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The
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JOHN: I will have to admit that since the elections things have been getting very dicey everywhere around the world – geopolitically, what’s going on in the Middle East politics; and the oil markets got a bombshell this week with the publication of a particular report. Let’s listen to one of the calls that came into us this week on our Q-Line: Hi Jim, it’s Peter calling from Toronto. I was wondering if you could comment on the Cambridge Energy Research report out this week saying that the peak oil theory is just a myth, and that we’re going to be fine for years and years. These guys seem to be pretty legitimate energy consultants. I’m wondering what your thoughts are. The report was actually entitled Why Peak Oil Falls Short and is a Myth, and not to be outdone, Jim Puplava actually bought the report. You spent money? – I don’t believe that. You read it? I’m assuming you’re going to disagree with this, right? JIM: John, in fairness to the folks at CERA it’s well worth a read if you want to get the other side of the peak oil story. You can go to the CERA website (www.cera.com) and you can purchase the report for $1000. We’re trying to get the author of that report, Peter Jackson, on the show next week. They want to review our website first. We also happened to contact Matt Simmons, who happens to be away on a Safari in Africa. So we hope to get him on the program shortly. And what I really want to do is get both Matt Simmons, and the gentleman who wrote the report, on the show, because I think that would be a great debate. And the gentleman who wrote this report is Peter Jackson, he’s Director of Oil Industry Activity at CERA. [1:55] JOHN: As in all great controversies that erupt – like global warming – there’s a huge amount of flap and nonsense that floats around it. The core issues that go right to the center and ask the hard questions: what are the basic beliefs and what are the key assumptions in this whole report? JIM: They basically made 4 key assumptions in the report. The first is the world doesn’t run out of oil, or oil doesn’t peak – till the year 2030. So that’s very soothing – I call that ‘don’t worry, be happy.’ Instead of a peak, they believe we’re going to experience an undulating plateau. So we’ll have these series of plateaus. In other words, conventional oil will start to peak, and then we’re going to have a big influx of unconventional oil that will take its place. That would allow production to rise and then that will peak for a while, and then we’re going to get some new discoveries and that will allow us to grow again etc. But anyway, their assumption is that peak oil doesn’t arrive till 2030. The second assumption is the global resource base is roughly 4.82 trillion barrels. We’ve already produced a trillion barrels of oil, so we’ve got roughly 3 ¾ trillion remaining. And that’s in contrast to the peak oil camp who believe we’ve got an endowment of roughly about 1.2 trillion remaining. The third assumption is that demand will outstrip conventional crude oil supplies, but then an abundance of unconventional oil kicks in, and then technology finds us new sources of supply. Now, their fourth assumption – and here’s the caveat – above ground risk could limit upstream investment. And these risks are war, political change, geopolitical decisions by government that could limit supply. So they’re saying, “Ok, here are our assumptions and here’s a way out for us.” Number 4 is really the caveat, which gives them a way out if their forecast falls short – much in the same way they issued a similar report back in the year 2000, when they said there’s all kinds of natural gas out there, and what did we do? We experienced $10 natural gas that year. [4:10] JOHN: The bottom line of the whole thing when we look at these assumptions, they really attack the whole peak oil debate, they believe that the whole thing is flawed. JIM: They believe that the peak oil crowd is not grounded in what I call a systematic evaluation of the data. It’s hard to believe that they would say that given the kind of research that Matt Simmons has done, for example, on the Saudi oil fields. They also question the Hubbert model of oil depletion which they feel avoids technological innovations. And finally, they feel that ‘peakers’ are shifting their debate from above ground risk to below ground risk, which are geological. [4:50] JIM: Here’s how the whole thing shaped out on CNBC this week. New research coming out, right now, showing that there is significantly more oil on earth than was previously estimated. Our Sharon Jefferson [ph.] is at the New York Mercantile Exchange with the details that could very well move the market today. Sharon? SHARON: Well, Michelle there is a new report out that says is the world running out of oil? – No way. The new report debunks the peak oil theory. That is of course the theory that when half of the oil is pumped out of the ground then it’s going to peak and decline precipitously from there. Well, today CERA – which is the Cambridge Energy Research Associates – is just out with a report saying that that is in fact a faulty theory. The peak oil theory that the world is running out of oil is simply a faulty premise. It says actually there are really 3 ¾ trillion barrels of oil out there. That is nearly 3 times the 1.2 trillion that most of the peak oil theorists think is out there. And they also say that this is too critical an issue to really allow fear to enter into the equation. Really it takes careful analysis. They talk about some of the challenges out there in delivering liquid fuels to economies that really need them. It’s very interesting that this comes out at this time, Michelle, because just about a week and a half ago Exxon-Mobil was out saying, “hey, we don’t really agree with peak oil theorists either.” The President of the Refining and Oil Initiative saying there that energy resources are adequate enough to sustain growth. And he told a Houston conference this that he believes there are actually more like 4 trillion barrels of available fuel out there, in fact, when things like oil shale and other non-conventional supplies. [6:30] In any scientific issue, one of the things you really need to do, like Aristotle said many, many years ago is know your assumptions. So let’s begin where you think their argument is flawed? JIM: Let’s begin with their reserve assumptions. I don’t buy their OPEC reserve numbers. We know that for example, OPEC over-inflated their reserves in the late 80s, in order to gain advantages in terms of production quotas. Then you get to their unconventional oils such as tar sands and oil shale. They estimate another roughly 1.2 trillion is in oil shale and in tar sands. That number, however, is meaningless because oil will never flow out of the tar sands the way it does out of Ghawar, for example. Oil sands and oil shale is essentially a mining operation. Yes, there are vast reserves there but that won’t translate into huge production runs. At best, if you’ve taken a look at the figures for Canadian tar sands, with massive amounts of investment they’re going to get production up to somewhere in the neighborhood of 3 to 4 million barrels per day. That’s not going to turn into another Ghawar, or replace Ghawar. [7:45] JOHN: So in essence, they’re making the mistake of equating large potential reserves and production – mixing those two things together. JIM: Exactly. Oil mining, as it takes place in the tar sands or oil shale, is very expensive and very energy consuming. A lot more [inputs] – or units of energy – go to create an output of energy. [8:08] JOHN: Anything else you disagree with in this? JIM: Sure, the potential on the exploration front, for example, they say is 900 billion in exploration potential. If there was that much unfound oil out there, the major oil companies would be spending money to find it. The reason that they’ve focused on enhanced recovery techniques is that the exploration potential is very limited. Also, the places that they can explore is limited as well – 85% of the world’s oil reserves is held by OPEC (75% of the 85); and then another 10% by Russia. [8:44] JOHN: What about enhanced recovery techniques? We keep hearing that technology is going to bail us out of this whole thing. JIM: Well, here is one case where I agree with CERA. Oil companies through enhanced recovery techniques have been able to get more oil out of existing wells. However, that really doesn’t solve the problem of production peaks or depletion. If you take for example the Hubbert model, and apply it to most wells, what you get is after about ½ of the oil has been produced it starts to go into decline. So you get that bell shaped production curve profile. The best example I can give you is US production peaked in 1971. Since that time, our production has fallen by over 50% from nearly 10 million barrels a day at its peak, to roughly about 5 million barrels of equivalent today. So despite new discoveries and new technology, production has continued to fall. That fact is also evident in other producing countries where production has peaked. So what we’ve got here is production has peaked in over 45 countries, out of the 65 oil producing countries. And John, once that production peaks that means it doesn’t go back up – it doesn’t increase, it begins to decline. You still may be getting more oil out of the well than what you thought you were going to get when you first discovered it, but the fact remains once you hit that half way point you’re on the downside of the slope that is on the production down side. [10:19] JOHN: It seems like the real issue here is the mistake of confusing