Putting the pieces together...

Hussman Revisited & what and When to Buy

John Hussman is an economist and fund adviser I have featured here before.  I agree with Hussman on most of what he writes, including his post today on long term stock Price/Earnings (P/E) ratios. Hussman writes very clearly and explains market economics in terms we can all grasp and understand. And he writes often enough that one can get to know his approach very well, compared to many epic mutual fund gurus who rarely convey information to retail investors, and if they do, only do so very cryptically.  Like most stock market-centric people---that is, about 98% of the entire investment community, which includes small private investors as well--Hussman is what I describe as generic stock-centric, which is short hand, and not meant at all in a perjorative manner, as it is a classic and quite legitimate preoccupation.

Hussman's universe consists of stocks divided into normally convenient capitalization sectors. He prefers mid cap US stocks as they are, or have been, likely to give larger gains over time than large caps do. I do think I once saw a foreign stock in his HSGFX: a Korean utility, I believe. I might have missed some others. But even if he covered and routinely invested in foreign stocks, my appraisal of him as a sectoral or generic stock-centric analyst would stand. He does avoid some industry sub-sectors and he favors others from time to time, but generally he sticks to his universe and looks for the best value candidates within it to own at all times, hedging with broader stock index futures (SPX and RUT) and/or options. This can, and did, work quite well in bear markets, as from 2000-2002 when value stocks (the longs) outperformed the generic stocks (the hedged ones). Value stocks had been undervalued relatively after 1997. Hussman also says, quite consistently and believably, that under conditions of longer term undervaluation (low P/E's and other measures), he could and would be largely net long (unhedged in his case).

As Hussman shows, the generic stock-centric universe has undeniably under-performed T Bills on a total return basis over what will be the past ten years as of July 2008. However, Hussman's own largely hedged Hussman Strategic Growth Fund (HSGFX) has itself under performed Vanguard's Prime Money Market Fund over the past four years ( see chart). Also we know that, when adjusted for inflation and US dollar depreciation over the past five years, the US generic stock-centric universe at large has actually lost money. I want to point out that Hussman's approach to income vehicles in his other fund, Hussman Strategic Total Return (HSTRX), which I own and have discussed, is pleasantly different in its returns.

One problem with exclusive attention to the generic stock-centric universe is that the long term generic stock Price/Earnings Ratio cycle is not always synchronized with the long term inflation/deflation cycle. In fact there is sometimes a humorous disconnect in generic stock-centric people, who readily believe in the seemingly esoteric but easily understood long term P/E Cycle but who often deny even the possibility of a Long Term Economic Cycle as nonsense or perhaps mythical. Oddly, no one argues about the causation of the P/E cycle, but it's usually all that is asked about when the Long Term Supply & Demand Economic Cycle comes up for discussion. In truth, the long term supply and demand cycle causation is much more understandable than the P/E cycle.
 
The long term supply/demand cycle for the crude goods, consumer goods, and the credit economy, often discussed at this blog, exists and is prolonged in time because of the long lead and lag times required to observe, diagnose, plan, finance, build, equip, and roll out new supply and its transport and/or storage to meet increased demand.*(see below) And there is a similarly long period of time during which demand and prices fall before the older supply chain becomes exhausted (for stockpiles), and  physically  deteriorates or otherwise becomes inadequate (for infra-structure) for the then current demand. We saw the peak of the demand half cycle in the 1970's--when over-supply was finally achieved due to over-investment in commodities and much else--and then we saw the  nadir of the supply half cycle in the late 1990's and early 2000's when supply had finally run down below demand due to chronic under-investment caused by falling prices. What could be simpler to understand?

Why is this important to us? Partly because P/E cycle reversals in generic stocks do not often synchronize with supply/demand cycle reversals. When the stock market starts up from depressed P/E levels, it's best to own good candidates in the generic stock-centric universe. 1949 was an excellent time. 1982 was an excellent time. Even 2002/3 was a good time. One didn't even need to be very selective intitally at times like those as all ships rose in the undervalued tides when they reversed. But when P/E's are into historically high ends of the cycle, it is better to look at stocks (and/or some bonds) which benefit from the asynchronous Inflation/Deflation Cycle. Even though 2002/3 was a decent time to buy generic stocks, even by Hussman's standards, and generic stocks have doubled, on average, it wasn't a great time since P/E's (based upon peak earnings) were 15 rather than being preferably under 10. 

One would do, and many did do, much better by buying stocks or other vehicles with the exposure to benefit from rising inflation and inflation growth rather than buying into the generic stock-centric universe in 2002/2003. So we buy generic stocks when P/E's are very low, as close in time and price to the price lows as we can, since they nearly all rise for quite a long time. And we buy inflation-favored or other vehicles with similar attributes when market lows occur and when P/E's are then relatively historically high at these important market lows.

