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BIG Picture Transcript
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JIM: Hello, everyone, I’m Jim Puplava, coming up on the program today we’ll have a shortened version as we head into the Summer months. My guest in the first hour is going to be author and reporter George Orwel, he’s written a new book called Black Gold: The New Frontier For Oil Investors, and then in the second hour, Evelyn Garriss of the Browning Newsletter will be joining us as we talk about this heat wave. [3:17] JOHN: And here’s a tip, you really need to buy oil. No, wait a minute – sell oil. Ok, here’s what you do, buy into… No, no, cancel the market…don’t buy the market…My gosh, are you running back and forth? Are you exhausted? Can you stand this? Well, what you need to do is learn lessons from the master. If you’re going to invest then really truly invest and what did some of the best do, we’ll look at Ben Graham’s The Intelligent Investor. As we look at gold, gold is heating up again, gold is back up over 650, silver above 12, and we’re witnessing a long string of takeovers. What is that going to mean? It seems like we’re going to have a wave of mergers and acquisitions in the precious metals industry. And finally, we’ll have sort of an eclectic segment here on the program. We weren’t sure how else to title this, just random thoughts: is the Fed going to do it, or not do it? Can we do a 180 in the economy, and keep ourselves out of a recession? Well, that remains to be seen, but it’s like sliding down the razor blade of life. Blue chips – why are they worthwhile? And we’ll give you some unpleasant truths about oil. JIM: Well, let’s head down to Wall Street as we do at the top of the hour. US stocks closed with slight losses Friday, although investors were heartened some degree by a weakened labor market that seemed to point to an imminent pause in the Fed’s current series of rate hikes. Until recently, investors have been puzzled in recent sessions as to whether the Fed will lift rates again when they meet on August 8th. Will they or won’t they? The soft data on non-farm payrolls seemed to provide the strongest possible incentive for the Fed. If it was looking for a reason to go on pause, they certainly have it now, with an increase in the unemployment report, fewer jobs, a dramatic slowdown in the second quarter. Well, some experts are saying the fed is done rally has run its course, the idea that the Fed may not lift rates next week is already priced in the market. The market is facing some serious headwind, which we’ll get to in a moment – chief among them is a slowing economy and a peak in corporate earnings. Here’s the way things shaped up on Friday, the Dow was down roughly about 2 ¼ points, closing out the session at 11,240. The S&P 500 was down less than a point to 1279, and the NASDAQ was down about 7 ¼ points at 2085. For the week, the Dow gained 0.2%, the S&P gained 0.1%, and the NASDAQ was up 0.4%. Volume was really light on Friday, and I expect we’re going to see that as we head in to the month of August. Volume was light with only about 1.7 million; they say after next week, after the Fed meets on Tuesday, just about everybody on Wall Street is heading to the beaches so look for lower volume. Well, let’s take a look at that big economic number which shaped the markets on Friday. According to the Labor Department, the market lost strength again in July: the the US economy added fewer jobs than expected – only 113,000 hypothetical jobs in July; and the unemployment rate rose to 4.8% – its highest level since February. Economists had been estimating 143,000 job gains, so this was far below expectations. The report – the latest evidence that economic growth is slowing – was greeted by Wall Street investors as a clear sign the Fed would not raise interest rates again when it meets next week. The sluggish pace of job growth, and the rise in the unemployment rate, will give the central bank room to pause. However, not everybody is buying that story. Lehman Brothers, which believes the Fed will pause on Tuesday, however, because of inflation fears Lehman is forecasting the Fed will hike rates twice, or two more times before the end of the year to sort of put inflation at bay. Here’s the way some of those job numbers shaped up in July. Goods producing industries lost 2,000 jobs, while retail jobs were basically flat; manufacturing continues to lose ground shedding 15,000 jobs in July. However, the good news – if there was any in this report – is about 53% of employers said they were adding jobs in at least the month of July. Well, the jobs number helped the bond market out Friday. Treasuries rallied, pushing the benchmark yield to its lowest level in 4 months after that much awaited employment report. The unemployment report seals the deal according to many on Wall Street, that the Fed will definitely go on pause when it meets next Tuesday. The only fly in the ointment was the average hourly earnings rose 0.4%; the 10 year Treasury note was up nearly ½% - its yield falling to about 4.9%. And of course that’s very good news for the mortgage market because that’ll bring down long term rates. The 10 year yield had dropped earlier in the day to 4.88; the 30 day Treasury bond was up almost ¾ of a point – its yield now below 5% at 4.99; and the 2 year note is also at 4.91 keeping the yield curve inverted. The odds of an interest rate hike in August fell sharply after that payroll report. Traders are now pricing in only a 16% probability that the Fed will raise rates to 5 ½ when it meets next Tuesday, that was down from a 43% chance on Thursday. A slowing US economy is well underway after those 17 rate hikes. However, signs of a slower economy are abounding everywhere. Consumer spending has softened despite the best efforts of car makers and retailers to keep sales growing. Have you looked at the papers lately? Just about everything is on sale. And of course, consumers are trying to keep their spending up by borrowing more and tapping into the equity in their homes. The one hope, or the one bright spot, was business investment. However, even that has weakened recently. While only a few voices in the wilderness see a recession on the horizon, such slowdowns usually take the economists by surprise. Yet the recent economic data are not pointing to a rate hike. Usually when the Fed is getting ready to lower interest rates you’ll see the 10 year note drop about ½% above the federal funds rate, which is currently at 5 ¼. So that would imply we’d need to see the 10 year note dropped about 4 ¾, and if that happens then you’re going to hear talk about rate cuts coming up. We’ll take a look at the dollar and other markets. The dollar fell to a two month low based on the payroll data indicating the Fed will go on pause. The dollar ended up $1.28, almost $1.29 against the euro; 114 Japanese yen; it’s almost up to $1.91 against the pound; and about 1.22 Swiss francs. Crude oil, even though it finished below the $75 mark on Friday still posted a gain for the week. Crude prices ended lower Friday, as the threat to the Gulf of Mexico energy installations receded after tropical storm Chris was downgraded to a depression. Crude for September delivery ended down 77 cents, at $74.76 on the New York Merc – that’s a gain of 2.1%. However, the unpredictability of tropical storms means investors will continue to pay close attention to any weather related updates. Meanwhile, the Middle East remains the focus. The Israeli army has been ordered to ready itself for a deeper push into Lebanon, as hideouts of the militant group Hezbollah are targeted. An Israeli air raid killed at least 28 people, meanwhile Hezbollah sent 190 rockets into Israeli cities. On the supply side, Nigerian oil output is expected to increase by the end of the year but they’re still having problems with kidnappings. We had a group of 3 workers who were kidnapped on Friday, and the latest kidnappings come a day after a German national was seized in the Nigerian city of Port Harcourt. Natural gas futures logged a small weekly gain as we saw prices saw nearly 14%, as a result of the Summer heat wave. Finally, looking at the gold market, gold futures slipped into negative territory on Friday. Gold was actually up about $9 earlier in the day, however we ended down about 90 cents – at 649.60. Everybody’s expecting a new all time high in gold this year, it’s not a question of if, it’s just a matter of when. There remains ample evidence that we still have inflation in the pipeline, and the combination of a slowing economy and rising inflation is a scenario a lot of people on Wall Street fear – it’s called stagflation. As a result, gold remains a safe haven in the mind of most investors. We’re seeing a combination of factors: everything from a weakening dollar that looks terminally ill, geopolitical hotspots look like they’re going to get worse, as well as favorable investment demand. Silver is also having a good week. It was up almost 10% for the week, as silver closed up about 40 cents on Friday to about $12.48. Copper also rose, it was up about 2.4%. However, the gold indexes which were up earlier in the day turned negative at the close: the Philadelphia Silver and Gold Index was down 0.1%; the HUI slipped 2.2%; and the CBO Gold Index was down 0.3%. Well, that’s the way things looked on Wall Street. Coming up next, John and I with the Big Picture, right after this. [12:56] JOHN: As we’re starting this segment, Jim, all I can think of is a German expression [German expression] which means ‘with much running back and forth.’ You know, it’s sort of…what do we call it here? – a Chinese fire drill. Remember how we used to do those in high school: you come up to a stop and everybody jumps out of the car and runs around and gets back in before the light changes. You know if you’ve been watching the stock market lately, one day everybody’s buying oil, the next day they’re selling oil. One day they’re buying the market, the next day they’re not buying the market. And it seems like everyone is running around, I guess following each other. It’s almost a herd mentality, rather than developing their own convictions in what they need to be doing as far as investment goes. And just as pilots and captains use navigation to help them get to their destination – by the way, no matter how bad the storm is, or what the technical problems are with the boat, they’re still using the navigational tools to remind them of where they are, where they’re going and how to get there – and so investors also need the same navigational tools to help them navigate through the investment world to reach again their destination – whatever their goals are. JIM: You know, John, you’re absolutely right. One of the problems I think investors have today is the underlying principles of sound investment should not alter from decade to decade. In other words, in one decade or one year you’re a value investor, next decade or next year you’re a momentum investor, the year after that who knows what you’re investing in –you’re a growth investor. In other words, once you develop a sound principle in terms of how you invest, you don’t alter that, you don’t change it – it’s like religion. You can’t be a Catholic one day, a Methodist the next day, a Jew on Friday, and a Muslim on Saturday – it just doesn’t work, your life would be a mess. The same thing happens in the investment world. And I think what you see today there are a lot of people making investment decisions without any underlying investment principles or beliefs in terms of why they are making these investments. And we get a lot of news, we have the internet today, we have television, newspapers, magazines, newsletters – I mean we’re bombarded with information, and it’s very easy some times to not see the forest for the trees. But you know what happens is if you aren’t grounded in some kind of principle it’s very easy to get lost. And I don’t care if you’re an individual investor, or pro, one of the exercises that I go through every single year, and I’ve done this for probably well over a decade is I reread in my opinion the most influential investment book ever written, which is Ben Graham’s The Intelligent Investor. The other book I always read is Seth Klarman’s book called Margin of Safety, which is a Graham concept of buying a dollar’s worth of assets for 50 cents. I have always found that these two books help to keep me grounded in sound investment principles, and even though I reread them every year, you know, I always manage to discover a new nugget – or it’s sort of, boy, I really understand Graham was saying about this point much better now with years of experience under my belt. So these are the things that I think are very important for an investor to have if they want to be successful. [16:34] JOHN: As I remember, Graham’s book was a major influence in Warren Buffet’s career. JIM: Sure, in fact, Warren Buffet read The Intelligent Investor in 1950 when it was first written. He was so impressed with the book that he actually went on to Columbia graduate school and studied under Benjamin Graham. Graham was teaching an investment course at Columbia. In fact, that course is still taught today at Columbia. And after graduation, Buffet basically wrote Graham a letter saying, “look, I’ll come work for you for free to just be tutored by you.” And actually Buffet spent a couple of years working at Graham’s fund called Graham-Newman. And in fact, he remained a very, very close friend of Benjamin Graham until Graham’s death in 1976. [17:22] JOHN: Didn’t Graham influence Buffet’s decision to get out of the markets before the big 73-74 bear market? JIM: Absolutely, in fact there’s a very famous story about Graham. In fact Buffet’s decision to unwind his partnership and give his investors all their money back, he couldn’t find any value investments in 1969 and 1970. So what he did is he called Ben Graham – and there were a lot of Graham disciples in that whole Buffet crowd, Bill Ruane, who ran the Sequoia fund, William Schloss [ph.]and a couple of other well known value investors. And what they did, is they all met at the Hotel Del Coronado with Graham and they spent the weekend with him and basically Graham’s advice was, “look, if you can’t find something that is attractively priced in an investment, then don’t buy. And if you’ve got something that’s overpriced, get out of it.” And this is one of the lessons that Graham learned the hard way in the stock market crash of 1929. As a result, a lot of these guys, Buffet went back to Omaha, disbanded his partnership, gave the shareholders all their money back, and put himself in a very good position as the bear market hit in 73 and 74. And what happened is after he liquidated his partnership, Buffet was very flush with cash when the bear market hit, and fear was at its peak. Remember, John? In October 73, the Yom Kippur war, the oil embargo, you had the Dow losing 55% of its value, you had in 1974 the resignation of Richard Nixon – I mean things were just very gloomy. And at the height of that fear, Buffet was plunging headfirst into the market buying major stakes in companies like Washington Post, a $10 million investment that grew to well over $2 billion; and also major stakes in other blue chips, and GEICO. So he was buying with complete abandon at a time when everybody was jumping out of stocks with fear. [19:36] JOHN: And or windows. You mentioned Ben Graham’s book, we’re talking about The Intelligent Investor, why do you think it’s important for every investor to read? JIM: I want to quote something that Buffet wrote. He wrote the preface to – I believe – the 4th edition to The Intelligent Investor which was the last edition of the book before Graham died. And in that preface Buffet said: To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights or inside information. What is needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework. And I put an emphasis on emotions. JOHN: I think it was a really succinct point because the emotions will distract you from where you need to be at a given point. Alright, let’s get in to some of Graham’s investment principles. JIM: Well, I believe one of the most important principles of Graham’s and one that Buffet mastered is to look at a stock for what it really represents, which is ownership interest in an actual business. And that business has an underlying value, John, that does not depend on its share price. In other words, if let’s say you and I were looking to buy a franchise or a dry cleaning business, we would want to look for its business sake. In other words, what is the cash flow with the business? What does it take to run it? What are the capital expenditures? What kind of return could I expect if I bought that business? If you and I were going out and buying another business in the marketplace, these are the kind of questions we would ask ourselves. It’s strange in some ways, people will invest in stocks, which underlying that piece of paper is a business which they look at in a totally separate way. [21:32] JOHN: That’s a really important concept because the way that stocks are viewed today is that the stock has an intrinsic value in and of itself, and so basically they’re looking at the stock market as a casino or a horse race, rather than looking at the value of the company that’s behind it. JIM: That’s so true. There are also a lot of investors that buy stocks – and this gets really dangerous – not really understanding what it is they really own, or the fundamental dynamics that drive that business. This brings me to another important Graham principle, which is to understand the difference between investment and speculation. [22:10] JOHN: And it would seem that this is going to be one of the more prominent issues of the day in the easy language of Wall Street, every one who buys or sells a security is an investor regardless of what he buys, or for what purpose, or for what price. He is still an investor. JIM: Yes, you really hit upon an issue that Graham addressed specifically in The Intelligent Investor, and I’m quoting Graham here when he said: There is an intelligent speculation as there is intelligent investing, but there are ways in which speculation may be unintelligent. Of these the foremost is: one, speculating when you think you are investing; two, speculating seriously, instead of as a pastime, when you lack proper knowledge and skill for it; and three, investing more money in speculation than you can afford to lose. [23:04] JOHN: Well, I think there would be another issue that’s going to confront any investor, say whether you’re a professional like yourself, or an individual investor. It’s really keeping the emotions under control. It’s amazing when money gets in the fray, how people’s emotions drive them rather than their intellect. JIM: This is really critical. An investor’s chief problem –probably his worst enemy – is likely to be himself. As we mentioned earlier there’s just too much information. Look at what you’re bombarded with on a daily basis: emails, e-alerts, the internet, news stories on radio, television. And everything is very short term trend oriented, and many times I think that can throw you off course if you allow it. Because, John, let’s face it, Wall Street and the financial media are always going to present you with a multitude of reasons to trade in and out of a position: “Alright, oil profits are up, the price of oil has gone up, it can’t stay up, you might as well take profits now.” And I think what you need more than anything else to become successful – and this is very hard – is patience, confidence, belief in what you’re doing, discipline, and courage to ride out those trends. And I think if you can master those 4 concepts, your chance of succeeding as an investor improves immensely. [24:30] JOHN: How about not listening to all the family members who have an opinion? I was thinking of that recently because a friend of mine had about $10,000 he had gotten out of a Treasury certificate that he had cashed and he said, “what do I do with it?” And so I looked at him and I said, “buy silver with it, just buy silver.” And then it doubled in value within six months of his having done that, and then all of a sudden family members were saying, “don’t you think we ought to get out?” And I said, “no, it’s going to keep going, just leave it there. Why do you have to get out right now?” So if we have to look at all of this, you consider yourself to be a value investor, is this something you learn strictly by studying Graham, or from other sources? JIM: Well, I probably have to go back [to when] I got exposed to investing back in graduate school. Ben Graham had just passed away, the year was 1976, and quite honestly, until