ETF: Mediocrity with No Pretense of Value

We're really in for it when this finally devolves. The following paragraph is the introduction to the Operation of Exchange-Traded Funds in the Federal Register:

"All ETFs trading today operate in a similar way. Unlike traditional mutual funds, ETFs do not sell or redeem their individual shares (‘‘ETF shares’’) at net asset value (‘‘NAV’’). Instead, financial institutions purchase and redeem ETF shares directly from the ETF, but only in large blocks called ‘creation units.’ A financial institution that purchases a creation unit of ETF shares first deposits with the ETF a ‘‘purchase basket’’ of certain securities and other assets identified by the ETF that day, and then receives the creation unit in return for those assets. The basket generally reflects the contents of the ETF’s portfolio and is equal in value to the aggregate NAV of the ETF shares in the creation unit. After purchasing a creation unit, the financial institution may hold the ETF shares, or sell some or all in secondary market transactions."
Securities and Exchange Commission Exchange-Traded Funds; Proposed Rules. Federal Register. March 18, 2008. Vol. 73, No. 53. page 14620.

My translation to the above is:

A financial institution can buy "creation units" or IOUs of questionable value from an Exchange-Traded Fund (ETF.) The acquiring institution can use a basket of stock of equally questionable value to pay for the IOUs. If for some reason the acquiring institution can find someone else to unload the IOU on then it can be sold in part or in whole on the secondary market.

I admit that I'm unfairly maligning the meaning and/or intent behind the language in the SEC's proposed rules for the way an ETF operates. However, there can't be no denying (double neg intentional) that this arrangement sounds a lot like the old collateralization of mortgage debt. Additionally, this is awfully similar to the way unit investment trusts operated from 1926 to 1929. The structure of a scheme like this only works when the market continues higher or new money floods in.

Exactly what do I see wrong with the SEC language? The above text allows firms that have stock of negligible value (or a value far less than what was originally paid) exchanged to another firm that gives "creation units" which are put into the accounts of retail clients who are not interested in dealing with the failure of actively managed mutual funds. At some point after the creation units have been designated to retail clients the financial institution can then sell the creation units to willing buyers on a secondary market.

Who would be willing to buy these creation units? Well, if enough interest is drummed up through advertising and buttressed by positive press then other financial firms can justify buying these units with the hopes of selling to a new wave of retail buyers.

The blowback from something like this is on par with the unwinding of a derivative contract gone bad. I hope that my skewed interpretation of this is due to the fact that it is now 3:30am. Touc.

related article:

• December 16, 2008

Values Biding Time

"Values go on increasing, while the market
rests..."
Samuel A. Nelson. The ABC of Stock
Speculation. Fraser Publishing. 1999. originally published
1903.

I think that this is the greatest gem of knowledge ever dispensed on the stock market. So what if the price of a stock is going nowhere? In fact, all things being equal, if the price is falling so much the better. To my thinking, value is accrued with the passage of time. With a steady dividend payment, especially a rising dividend, wealth is accruing at a rapid rate. Throw in a little inflation and you've got an honest to goodness asset.

A graphical example of value being accrued over time is the 13-year chart of Wal-Mart (WMT) below. If you ever come across a similar chart pattern then it would be worth your time to examine the company financials to verify the true value. Here is what I found out when I tried to confirm if Wal-Mart was actually increasing in value:

• Number of shares outstanding have decreased about 1% each year (good)
• Dividends increased every year for 33 years (good)
• Return on Equity in the high-teens (good)
• Above historical high dividend yield, according to IQ Trends (good)
• Long-term debt has doubled in last 10 years (bad)

The price pattern on Wal-Mart reflects a concern by investors, starting in 2000, that the consumer economy was going to be in trouble. If the price goes above $70 or goes below $45 then we'll have some advanced warning about what may be around the corner for the U.S. and Chinese economy. Seems that this company is a leading or more reliable indicator (for the time being).