At such lows, as in 2002/2003, generic stocks were OK, but one needed to buy stocks which benefit from higher commodity prices: selected mining companies, agricultural companies, and energy producers. Also gold bullion coins and direct commodity funds which are now widely available, as I have detailed on this blog. Also one then bought stocks in nations which are massive commodity producers and exporters, whose economies are geared to rising commodity prices: Canada, Russia, South Africa, Australia, and Chile come quickly to mind. Then one looks at stocks in rapidly developing nations, particularly in their infra-structure stocks and their own commodity-favored stocks. Infra-structure is favored during this long term expansion phase. Since interest rates will also be rising at some point in the inflation half cycle, financial stocks such as banks should be avoided except perhaps in commodity-favored nations. Also bonds are not favored except for income generation at the very short end of the duration curve: 1-3 year maturities. There are some exceptions at such times to a "no long bond" portfolio, such as high yield corporate bonds and high yield bonds of developing nations. Their credit ratings will be rising and hence the interest rates will be falling with economic improvement, and their bonds will go up. Such bonds are in effect "quasi-stocks".

As we saw, the generic stock-centric universe hasn't outperformed US T Bills for nearly ten years, nor has it since the 2002/2003 lows. But inflation-favored stocks, as outlined here, have far out performed: many commodity and developing world stocks have risen ten fold or more since 2002/2003.

Close readers will have  noticed that I've left out one  possible investment point in the stock-centric P/E and Inflation/Deflation cycles matrix, namely what to buy when generic stocks sport very low P/E's and commodity prices are very high? Obviously, as discussed above, buying generic stocks makes sense then, but this will also generally be when interest rates are high, so longer term bonds make sense as well. Instances like these occur only about twice per century, 1932/33 and 1981/2 being the last such cycle intersection points. After such points both bonds and stocks do well for long periods of times since both are then "undervalued" in terms of P/E ratio and interest rate.

What do we do right now? As Hussman points out, both generic stocks and generic bonds are now expensive or over-valued in terms of P/E's and interest rate coupons. We know that historically it's going to be a relatively long time before either or both return to good value points with low P/E's which will start to rise and with high interest rates which which will then be about about to start declining. At this time, commodity prices and developing nation stocks have been rising for 5-8 years, depending upon which commodity and which nations. They are still the place to be, but we have to be more selective and judicious now in buying abroad. If you have exited or cut back on generic stocks and bonds, as I have over the past year, you want to keep those inflation-favored stocks or funds you may already have: energy funds, natural resource funds, gold funds, and direct commodity funds. If your allocations to these are slight to nil, you may want to buy into such funds on a small basis now, or whenever you are ready, and add to positions on pullbacks. They will likely have ten or more years yet of continued bull markets. Naturally nothing goes up every day or month, but the shortages of many commodities and the current rather low interest rates support continued commodity inflation for quite a long time.

With commodity funds, which I like, one avoids many of the stock selection hurdles such as inflation of costs or shortages of utilities now plaguing some commodity industry sectors and nations. Also many of the developing market nations have not been severely tested in terms of business law and accounting adequacy or scandals as in developed nations. And we are seeing creeping nationalizations or squeeze outs of commodity producers by some grasping sovereign governments. Investing in the product rather than the producertherefore has a real place in current portfolios.

The key point of this post is that when people say that the stock market is "over-valued or due for a fall", ask which "stock market" are they talking about? As a rule they are talking about the generic stock-centric universe of US and foreign developed nations. As Hussman makes clear for the current case, over-valued generic stocks may under perform for years as the P/E cycle unwinds and reverts to long term undervaluation. Right now, and for some time to come, that should not be true with commodities and with stocks that benefit from inflation.

As always, bear in mind that I am not an investment advisor and invest only for myself and for family members. I am connected in NO way to the investment industry or any corporation in any way except as an owner of exchange-listed stocks and funds or mutual funds. My writings are my own analysis except where referenced to others, and conclusions are simply my own amateur opinions.

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*Just as I finished writing this today, I, along with two million other people, received an email from John Mauldin which elucidates perfectly what I described for the supply catch up phase for the price discovery to new production pathway for commodity producers--in this case gold miners--after demand picks up. This is by David Galland of Casey Research, Doug Casey's firm:

"Consider: as recently as the year 2002, gold was still trading near $280. Against that number was a cash cost of around $250 per ounce for a typical company. That cost figure is about as low as the number could go, and it was the response of an industry beaten down and huddling in a trench.

"Caution lingers after the reason for it has gone. As gold began its upward move in 2002, it did so against the backdrop of an industry still in mothballs and still run by managers whose primary skills were cost cutting and frugality. This is important on a number of fronts.

