Great Earnings this morning (Tuesday, October 20) from CAT, UTX, PFE and KO. CAT guidance was the economy is improving much faster than expected and the risk of a double dip recession is now "very low" in 2010. CAT (a proxy for the export driven, industrial equipment market) beat earnings estimates by 85% and had higher revenues than forecast (which is supposedly what the market is begging for). So, what happened to its stock price? Sold off.

This earnings season has become the typical denial event by the Bears. The hardcore bear traders try and sell down every rally and discount any good news as either lies or misinterpretation. They first criticize the weakness of economic growth and unemployment levels, and then turn around and criticize the Fed for using accomodative policy to ramp back up the economy.  (Earth to Bears: you can't have it both ways, unless Armageddon is your objective, in which case, tight policy will deliver the economic disaster you are awaiting)

This market is still climbing a huge "wall of worry" and so it will continue climbing higher (until all the Bears throw in the towel). When I stop seeing Michael Pento, David Rosenberg , Peter Schiff, Joe Battapaglia, etc on CNBC blasting the Fed and the market, that is when I will Sell.  There is no Euphoria.  There are no "rose-colored glasses.  There are only Bears (likely still short since SP500 of 666) begging for their wishes to be fulfilled.  Please keep ripping the market and economy.  It is making me wealthy.

Today, I was able to roll my October FLRs that were exercised on Friday to November sold puts, and picked up another 0.50 per contract in the process. I also flipped my BHP for a 2.47 gain the past 12 days (closed my Nov 70 puts at 1.75 and opened same number of Nov 75 puts at 4.50 a few minutes later) during the morning sell off. I am now waiting to get back into EWZ as Brazil sold off big today (down to 70 from 76). I will wait for $67 to get back in with some DITM calls on Mar 2010.

I also doubled down on my GE Mar 2010 Calls ($10s) at $5.80. They had been almost $7 a few days ago. Now I have 10 contracts (1000 shares) plus another 500 shares of GE.

Reflation. It is a very provocative concept. We all know what is meant by the term Inflation. It is almost intuitive because we have lived with it all of our lives. Those of us over 40 have a special affection with that word as we experienced the 1970s and some of the worst that inflation can bring.

But few of us have a good idea what is meant by the term reflation. Whether we should embrace or fear it. My way of looking at reflation is to "fill the hole" left by the deflation caused by housing, stock market and other financial asset price contraction. All that asset value had to go somewhere. The assets underlying value didn't just disappear, though much of the derivative paper might have.  Assets were revalued by a mass panic of the entire American and global population. But this was a psychological phenomonon, and so it can be reversed.  It is quite possible for assets to regain their previous value with some encouragement.  That encouragement comes in the form of reflation and what it encourages: the "animal spirits" of the market place.  Until we find asset price recovery through the process of reflation, diminished values will wreak havoc on the economy through slashed consumption, falling corporate and tax revenues, declining profits and higher unemployment.

Reflation is made possible by the expansion of the monetary supply, offsetting money supply reduction that occurs from asset price contraction. But it is an indirect offset. If my house was worth $600,000 in 2007 and is now worth $400,000 in July 2009, to reflate the economy the government doesn't just send me a check for $200,000 (though a case can be made for doing just this ala "Helicopter Ben"). Rather, monetary expansion trickles through the economy: first to bolster the banking system where it originates from programs like TARP and TALF, then through Federal "stimulus programs" that eventually (belatedly?) result in a "Cash for Clunkers" program, and finally to home owners through firming home prices and higher wages with economic expansion and increasing demand; all from the proverbial "thawing" of a frozen credit system enabled by backstopping the banking system.

But reflation comes with a price, and it is political, not numerical. Because reflation originates within the Federal government (the Federal Reserve Banking system and the Treasury), the only entity which can legally create money from nothing, it comes with plenty of strings attached. Those strings will be pulled by the majority political power, Democrats at this point in time. The party in power will seek to use economic reflation policy to achieve social policy and, in the case of liberals, a redistribution of wealth. Whether one agrees or disagrees with a specific policy or program,  it is beside the point. The point: because there are strings attached, reflation through fiscal policy or monetary means there are conditions that are inefficient and carry plenty of future baggage (entitlements).

Bill Gross wrote about our economic reflation policies and what it means for our economic future. In his eyes, the future is none too optimistic. Bill Gross suggests we are doomed to many years, perhaps decades, of below trend economic growth, his "new normal". Those of us less than 70 years old, who did not experience life during the 1930s and 40s, will probably need to recalibrate our expectations.