In general, Wal-Mart's stock is not being recognized for the simple fact that the company can generate positive earnings. Although WMT's debt really bothers me, company management may be clever like a fox by amassing huge amounts of debt now to be paid off later with inflated dollars.

As much as this company appears to be increasing in value, I can't get the image of F.W. Woolworth's (the original five and dime store and former Dow Industrials component) out of my mind. Woolworth's was the equivalent of Wal-Mart but couldn't last even though it was offering rock bottom prices to the public.

Despite my concerns about WMT, I am looking for other Dividend Achievers with similar price patterns of trading in a "narrow" range. The longer the range, like 1906 to 1924 and 1966 to 1982 for the Dow Industrials, the more values are guaranteed to have increased. Touc.

Sell Meridian Biosciences (VIVO) at the Market

It is now time to recommend that Meridian Biosciences (VIVO) be sold at the market. The stock has performed reasonably since the research recommendation was issued on March 26, 2009. It is highly recommended that anyone who bought the stock based on my research should re-read the posting. The stock initially went down, but once the reporting of the swine flu came out the stock recovered all the losses and then started going higher. From the current level VIVO is poised to reach the $23.33 with little effort. However, the returns that this stock has provided within the last seventy-eight (78) days say that it is worthwhile considering alternatives.

VIVO was recommended when it was trading at $18.21. As of Friday June 12, 2009, VIVO was quoted at $20.35. This equals a return of 11.75% in almost 3 months. Conservatively, on an annualized basis this would equal approximately 54% return. Selling this stock now also generates a return 286% greater than the amount of the dividend yield if the stock was held for a whole year.

It is always recommended that when selling a stock, one should not place an order after hours or when the market is closed. This leaves the seller in the position of being vulnerable to the whims of the market makers. Instead, place your sell orders only as a market order during market hours. Some would complain that a market order during market hours might leave some profits on the table. However, I would rather leave some money on the table rather than have it taken away from me by the trades that are placed by institutions and market makers. Touc.

Sell H&R Block (HRB) at the Market

It is with regret that I have to recommend that H&R Block be sold at the market. The stock has performed reasonably since the research recommendation was issued on May 19, 2009. It is highly recommended that anyone who bought the stock based on my research should re-read the posting. The stock essentially went up from the date of recommendation. From the current level HRB is poised to reach the $19.15 level with little effort. However, the returns that this stock has provided within the last eighteen (18) days say that it is worthwhile considering alternatives.

HRB was recommended when it was trading at $14.42. As of Friday June 5, 2009 HRB was quoted at 16.06. This equals a return of 11.50% in a little more than two weeks. Conservatively, on an annualized basis this would equal approximately 233% return. Selling this stock now also generates a return 288% greater than the amount of the dividend yield if the stock was held for a whole year.

It is always recommended that when selling a stock, one should not place an order after hours or when the market is closed. This leaves the seller in the position of being vulnerable to the whims of the market makers. Instead, place your sell orders only as a market order during market hours. Some would complain that a market order during market hours might leave some profits on the table. However, I would rather leave some money on the table rather than have it taken away from me by the trades that are placed by institutions and market makers. Touc.

Research Recommendation: Cardinal Health (CAH) at $29.95

According to MergentOnline, "Cardinal Health is a provider of products and services for the healthcare industry." Cardinal Health (CAH) has increased its dividend every year for 12 years straight.

Cardinal Health (CAH) is in a declining trend and is about to do a technical triple bottom. If successful, the stock of Cardinal Health will have a tremendous move up from the $27.75 level. On the other hand, if CAH cannot hold above $27.75 then the downside could take the stock to $9.60.

In June of 1997, Value Line Investment Survey said that with CAH trading at $25 the stock was expected to go to $50 by 2002. By 2002, CAH had gone to $70. In the Value Line dated May 29, 2009, CAH is conservatively expected to go to $85. If we cut that $85 in half we get $42.50 which is 42% above the current quoted price. Value Line has a mean price-to-cash flow ratio of 16. Based on 2008 cash flow figures, CAH is now selling 62% below the historical average price-to-cash flow ratio. Either the books are being cooked or this stock is ridiculously underpriced.

