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Calling All Individual Stock Investors

(April 20, 2006)

Dear Subscribers and Readers,

All the talk in the stock market over the last couple of days has been focused on the March 28th meeting Fed minutes – not to mention the subsequent decline of the U.S. Dollar Index and the extreme “blowoff rally” in metals prices such as gold, silver, copper, zinc, etc.  As of Tuesday evening, the Market Vane Bullish Consensus readings for gold, silver, and copper were 90%, 97%, and 96%, respectively – all extremely high readings with the silver and copper bullish sentiment readings being the highest since April 4, 1972 and August 29, 1972, respectively.

Judging by the movement in the gold price and the introduction of the silver ETF, silver should continue to rise (although this author would be selling all his silver eagles and Kennedy half dollars should spot silver rise to $20 an ounce this year), but the latest rise in copper may be coming to an end, given the following:

  1. The parabolic rise in copper prices since 2005 (a 43% rise since the end of 2005 and an 18% rise since the end of March) is not sustainable.  Moreover, the latest spike in copper prices has been attributed to the Grupo Mexico copper mine strike (the company is claiming a loss of 1,100 metric tons of daily copper production) as well as the higher-than-expected 1Q GDP number coming out of China last Sunday evening.  Hedge funds and retail investors alike are now betting that Grupo Mexico will miss its May delivery – given that the strike has already gone on for 27 days.  But whether Grupo Mexico will miss its May delivery is not really important in the long-run, as price spikes due to temporary supply shortages (think the OPEC embargo and the Hurricane Katrina spike in oil and gasoline prices) are usually not sustainable.  As for China, it is interesting to note that copper imports into China for both January and February of this year have been dismal – which means part of the reason why China had a higher-than-expected 1Q GDP was because it imported less base metals and copper (as one may remember from macro 101, GDP is equal to C + I + G + E – X)!  John Kemp of Sempra Metals claims that most of the copper that was headed to China had been re-routed to the U.S. instead – but given the slowdown in housing and given the not-too-exciting automobile production numbers for the first quarter, one has to wonder where all this copper disappeared to.  Word is that hedge funds have actually been taking delivery and putting them into warehouses – but details at this point are very sketchy.

  2. At current prices, a significant amount of “scrap copper” should now also be coming to the market.  Much of this news is anecdotal – but the theft of copper pipes or copper wires from abandoned buildings or warehouses have been featured in many recent headlines.  Quoting the Copper Development Association: “Each year in the USA more copper is recovered and put back into service from recycled material than is derived from newly mined ore. Copper's recycle value is so great that premium-grade scrap normally has at least 95% of the value of primary metal from newly mined ore.”  Make no mistake: Today, one can make a living by finding and selling “copper scrap.” 

Let's now get back to the March 28th Fed minutes and discuss the potential implications.  By far the three sentences that most of Wall Street focused on were the following: “Most members thought that the end of the tightening process was likely to be near, and some expressed concerns about the dangers of tightening too much, given the lags in the effects of policy. However, members also recognized that in current circumstances, checking upside risks to inflation was important to sustaining good economic performance. The need for further policy firming would be determined by the implications of incoming information for future activity and inflation.”  Right after the release of the Fed minutes on Tuesday, the odds (as determined by the Fed Funds futures traders) of a further June rate hike to 5.25% immediately dropped from 54% to as low as 30%.  The market immediately began to build on its morning rally, with the Dow Industrials closing up 194.99 points for the day.  A Fed friendly environment will obviously lend a hand to “cash flow negative” assets such as commodities, and surely, the metals did not disappoint – with gold, silver, copper, and aluminum closing at their highs for the day and mostly building on those highs on Wednesday.

What most folks do not realize, however, is that these minutes were recorded three weeks ago, and since then gold has risen 13%, silver 33%, copper 22%, crude oil 12%, and natural gas 13%.  Like I have mentioned before, however, the Fed will make sure that they have “done their jobs” before putting a stop to their rate hiking campaign – whether it is in the form of a drop in the stock market or commodity prices.  The rise in commodities since the March 28th Fed meeting is very troubling – especially since there is now some evidence of an increase in commodity pass-through inflation to the CPI core number (one example: GM ditching its employee discount incentives).  Quoting a few selected paragraphs from the same Fed minutes: “Some meeting participants expressed surprise at how little of the previous rise in energy prices appeared to have passed through into core inflation measures. However, with energy prices remaining high, and prices of some other commodities continuing to rise, the risk of at least a temporary impact on core inflation remained a concern.” 

With oil prices currently trading at $72 a barrel on the NYMEX – in the absence of a “aggregate supply shock” (such as the destruction of oil platforms during a Hurricane or a crisis in the Middle East) – you can bet that the Fed is definitely worried.  Today, both the Fed Chairman and most of the Fed's governors are in favor of an “inflation targeting” regime – as opposed to during Greenspan's policy where the Fed had the dual policy of targeting both inflation and sustainable economic growth.  In his book, "Inflation Targeting," Bernanke and other authors wrote that inflation targets can sometimes be changed, but only in special circumstances, such as:

The decision about whether to change the target depends pretty much on the type of shock hitting the economy. In general, there is no conflict between output and inflation stabilization when the precipitating shock is an unexpected change in aggregate spending; using monetary policy to offset an aggregate demand shock is nearly always the correct response. However, an aggregate supply shock, such as a sharp increase in oil prices, may cause a conflict between stablizing output and employment in the short run and stablizing inflation in the long run. Targeting a price index that excludes the first-round effects of common supply shocks can, as we have seen, ameliorate this conflict to some degree. But a supply shock that is great enough, or that arises from some unanticipated source, may justify missing or changing a previously announced inflation target.