reserves with production; and also the fact that once major wells go into decline they stay there, they don’t come back. JIM: You’ve really hit in my opinion what is at the heart of the issue. We’re not finding or making new discoveries at a rate that would replace what we are consuming. It’s new discoveries which give us future production. If demand grows then supply must grow. and the greatest source of supply is now discoveries. The plain fact is that discoveries peaked 30 years ago, and we haven’t discovered what we consume each year for more than 2 decades. [11:01] JOHN: If you look at their caveats – meaning warnings I guess or qualifications – the caveats themselves raise a big issue which are really the geopolitical events, and those are not very predictable. JIM: No. In fact, one of the main problems that the world hasn’t woken up to is that NOCs – national oil companies – account for about 85% of the world’s oil reserves. The motivation of an NOC is much different than an IOC, or international oil company. The NOCs don’t reinvest the bulk of their money back into exploration and production. Instead, the money is used to maintain welfare, public works and pay for the state bureaucracy. Their motivations aren’t the same as those of a public oil company. And the best example I can give is look at Venezuela, which is a perfect example of this. Chavez is using oil revenues to fund his geopolitical ambitions. Production is down over 40%; the country’s oil infrastructure is falling apart. Now, he’s been able to get away with this because over the last couple of years oil has gone from $20 to $80 – it’s currently at $60. But what has happened is prices have risen, and so that has offset declining production. Now that they’ve fallen, he’s starting to run a budget deficit. So NOCs tend to be a main source of revenue for the state, and a state may have different goals and objectives than an independent oil company. [12:33] JOHN: You also have political instability to deal with. JIM: Sure, just look at Nigeria where you have companies pulling out of the country. Willbros Group, a pipeline contractor, has seen in the last year 9 of its employees kidnapped and held hostage. The company, after doing business for 45 years in the country, is finally pulling out. They’re selling out their interest. In a press conference, they said it is pulling out because conditions in Nigeria have become too risky. The ability of building and maintaining pipelines with any degree of certainty isn’t possible anymore. In Nigeria, it’s not just Willbros company, major oil executives and employees at companies such as Exxon and Shell are being kidnapped and executed. They’ve been able to shutdown Shell’s oil production platform. Now the guerrillas are saying they’re going to shut down Exxon. [13:25] JOHN: It’s interesting when you realize it’s almost suicidal for the national economy there. But anyway, I would assume that you don’t buy the CERA thesis, that’s what we’re looking at here. JIM: Well, let’s put it this way, I wouldn’t go out and buy a Hummer based on this report. [13:37] JOHN: We hear so much talk about the economy today that is mixed. So, some say we have a goldilocks economy, others call for a soft landing, others are saying the ‘r’ word – recession. Which one is it going to be, Jim? JIM: As I look at this economy, I think there are 3 factors that determine whether we’re going to experience a recession next year: there are interest rates, real estate and taxes – in that order. [14:36] JOHN: Interest rates are probably the key here I would think. JIM: Absolutely, I’ve heard figures from 1 to 1 ½ trillion in adjustable rate mortgages that come due next year are due to reset. In order to keep that from turning into a disaster I think the Fed needs to start lowering interest rates. However, in order to do that they need a cover. So just as they hammered the commodity markets through derivatives as we talked about in the Spring, they need to create a deflation scare. They can do this with a falling CPI, or a falling PPI, the way they did in 2003, when they rejiggered the housing number and car prices. [15:15] JOHN: You’d better explain that one, Jim. JIM: Back in 2003, remember we were coming out of a recession, the economy was acting anemically, you heard talk about the worst recovery that they had seen. And what was happening at that time, as the Fed was lowering interest rates they were also goosing the money supply, and I mean we were growing at upper single digit rates – they were almost 8-10%. So what happened is in 2003 they changed a few things in the CPI index. Instead of measuring real estate prices which were going up double digits every year, they changed the weight to owner’s equivalent rent. With more people moving out of rentals, and buying homes, rents remained weak and were going down. So that modified the CPI because it looked like as a result of real estate that prices were coming down, when in reality the prices of homes were going up double digits. When we were coming out of the recession of 2001, all of the incentives the automobile companies were making to us as consumers - zero interest, massive rebates, also we became ‘employees’ of GM etc. – well, what they did is instead of measuring new car prices, which on the whole were going up, they substituted used car prices. And as a result, CPI went from over 3% down to 1.6%. And so everybody says, “oh my God, we’re worried about inflation. Do something about it. Help us, oh Fed one.” And what happened is the Fed goosed the money supply, they took interest rates down to 1%. As it turned out, had we not made those two changes to CPI, the CPI would have remained around 3%. So, I suspect, with real estate prices falling, and rates going up, they’re not going to want to leave owner’s equivalent rent with same amount of weighting in the index. So they’re going to rejigger it and rechange it, and especially with the geometric weighting. That way we get the CPI rates to come down, and as CPI comes down and starts falling precipitously, you’re going to start hearing deflation worries. That will give them the cover to lower interest rates. [17:29] JOHN: So assuming they get interest rates down, that eases the pressure on real estate, but what about taxes? JIM: That’s really a tough one to gauge. You already have rising taxes on Social Security and AMT. Everybody knows that each year your wage base gets indexed by a special inflation rate so more and more of your income is subject to Social Security tax. And also, as your income moves up when you get more deductions things from capital gains, you’re subject to an AMT tax. So taxes are going up for most Americans. However, the Democratic leadership is now talking about raising taxes on capital gains and dividends. These two items have always been a political football. Republicans are in favor and always lower capital gains and taxation and on dividends; Democrats raise them. The other issue is raising the top tax brackets which they also want to do. JOHN: That wouldn’t seem really smart, would it? I mean, not to me anyway, when you have the economy slowing, house prices are coming down, investment of capital equipment is slowing down, interest rates on the way up – this looks like the same formula that gave us the Great Depression. JIM: You know, it really is. I mean they could be applying the wrong medicine at the wrong time. If you look at the stock market crash in 29, what really made a stock market crash, and maybe a weakening economy turn into a depression, was government policy. One of the things that you had is you had the money supply that was contracting; you had debt defaults. And when you have a money supply contracting, the antidote to that is lower prices. It’s lower prices that allow you to buy you the same goods and services with fewer dollars around. Well, the government did just the opposite. Hoover initially lowered taxes, then he raised taxes; he increased government spending; increased regulation; and what they tried to do is come in and support prices – whether it was prices for commodities, prices for oil. Everybody remembers the Texas Railroad Commission put into effect as a result of the Great Depression. So they began to support wages and prices artificially. They added more regulations, and then Hoover was thrown out of office as a spendthrift for raising taxes. Roosevelt came in and raised tax rates from 60% to 90% and basically just killed the economy. And what they did, in order to expand the money supply, instead of contracting it, they confiscated gold. And the gold confiscation were the reserves that were used to back an increasing money supply. So you’re absolutely right, John. The kind of things they’re talking about – minimum wage; price supports; regulation; price controls; raising taxes – that’s the kind of stuff that can give you a depression. [20:27] JOHN: A number of types of depression as a matter of fact. Speaking of depression, it seems like a prescription for a disaster, but if we were to say what should be doing, what is it? JIM: Right now, they need to be lowering taxes. And more importantly, they need to change the tax code to create incentives to save and invest. Americans don’t save. Everything in our economic system is based on borrow-spend-consume, not save and invest. I would recommend that they go to a flat tax. And then the other thing they should do is begin slashing government spending, phasing out entitlements and in place of government spending they need to spur private investment in this country versus government spending which is grossly inefficient. [21:14]