I took my first investment course I never even heard of Ben Graham or somebody like Warren Buffet, as he wasn’t as well known as he is today. But I got Forbes magazine, which had written a tribute to Benjamin Graham –I think you can still find this article on the Internet – it was called Ben Graham’s Last Will and Testament. And after reading that, it had his 10 tenets of investing. I was immediately attracted to Graham’s philosophy, so the first thing I did is I found out who he was, and I went out and got The Intelligent Investor. In fact, gosh, I must have probably 5 or 6 copies of The Intelligent Investor – every edition, and there’s a new edition that I’ll mention as we get done with this that I’m going to recommend to our listeners. But anyway, I went out and bought The Intelligent Investor as I read that, I read and bought Graham’s original book which really created a foundation for the securities industry which was Security Analysis which he wrote with Professor Dodd. At that time, after reading those books, as I first got involved in investing in the 70s, you know, I didn’t have a lot of money to invest but we were savers, and I can remember my wife and I going through the Wall Street Journal and Barron’s on Saturdays during the 70s, and applying his principles to picking stocks. And I suppose, ever since then I’ve been a student of value investing – I’m still learning today. [26:41] JOHN: Well, since you’ve used it, what do you think are the most important principles that you’ve gleaned from that? JIM: I would say probably the most important one is the habit of relating what it is you paid to what it is being offered. I think that’s one of the most invaluable traits. For example, if I’m going to go out and invest our clients money, or my own, I try to look at what I believe a business is worth. So, I tend to look at something called an intrinsic value of a business, and this is what Graham was referring to, that the intrinsic value of a business is entirely separate from the price of that business. In other words, just like once again, John, going back to that analogy, if you and I were going to go out and buy a business tomorrow, we would want to know what’s a fair price for that business given its cash flow, given its earnings prospects. What would be a fair price for that? And there’s several variables that we tend to look at, most or all are related in one form or another to valuing that business. This brings me to another important Graham principle which is to understand the difference between investment and speculation. [27:50] JOHN: Well, I guess then, if you were looking for undervalued stocks that’s obviously going to put you at odds with Wall Street, since for as long as I’ve known you, my assessment of your style I guess is that you tend to be ahead of the crowd, which means you’re often out in thin air alone as a matter of fact, usually buying something that is unpopular – there’s why you have to ignore the family – and even if you’re on the unpopular side of things you tend to hold your course. JIM: You know, I just believe in Graham’s principle, if I can buy a dollar’s worth of assets for 50 cents, 60 cents, I just believe I have a better chance of producing a better return as well as increasing my margin of safety. You know, so many times investors pay $2 for a dollar’s worth of assets – or $3. I mean, just look at some of the crazy things that were going on during the internet mania in the late 90s, where investors were taking businesses that had no sales or very little sales and absolutely no profits or anything, and they were valuing these businesses at billions of dollars. I mean it made absolutely no sense and they paid a very dear price for that in my opinion when the whole thing collapsed. But the one aspect I think that in addition to buying assets at a discount, I think another important trait of being a long term investor increases my chance of success over time. In other words, I don’t know where the Dow’s going to be tomorrow, where it’s going to be next week or where it’s going to be next year. I remember about 10 years ago, this was back in the 90s when they had the investment clubs, and we were having dinner at this gentleman’s house, and he sort of headed up the investment club. And I guess they had quite a few members at that time, and these guys were making some pretty good money. I mean they got in on some of the internet stocks, Amazon, Yahoo, and a lot of the tech stocks, Cisco, they owned all the name stocks at that time. And one of the exercises when we got together, he would say, “where do you think the Dow is going to be at the end of the year? Where do you think it’s going to be in six months? I said, “I don’t know.” And they would look at me like, “Well, you’re in the investment business. You should know that.” And I said, “I really don’t, and I really don’t care. I care more about what it is I’m going to buy, what it is I own, and what the prospects are for those companies than where the Dow is going to be.” And so this is one of the concepts I’ve always thought is very important, because if you buy a good business and that business is earning money, it’s generating cash, it has a franchise value, or a moat around it, or something that makes that business very successful, then the odds are over time the sales are going to increase. The earnings are going to increase, cash flow and dividends – those things are going to increase with time. They may miss a quarter, maybe their earnings fall short, or they have a product introduction problem, but usually if you find good management with consistent records over time that management will work their way out of it, and you can make money. [31:01] JOHN: I guess basically you would say that if you’re a speculator you’re following every bounce and jounce, but when you make investment decisions basically you’re leveling out all of those bumps, and the profit is just taken on a long term basis. Could you give us a few examples of where you were at odds with everybody? What played out? JIM: I think probably the toughest one was December of 1999. I mean it was just getting out right goofy. Quite honestly I was frightened of the PE multiples and of course, John, you remember Y2K. I know as a firm we spent a lot of money getting our software and our computers ready. I had no idea whether the lights were going to be on come January. Remember the big scare. I knew companies were spending billions of dollars to hopefully mitigate that issue, but I sold my tech stocks in December of 1999, and I just kind of watched the next 3 months as the NASDAQ went from 4,000 to 5,000. In fact, I lost about 5% of my clients – they were seeing their accountants in April, paying a large capital gains tax. The accountants told them that I was an idiot: “you, know I can’t believe Puplava sold your tech stocks – these are good companies.” And I mean it was a very tough time. I wrote an article called Planes, Trains and Dotcoms that we published on our website, January 4th of the year 2000, and then of course I wrote my Perfect Storm series, and people just didn’t want to hear it. I can remember being interviewed on a local radio show, that was syndicated, on my views on the market that we were heading for a downturn – a recession – and of the people calling in, they weren’t nice questions. I mean it was like basically go take a hike, you’re an idiot. And probably some of the more controversial things we did we got into the gold market in 2001 and I wrote on that. And then of course in 2002 we went very heavily in the oil business and I can still remember today a particular client calling me up, and he goes, “why are you buying so many oil stocks, don’t you think we ought to go into the market and buy tech stocks, now that they’ve come back?” So, you know, that call and probably my call on commodities in 2003 – those have been sort of at odds with the market place. As is my call today that the big cap, large cap growth stocks that everybody loved and wanted to own at the end of the 90s – the GEs, the Walmarts, the Johnson & Johnsons, the Buds, the Cokes, the Microsofts – all of these things are being discarded today, so you know, once again I’m at odds. But, you know, sometimes we get these things right. We make mistakes but as you say, sometimes we tend to be early but the one advantage of being early is we get in at a very good price which in my opinion, once again, if I can buy a dollar’s worth of assets for 50 cents, I increase my odds of success. [33:59] JOHN: Somebody once said that the best revenge is raging success. And I always thought that was a good one. So it seems like the issue is not necessarily making the choice for a proper investment but rather bucking the trend. A lot of times that carries a lot of political weight for people. There’s that emotional factor too by the way that comes in there. One of the things that you keep hearing say for example, down on the street, and we hear this every quarter this comes back like the seasons, we’re going to have lower oil prices. And so far, it just simply hasn’t happened. And I remember, just before we got on the air, you were talking about a conversation you had with one of your sons the other night. JIM: Yes, I was talking about this very issue with my middle son who works for me – he’s a CFA candidate – and he was just saying, “it doesn’t make sense, Dad, these stocks are cheap the price of oil is going up.” And he was commenting about something that he was seeing, and that is at the end of the first quarter if you managed more than $100 million a year, you file what is called a 13F with the SEC, which basically discloses your positions and all the companies that you own. And what was absolutely amazing is we saw record profits in the fourth quarter in oil companies – of course, high oil prices; we saw record profits in the first quarter. And yet when the 13Fs were filed by all the major mutual funds, you take a look, I don’t care if you’re looking at Exxon, Conoco-Phillips, Chevron, Occidental Petroleum, all of the major – I mean when I go on my Bloomberg I have pages of who owns Exxon. I can look at any stock and it will tell me who the largest shareholders are, the percent of the company they own, and what their latest change in their filing status. And the front page of Exxon, every single mutual fund manager was selling; I mean they