Cause for Pause

Now I'm towing my car, there's a hole in the roof
My possessions are causing me suspicion but there's no proof
In the paper today, tales of war and of waste
But you turn right over to the TV page
--Crowded House

Masterpiece by Mr Practical today that advises staying focused on the big picture rather than the noise and misinformation that pervades deflationary situations such as ours. He suggests that individuals reduce risk so that they are better positioned to capitalize on opportunities down the road.

While I have heard and heeded Mr P's call for risk reduction to some degree, I'm far from 'out of the market.' In fact, the last couple of months has found me increasing risk such that I'm currently carrying lower cash levels than I have in a while. Current cash stands at about 48% of liquid assets. Not exactly illiquid but down significantly from a ~2/3 cash position at end of Q1.

Bureaucratic interventions over the past couple of months that ultimately seem dollar destructive have led me to assign a higher probability to hyperinflationary outcomes than I had previously. Currently, my scenario analysis looks like this:

Hyperinflation (30% chance--up from 20%)
'Normal' inflation (20%)
Deflation (50% down from 60%)

What makes it tough is that I'm 'seeing' greater chance of either extreme than the middle of the road case. And the actions for coping with hyperinflation vs deflation are diametrically opposed to each other. Because the chances of extreme inflation have upticked in my mind, I've been acting accordingly by adding risky assets that might benefit from, or offset, dollar devaluation--such as select decently valued pharma stocks such as Pfizer (PFE) and various commodities.

But Mr P's continued voice of reason has given me pause, and is causing me to once again re-examine my asset allocation. Should this nascent rally have legs, I'll likely be looking for opportunities to reduce my risk profile.

position in PFE, commodities

Uncomfortably Numb

Come on now
I hear you're feeling down
Well I can ease your pain
Get you on your feet again
--Pink Floyd

Nice piece by Scott Reeves on Cali's latest attempt to save people from themselves. This time, lawmakers want to protect us from the evil food at the McDonald's (MCD) drive thru.

Call it what you want. The Nanny State. Good-for-you legislation.

But all in all it's just another brick in the wall of liberty lost.

no positions

Home Invasion

A jumpin' up, fallin' down,
Don't misunderstand me.
You don't think that I know your plan,
What you try'n to hand me?
--James Gang

Insightful personal account by WSJ's Paul Gigot on the historical heavy handedness dished out by political and business friends of Fannie Mae (FNM). Mr Gigot concludes:

"The abiding lesson here is what happens when you combine private profit with government power. You create political monsters that are protected both by journalists on the left and pseudo-capitalists on Wall Street, by liberal Democrats and country-club Republicans. Even now, after all of their dishonesty and failure, Fannie and Freddie could emerge from this taxpayer rescue more powerful than ever."

Although this is a riveting life-is-stranger-than-fiction tale (that continues to unfold), because of its powerful backing, it seems doubtful that the movie version of The Fannie Mae Gang will appear anytime soon.

no positions

Beggar's Banquet

I stuck around St Petersburg
When I saw it was a time for a change
Killed the czar and his ministers
Anastasia screamed in vain
--Rolling Stones

As Fannie Mae (FNM), Freddie Mac (FRE), and other financial institutions line Capitol Hill looking for handouts, Jim Grant ponders why U.S. citizens are not outraged. Although he offers many plausible reasons for the lack of Everyman's wrath, his favorite theory is that the Populist Party actually won their battle to overthrow capitalism over a century ago. In Jim's words:

"They had demanded paper money, federally insured bank deposits and a heavy governmental hand in the distribution of credit, and now they have them. The Populist Party might have lost the elections in the hard times of the 1890s. But it won the future."

Sadly, an excellent observation.

It's increasingly difficult for me to see how our country's socialistic trends can be peacefully reversed in the name of liberty. Emphasis on 'peacefully.'

no positions

Brute Force

In violent times
You shouldn't have to sell your soul
In black and white
They really, really ought to know
--Tears for Fears

It is often assumed that liberty and democracy are strongly linked. However, this linkage breaks down if a democratically elected government fails to uphold property rights. Consider, for example, the situation where a democracy votes to collect taxes from the citizenry. If the issue becomes law, then tax collection is the legalized, coercive appropriation of property. Tax collection is clearly a restriction of liberty as it reduces an individual's capacity to live freely.

