Stocks I Like - Taseko Mines

Taseko Mines (TKO) is a gloriously priced stock, due to investor overreaction to a recent "disaster."

Taseko's Prosperity Mine is a property in British Columbia, Canada, with indicated resources of 7.7 million ounces of gold and 3.6 billion pounds of copper: in other words, it is massive. Importantly, the financial estimates of the mine are based on realistic long-term prices of $1.65/pound for copper and $650/ounce for gold.

In November of 2010, the Federal Ministry of the Environment announced that the Prosperity mine project, as proposed, cannot proceed due to environmental concerns. This is despite already having received approval by the Provincial Government, and Taseko having already built a portion of the proposed expansion.

Today's stock price does not accurately reflect the true value of Taseko mines. First of all, Taseko is not a startup. It already has producing properties, giving it earnings of $0.65 CDN per share, and a current P/E ratio of only 8 (at today closing price of $5.22). In short, even without the Prosperity Mine, Taseko has real value.

Of course, Taseko is not giving up on the expansion of its Prosperity Mine. No one seriously believes that Taseko will abandon 7.7 million ounces of gold and almost 4 billion ounces of copper.

According to the company's website, "Taseko is currently in discussions with both the Federal and Provincial Governments to define the issues and determine solutions so that this mining project can move forward and meet the criteria that the Federal Government deem appropriate. The company expects to have more information early in 2011."

Taseko mines is priced like a lightweight, is already a middleweight, and has heavyweight potential.

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“The desire of gold is not for gold. It is for the means of freedom and benefit.”

Ralph Waldo Emerson, poet.

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Disclosure

Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.

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Canadian Debt Levels Hit Record

In a speech this week that was as straightforward as possible, Bank of Canada governor Mark Carney told the crowd at the Economic Club in Toronto that "low rates today do not necessarily mean low rates tomorrow. Risk reversals when they happen can be fierce; the greater the complacency, the more brutal the reckoning."

Mr. Carney was, of course, referring to Statistic's Canada's announcement that household debt ratios have hit a record high, and that people could get stung badly if rates increase. Statistics Canada's announcement was surely a frustrating development for Mr. Carney, who has been warning Canadians about their debts for over a year.

The debt-to-income ratio for Canadians is now higher than that of Americans - a fact which many Canadians likely refuse to believe, since their self-image is that of financial prudence compared with their Southern neighbors.

Dangerously, these record debt levels coincide with unusually high home prices and unusually low interest rates: a situation that could easily lead to the double-whammy of rising payments on falling equity values - a sure formula for financial disaster.

Meanwhile, deaf ears continue to buy new condos and pull out the plastic for Christmas shopping. It is likely that most indebted Canadians will never read this article, or, for that matter, give it a second thought even if they do.

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"It’s a matter of concern but it’s not a matter with respect to which we’re going to act immediately."

Jim Flaherty, Canadian Finance Minister, December 2010, when asked if Canadian personal debt levels are a concern.

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See also:

Canadian Debt Levels now Higher than Americans

Back to Business

This blog is a quick apology....Oct 31st is Financial Institution fiscal year-end, which made me extremely busy for weeks before and after. Then a couple more weeks for recuperation and now...The Frost Report is back.

Sorry for the delay!

World Housing Bubble - All Aboard!

For months, I was clearly the minority in saying that real estate prices in places like China, Australia, Canada, Hong Kong etc are experiencing a bubble. I was also the minority in saying that US home prices are, in fact, undervalued. In recent weeks though, such ideas have become accepted, even mainstream.

By now, I have to admit that I am actually sick of writing about housing bubbles. However, I know from emails I have received that as a result of these articles, at least some people have been dissuaded from purchasing high-priced condos at the edge of personal affordability, and for this I feel that repeating the same message ad nauseum is worth it.

Paradoxically, money tends to flow to assets and areas that are considered "safest," without regard to whether or not they are "reasonably priced." For investors, immediate safety of capital (or immediate gain) is paramount, and everything else is secondary. It is precisely this desire for immediate reward that results in horrible long-term investment choices.

In some countries, such as China, investment dollars are still incoming. In the US, real estate is stagnant water, despite low prices and excellent investment opportunities. In Canada, the flow is now a trickle, and ready to backflow.

The educated media is coming on board. For the masses, the onset of reality will still take several months.

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Video: Bubble Trouble - MSN Money
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See also the previous Frost Report articles:

The World Housing Bubble – Part II

The World Housing Bubble

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Stocks I Like – Left Behind Games

When I was in grade school, I heard people talking about a new heavy metal band (a genre which was then very popular) called “Stryper.” I learned that Stryper was a Christian heavy metal band. That is, they were Christians playing heavy metal, wearing leather pants and singing about Jesus. I thought the whole idea was ridiculous. However, they proved me wrong by selling millions of albums. I learned not to underestimate the size of the Christian marketplace, or the “cool factor” in Christian marketing.

Left Behind Games Inc (dba Inspired Media Entertainment) is a video game company specializing in faith-based videogames. They boast a selection of titles including action games such as its trademark “Left Behind” series, as well as mild-mannered educational games such as the “Charlie Church Mouse” children’s series.

In the past few years, Left Behind has successfully employed guerrilla-marketing techniques to expand its market, such as sending free copies of their video games to young followers. Word of mouth further moves the video games, and encourages these young Christians to buy future titles.

This holiday season, Left Behind Games will go mainstream, with their titles being carried by Wal-Mart in addition to existing Christian retailers.

Left Behind is a true penny stock, selling at the ridiculous price of just $0.003 dollars per share: yes, that’s correct, less than a penny a share. Why, you may ask, would this company be selling at less than a penny a share?

Left Behind is an evangelical Christian company, which in itself offends many. It has been accused of, among other things, making games that instill religious bigotry. In addition, the company’s strength (niche marketing) may also be its weakness from an investor’s standpoint, since they sometimes seem more intent on spreading Christianity than actually making a profit (though they are currently profitable).

Left Behind Games is a controversial and unproven company, in a volatile market with a battered stock that is traded over-the-counter: it doesn’t get any riskier than that. However, since you can currently buy 5,000 shares for the cost of a movie, I feel that a modest investment is warranted. As with all penny stocks, invest only an amount that you would be completely comfortable losing.

If video game sales go well, Left Behind Games (LFBG: OTC BB) may just be the stock purchase that you tell your grandkids about.

For more information, visit: www.leftbehindgames.com/index.php
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"Never underestimate Jesus, because he will just prove you wrong."

Brian Gurney
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The Mortgage Foreclosure Mess

YET ANOTHER KICK AT THE CAN



US Bank stocks skidded downward this week, based on a moratorium on foreclosures. Major US banks, including Wells Fargo and Bank of America, are accused of (among other things) using “robo-signers”: employees who rubber stamp foreclosure documents without properly reviewing them.

The mass-producing and bulk-signing of documents has a disgusting and immoral aura to it, similar to the revulsion for traffic tickets issued by speed radar cameras.

Having an employee decide the fate of someone’s home without reading the documentation is cold-hearted, and people are understandably upset. Having said that, it isn’t like the banks haven’t been trying. Wells Fargo alone has 17 thousand employees working on foreclosure and mortgage modification paperwork: they are simply overwhelmed by the volume.