Missing a target need not signal that the entire inflation-targeting strategy should be abandoned, however. So long as the central bank is able to explain that the miss is the result of unforeseen events, the credibility of the central bank with the public need not be compromised.

In other words, the Fed is willing to stop hiking (or even cut) even if oil prices touch $80 a barrel if that spike is due to an unforeseen supply shock (such as another rampaging hurricane on the Gulf Coast). If the Fed was reasonably confident that this spike was a one-time spike, then they will turn a blind eye - justifying this by explaining why this will not have any inflationary effects over the long-run. Unfortunately (for those wishing the Fed to stop hiking), current events in the markets do not qualify itself into this category.

So Henry, in the past, you have discussed soaring prices in the metals such as copper or gold – so why are you and the Fed choosing to focus on oil and energy in general?

That is a great question – and the primary reason for this focus is that crude oil is involved in virtually all of the production processes in the United States – with the exception of power generation.  In annual terms, U.S. consumers spend approximately $525 billion on crude oil each year ($72 x 365 x 20 million barrels a day), while the consumption of copper only totals a mere $14 billion a year (2.2 million metric tons x $6,400 a ton).  The rise in copper prices is merely a reflection of the general speculation and inflation of commodity prices.  Should copper rise in the absence of a rise in general commodity prices, the Fed will most likely turn a blind eye – unless copper rises to $10 a pound or more.

The second focus is natural gas, as natural gas is responsible for powering 25% of the U.S. economy.  According to the Energy Information Administration, U.S. consumers “consumed” 22 Tcf (trillion cubic feet) of natural gas last year – or in absolute dollar terms, $200 billion ($9/Mcf x 22,000,000,000 Mcf) worth of natural gas.  So my message to subscribers: Watch natural gas, and watch it like a hawk.  Natural gas prices have already jumped significantly since the March 28th Fed meeting, and should it continue to rise in the days ahead in the absence of a supply shock, then there is no question that the Fed will keep on raising the Fed Funds rate beyond the May 10th meeting.

As for the stock market, this author has previously stated in our weekend commentary that many of our “ultra short-term indicators” were reaching oversold status (such as the daily McClellan Oscillator index and the percentage of NYSE issues below their 20-day EMAs) – and therefore, readers should not have been “too surprised” by the latest rally (isn't easy to say this in retrospect!).  This author was waiting for a slightly more oversold condition before getting rid of the 25% short position that we had initiated on March 20th in our DJIA Timing System, but it was not to be. 

Speaking of the market, Lowry's confirmed that the broad-based rally on Tuesday may have been a “90% upside day.”  In the absence of an oversold condition and at least one preceding “90% downside day,” Lowry's contends that Tuesday's rally most likely was a mere “blow off rally” and that the market should head back down going forward.  This is the contention of this author as well – as any rally from current levels should be severely capped given that the market had really not been in an oversold condition since early October 2005.

Before we go further, this author would like to once again update our readers with the latest reading of the Barnes Index.  I know – this is only one indicator, but as I have previously mentioned, readers should start to be generally alarmed once the Barnes Index reaches the 65 to 70 zone, and since the latest update from our weekend commentary, the Barnes Index has risen further from a reading of 57.20 to a whopping 61.60 only in the last three days.  Following is the latest chart of the Barnes Index vs. the NYSE Composite Index, courtesy of

Barnes Index

A further Fed funds hike and an additional 25 basis point spike in the 10-year Treasury yield (i.e. a further steepening of the yield curve, which is very plausible) will no doubt get us to the 65 to 70 range.  Readers who are still long individual stocks should continue to watch the action in the bonds, crude oil, and natural gas prices.

As an aside, the Fed minutes also contained one interesting note, that being the following: “Regarding the major sectors of the economy, meeting participants noted that consumer spending appeared to be growing at a solid pace, notwithstanding earlier rises in energy prices. Contacts in the retail sector reported strong demand, and lending to households seemed to be robust. However, some automobile dealers reported subdued demand for domestic name-plate products.”  At the same time, GM has come out and stated that first quarter sales worldwide grew 4.4% in the first quarter, although North American sales were a full 5% lower.  The 5% sales decline may have already fully justified the “subdued demand for domestic name-plate products” statement that came out of the Fed, but as a recent WSJ article pointed out, GM books sales on its vehicles as soon as the vehicles are sent to dealerships – and given that GM ramp up production quite dramatically in the first quarter of this year, there is a good change that all these SUVs will be sitting on the dealers' lots for the rest of the summer as gasoline tops $3 a gallon.  That is, the second quarter may not be all that pretty for the General – as they may be forced to cut back on production volumes as dealers work through their inventories this summer.  In other words, the first quarter earnings number from GM should pretty much be meaningless, given that they are still facing a lot of headwinds (not to mention that their dealers are going to have a hard time selling the Tahoes and the Escalades with $3 gas) and given that they will “sugar coat” their first quarter earnings as much as they could in order to buy more time for the turnaround.