Applying Dow Theory to CAH gives us the following upside and downside targets:

• Upside
• $43.04
• $58.33
• $73.63

• Downside (focus on the downside risk)
  
• $28.70 (prior fair value based on 4/92 to 12/98 range)
  
• $23.80
• $9.60
  

If we were to invest in stocks the way that Charles H. Dow would then we would buy half of the intended amount now and purchase the second half if the price declines. For example, let's say that you wanted to invest $6000 in this company. What you would do is buy $3000 worth of stock now (approximately 100 shares) and hold the stock if the price goes up. If the stock goes down then you would invest the remaining $3ooo at the next level that you felt was ideal. This approach works well regardless of the market that you're in as long as you set aside the amount that you intend to invest before making the first purchase. Also, after making the first investment never invest the second half somewhere else.

The purpose of my research recommendations is to point out quality Dividend Achievers that have reached a new 52-week low. From this point begins the research to verify the quality of the stock for both short and long-term investing. These recommendations are within the context of the 2nd year of an 18-year bear market. A bear market that I expect to trade in a range between 16,000 and 5,000. Touc.

It Isn't Easy Being Green

One person that I think small investors of today can learn a lot from is Hetty Green. Mrs. Green, born Henrietta Howland Robinson in 1834, increased her investment holdings from $6 million in 1865 to $100 million, in cash, by 1900. And while the average investor doesn’t have six million dollars to start with, the lesson to be learned is far greater than the amount an individual has to invest.

The goal for this “infamous” investor was “to make and keep 6% every year.” How was this accomplished? Hetty Green never aimed for the “big hit” or large gains in the stock market. Instead, she sought reasonable gains which were secured and then rolled over to “real estate mortgages, government and municipal bonds, and other safe, income-oriented investments.” The money was moved out of the safe investments when the stock market was at extreme panic lows.

There are two points about the preceding paragraph that I feel are important. First, seek reasonable gains or “fair” profits. Never set out to beat the stock market. The market will fail to perform at some point, either individually or as a whole, and that is the opportunity to buy the stocks that you want. As you’ll see in the section About This Site, I only seek to exceed the rate of return on “guaranteed” money while all stocks purchases are done after the price has reached an extreme on the downside. Seeking “fair” profits implies that an investor considers selling a stock after achieving the goal of exceeding the return of “guaranteed” money rates.

The second point is that without panics or crashes small investors have little chance of succeeding in the stock market, especially through use of mutual funds and ETFs. Real wealth in stocks is built on understanding values and then seizing those values, en mass, whenever possible. Most great “speculators” have secured their wealth by investing during panics and with the selection of very few companies, typically 3 or 4. With the government constantly trying to smooth out the business cycle what ends up happening is a concerted effort to keep the wealth of the nation in the same powerful hands with the guise of protecting the average citizen.

Unfortunately, there was a tremendous price for Hetty Green to pay in order achieve such outstanding gains. Mrs. Green was known to avoid spending money at every turn. As an example, when her son was in need of medical attention on his leg, she concocted her own remedy. Her son later had to have his leg amputated due to the lack of proper medical attention.

After getting married to Ned Green, a well known speculator, Hetty's image didn't improve. In fact, Hetty Green was known as the "Witch of Wall Street." With her black dress and hat, miserly ways along with above average financial success didn't endear Hetty to the male dominated confines of Wall Street. However, her 9.50% after-tax returns certainly couldn't be ignored. Touc.

Sources:

• Fisher, Kenneth L. 100 Minds That Made The Market. Business Classics. 1993.
• Lewis, Arthur H. The Day They Shook the Plum Tree. Harcourt, Brace & World. 1962.

All the Data That Seems Fit to Print

As a person who follows the stock market and the economy, I find it surprising that the National Bureau of Economic Research (NBER), as opposed to Dow's Theory or the stock market, is looked to in determining when we're in a recession or a recovery. The evidence is resoundingly against having NBER guide us to clarity in the economy.