I personally take exception to the characterization of 3% Nominal GDP growth, as Bill Gross forecasts, as being a "New Normal".  Such a growth rate is an aberration and would mean perpetual recession. It is actually an old normal at a time of zero or negative inflation, like right now when Nominal GDP equals Real GDP.  Rather, 3% "real" growth in a mature economy like the American, is an "old normal"; more like the economy of the 1950s, 60s, 70s and 80s, on average. In fact, the Real GDP expanded by an average of 3.45% between 1951 and 2004. It is important to look at "REAL" data as it strips out the effect of inflation, which was pronounced during the latter half of that range.

In Bill Gross' words:

Reflating nominal GDP by inflating asset prices is the fundamental, yet infrequently acknowledged, goal of policymakers. If they can do that, then employment and economic stability may ultimately follow.

Gross goes on to make the point that we can't expect to see 5% Nominal GDP growth as we did in old normal times.  But his point doesn't make much sense as it was actually much higher on average in the past 50 years.  Even at face value, his statement begs the question "what part of that nominal GDP  will be inflation?"

I expect we will actually see moderate inflation once reflation has been achieved.  It is the natural result of successfully reflating the economy and having it run at productive capacity and full employment all while running a Federal fiscal deficit to fnance reflation policy. Because full employment (around 95% of the workage population) is a Federal policy goal, and because the Feds have the means to control reflation (monetary expansion), I expect this goal to be successfully met.  So, we can therefore expect moderate inflation once stability is achieved.

Bill Gross concludes his August 2009 newsletter by making the case for 3% Nominal GDP for the forseeable future:

A 3% nominal GDP “new normal” means lower profit growth, permanently higher unemployment, capped consumer spending growth rates and an increasing involvement of the government sector, which substantially changes the character of the American capitalistic model. High risk bonds, commercial real estate, and even lower quality municipal bonds may suffer more than cyclical defaults if not government supported. Stock P/Es will rest at lower historical norms, and higher stock prices will ultimately depend on tangible earnings growth in the form of increased dividends, not green shoots hope. An investor should remember that a journey to 3% nominal GDP means default/haircuts for assets on the upper end of the risk spectrum, as well as extremely low yielding returns for government and government-guaranteed assets at the bottom end.

Yes, I suppose a 3% Nominal GDP would have the effects described if it were possible.  But the PIMCO scenario is highly unlikely and Gross' reasoning is flawed in many ways.  If we are  indeed in a period of lower interest rates, then P/Es will not contract but will likely expand.  P/Es run inverse to the Treasury Yield Curve, the infamous Greenspan "Treasury discount model".    So, low interest rates should result in higher stock prices once stability returns to the economy.  However, I believe we will see higher interest rates once the economy is reflated and the economy stabilized.  This will result in attenuated economic growth of around 2-3% Real GDP, plus an inflation rate of 5% which will cause Nominal GDP to run above 7% as opposed to the 3% forecast by Bill Gross.  American Nominal GDP ran between 7 to 13% during the late 1970s, a period of anemic economic growth (real), large fiscal deficits and moderate to high inflation.  Even in 1981, during a severe recession, nominal GDP grew by 4.4% due to the high embedded inflation.

Like Gross, I do worry that the "strings attached" to reflation policy will "substantially change the character of the American capitalistic model".  But political pressure from the right should counter the most extreme of what the left has to offer.  We already see evidence of this in respect to nationalized medicine and "cap and trade".  So, even this concern of Gross' is overblown.  Another threat comes from foreign interests who might not want to help America reflate by continuing to buy Treasury bond issues that support monetary expansion / quantitative easing.  But I think these foreign entities (China, India, Oil Nations, etc) see that it is their own self-interest to reflate the American economy and rekindle its consumer sentiments.

I think Mr. Gross has fallen prey to his shifted paradigm of a "New Normal". His position does not take into account the resultant moderate inflation that must naturally  follows a reflationary policy.  We can expect inflation in 2012 and after of perhaps 5 to 7%. This will result in a Real GDP that is negative if we sutract inflation from the Nominal GDP forecast of 3% suggested by Mr. Gross. Zero or negative Real GDP is not consistent with full employment and will not be tolerated by our political process.  So it cannot happen for an extended period of time invalidating the PIMCO argument. I suggest the PIMCO triumverate re-examine their assumptions.

