The Deipnosophist

Where the science of investing becomes an art of living

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Location: Summerlin, Nevada, United States

A private investor for 20+ years, I manage private portfolios and write about investing. You can read my market musings on three different sites: 1) The Deipnosophist, dedicated to teaching the market's processes and mechanics; 2) Investment Poetry, a subscription site dedicated to real time investment recommendations; and 3) Seeking Alpha, a combination of the other two sites with a mix of reprints from this site and all-original content. See you here, there, or the other site!

27 July 2007

The Summer of Our Discontent

So the markets have turned down, seemingly suddenly and with ferocity; fortunately, this blog's readers had ample time to prepare their portfolios, if necessary.

Please recall that changes in price levels are merely the memorialization of everything that has occurred in advance and under the surface. The afore-mentioned post represented the initial warning of the changes that were occurring then, and that continue to occur now. The market is a dynamic process, which serves as one reason many investors fail to find sanctuary in its embrace; instead, for them, the market's embrace is in fact a strangle-hold.

I want to be careful, however; this post must not be an I told you so but instead be helpful: what might occur next?, how best to deal with these particular changes?, for how long might they endure?, etc. Which is why I appreciate your public comments: they help me help you.

The first item to seek is support for individual stocks (especially your favorites) -- and then the general markets; because general market measures are averages or indices, they will rise or decline less than most individual stocks. Are your stocks among the market's leaders; i.e., do they decline less than the general markets? When the markets stabilize, do your stocks rebound with alacrity? Whether yes or no, the answers are a crucial tell; always listen to the market's message.

If, as, and when your stocks rebound, do they rebound to easily identifiable upside objectives, exceed those levels, or, shiver, fall shy? Is the subsequent decline shallower than the prior (this) decline? Etc. This series of testing is necessary to heal such a tremendous and ferocious price drop; it becomes what commonly is called a base -- a base obvious to most investors only retrospectively. (My next post will highlight a massive longside opportunity for an entire sector.)

Next, identify your investing time frame, if not already done. Is this decline mere noise within your time frame? If so (and it is mine), do nothing (do not panic!), but be prepared to purchase more shares of your leading opportunities. Moments such as now are what separate the men from the boys, the prepared from the frightened.

As this or any price decline continues, great opportunities become available at price levels that represent sheer value; all that remains is more shakeout albeit at a slackening pace -- and time, more time. But you, the prepared, are ready for that, and more.

The morning brought such a lashing rain
I decided I might as well stay inside
And tackle those jobs that had multiplied
Like an old man's minor aches and pains.
I found a screw for the strikerplate,
Tightened the handle on the bathroom door,
Cleared the drain in the basement floor,
And straightened the hinge for the backyard gate.
Each task had been a nagging distraction,
An itch in the mind, a dangling thread;
Knocking a tiny brass brad on the head,
I felt an insane sense of satisfaction.
Then I heard a great crash in the yard.
The maple had fallen and smashed our car.
-- Barton Sutter

Full Disclosure: Long the 9 Core Opportunities (Apple/AAPL, Chipotle Mexican Grill/CMG, Google/GOOG, Colgate-Palmolive/CL, Intuitive Surgical/ISRG, J Crew/JCG, MasterCard/MA, Research in Motion/RIMM)
-- David M Gordon / The Deipnosophist

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25 July 2007

Keeping things in perspective

The following excellent commentary is by Scott Grannis, Chief Economist at Western Asset Management.
-- David M Gordon / The Deipnosophist
There's been no shortage of bad news recently, with subprime lending problems topping the list, followed by a housing downturn that is almost two years old and which has seen building permits plunge 35% with no end yet in sight. Subprime losses may eventual total in the hundreds of billions of dollars, and spreads have widened significantly even for the highest-rated subprime tranches. Housing prices have only just begun to fall. The level of financial stress in the system is perhaps best summed up by the 10-year swap spread, which has now reached levels that are reminiscent of the Russia/LTCM crisis in 1998.