My first example of why the NBER isn't a great guide for the state of the economy starts with the November 2001 press release telling us that the peak in the economy took place in March 2001. This would be great if we were informed in May or June of 2001. I mean, none other than Ben Bernanke was on the team that issued the press release. Contrast that with Dow's Theory which gave a bear market indication on February 22, 2000. The difference between the NBER peak in the economy and the Dow Theory indication was 9 months. The stock market, as represented by the Dow Jones Industrial Average, peaked in January 2000.

On July 17, 2003, the NBER announced that the bottom in the economy occurred on November 2001. This was a full one year and eight months after the fact. The stock market bottomed September 2002 while Dow's Theory gave the indication that the economy had bottomed on June 3, 2003. It seems that what is useful is the most accurate and timely not the most spurious.

Finally, on December 1, 2008, NBER announced that the peak in the economy had occurred on December 2007. During the week of June 16, 2008, Dow's Theory indicated that the bull market was over. This was six months before the actual announcement by the NBER. The stock market peaked in October of 2007.

How useful are the NBER announcements of when a peak or trough occurred in the economy? Judging by the extreme lag in time when the public is notified, there seems to be little use of a committee that tells us almost two years after the fact that we're in a recession. As we go back in time we can easily see that the averages (Dow Industrials and Transports) discount everything while the NBER selectively chooses when the data seems to fit. Touc.

Dow Theory Updates

Research Recommendation: H&R Block (HRB) at $14.42

H&B Block (HRB) is one of the leading tax preparation companies in the U.S. On Monday May 18th, HRB reached a new 52-week low at a price of $13.73. HRB has increased its dividend every year for 11 consecutive years in row. Prior to cutting the dividend by 31%, from 1995 to 1997, HRB had increased the dividend payment 13 years in a row.

According to Value Line Investment Survey (dated 5/22/2009), HRB is selling under the average price-to-cash flow of 12 times. Using the full year cash flow of $1.84 for 2007, HRB has a mean price of $22.08. At the current price, HRB is expected to increase by 35% if it were to revert to the mean.

Unless we're going the way of an even "Greater" Depression, this stock has an exceptional amount of potential. HRB has rid itself of the toxic waste of subprime mortgages that it once owned. Unlike the major banks, which recently had to water down their stock, HRB has maintained the same number of share outstanding. This means that any earnings in the future will be dramatic compared to the last two years.

According to Morningstar (dated 4/24/2009), HRB faces lawsuits related to the former mortgage unit that was involved in subprime lending. Additionally, HRB has accumulated massive amounts of long-term debt as well as sub par return-on-equity and return-on-assets in 2007 and 2008.

Applying Dow Theory to HRB gives us the following upside and downside targets:

• Upside
• $19.15
• $24.57
• $30
• Downside
• $7.71

By falling to $13.73 intra-day, HRB pierced a prior technical support level ($13.90). If HRB can hold at the current levels then a 24% gain to the $19 level would be easy to accomplish. HRB seems like a great company to investigate for your next investment purchase. It is my hope that the stock price can continue to fall so that the shares can be acquired at a better price. Emphasis should be placed on the downside risk of HRB going to $7.71.

The purpose of my research recommendations is to point out quality Dividend Achievers that have reached a new 52-week low. From this point begins the research to verify the quality of the stock for both short and long-term investing. These recommendations are within the context of the 2nd year of an 18-year bear market. A bear market that I expect to trade in a range between 16,000 and 5,000. Touc.

Financial Panic Chronicles

On October 6, 1929, it was reported that BodenKreditAnstalt would be merged into CreditAnstalt in a deal valued at $17,000,000 or $211,000,000 in 2008 dollars. The merger of the number two bank into the number one bank was due to the low capital position of BodenKreditAnstalt after WWI and the excessively loose credit standards that essentially put the bank on the ropes.

At the time, the deal was pushed through by the Austrian government and had to be backed by F.M. Rothschild and several London banks. In an effort to boost confidence, the Austrian government guaranteed all bank deposits.