Bill Gross August 2009 Investment Newsletter

Kiplinger's Personal Finance magazine provides affluent readers with the information they need to make smart decisions about their money. Each issue includes intelligent reporting on investments, taxes, insurance, paying for college, planning for retirement, home ownership, major purchases such as cars and computers and other personal finance topics.

(more...)

Financial reports speak their own language, and managers without a strong finance background often find themselves bewildered by what is being said. Finance for NonFinancial Managers helps managers become familiar with essential financial information, showing them how to "speak the language of numbers" and implement financial data in their daily business decisions. In addition, it clarifies how and why financial decisions impact business and operational objectives.

(more...)

Why is Natural Gas so cheap (3.87 per mmBTU as of today) while Oil is moving ever higher? This is a significant disconnect that does not make long term sense. Historically, the average ratio between West Texas crude and Henry Hub natural gas has been 8.5 to 1.  Currently, it is at a historic ratio of 19:1.

With oil at $72 per barrel, natural gas should be around $8.47. That represents a 125% potential pop in the price of natural gas if the price of oil stays constant. Many experts believe that oil is fairly priced right now, give the costs of exploration and extraction.

UNG is the easiest pure play on the price of natural gas. This ETF is based on natural gas futures and moves directly with that price. UNG trades for $14.50 as of today, but would be over $30 if natural gas normalized its pricing against oil. So, just on current relative value, natural gas is a value play with great upside potential in the intermediate term (12 months). But it is an even better play in the longer term (1-5 years).

President Obama and the Democrat controlled Congress will definitely pass some type of environmental legislation this year or early next. That legislation is aimed directly against carbon and its role in global warming (or the theory thereof, since it is not conclusively proven). In the next several months, either a "Cap and Trade" or a straight up carbon tax will be passed. The moderates in Congress and most of the heavy industrial world, faced with the reality of some type of legislation, are rallying behind a carbon tax for its simplicity and for the fact that the cost can be passed along to the consumer much more efficiently and without the distortion and potential fraud of cap and trade.

For natural gas, either scenario is very attractive. Natural gas per BTU of energy, is much cleaner than oil or coal, the two primary fossil fuel alternatives. So, if a carbon tax is passed by legislation this year, natural gas will immediately become more competitive. Its historical relationship to oil should decline even below 8.5. If it moves to 7.0, then the relative cost today should be $10 per mmBTU for natural gas.

Longer term, with or without a tax advantage over oil, natural gas promises to be used as a transitional fuel to alternative energies like solar, wind and geothermal. T Boone Pickens has proposed, and spent a considerable portion of his wealth, promoting the idea of natural gas powered vehicles. Once fuel cell powered vehicles become practical, within 10 years with government encouragement / subsidy, natural gas is likely to be the first fuel used by such vehicles. This reality will be encouraged if Pickens is successful in getting existing fuel stations in North America to add natural gas to their product offering at the pump.

Pure hydrogen vehicles are a better environmental option, since the byproduct of the chemical reaction is pure water. But the manufacture, storage and distribution of highly combustible hydrogen has many science, engineering and production problems yet to be solved.

So, how can we benefit from this megatrend?

The Canadian Canroys are one good way to anticipate this new trend.  Much of North American natural gas is in the western provinces of Canada. I have owned and benefited from Pennwest (PWE), Pengrowth (PGH), Provident (PVX), Daylight (DAYYF), Baytex and Harvest Energy for many years (until last July when the entire commodity complex hit the skids).  U.S. based producers include Anadarko, Chesapeake, XTO, Southwest Energy and Lynn Energy.   All the above offer decent dividends, though not nearly as attractive as a year ago, so there is somewhat less reason to buy and hold as there was in the past.

For extra leverage, sell "In the Money" UNG put options on the October $18 strike price (UNEVR) for around $4.50 premium per share of underlying stock (with the stock price at $14.50 as of today). This buys $1 of downside protection and provides over $3 of upside opportunity. If the price finishes above $18 on October 16, the puts will expire worthless and you will keep the $4.50 premium. The stock price of the UNG ETF will only need to move to about $5.00 from the current $4.00 for this to happen. But execute a "Buy to Close" order any where along the way, for example, when the premium falls to $2 for a double on your investment (times 5 for the inherent leverage of options) to lock in profits. This gives a 500% return in less than six months.

Because the market, especially commodity stocks, looks ready to correct, it may be prudent and profitable to wait on this until after a market correction.  I am looking for a move back down to SP500 of 875 in the next couple of weeks.  Once that move is done, it may be possible to sell the same puts for $5.50 (with the underlying UNG at $13). 

Have fun making money.