were unloading large positions in the oil stocks. Then you look on the other hand at companies like Conoco-Phillips, and you have Warren Buffet who doubled his position in Conoco-Phillips, while his compatriots in the mutual fund industry were selling. You know, another example, is today with the record heat wave. Throughout the country we have record heat which means utilities all across the country are operating at maximum capacity – whether it’s a coal fired utility, a nuclear powered plant, and natural gas powered plant. And during this whole period of time, investors in the second quarter were selling off coal stocks, they were selling off uranium stocks, they were selling off alternative energy stocks. And John, you have to shake your head and go why? Coal is in short supply right now. The railroads don’t have enough railroad cars and engines to get the coal to the utilities so the utilities are scrambling, and sometimes paying a premium to make sure they have adequate supply to keep their power plants running. So, you’ve had rising energy prices, you’ve got rising natural gas prices. We’re finding out that you know our natural gas plants run on natural gas; and that’s what powers a lot of air conditioning during the Summer months with this record heat wave. So once again, you had people that were basically trading out of something and you have to shake your head and ask yourself why. [37:39] JOHN: Do I dare ask why? Do you have any theories? Now you’ve got my curiosity piqued. JIM: I think there’s this constant mentality to trade. When oil got to $70, it was like this is going to slow down the economy, it’s going to destroy demand, we’re looking at $50 oil prices here in the next six months, the inventory levels were building. We’ve talked about this a number of times on the program, these inventory numbers that we get every Wednesday and Thursday on oil and natural gas, there’s nobody out there with a dipstick that’s sticking it in the engine, and saying, “aha, that’s how much we have.” These are seasonal statistical models that they manipulate and release every week based on past seasonal patterns. And the only way that we really know, other than taking a look at some very ominous trends, for example the BP Statistical Review, just came out and last year if you take all of the countries that have the capacity to increase their oil production, they increased that oil production by almost 2.3 million barrels a day. But subtract from that all the countries that are going into decline in their oil production – Kuwait, with the peaking of Burgan, Mexico with the peaking of the Cantarell field. There are continuous declines in the United States, continuous declines in the North Sea. If you take those declines of like 1.4 million barrels a day, the world last year collectively could only increase production by 890,000 barrels a day, and demand is expected to grow at 1 to 1 ½ million barrels a day because of demand growth coming from India and China. I mean these are the kinds of things that are fundamental that are driving the oil price where it is today. And it is something that you have to wonder what people are thinking. [39:31] JOHN: Well, Jim, just out of curiosity as we end this segment – this has been dangling in the back of my head as you’ve been talking – how do these firms then that don’t operate on the principles that you’re talking about make money? Is it strictly to keep their investors moving their monies through their firms so that they make money on the trades; pooling their investors’ money and using it for their own advantage – you know, pump and dump or whatever. How do they then? JIM: I think one of the main reasons, John, that the vast majority of fund managers underperform the market is this constant cheap mentality of too much trading. I think it was a statistic about two or three decades ago, the average turnover of a mutual fund was about 20% or more, 27% a year – I forget which figure it is. Today that’s between 100% and 200%. There’s a book written by Michael Malboussin, he’s investment strategist at Legg-Mason, and he’s written a book called More Than You Know. He was taking a look at the most successful investors, those that consistently beat the major market indexes, and one of the key characteristics was low turnover in their portfolio. Their turnover was somewhere in the neighborhood of 25 to 30% versus the average mutual fund of 100% to 200%. Another factor in their success that was common to all of them was an average holding period of 3 to 5 years. And then probably even more considerable and this was a Buffet principle, is they were very focused investors. In other words, their top 10 holdings represented almost 40 to 50% of their fund – they tended to concentrate and focus rather than take a shotgun approach and say, “well, we’re going to own 200 stocks in 50 different industries,” – and know very little about any of them. Versus, “you know, our top 10 holdings are going to make up almost 50% of the portfolio, we’re going to hold concentrated positions in these companies, but we’re going to know a lot about them – about the companies, about the business, what drives them.” And those I would say are what distinguish people that do well, versus those who consistently underperform. [41:49] JOHN: I noticed that you have just reread for the 475th time The Intelligent Investor, and I’m assuming you would recommend to all of our listeners to do so, and this September we’ll be giving an exam on air, right? JIM: You know, I really would. If you’ve never read the book before, I would recommend it. It’s out in paperback form and there’s a new edition to it that has been appended by Jason Zweig – he was a reporter at Forbes in the 80s, and what he has done is taken every one of Graham’s original chapters because I think the last time The Intelligent Investor was updated by Graham was 1973 – the 4th edition. And what he’s done is taken every single chapter in the book, and then he has added commentary on each chapter. In other words, he’ll bring you up to date in terms of where the markets have gone since Graham’s passing in 1976. So I think the more modern version today with Jason Zweig’s commentary – and you want to make sure if you look it up on Amazon or go to a book store it says Benjamin Graham updated with new commentary by Jason Zweig. And I think this is a better edition. And definitely I would recommend that you pick up a copy. It’s the investors bible, it should be in every investor’s library. [43:09]
JIM: Well, I’m sure I don’t have to tell you that weather conditions have been changed abruptly here. Here in Southern California it’s probably the warmest Summer that I’ve seen on record since I moved here in 1982; the Midwest is warm. In fact all over the United States we’re experiencing warm weather conditions, as well as other parts of the world. Joining me on the program is Evelyn Garriss of the Browning Newsletter. And Evelyn, your latest publication starts with the headline: Heat, Monsoons and Stormy Weather. What’s going on? EVELYN GARRISS: Well, among other things, we have been seeing a worldwide phenomenon where the monsoons which we usually think of just in terms of India, but are actually a global phenomenon, this year have come further North than normal. And since the area South of the monsoons are tropical heat, when the monsoons come further North they bring the heat with them – and so that’s what you’ve been seeing. Welcome to monsoon season. [44:20] JIM: Evelyn, there’s another phenomenon that has changed. I periodically fly to Vancouver, just about every other month, and usually when I’m going North, I’m going against headwinds and it takes me longer to get to Vancouver; on the way back, I’ve got tailwinds. This last trip, just a couple of weeks ago, it was just the reverse – we were getting tailwinds going up to Vancouver and headwinds on the way back. It seems like the jet stream has also changed. EVELYN: What we’re seeing is a great shift in a lot of the global wind patterns where the high pressure zones are, where the low pressure zones are. So one of the things we’re having is a pressure so the normal wind patterns are not available for pilots to count on this year. It is different enough that the Bermuda High on the East coast is in a position that would normally steer hurricanes and tropical storms more towards the East coast. We don’t have quite as bad a line-up here in the West, but what you are seeing is the winds from Vancouver blowing in a different direction than you’re used to. [45:28] JIM: How has this affected because we’re seeing not only just warm temperatures in the Southwest, California, even as far North as Vancouver, but we’re also seeing it across the United States? EVELYN: One of the things that we’re seeing is the prevailing Westerlies take the desert heat West, where it gets to combine with the humidity of the Gulf coast and then gets carried in to the East, so they have the worst of both worlds. They have some of the heat that we’re experiencing here in the West, with the humidity that they normally experience. And it is just wretched conditions – it is killer conditions for a lot of people. JIM: Let’s talk about some of the implications for that in terms of how this is going to impact the commodity markets, especially the agricultural markets with farming – not only in the Midwest, but also in Canada. EVELYN: One of the things we’re seeing with our crops is our crops have been going through enormous heat stress. And it’s ironic that just as we have a policy that says let’s switch from foreign oil to domestic corn, we’re seeing weather that makes it a lot harder to grow that corn. We’re seeing heat that causes a lot of the grain products to ripen earlier before they’re at their top quality. Worldwide we have been seeing some bad growing conditions for both corn and wheat. [46:53] JIM: I was reading a statistic that in terms of our stockpiles of grains globally, they’re at some of their lowest levels that we’ve seen in decades. EVELYN: Yes, and the implications of that are going to be rather grim for people who live in poorer countries; for Americans it may mean higher food prices, but most Americans can afford that. For some countries, people there can’t afford higher prices and we’ll be seeing a lot of hunger. JIM: Evelyn, in your newsletter you talk about two volcanic eruptions in Russia