"1) Having been trained in the acid bath of razor-thin margins, management was intensely skeptical about gold's rally. They suspected it might be just another bear market trap, ready to punish unwary optimists who parted with cash to ramp up production.

"2) In the hunkered-down years, miners focused on the higher-grade, easy-to-mine material that gave them the best shot at turning a profit, however small that might be. And being in survival mode, they were extremely cautious about buying new equipment or maintaining a large workforce. Employee rosters were reduced to the bare minimum.

"3) Because staying in business was such an urgent goal, they were willing, even eager, to sell future production at a set price -- a perfectly rational strategy in a bear market, because it at least assured they would receive a price that covered the known costs.

"With all these factors taken together, it's easy to understand why the industry was slow to respond when gold started rising. In fact, it was only in February 2003, with gold trending over $350, that Barrick Gold Corp., the world's largest gold miner, began the expensive process of unwinding its hedges. And it wasn't until November of that year that the company announced it would stop forward selling altogether and would eliminate its entire hedge book.

"Once the turning point came - when management finally realized the bull market was for real -- the industry began to scramble to catch up. Which, in a choo-choo industry like mining, means hiring and training lots of people, buying or refurbishing the equipment needed to reestablish production on second-tier deposits, upgrading facilities, building expensive new mills, etc., etc. And, of course, dealing with the challenge and expense of unwinding hundreds of millions of dollars worth of forward hedge contracts.

"The rebuilding of the gold mining industry, in short, really only began in earnest over the past few years.

"The Ugly Duckling Years

"As would be expected, the costs associated with rebuilding the industry sent big hits to the bottom line, resulting in the kind of ugly financial metrics that repel institutional investors.

"The metrics were not at all helped by the shift away from high-grade ore, because the lower the grade, the more the material you have to dig, hoist, haul and process, meaning increased production costs. In addition, the industry rebuild occurred against a backdrop of generally rising inflation and a falling dollar, which helped push the cash cost of production up by more than double from the mothball years, keeping the miners unattractive as investments.

"By contrast, the base metals companies, which had hit bottom earlier, near the end of 1998, had already emerged from the mothball stage, thanks to increasing demand from China and elsewhere. They were, as a result, well on the road to recovery when the big price increases for base metals kicked off in 2004. So, while the gold miners have been widely shunned as ugly ducklings in recent times, the base metals sector has been enjoying salad days, reflected in multi-billion mergers and acquisitions and, of course, sharply higher share prices.

"The Golden Years

"Here at Casey Research, we are of the firm opinion that, now that the biggest costs related to restarting their industry are behind them, the big gold companies are poised to take off. The proof should come in rapidly improving margins which, lo and behold, we have begun to see in the quarterly reports now being released......"   

See here for John Mauldin's direct version of this post by Galland and reference url's therein for Casey Research.

http://www.investorsinsight.com/otb_va_print.aspx?EditionID=657

Commodity Funds: Some Tax and Selection Issues

Needless to say, commodity funds of all kinds have been doing well recently. The weekly chart of DBC shows the general commodity market over the past two years, represented by crude and heating oil, gold and aluminum, wheat and corn. Until August 2007  there was a flat consolidation range after the rises into 2005/2006. Then with the central bank lowering of interest rates, and with strong suggestions from them of further reductions, both the hopes of avoiding deep recession, and the fears (or bets on) further inflation. led to upside breakouts in many broadly-based liquid commodity markets.

This year I have posted two articles on some of the commodity funds available to ETF and ETN stock and to mutual fund investors: January 27, 2008  and February 10, 2008. In the more recent article I showed a chart which was forwarded to me and whose origins I do not know. It lays out the sector weightings of the major US commodity Indexes which are often used as benchmarks and actual allocations by ETF. These indexes are key to choosing one's own preferred commodity exposure. Commodity Index Allocations

I've explained my own biases, or preferences before: in tax-deferred accounts (IRA's and 401k's in the US) there is little to be gained by putting funds in which generate no income. With tax-deferred accounts everything coming out eventually will be taxed at ordinary income tax rates of up to 35% and tax rates are virtually certain to rise in 2009/2010. With commodities we are primarily looking for  capital appreciation, not income. So commodity funds which give you only capital appreciation should be in taxable accounts, in my personal opinion.

For commodity exposure inside tax-deferred accounts I am using two mutual funds I have discussed in the January and February posts above: HSTRX (Hussman Strategic Total Return) and PCRIX (Pimco Commodity Real Return). Both use US TIPs as their income-yielding base. HSTRX gets an exposure to gold (and some minor exposure to other metals) through trading gold stocks around a basic allocation of approximately 15%. PCRIX (or PCRDX with lower minimums) overlays its TIPs with a commodity-linked note tied to the Dow Jone-AIG Index, a broad-based index based on US commodities and three London metals (see the allocation gif).  Both of these funds paid dividends over 5% last year and the TIPs of course are adjusted for US CPI inflation. Since TIPs taxation can be an extra issue in taxable funds, I prefer to avoid it by carrying funds with TIPs in tax deferred accounts. So for PCRIX and HSTRX (I own both) I like them for my tax-deferred funds and they give commodity/gold exposure with an income kicker.