JIM: The Dow is hitting new records; base metals are down; oil prices have come back down; and interest rates as well. Joining me on the program this week is Dennis Gartman, he’s editor of the Gartman letter, husband of Margaret and two great daughters. Dennis, how are ya? DENNIS: I’m doing great, Jim. How are you, my friend? JIM: Pretty good. I want to begin with what we’ve seen here. We’ve seen a pull back in the base metals, the CRB index, oil’s down – come back down from $80; the Dow’s at new records. If we’re looking at this scenario, is this the goldilocks scenario that everybody’s talking about? What’s going on here? Give us your take. DENNIS: For right now, in the aftermath of the election I think it is indeed at least a reasonable facsimile of a goldilocks scenario. You have a government here in the United States that is the best of all worlds – nothing will be done. It’s a libertarian’s dream. The Democrats will do what they can to open investigations and cause all sorts of mischief, but they won’t be able to pass any legislation – and that’s a beautiful thing. And I think the equities market is taking that in hand, and saying, “Gee, we’ve seen this before. We like limited government, that’s what we’re going to get, so let’s move higher.” And indeed that’s what’s going on. [22:38] JIM: Let’s talk about the base metals. There’s a worry on the Street that China’s economy may start to soften as ours does, and as a result there will be less demand for commodities and base metals – whether it’s copper, lead or zinc. But Dennis, I haven’t seen large inventory builds in the base metals yet. Have you? DENNIS: No, you’ve not. Actually, all you’ve seen for the past 3 years is the wearing down of inventories. As I like to say, on a chart the inventories of copper have gone from the upper left to the lower right in almost a linear fashion. So too with nickel; so too with aluminum; so too with any of the base metals – it makes no difference: inventories are very, very low. Now, in all likelihood inventories will build. You can’t get to the levels of copper inventories that we’ve gotten too in the last several months without actually building them. It’s not that I think there will be a decline in demand, so much as there’s an increase in supply that’s likely to come at us that will build those inventories. I think copper prices at these levels are egregiously, preposterously, stunningly, shockingly high. And I wouldn’t be surprised if they back off a good deal from here through the course of the next 6 months to a year. [23:56] JIM: Let’s take it from another perspective, and look at the gold market. If you take a look at base metals over the last couple of years, they’ve actually done much better in many ways than gold. Let me get your take on gold and silver. DENNIS: First of all, I’ve been bullish on gold for some while. On balance, as I’ve told people for the past 2 ½ to 3 years, it is a bull market in gold, and in a bull market you’re either really long, long – or at your most bearish you’re going to be neutral. That’s how one has to trade a bull market. And this is a bull market. I think the reason for the bull market has nothing whatsoever to do with the trade numbers in the United States; I think it has nothing whatsoever to do with our budget deficit; I think it has very little to do with government – I am not a conspiratorialist, I am not a gold bug, I don’t believe in the demise of Western Civilization. But I don’t really like the gold bugs, but nonetheless the trend of gold is upward. And I think that’s simply because if you look at the reserves that the Chinese hold, if you look at the reserves that the Indians hold, if you look at the reserves that the Thais hold, that the Vietnamese hold, that almost anybody in Southeast Asia or Asia holds – all of those are in dollar denominated US assets and their propensity to at the margin migrate – not away from those assets but as their imbalances of trade continue to pick up as they continue to export more and more stuff to the United States – at the margin they’re going to say to themselves, “Gee, we only hold 1 or 2% of our assets in gold, the old legacy central banks of Europe – the Bank of France, the Bank of Italy, the old Bundesbank – holds 14, 17, 18% of their reserve assets in gold. Perhaps it would do us some good if we would merely double or even triple our gold reserves.” And I think that’s the bid in the gold market. It’s not that they will wholesale dump dollars – that’s illogical to think that the Chinese are going to do that; it’s even more illogical to think that the Indians are going to do that. But it is reasonably logical to think that rather than increase their holding of US dollar reserves they may increase their holdings of gold instead. [26:06] JIM: One of the comments you often hear about the gold market or the currency market, is the trade deficit, but we’ve been incurring trade deficits going on for almost 3 decades now, and they’ve got more pronounced in the 90s. That seems to have little correlation if you look at what’s happened to the dollar. How do you explain that? DENNIS: First of all, I think it has zero correlation, and I think that those people that try to impose the rules of the 19th Century or 18th Century mercantilist economies upon a modern world are just serving themselves ill. I find it comical that there have been people betting against the strength of the US dollar, or the strength of the US economy for – as you say – three decades. My bet is that those same people will be betting against the ever rising imbalance of trade deficit that the United States has a decade further into the future; and two decades, they’ll continue to argue that this cannot continue. Eventually, like the proverbial stopped clock, they’ll be right but thus far they’ve been wrong for 30 years and that seems to me to be a relatively long period of time to carry a bad trade. The problem that they have is they don’t know, neither does the government know how to measure trade. In the United States, in Canada, in Germany, in France, in the industrialized world we are not any longer exporters of – for lack of a better term – stuff. We don’t export tires, we don’t export – we export a few cars – but we don’t export many cars; we don’t export steel. We don’t really export the things that are easily weighed – the things that are dropped into the bottom of the hold of a ship. We import a lot of that stuff, but we don’t export that anymore. What we export is wisdom, we export design, we export legal services, we export accounting, we export medical knowledge, we export software. We are a postindustrialized nation, and we export the things that the bean counters on the docks of the world don’t count very well. And I think that we misunderstand what the imbalance of trade is. I will posit that if we counted things properly, and were able to count the balances of the export of wisdom we may actually in the United States be running an imbalance of trade surplus. We just don’t know it. [28:29] JIM: Looking at this into the future, you’re very bullish on gold right now. DENNIS: I would say bullish. I would hesitate to use the word ‘very.’ I will simply say I am bullish on gold. JIM: Ok, we’ll accept that. You like gold, how about that? DENNIS: That’s good. JIM: Ok. Let’s go on. What’s your view of the energy markets? We’ve seen a strong pull back in the oil markets; we had a strong pull back in natural gas; natural gas seasonally has bounced back. Your take on energy. DENNIS: I think that $80 WTI is an inordinately expensive price for crude oil. And I think that at $80 high prices are the greatest fertilizer in the world to find a new crop. $80 crude oil brings every drilling rig out of the woodwork, brings greater exploration, and brings such things as that marvelous new find down in the Gulf of Mexico which may be the largest new find of the last 30 years anywhere in the world. $80 crude does that; $50 crude is probably inexpensive – that’s probably a bit too cheap. I think the world is happy at $60 to $65 WTI, and my bet is that we’ll probably get somewhere closer to 60 or $65, maybe even 70 if we had any inordinately cold weather this Winter, which right now it doesn’t look like it’s going to be. It’s a very balmy 70 degrees here in Southeast Virginia. And that’s about 12 degrees above where it should be here in the middle of November. [30:02] JIM: Do you think we’re getting in to a new trading range. For almost decades we saw oil trade in the mid-teens to the twenty dollar level, do you think that new level now is maybe the high-50s to upper-60s. DENNIS: I actually think that the range is probably the middle-50s to 70 to $80. I bet we stay in that range for a rather long period of time, honestly. I think you’re spot on there. [30:27] JIM: Alright. DENNIS: $80 brings new…it fertilizes an awful lot of drilling rigs; $50 throws water on an awful lot of drilling rigs. So I suspect between 50 and 80, which is a very, very wide range – for traders, a wonderful period of time. My guess is that’s what we’re going to see for a long period of time. I am not one of those people who believes in Hubbert’s peak and that oil production is going to fall of the edge of a cliff, and that we’re going to suddenly have $100 crude oil. I really do believe that’s an absurd argument, I just don’t believe it. [31:02] JIM: Alright, Dennis, as we close, why don’t you tell people about your newsletter, and if they’d like to get information about it how they could do so? DENNIS: I’ve been at this now for a mere 25 years. I was a member of the Chicago Board of Trade, I traded in the bond pits for 8 years back in the late 70s and early 80s. I’ve been writing this macroeconomic view of what’s going on in the world; every day I get up at 1:45 Eastern Time to have it to my clients in England by about noon their time. Here in the