke honky tonk man) home.

I do find it difficult to imagine a new leg of the bull market beginning without a huge injection of liquidity of some sort or another, which would crush the dollar. However, the extreme negativity and the almost universal conviction that financials are in big trouble could provide more surprising pressure to the upside. So I remain agnostic.

Liquidity Zombies

Despite the current churning, I believe that there are some concerns bubbling beneath the economic surface that have not been fully discounted by the market. The world economy contains a number of non-self-financing, debt-reliant, easy money-coddled "zombie companies" that exist simply because of the lush liquidity environment of the past five years. Not only have these walking dead thrived under the unprecedented infusion of liquidity, but they have grown their tendrils around it, changing their function and their purpose to exploit cheap money.

We've already uncovered a couple of these in Fannie Mae (FNM) and Countrywide Financial (CFC), but the transformation of the US economy from a service to a financial economy has left many other companies--General Electric (GE) comes to mind--much more beholden to the credit markets than most people are generally aware. I also believe that liquidity has put much of the sheen on today's emerging markets, and that many high-flying "miracle economies" could find themselves in deep trouble very soon.

The Small-Cap Trap

Domestically, I believe the most fertile ground for such liquidity zombies, if they do in fact exist, is the small-cap arena. It's important to remember that there was a time when large companies commanded a premium in the marketplace to small companies because of the much greater likelihood of failure among these small companies.

No longer. The iShares Russell 2000 ETF (IWM) is priced at 17.7x earnings versus the S&P 500's 15.7. The Russell 2000 has well outperformed the S&P since 2000, a long enough period that there are many people in the market today who have never encountered a real small-cap bear market.
(yahoo.com)
Having never experienced a brutal small-cap bear market personally, they follow age-old Wall Street custom and deem such a thing impossible.

The big picture supply-demand of stock supports this view. Small-caps seem to have begun a new downtrend, marked by lower highs and lower lows. This seems to be a crowded trade, but there should be enough room for everybody.

(yahoo.com)

I've been taking occasional shots at these on the short side via TWM (the Russell 2000 UltraShort), without much success so far.

If the current illiquidity does not get better, and quick, I believe the carnage among the small-caps will surprise a lot of people.

Links of Fury

Only the best for my readers.

• Inflation in China is at an 11-year high. People over there have been getting more and more upset for months over rising consumer prices. The PBC is going to have to take this inflation threat seriously, which places upward pressure on Chinese interest rates. Don't look for a return to the kind of footloose lending that drove this boom.
• Ken Fisher argues that this bull market is being driven by the yen carry trade. When the yen goes up, the assets it's being borrowed to buy go down. A spike in the yen could spell real danger in the global asset markets.
• Has the backlash against Cramer begun? I've always wondered what would happen to Cramer when the bull market ended. Will he be tarred and feathered like all other bull market gurus when his disillusioned followers blame him for their mistakes? We may be about to find out.
• Bill Gross surveys the subprime damage.

Other Thoughts . . .

• Is the eye-popping oil-natural gas spread exploitable? The obvious--too obvious--play is to be long NG, but I need to know what I'm missing. If you follow NG closely and have an opinion on this, drop me a line.

If you are one of my purely value-minded friends, please turn away from your computer right now so you don't vomit all over it . . .

• I'm still short the financials, but I'm ready to be proven wrong. We'll probably pop back up to 34 or so in the next few weeks, but I have a moral obligation to be short this chart long-term. Prove me wrong, banks.
  

I'm not a nut for moving averages, but my own experience suggests that decisive crossovers (and retests, like we have here) of the 200-day are good for catching the beginnings and endings of very large, long-term trending moves. Here's the 5-year chart, which shows that we're below the 200-day while the average is declining for the first time in this bull market. Make of that what you will (also, notice the tremendous support around 30 that should keep this market from going straight down).

Smallball

Because of the choppy market these days, I've recently been investing somewhat differently than usual.

Ideally, I'd like to have lots of money invested in companies that I hope will offer prospective long-term returns of somewhere north of 20-25 percent per annum. I don't see any right now, but I hope that within the next two years we may see enough of a decline (or at least a sideways market while earnings rise) that I can get some money into great companies that are deeply undervalued.

But because I don't want to be sitting on huge, moderately undervalued long positions in this fragile market environment (with the exception of extremely financially secure companies like Berkshire Hathaway and Johnson & Johnson), I've been playing "smallball" instead. I've been taking gains of 10-20 percent on both the long and the short side when they present themselves and then reverting some position that approximates neutral.