For the banks, any moratorium on foreclosures is definitely negative. Moving foreclosed homes into the stabilized marketplace has been an order of priority for months now.

As an investor, there is a series of questions that should be asked in any situation where the immediate outlook seems negative. 1) Is this going to reduce earnings, and therefore stock prices? 2) Will this cause the company to go bankrupt, resulting in a permanent loss of capital? 3) Will the reduction in earnings be permanent?

In this case, the answers are clear: yes, this is going to reduce earnings and stock prices (and already has); no, this is not going to cause the major banks to go bankrupt (since their balance sheets are already positioned to withstand major calamities); and no, the reduction in earnings will not be permanent.

As usual, where there is fear there is opportunity.

The big chance to load up on bank stocks was in Feb-Mar of 2009, but there have been several smaller opportunities since: this may be another one. While today’s drop in bank stocks was just a small bump in the 3-year chart, a few more days of declines will result in some real bargains.

Bank of America (BAC), Citigroup (C), Wells Fargo and Co. (WFC), and JP Morgan (JPM) have all dropped nicely. That is, four of the biggest banks in America - with the greatest profit potential - are on sale again. Depending on next week's hype, bank stocks could drop even further.

If you missed out on the biggest run (when banking index fund XLF went from $6 to $15 in about a year), this is looking like another fine opportunity.

Hope for fear!

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"If I owe you a Pound, I have a problem; but if I owe you a million (Pounds), the problem is yours."

John Maynard Keynes

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Disclosure
Do not buy stocks, sell short, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.

Beware of the Bond

In one of the earliest posts on this site, I wrote: “Bond Fund – ‘Bonds’ are essentially loans that you give to a company. In return, these companies pay you interest. A bond fund is a nice mix of short- and long-term bonds of good companies that pay a rate of interest beating inflation. Almost everyone should own at least some bonds in their investment portfolio.”

Times have changed.

While short-term bond funds are still reasonable, those holding medium- and long-term bonds - and especially bond funds that contain government debt - should strongly consider getting rid of them.

During the credit crisis and still today, the retail investor stayed away from stocks entirely, shunning the very word “equity mutual fund.” This of course resulted, and is still resulting, in excellent bargains for some areas in equities. But, where did all the retail investors go?

Retail investors did not buy stocks, as indicated previously. They certainly did not and are not buying real estate, even in the bargain zone that is the USA. Instead, they bought gold (hence ridiculous current prices), money market funds, bond funds, and government debt.

Whenever the retail investor shun a large asset class like stocks, other areas grow bloated and overpriced. As the chart below indicates, whenever the financial news was worst, investors bought bonds the most (bond yields decline when purchases increase).


(click to enlarge)

If you want income-producing investments, consider purchasing those investments that remain deeply unpopular in today’s market: dividend mutual funds or ETFs (consisting of dividend-paying corporations) such as SDY and DWX; Real-Estate Investment Trusts such as IYR; Mortgage Bonds (which are currently being avoided like the plague) such as MBG and VMBS; and, stocks of large oil and gas companies (that are backed by hard assets and typically also pay a dividend) such as CVX and BP.

Like the gooey, sticky mess in the 1950s classic, “The Blob,” the long-term bond market is currently bloated from gluttony, and only a cooling off period can stop it.
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"When a horse learns to buy martinis, I'll learn to like horses."

Steve McQueen, actor
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Disclosure
Do not buy stocks, sell short, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.
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Loose Wallets Sink Ships

How bad is it? Bad.

In many previous articles, I explained the obvious: that the Canadian housing market is grossly overpriced - driven by low interest rates and personal debt - and ripe for a crash.

Many disagreed. Those who disagreed most strongly were, unsurprisingly, those who had bought rental properties or first homes within the last 3 years (for the reason why, see Cognitive Dissonance). Yet, what was obvious to some is slowly becoming obvious to all: the Canadian housing market is sinking.

A recent press release by the Bank of Canada was brutally straightforward: “The slowing since the spring in resale, renovation, and new home construction activity has been driven by a number of factors, including the passing of pent-up and pulled-forward demand; the expiration of the federal Home Renovation Tax Credit in January; the tightening of standards for government-backed insured mortgages that came into effect in April; the introduction of the HST in Ontario and British Columbia in July; declining affordability; and subdued income growth.” This painful laundry list is the reality of the Canadian housing market today.

The demise of the housing market has received surprisingly little coverage in Canadian news. In fact, a recent headline in the Financial Post (Ottawa ponders further tightening of mortgage rules) suggests that the housing market is still hot and may require cooling.

Canadian personal debt levels, which have risen along with the housing market, have been a cause of great concern for the Bank of Canada for some time. Again, the Bank of Canada has been blunt, noting that “Canadian households have now collectively run a net financial deficit for 37 consecutive quarters. That is, their investment in housing has outstripped their total savings for over nine straight years.” The Bank of Canada concludes in a single line, “This cannot continue.”

Debt levels have reached the point where any further increase in interest rates – which may be necessary to combat inflation – will strain Canadian families. If inflation rises, the BOC may be forced to raise interest rates and push those citizens who are now “just hanging on” into bankruptcy.

The Canadian housing market’s decline is just beginning. How long this process will take is anyone’s guess, but it will likely be measured in years, not months. A decline in value of an asset class this large ensures no quick recovery.

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To review the progression...

The Canadian Housing Market
Canadian Debt II
Spin City
The Canadian Housing Bubble - CREA to the Rescue
The Canadian Real Estate Market: Trouble in the Pipeline
Canadian Real Estate: Stick a Fork in It

The Bank of Canada - Employment in a Modest Recovery
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"Results - Fall 2010

The Canadian Real Estate Association says first-time home buying activity is slowing. What’s happening in your region?

I’m seeing more first-time homebuyers this year - 24%
I’m seeing fewer first-time homebuyers this year - 66%
I haven’t noticed a change - 10%

Genworth Financial Canada - The Homeownership CompanyPrime Source"

A recent poll by Genworth Financial Corp, given to mortgage brokers and bankers across Canada
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The Retail Gold Rush

Gold bullion is at record highs, and is set to rocket still higher. At least, this is the official sentiment of The London Bullion Market Association. But with prices already at record highs, is this the time to buy gold or the time to sell it?



There are two reasons commonly given to buy gold now. The first is that gold is a store of value. That is, although inflation eats away at the value of currencies, gold has a value that cannot be taken away. The second reason is that uncertainty drives gold prices higher, and today’s markets are certainly uncertain.

Gold is indeed a store of value, a currency, a component of jewelry and electronics, and more. The problem is that gold – like other commodities - usually keeps up with inflation and the business cycle but does not exceed it. In the past 3 years, however, gold has exceeded inflation greatly. Fear and speculation are the drivers of gold prices now.

Earlier this year, we saw the advent of gold-to-go machines. These vending machines hold a quote for 10 minutes, then scan the market and recalculate so the customer is always getting an up to date (but marked up) price. In Europe, these machines can be found in airports, hotels, and even supermarkets. For me, the gold-to-go machine marked the entry of retail “stupid money” into the market - money that arrives too late and stays too long.

If gold vending machines weren’t enough, consider the rise of solid or yellow gold miniatures. A few years ago, gold miniatures were an exclusive novelty. These days, the windows of high-end Chinese jewelry stores are loaded with solid gold rabbits, dragons, boars, oxen, and popular cartoon characters. The miniatures are popular with Chinese, since they offer a way to store wealth for posterity while simultaneously flaunting it.