After the initial stock market decline from September 3, 1929 to November 13, 1929, the stock market rallied 48% to the peak on April 17, 1930. For many, the rise in the market seemed to provide some reassurance that the financial system had been restored. Unfortunately, because a bank's financial strength is closely tied to the value of the stock price, the subsequent worldwide financial meltdown from April 18, 1930 ensured that any, and all, bad loans from the BodenKreditAnstalt/CreditAnstalt merger would be next to impossible to resolve.

CreditAnstalt, ladened with the bad debts of BodenKreditAnstalt, soon suffered from it's own problem lending and falling stock price. CreditAnstalt, founded by S.M. von Rothschild and banker to the Hapsburg empire, was now in need of a lifeline. London banks, the Bank of England, Germany's Reichsbank, Bank for International Settlement and the Bank of Austria all threw money at CreditAnstalt starting in May of 1930 in a failed attempt to shore up the problem. The ultimate failure of CreditAnstalt in 1931 led to the worldwide banking crisis and bank holidays in the U.S. that same year.

According to the New York Times, the failure of CreditAnstalt, Austria's largest bank, lay squarely on the shoulders of the government effort to merge BodenKreditAnstalt. The newspaper aptly stated:

"The troubles of the CreditAnstalt are quite unanimously ascribed here to the unsound policy pursued in 1929, when the crippled BodenKreditAnstalt was attached to the larger concern."

"Vienna's Market Calm in Bank Crisis." New York Times. May 18, 1931. p. 31.

Similar tactics have been displayed with the government imposed mergers of Bear Stearns with J.P. Morgan, Bank of America with Merrill Lynch, and Wachovia with Wells Fargo. How do I know that these mergers were forced on the acquiring institutions by the government?

• On the Bob Brinker radio show in an interview, available until 5/15/2009 (Saturday, 3pm-4pm hour), with the fawning Patricia Crisafulli, author of House of Dimon, it was stated emphatically that Jamie Dimon, CEO of J.P. Morgan, said that "we were asked (by the government) to do this. Bear Stearns was never something we would have gone out to buy..."
  
• The Bank of America and Merrill Lynch deal has been recently exposed by BofA CEO Ken Lay Lewis as a sort of "strong-armed" tactic by Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke.
  
• I cannot say for sure that the deal between Wells and Wachovia was government forced. However, it is my observation that the Wells deal with Wachovia was simply a PR ploy to get the public to believe that Wells was healthier than Citigroup and therefore better positioned to take on new reponsibilities. This strategy was crafty and similar to forcing $225 billion on nine "select" banks as a way to mask who is really the weakest. Citi was already known by the public to be a zombie bank so Wells was the target of a spin campaign by regulators.

The passing off of one troubled institution to the next, in the hopes that the headache would go away, did not resolve the problems associated with the bad lending practices or malinvestment from prior periods. The fact that this approach to solving the problem has been repeated throughout the G8 nations and beyond leaves little room for error. The blowback from such policies could set off a financial storm of unimaginable length and depth. All it would take is one slip up, in a far flung region, that could set the dominoes in motion. Touc.

Values According to Samuel A. Nelson

S.A. Nelson is credited with coining the term "Dow's Theory." In fact, Nelson tried to convince Charles Dow to write a book about his articles in the Wall Street Journal but did not succeed. After failing to get Dow to write a book, Nelson wrote his own based on Dow's writing. The book titled ABC of Stock Speculation neatly lays the groundwork for Dow's Theory to be recognized and interpreted throughout history.

In one excerpt from the book A Treasury of Wall Street Wisdom, Nelson says:

"...stocks have recovered after artificial depression and relapsed after artificial advances to the middle point which represented value as it was understood by those who bought or held as investors."

This means that if an index or stock that has fallen below the halfway point of the previous advance or risen above the halfway point of a previous decline, then the index/stock is either undervalued or overvalued. If the index/stock has fallen close to the prior level of where the advance started and the index/stock is still fundamentally sound then the index/stock could be considered extremely undervalued. Likewise, if the index/stock has risen far above the prior high then it is considered overvalued.
 