I think of this strategy as hitting singles rather than home runs. I'd like to be Barry Bonds, but the market isn't offering that chance, so Ichiro will have to suffice. As far as I'm concerned, it's just not longball time right now. Just as a matter of probability, home runs are going to be much rarer in the fifth year of a bull market than they would be in, say, 2002.

This smallball strategy is very conservative, and has forced me to leave money on the table at points. For example, I was heavily short Countrywide Financial (CFC) and D.R. Horton (DHI) during the August breakdown, but covered them far too quickly.

Still, I think that the ability to remain liquid while seizing the occasional opportunity has made up for these lost profits. The whole idea is to maintain my capital in real terms so that when it's time to play longball again (read: prospective long-term annualized returns of 20% or greater), I will have enough money left in my pockets to play.

What Keeps Me Up at Night

It's well past midnight here in Oklahoma, and I'm having some difficulty sleeping. I've been thinking and re-thinking my positions as we go into what is likely to be an eventful week in the markets.

I suppose I could have more serious problems keeping me up. Lady Macbeth (pictured) sleepwalked because of the guilt of having the King of Scotland's blood on her hands.

I suspect that my subconscious somehow knows when I've left myself overexposed, and won't let me relax until that exposure is dealt with. So I'm going to think through my positions yet again . . .

First, I worry that I could be overexposed against the dollar with my substantial gold position. I bought gold as it broke out above $700/oz, but as we run closer to gold's all-time nominal high reached in 1980 of $850, we should hit some pretty stout selling. Additionally, pessimism is rampant, and I'm not comfortable staying in a crowd that is this committed to one side of the trade.

I have to determine whether I'm going to be happy with a quick 20 percent or if I'm willing to put up with some turmoil in order to see gold through above $1000/oz, which I believe is on the way. My current stance is to stick it out and hang on, but that view will take a lot of stomach if a gold decline pulls back into the $600s. It isn't fun to see a perfectly good profit disappear on principle.

. . .

I'm also concerned about the very sizable short position I have against US financials as they appear to have started breaking down . . .


I've been bearish on financials for some time, and remain so. My research convinces me that the credit downturn has much further to go, and that people who think that banks can write down $300 billion in assets and then continue on their merry way frankly haven't done their homework.

Credit crises are crises of faith. When people stop believing in the value of an asset, whether it is the US dollar or the value of a mortgage derivative, they don't just begin believing again.

Particularly strange to me are the "value investors" who are piling into the financials they now call "bargains." I have no idea how these people, many of whom quote Warren Buffett and Ben Graham like scripture, have determined the asset values of these companies when even the companies themselves don't know what they're worth.

I would urge buyers of financial stocks right now to really think their purchases through. The analyst consensus for EPS growth at Citigroup (C), for example, is 8% over the next two years, just 2 points below the growth rate of the last five years.

Exactly where is all this growth going to come from, particularly since the i-banks are in the process of dismantling one of, if not the highest-growth areas, the packaging and selling of derivatives?

I believe that even 8 percent growth is too optimistic. Like the tech stocks in 2000 and like the homebuilders in 2006-2007, the financials' growth rates will not just slow, they will go negative. The investment banks are going to go into the red, and the 7 P/Es will, like those of the homebuilders, balloon out into double digits as the earnings denominator shrinks while the price numerator declines more slowly.

For these reasons, I've avoided financials for some time (Berkshire Hathaway being the main exception), but the apparent breakdown in the form of lower highs and lower lows is finally giving me reason to act against them aggressively.

However, as I look more closely at the chart, I realize that could have been more patient. I should have bought half of my position at current prices and then waited for the rally that should be here next week to retrace to 33 or so, where I could sell the rest short.

The volatility of this ride isn't going to be fun either, but I would be surprised to see the financials make new highs here.

That said, I accept that it could happen. If they begin a new uptrend, I'll get out.

Don't let the bedbugs bite.

The painting of Lady Macbeth is by Henry Fuseli, German-Swiss painter who was from Zurich.

James Grant Interview

James Grant of Grant's Interest Rate Observer has a view of the current financial situation that is very similar to my own.

Grant also sees an unusual problem created by simultaneous credit and currency troubles, and believes that we are right in the middle of what he calls an "Old Testament credit crisis." Wish I'd come up with that term . . .

Check it out.

Checkmate for the Fed?

For the first time since the 1970s, the United States is facing the potential of a serious banking crisis and a serious currency crisis at the same time.

So it appears that the stopped-clock permabears may be right, at least for the time being. Let me explain . . .

The Fed's customary solution to financial problems has, of course, been to pump money into the financial system when it is under strain. This strategy worked OK in 1987, after the Asian Crisis (despite creating the tech bubble), after the tech crash (despite creating the housing bubble and the current credit bubble), and during the first phase of the subprime crisis. Bears have each time proclaimed each crisis to be the end of the world, and their fears have always been overblown. And of course, the world won't end this time either.