[click on each chart to enlarge]

But not all is doom and gloom. The economy has proved fairly resilient so far, as evidenced by low and stable weekly unemployment claims and double-digit growth in federal tax revenues. Second quarter growth was almost certainly much stronger than the first quarter's anemic 0.6% pace, and stock prices continue to move broadly higher all over the world, bolstered in no small part by record-setting profits. Industrial commodity prices are making new highs across the board, European and Japanese growth has accelerated, and Asia is booming. Real interest rates are not particularly high anywhere in the world. Although energy prices are elevated, they are no higher in real terms than they were in the early 1980s, when it took twice as much oil to produce a unit of output as it does today. It's hard to see the U.S. economy going into a recession with this sort of backdrop. I'm reminded of how the 9/11 terrorist attacks coincided almost to the day to the end of the relatively mild 2001 recession. It takes a lot to bring the U.S. economy to its knees.

What's disturbing about recent developments in the bond market is that spreads of all stripes are wider. Only the most prudent of investors (e.g., those investing only in Treasuries) have escaped the subprime debacle unscathed. Does this presage a widespread contagion of subprime problems to the financial market and the economy in general? A quick check of low-quality spreads shows they too have widened, but not by much when viewed from an historical perspective. Emerging market spreads blew out to 1600 bps in the wake of the Russia/LTCM crisis, but today they are less than 200 bps. BBB-rated subprime loans are the only securities trading with four-digit spreads today.

With all the widening of spreads and the gyrating of interest rates, it's not surprising that actual and implied volatility in the bond market have shot up. But here again, from an historical perspective the current level of volatility is still generally low. Indeed, the only time that bond volatility was lower than it is today was in the months leading up to the Russia/LTCM crisis. Low volatility is a sign of complacency and conducive to leverage, which then exposes those who have levered up to unexpected risks. That's a painful lesson that some bond investors have yet to learn.

Although conditions in the financial markets are certainly stressed, it's likely the case that the damage will be relatively contained. Potential losses in subprime lending could eventually register in the hundreds of billions, but would not likely exceed 1% of the $35 trillion liquid global bond market. Moreover, those losses have already been eclipsed by the rise in equity market valuation year to date. Wider swap spreads might thus be telling us that there is a relatively small group of investors who are trying very hard to reduce their risk exposure and/or leverage. For example, CDOs that loaded up on subprime mortgage paper are facing big losses and are being forced to hedge and/or close out their positions. The market's appetite for risk has been falling all year but has really plunged in the past month or so. The subprime crisis appears to be the trigger, but things have been complicated by the sudden rise in volatility and the recent rise in interest rates, both of which fueled a lot of hedging from mortgage investors. Financial institutions around the world are scrambling, especially those with significant exposure to subprime, since no one wants to be caught with their fingers in this poisoned pie. It's a classic rush for the exits.

But already we see that 10-year Treasury yields have dropped 40 bps from their June highs, and volatility also is lower today than June highs. And while some home owners are getting squeezed by the subprime lending fiasco, small businesses have seen a huge improvement in their ability to raise funds: non-financial commercial paper has doubled since early 2004, and commercial and industrial loans are up over 40%. Similarly, nonresidential construction has picked up almost all of the slack to date that has been generated by the residential construction market. Asset markets can undergo huge repricings (e.g., the 1987 stock market collapse) without meaningful consequences for the economy.

Of course, even though subprime losses will likely be only a drop in the bucket of global liquidity, the market requires some time to digest everything. No one walks away from losses of this magnitude without putting up a fight, and we probably haven't seen all of the bankruptcies that are likely to occur.

On another front, the weak dollar is nearing levels that begin to raise warning flags. On a nominal basis it's as weak as it's ever been. On an inflation adjusted basis it's been weaker, so the sky is not yet falling. But it's worth noting that with the dollar undeniably weak and falling, Fed Chairman Bernanke's Humphrey-Hawkins testimony the other day did not contain a single mention of the word "dollar." Indeed, Bernanke has not referenced the value of the dollar in any of his speeches or testimony so far this year, and neither have the other Fed governors. The last time Bernanke referenced the value of the dollar was in a speech last December, when he noted that the dollar's weakness presented a problem to the Chinese economy that could be solved by a revaluation of its currency. That's a roundabout way of endorsing a weaker dollar. Treasury has also been conspicuous by its absence on the subject of the dollar this year. The last time Secretary Paulson mentioned the dollar (August of last year), the best he could muster was "a strong dollar is in our nation's interest," but he qualified that by noting that the dollar's value was determined by market forces. If this isn't benign neglect I don't know what it is.