The final sign of the gold peak is the de-hedging process of the gold producers themselves. In order to reduce income fluctuations caused by changing gold prices, most gold producers partially hedge their gold using futures or options. For example, companies buy futures that go up in value when gold goes down, and that go down in value when gold goes up. By hedging with futures, companies will not benefit as much from rising prices, but they will also not get stung by falling prices (arguably more important for profitable companies).

This year, many major gold producers have greatly reduced or even stopped hedging in the expectation of forever-rising prices. Barrick Gold, AngloGold Ashanti, Gold Fields and other companies have reduced their gold hedging by millions of ounces.

So, is gold going to drop? Should you short it?

At this point, there is still widespread fear all over the world, and this is partially justified by a worldwide housing bubble and precarious economies. Shorting gold at this point is probably not justified. However, neither is jumping on the bandwagon.

Gold prices are high – really high. Both as an investment and as a novelty, gold is more popular now than it has been in a very long time. I would refrain from buying. If you already own gold, consider selling some.

If you believe the world's currencies are being debased and you need to protect yourself, buy producers of commodities that have uses beyond merely a store of value - such as oil, uranium, lithium, and copper.

Buying something at the peak of its popularity is not always a stupid financial move, but statistics are against you.

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"My dear girl, there are some things that just aren't done, such as drinking Dom Perignon '53 above the temperature of 38 degrees Fahrenheit."

Sean Connery as James Bond, GoldFinger, 1964

Rare Earth Metals – China’s Trump Card?

Historical enemies Japan and China are at it again, this time about a disputed territory in the Diaoyu islands (known as the Senkaku islands in Japan).

On Sept 7th, two Japanese coast guard ships collided with a Chinese fishing vessel (or perhaps spy ship, since fishing vessels are used as spy ships by many nations). The Chinese captain (agent?) is now incarcerated in Japan, and Chinese officials are demanding his release.

There are many uninhabited "islands" in the oceans East of Japan, some of which are no more than lumps of rock a few inches above sea level, surrounded by concrete and tetrapods so they don’t wash away. The islands are important, of course, because whoever owns them can claim the surrounding mineral rights. At least, this is the presumption, despite a UN convention that “rocks that cannot sustain human or economic life of their own shall have no exclusive economic zone…”

What is interesting about this most recent incident is that China may be playing the “rare earth metals trump card" to end the conflict.

Rare earth metals are used in batteries, wind turbines, lasers, cell phones and other high-tech devices. In this latest diplomatic incident, China's customs clearance of rare earth metals into Japan has been “delayed.” China of course denies that they have implemented a trade ban.

Since China produces the vast majority of the world’s rare earth metals (more than 97% by some estimates), rare earth could become a handy negotiating tool for China in the future.

There is no doubt that rare earth metals - and therefore rare earth mining - will be an important area for investors to watch in the years to come.
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See also:

Govt Probing China's Rare Earth Trade Embargo

China will never waiver on issue of sovereignty: experts

Chinese people's willingness to travel to Japan drops amid diplomatic dispute

China denies tightening rare earth trade

Mabuchi worried about China fallout
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“Life is really simple, but we insist on making it complicated.”

Confucius
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Thank you, Frost Report Readers!

Last Wednesday marked the 10,000th unique visitor to the pages of The Frost Report.

I would like to thank all those who have visited my site, and all those who took the time to email me with their feedback and ideas (marketsandfinance AT gmail.com).

I try to reach strong conclusions only after studying all the facts (never predetermined), and point out prevailing illogical bias whenever possible. I am suspicious of any news article that gives opinions without revealing the facts that formed them. And, as every good investor should, I regularly try to prove myself wrong.
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To date, the top five all-time favorite articles for The Frost Report are:

Spin City

Chinese Real Estate - Trip Report

Stocks I Like – Citigroup

The World Housing Bubble

The US Economy - Headed in the Right Direction?
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Thanks again for your readership, and cheers to more insight in the future!

E. Frost,
The Frost Report

Mad About Taxes

The media and the public are divided and angry.

Some people, such as billionaire Warren Buffett, say that tax increases for the rich are “fair,” since the rich currently pay less tax than the poor. For others, any increase in taxes for the wealthy is an example of socialist government, and a disincentive for hard work.

The expiration of the Bush tax cuts has been called “the wrong move at the wrong time.” This expiration, combined with Obama’s proposed tax increases for those earning more than $200,000 per year has been dubbed the “small business killer.” Should we be worried?

When I worked as a lender, a consistent thing I noticed about small business owners is that they claim to have almost no income. A man could own a successful business, drive a Mercedes and take annual vacations to France, yet according to his company's financial statements be making $20,000 a year. This was normal.

For lenders, the financial statements of small business owners can be frustrating. Owners typically often write off so much (to avoid taxes) that it becomes difficult to approve their loans.

“Just show a little more income next year,” lenders often tell business owners.
“But then I will have to pay income tax," the owners counter. "You know I make lots of money. Can’t you just approve it?”

The proposed tax changes would raise taxes for individuals earning $200,000 per year, or families earning $250,000 per year, with lower taxes for those earning less: this is hardly a small business killer. A small business owner that shows an income of $200,000 per year would, in all likelihood, be earning at least 3 times that much - and there are simply not many small businesses pulling in that level of income.

Then there is the debate about lowering taxes for the middle class. Many members of the middle class themselves are opposed. Personally, I find this hilarious. One of my favorite things about the GOP is that they have actually convinced people earning less than $200K a year that tax cuts for the rich are good for the economy, but tax cuts for themselves are unnecessary. I love it! Gullibility knows no limits.

From an economic standpoint, lowering taxes for the nation’s middle class makes sense. The middle class tends to live “paycheck to paycheck,” spending almost everything they earn. Any decrease in taxes (increase in money to spend) would go directly into the local economy. High-income earners, on the other hand, tend to save more, or spend their money overseas. In terms of boosting the economy, a tax decrease for low- and medium-income earners gives far more bang for the buck.

Being that the US has a record deficit, somebody’s taxes need to increase. Increasing taxes for corporations is a bad idea, since unemployment is still far too high and corporations are the nations largest employers. Tax increases for the middle class is also a bad idea, since their spending levels (which constitute most of the US economy) are already low. The wealthy are the best choice for tax increases, because their personal spending levels will be least affected.

Tax cuts for the rich after the economy is rolling smoothly again – sure, why not? Everyone believes in the American dream. Everyone believes that someday, they too will earn more than $200,000 per year. And, they want to make sure tax levels are low when they get there.
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“In 1790, the nation which had fought a revolution against taxation without representation discovered that some of its citizens weren't much happier about taxation with representation.”

President Lyndon B Johnson

The Failure of Incubator Bank

Incubator Bank of Japan, which specializes in loans to small and medium-size enterprises, filed for bankruptcy last Friday. With it, the assumed infallibility of the Japanese bank failed as well – a profound moment.

In Japan, corporations typically partner with a bank from inception, and never change. The loyalty of companies to their banks, and vice versa, is therefore extremely high. Traditionally, this meant that a bank would give loans to its corporate partners, even when it was clear that these companies were on the brink (or over the brink) of insolvency: this was considered "dedication."