But I believe that the current situation differs slightly from previous crises, for a single reason: today's Fed faces much steeper consequences for resorting to its favorite solution of credit injection.

Today's dollar market has stopped shrugging off injections of credit. Worried about the decline in the dollar, people now appear to believe that rate cuts and other forms of liquidity injection and preservation plans (the super-SIV plan) place enormous further downward pressure on the dollar. The Chinese, in particular, are reacting to worries about the weak dollar by dumping it and threatening to dump more, which is what most people paying attention have expected to happen for several years.

In many ways what we have is a financial crisis that is based in a crisis of belief. People around the world have stopped giving the dollar the benefit of the doubt simply because it is the dollar.

Notice how the gold ETF has continued to rise after the September surprise half-point rate cut, even while the bank index appears to have received little benefit from these cuts . . .



(Yahoo! Finance)

What does this mean? It means that the Fed's primary weapon of liquidity/credit injection has begun to backfire.

Further injections of liquidity, surprise or otherwise, will almost certainly endanger the dollar, to the point of sparking a free-for-all to escape from it among foreign holders. The Fed, in short, appears to be checkmated.

You have to make your own judgment about how you want to be positioned here, but I am currently positioned very short the money center banks via the Financial Select Sector SPDR (AMEX:XLF) and long gold (via GLD).

If the Fed chooses to try another bailout (the most likely development given its previous behavior), the run on the dollar could turn into a rout, driving gold past $1000/oz. If the last cuts are any indication, further bailouts shouldn't provide a great boost to the banks.

If the Fed opts not to bail out the banks, XLF will really be in for it, and gold should not suffer.

However, a dollar rally (way overdue) will decimate my gold position, so I will be very wary.

Additionally, my current sense from looking at the price action is that the "Smartest Guys in the Room" at the banks are trying desperately to get out of these stocks before everyone else realizes how bad the crisis really is.

Please remember that these are my opinions, and you must formulate your own investment strategies.

The Fed is full of smart people, and it will be quite interesting to see how and if they can escape from this pickle . . .

Dr. Doom Interview

There are only a handful of people you'll ever see on TV that are worth listening to on financial subjects.

Jim Rogers is one. To complement the other day's Rogers interview, here's an interview with Marc Faber, the Michael Jordan of bearish commentary.

Understanding Writedowns

This is a skill that's going to come in handy over the next year or so, particularly when evaluating financial companies.

Here's a good primer.

Macro Reflections

Although my basic outlook on the market is value-based, I frequently like to commit the Grahamian sin of thinking through the major economic factors affecting asset classes in order to determine what markets I want to be in. Quantitative analysis only gets you so far.

I do this is by framing hypotheses about the main story in each asset class. Once I have formulated these, I sit and wait. Over time, the markets either prove or disprove them, and I adjust my stance accordingly.

I discard the hypotheses for two reasons. Either 1) They are proved wrong or 2) They have been proven so completely that they are common knowledge, and are therefore fully valued.

An example of the first was my belief at Google's IPO that it was overvalued, and that it would be dangerous to buy a company trading at 50X earnings. So I opted to sit it out. This is obviously a decision I regret, and it has forced me to accept that a few extraordinary companies are worth paying up for.

An example of the second was my belief this year that U.S. financials were extremely weak and quite vulnerable to the problems of rising interest rates. This view was proved correct, and so I reduced my bets against financials . . . although I still do expect this situation to worsen considerably.

Here are the hypotheses I currently subscribe to:

1) ACCELERATING INFLATION.
The world is in a period of accelerating inflation which still remains largely unrecognized, fueled both by 1) decades of underinvestment in commodities (creating the current supply-side problems) as well as 2) loose credit from the world's central banks (demand pulling prices up).

Money supply in many areas worldwide is growing at double digits . . . and the arguments of individuals who defend the CPI calculations leave me pretty blank. To understand why the Fed understates inflation, you have to think about the Fed's motivations as people rather than as an institution. They are afraid of economic slowdowns, but also of wage inflation.

The moment that the average person begins to realize that his or her cash is being destroyed, they demand higher wages, which pushes prices higher, and so on (the wage-price spiral). "Fixing" the CPI to understate inflation is a way to avoid this extremely unpleasant outcome.

POSITIONING:
Stocks (which should continue to rise until people realize that inflation has been driving the bull market)
Hard Assets (which I will begin to buy once wage inflation begins)

2) DOLLAR TROUBLE REDUX.
This is obviously something that everybody and his grandma are worried about. So I agree with Jim Rogers that a rally--probably a huge one--is in the offing soon.