United States people are getting it about 6 o’clock on the East coast, about 3 o’clock on the West coast. And I’ve got mostly institutional clients all around the world, name the large hedge funds – they are probably subscribers and I speak to the gentlemen who run them on a consistent basis; a large number of energy companies subscribe; a large number of international grain trading firms; bond dealers; major banks. I’ve been very fortunate to piece together in 4 pages, maybe 5, what’s going on over night, what are the major themes that I see happening, and try to look at the markets away from the maelstrom of the pits, away from the maelstrom of the trading floor, away from the excitement of New York, or London or Chicago. I try to do it from here in Southern Virginia where it’s a bit quieter, and where one can raise one’s hand every once in a while and say, “hey, I think you all ought to take a look at what’s going on here.” That’s my job: to find the obscure piece of information that might be on page 32 of the Sud Deutsche Zeitung, that makes its way to page one six months later in the United States; or find the obscure piece of information in the grain market that may somebody in the energy market from doing something untoward. I can’t possibly tell an energy trader more about the energy market than he knows; nor can I tell a bond trader more about the bond market than he knows; nor can I tell a foreign exchange trader more about the forex market than he knows. But what I do think I do a decent job of is having a broad overview of how all the markets function, trying to find that elusive grand unifying theme and presenting it in a reasonable and perhaps even humorous methodology every business day. I try to convince my British friends they need to take July 4th off, but by golly, I can’t get them to do that. I have to even write on July 4th, Labor Day. I do take Christmas, and I do get the one international holiday in the year off – January 1st. [33:35] JIM: Alright. Well, Dennis, if people would like to find out why don’t you tell them your website or a number that they can contact you. DENNIS: Well, the easiest place is to write to Chip, the young man who takes care of that for us, chip@thegartmanletter.com. And Chip’ll put you on trial through the end of the month, and if you like it – it is I must say quite expensive, unlike most, since it is every day. It’s $500 per month, so it is not cheap. [34:11] JIM: Well, Dennis, I want to thank you for joining us on Other Voices this week. All the best to you, sir, and I hope you’ll come back and talk to us in the future. DENNIS: Jim, I’m honored to be asked, and I would be happy to do so, thank you my friend. JOHN: Well, Jim, there was a stampede this Summer, right out of energy service stocks. I don’t remember when that happened, but anyway. You believe the cycle for service stocks isn’t over. I guess that means that you’re going to be a buyer in this case. JIM: First things first. We need to find more oil, and that applies both to national oil companies as well as international oil companies. In order to do that, you’re going to need oil service companies. [34:59] JOHN: And what are the fundamentals telling you? JIM: To begin with, we know that global production growth has been decelerating for the past two years. This I find rather striking, given the fact that the number of rigs drilling for energy has climbed by almost 50% during this same time frame. Also, on a global scale, crude oil inventories are at new high for the OECD countries. Now this is the number which I think is misleading because if you look at inventory numbers – OK, they’re up – but when you adjust those inventory numbers for demand growth in the amount that we use each day supplies are actually at new secular lows. This is indicative to me of declining well productivity. Meanwhile, you have global oil consumption continuing to rise at a faster clip than production, so despite the rise in rig counts there is no evidence that over production is occurring. [35:52] JOHN: We’ve seen reports that OPEC has been producing below capacity, is that intentional? JIM: I think it probably indicates to me that they have very little spare capacity left. And remember when oil prices were rising from 60 to 70 to 80, and OPEC would hold a press conference announcing, “we’re going to produce more” – the price of oil didn’t go down. Nobody believed them – they really didn’t have the capacity and everybody knew it. However, they appear ready right now to defend prices, by cutting output, and we verified that by tanker shipments. So OPEC is more effective on putting a floor underneath the price of oil than they are capping the price. [36:36] JOHN: If we take a snapshot of everything, there’s global demand growing for oil and natural gas, drilling productivity is falling, inventory to consumption levels are definitely down. So at this stage I think that you feel oil service stocks are probably a bargain. JIM: We know drilling activity isn’t softening; day rates are rising. The big large drill ships, for example, in the Gulf of Mexico – I can think of one that is working – Trans Ocean Rigs for BP, the rate has gone from 190 thousand this year, to over 520,000 next year. We also know that demand is growing. So from that perspective the future looks bright for this sector, moreover I think the momentum crowd has bailed out of these stocks, so they’re selling at low historical PE multiples. [37:22] JOHN: Why don’t you give us an example of that? JIM: Let’s take one of the big oil service stocks like Schlumberger as an example. It has seen its PE multiple fall from a high back in 2002, when the company was selling at 48 times earnings – typically oil service companies do sell at high PE multiples because of their growth rate. But today the multiple for Schlumberger is 24 times this year’s earnings, and about 16 times next year’s earnings. Other service companies are selling at 10 to 12 times earnings with earnings growth at well over 20%. [37:34] JOHN: So who’s right? The momentum traders who have exited the stock, or the fundamentals you speak of. JIM: I believe in the end the fundamentals are going to win out. The reason you have oil service stocks selling at this level pure and simple is investor psychology, which as we know, from time to time happens to be temporarily out of whack with the underlying economic reality. [38:18] JOHN: And so you would be a buyer? JIM: The best buying opportunities come to you when the sheep are jumping off a cliff. And right now, the sheep are giving you another buying opportunity, not just in the oil service sector – the same could apply to international oil companies which have been sold off; the same can apply to base metals companies which have sold off; and the same could be applied equally to what they’re doing to the gold mining junior sector. [38:42] JOHN: The American economy has been called a bubble economy. As a matter of fact, we have bubbles everywhere you look from real estate and mortgages, to bonds and consumption. There are many on Wall Street who believe commodities have become an asset bubble as well. I mean after all, oil prices have risen from $20 a barrel to today’s prices of close to 60; copper prices have gone from 60 cents, to over $3. Some would argue that base metals prices don’t reflect the economics of production and are due for a sharp fall. In the short term, prices may decline based on investor perceptions, however the bubble theory for commodity prices doesn’t hold up on closer scrutiny. Unlike real estate or tech stocks, there aren’t large stockpiles of supply and Larry Lawnmower and John Q. are not buying commodities as they did in the late 1970s. And, unlike most asset bubbles, there aren’t any signs of excess supply, and the public has not come onboard. JIM: John, there are two things that strike me about the bubble theory. Number one is usually when you get to a bubble as we had in real estate, what did you see? Large amounts of inventory. Inventories of supply of new home got to I think 7 ½ months supply at its peak – now that’s been gradually working its way down. You don’t have 7 ½ months of supply of base metals or energy out there. More importantly, the public hasn’t come onboard. Talk to your neighbor. I would doubt very seriously if your neighbor is buying sugar or cotton futures, or cashing in the family silverware. Remember when they were doing that at the end of the 70s when silver prices got to $50 there were lines of people saying, “let’s take the family silverware and cash it in.” You talk to your neighbors, are they hoarding bullion coins? [40:45] JOHN: No, as a matter of fact if you ask most of them about it they look at you a little strangely. JIM: Yeah, investing in commodities or gold are just not in the mainstream. Yes, you might have hedge funds that move into and out of the sector – and that’s one of the problems about the commodity markets. The market is so small in comparison to the metals markets which in its totality is probably no bigger than $100 billion a year. What happens when Harry Hedgefund starts coming in with leverage and starts buying into this market? Any time you have a market this small, and you have new money moving in, it moves it in a great wave – just like, for example, a junior mining stock where you can see maybe 10 to 20,000 shares trade in a day. All of a sudden they have a great news announcement, and then everybody wants to move into the stock and it goes up 100% in a single day. Well, that’s what has happened to the commodity market where you’ve had institutions, either a hedge fund or a pension fund, and when they start investing that has a large impact on a small market. And if you take leveraging or concentration