Getting to the subject of this commentary, I would like all our subscribers that are individual stock investors to send me your thoughts on what you like and what you dislike, etc.  No one and no hedge fund has a monopoly on stock market knowledge, and this author feels we can learn the best by learning from each other.  Moreover – given that program trading now accounts for over 60% of all trading in the NYSE, and given the proliferation of hedge funds that engage in macro and ETF investing, this author feels the best way to outperform the market going forward is to purchase individual stocks that you have studied from top to bottom and from left to right.  Look – the hedge funds with their sophisticated models – can generally perform and manage its risks better when it comes to trading currencies, commodities, or major stock indices, but even supercomputers cannot model management behavior, industry variables, and consumer tastes.  That is why individual investors should actually have the hedge here – not to mention the hundreds of small cap and mid caps stocks that are available to individual investors that may be too small for a multi-million dollar hedge fund or Warren Buffet to invest in.

Readers who interested should send in a pick complete with a “big picture” analysis of why a particular stock or industry is a good pick.  Please also disclosure any positions that you may have in the stock or industry.  I would like to see both a “bull's argument” and a “bear's argument” about the stock.  Detailed financial analysis is not required but I would definitely like to see some demonstrated knowledge that you have at least read the latest 10-K and the 10-Q.  Picks can be based on valuation (and the belief that the firm's profits can be sustained going forward) or growth – but please, no momentum plays or penny/bulletin board stocks.  Picks based on valuations are a little bit more obvious, but growth investing isn't.  One of the best growth investors of the 1990s, Andy Kessler, mentioned that in all his years in the Street, he had only found two meaningful “signposts” for growth investing.  In his own words, having only two signposts are “lame” but in retrospect, this is all that you really needed.  Those two signposts are:

  • Elasticity: lower cost creates its own huge markets.
  • Intelligence moves out to the edge of the network.

I highly recommend subscribers to pick up Andy Kessler's books and to read the first chapter (also written by Andy Kessler) of John Mauldin's “Just One Thing.”  Nothing is obvious – especially when it comes to investing.  There are multi-year or multi-decade trends out there for the enterprising investor – but these trends are not obvious (once they are, they cease to be profitable).  Andy Kessler cites investing in the semiconductor industry during the 1960s to 1990s as an example of the first point – when lower production costs and thus lower semiconductor prices generated its own exponentially increasing demand.  The same could have been said for the discount brokerage industry in the 1980s to 1990s.  Still more could be said now for the various option and derivative exchanges such as CME, BOT, or the NYMEX – as derivative commissions have declined significantly and as retail investors and traders get better access to both price and fundamental information.  On the second point, I will leave our readers to find out for themselves the meaning as well as examples of investment trends based around that point.

A reader recently asked how its portfolio should look like given that he is very close to retirement and that there may be a danger of losing his job.  Obviously, there is no single answer to this – it all depends on your risk tolerance and investment prowess when it comes to investing in stocks or bonds.  Disclaimer: Please note that I am not a personal advisor and nor am I a financial planner.  I am sure many of our subscribers are – so they could help you out (for a reduced fee?) should you really want to seek some advice from a financial planner that actually have a good grasp of the markets.  But in a nutshell, I would definitely ask the following questions:

  • How much savings would I need to support myself assuming I live another 30 years – and instead of slapping an optimistic 8 or 10% annual return for your portfolio, assume a return of 5%, which is right about where the U.S. Treasury yield curve is trading at right now.

  • Obviously, an individual in his late 50s or early 60s can supplement his or her income by investing in individual stocks, but unless you are willing to devote over 20 hours of your time every week to research and analysis (assuming you have the right psychology for individual stock investing and have the investment prowess to do it), one should really stay away from individual stocks when one is close to retiring.  Another question to ask is: Can you continue to work part-time (such as on a consulting basis with your former company) when you retire or if you're laid off from your job before you retire?

  • In my past commentaries, I have discussed (as I see it) the low-return environment for both stocks and bonds going forward, and so stock-picking may be the “only way out” if one wants to see double-digit returns going forward.  That being said, nothing is impossible – and we may see ever-rising stock and bond prices even as the aging baby boomers retire, for example.  After all, wasn't it only a few years ago when we said baby boomers as a group were going to downsize their homes once they are retiring or getting close to retirement?  Well, at this point, this author is still seeing the trend of bigger and bigger homes.  There has been no reversal so far and my guess is that baby boomers will continue to buy bigger and bigger homes (not to mention SUVs) until they can't afford to.  As a whole, the spending habits of baby boomers are second only to their kids – as neither the boomers nor their kids have never experienced “hard times” such as World War II or the Great Depression.

Signing off,

Henry K. To, CFA

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