Still, the dollar is in for still more hurt over the long term in my view. As George Soros explains in The Alchemy of Finance, because so much of a currency's value is collateral value, the decline in a currency tends to picks up speed as it goes.

This applies especially well to the US dollar right now. The dollar is valuable throughout much of the world because, as the world's reserve currency, it is seen as a store of wealth. But each decline in the dollar further erodes its value as a safe haven, thus prompting more selling. So the selling spiral is likely to accelerate until there is a crisis.

Add to this the fact that there is no real constituency inside the Fed or outside of it that wants to see the dollar defended, and it looks like the path of least resistance is down.

This hypothesis has been very profitable so far, although there is likely to be some turbulence soon with the coming dollar rally.

POSITIONING:
Gold
Swiss Franc (FXF; an excellent currency)
Berkshire Hathaway (Large overseas currency holdings as well as increasing commitment to finding earnings streams in overseas companies, such as the Iscar purchase)

3) EMERGING MARKETS' PROBLEMS ARE MASKED BY CHEAP CREDIT.

I discussed this point before.

POSITIONING:
Prepare to go short in these areas at signs that credit is drying up. Emerging market banks will be especially vulnerable . . . as their loan portfolios go bad, they will go under.

4) THE WORLDWIDE BOOM IS PULLING OIL ALONG.
I have been long oil for some time for the simple reason that I can't see how oil prices are going to decline when the global credit boom (described above) is throwing so much money into the pockets of the industrializing world for capital expenditures and personal consumptions (cars, specifically).

I'm not a "peak oil" believer, per se, but I think some of their arguments are great, such as the fact that OPEC member nations are incentivized to overstate their reserves, allowing them to ramp up output. This means, of course, that worldwide crude stocks are vastly understated.

This has worked well so far, but I'm beginning to worry that a bullish consensus is forming on oil . . .

As part of this outlook, I also like oil exploration companies. If you look at the bull market in oil stocks over the last several years, the market has gone up almost entirely because of higher earnings. P/Es haven't expanded. I believe that if the bull market in oil stocks is like every other bull market in history, eventually P/Es will rise to reflect the growth these companies have shown, and we could see these stocks double very quickly.

Right now, you can buy the iShares Oil and Gas Exploration Index for 5.6 times cash flow. It's likely to do well even if oil prices collapse, and you have no company risk.

POSITIONING:
Oil (USO)
Companies that are leveraged to higher oil prices (IEO)

Note: I currently hold the following securities mentioned in this article: BRKB, GLD, IEO. I will try to remember to include these disclosures, though you have my word that I am not using this blog to try to move the world gold price in my favor.

Jim Rogers FT interview

I have to say I've learned more over the years from Rogers' take on the markets than from anyone else.

So here's a four-part interview with the original gnome of Zurich investor.

"Lynch Rebates"

Most people today who write about value investing emphasize discounted cash flow valuations and various other techniques that rely on projections of future earnings or cash flow in determining the intrinsic value of a stock.

That's fine. But if you read the beginning of Graham and Dodd's 1940 edition of Security Analysis you find that Graham's entire argument for asset-based investing is that projection of current earnings trends into the future is inherently an unreliable exercise. Anticipating today's behavioral economists, Graham understood far better than most (with the help of being bankrupted by the Great Depression) that we as investors are not nearly as accurate in predicting the future as we think we are.

To fight this bias, Graham argued for investment in stocks that had share prices trading at less than two-thirds of their net current asset value. Buying cheaply in this sense, or at any other deep discount to readily ascertainable corporate value, meant that an investor didn't have to predict anything to make money.

Many extremely literal readers of Graham and Dodd (we could call these "value fundamentalists") took this advice to mean that investors must only buy Graham's "net-nets." So they sat around through the second half of the twentieth century with their hands in their pockets as the population of always-rare net-nets thinned out further and further.

Peter Lynch introduced a brilliant solution to this problem in One Up on Wall Street, a book that is far too often caricatured as a simplistic "buy what you know" manifesto. Lynch's technique is to take the net cash of a company--that is, cash on the books net of long-term debt, and apply that figure to the share price as a "rebate" of sorts.

Here's an example of how this works . . .

Take 4Kids Entertainment (NYSE:KDE), which licenses the rights to use Pokemon and several other children's entertainment franchises that may or may not have value.

The stock closed today at $16.85. According to the most recent balance sheet, the company has 105.64 million of cash and liquid short-term investments, along with no long-term debt. For the sake of simplicity, this is assuming that there are no substantial lease obligations or other obligations that are not readily ascertainable from the balance sheet. That gives us a figure of about $9 a share in cash or assets readily convertible to cash.