For taxable accounts I prefer the commodity exposure with  potentially the lowest capital gains exposure and little if any income exposure. In my view the worst funds for this scenario are the gold and silver ETFs which actually hold bullion: GLD, SLV, and CEF (Canadian) and other physical holders of commodities (gold). First of all they do not permit you to convert your shares to gold (or other  holdings) unless you convert very large amounts (see individual prospecti for limits and fees), so in owning them you do not really own the gold, only share certificates for that gold which you can sell or buy. So these ETF's are in effect "derivatives" in a generic sense. However, the IRS regards their holdings as "collectibles" whose gains are taxed at a flat rate of 28% even if you were in a 10-25% normal Federal income tax bracket. So I can see no advantages to owning them either inside or outside a tax-deferred account.

CEF has another disadvantage in that it can and may be deemed by the US IRS  to be a "passive foreign trust". That designation requires you to file a "special election"  form with the US IRS, with your first annual return after purchase of CEF (and its all gold sibling GTU), on which of two possible tax statuses you wish to adopt  with regard to passive foreign trusts. Then too, CEF holds physical gold and silver which you cannot get in redemption, as with SLD, SYL and others, and you will be subject to Canadian taxes as well. If you own enough of it to make having an accountant and possibly a tax lawyer's time be worth while on these issues, these funds may be feasible holdings. But I'll skip them. If I want physical gold, I buy physical gold.

Since those funds are in fact derivatives and not your own segregated gold or silver, why not use real exchange-traded regulated derivatives in an unleveraged manner? I'm talking about unleveraged US futures contracts which are taxed at a much more favorable US tax rate. With futures, all capital gains, no matter whether a day trader or of a long term investor are taxed such that 60% of any gains are considered long term and 40% short term. With current long term rates of 10-15% and maximum short rates of  33-35%, you come out far ahead with futures-based derivatives rather than with collectible ETF derivatives. As an example, on $200,000 taxable joint filing income, collectibles gains would be taxed at a flat 28% rate while futures gains would be taxed at 18.04% , a sizable difference! Keep in  mind, as always, that I am not a tax adviser, and this discussion is just my amateur tax payer opinion. Do the math yourself, or ask your own tax accountant and/or tax attorney. Also I am not a licensed investment adviser, just an amateur investor of my own family's accounts, so none of this should be considered as advice, merely my own analysis for my own sake.

There are several ETF's which do invest in commodity futures in an unleveraged manner. They deposit their dollar assets as US T Bills (or similar money market instruments) and buy commodity futures contracts whose values are not to exceed the face value of the contract. ZERO leverage. I have looked at the iShares DB funds:

DBC (gold, aluminum, crude and heating oil, corn and wheat); DBE (light sweet WTI and Brent crude oil, RBOB gasoline, and natural gas); DBO (light sweet WTI crude oil only); DBP (gold 80%/silver 20%); DGL (gold); DBS (silver); DBB (aluminum, zinc, copper);  and DBA (corn, wheat, soybeans and sugar). These may fit a niche need for some portfolios or work as good trading vehicles. I do not own any of these funds but DBC does track the large commodity universe quite well. DB's futures traders have a long and admired history, so managing indexed and re-balanced portfolios is like falling out of bed for them. The volumes of their trading should/could result in lower than average commissions and other transaction costs.

My favorite to date in the tax-favored, futures-based a category is Greenhaven Continuous Commodity Index Fund (GCC). The CCI is a previous incarnation of the famous CRB Index and has 17  US-traded commodity futures in it with equal weighting for each. So crude oil and cocoa are equally weighted. In a long term commodity bull market, which I believe we are in, every commodity will have its day in the sun, and I want to be there and own them all. Volatility should also be lower in a fund with 17 equally-weighted holdings than with two to six commodities. So I will feel safer carrying a larger position in this rather than an energy or metals heavy fund. This fund is new and is the only listed fund of its management. But they have led public commodity pools for a long time.

As a former commodity futures trader for decades I feel cvery omfortable with the commodity futures, with the US futures exchanges, with their clearing houses, and with CFTC and SEC regulation. US futures have been around for 150 years and have a splendid record of safety and regulatory excellence. And with  zero leverage I feel these are safe for me with modest amounts in order to hedge against inflation and achieve additional diversification in a complete portfolio. I own this fund, and made my first purchase on their third day of existence.  As always let me assure you that I have no other connection with these people or any of the others of any funds. I am totally and only a private investor with no personal or family ties to the investment industry. These are simply my own opinions which may be of interest.