The failure of Incubator Bank is profound because the bank was actually allowed to fail. The Deposit Insurance Corporation of Japan - which protects customer deposits up to 10 million yen - was instituted way back in 1971, yet this is the first time is has ever been used.

Though Incubator Bank is relatively small, large Japanese banks will recognize this as the warning shot that it is. The Government will not allow a long recession of zombie companies - barely alive - to occur again.

The Japanese financial system is coming of age, and the “modern zaibatsu” (interconnected business-banking conglomerates), are no longer untouchable. The failure of a Japanese bank is a sign that the system has become more mature, confident, and responsible. Japan Inc. has been warned.
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"Always strive to stay one step ahead. Standing still is retrogressive."

Nomura Tokuanden
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American Economic Dictionary 2010

Knowing this list of terms will not help you make money in the stock market. It will, however, give you a few laughs at a cocktail party (or a few nods of agreement, depending on your crowd).
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Bankster – n. A banker, since bankers and gangsters have the same profession (stealing).

Bernanke Clown Confetti – n. Common stock certificates.

Big Casino (The) – n. The New York Stock Exchange.

Corporapists – n. Evil organizations (corporations) that no one can trust, despite the fact that most people who believe this belong to one.

Green Shoots – n. Any hint of economic recovery, no matter how small. Popularized by CNBC’s Larry Kudlow.

Helicopter Ben – n. Ben Bernanke, Chairman of the Federal Reserve Board. The nickname comes from a speech he gave in 2002, in which he referenced economist Milton Friedman's metaphor of a helicopter dropping money on the community as a way to rescue the economy.

Hummer – n. A heavy, unaffordable, and somewhat useless off-road vehicle. Also denotes buxom women who date only wealthy men (ie. “Watch out, she’s a hummer.”)

McGlobalization – n. The evil result of cultural export (ex. Hamburgers in France, or rap music at nightclubs in Mongolia).

Nuclear Banana Republic – n. The USA

Perceived Recession – n. An economic situation that makes life uncomfortable for an extended period of time. The technical definition of recession (two consecutive quarters of negative GDP) no longer applies, since by this definition the US is already out of recession.

Sheeple – n. Individuals who do not recognize that the world’s economy is under the control of big business/Jewish Zionists/communists/hedge funds/The Federal Reserve/ Literati/Right-Wing Christian Fundamentalists/The Freemasons, or any combination of the above.

Staycation – n. A vacation spent at home, since one can’t afford to go anywhere.

Toxic Waste – n. Income products composed of sub-prime loans. Named by the traders who sold them to unsuspecting clients.

Turbo-Tax Timmy – n. Timothy Geithner, United States Secretary of the Treasury. Named for an incident during his stint at the International Monetary Fund, where he blamed his late income tax filing on the popular tax preparation software “Turbo Tax."

Zero Interest - n. The basic rate of interest during the credit crisis. Also used to denote the lackadaisical attitude caused by the credit crisis (ie. "I'm not going to the party. Zero interest.")
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“Men can acquire knowledge, but not wisdom. Some of the greatest fools ever known were learned men.”

Spanish proverb

Pessimism is Wonderful

At dinner parties, coffee shops, classrooms and churches, the common voice of America is focused on the same two topics: recession & unemployment.

I have personally never seen a collective outlook so hopeless and dejected, where being positive about anything is seen as foolish. In short, the opportunity to invest in stocks continues to be wonderful.

I have written ad nauseum about the fact that times of great pessimism are the best times to buy stocks. But, since people find this so counter intuitive, here is the reason expressed in simple numbers…

Stock prices are determined by two major factors – company earnings and popularity. Times of pessimism tend to follow some great crisis that hurts company earnings and creates walls of worry.

Worry causes people to pay less for what earnings companies have, as reflected in a low price-to-earnings (P/E) ratio. During times of prosperity, the average P/E ratio of the market might be over 20. During times of deep pessimism, the average P/E of the market might be in the single digits. For the patient investor, the effects of company earnings and market P/E over the course of the business cycle is profound.

Say, for example, that during a recession, manufacturer General Electric's earnings are $1.00 per share at a P/E of 15, giving it a stock price of $15.00. After a few years, as the economy improves, GE’s income returns to $2.00 per share (the same level as before the recession, assuming that the company doesn't grow at all). At the same time, newly optimistic citizens begin buying stocks again, and stock prices rise to an average P/E of 20. This means that GE will now be priced at $2 x 20 or $40. Since one business cycle takes from between 3-7 years, in seven years or less you could make a return of 267% (from $15.00 to $40). The stock market rewards patience well.

At present, company earnings are low, P/E ratios are low, and negativity is high - the perfect formula for value investing.
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“The most common cause of low prices is pessimism - sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.”

Warren Buffett
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Disclosure

Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.
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Throwing Away Money on Rent

“I want to buy my own place. I don’t want to ‘throw my money away’ on rent anymore.”

As a banker, I hear this sentiment often.

Amongst the reasons renters want to purchase their own place is because it annoys them to “give their money to a landlord” every month, allowing the landlord to get rich.

For most people, buying real estate is indeed a worthwhile and sensible economic decision, to say nothing of the pride of ownership and positive sense of responsibility that comes with owning a home. However, many renters have a twisted idea of how their finances will change once they purchase. To illustrate, I will use “Bob,” a typical renter.

In Bob’s marketplace, he pays $1000 per month for a 1-bedroom apartment with den, with hot water and cable TV included. He hates the idea of throwing away $1000 every month, so decides to purchase a condo in the same area.

Bob buys a $260,000 condo, using a down payment of $30,000 and a $230,000 mortgage. Bob’s monthly mortgage payment is $1234.69. He pays an additional $200 per month for condo maintenance fees and $100 for property taxes, for a total monthly payment of $1534.69. Bob is pleased with his decision. What Bob is not aware of is that he is actually “throwing away” more money now than he was prior to his purchase.

Bob’s first monthly payment will be $1534.69, of which $958.33 will be interest, $200 for maintenance fees and $100 for taxes, with only $276.36 going toward the principle. That is, Bob is now “throwing away” $1258.36 ($1534.69 – $276.36) - a full $258 more than before, not including the utilities and cable that he now has to pay for himself. Over time, more of Bob’s money will go toward the principle, but at the moment Bob is deeply in the red compared to his previous situation. Did Bob make a mistake?

In order to make a wise real estate investment decision, certain rules are best followed:

1) Don’t buy into a declining market (or an exceptionally “hot” market which could soon decline) unless you plan to stay in your home for several years. It is best to purchase when values during the previous 6 months have been roughly flat or rising. There is no point paying $276 toward the principle every month (like Bob), if the value of your property is dropping more than that.

2) Don’t purchase unless you intend to stay in a place for 3+ years, with 5 or more being optimal. During shorter periods of time market values can decline (see Rule 1), and fees (such as moving fees, agent commissions, taxes etc) will take a bite out of any potential profits.

3) Buy something well within your comfort zone. No more than 32% of your monthly pre-tax income should go toward mortgage payments and condo fees.

4) Make sure you have fallback funds. Too many people put all of their savings toward a purchase, leaving nothing for emergencies.