So you subtract that $9 from the share price of $16.85, leaving you an effective share price of $7.85, since you're getting paid 9 bucks to hold each share. So you're buying the business at about a 53% discount.

You then compare that $7.85 to the value of each share of the business to see whether the business is worth that discounted price. I don't know if the business at 4Kids is attractive at that price, but it's clear that it's considerably more attractive than it would appear without getting this sort of discount.

In my experience, this technique is a terrific way to find businesses at extremely attractive values.

Disclosure: I do not own shares of KDE.

China Goes Parabolic . . .

See for yourself.


I believe China is headed for a 1929-style wipeout, which will be bad news in the short term for them, but good news in the long term as they implement a range of market and economic controls that mirror those imposed in the US depression era.

China now has the financial clout of a world power, but the market infrastructure of an emerging country. This is great for them on the upside (the above chart) as it accelerates the boom, but is going to make the bust equally ugly.

And unlike Japan in the 1980s, I don't believe China has a stable, coordinated-enough banking system to prop its equities up indefinitely.

We're likely to see some great opportunities in China over the next 5-7 years--I mean the exact same companies now, but at PEs of 3-5.

Keep your powder dry.

Reading Berkshire's Chart

I've found that Berkshire Hathaway (BRK-A), run by a man with no use for technical analysis, is more technically driven than just about any stock I deal with.

That may not be the definition of irony, but it's not far off.

I guess this is because 1) there are not many traders who want to swing 115K chunks of stock around and 2) the stock attracts people who are thinking in the long term anyway.

Look at how BRK has struggled to clear each major round number, then usually dutifully held above it.

I'm holding the B-shares, which basically mirror the performance of the A-shares. Are we about to see a break above 120K?

Quiet Booms

Those of us who live in commodity-producing areas have noticed something recently that many others haven't: the commodity boom is beginning to make its way into the broader economies of these areas throughout the US and Canada.

Cash generated by high prices for tangibles is trickling out into banks, real estate, luxury purchases, and capital investment of every part of North America that has an economy reliant on production or distribution of "stuff."

Minyanville's Ryan Krueger, for example, sees a petrodollar-driven boom unfolding in the oil-refining region of Port Arthur, Texas.

There has been some scattered coverage in the national media about this. Both New York Times and the Los Angeles Times have noted Houston's boom-town characteristics over the past year.

By the time it's all said and done, Houston will prove to have been just the first (and probably the biggest) of many of these kinds of booms.

Dallas, Denver, Kansas City, Oklahoma City (where I live) and other centers of commodity production and distribution will experience similar effects on capital investment, luxury spending, and high-end real estate as oil, grains, livestock, and metals prices remain high.

Maybe it's some facet of this boom-time mentality that has rich OKC oil execs barely able to disguise their lust for other cities' sports teams.

The point I would take from this whole phenomenon of quiet booms, as illustrated by Mr. Krueger's observation, is to avoid letting a blanket conviction obscure the potentially profitable subtleties of a situation.

You don't want to let the idea, for example, that "all real estate is going down" lead you astray any more than the thought that "all real estate is going up" led many investors astray several years ago.

Gross national figures can be illusory: there's no reason an economy or an asset market has to correspond to a national boundary.

They say "all real estate is local." Well, all economics is local, too . . . and it's worth it for an investor to pay very close attention to what's really driving the economy of a particular area before those numbers get folded into GDP.

An Emerging Consensus

Recently, more and more investors and journalists have begun to argue that the center of world financial gravity is shifting decisively away from the US.

There's an emerging consensus that emerging markets are the place to be for the near future, and potentially for longer.

This author points to the fact that increased accumulation of foreign reserves has put many emerging market countries in the position of being net creditors, describing emerging markets as being in a "golden age."

The Washington Post has a piece that is even more eyebrow-raising, showing how hot money is pushing further and further out along the risk curve by investing in "frontiers" around the world. For a potential target, the piece even points to the hyperinflationary disaster that is Zimbabwe, once one of Africa's most promising states before the tyrannical Robert Mugabe (pictured) single-handedly ran it into the ground.

Past performance, of course, doesn't necessarily have any bearing on what's going to happen in the future. It's worth looking at the explosive growth these markets have already experienced over the last five years, though.


All the "golden age" talk has me skeptical. Emerging markets' expansion has run in lockstep with the unprecedented credit expansion in the developed world beginning in 2001-2002, and as we know, a rising tide lifts all boats.

We have yet to see how these countries will respond to slowing growth in their primary export markets, or if they truly are as immune to the need to access credit markets as the bulls contend.