of investing, any institution of size can have a huge impact on a commodity’s price. I don’t care if it’s sugar, copper, natural gas, or even oil. So money coming in drives up prices precipitously. And conversely in the opposite direction, when the hot money exits a trade like natural gas at late August and September the price falls down. [42:18] JIM: Well, this bull market in commodities is based on the simple economics of supply and demand. It still rides on the fundamentals. But if we look at demand it continues to go up, not necessarily supply but demand is certainly going up. And there is no demand destruction. It’s on the rise. JOHN: Let’s begin with what we call the fundamentals. We know that demand continues to grow. And in the commodity area prices are determined at the margin. And that marginal demand is coming from mainly Asia, China and India where you have 2.4 billion people; and these people are increasing their demand for basic commodities from energy to cotton to food – you name it – cement, iron ore, etc.. So we know demand is growing. But what we’re seeing is the theory that with the US economy slowing down we’re going to have demand destruction. And if the US economy slows down, therefore the rest of the global economy will slow down as well. We looked back and we did some graphs of miles traveled and oil prices. And the only time that we had real demand destruction was back in the bear market and recession of 74, and the recession of 78 and 81, the recession of 1991, and the recession in the year 2000. Since 2000, we have seen prices go from around $18 a barrel, all the way up to 70 – and we have not seen any demand destruction. Furthermore, are we to believe that for example if oil prices go up and the demand for energy is supposed to go down as a result of the US economy, that a Chinese consumer who just bought his first car is saying, “oh prices are up, the economy is slowing down in the US, I’m putting the car back in the garage, and out comes the bicycle.” I don’t think so. [44:13] JOHN: It’s true because prices have indeed gone up. Look at the zinging prices on oil. But stockpiles haven’t changed. JIM: No, we’re not building any large stockpiles – I don’t care if it’s copper, zinc, oil, nickel, lead – you name it. And that’s a prerequisite for a bubble. Normally, increasing supply comes online, it oversaturates the market, then you start seeing a spiraling downturn in prices because now supply has caught up with demand, and you have more supply than you have demand. That’s the opposite of what’s going on right now in basic commodity consumption. Let’s say that GDP growth slows down in the United States, I don’t see fewer cars on the road here in California. In fact, it’s getting so bad even on the weekends now you can run into traffic jams, so you have to watch what time you get on the road on Saturday because of traffic problems. And if China’s economy stops growing at 11% annual rate, and slows down to a 9 or 10% rate, if India’s economy slows down from a 9% growth rate to a 6 or 7% growth rate, that is still increased economic activity which means an increase in consumption. So a lot of these arguments are just utter economic nonsense. [45:36] JOHN: That doesn’t keep people from uttering them. And you also hear people out there talking about an increase in energy; there’s increasing energy exploration – you know, the great white shining hope here. But in reality there’s no results so far. JIM: Not only has productivity in oil finds gone down, but the Wall Street Journal had an article last week where they talked about oil companies investing about 340 billion in the year 2005. That’s up 70% from the year 2000. However, oil company inflation has been running at around 35%. If you back out the inflation rates from the spending, real spending in the oil industry has only increased by 5% in the last 5 years – that is nothing, and hardly a figure that is going to generate the vast new supplies that are going to be needed to fuel global GDP growth in the next decade. And another factor too is if you’re a mining company executive, you’ve grown up in two decades of a bear market where you were struggling to survive. And the only way that you survived is you cut down production, you slashed costs, you cut back output, you cut back capital expenditures, you’ve lived with this for two decades. At the end of your career, now that your bank account is flush with cash again, are you about to take all that money and just throw it out and say, “let’s build as many mines as we can.” [47:08] JOHN: Absolutely not, because even if you could do that look at how long it would take to get approval to jump through all the hoops to be able to do that. JIM: Yes, today from the time you discover a mine to the time you bring it in to production, it could take 7 to 10 years. That’s why I believe you’re seeing a lot more companies go out and acquire assets rather than explore for them, because the exploration risks are bigger, the exploration targets aren’t that great; they’re also located in very dangerous parts of the world. And even if you make a discovery all the payoffs the bribes, and all the legal battles you’re going to have with the environmental whackos, it could take you 10 years even if you’re successful. So it’s much easier to go where it’s safer, it’s much easier to buy somebody else who’s already done the work for you. So the whole idea that we’re in a commodity bubble just shows lack of people doing their homework or understanding what the real fundamentals are. [48:09] JOHN: Well, obviously if the pack is running one way, there seems to be opportunity to be had running the other way.
JIM: It’s time to throw conventional wisdom aside and start to think like a contrarian. Joining me on the program is Brian Pretti from contraryinvestor.com. Brian, your latest piece is The Attack of the 50 Foot Woman.I want to talk about a concept that’s out there, we saw the markets pull back in the Spring and early part of Summer, and you were writing about the liquidity that was being taken out of the Japanese market – certainly, if you looked at some of the charts you had in your newsletter. Now it looks like it has to be stabilized, growth has slowed down, some of the Japanese political figures are worried about where their economy is going. Let’s talk about the big 50 foot woman. BRIAN: Sure, Jim. As probably everyone knows at the moment, and I think it’s been pretty widely publicized, maybe an initial kernel for this began at I think one of the G7 meetings earlier this year, a lot of the central bankers collectively joined hands and pointed right at the BOJ, and basically told them you guys are creating too much money. So to roll the tape back just a little bit, we’ve seen a dramatic rise in the Japanese monetary base over the last 5 or 6 years – it’s almost a double. That’s a lot. And clearly, the Japanese monetary base has fed the global carry trade, and has really been a source of global liquidity more than not. Certainly, the Japanese were doing this to reinvigorate their own economy, but in today’s wonderful world that spills over. And I think as we all know, when that spills over into stocks as it did in the late 90s, that’s prosperity. When it spills over into mortgage lending in the United States vis a vis the credit markets, well, that’s wealth creation. But when it spills over into oil that quadruples, or copper that quadruples, or zinc or tin or any other base metal in addition to lumber, etc., as we all know, in the United States that’s unwanted inflation. So here comes this G7 meeting, here comes a lot of finger pointing and from that finger pointing comes action on the part of the BOJ themselves. Probably between April and May and let’s call it October, the BOJ drained roughly 24% of the Japanese monetary base. Jim, I know we’re not looking at charts, but to give you a sense of how big that is we need to roll the tape back to early 2002 to see a level in the Japanese monetary base that we see today. It’s an incredible drain. And clearly, as we all know in hindsight right now, that started in April and May, down go the equity markets, beginning in May; down go a lot of the commodity markets that are associated with futures trading; down go the bonds – as we know, the 10 year Treasury ascended to 5 ¼ during that July period. So that contraction in the monetary base by Japan had been blamed for what really set off the decline in prices in many, many asset classes starting in that May period. So it’s been very, very meaningful more than not. [51:54] JIM: And I wonder what if those central bankers were to get together now taking a look at what’s happened since then, what they would be saying to the Bank of Japan now? BRIAN: Quite an interesting question, Jim. Maybe we have a little bit of an answer, and that’s for anybody who chooses to watch Federal Open Market operations by the Fed on the New York Fed website, will know that somewhere around mid-August of this year on go the liquidity pumps if you will. And it’s temporary and permanent open market operations: a plethora of repos; a plethora of temporary lending; a plethora of coupon passes. In fact, I guess the ultimate irony is that if the Fed actually did a coupon pass on election day – you know, can it be any other way, you know? But up goes the market with this liquidity pump – and I don’t mean that in a bad way, these numbers are what they are – so I think we had a response by the Fed especially in Summer, and of course this coincides with the preelection period where there might have been a little bit of a push to make the markets look a little bit better. But I think recently, and what we need to keep an eye on here is that literally in the last month or so – and clearly, a month does not make a long term trend – the BOJ has stopped the drain on the monetary base. In fact, in the recent numbers that came out of the BOJ regarding the monetary base there was actually a month over month tick up in the base itself. It was very, very small but maybe the important issue is it’s stopped declining. And a question, just looking ahead, given that liquidity is so important to not only domestic markets by any means, but really the foreign markets, will that spark some type of resurgence in the carry trade? Will there be more liquidity coming from Japan? As you mentioned, Jim, in recent weeks we’ve seen rates of change in Japan in machinery orders, the manufacturing index, quarter over quarter decline in consumer spending, the rate of change of slowing loan growth at the banks; the leading indicator for Japan took a huge drop in the recent reading; and inventories have clicked up a little bit here too. So it may indeed be that the central bankers of Japan have looked at themselves and said, “that’s it, we need to stop the drain because we’re actually hurting the real economy.” And as you would imagine, when you look across the global financial markets this year and you just look at the rate of change in price, there is one massive stand out anomaly – and this is excluding the Middle Eastern markets which have done very, very poorly lately – that standout especially among the industrialized markets is Japan. The year to date rate of change in price gains in the Nikkei is for all intents and purposes zero. We may be up a percent or so, I haven’t’ checked – this is of this morning – but clearly, while all the other foreign markets are up well into double digits territory. So has this drain in the monetary base hurt the folks at home? I think the answer is yes in terms of Japan. Not only has it been a block on the Nikkei which did really, really well in the prior year but also on the economy in that it’s starting to roll over just a little touch here. And we may even see a little bit of softness when ultimately the 4th quarter GDP report comes out for Japan. [55:25] JIM: I’m just looking at a Bloomberg screen where we’ve got a 14% gain in the Dow, almost 12% in the S&P, you’ve got the Dow Jones Stock 50 index in Europe up 11%, and Bryan, the Nikkei up less than 1%. BRIAN: Exactly, Jim. JIM: I want to move on to another topic. We’ve got a lot of production going on in Asia; we have a lot of inventory build of finished products. We’re getting into the Christmas season and we just had Walmart saying that they’re cutting prices on electronics – and I don’t need to tell anybody who’s gone into a Best Buy or a Circuit City, look at a camcorder or a plasma screen, you’re seeing prices you would never have though you would have seen a year ago. So, we’ve had the pull back from oil, from $80 to $60 a barrel; we had a pull back in the base metals; now we have some discounting going on at the retail level. And a lot of these stores getting ready for the Christmas Season and if somebody starts cutting prices aggressively that spawns a reaction by somebody else. I heard yesterday, for the first time on Kudlow, the word ‘deflation’. [56:42] BRIAN: God forbid, Jim. JIM: Yeah, I know. Outside of the stuff you need…But any way, they were talking about deflation, and wouldn’t this be the great idea that maybe gives the Fed cover to maybe start slashing rates next year. BRIAN: You know, in one sense, and I think we heard Fed Governor Fisher get close to this a couple of weeks ago when he declared maybe we went a little too far when we dropped the Fed Funds rate to 1%. It would give them absolutely perfect cover. In addition to the liquidity creation, or the tolerance for, or the allowing the system to keep creating excess liquidity if you will, they absolutely could do that. What I don’t know, and this is something that we’ll need to watch and here we are talking on Wednesday afternoon, more of the CPI will be reported, some of the on-record comments by Bernanke, over the last few years, and he’s even made more of this recently where he’s alluded to and/or talked about inflation targeting, you know we’ve got year over year rates of change – again, I don’t know what that CPI number’s going to look like tomorrow – but as of last month year over year rates of change in the core CPI that are at decade highs. In the recent productivity – or I should probably say lack thereof – report, we saw a virtual zero productivity number and as part of that calculation, by default, unit labor costs go higher. I took a look at the year over year rate of change in unit labor costs from that report historically. And you’ve got to go back to the early 1980s to see the type of rate of change in unit labor costs that we saw in the most recent numbers. And again, that’s really because productivity looks so poor. So one question I would throw out is – and no matter what, the Fed will always vote for long term inflation, long term credit ease, and long term liquidity creation – but can Bernanke, if you will, save face here, or save credibility if we don’t get some down ticks in some of these core numbers, the core PCE number, unit labor costs number, before he starts to cut rates? We’ll see how all that shakes out. [58:54] JIM: Something else that strikes me as we’re talking about labor, the one thing that the Democrats want to put into place as soon as they take power in January, they’re talking about a rise in the minimum wage. Even the President said that there was something there that [he] could work with them. If you put the minimum wage and raise it from 5-something to $7, now all of a sudden you just raised what we call wage inflation. Wouldn’t it be ironic, here they are raising the minimum wage and then the Fed uses that as a reason to either to hike rates, not lower rates – it’s almost like at cross-purposes here. BRIAN: It really seems that would be the irony of all ironies. And in one of the last reports on wages, basically the quarterly report, the ECI (the employment cost index) numbers – I took a look at those darn things and as always I guess the real news is below the headlines in almost every economic report that comes out – but one of the things that’s really striking is: we’ve already started to see, in terms of rate of change year-over-year, acceleration; and many anecdotes of wage numbers whatever they may be (whether it’s average hourly wages coming out of the payroll report every month, or the quarterly employment cost index numbers). But what a lot of people aren’t talking about – and it’s clear as a bell when you look at the numbers – the year over year rate of change in benefits costs have dropped like a rock over the last 2 or 3 years. So we’re really seeing a dichotomy in that, yes, nominal wages on a rate of change basis are starting to go higher, but corporate benefit costs for employee benefits have been dropping at an even faster rate. So I ask myself, because if you look at the anecdotes regarding the US consumer we’ve got a few things here that at least demand some monitoring, not necessarily striking, but the recent consumer credit numbers actually showed that people paid off their credit cards in the most recent for the first time since 93. Now, admittedly, those numbers are subject to such heavy revision that could go away in a matter of weeks once the numbers are revised again. But even yesterday’s retail sales number – I took a look at the longer term year-over-year rates of change in non-auto and non-gasoline retail sales – the number was close to 5.4% for the recent month. That’s not a bad number, but happens to be one of the lowest numbers that we’ve seen since 2003. So here’s an incredibly radical thought for you, and God forbid that I’m even bringing this up, could it actually be that consumers are actually getting to the point where they’re starting to repair their own balance sheets as corporate America had really done, after the downturn in corporate earnings a while back. So if you look at wages, we look at the pressures on consumers and we look at what really is a decline in the rate of change of benefits that corporations are providing. And you know this, we’ve seen IBM shut down their defined benefits plan, we’ve seen Verizon shut down their defined benefits plan; we’ve seen strikes occur – at least locally, in California – over co-pays and over sharing of medical costs. It could very well be, even though we are seeing that rise in wages the consumer really isn’t all that better off in that their benefits are declining on a rate change basis. But for the street, and how perceptions influence decision making, I think you’re dead right – those wage numbers are very, very important. I think Bernanke wouldn’t have too easy a time standing up saying, “well, wait a minute, corporations are slashing benefits like there’s no tomorrow for employees – that’s a great thing. So don’t worry about inflation.” It’s the wage numbers that are such the highlight. [1:02:52] JIM: You also pointed out something in your recent newsletter that caught my eye, because you’ve heard about all this liquidity coming into the market, well it certainly isn’t coming from John Q. Public, because according to that chart that you showed John Q. has been pulling a few bucks out of the mutual funds. BRIAN: In fact I was surprised when I saw these numbers myself. And it’s just basically the weekly in flow numbers into domestic equity funds. On a year to date basis, if I’m not incorrect, the numbers were about $30 billion going into domestic equity mutual funds this year. Relative to historical precedent, that’s pocket change – in the greater world that might buy a Happy Meal, so to speak – relative to monies we’ve seen come over