and elsewhere, what effect did this have on weather patterns? EVELYN: With the Russian volcano, it went off in May, and when you get a lot of dust in the air – volcanic dust – it absorbs moisture. So instead of raining out immediately around where the volcano is, it absorbs the moisture where the area is, the winds carry the dust and the moisture in the form of clouds elsewhere, and the weather gets cooler around and under that cloud mass. And then finally it rains out some place else. So the Russian dust was blown into the US and when we had a cold front, that cold air mass with the dust and the cloud cover went very far South. And it went so far South in May, you had a separate low, and you had the low stall. And so you ended up with a lot of moisture being pulled on the East coast. Meanwhile in the West, we had heat wave, after heat wave, after heat wave come and get stalled, so the heat built up in the West. So we’ve started seeing heat build up in the West in May; we saw it build up in June and by the time the monsoon season arrived, it was already hot, and then the monsoon heat arrived and it just became explosively hot here in the West. The other thing we saw was the volcano in the Caribbean put a lot of dust in the air. And remember as I said the dust absorbs moisture. They’ve already found in studies that sometimes when a lot of the Sahara dust blows into the Atlantic, it stalls the development of tropical storms because the dust absorbs the moisture of the storms. By having a very large volcano go off in the Caribbean, you have a lot of dust there and it has been absorbing the moisture. By this time last year, we had six tropical storms; we’ve had 3 this year. And notice when Chris was a tropical storm, as soon as it started getting near the Caribbean it dropped back into a tropical depression. We have seen the dust from Soufriere Hills in Montserrat absorbing moisture and calming down the tropical storm season. The Atlantic waters are very warm but that dust has made it a lot calmer in the Gulf and the Caribbean, which is great news for our oil producers. [49:59] JIM: How does this play out going forward, let’s say in the Fall and Winter, given the abrupt change in weather patterns this Summer? Are we looking at a different weather pattern this Winter? EVELYN: We don’t know for sure. The patterns that we’re looking at, I wouldn’t be surprised if the monsoon which has come so far North lingers longer which is certainly going to warm the West for a longer period of time. I would not be surprised if we see a very cool Autumn around the Great Lakes, and a lot of moisture around the Eastern corn belt, which is not good news for their harvest. For Winter, most of the stuff that I’ve seen, seems to indicate that there’ll probably be a warmer Winter than normal. I’m still trying to do the research on that, but at this point it looks like a warmer, dryer Winter from the interior of the country, and then the coastlines should be wetter than normal this Autumn. [51:00] JIM: Well, that’s welcome news for us here in Southern California where it is a rare day that you get 3 or 4 days of rain in the middle of July, which is what we got. EVELYN: Well, what you normally have is June gloom, and it seems like now you’re getting it in August – it’s not following its normal schedule. JIM: Yes, everything is kind of in disarray here, but we’ll take the rain when we can get it. Well, Evelyn, as you look forward here, is there anything our listeners should be aware of in terms of what might happen weather-wise? I know for example with the drought and the heat conditions, that could have a severe impact on our agricultural output this year, especially the corn crop; and then of course, if we change in the Fall, and especially if it can be cooler than normal then that’s going to mean increased energy demand at a time when you’re already looking at $75 oil. EVELYN: When you start looking at where the commodities – there’s sort of a joke about the commodities in Chicago depend on what the weather is locally – if you start getting an unusually cool Fall, then it means a lot of people are going to be anticipating a cooler Winter, and so you can expect to see a definite [garbled]. The good news is everything I’ve seen indicates while there’s a still a high probability of a busy tropical storm, and hurricane season – although Superhills has calmed down the early stages of it (the volcanic eruption) – I’ve been telling my clients all along, it did not look like we were going to have big hurricanes this year hitting around where the Gulf oil is being produced. It looks like the big storms are going to be more along the East coast. You were saying Californians were going to be glad for the moisture, but I can tell you there’s a lot of people in Massachusetts who are really tired of rain by now, and are not pleased with the prospect of more wet weather all Fall long. So, yes, I think we’re going to be seeing increased difficulty in the grain growing belt, and we’re going to see a lot of people anticipating a cold Winter. I don’t necessarily see a cold Winter, but I do see a lot of people anticipating one, and let’s face it, it’s what investors anticipate that shapes the market. [53:20] JIM: Alright, Evelyn, if our listeners would like to find out more about your newsletter – the Browning Newsletter – how could they do so? EVELYN: Well, they could email linda@fraser.com, and it’s ‘fraser’ F-R-A-S-E-R and just let her know that they are interested, she’ll be glad to send them a sample copy of the latest newsletter which will show exactly what I’ve been talking about and what the possible consequences are. JIM: Alright, Evelyn, as always it’s a pleasure to have you on the program. As we get into the Fall weather, I’d love to have you back and tell us what Winter’s looking like. EVELYN: I’d be glad to. I’ve been noticing a lot of people have talked about it being neutral with no El Nino, or La Nina this year but everybody’s been surprised about just how much warm water has just suddenly started showing up in the Pacific, including that warm water off your coast, which is helping to give you so much, first so much heat, now so much rain. [54:25] JIM: I look forward to talking with you in the Fall. In the meantime, have a great Summer, Evelyn, and we’ll talk to you later on this year. EVELYN: Great. It’s been nice talking with you. Thank you.
JOHN: Well, speaking of heat going on around the country, it looks like the gold industry is heating up again: gold is back above – let me look – 650, and silver has poked it’s nose above $12. We’re witnessing a string of takeovers as well: the Barrick purchase of Nova Gold being probably the most recent. JIM: John, one aspect that I have noticed and we have been commenting on this show, probably since the beginning of the year, is that as the price of gold is headed is up, the premiums on senior and intermediate producers went from a large premium to a discount today. And that’s something I have not seen following the gold market here very closely for the last 5 or 6 years. And for junior producers, I mean they’ve always sold at a discount to net asset value, but that discount has even gotten larger this year, and in the case of juniors the discounts have gotten even greater – they’re practically giving away these companies right now. [55:49] JOHN: Ok, so where do you think this is all going? JIM: I think we’re going to see – in fact, we are seeing it already – a wave of takeovers and mergers in the gold industry. And at issue here is the enormous pressure, and rising pressure, on tier 1 and tier 2 gold producers to replace their reserves. And even though these companies have been spending a lot of money on exploration spending which has increased significantly in recent years, very few gold deposits have been discovered over the last 5 years. JOHN: So why do you think then that these tier 1 and tier 2 companies are going to go this acquisition route? JIM: Well, a couple of things. One, the steep discounts that exist in the junior market presently. The juniors in my opinion are generally priced for takeover activity right now. And if you look at the cost of acquiring ounces it has never been more attractive. [56:42] JOHN: Why is that? JIM: If you look at the total cost of acquisition, if a Barrick buys Nova Gold. Ok, part of that cost of acquisition is going to be the market cap, plus any net debt that the company assumes. Then if they buy a company like Nova Gold, you also have the capital expenditures that a mining company is going to have to spend over the life of the mine. And then of course, you have the cost to extract the ounces out of the ground. The three of those added up together today is around $550 an ounce, or roughly about 84% of the cost of the current price of gold. Now in the past, if we take a look at, for example, the 90s, and probably the first few years of this decade, acquisitions were made at a total acquisition cost that was equal to probably spot gold prices or above. So, getting back to what we talked about in the first hour, when we talked about Ben Graham’s Value Investing – in other words, if I can buy an ounce of gold, in terms of acquiring the ounce, the cost of putting in a mill to extract the ounce, the cost of mining it; if that all adds up to be less than the current spot price of gold, I am buying gold in the ground cheaper than if I could go out and explore for it. So if you look at the last 10 to 15 years, gold acquirers had to pay spot prices to acquire companies today that can be bought at a steep discount. This changes in my opinion the whole game. And you would probably have to ask yourself as a company: why does it make sense to go and explore, spend a lot of money, take on the risk when you can go out and buy quality juniors at a discount to the price of gold? The economics of gold mining, now in my opinion, favor the acquisition route. [58:39] JOHN: You know, what would help here is if you could give us a few examples to illustrate what you mean. JIM: Well, if we go back, and gosh, I could give you hundreds of examples, but if we go back for example in to the 90s, you had Barrick buying Black Minerals in July of 1994. they paid 104% over the spot price of gold at the time of that acquisition; Newmont Mining buying Santa Fe Gold in 1997 paid 118% over the spot price of gold; Homestake buying Plutonic, paying 