If Bob intends to stay in his property for 5 years or more, has funds set aside for emergencies, and has purchased in a flat or rising market, he has probably made a wise investment decision. Over the years, his monthly payments will remain the same while local rents rise, with more of his payment going toward the principle (and less toward interest) every month. And, he will see his property increase in value while he enjoys living there.

Real estate can be a great investment. Just make sure you do it right.
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“The only difference between a cult and a religion is the amount of real estate they own.”

Frank Zappa, musician

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Bob’s Mortgage

Principal = $230000
Interest Rate = 5%
Amortization Period = 30 Years
Bob’s monthly payment is $1234.69
First year mortgage amortization schedule (click to enlarge):

ETFMFs – Money Maker (but not for you)

Due to low fees and the ease of buying & selling, Exchange-Traded Funds (ETFs) have developed an excellent reputation amongst small investors. In fact, many people are cashing in their mutual funds to purchase ETFs through discount brokerages (such as E-Trade, TD Waterhouse etc.).

To compete, the mutual fund industry has retaliated with perhaps the most senseless investment product created in years – the Exchange-Traded Fund Mutual Fund.

Traditional Exchange-Traded Funds (ETFs) are similar to mutual funds. Each ETF is actually a “basket” of stocks, so by purchasing a single ETF you make a small investment in several companies. For example, if you buy stock symbol ZEO (A Canadian Oil and Gas Index Exchange-Traded Fund), you purchase a portfolio of common shares of Canadian oil and gas companies. ETFs are therefore a great way for the small investor to diversify.

There are 2 major things that make ETFs superior to mutual funds. 1) ETFs can be bought or sold at any point in the day, instantly, just like a stock. In contrast, mutual fund prices are determined only at the end of the day, and require 1-3 days for processing. 2) ETFs have lower management fees than mutual funds - sometimes much lower.

An Exchange-Traded Fund Mutual Fund (ETFMF) is basically a basket of ETFs, put together to form a mutual fund. That is, you take stocks from several companies and put them in a portfolio, then take several of these portfolios and put them in a portfolio, and the result is an “ETFMF.” With an ETFMF, you get all the disadvantages of a mutual fund with none of the benefits. You pay the high fees of a mutual fund, except now in multiple layers (since you pay the ETF fees, and then mutual fund fees on top). And, you cannot buy or sell them in the market like real ETFs, since they are actually mutual funds.

The reason ETFMFs were created, from what I can tell, is to satisfy naive customers who don’t really understand what an ETF is. Now, customers can ask a mutual fund salesperson, “Do you sell ETFs?” and the salesperson can answer “Yes.” Other than this, I see no benefit to them whatsoever.

If you want to buy a mutual fund that is similar to an ETF, buy an Index Mutual Fund, which is also a basket of companies and has low fees. If you want to buy an ETF, buy a real ETF. ETFMFs are a hybrid product that someone dreamed up in a back room, and have no place in your portfolio.
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“It’s likely that some don’t even know that these fees are being deducted from their funds or who they are ultimately compensating.”

SEC Chairman Mary Schapiro, regarding mutual fund fees.
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US Banks: What a Difference a Year Makes

Although recent financial news has a decidedly cataclysmic tone, evidence continues to mount that things are improving frustratingly slowly and steadily, exactly as expected.



Today, the FDIC announced that US banks earned, in aggregate, 21.6 billion dollars in the second quarter of this year (FDIC). Though this is still well below historical standards, what is striking is that most banks (80% of them) have returned to profitability.

Back in May, when I first publicly recommended bank stocks (US Banks), headlines warned that the government might force banks to be broken up and sold, that financial regulation could destroy them, and that a new debt crisis (ex. Greece) might soon cripple them. None of these things has materialized.

Since May the US financials index (XLF) has nonetheless dropped from $15.36 to $13.44, despite quantitative improvements in all areas of banking: decreased leverage, reduced loan loss provisions, increased profitability, improved credit market stability, and more.

The new worries for banks include a flattened yield curve (making credit spreads less profitable), a potential double-dip in housing, and that Barack Obama is secretly a communist Muslim and/or Biblical Anti-Christ whose intention is to destroy the US financial system.

If you truly believe that the US economy will never improve, and that US families will never again buy cars or houses, use credit cards or keep bank accounts, you should definitely stay away from bank stocks.

If you believe that banking has a future in America (and that America has a future at all), this year’s prices may well mark the single greatest buying opportunity we will see in our lifetimes.
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"After 1929, so many people had been traumatized by the stock market crash that there was a lost generation."

Ron Chernow
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Disclosure and Disclaimer

Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.
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Related amusement:

Happy Birthday, Warren

The richest man in America turns 80 today.

In his time, Warren Buffett has positively affected the lives of thousands of investors, including those who became wealthy employing his techniques (based on the work of Benjamin Graham), as well as those who simply bought his stock (BRK.A & BRK.B).




In addition to being a great investor, people connect with Buffett because he just doesn’t act like a typical billionaire. He is frequently spotted chatting with shareholders, enjoying T-bones at the local steakhouse, or playing bridge. Several years ago, a shareholder was surprised to see Buffett and his friend, Bill Gates, walking around a McDonalds restaurant in China, looking for a table.

In recent years, Buffett has developed an almost saintly reputation, which is not entirely accurate. He has always had a complicated social life that includes “female friends.” He unapologetically buys stocks of military hardware developers, tobacco companies and breweries if he considers them to be of good value. He takes advantage of the suffering of large companies (like all good value investors) by rescuing them in return for convertible preferred shares paying high rates of interest.

Despite his arguable flaws, however, most agree that his positive attributes - both personal and business - vastly outweigh them. While most billionaires are hated simply because they are billionaires, Warren Buffett’s likability and charm have actually grown with his riches.

Honesty and humility go a long way.

Rationality adds still more.
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”Testing…one million, two million, three million.”

Warren Buffett, at the microphone of the University of Florida
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Is the US Recovery in Danger?

This week saw low sales numbers in housing, lowered (but still rising) durable goods orders, and a generally pessimistic attitude all across the board.

In fact, “pessimistic” may be an understatement. One website effectively summarized the prevailing mood: “Things will never get better. We are all doomed.”

One of many problems with doom and gloom reporting is the resulting dialectical materialism (George Soros calls it “reflexivity”). When people believe something it can become a reality, even if it wasn’t a reality at the time people began to believe it. For example, if people believe there is an increasing chance they will lose their jobs or homes due to recession, they will curtail their spending, thereby causing the recession that they feared. Despite the reflexivity effect, however, I do not believe that this recovery is endangered.

Consumer “entrenchment mentality” is already in full force, and has been for some time. As noted earlier in The Frost Report (The Spending Zone), Americans have been paying off their debts and increasing their savings for seven months straight, and are almost at the point where their free cash flow will increase substantially. As a result of these debt repayments and savings, consumer credit scores are already the highest they have been since 1998.

The corporate world largely reflects the personal one: businesses have vast amounts of emergency cash, have paid down and/or refinanced debts, and have streamlined staff and operations. Corporate America is mean and hungry. With solid balance sheets and low stock prices, M&A activity should rise soon and remain high for months.

The combination of high cash flow, lower debts, higher savings, and excellent credit ratings simply does not match the “we are all doomed” mentality. Similar to cult members who wait for the mother ship, at some point people will realize that the economic apocalypse they are preparing for is simply not going to occur.