The dollar is beset by some powerful negatives to be sure: Benign neglect on the part of the Fed and Treasury, an economy that is underperforming most of Europe and Asia, and a subprime lending panic that seemingly strips the Fed of any ability to raise rates in its defense. A Democratic-controlled Congress is pushing hard for a meaningful increase in taxes on income and capital gains, at a time when tax competition is resulting in lower and flatter taxes across new and old Europe. Protectionist sentiment on both sides of the aisle is steadily rising, with potentially negative consequences for the economy and world trade in general.

With the dollar falling and risk levels rising, it's not surprising that gold is rising. In real terms it's not yet at the extremes we saw as inflation spiraled up to double-digit levels in the late 1970s, but it is significantly higher today than its average of the past 30 years.

Commodities are making new highs almost every day (with the notable exception of gasoline prices which are falling), but most of the rise in the past year is due to the weakness of the dollar. For example, commodity prices are relatively unchanged since early 2006 when measured in Australian dollars, euros, or sterling. In inflation-adjusted dollar terms, spot commodities today are still less expensive than they were in 1970.

The dollar's gyrations don't mean much to the man on the street, and it's tough to find a significant statistical link between the dollar's value and the rate of U.S. inflation. But it's probably true that the dollar can't fall a whole lot more without posing some serious problems. The world's demand for dollars is weak and falling, and the Fed has not taken sufficient steps to shrink the supply of dollars. The good news is that there is no apparent shortage of dollar liquidity in the world, so that should help us get through the subprime and housing problems. But the bad news is that an excess of dollars may eventually contribute to higher U.S. inflation. Consider: if the rest of the world wants to reduce its holdings of dollar bonds and deposits, those dollars must be spent on goods, services, or other tangible assets in the U.S. economy. This would mean a rise in money velocity and that in turn could fuel a rise in the general price level.

But for all the dollar's problems, a fix is hardly elusive. With the budget deficit on track to reach zero as early as next year, Congress may find it difficult to justify higher taxes. (Corollary: even if central banks' demand for Treasuries is collapsing, so too is the supply of Treasuries.) For its part, the Fed wouldn't need to do much to increase its non-existent support of the dollar. And if housing merely declines at a slower pace, the drag on the economy will ease.

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20 July 2007

Hitting the barn door

How could Google/GOOG miss its earnings forecasts by such a wide margin...? And what about the stock...? First (via Seeking Alpha),

"Google shares were down 8% in pre-opening trading, after the company said second-quarter earnings fell just short of analyst estimates, while profit margins missed expectations by over four basis points. Net income jumped over 28% to $925.1 million ($2.93/share), up from $721.1 million ($2.33) a year ago, while revenue surged 63% to $2.72 billion. Excluding stock options costs EPS were $3.56, shy of analyst consensus estimates of $3.59/share, while revenues were slightly ahead of analyst calls of $2.68 billion. In a note to clients, Citigroup analyst Mark Mahaney said Google's negative margin trends were the key issue. Pro-forma operating income was about $1.35 billion (50% margin) vs. estimates of $1.45B (54.4%). Year-over-year, its margins have dropped five basis points. In 10 of its 11 previous quarters as a publicly-traded company, Google has beaten estimates."
The truth is that Google missed expectations by a 'whopping' 3¢/share -- more if you factor in the whisper numbers; in either case, not a wide margin (3¢ on $3.50!) for a company whose earnings and revenue numbers (and growth) are this massive. Too, Google delivered 2Q07 revenue growth above expectations; however, this was offset by much higher spending on employment gains and change in bonus accrual, which could have cost $0.10-0.15 in earnings/share.

But what of the stock? This seemingly substantial price decline in reaction to the earnings news is how it goes for growth stocks, the great ones included; this type of occurrence can be expected. (And was.)
After trading down by more than $45 (to ~$502), the shares quietly rebound to a last trade of ~$515, as investors recognize this decline to be a buying opportunity for those with a long term horizon. I know that I, too, will purchase more shares at a safe harbor price. I will do so because at $500/share (rounded down) and including yesterday's reported earnings, the stock sells at 26x earnings; an incredibly cheap price and value that will not linger for long. Although I am loathe to place a time frame on it, my guess would be that by the time of the Q3 report, certainly the Q4 report, Google/GOOG will again be stretching its grasp into new high territory.