My opinion is that the emerging market talk is evidence that the longtime market advance is probably picking up speed as we enter a euphoric phase. Viable investment opportunities are saturated with capital, so creative investors are moving to places that aren't really viable, as they assume that the bull market will continue forever.

Speculators should see this as an opportunity to ride a sector that is beginning to go parabolic, and may have already begun to do so.

Long-term investors, however, should tread lightly. All of this stuff should be available in the future much more cheaply, after these countries have proven that they can thrive when credit is not so plentiful.

A Bubble in Retrospect

Barry Ritholtz's excellent summary of the housing market's woes got me thinking as he discussed David Lereah, the former chief economist for the National Association of Realtors. Lereah wrote a number of ill-advised and ill-timed investment books, ranging from tech stocks to real estate.

In 2005, Lereah published Why the Real Estate Boom Will Not Bust, which looks fated to become an inadvertent classic of bubble-market psychology, taking its place alongside James Glassman's Dow 36,000 and the South Sea Bubble-era launch of "an undertaking of great advantage, but no one to know what it is."

I was curious about what people said about the book when it was published, so I looked back at the oldest reader comments from Amazon, circa 2005.

What I found was interesting. The first thing that jumped out was that a few people recognized that following the book's bullish advice would be dangerous.

But at the same time, the emotional momentum remained with the bulls. As you move from older to newer comments, you can see the bulls disappear and the bears gain confidence as the comments shift from optimistic to dismissive.

I think this little exercise shows that--contrary to the views of Alan Greenspan and others--it's entirely possible to identify financial bubbles as they are going on.

The trick is having the stomach to resist the crowd. I have to say that it does gets easier, though, as you experience and read about more historical bubbles.

Here are a couple of books that will help out by giving you indigestion at stories of monks who day trade:

• Edward Chancellor, Devil Take the Hindmost: A History of Financial Speculation
  
• John Kenneth Galbraith, A Short History of Financial Euphoria
• Charles Kindleberger, Manias, Panics, and Crashes
  

The Gnome's 10 Most Valuable Financial Reads: Honorable Mentions

Before I start on the top 10 Most Valuable Financial Reads, here are the honorable mentions, divided by category:

Fundamental Investing:

• Philip Fisher, Common Stocks and Uncommon Profits: why sell a quality business? This book is the most cogent defense of buying great companies and hanging on as long as they stay that way.
• Joel Greenblatt, You Can Be a Stock Market Genius: A silly title, but the content is sound. Don't believe that there could be a book explaining bankruptcy investing to a middle-schooler? Well, here you go.
• Robert Hagstrom, The Warren Buffett Way: The best place to start learning about Buffett. New readers should be aware, though, that the Buffett bag of tricks is quite a bit deeper than this book lets on.
• John Neff, Neff on Investing: A very humble and matter-of-fact introduction to what Neff calls his "low P/E shooter" investing style. It blends biography and investing strategy seamlessly, showing the stomach it took to stick to his guns, particularly in the rough-and-tumble 1970s.

Technical/Trading:

• Nicholas Darvas, How I Made $2,000,000 in the Stock Market: The title is ridiculous, Darvas's risk management leaves much to be desired, and some have questioned if any of this ever really happened. But this is still probably the best introduction to how stock prices work. Plus, you can read it on a Saturday afternoon.
• Edwards and Magee, Technical Analysis of Stock Trends: The Bible of technical analysis. The sections explaining the logic behind support and resistance work are unmatched, anticipating by more than half a century much of what modern behavioral finance is only starting to discover about how people think about and act toward their stocks.
• William O'Neil, How To Make Money in Stocks: Great investment book or cross-promotion machine for Investor's Business Daily? Well, a little of both. Clearly O'Neil hit on something with his CANSLIM strategy. The problem for the serious investor is that it's difficult to integrate the CANSLIM method with other approaches (let me know if you've done this successfully). The problem for the serious reader is the incessant IBD trolling.
  
• John Train, The Money Masters: A group biography of highly successful investors, this is one of the best ways to gain quick exposure to a variety of fundamentally based investing styles. The chapter on Robert Wilson's harrowing Resorts International short is classic.
  

Macro/Other:

• Jim Rogers, Investment Biker: Primarily a travelogue, the parts of this book on macro investing are among the most useful material any investor can read, and aren't really duplicated anywhere else. Really understanding Rogers's approach to global investing is one of the most valuable investments you can make with your time. Now if he would just write a book that focused purely on his investment style. Are you listening, Jim?
• Victor Sperandeo, Trader Vic: Methods of a Wall Street Master: This eclectic read provides a great introduction to Austrian economics suitable for investors, very helpful definitions of a trend and a trend break, and deals with the emotional side of trading to boot.
• Nassim Taleb, Fooled By Randomness: An excellent discussion on how randomness, by definition, cannot be controlled for, and how we frequently ascribe to skill much that is in fact produced by variance.
  