the years. And maybe one of the craziest parts, I know the listeners can’t see this chart but you’ll have to follow along with me in your imagination – the public really started selling their mutual funds in May of this year – gee, what a coincidence – and kept selling those. In fact, in the most recent week we’ve seen one of the largest sales numbers in a long, long time. It’s very, very striking, Jim, and usually the public always chases the inflating asset. And with the S&P and the Dow and the NASDAQ etc., literally producing their entire year to date gains plus since the middle of August, I sure as heck would’ve thought that the public would have been chasing along. So maybe part and parcel with this decline in consumer credit month-over-month with the slowing year-over-year rate of change in non-auto and gas retail sales etc., here’s the wildest question of all for you: is the public selling their funds for liquidity? If that’s the case, we’re probably a lot further down the road here than even I could have imagined in terms of households really needing or being somewhat desperate to repair some of the damage that’s been done. And again, we’ve got the ARM resets happening at the same time, households are under a lot of pressure right here. So this is really the anomalistic behavior right here. In fact, I think when I look at the really, really long term mutual fund data, you’ve almost got to go back to 1974 and its aftermath – the aftermath of the bear market at that time, which was devastating beyond all belief in terms of if that happened today I don’t think anyone or their brother would be prepared for something like that – but the public sold their funds after that and were in firm disbelief; they did not want anything to do with the equity markets. I’ve been very surprised. It says two things: there may be some desperation at the household level; and then the second issue, clearly for investors is this is an institutionally driven equity market period – Mom and Pop aren’t playing along in the least. [1:05:47] JIM: Carrying this forward, looking into next year, you’ve got a lot of people that are saying mid cycle slowdown, some people saying hard landing, some people saying goldilocks is here. And it strikes me all of this depends on three things: one would be interest rates – I think if the Fed could start lowering interest rates that would help adjustable rate mortgages, it would also help the housing market. So one key factor I think in terms of whether we hit a recession is interest rates. The second is taxes. You’ve got talks now coming out that they want to raise taxes – they want to get rid of or have help on the Alternative Minimum Tax. But on the other hand they want to put up the upper bracket taxes. So I think a tax increase, coming at a time the economy is slowing is a bad idea. And then, third, I guess is the fate of real estate. But it seems those 3 items there are very key. And maybe if I throw the fourth one out and that is confidence in the dollar. BRIAN: It’s kind of funny that you should mention that and I don’t know if this article came out today or yesterday, but it was Bob Rubin and it was Paul Volcker, again, kind of standing up saying (speaking to the government), “if we were you, we’d be very, very careful about reconciling the fiscal situation prior to – call it the next half decade – when the transfer payments (the Social Security payments, the Medicare payments) really start to exponentially increase.” And if I’m not incorrect, I think Rubin said something like for the next 2 ½ years we face a potential dollar problem unless these things are reconciled. Again, I guess we could have rolled the tape back 2 years and heard exactly the same thing from those two exact guys – no question about that. I agree with you and maybe one of the craziest parts is we’re seeing tax inflows right now to the Federal government, both on the corporate level and from the personal level at very, very high levels – very. And yet that still isn’t good enough to put any kind of reconciliatory set of circumstances on our fiscal situation at all. We’ve got a big job ahead of us here. And I agree with you, the Fed would love to lower rates. And my bet, personally I guess, is that one when push comes to shove, regardless of inflation, regardless of any kind of anecdotal data they will bet on the side of lowering rates to save any type of an economic downturn. On the tax issue, it may be again a little bit fatalistic here, we’ve got more Democratic control than not, we’ll see if they’ve got the intestinal fortitude to actually do this. Again, this is an extreme analogy and may have nothing to do with anything – but you look at the Canadian royalty trusts over the last couple of weeks with the change in the tax law that is to come in 4 years – now, admittedly, I’m not advocating you run right out and buy these things – but we’ve got a tax change that comes 4 years and it took, if I’m not incorrect, somewhere between 4 seconds and 4 minutes to discount those in current prices. If we start to get the chatter – even just the talk from the Democratic side – that we’re going to need to raise taxes somewhere in the out-years, I don’t think that’s a really good thing for current financial asset prices. And we might start pricing that in right now. Jim, on the real estate question. If I had to pick 2 things in 2007 that will determine the fate of the real economy – not necessarily the financial markets but the real economy – it’s real estate and the credit cycle. Both of those in my mind are the absolute two kingpins. Personally, and I don’t mean this to sound perennially pessimistic, but I just don’t see how we’re going to pull out of any kind of continued slowing in real estate: given the inventories that are out there; given the construction that continues to happen; and given the lack of activity (the year over year rates of change and declining activity). So I’ve been surprised it hasn’t hurt confidence a little more than it has. But real estate, at least historically has absolutely led the real economy: personal consumption expenditures, year over year rates of change in employment. Housing leads – at least, that’s what history says. So unless we’re going to rewrite the history books here, real estate is extremely important. And then lastly, the credit cycle. Maybe circling back just very quickly and I know this is a little bit of a tangent, but we talked about the fact that Mom and Pop America, if you will, are not buying mutual funds here; and are not part of the reason why the equity markets have gone higher. The credit cycle it seems there is a little bit of a financial feedback loop, and if you look at the long term charts, the greater the credit cycle has grown in the United States – and this is just total credit outstanding relative to GDP – the mirror image is our trade deficit. So the further we’ve grown the credit cycle, the more we’ve grown the trade deficit and the more that feedback loop of the foreign buying of financial assets comes back into the US markets and really puts a bid under them. As you know, in the latest data, the August data, and I know it’s dated, you saw the single greatest month for foreign purchases of US financial assets. And again I link this back to our own credit cycle, and that the further the credit grows, the more consumers spend, the more they spend on foreign products, the more the foreigners have to put back into US financial assets and hold up the market. So in one sense, the credit cycle isn’t just about refi-ing the house, buying the new SUV, or the flat-screen TV – it’s also implicitly, and maybe tangentially, putting an indirect bid under US financial asset prices. And secondly, in terms of the markets themselves, if you look at the buyback activity on the part of corporate America, here is just a very quick anecdote. We had Home Depot report a day ago – the numbers weren’t all that hot at all, you know, not looking too good. And one thing I didn’t mention is when you look at the year over year rate of change in the retail sales report regarding building materials we haven’t seen anything like this in at least a half decade. That’s how low it is – 1.6%. It might as well be zero. And I think Home Depot and Lowes are absolutely telling you that. But underneath the numbers for Home Depot, this is just a quick anecdote I want to share with you from the release. In the current quarter, Home Depot bought back 24 million shares. I went and looked at the lowest stock price of the quarter, which happened to be near $33. If they bought all of it back at the lows, which you know they did not do, they spent $800 million buying back stock. In the earnings report, they said that in the next 6 months they’d spend $360 million in capital expenditures – and part of that was incentive programs for their employees. So in very, very rough terms, they’re probably buying their stock back at a rate relative to capital expenditures of 3 to 1. So in one sense – and I know again this is a very sarcastic question on my part – what is Home Depot in the current quarter? An operating company, or a company which is performing financial engineering? Which one is it? But that puts a bid under the markets. So again, credit cycle, real estate, absolutely key as we move into 2007. [1:13:18] JIM: Alright, Brian. As always, it’s a pleasure to have you on the program. Your letters are always interesting reading. If our listeners would like to find out more about you, how can they do so. BRIAN: Jim, you’ll find us at www.contraryinvestor.com quite literally. And we’re just trying to provide some perspective that you probably won’t here on the Kudlow show… JIM: Ok. BRIAN: […but] you never know. JIM: When they have you on that show, we’re in trouble. BRIAN: In a big way, Jim. JIM: Ok, my friend, good talking with you and thanks for joining us on the program. BRIAN: Many thanks for your time, and our best regards to all of your listeners. [1:13:57]