There are a number of other commodity funds not covered here as I haven't looked at them as deeply, so leaving them out does not necessarily imply I find them wanting, and I might include some of them in future . 

   

Peak Oil or Freak Oil?

There is a raging bull market in "peak oil" websites and books. Four recent books on the subject, and the obligatory darkening days ahead, grace the "Life After the Oil Crash" front page along with do-it-yourself solar equipment, dried foods and how to build an atomic shelter in your home. We are led to believe this is all essential stuff for '08 and beyond.

I've read a lot about the coming oil shortages for the past 50 years. Shortages and exhaustions are phenomena that engineers or accountants can measure, and they have: discovery rates, flow rates, inventories, and a heavy overlay of dubious but always bearish assumptions lead to exhaustion. My grandfather used to laugh about predictions of running out of oil that he heard in the 1920's, an observation which always elicits wan but knowing smiles of disdain when related to engineers and modern analysts.

The assumptions for peak oil are that oil in the earth is of a finite amount from "creation" forward; that all very large oil fields have already found; and that producers are producing as fast as can be done. On the face of it these arguments are similar to the flat earth argument and are somewhat similar to Biblical creationism. It is given.

The undeniable fact that the rate of oil output has slowed over the past twenty to thirty years seems ample evidence for the assumptions of peak oil enthusiasts which are then confidently projected forward. Case closed. There are, however, a number of important factors left out of this theory: primarily economics, politics, and history which are rather more difficult to measure than are flow rates. In fact they require thinking and some fore-knowledge.

However, despite all the "peak oil" talk, none of the multi-national oil giants has yet taken T. Boone Pickens' route from nearly thirty years ago and spun off their mature "wasting assets" into royalty trusts. If oil were truly winding down forever, at least one of the mega-cap and multi-national oil companies should already have elected to spin off (but still service) their oil fiefdoms in trust for their shareholders, and redeploy their capital elsewhere. Exchange traded pass-through, tax-free grantor trust units are now well-established as an investment medium in a number of countries.

For some background it's well to review Pickens' outline of a speech he gave in October 1982 in Lubbock, Texas. This is fairly long for a blog, but it's well worth reviewing what happened after the last bull market in oil ended in 1980:

"I have been asked to provide an outlook for the oil and gas industry. I will address this topic by first assessing where we are today in the industry and projecting what i believe will spell the difference between success and failure for oil and gas companies in the future.

"Now, let's take a brief look at the current state of the industry. The year 1982 will be remembered as the end of a boom era in the industry that began in 1973, culminating in 1980-1981 with new highs recorded in the industry in revenues and profits. The major factor for the prosperous eight year period was the escalating price of crude oil...prices orchestrated by OPEC. During this period, a period in which there was a twelve-fold increase in the price of crude oil, "boom time mentality" became commonplace; cash was plentiful, drilling was skyrocketing, and everyone was rushing to get into the business...and I mean everyone from tennis pros to doctors."

"Even though our management began to see the symptoms of a decline as early as October of 1981, it was very difficult to turn things around quickly. The point i want to make here is that as long as record revenues and income were being recorded in the industry due primarily to OPEC price increases, most managements were not overly concerned with rising finding costs, rising interest rates, and temporary over supplies of gas and crude oil."

"But with the drop and eventual stabilization of prices, these symptoms surfaced as major problems for many companies in the business. We have seen the drilling rig count continue to decline from its high water mark of 4,530 in december 1981 to the current level of 2,380. (Eventually the rig count sank to under 800.)"

"Managements have responded to these conditions by slashing capital budgets,tightening up on personnel and postponing projects dealing with alternative energy sources. Management themes have become "greater efficiency and productivity." Drillable prospects are being scrutinized more cautiously now, and managements are reversing the trend toward diversification. The confidence of many, within the industry and on Wall Street, is fading. It's difficult to sell a deal in today's market."

"However, i do not believe the uncomfortable conditions that exist within the industry, brought on in large part by the drop and stabilization of prices, are necessarily unhealthy. Consumers have benefited and inflation in our country has been blunted. This tough period that we are in has forced our industry to take a good, hard look at itself. As a result, I believe we will see revolutionary changes occur within the industry during the next several years,resulting in an overall strengthening of the oil and gas business. Challenging times are upon us—some will make it and some will not. We are already seeing some companies fall by the wayside."

"This raises the question "who will be the most successful in the new business environment?" One answer to this question is..."the managements that can determine and maintain the optimum size of their companies." The overriding goal of management should be to protect and expand the assets of the company and the value of their shareholders' interests."