Next installment: Most Valuable Financial Read #10.

Links of Fury

• The Economist wonders if the global age of stable growth is over
• Returns around the globe since the start of the bull market I didn't realize how high the P/Es were in China. Good thing those stocks always go up . . . as the day trading monks have already informed us.
  
• Investing with the stars--literally
• Oil's not made of dead dinosaurs? The Russians have what you could call a contrarian opinion on the nature of so-called "fossil fuels" . . .
  
• Goodbye, Age of Agriculture . . . It's been a great 10,000 years.
• The Kirk Report's link post is the daddy of them all

Napoleon on Investing

A quote that applies well to finance, courtesy of Napoleon Bonaparte, of all people:

"The whole art of war consists in a well-reasoned and extremely circumspect defensive, followed by rapid and audacious attack."

Replace "war" with "investing" or "trading" and you have a pretty succinct blueprint for doing well.

The point, of course, is to obsess over covering your tail. . . but to strike quickly and decisively when the situation warrants it. I could think of worse advice to follow.

How Deep Is Your Value?

Here's a deep value screen I run from time to time. It's been lighting up recently, for whatever reason--many more results than normal.

It uses the following criteria:

Current P/E less than 10, Forward P/E less than current P/E, Debt/Equity Ratio less than 1, Quick (Acid Test) ratio greater than 1.

This is not a screen for quality by any stretch (although I'll run some of those later on). The idea is to find very inexpensive companies that are not crushed by debt and are liquid enough to stay afloat long enough for that value to be recognized.

If you're interested in getting quality as well, you'll want to screen for return on equity or invested capital. But you're going to have to make some substantial concessions on price.

These are not exactly Ben Graham's net-nets (which would sell at a 33% discount to net current assets), but it's roughly the same idea. These are "cigar butts," as Buffett would put it, generally good for one puff.


(Scroll way down) . . .

Deep Value Screen

Symbol	Company Name	Current P/E	Forward P/E	Quick Ratio
IMMR	Immersion Corp	3.60	3.50	9.50
ASPV	Aspreva Pharmaceuticals Corp	5.70	4.80	10.10
HSOA	Home Solutions Of America Inc	6.00	5.00	2.70
AVCI	Avici Systems Inc	6.20	3.00	3.80
MTEX	Mannatech, Inc	6.80	5.10	1.10
VLO	Valero Energy Ord Shs	7.20	7.20	1.00
TX	Ternium SA	7.30	7.00	1.10
GNA	Gerdau AmeriSteel Corp	7.80	7.10	1.80
CPX	Complete Production Services Inc	8.50	8.00	2.50
BRLC	Syntax-Brillian Corp	8.70	6.10	2.00
SIM	Grupo Simec ADR	8.90	6.80	2.80
ZINC	Horsehead Holding Ord Shs	8.90	7.90	1.50
ESV	ENSCO International Inc	9.20	8.10	2.60
MTL	Mechel ADR Rep 3 Ord Shs	9.20	7.90	1.40
VIRC	Virco Manufacturing Corp	9.20	8.60	1.20
KG	King Pharmaceuticals Inc	9.40	6.50	3.20
LMC	Lundin Mining Ord Shs	9.40	8.30	2.90
ZEUS	Olympic Steel Inc	9.80	9.70	1.30

Bear with me on the screwy formatting. If any of you are HTML-inclined and have some thoughts on good ways to present tables, drop me a line at gnomeofzurich1@gmail.com.

Next, I'll give these a closer look and we can see if anything decent turns up.

Uncle!

This week's rate cut does make me wonder what's going to keep the dollar from continuing its decline.

Maybe I'm inadvertently calling a bottom here, but I wonder how much longer it is logical to keep hanging on to the dollar. Is it time to say "uncle"?

My answer has been to hedge pretty thoroughly. I've generally diversified my currency positions out of the dollar, although I retain significant exposure to the dollar through stocks.

The dollar could certainly bounce from here, but a rally would be pretty easy to catch.

I'm all about capital preservation right now until we prove that we can hold above 1500.

The good news for people who like to think about nominal returns is that if the current currency declines against hard and financial assets accelerate, we will definitely see new equity highs. The bad news, of course, is that this will be a paper gain, without meaning in purchasing power terms.

Another Massive Trading Range?