Full Disclosure: Long the shares of Google/GOOG, and about to get more long.
-- David M Gordon / The Deipnosophist

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14 July 2007

Incredible shrinking deficit (cont.) + Retail sales growth quite modest

The following commentary is by Scott Grannis, Chief Economist at Western Asset Management.
-- David M Gordon / The Deipnosophist
Incredible shrinking deficit (cont.)

[President] Bush needs a better PR person, because the budget numbers are way better than the projections released yesterday in the Administration's midsession budget review. The review predicts the current fiscal year deficit will fall to $205 billion by September, but as of June 30 it had already fallen to $120 billion, a mere 0.9% of GDP! If recent trends continue, the deficit could reach zero within a year. Maybe they want keep the good news for later in the election cycle, or maybe they are just making some extremely conservative assumptions for the next three months. Whatever the case, it's one more example of how optimism is in short supply these days.

The good news is that federal tax revenues continue to flood in at a pace that is substantially faster than the growth of the economy, as they have since tax rates were cut three years ago. Jobs may be growing at a meager pace, but incomes, corporate profits, and capital gains remain strong across the board. There's even more good news: despite Bush's reputation as a spendthrift unable to wield his veto pen, government spending has grown at the same pace as the economy for the past four years, despite the ongoing Iraq war expenditures. And believe it or not, spending grew by only 2.7% in the 12 months ended June!

till more good news came out today as we learned that U.S. exports of goods and services in May continued to grow at the double-digit pace which has prevailed since late 2003, driven by a robust global economy and a weaker dollar. Import growth, not surprisingly, has slowed over the past year due to the weaker economy. Housing is still the principal drag on growth, but net exports have now become a key source of strength.

Returning to the jobs market, it's comforting that the 4-week moving average of weekly claims for unemployment is the same today as it was almost two years ago. The housing market is still in trouble, but life goes on. Supply-side logic says that falling home prices and a drying up of mortgage equity withdrawal (MEW) aren't really the economy killers that they are made out to be. MEW may enable some households to finance extra spending, but the money has to come from someone else's pocket, so it doesn't really represent any addition to the size of the economy. Even if falling home prices caused MEW to go to zero, the economy could still grow as long as jobs didn't start to disappear. (If spending could make the economy grow, we could spend our way to prosperity, as Art Laffer wryly notes.) In the end, the economy only grows if we work more. Claims, tax revenues and corporate profits tell us that more and more people are working productively, and that's what really counts.

Retail sales growth quite modest

Retail sales have not been very strong for the past year, and June was no exception. The year over year growth in inflation-adjusted retail sales is about as weak as it has been for a long time. Does this point toward a recession? Not necessarily.

So many things were different the last time that retail sales slumped (2000-2001) that it's hard to know where to begin. Back then the Fed was very tight, the dollar was rising, inflation was falling, gold and commodity prices were collapsing, spreads were on the moon, corporate profits had been declining for several years, and weekly unemployment claims were high and rising. All those developments reflected stress in the system, if not an outright liquidity shortage. Today there are few signs of stress or liquidity shortages. The Fed is not tight, the dollar is at the very low end of its historical range, inflation has been trending slowly up for the past 4 years, gold and commodity prices are rising, spreads are generally well-behaved (though I would note that 10-yr swap spreads at 65 bps do reflect some degree of stress, likely related to subprime mortgage and MBS-related hedging), corporate profits are at record-high levels, and unemployment claims are low and stable. About the only thing that's ominous today is the housing market, since it is clearly weak now, while back then it was going gangbusters.

It's just my opinion, but I think the overall picture is not very grim, and I'm encouraged by the ongoing strength in the global economy. It's hard to see a recession coming, but it's equally hard to see a boom. The thing I worry most about is the Democrats' relentless urge to raise taxes on the most productive sectors of the economy. Isn't there anyone in the Republican ranks who can point out that the deficit has all but disappeared and the last thing the economy needs at this point is higher taxes?