Based on the numbers, I suspect that this revelation will strike the US consumer within the next 3 quarters. Regular (if not exceptional) spending will resume shortly thereafter, and corporate America will follow suit with mergers, expansions and hiring.

Though the international picture is deteriorating, it will not be enough to derail the US turnaround.
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“Hysteria has now disappeared from Wall Street.”

The Times of London, November 2, 1929
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Canada’s Banking Albatross

And How to Benefit from it.



Deathly afraid to enter the stock market, Canadian retail investors are keeping their money in low-yielding GICs and bond funds - if they are investing at all. Mortgage and refinance business has collapsed. The self-employed have entrenched. Business is slow.

With mortgages newly dead and rigor mortis setting in on investing, there is nothing to sustain the currently high stock prices of Canadian banks. As an investor, what can you do to protect yourself, and perhaps make some money in the process? The Frost Report states the case in black and white.

First off, sell your Canadian bank stocks, as well as your Canadian dividend mutual funds (which usually contain 50% bank stocks). In order for stocks to drop, banks don’t need to have a disastrous quarter; they just need to have a quarter that is less spectacular than the last one.

Secondly, sell your Canadian REITs (Real Estate Investment/Income Trusts). There is no point holding on to REITs to generate income when you know that income from real estate will soon drop, and the price of REITs along with it.

Thirdly, buy distant at-the-money put options on Canadian banks, so that you can make a profit on the coming stock price decline. If you don’t know what an at-the-money put option is or how it works, completely ignore this piece of advice, for now is not the time to be learning.

Alternatively, you can buy Inverse financial ETFs, such as the Horizons BetaPro S&P/TSX Capped Financials Bear Plus ETF 2X, (symbol HFD). Again, if you just read this description and have no idea what any of it means, don’t even consider buying HFD. For those who understand, read the full prospectus.

Lastly, Canadians should start paying down debts and building cash reserves. While everyone else is experiencing a crisis, you can be comfortable. Cash gives you a sense of control & security, and, when things start to pick up again (which they always do), you can take advantage of the bargains that will be everywhere.

The Bank of Canada shot the albatross with its low interest rates months ago, and for a while the results looked good. Now, however, the storm is approaching. As with any other impending disaster, preparation is crucial.
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Bank of Montreal reports Tuesday Aug 24th. Analysts expect third-quarter share profit of $1.21, up from $1.05.

Canadian Imperial Bank of Commerce reports Wednesday Aug 25th. Analysts expect third-quarter share profit of $1.53, up from $1.36.

Royal Bank of Canada reports Thursday Aug 26th. Analysts expect third-quarter share profit of $1.02, down from $1.21.
National Bank of Canada also reports Thursday Aug 26th. A third-quarter share profit of $1.52 is expected, down from $1.79.

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Disclosure
Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.
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“Instead of the cross, the albatross / About my neck was hung”

The Rime of the Ancyent Marinere, Samuel Taylor Coleridge.
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Canadian Real Estate: Stick a Fork in It

IT'S DONE.



The Canadian housing boom is officially over.

In addition to the myriad of anecdotal stories from real estate agents and mortgage specialists who tell me that the market “has shifted in favor of buyers,” banks are finally experiencing the inevitable decline.

Back in July, I mentioned that the mortgage pipeline was drying up, and that the results should soon hit the banks. Well, they have. According to my contacts at three of Canada’s major banks, new mortgage and refinance business has fallen off a cliff. Pre-approved mortgage applications – an indication of sales beyond 30 days - are virtually non-existent. Any of this may be confirmed by a casual visit to a local bank or credit union, which reveals empty reception areas and bored lenders.

In an effort to kick some life back into the markets, major Canadian banks reduced their mortgage rates twice in the past two weeks, but it had no impact whatsoever. In light of these circumstances, I suspect the Bank of Canada will rethink its intention to slowly raise interest rates.

At the same time as the Canadian media was announcing that home prices have dropped, sales have slipped, and housing starts fallen, the Canadian Real Estate Association was busy announcing that home prices will continue to rise. I love the CREA. When sales and demand increase, they announce that real estate prices will rise. When sales and demand drop, they announce that real estate prices will rise. You can say a lot about the CREA, but you can’t fault them for inconsistency.

I suspect that several months will pass before the severity of the downturn becomes fully apparent. By then, it should be so obvious that not even the CREA will be able to ignore it.
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Further reading:

The CREA's Use of Spin (The Frost Report)
The Canadian Real Estate Market - Trouble in the Pipeline (The Frost Report)
Housing Starts Slip in July
Shaky Days in the Housing Market
Homeowners Sell, Start Renting Instead
CREA's Resale Housing Forecast

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The Golden Age of Appraisals

“What are you looking for?” the man on the phone would ask me. At the time, I was a retail lender for a major bank.

“Uh, they need 680 thousand,” I would answer. A few days later, the appraisal would arrive on my desk. The home’s appraised value: exactly $680,000.

I miss the golden age of appraisals; the days when an appraiser would ask their banker what value they needed to complete the deal, and the result would neatly correspond. Of course, it didn’t always happen that way. Occasionally, when a client was buying a property that was obscenely overvalued, the appraiser just wouldn’t do it. “The most I can give you is “X,” they would tell me, apologetically.

The Golden Age of Appraisals (and the housing bubble itself) resulted from general human psychology, and a lack of regulation to counteract it. The government wanted a robust market so that voters would be happy. Bank executives wanted stunning results so they could exercise their stock options. Lenders wanted to underwrite mortgages to exceed their targets and get good bonuses. Appraisers wanted to keep lenders happy and get bank business. Clients wanted to be approved so they could buy homes to flip and get rich. And so, everyone worked together to create a royal mess.

At the time, I didn’t even realize that by answering the appraiser’s question, “What are you looking for?” I was contributing to a bubble. I recognized that the question was suspect, but thought I was simply helping them cheat at their jobs by giving them an anchor figure to work from.

Housing appraisals go by either “replacement value” or “the comparison approach,” the latter of which is the most common. In this approach, a home is compared to the recent sales of similar homes in the area, adding or subtracting value for any differences. In the bubble years, the values given to differences were often generous. After all, who’s to say that the $500 of gardening supplies and weekend of sweaty work didn’t add $20,000 to the value of the home? It’s a judgment call.

These days, most appraisers no longer ask their banker what he is “looking for.” They rarely assign a value of $20,000 to a small garden plot, or $30,000 to a new paint job. And, they often anchor their appraisal based on the price of the nearest foreclosure, knowing that foreclosures drag down prices for everyone. The old days are gone. Appraisals are becoming – dare I say it – accurate.

That is, until the next hot economy…
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“Until you play it, St. Andrews looks like the sort of real estate you couldn't give away.”

Sam Snead
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FOR and "The Spending Zone"

AND ITS IMPORTANCE TO THE US ECONOMIC RECOVERY





The FOR, or “Financial Obligations Ratio,” is a surprisingly overlooked indicator of a nations economic health; specifically, an indicator of the financial health of its citizens. If the US is to truly experience an economic turnaround, the FOR is the number to watch.

The Financial Obligations Ratio is a ratio of the amount of debt that citizens of the US pay in comparison to income. For example, an individual with an income of $4000 per month (before tax) that makes monthly payments (rent, car, credit card, and other payments) of $2000 has a FOR of 50% ($2000 / $4000). The “safe zone,” where living is easy and spending is comfortable, is a FOR or 40% or less, with 32-35% being optimal. The higher the FOR, the more difficult it will be for a person to save for emergencies, spend, or invest.