Such legalized robbery is exacerbated due to the phenomenon of unequal distribution of wealth. Since Pareto's observation hundreds of years ago, we know that a large portion of society's wealth rests with a subset of the population.

It should come as no surprise that democratic votes on issues designed to redistribute wealth away from rich minorities towards poor majorities (or other influential special interest groups) tend to carry the day.

Once democratic governments operate to redistribute, rather than to protect, individuals' property, then it is easy to see how democratic states can morph into nothing more than greedy mobs having their way over individuals who are incapable of defending themselves.

Oil Slick

I know it's too late now
But I wish I could go back in time
And start all over somehow
And get it right from the start
--Jefferson Starship

Crude's two day, 10 handle decline has some thinking that the monster uptrend in oil is over for now. Technically, the chart certainly sports a parabolic look often associated with bubbly tops. On the other hand, it's hard to ignore the macro supply/demand imbalances in black gold.

Personally, I've largely been observing the energy bull market from the sidelines. My big picture view makes me bearish on world GDP, and it's been difficult for me to confidently bet on higher oil prices given the probability I assign to a scenario of slowing world demand.

One oil-related name that has caught my eye is Valero (VLO). North America's largest (and I think best) refiner has seen its stock price crushed as crude rocketed higher. Higher crude prices mean higher feedstock costs for VLO, resulting in lower crackspreads and profits.

Because VLO has largely been trading inverse to crude, it seems an attractive way to play a pullback in oil. Moreover, general market action over the past couple of days suggests an oversold rally may be at hand--one that could put the wind at the back of the average stock for a while.

While my primary thesis is shorter term and trading oriented, I think there's a decent fundamentally-driven investment story as well. This is a well managed company in an industry that lacks spare domestic capacity. Unlike others, VLO has retrofitted facilities to efficiently refine heavy sour crude. The heavy stuff is cheaper than light sweet crude, and as light supplies dwindle, VLO is positioned to refine at wider crackspreads than others. This is an interesting strategic position.

Financially, the company's been throwing off $2-3 billion in free cash flow annually for the last few years, and sports a manageable debt:equity of 0.3. At today's close of $33.56, VLO's free cash flow to enterprise value is nearly 7, which is about as cheap as I've seen among companies I follow.

Boo's side of the story? Resumption of crude's march higher for one thing. More offshore refined gasoline shipped to the US for another, which would impair ability of domestic refiners to raise prices.

The risk/reward looks favorable enough to me for at least a trade.

position in VLO

Blast Off

And all this science I don't understand
It's just my job five days a week
A rocket man, a rocket man
--Elton John

The moonshot moves in the financials today demonstrate the volatility possible during extremes. Led by Wells Fargo's (WFC) positive earnings report, the BKX screamed 17% higher (has to be close to a single day record). WFC was up 33% on the day! Other big name movers included Fannie Mae (FNM) +30%, Bank of America (BAC) +22%, and JP Morgan (JPM) +16%.

Of course, even with today's screamer the above names are still down big on the year.

Experienced a little premature evacuation by kicking out my bank exposure early in the day before the group really got going. Perhaps I should adopt Prof Nelson's 10:30 rule.

Regardless, still felt good to make some sales. Should this rally continue, am hoping to use price to my advantage for unloading a couple stale trading positions (e.g., GE) and pruning risk in some longer term holdings.

Would like to better match my risk profile to my view of the world which, increasingly, looks deflationary. Viewed thru a deflationary lens, cash is king.

position in GE

Bio Rhythm

Everybody gather 'round now
Let your body feel the heat.
Don't you worry if you can't dance
Let the music move your feet.
--Miami Sound Machine

One nice thing about a blog is that you can record real time experiences and feelings so that, in the future, you can go back to old posts and remember what certain environments felt like. Otherwise, once removed from the context, it's easy to lose that feel.

Getting back in touch with past experiences comes in handy during market extremes. If you're able to recall what it felt like during past market tops and bottoms, then it might help you make better decisions during periods that are often wrought with emotion of greed and fear.