11 July 2007

Google's continuum

Does it ever seem to you - it does me - that the Wall of Worry can often be a tiresome climb? I know that as Google/GOOG climbs ever higher in price, news stories of this type proliferate...
reports that Nielsen/NetRatings has changed the way it rates Web sites and in the process has upended the rankings of the top online destinations, vaulting AOL (TWX) and Yahoo (YHOO) over rival Google (GOOG). The research service announced yesterday it would measure popularity by how long users linger on sites, not by how many pages they view, a move that could affect how online advertising works. Making the biggest leap, AOL moved to the No. 1 U.S. site, logging 25 bln minutes, according to Nielsen's May data. If ranked by Web page views, AOL would be No. 6. GOOG dropped to fifth from third by page view ranking by minutes of use, at about 7 billion minutes. Jennifer Simpson, a senior analyst for Yankee Group, said the new rankings may prompt advertisers to change they way they present and place ads. It could also hurt search engines like GOOG that generally serve as pit stops for users looking for something else.

Which causes some bulls to worry. Peter Kafka, writing on Henry Blodgett's website, however, showers disrespect on this news, and I agree. Note that Google/GOOG's march to higher highs continues...

[click on chart to enlarge]

Despite the arguments and wails and whines of the many investors not long the shares, Google/GOOG's move to higher prices is resolute. The trend line delineates Google/GOOG's trend, yes, but also its trajectory and its continuum. Please recall that I last recommended purchase ~$100/share lower than its current price based on its then-proximity to that trend line; I argued then that it represented value on a fundamental and valuation basis, but also on the chart. Which means that purchases made on that upward trending line (here comes a secret, sshh!) are safe, as even should the stock breach the line and begin a correction or, shudder, a bear market, there will come a test of former support (the upward rising trend line) which assures a profitable exit before lower prices set in. So why the need to worry?

Next up, is Google's Q2 2007 earnings report due Thursday the 19th...

Google/GOOG announced that it will hold its quarterly conference call to discuss second quarter 2007 financial results on Thursday, July 19, 2007 at 1:30 p.m. Pacific Time (4:30 p.m. Eastern Time). The live webcast of Google's earnings conference call can be accessed at The webcast version of the conference call will be available through the same link following the conference call. reports that the brokerage firm of Thomas Weisel previews GOOG Q2 earnings (set for 7/19), saying GOOG continues to take search market share and extend its lead in monetization innovations and improvements in 2Q. Given the stock has performed well in 2Q07, up 14% compared with the S&P that was up 6% during the same time period, firm believes investors are beginning to look at emerging categories of revenue growth including mobile, display and video. Firm expects $2.69 bln in 2Q07 net rev (up 6.0% q/q and up 61.1% y/y) compared with First Call, which is expecting $2.67 bln (up 5.3% q/q and up 59.9% y/y). The firm expects currency could add nearly $123 mln in gross revs in 2Q and provide 7.2% lift to Google's international operations on a y/y basis. Despite these industry-leading expectations (they expect Yahoo!'s (YHOO) net search rev should be up 5.2% y/y), they believe investors continue to look toward new avenues of growth at GOOG. Firm likes YouTube's upside potential in terms of rev, suggesting that should GOOG begin to advertise in-stream, the co could reasonably start to see $500 mln a quarter in ad rev.


Oppenheimer notes GOOG reports on Thursday, July 19, after market close. Thefirm is estimating net rev of $2.69 bln, EBITDA of $1.69 bln and pro forma EPSof $3.63 vs. Street at $2.67 bln, $1.66 bln and $3.58 in rev, EBITDA and proforma EPS, respectively. Firm's net rev est for June quarter implies Q/Qgrowth of 6% vs. Street at 5%. Firm thinks GOOG's ability to come outunscathed post MSFT's launch of Vista and YHOO's launch of Panama muted therisk perception of the likelihood of Google losing market share in search, contributing to the upsurge of stock price in the last three months. Firm'sabove-Street 07 est reflects positive view to generate rev from Videoadvertising, to continue to improve search monetization, and to gain marketshare in search queries.

Full Disclosure: Long the shares of Google/GOOG.
-- David M Gordon / The Deipnosophist

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Photos from an exhausting week

The web album might be mine, but new friend, Mike Zaczek, snapped the photos. Mike is the fellow with the burgundy-colored shirt to my left.

I want to call attention as well to new friends, Ryan Michaels (in front of me), an excellent musician whose music I hope to share here soon, and Mauri Pioppo (behind my left shoulder), who creates stunning jewelry among her many positive attributes. (Permanent link in the sidebar under "Friends.")

A week in Hell... er, the Ashram!

It was a trying week, yes, but worth every moment. Note our smiling faces.
-- David M Gordon / The Deipnosophist


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