119%; Homestake buying Argentina Gold paying 112%; Anglo Gold buying Akasha [ph.]paying 116%; Barrick buying Homestake in 2001, paying 117% in that acquisition to the price of spot; Placer Dome buying Orion, 103%; IAM gold buying Wheaton River – 113%; Harmony buying Gold Fields – 112%. Or, Barrick, buying Placer Dome, they paid 101% of the spot price of gold. Now you compare that to Barrick’s recent purchase of Nova Gold, they bought that at 65% to the price of spot gold. So they basically bought this at a 35% discount from the price of spot gold, at the time of the acquisition. That really changes the whole gold scenario in terms of what companies do today, in terms of how to quickly replace their reserves. Let’s face it, let’s say you were Barrick or Newmont, you go out and acquire a piece of land, stake it, drill it, explore it, file the permits, go through the permitting process, it may be 7 to 10 years today, before you can discover and bring that mine into production. What are you going to do in the meantime when your reserves fall and your production falls? The acquisition route just makes more financial sense today than going out and trying to do it on your own. [1:00:47] JOHN: Well, as we try to look at things that work and don’t work. I know you have a formula that has proven successful, and we’ve talked about it before here on the program, but it probably bears repeating here in today’s conversation, especially what we see coming towards the gold market right now. JIM: There are a number of things that I have found to be very helpful in looking at juniors. One, I like to acquire late stage development companies because there’s less risk involved: they’ve got a known deposit; they’ve proven out some reserves – there’s usually a reserve estimate; they have ounces in the ground that are measured and indicated versus inferred, which are less probable. And the other thing I like to do when I work with companies is take them on a dual track. If you’re just going out and basically doing in field development, where you just take an existing deposit, you have a million ounces of inferred resources, and you want to take them to prefeasibility, so you’re going to have to do close in field drilling – John, that’s not news, you’re not acquiring ounces, you’re not making a new discoveries. You know, for the most part, investors are going to sell your stock and go on to something new and exciting, so your stock is usually dead when you go through this period. So what I like to do is look at juniors that have a large enough land package, and exploration package, that they take a dual track approach. In other words, they are developing a major deposit, and they’re bringing it to prefeasibility, because ultimately you have to find out are these mineable ounces, will there be a mine here, and if there is a mine, are we going to make money? But on the other hand, you also want them using the exploration drill bit to go out and acquire additional ounces and making new discoveries. So that at the same time that they’re developing one part of the project and bringing it closer to discovery they also have the blue sky potential on the exploration side, and that’s what keeps investors’ interest. Another thing that I like to see is a company that is close to prefeasibility, or feasibility, because that takes even more risk out of the project, and once you have a prefeasibility the ounces that you have get upgraded to what we call the reserve status – and reserve ounces are valued at $100, $125 an ounce, versus let’s say, inferred ounces which may be only valued by investors at 50 to 60. The other thing which I think is very important today in the geopolitical world is that you have a company that is mining, or exploring, or developing in a mining friendly territory, because we all know for example the geopolitical risk in Russia, and Africa; the geopolitical risk that is now going on in Latin America as Latin America now goes Marxist. And then I think another criteria, I call it either 2+2, or 3+3, is that is a two million ounce deposit which is capable of producing 200,000 ounces a year, or a 3 million ounce deposit capable of 300,000 ounces of production. These are the kinds of things that become attractive to another mining company to take over. So the dual track approach that I like is either taking a company to production in case nobody buys you, but on the other hand, the other track is using your exploration to build the ounces so you do become large enough and big enough and attractive for another company to acquire you. And also part of that is a company that has a large enough land package that there’s enough blue sky potential. And I would say, probably, maybe the seventh factor is a company that really understands how the financial game is played. Juniors do not earn any money. They have to go out and finance, and there’s a whole, big pump-dump cycle which is played in the financing game. And you really have to get companies away from that because they can actually have a great deposit but their company can be ruined by this pump, dump and short cycle that takes place in the financing of juniors. And a lot of mining companies simply don’t understand that, so one of the things that we try to do is change the financial cycle for a company, and get them on a less dilutive track for shareholders. [1:05:13] JOHN: That makes sense. There’s nothing like experience. I know you sit on one company board and you’ve been asked to sit on others. Has this changed the way you view investments in this sector at all? JIM: Let me think about that for a moment. Yes, I would say probably, there’s been a great sea change in terms of how I view the junior market today. Before, going back I would say 5 or 6 years ago, I was no different than other investors or fund managers, I used to count ounces: “Ok, this company has this amount of ounces, and their market cap of ounces is this. This company – gosh – they have more ounces and their market cap is this.” When I look at a company today I look at what I call mineable ounces. I want to know immediately if there’s going to be a mine potential, and probably more importantly, not just will there be a mine but will that mine be economic. And John, mining is no different than any other business. Can a mine make money, and like any other investment I make, at what price can I buy the assets of this company? So I prefer buying assets that are steeply discounted from the market, and in my opinion this reduces my risk and also increases my odds for success. [1:06:25] JOHN: Any other pointers, Jim, that we should point out? JIM: There’s always the qualitative end: management, management’s integrity; their openness and flexibility to suggestions; and I guess having a good geologist working for you also helps too. You know, I have no desire to go into the jungles of the Amazon with snake bite kits. I remember my geologist was telling me about one trip that he had in a very heavily forested area – not the Amazon –he had to get ready, he had snake bite kits for the fer-de-lance and a couple of other snakes I never even heard of, but never do I want to meet. And he was telling me he was camped out and there was this special kind of worm – I forget what he called it – it burrows inside of you, and what happened, because sleeping on the ground in a sleeping bag, this worm had burrowed itself into his back. And the only way to get it out other than to do an operation – actually this is going to sound crazy but they put bacon on your back and that bacon attracts the worm and causes it to come out of you. And he had like two of these – I mean some of the stories he tells me about the snakes, the insects and stuff like that and some of the difficult terrain – no thanks, I’ll watch that on TV. [1:07:50] JOHN: I remember I was in Honduras about 20 years ago, and we were going to go out and see some of these old Mayan ruins and I wasn’t feeling very well. I had a little case of what I call Lampera’s [ph.]Revenge – he’s sort of the Honduran equivalent of Montezuma – and they said, “well, you can lie down in the back, and you know if you have to go we’ll stop and you can get out.” And I said, you know they have snakes down here called two-steps, you know why they’re called two-steps, because when they bite you, you take two steps and you fall over dead. I am not going to fight off fer-de-lances for potty privileges. JIM: When they were building the Panama canal they lost quite a few of their workers to the fer-de-lance. I mean they hang on tree branches and they are a very venomous snake. And there’s a couple of other pit vipers they have down there, but yeah, it’s very important for these guys when they’re out in the bush like that doing their exploration, that they have snake kits very close at hand because some of the risks and dangers. I really admire these guys because in my opinion they are the real Indiana Jones of the world. In fact, the geologist I use, he sent me a picture and he had the hat, the beard, and I just mean right out of Indiana Jones, except Indiana Jones with a beard. [1:09:04] JOHN: There really is that type of person. JOHN: Well, Jim, recently there was a major corporation that shall go nameless that was looking for a new CFO – Chief Financial Officer – and as part of the interview process they had 3 finalists (3 candidates) that were being interviewed by the CEO. And the CEO, one by one, takes them in to their interview session, and to the first gentleman when he sits down, he looks at him and says, “tell me, how much is 2 plus 2?” And the man looks at him, and he says why, ‘4,’ of course. And the CEO looks at the CFO candidate and says, “well, you’re just not going to be good for this job, we can tell you don’t have the right feel for it.” So the next candidate shows up and he sits down and the CEO says, “how much is 2 plus 2?” And the man responds, “well, it’s 5” And the CEO says, “well, you’re not qualified for this job for Pete’s sake, you can’t even add correctly.” And finally the third candidate comes in and he sits down and the same question gets posed to him, “how much is 2 plus 2?” And the CFO candidate looks at the CEO and says, “exactly what number did you have in mind JIM: Hired. JOHN: And he was the man for the job. And if we watch a lot of the government numbers that are out there, basically they look for what they want the outcome to be in a lot of these reports to achieve a political spin, and then they try to work everything backwards from there. It’s not running the data forward and living in the real world. It’s just the reverse. We’ve got a number of things we want to talk about here, and you and I could not figure out how to tie this in to a coherent single segment so we’re going to call this ‘miscellaneous thoughts about the economy.’ Above all things, doing a 180, are we really heading headlong into a recession, or are they going to be able to turn this thing around; sticking with blue chips; and finally, we’ll look at an unpleasant truth – talking about outcomes, and what people do or don’t want to hear. So, what is the first item up, looking at the economy? JIM: Well, let’s take a look at some of the economic numbers, John. When an economy slows down or possibly heads into a recession, there are certain things that you see historically happen. Typically, with the exception of the 2001 recession, the first thing that heads down is housing. I mean if you look at the 1991 recession, housing led that recession. If you look at the 1981 recession housing led that recession. And that’s exactly what we’re seeing right now. I don’t care if you look at the number of inventory levels, housing sales, new home sales, housing permits, mortgage applications – everything is indicating that housing is definitely in a downturn. So that’s typically what you see on the front end of a recession. The second thing you see on the front end of a recession is manufacturing starting to slow down. You’re starting to hear lay offs: Intel laying off 1,000 managers. And then what we got on Friday – remember, we’ve moved more from a manufacturing economy to a service economy, to a financial economy – and then on Friday, in addition to lower hypothetical jobs, the ISM non-manufacturing index fell from 57 in June, to 54.8. As long as it’s above 50, it shows an economy that’s still growing; when it goes below 50 it shows an economy that’s contracting. So the trend – and this number by the way is the third month of continuous decline – so we’re seeing the ISM manufacturing index decline consistently, the ISM service index decline consistently; we’re seeing retail jobs reports showing that retail is slowing down to some of the slowest numbers; we’re seeing for example unemployment claims have risen to a 4 month high; and then we saw on Friday, instead of the 143,000 anticipated jobs, created for the month of July by economists, we came in around 113. So everything we see indicates the economy is slowing down if not heading into a recession. The more difficult thing, as you pointed out with your related story with the CFO that was interviewing for a job, we start out with the GDP numbers with what we call nominal GDP. Those are the gross dollars of all goods and services that transpire in the economy in the second quarter. Then what you have to do is you have to back out the impact of inflation, because, for example, if you’re a manufacturer and you only sold 1,000 widgets in the second quarter but you raised your prices 5%, in nominal dollars it sounds like the economy grew because there were more dollars that were created in the economy in terms of economic activity. But as a manufacturer, if you didn’t create or sell any more widgets, and the only thing that you did is raise prices that’s really why you have to back out the impact of inflation to get at what we call real GDP. Well, in the second quarter, where we went from 5.6% growth rate in the first quarter to 2 ½% growth rate in the second quarter, what was amazing while the world financial press was talking about the rise of inflation, while our financial press, Washington, and Wall Street were talking about rising inflation rates, the GDP inflator number was actually lower in the second quarter. So we achieved that economic growth by lower inflation numbers, which just doesn’t add up in terms of what we’re seeing in the real world. So we in effect, as John Williams from shadowstats claims, he believes because we’ve understated the inflation rate, we actually went into a recession beginning last Summer. And certainly you could see it with the housing numbers, with the retail numbers. In other words, we’re seeing a definite consistent downtrend across all segments of the economy now. A one month trend, you might say, “well, Ok, that was an unusual month, it could have been weather, it could have been inventory, or who know what that number when you see the ISM numbers, service manufacturing, decline 4 to 5 months in a row, you know you’re in a definite downtrend. [1:16:07] JOHN: One of the articles I was reading about the Pacific Northwest, is a lot of speculators because of the accelerated growth of properties here, and mortgage areas, have been buying whole blocks of real estate expecting them to go up 10 or 20% and they’d flip them. Guess what? They didn’t. Now the question is, are they going to be able to hang on to them? So we’re beginning to see this turn over. JIM: Yes, here in San Diego we’ve had condo sales down over 30%, and it’s amazing because many people who listen to this show or come to our website remember a series I wrote last year, The Day After Tomorrow that really profiled the economy and what was happening in the housing sector. And it was really based on a large scale housing development that’s right next door to us. And John, it is absolutely amazing, there are 4 major condominium projects that are going up right now. One developer has 115 condominiums that are being built that are unsold. Another project by Standard Pacific, they have 248 condos that they are building – I think only about 90 or 100 are sold; and then there are two other projects. So we have in that neighborhood, over 500 condominiums that are coming on stream here in the next 3 to 6 months. And it’s amazing, they’re just not selling. And even though the developers are not lowering prices, what you’re starting to see is they’re going to cover your closing costs, they’re giving you upgrades like granite counters, throwing in appliances, throwing in decorations and things like that. So, they’re not lowering prices, but they’re giving away a lot of goodies. You may not want to call them rebates but that’s exactly what they are. [1:17:56] JOHN: Let ask this, does this keep going sort of like a ship, even after you turn off the engines things tend to keep floating forward. In other words, the builders are still building, the speculators are still speculating, they haven’t reckoned with the sea change that’s occurring here again. JIM: Yes, what I’m seeing is a lot of these builders that are building their condominium projects also had housing projects where they were building homes. Their home developments have sold out. So what they’re doing is when you come into a planned community like that you bid for property, so you bid one area where you’re going to build your single family homes, another area you bid for the land, you’re going to build your condominium projects. So what they’ve done, most of the builders have built out their single family home projects, those are sold out. Now what they’re doing is rolling that over and they’re building out their condominium projects – figuring that with the high cost of housing people who can’t afford to buy a single family home will roll over into the condominiums. And that seemed to work to some extent last year, because a lot of these condominium projects were presold even though they hadn’t been erected yet. Now what they’re doing is building out these projects, and I think what you’re going to see is some of these builders start to panic as we get towards the end of the year when they’re sitting on all this inventory. We’ve got some builders who are offering for example if you buy a condo they’re going to throw in a Honda Civic. So they’re saying live economically, you own your own condo and you have a car that gets good gas mileage. So you’re going to see all kinds of incentive plans. Remember in the 2001 recession, when the auto manufacturers came out with the incentive program – 0% interest rates, or we all became employees of GM – I think we’re going to see that increase as we go forward here. [1:19:51] JOHN: Ok, now of the course the big issue we’ve been talking about here on the show for the last few weeks is how far is the Fed going to push this. Assuming that the Fed goes on pause as they stop raising interest rates, we’re still seeing everything going down – housing, service, manufacturing, retail. How are they going to turn this around? It’s not just a matter of stopping it, it’s a matter of trying to make things go the other way. JIM: Well, if you take a look at the economy, there are 3 segments. Government – the state governments are pretty flush with cash right now as a result of property taxes; the Federal government is flush – well, they’re still running a deficit and the deficit numbers are bigger than what we report but tax revenues are up because of capital gains, taxes etc; and corporate profits which have been at a record level. Then we take the consumer who’s leveraged to the hilt, and is going heavily into debt whether it’s credit card debt, installment debt. And remember, a good segment of the population is going to see their mortgage payments go up here, in the next 12 to 18 months as these adjustable rate mortgages readjust. If you take a look at any segment of the economy that’s in good shape, it’s the business sector. Corporations have had record breaking profits. I think it’s like the 11th or 12th quarter of record profits. They’re flush with cash on the balance sheet, so if there’s any segment of the economy that’s in good shape right now it’s the corporate sector. [1:21:50]. JOHN: Ok, translation, I guess is what they’re saying, business spending is supposed to prop the whole economy up, but is this realistic? I don’t think that’s what businesses are doing, they are not interested in doing that. JIM: No. In fact, if you look at businesses they’re building up their cash on their balance sheet. But John, if you were a businessman and you were looking at the economic numbers, you see housing going into a downturn, you see manufacturing going into a downturn, service going into a downturn; retailing going into a downturn, would you take money and let’s say build a new plant here in the United States? Absolutely