When I start to consider investing in an individual stock, I only want to know if the price of the stock has reached a new 1-year low. From this vantage point, I can determine if the stock is trading at an extreme relative to the halfway point of the previous advance and decline. Again, this approach can only work if the company is generally in fair condition. This means that earnings exist, the dividend payout ratio isn't too high and management has a track record of rewarding the shareholders and etc.

The halfway point of the previous advance or decline is the point at which "long-term" investors would consider the stock or index fairly valued. Traders can take advantage of this fact and use it to their benefit. In the chart below, I show the Dow Jones Industrial Average since 1997.
What is important to notice is that the artificial advance and artificial depression meet at the halfway point of 10,302.31 (dark blue horizontal line.) If drawn backwards to the point when the Dow first went above 10,000, we can see an enormous amount of time spent at or around 10,302.31. This indicates that, for now, "long-term" investors fairly value the market at the 10.3K level.

Dividend Achiever Notes

In all of the market turmoil of the last two years, it is interesting to note that three Dividend Achievers are above their 2007 highs. The three companies are:

• Lancaster Colony (LANC) 39 years of div. increases and within 6% of top
  
• Family Dollar (FDO) 32 years of div. increases and within 6% of top
  
• Ross Stores (ROST) 14 years of div. increases and within 7.84% of top
  

Not far behind are the following companies:This blog is being featured on www.condron.us, I hope you find this useful.

• Suburban Propane (SPH) 10 years of div. increases and within 18% of top
  
• Valspar (VAL) 30 years of div. increases and within 17% of top
  

One way to look at these stocks is that if you bought them at their prior highs then you have lost little or nothing during one of the worst bear markets in history.

Another way to look at these stocks is that they are the most likely sell candidates since it is clear that they are selling at relatively high levels. Ross Stores (ROST) has the most interesting chart pattern because it has gone down to the $23 level 5 times since 2004 at regular intervals and moved up from there. This might mean that ROST can be considered a buy candidate at $24 or a short sell candidate at the current level. I hope to be on top of ROST when and if it hits $24 again. Touc.

Dow Theory

With the Dow Jones Transportation index closing above the 3204 level and the Dow Jones Industrial index closing above the 8281 level we have received the confirmation that a new resistance level is in place. This means that the Dow Jones Industrial index will go up to the point 9000 while the Transports will go up to 3717. Unfortunately, NYSE volume is not supporting the upside move so the indication is that we're still in a bear market.

From the standpoint of a trader, the Tranports would go up 16% while the Industrials would go up 8% from the current levels. If I were to "trade" this potential move, the best one would be on the Dow Jones Transports Index. The exchange traded fund that mirrors the DJT is IShares DJ Transport Average (IYT). For an investor who is concerned about being forced to hold for an extended period of time the following Dividend Achievers are within 10% of their 1 year low:

• H&R Block (HRB)
• Abbott Labs (ABT)
• Becton, Dickinson (BDX)
• McCormick & Co. (MKC)
• Wal-Mart (WMT)

These five companies are great if you're willing to accept the downside risk. The downside risk is that we're still in a bear market and although these might be great companies the market can turn down at any point, which would bringing down the price of these relatively undervalued companies. Touc.

Dow Theory Updates

Seeking Fair Profits in Investment Portfolios

Charles Dow, founder of the Wall Street Journal, once said:

"...secure stock at a time and at a price which will give fair profits on the investment."

The most essential piece in this concept is the idea of fairness in stock investing. For some, this idea might seem like a quaint notion however it exemplifies an essential quality that is necessary for all stock market participants. What exactly is "fair profits?" Dow covers this concept over and over again. Dow says:

"A 10-point decline under such conditions would be almost certain to bring in a bull market more than 5 points recovery and a full 10 points would not be unreasonable..."