"Perhaps the most important remark that I will make today is...(pause)...oil and gas companies, both large and small, are managers of depletable assets...their reserves of oil and gas. It is incumbent upon companies to increase reserves annually to ensure the maintenance and growth of their shareholders' investment. Therefore, the enhancement of reserves becomes an important measurement when evaluating whether or not a company is at its optimum size."

"Many companies in our industry, misled by rising oil prices and record earnings, have been liquidating for years; they simply have not been increasing their reserves annually. After paying corporate and windfall profit taxes, the dividend check that they have been sending their shareholders has been merely a return of capital."

"The biggest job facing exploration and production companies is to protect their reserve base and to expand it at a reasonable cost...either through exploration or acquisition. Recently, the finding cost and purchase price curves have been too far apart...they must come closer together to spur new drilling activity. Currently, merger and/or acquisition are very attractive ways of increasing reserves. Some of you may recall that we recently made an acquisition attempt! if a white knight had not come to our target's rescue,we would have purchased oil in the ground for about $3 per barrel."

"Other than utilizing exploration and acquisition measures to ensure optimum size, managements should also consider the benefits of restructuring based upon the royalty trust concept, pioneered by Mesa in 1979, with the formation of Mesa Royalty Trust. We have also announced our second trust, the proposed Mesa Offshore Trust, which will be created by the end of the year."

"The Mesa Royalty Trust and Mesa Offshore Trust were not created to solve a reserve problem—for we have consistently increased reserves for 18 years. Rather, we created the trusts as a means of ensuring realistic value for the company's assets. Our shareholders have a direct income stream from the properties placed in trust, avoiding two levels of taxation at the corporate level."

"Incidentally, the IRS has ruled that the Mesa Royalty Trust is a grantor trust and most recently has concluded that royalty

income attributable to the trust will not be taxable to Mesa."

"By reducing size, new discoveries have a greater impact on a company and increase the value of the shareholders' investment. Some managements equate success with bigness—they should be concerned with keeping their company's size at a level that provides its shareholders the best opportunity to make a profit. The managements that will be the most successful in achieving this goal will be ones that know their assets well and can make the necessary adjustments quickly."

"Let's quickly review some of the adjustments our management has made to maintain optimum size: when it appeared that Canadian E&P operations would be severely impacted by government regulation—we sold out in 1979. When our management foresaw the impending taxation and regulation of North Sea operations by the United Kingdom—we sold out in 1979. When our management addressed the question "why sell at below asset value if you are increasing reserves?"—we formed the Mesa Royalty Trust in 1979 and our stockholders received a direct ownership in producing properties. As finding and development costs of Gulf Coast properties escalated and became less economically viable—we announced a second trust—Mesa Offshore Trust—to place the assets of these high potential properties directly in the hands of our shareholders. Each of these strategic decisions was made with one overriding objective—to maintain the optimum size of our company, thereby benefiting our shareholders in the most positive way possible."

"This brings me to a question I would like to pose: "are we embarking upon an age of awareness in the oil and gas business?" I believe the answer to this question is..."yes." The investing public is becoming more aware that oil and gas companies are managers of depletable assets and that reserves must be increased annually to protect and enhance their investment."

"I believe we will see shareholders speak out more...particularly when the assets of the company are being liquidated. It's incredible to me the attitudes some CEO's have toward their shareholders...they forget that we are paid to get the best return for the stockholder. They often equate company with management rather than equating company with shareholders. To help "force" managements to begin thinking as investors—I believe shareholders will begin to insist that management be given meaningful stock options. They will then be somewhat assured that management will make decisions which are in the best interest of shareholders—not decisions which will merely perpetuate managements' jobs."

This short T. Boone Pickens speech is a graduate school seminar on the oil business. Rarely do we hear the insider candor and vision of good business leaders, but here we see the whole landscape of the greed of governments and the sometimes incompetence of business leaders, and the history of a transitional period of time when prices went from up to down. But for current purposes the critical issue was the wasting asset in the hands of its owners. Every well and every mine is a wasting asset, unlike the forestry or agricultural industry. Not to say that vast acreages of forest and field haven't been wasted. They have, but in theory, and under good practice, they are renewable. Even under good management wells and mines are wasting assets, but they are sometimes also wasted beyond their natural lifespans by imprudent management. The most imprudent management is applied by governments which are rarely headed by the best or most competent managers, to be kind. They are headed by mad men and mobs more often than not whose goals are instantaneous and totally inconsiderate of the future.