As we well know, during the boom ending in 2007 many US citizens overextended themselves. In some cases, people were running at debt levels of 50% of more – a completely unsustainable level. Sometimes this was to “get rich quick” by investing in real estate. In other cases it was merely to keep up appearances.

In 2008 - with the collapse of housing and the markets in general - people finally woke up to the dangers of borrowing and started paying off their debts. In some cases, credit was cancelled and they were forced to start paying off debts.

The FOR statistic, as reported by the Fed, is somewhat deceptive. Retired people who tend to have almost no debt whatsoever skew the reported numbers downward. Most people in the U.S. do not actually have a FOR as low as 16%, for example. In reality, the average working person runs at 30% - 45% (even though 40% is the maximum recommended).

The most important thing to know is that free cash flow (spending money) becomes vastly more available as FOR declines. Say, for example, that someone has an income of about $50K, or $4167 per month. If they have a FOR of 45%, they will have approx. $1000 spending money available per month after paying bills and taxes. That's $1000 for groceries, evenings out, vacations, clothes - everything. However, if they pay down their debts to get a FOR of 40%, they will have approx $1210 per month. That's a 21% increase in spending money from a FOR only 5% lower!

Economists - ignoring reality, as usual - refer to the process of people paying off their debts and saving money as “consumer weakness.” The media often laments the currently high US savings rate, saying that it is “bad” for the economy. I could not disagree more. In order to have a long-term, sustainable economic advantage, the US needs to be a creditor nation, whose people use debt wisely and sparingly.

After people started paying off their debts in 2007, dramatic things happened. The national FOR rate for homeowners has dropped from 17.64 to 15.93 – the lowest level since 2002.

Since debts have been paid down and savings increased, credit ratings have consequently improved. The media routinely tells us about the thousands of consumers whose credit has been ruined since the crisis, but they ignore the millions of consumers whose credit has vastly improved. Equifax Inc. (commonly known as “the credit bureau”) reported that as of July 2010, the average credit score of the US consumer rose to 704 – the highest level since 1998.

Once people pay off enough debt to get into the spending zone (15.5% average), they will have enough cash flow to simultaneously spend freely and save. In addition, they will have better credit ratings than at any point in the last decade. It is a pivotal point that will cause the economy to turn around faster than anyone expects.

If current trends continue, this magic 15.5% cash flow level will be reached by the end of 2010.

For additional information, see
The Federal Reserve - household debt
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"Never keep up with the Joneses. Drag them down to your level. It's cheaper."

Quentin Crisp, Raconteur

US Foreclosures – The “Las Vegas Index”

In the past few months, foreclosure rates have climbed.



Under any normal circumstances, an increasing rate of foreclosures would indicate that the housing market and economy are declining/struggling/suffering. But, these are not normal circumstances.

As everyone knows, US banks are sitting on large numbers of properties where the owners have not paid in months. Previously, the banks wanted to foreclose on these properties but could not, since any increase in foreclosures would have only added to the already large glut. The fact that foreclosures are climbing means that banks are actually able to foreclose. Put another way, foreclosure rates are climbing because the economy is improving, and banks are able to sell their foreclosed properties faster than they were several months ago.

To illustrate, I give you The Frost Report’s “Las Vegas Index.” I chose Las Vegas to measure the nation’s real estate health because it is, officially, the worst housing market in America - with the highest percentage of foreclosures and the largest peak-to-trough drop in prices. The Las Vegas Index is simple: it measures the number of detached foreclosures and listed properties available for sale between 0-$1 million USD, with 1 bed and 1 bath or more.



There are two things that are clearly evident by studying this chart. First, non-foreclosed properties are simply not selling. Therefore, many of the existing home sales statistics are, at this point in the economic recovery, essentially meaningless. Foreclosures will have to clear before regular home sales will make any meaningful recovery. Secondly, the number of foreclosures on the market has not increased in recent months, despite a larger number of properties being foreclosed upon: this means they are selling.

The increasing rate of foreclosures is a positive sign, not a negative one, for the US economic recovery. The sooner bad mortgages and loans clear out, the sooner bankers (and citizens) can get on with their lives. The US real estate market, though it has a long way to go, is improving steadily.

PS - If you were ever considering purchasing real estate in Las Vegas, now would be a very, very good time.
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"...the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated."

The Federal Reserve, Aug 10th 2010

Are U.S. Stocks “Cheap?”

Reading the news, one could easily be duped into believing that stock prices accurately reflect the business potential and economic health of a nation. Of course, this is false.



Although stocks do, over the long run, tend to reflect underlying profitability and growth, in the short term stock prices and reality are not even necessarily related.

In the short term, stock prices are largely dependent upon the mood of investors. During times of pessimism, a company's earnings of $1.00 per share may give the stock a value of approx $10-14, or a P/E of 10-14. During times of optimism, the exact same stock with the exact same earnings may be valued at between $17-20, with a P/E of 17-20 or higher.

At present, the DOW 30 Index (thirty of the largest corporations in the US) has a collective P/E ratio of approx 18. Is this cheap? No. Is this expensive? It depends on your expectations.

A P/E ratio of 18 indicates that investors expect the profitability of the companies in the DOW to improve. That is, investors are willing to pay a slight premium over current earnings, with the understanding that earnings in in the near future will be greater.

Yesterday’s selloff was thousands of investors second-guessing their expectation that the US and world economies will improve. If the US economy declines, today’s stock prices are indeed slightly overpriced. If the US economy improves – even modestly – today’s stock prices are perfectly in line: neither overpriced nor underpriced.

Many world markets are set to slow down or even decline, including mainland China, Hong Kong, Taiwan, Canada, Australia, Israel and others – all of which has been well-documented in this blog. Yet, the US market will continue to improve, albeit slowly, because of various factors that I will be covering in detail in the days and weeks to come. The US economy was hit by the crisis first, and it will also be the first to emerge from the crisis, potentially stronger and more competitive that it has been in decades.

The US recovery may stall temporarily, but it is not in jeopardy. But of course I must add this caveat – in the short term, psychology trumps intrinsic value every time. That is, being fairly valued does not mean that prices cannot fall. Since I have no crystal ball, I unfortunately cannot tell you what stocks will do tomorrow.

My advice, as usual, is to buy the stocks of solid companies that are valued as if the present gloom will last forever.

PS – Don’t go looking for bargains in the Nasdaq. Thank you.
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"Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions..."

Benjamin Graham
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Chinese Real Estate - Trip Report

Back from China…

First off, my impressions of the housing market in China - one of my primary reasons for visiting Shanghai.

Virtually everyone I spoke with admitted that the Chinese housing market is “expensive.” Yet, when asked if prices would drop, almost everyone answered with a blunt, “No.” When I inquired further (ex. “Why not?”) I received any one of a number of points exhibiting national or local pride. For example, that Shanghai is “a great place to live. Everyone wants to live here.” Or, that “the Chinese people have an entrepreneurial spirit, and so prices will keep going up.” And of course the real estate bubble classic: “There is a limited amount of space.”