JOHN: It helps to look at certain things in perspective. If you remember, Jim, back at the beginning of the year – as a matter of fact, it was the first show of the year and here we are right at the tail end of November when you said the Dow was going to hit new highs. And then in May, you were talking about the fact that commodities were going to be really good, and large cap stocks – and we took a lot of grief over all that. But voila, here we are 8 months later or so, and we stand here and say: it all happened. JIM: Well, we got the Dow up 15% for the year; the S&P up over 12, and the NASDAQ up close to 11. But one exercise that we try to do on a monthly basis is we take the Dow 30 stocks and we take the top 50 stocks in the S&P 500, and what we do is we take a look at their current PE, we take a look at their 5 year lowest PE, their average PE, their highest PE, and then we take a look at their discounts to their highest PE and the discount to their average PE. We also take a look and we compute intrinsic value. We use two different systems and we take a look at whether these companies are selling at a discount from their intrinsic value. And John, I hate to say it, but if we take a look at the Dow 30 stocks, there are very few of these stocks that are overvalued at this point. One stock that is overvalued in terms of its discount to its average PE is Boeing; and it’s also selling at a premium to its intrinsic value in both models that we use – so that was an overvalued stock. Another one that we looked at that was sort of overvalued was Hewlett-Packard. A couple of other stocks that we saw that were overvalued were Phillip Morris on one method that we used; and then Procter & Gamble, and AT&T, and then finally Verizon. And we compute these once a month. Most of these stocks are still selling at huge discounts to their intrinsic value. They’re selling at discounts to their average PE. And I know that sounds strange for a lot of people, even given the fact that the Dow has moved from its low of 9,000 something or 7,000 something, back in 2002 to today’s closing level of 12,342. But you’ve got to remember, even though the Dow has moved up, it’s moved up in nominal values. If you take the Dow in the year 2000, and take where it is today and discount it by an inflation rate, you know we have actually been going down. And if you discount the Dow and take a look at it in terms of gold and other hard assets, it has also been falling. But in nominal values, it’s still going up. [1:16:57] JOHN: Well, given the fact that the economy seems to be slowing down, or even sliding into a recession, it seems like a cautious investor would want to buy something at a discount, or something in that direction. JIM: The first thing that you want to do – given the fact that we know that the economic growth rates here in the US are slowing down and that’s a definite trend – I think you’re going to want to shift to large cap growth stocks, or companies that have an international business that aren’t as impacted as much by a domestic slowdown; so they get a good majority of their sales from overseas. That’s going to help them in a number of ways. Number one, they’re open to international markets so if China’s economy is growing at 10 to 11%, or India’s economy is growing at 9%, or Asia’s economy overall is growing at 7 to 8% - you want to be in that market, because it’s growing at a much faster rate than let’s say the US market. So that’s number one. Number two, with the economy slowing down you want a company that has the ability to increase its sales because companies that can increase their sales that means higher profits versus a cyclical company that, for example in an economic slowdown, experiences contracting sales and therefore contracting profits. And thirdly, I think you would want an international company because with the dollar soon to come under pressure, one way to hedge against that would be with the company that it gets the bulk of its sales overseas. So if the dollar goes down, and it’s getting paid in euros, that means the value of its sales will increase even more, because the euro will be worth more against the dollar; or the Japanese yen, or the Chinese yuan is going to be worth more against the dollar - we know those currencies are going to end up probably appreciating. And then, I think another factor that you see as central banks begin to diversify out of dollars, that means that they’re going to begin going into gold, precious metals, and also they’re going to be going in to other currencies. Which currencies will they be going into? Probably the stronger, large tradable currencies – what I call the inflation resource rich countries: New Zealand, Australia, Canada, the euro, the Japanese yen. So you’ll see a transfer out of US dollars into other currencies. That also helps the international growth companies that are listed in the Dow. [1:19:18] JOHN:: That is really one true characteristic of the Dow, if you look at Exxon, Microsoft, 3M, McDonalds, Coca-Cola, Johnson & Johnson, IBM – all of these are truly international companies. JIM: Sure, and that’s where you want to be in this kind of environment. You want a company that has a business plan that allows it to increase sales; you want a company that is diversified internationally so that if the United States economy slows down, maybe the Japanese economy is growing or let’s say the Latin American economy is growing, and so they’re diversified. They’re not dependent on one big economy, and especially since trade within Asia is really growing strongly today – that just spells a big opportunity. So, number one, you’ve got an international company, if you’re talking about the Dow stocks. Number two, you’ve got a large stable company, a company that’s been around for a long time; number three, a strong balance sheet – they’re an international company that is based on a business model that sees the globe as its market place rather than the domestic economy. And number 4, as we have computed, a lot of these companies are selling at a discount to their intrinsic value, at a discount to their average PE ratio over the last 5 years, and at a discount to their high PE. And I think that’s why money is coming into this area. This is I think, one of the other plays. Yes, you can go into resource companies, but you don’t want to be totally invested in one sector. And I think that the international growth companies as reflected in many of the Dow stocks is going to be one of the places to be in the future. [1:21:05] JOHN: Time for the Q-Line. The Q-Line is open 24 hours a day for you to call in your questions to the program. It’s obviously recorded since it’s up their 24 hours a day. The number is toll-free in the US and Canada is 1-800 794-6480. It does work for the entire world but it’s only toll-free in the US and Canada. Hi my name is Bruce, this question is for Jim and John, I’m looking at your website and I’d like to find on your website areas that will tell me how much gold is in the ground per company in the juniors, so that I can evaluate some of these companies and get a handle on them. I believe at one time there was a list I found on one of the web pages that laid it all out: how many ounces of gold they had in the ground, and approximately how much the cost was per ounce, but I can’t seem to find that. Look forward to your direction and next week’s program. You know, Jim, we get a lot of questions in this category so it’s probably good that this question came in: how much is gold in the ground, what juniors are out there, what are the good ones, bad ones, and the big secret – what are you buying – etc., etc. So, why can’t you tell people that? JIM: Well, number one, I can’t because I’m a registered investment advisor, and number two I am my own broker-dealer, and number three I don’t want to tell people what I’m buying – that’s going to drive the price up. Bruce, we did a story a couple of years ago, it was probably what you were referring to. I was showing some methods to evaluate juniors, and then we went through a list of them. I may do another story like that in the future. In fact, I’m thinking of working on one in the junior sector but it’s not going to be what people think it’s going to be. It’s going to blow a lot of people away about the machinations occur in the financing end of the junior market – but that’s the article I’m writing. But the best way to find out about a junior is to go to the company’s website. You can go to the website, they usually have investor presentations. You can look at some of their press releases and financials. In fact, most of these companies will tell you how many ounces they have in measured and indicated reserves, or inferred, and then what you can do is take those ounces and divide it into the company’s market cap to get a sort of valuation of what it is. So that would be one thing to do. And you know, one reason why people are saying, “what are you buying, Jim?” We simply can’t do that. I can’t tell you what it is we’re buying and we don’t make individual recommendations on this program, and we try to keep this program open and fair about that. We don’t push particular stocks; we don’t take advertising on the site. That’s just the way we’re going to be. But I can tell you, I am buying right now, I’m backing up the truck actually on 4 stocks right now. And two of them we see big short positions and we’ve cleaned the shorts out and we’ve gotten rid of them, and that’s a great buying opportunity. But, you |