According to Pickens and most others, OPEC had "caused" the price rises of the 1970's due to political pay back for earlier real and imaginary losses. My own view is that much of the rise was a simple matter of supply and demand in the long wave cycle since it happened just at the "right time" in that cycle. But note how many governments reacted to events by taxation, price increases, and nationalizations of oil companies,  developments we we are seeing now from Indonesia and Venezuela, Canada, and Alaska and Russia. When prices are low, government wants nothing to do with maintenance and development. When prices grow high they want the whole hog. So oil output depends to a great extent upon price and upon government intervention. When prices are low many oil companies themselves have little incentive to spend a lot of money for maintenance, discovery and development. As Pickens described, it was a great time to merge with or buy out weaker players. When the prices are high the governments come in and take more and more, and the companies are satisfied to see great profits roll in to share with government. In earlier times governments were smaller and weaker and not so numerous as they are now. Mexico and Saudi Arabia nationalized their oil early on and Iran just a bit later. Now oil is nationalized or controlled nearly everywhere. Russian de-nationalized and then re-nationalized in under a decade. The UK did the opposite.

In the end, governments all over the world weaken oil development and maintenance, and also prevent companies from making gains on new developments. The higher prices resulting from this then make spending mega-billions for new development less realistic. Governments want to spend their profits on various other national goals, and oil companies will not have the continued profits or future prospects to warrant their making bold new moves. Pickens described all this in the early 1980's, but the situation has grown even worse. And this is largely due to accelerating government intervention everywhere rather than from probable "exhaustion" of natural supply. Communism failed, but state socialism has "triumphed" to create high prices and supply shortages beginning when demand naturally picked up after the 1997-98 Asian crisis.

This is why I see "Freak Oil" as a better phrase to describe shortages and high prices than "Peak Oil". Just as tobacco became a great source of government taxation, so too has energy. Over one-half the price of gasoline at the US pump consists of taxes at all levels. Governments are taxing and nationalizing energy, and the economies which depend upon it into oblivion. The simple mechanistic exhaustion formulas of of the Peak Oil internet industry can recommend no solution, only a grim future for all of us. But politics and economics are always amenable to reversal and to progress if the real facts are widely understood.

Commodity/Inflation Funds: Update

Inflation funds had a good week from February 4-8, 2008. I have looked closely at six funds with at least 20 months of operating history, including several with two decades of history.

FastTrack fund data base charts are always "total return" with all paid out dividends reinvested. I own HSTRX, PCRIX, and VGPMX in various family accounts. I also own GCC which has only been in operation a few weeks and not shown on the chart.

Recently I have discussed HSTRX and PCRIX in some detail on this blog site. The base of each one is US TIPS (Treasury Inflation-Protected notes). HSTRX has a fairly short maturity/duration (<2 years), PCRIX somewhat longer. HSTRX trades the duration spectrum of its TIPs as well as a position varying from 10%-25% in gold stocks according to proprietary indications. PCRIX overlays its TIPs with a note linked to the DJ-AIG Commodity Index. Since both pay a decent dividend (2.93% and 5.48% respectively for 2007 per Morningstar) I have them in tax-deferred retirement accounts. As you can see, HSTRX is far less volatile than the rest.

DJP is an ETN or exchange-traded note based on the same DJ-AIG Index that PCRIX uses. PCRIX has outperformed DJP since last August due to the fact that PCRIX's TIPS were in a bull market as well as were commodities. DJP uses a TBill rate "assumption" in its note. I have not read the prospectus for DJP, but I would advise doing so as always for any ETN, ETF or Fund purchase.  (I do not know the source of the Commodity Index sector weight chart)

Two mutual funds which are also "inflation funds" are CGMRX and VGPMX. I own the latter one. VGPMX I have discussed many time on the blog. It is Vanguard's Precious Metals & Mining Fund advised by Graham French in London. It has French's substantial skills and Vanguard's low costs which makes it hard to beat. CGM Realty is fascinating because of adviser Kenneth Heebner's concept of real estate: namely commercial real estate of all kinds including forests, mines and wells. Take a look at the portfolio at CGM's,  Morningstar's, or other fund website. As you can see from the FastTrack total return chart, the return shapes and annualized rates of CGMRX and VGPMX are virtually identical for the past 20 months. Since VGPMX is closed to new investors,  CGMRX would be a viable alternative for new investors. Also CGMRX can switch back to more traditional real estate holdings if and when they seem better to Heebner. Heebner has been managing CGM funds for 30 years, so I would be watching for any signs he might be getting ready to retire. I can say that traders as good as Heebner often never retire since they are having so much fun. Martin Whitman at Third Avenue Funds is over 80 and going strong.

Either or both of these funds would be a good complement to a commodity fund and physical gold in an inflation portfolio sector.