not. There’s no incentive. JOHN: Yeah, it’s ‘circle the wagons’ time is what it is. JIM: Yeah, you’re saying, Ok, it’s time to be cautious and if you were going to build a new factory where are you going to build it, you’re going to build it in those place of the globe that are growing the fastest, and that’s the emerging markets. So that’s why you see all kinds of factories going up in Asia, factories going up in India, factories going up in Mexico and Latin America. So if business is expanding, it’s not expanding here. [1:22:29] JOHN: Yeah, but it would seem like what businesses are doing, is they’re buying back their stock, they see that as the best thing to do right now, but that doesn’t really create further wealth, it doesn’t really help the economy in any way whatsoever. All it does is like we said earlier: [it let’s them] circle the wagons and hunker down a bit, while this thing goes through. JIM: That’s exactly what they’re doing. You don’t have to pick up the papers to see what business is doing. I mean in the first quarter of this year there was almost like an annualized rate of 350 billion in share buybacks. Second quarter, if we take a look at what’s going on now, just a couple of weeks ago, Microsoft is buying back $40 billion worth of stock, $20 billion in a tender offer, and then 20 in the open market. You had Pfizer announcing they’re buying back stock; Coca-Cola. And if they aren’t buying back stock, the other thing that you’re seeing is record merger activity. For example, in 2002, there were $440 billion of mergers. In 2003, that increased almost half a trillion; 2004, $805 billion in buybacks; in 2005, almost $1.2 trillion in mergers; and in 2006, so far, as of the first 6 months of the year, 743 billion in mergers to date. So companies, if they buy another company, the first thing that they do is they usually end up consolidating payroll, jobs are eliminated, but there are no new factories that are being built as they do that. So in essence, you’re shrinking the economic base by doing so, because if I buy my competitor, what I’ve done is I haven’t created any new jobs, usually what I’m going to do is eliminate jobs because a lot of jobs are duplicated so you don’t need two personnel managers and what you end up doing is cutting down your staff; [you] shut down a couple of plants because you don’t need as many. So you tighten your manufacturing base or your business base and as a result what you’re doing in effect is shrinking the economy. So, in terms of this myopic belief that business is going to lead us into recovery, well, yes, business is flush with cash but you have to take a look at where they’re using it. [1:24:51] JOHN: Yes, so basically, buying back your stock is most definitely not creating any economic growth. JIM: Well, sure. And that’s why I think if there is any kind of recovery here, and once again we go back to our premise that over the last 30 or 40 years the United States has moved from a manufacturing economy to a service economy to a financial economy. So if there is any recovery as a result of what the Fed does, let’s say that they go on pause or they start lowering interest rates, what you’re going to have is basically if there is any recovery it’ll take place in the financial economy which is the financial markets. And, John Williams, who’s been tracking all of this high powered money that we no longer report which is reflected in M3, says that M3 is running somewhere in the neighborhood of 9-10%. If the Fed keeps continuing to goose M3, then where you’re going to see the recovery first when the Fed goes on pause, if they start lowering interest rates, the first sign of a recovery will be shown in the financial markets. So you can see an expanding financial market as represented by the Dow, or the S&P, but that’s not going to be doing anything for the service economy, or the manufacturing economy. So you may get sort of a midcycle slowdown in the economy where many sectors look like they’re in recession, but you could have a rising stock market. [1:26:26] JOHN: So let’s assume that we do have some kind of a midcycle recovery, the Fed goes on pause, but this is really going to appear in the financial markets is where we’re anticipating it, not in the real economy. And of course, that has an impact upon Joe Average out there because he may or may not feel that. JIM: Yes, if you’re running a retail business you may not be feeling the recovery because you’ll probably see a slowdown in retail spending. But remember as we just talked about previously with companies buying back their stock, with mergers, what you might see is a recovery in the stock market where you see for example the averages such as the Dow, or for example, the S&P 500 set new records. I really still believe that you’re going to see new record in the Dow this year and especially as the Fed goes on pause, there’s a lot of money on the sidelines and you have a lot of hedge fund managers, a lot of mutual fund managers and they’re not paid to get out of the stock market and put their money in a bank account. These guys are going to be looking at: “Ok, where do I put this money? Where is the safest place going to be? Where is there going to be an area of the economy that’s immune to a slowdown? What represents the best values.” And one thing that we have seen consistently since the year 2000 is we’ve seen a consistent contraction in the PE multiples of the blue chip stocks. Small caps may have gone up, that’s not what happened with the blue chip stocks they continue to contract. So I think you’re going to see a recovery in the Dow; you’re going to see higher record levels in the Dow. [1:28:11] JOHN: Yes, but Jim if we go back to May, if you recall, we were almost at a record there, we were just about what? 75 points of taking out the old Dow record. JIM: And you know, John, there’s a lot of money sitting on cash, so if the Fed goes on pause, one of the things that you could see and Bank Credit Analysts did a great story on this and they said, “Ok, profits have peaked, can the stock market go higher?” And they took a look at previous cycles, previous recessions, and one of the reasons that you see PE multiples of stocks either expand, or contract has a lot to do with interest rates. So if interest rates are going up, PE multiples are contracting, and that’s certainly what we’ve seen with the blue chip stocks represented by the Dow when some of the big blue chip growth names like the Walmarts, the GE’s, the Johnson&Johnsons, the Pfizers and all the growth stocks that everybody had to own in the late 90s. Now, if the Fed goes on pause, and if the economy slows down they start to actually lower rates, you could see PE multiples expand. [1:29:21] JOHN: So even though at this stage profit growth would be slowing down, the PEs are getting better, and that results in better stock prices. JIM: Absolutely, and you only have to go back to look at the 1990s, one of the biggest reasons for higher stock prices in the 90s, especially from 1995, to the year 2000, was almost a doubling of PE multiples on stocks. In other words, the earnings weren’t growing at a level that would have justified the stock price alone. What happened in the late 90s was that PE multiples expanded. And so if you look at, for example, all the major Dow stocks right now, all the major growth stocks the PE multiples on these companies are below 20. And we did a story on this – I think a couple of months ago – one of the things that we do every month is we take, for example, the Dow 30 stocks, we take a look at the top 100 stocks of the S&P. What we do is track their PE multiples against their 5 year averages on the low side, on the high side, and then what we do is take a look at their discount – we compute a discounted or intrinsic value for them. We use 2 different services: one, we use Bloomberg’s dividend discount model; we use Forbes’ dividend discount model; and then also we compute what is called internal earnings growth. And we do that on all the major stocks, and what we find – at least on the blue chips – is many of these companies are selling at steep discounts to their intrinsic value. You see this in the drug stock area; you see this especially in the energy area – we’ve been pounding the table that a lot of these energy stocks are grossly undervalued; you see it in consumer staples stocks with consistent earnings. So it was a consistent trend where we saw discounts to what a company’s value is actually worth. And a lot of people would argue, “well, stocks still aren’t cheap; they’re not selling at 7 times earnings, or 6 times earnings as you would see in a bear market,” but relative values for these stocks in a period of fiat money and inflation, that’s where I think the money is going to go. [1:31:40] JOHN: Let’s do a reality check here on this whole thing. What are there? 8 to 9 thousand hedge fund managers out there, about an equivalent number of mutual funds guys, pension managers, college fund managers. I mean they make money on the turnover and the churn, right? So they’re not going to just sell everything, and put everything in CDs and sit and go to the Bahamas for a while. JIM: No, absolutely. Every time mutual funds have to send out six month reports, fund managers are evaluated on how well they’ve done on a quarterly basis, and they’re not going to sit there and send out a report to their shareholders and say: “We’re 100% in T-bills, and, by the way, pay us a 2% management fee. And when stocks drop to 6 times earnings we’ll get back into the market. But in the meantime, I’m going sailing.” It’s just not the way things work in the real world, so fund managers are going to have to look at…Ok, what are the givens right now. We know the Fed is close to the end of a rate raising cycle, so one of the negatives is being taken out of the markets; secondly, we know that the economy is slowing down, so that means economic growth and earnings growth have probably peaked. So, if the economy is slowing down, the Fed is going to go on pause, or lowering rates, in what areas of the economy should I be investing my money? Where are the cheapest areas, something that isn’t overly priced, something that is relatively safe in terms of earnings stability, and that’s what I think they’re going to be doing. They’re going to be looking at consumer staples. Obviously with $75 oil, and PE |
Jim's Market Wrap