The current S&P 1-year chart doesn't look terrific, and the ugly July decline appears to have come out of almost nowhere to test the March lows.

(BigCharts.com)

Backing up chronologically gives us a little more perspective, though. Look at how significant the 1500 level is: the selling kicked off as soon as we crossed it.

(BigCharts.com)

Clearly we're at a major pivot point. Holding above 1500 would be very bullish. Failing and dropping down again would be equally bearish.

A final chart to provide some historical background:

This is the Dow Jones Industrials in the great bear market of the 1970s (then the most watched index). The Dow had an extremely rough relationship with 1000. It first tested it before this chart begins in the late 60s, then retested it several times before eventually breaking it decisively in 1982.

(Dow Jones)

If the current rally breaks down, does it suggest that we may have just made the second peak of a massive long-term trading range?

Surveying the cut's dollar damage

Because the dollar has been declining against a basket of currencies and of assets recently, whenever there's a rally I like to check the returns of dollar-competitive assets and currencies. I use this to see if the gains are just reflections of a dollar slide, or whether they are outpacing the dollar's decline.














Here's a chart of the nearly 3% S&P return for today (The Nasdaq & DJIA were slightly lower), compared to the return in USD terms of the Swiss
Franc (FXF), the Euro (FXE), and the Gold ETF. Since these are ETFs, the returns are not precisely the same as the underlying assets, but you get the idea.

As you can see, these dollar-competitive currencies and currency alternatives (gold) benefited in dollar terms today, though not nearly enough to compensate for the blowout day in the major averages.

My very unscientific conclusion if that if you were long today, you made money even controlling for the accompanying dollar sell-off.

Whether the returns will continue to be positive in currency-adjusted terms is anybody guess.

Links of Fury

The must-read stories of the last several days . . .

• Enough with the Weimar Germany analogies!
  
• Did what happened have to happen?: Legg Mason gets counterfactual
• How to value cyclicals
• The Fed Funds futures are not taking inflation seriously enough
  
• A dollar collapse could mean the end of US economic dominance

Fire or Ice?

Fire and Ice
by Robert Frost

Some say the world will end in fire
Some say in ice.
From what I've tasted of desire
I hold with those who favor fire.
But if I had to perish twice,
I think I know enough of hate
To say that for destruction ice
Is also great
And would suffice.

I doubt Robert Frost was thinking of the inflation/deflation debate when he wrote this, but he might as well have been.

Will the out-of-control money supply expansion of the last six years result in a credit contraction and ultimately something as bad as a deflationary depression, as Robert Prechter argues? (Ice) That seems to be the fear shared by the world's central bankers, who have collectively shoveled more than $300 billion of liquidity into the system in the wake of the subprime collapse.

Or will Ben Bernanke get into his helicopter to stave this deflation off, madly throwing out bushels of dollars and hyperinflating us all back to Weimar Germany? (Fire)

Neither, of course, would be great. And to paraphrase Frost, for destruction, either would suffice.

I am no permabear, and I am not a gold bug (although I am holding gold currently). But it strikes me as somewhat far-fetched that a US Federal Reserve that has said that the problem with Japan in the 1990s was lack of monetary stimulus can somehow be expected to sit idly by while the US money supply contracts.

Fire, or out-of control inflation, gets my vote as the more likely outcome.

Additionally, I am convinced by the Austrian permabear argument that the bull markets in virtually every asset in the world over the last five years does not indicate a miraculous period of everything getting more valuable, but rather suggests that all global assets are appreciating against all currencies, but especially the US dollar.

Further, global money supply has been increasing at double-digit annualized rates. The US is a relatively mild offender by world standards, rising at "only" 12%.

Still, even though the dollar might be better than other currencies, I frankly don't think it's safe to hold dollars any longer. I've moved into gold on the recent breakout, but if this gold rally fails, I will probably have my hands full of Swiss Francs (FXF).

Every dog gets his day, and the Gold Is Money gang's day is probably going to continue for the foreseeable future. Might as well be along for the ride . . .

WELCOME!

There's plenty to talk about, so let's dive on in . . .

Money's Jason Zweig finds some new investment insights in recent advances in behavioral finance. Among other things, he describes how, for us homo sapiens sapiens, the anticipation of a reward is much greater than the satisfaction of actually getting the reward.
http://money.cnn.com/2007/08/14/pf/zweig.moneymag/index.htm

So we run stocks up to ridiculous levels when something good is over the horizon, and we sell them off when that good thing actually happens.

Apparently, this whole mechanism works in reverse, too, as fears of something bad or dangerous excite more anxiety than the actual arrival of the dreaded event.

Could this be why war scares tend to be such a great time to buy?