GCC (Greenhaven Continuous Commodity Index Fund) has only been trading for 11 days and is up 13%! I own it and now wish I'd bought a lot more, of course. GCC and DBC (PowerShares DB Commodity Index Tracking Fund) have a different structure than the mutual funds or ETNs above. First of all GCC tracks the equally-weighted CCI-TR which was the old CRB index, NOT the newer Reuters-Jeffries CRB Index. Each commodity is 1/17th of the value and it is re-balanced frequently. You can see from the second chart how diversified CCI is compared to GSCI and DBC: it is the entire US physical commodity market excluding a few grain, soy products (meal and oil) and energy items. DBC has just six commodities based on liquidity and some other rules: gold, silver, crude and heating oils, corn and wheat.

So there are many choices for people with different goals. GCC and DBC are also structured as grantor trusts who elected to be taxed as partnerships. This is a great format in my personal experience with it in real estate investments. Since both of these funds use unleveraged futures contracts fully collateralized with TBills, and do not pay taxes, the stock share owners are limited partners who receive the gains and losses and interest b net of expenses. Since futures contracts receive favorable tax treat for gains which came from the great 1982 tax law compromise, even a day trader will pay long term capital gains tax on 60% of her gains and short term cap gains tax on 40%. IN my case I prefer to hold these funds/Trusts/partnerships in taxable accounts for that reason. But you will need to keep track of your BC or FCC tax basis if you are holding them for long periods of time. This can be simply an annual thing to do at US tax time.

I just read the prospecti on both these funds. They are virtually identical except for their indexes. They sound daunting when read for the first time, but fortunately for me I was familiar with the concept from long experience.

Please understand that this is my own thinking out loud, and my own research and opinions. I do not manage money except for my family, and I am not an advisor. One should always do the work oneself or have a licensed professional advise us.

Sentiment Failure in 2007

Earlier today I posted this below at Bill Luby's superb Vix and More blog. Excellent sentiment analysis is always rare, as one would  hope. It requires art and even perhaps the talents of a forensic psychiatrist. Bill's site is the best. I have seen nearly all sentiment sites available to private traders.

The thread at Bill's shop today concerned sentiment failure, and the learning experience it provides for skilled practitioners. I re-edited this post a bit to correct some minor errors:

I think that sentiment "failure" showed itself at the July top and then was confirmed at the first low. The 2CS, which I define as the five day running total of daily VXO and the CBOE combined P/C, had been giving multiple deliriously bullish readings (<50) in late 1996 and then at the February 2007 highs and once only in April as the indices resumed their climb out of the March 2007 lows. But as the market marched up to July, the 2CS began to rise. It was 71 at the July high. This was a major change of sentiment character. This was a reversion to 2CS range extremes seen at rally highs during the bear market to 2003.

I mentioned my monitor label, "sentiment divergence happens", but that is a short term happening. When divergences are as great as that from February to the July highs, there is definite range shifting going on, and that means that the markets are "in the process of" making a longer term top.

From the July highs to the end of July the 2CS was already nearly 150, not seen since the first half of 2003. This was the confirmation of probable longer term trend change. The delirious bullish high range had shifted but also the rather placid low range had now become somewhat delirious. Bearish delirium reached 198 on July 17.

By then it was evident that a broadening distribution top, called different things by different people--reverse point waves, expanding triangle, etc.--was also forming in many indices. Since distribution in a top takes a long time, it was reasonable that it should last longer that three months from May to August.

On the rally to October new highs 2CS only got as low as 63. No more delirious 50's or 40's as in 2006 and up to February 2007. 63 is almost exactly the number attained on the rally into May 2002 and on other bear market rally tops. The top was in.

Personally I did not run out that day and shout in the streets or liquidate everything and load up on puts. I had been trimming into strength all year.

Sentiment does diverge and it exhibits range-shifting longer term, as it also did in 2002/2003 at the lows. To grasp it requires a mental shift from the notion that the majority is always wrong at the wrong times, as you clearly see. Range shifting is the sentiment equivalent of Dow Theory price waves. I think it's even better.

Chart 1 shows monthly and longer term 2CS sentiment (in red and, notably, inverted to price) at intermediate term highs and lows from 1997-2007. After the 1998 lows  it was reasonable on many technical grounds to expect a large distribution top. Despite the internet and junk bubble extending gains, sentiment began to cool decidedly by March 2000 and the April low.

The same was true for the 2001-2003 lows.  In both cases it took about 18 months to play out from the first disjunction or divergence point and about six months from the divergence.  Although post is primarily about 2007, the early warning signs were already present in 2006 at the May high and June/July lows. Delirium reached it's peak in May 2006 but at the summer lows bearish sentiment greater than any since 2003 was seen. At the time this was seen, correctly, as being quite bullish, but it also was an early warning.

Chart 2 is a daily close-up of the 2007 action, already discussed, with a summary of my interpretation. (Click on chart images for a larger view.)