Then I asked the follow-up question: “Are you planning on buying a home?” Only two out of dozens said “Yes.” A few said they already own one. Many added that they would buy “if they had enough money.” Therein lies the problem.

An inexpensive one-bedroom condo in Shanghai costs around $140,000 USD. An inexpensive two-bedroom condo costs around $205,000 USD. At the surface, this does not seem overly expensive; that is, not until one remembers the reality of Chinese prices.

For reference, I had a three-course meal and two beer at a local restaurant for $6 USD. A 30-minute subway ride costs 22 cents. Despite recent prosperity, the average salary in China is 1/7th that of the United States.

So, that one-bedroom condo is equivalent to $980,000 USD, while the two-bedroom is equivalent to $1.44 million. The average Chinese citizen has no hope of buying even a basic home (unless several generations come together to make a purchase), while wealthy Chinese continue to buy multiple homes on speculation. This cannot last.

When I first started writing about the Chinese housing bubble in January, the media was speaking about it as an “if.” Since then, reality has started to set in. The Chinese government is – to their credit – well aware of the situation, and continues to take steps to lessen the coming catastrophe.

Beginning Aug. 31st 2010, insurance companies will no longer be allowed to hold more than 10% of their assets in property development. The government is also instructing banks to tighten (again) the lending requirements for 3rd+ homebuyers in Beijing, Shanghai and Hangzhou. I would list all the bubble-busting measures the government has implemented previously, but it would be a long list.

As the Chinese and related Asian markets unravel, worldwide construction-related commodity prices (iron, coal, copper etc) should decline. In addition, one should obviously avoid Asian banks, development companies, and in fact any company with non-essential products or services that relies on China for a substantial part of its business.

Despite government measures and media warnings, the Chinese housing bubble remains steadfast: greed, pride, and cognitive dissonance are hard to break. But, as soon as the cracks appear, reality will set in with a vengeance. This bubble is BIG.
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See also: Sell the Chinese Market SHORT!
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"China's economy, in general, is in line with the government's macro-economic regulation and control."

Chinese Premier Wen Jiabao, July 18th 2010
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Shanghai Financial District

Shanghai's financial district has everything you might expect - gleaming towers, wide streets, metal detectors & bomb sniffing dogs, fake designer watches, and receptionists in high-heels galore.

Chinese Real Estate - the Time Bomb keeps ticking

Back in April, I recommended selling the Chinese market short, a move which many thought "suicidal." Chinese industrial numbers at the time looked fantastic - and still do. Nonetheless, the Shanghai Composite Index tanked exactly as I suspected, going from 3130 to 2365, a 32% loss (providing a 32% gain for short-sellers) in only two and a half months.

The market has since recovered slightly (to 2560), and the world economic picture looks somewhat brighter. So the question is, should you finish taking profits or keep the short sale going?

Despite drastic government measures, the euphoric mood of the Chinese market appears to have barely subsided. Prices remain stratospheric. Speculation remains rampant. Gleaming condos continue to rise.

A Xinhua news agency article from July 24th (Realty trouble in the offing), recognized that the housing bubble is still out of control, bluntly noting that "skyrocketing housing prices are the outcome of artificial speculation." In addition to calling the market "bloated," it adds that price rises could result in "social conflicts and lead to social unrests."

No, the Chinese meltdown is not over. But, the market fall may take a short hiatus (ie. make a slight recovery) as the world situation temporarily improves. Hopefully not for long, however, since the longer the Chinese euphoria lasts, the more devastating the final fall will be. Be ready to sell short again when the market plateaus.
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This will likely be the last article for the next two weeks, as I am off to Shanghai to find out about the market firsthand.

Thank you for reading The Frost Report.
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Additional reading: Sell the Chinese Market Short
Big realty program to solve house woes
Foreign investors eye China's realty market

Truth or Dare - The Fed vs CNBC

In past articles I have emphasized the importance – no, the necessity – of getting the facts and then forming your own opinions, rather than having your opinions formed for you.

In a hilarious exchange (to me), the Federal Reserve on Wednesday released the minutes of their June 22-23rd meeting, while CNBC simultaneously released a series of articles and commentaries on the same topics as seen in the Fed’s report.

The Frost Report today contrasts the differences between fact and opinion, or, more specifically, the impressions created by a non-emotional source versus the impressions created by a source that is necessarily dependent upon ratings.
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The Fed
“The rise in consumer spending slowed in recent months after a brisk increase in the first quarter….The moderation in spending appeared, on balance, to be aligning the pace of consumption with recent trends in income, wealth, and consumer sentiment. Real disposable personal income moved up at a solid rate in March and April, reflecting increases in employment and hours worked as well as slightly higher real wages, but home values declined in recent months and equity prices moved down since the April meeting. Measures of consumer sentiment improved in May and early June but were still at relatively low levels."

CNBC
Economic Recovery Is Faltering As Shoppers Head to Sidelines
"Even Federal Reserve officials have rolled back their economic outlook for the first time in more than year, saying Wednesday that continued weakness in the job market is hampering growth."
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The Fed
“The anticipated expiration of the homebuyer tax credit appeared to have pulled home sales forward, boosting their level in recent months. Sales of existing single-family homes rose strongly in April, and, although they moved down in May, these sales were still above their level earlier in the year. Purchases of new single-family homes also jumped in April, but then fell steeply in May.”

CNBC
Home Sellers Slashing Prices, While Banks Mow the Lawn
"That heady buzz from the home buyer tax credit is now turning into a grinding headache, as home sellers realize their very temporary, government-induced catbird seat has now fallen back to earth."
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The Fed
"The staff's forecasts for headline and core inflation were also reduced slightly. The changes were a response to the lower prices of oil and other commodities, the appreciation of the dollar, and the greater amount of economic slack in the forecast. Despite these developments, inflation expectations had remained stable, likely limiting movements in inflation."

CNBC
White House Economic Adviser Sees Deflation Risk
"'Yes, it is a risk,' Romer replied when asked during a congressional hearing whether deflation was a risk. Romer also said she did not expect the economy to slip back into recession."
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The Fed
"In sum, the changes to the outlook were viewed as relatively modest and as not warranting policy accommodation beyond that already in place. However, members noted that in addition to continuing to develop and test instruments to exit from the period of unusually accommodative monetary policy, the Committee would need to consider whether further policy stimulus might become appropriate if the outlook were to worsen appreciably."

CNBC
Fed Discussed Steps to Bolster Sputtering Recovery
"Federal Reserve officials cut their forecasts for growth this year and signaled they stood ready to take new steps to keep the recovery alive if the economy takes a turn for the worst."
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Great investors read annual reports (at least the financial sections) before purchasing a stock. They read complex Federal Reserve statements firsthand. They know that in order to be ahead of the game, they need to do the things that average investors do not. When it comes to information, they never take the easy way out. Great investors know that second-hand information results in second-rate decisions.
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Sources used in this article:
Minutes of the Federal Open Market Committee, June 22-23, 2010
Economic Recovery Is Faltering As Shoppers Head to Sidelines
Home Sellers Slashing Prices, While Banks Mow the Lawn
White House Economic Adviser Sees Deflation Risk
Fed Discussed Steps to Bolster Sputtering Recovery
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"I am suspicious of the idea of a new paradigm, to use that word, an entirely new structure of the economy."

Paul Volcker, former chairman of the Federal Reserve