We may be experiencing one of those extremes currently. While I have big picture concerns that lead me to believe that stock indices will be signficantly lower over the next few years, in the near term, fear seems to be growing mighty palpable. As Toddo offered earlier this am, it feels like a 'bid wanted' situation in the financials.

Not to say things couldn't get more extreme. Indeed, chances of an outright crash have increased substatially (although, by definition, dislocations are always a low probability event).

But I'm smelling a rally. If we get one, then I'll be looking to lighten up my risk profile--even on longer term holdings.

position in select financials

Early Bird Special

Take a load off Fannie
Take a load for free
Take a load off Fannie
And you can put the load right on me
--The Band

The problems now surfacing in Fannie Mae (FNM), and her cousin Freddie Mac (FRE), were 'easy' to spot many years back. However, shorts who immediately acted on that perception may not have lasted to collect their reward when, years later, Fannie finally came unglued.

Count me among them. Short FNM since 2003, I was worn down by the market's ebb and flow while waiting for 'the big one'--that period when the collective market 'saw' Fannie's fundamental problems. Classically, I capitulated last summer--just before the financials blew.

There's little room for 'woulda, coulda, shoulda' in financial decision-making. Still, it's hard not to look at the 75% decline in Fannie over the past 12 months and marvel at the market's ability to dissolve an individual's commitment to an investment thesis at precisely the wrong time.

no positions

Value Quest

Why can't they just say, 'Go to this place and here is the treasure; spend it wisely?'
--Riley Poole (National Treasure)

Recently some have opined that General Motors (GM) is a buy here because of its low market capitalization. Market capitalization, or 'market cap', is found by multiplying the number of shares outstanding in a stock (a.k.a. 'the float') by the share price.

market capitalization = number of shares outstanding * stock price

With a float of about 556 million shares and a share price of $10.17 (July 3rd close), GM's market cap is approximately $5.8 billion. As a component of the Dow Jones Industrial Average, GM's market cap is significantly lower than the other 29 stocks that comprise index. Next lowest are Alcoa (AA) at about $27 billion, and DuPont (DD) and Home Depot (HD) at about $38 billion.

Market cap is often viewed as a measure of overall company value. And, in the eyes of some, GM's low market cap reflects a company that is inexpensive and worthy of investment (or at least a trade).

As a measure of overall corporation value, however, market capitalization is incomplete since it does not directly account for a company's debt and cash positions. In the event of a buyout, the buyer would have to assume the company's debts while pocketing its cash.

A better reflection of takeover value is enterprise value. Enterprise value equals the company's market cap plus its debt (which could include minority positions and preferred stock) minus its cash.

enterprise value = market capitalization + debt - cash

GM's March 2008 balance sheet indicates total debt of about $44 billion and cash of about $22 billion which implies an enterprise value of about $28 billion. As such, GM's enterprise value is more than 4 times its market capitalization--due to the large amount of debt to be assumed by any would-be acquirer.

Big discrepancies between market cap and enterprise value are common, which shouldn't be too surprising given the degree of corporate leverage these days. As a further example, consider the other 'General' in the Dow 30, General Electric (GE). GE's market cap currently stands at nearly $270 billion. However, due to the company's half a trillion dollar debt load, GE's enterprise value balloons to about $800 billion.

When trying to get a picture of the overall value that the market is assigning to a company, enterprise value often adds perspective not offered by market capitalization alone.

position in GE

Battery Park

"You know, I know this steak doesn't exist. I know that when I put it in my mouth, the Matrix is telling my brain that it is juicy and delicious. After nine years, you know what I realize? Ignorance is bliss."
--Cypher (The Matrix)

We know that humans are subject to herd behavior and social influence. However, humans possess self-awareness. Self-awareness allows us to recognize context, and select our response (e.g., comply with the herd or go our own way). It is perhaps the most fundamental way in which we differ from the rest of the animal kingdom.

Self-awareness facilitates freedom of choice.

Cypher exemplifies those who prefer to cede their freedom for a State of Dependence. The comfort and satisfaction offered by this state is, like Cypher's steak, an illusion. In reality, we surrender our persona and become, well, part of a battery park. And folks go willingly.

Perhaps the greatest barrier to liberty is not the desire of some to rule, but rather the desire of many to be ruled.