Another example of how to determine what is fair is said in this way:

"A much more practicable theory is that founded on the law of action and reaction. It seems to be a fact that primary movement in the market will generally have a secondary movement in the opposite direction of at least three-eights of the primary movement. If a stock advances 10 points, it is very likely to have a relapse of 4 points or more. The law seems to hold good no matter how far the advance goes. A rise of 20 points will not infrequently bring a decline 8 points or more."

In the preceding examples, when a stock or index is rising or falling, we should be able to expect a decline or rise to retrace at least 38% to 50% and quite possibly 100% of the move. To be fair, we should be willing to accept that we'll never catch the exact bottom. Therefore, we should content ourselves with getting between 15% to 25% of any movement.

To better illustrate how this concept works, let us use the peak of the Dow Jones Industrials on October 2007 at 14,164.53 to the most recent low of 6440.08 on March 9, 2009. According to Dow's theory the market should go back to the 9375.37 for a 38% reaction (bear market rally) or 10,302.31 for a 50% reaction (bear market rally). Since we cannot say for certain that the decline is over at the 6440.08 level, the best we could do is to buy as the market is moving up, when Industrials and Transports go up together on strong volume.

What would I buy if I were investing based on the expectation of a rebound in the stock market? The best option for "trading" purposes is to buy the Diamonds (DIA) which are supposed to replicate the movement of the Dow Industrials. However, I prefer individual Dividend Achiever stocks which pay me while I wait. On March 10th, I bought Helmerich and Payne (HP) when both the Industrials and Transports reversed their direction. At $22.56 the price of HP was reasonably low. Not knowing where the top would be I sold my position in HP at $26.22 on March 26th for a gain of 16%.

After I sold HP, the stock went as high as $34.50. Basically I gave up the opportunity to receive a 53% gain. However, Dow's idea of "fair profits" means that I must be satisfied to receive the 16%. While I could have bought Citigroup (C) or Bank of America (BAC) I couldn't justify putting my money into stocks that weren't transparent and had discontinued their dividend increasing policy. After selling HP, I bought Meridian Biosciences (VIVO), a Dividend Achiever that had reached a 1 year low on the same day.

In the example that I've just given it is important to know that according to Dow, a gain of 5% was considered to be "fair profit." I guess if "guaranteed" money rates can easily be exceeded in a stock transaction then it might be worth the investment. Touc

Dow Theory

The movement of the Dow Jones Industrial Average and Transportation Average was extraordinary on Thursday March 30th. According to Dow's Theory, the indices only needed to close above 8280.58 for the Industrials and 3203.74 for the Transports. Both averages traded above these levels during the day but could not hold on for the close.

As I said in my previous posting of March 27th, if these levels can be breached the stock market is likely to go to the 3717.26 level for the Transports and the 9086.21 level for the Industrials. This would have been a stepping stone towards reaching the 10,000 level in the Dow. However, the action of the Transports and the Industrials was somewhat alarming. Both indices crossed above both levels by a wide margin but closed below the most important Dow Theory levels. It is hoped that the market can establish a trading range around the current levels. Otherwise, we're about to face significant resistance that could push the market back to the 6400 level. Touc.

The $12 Trillion Bailout

The tally on the bailout has reached the $12 trillion mark. At this point, I'm no longer a fan of letting the system work out the problems of the past few years. $12 trillion better work or we're toast. After all, as a nation, we've bankrupted any semblance of credibility that our financial system had. If our situation gets any worse, a la Japan, then we won't have any means to backstop the problem.

My prior bailout tallies:

• $8.5 Trillion Spent and No Relief in Sight
• The Fed's $1.8 Trillion Lifeline Didn't Work
  

Source:

• Mark Pittman and Bob Ivry. "Financial Rescue Nears GDP as Pledges Top $12.8 Trillion." Bloomberg.com. Accessed April 28, 2009.
  

Graham and Dodd On Market Timing

The following is my critique of a passage of the investment "bible" Security Analysis by Graham, Dodd, and Cottle. This book is credited with providing Warren Buffet with the knowledge and background on how to accurately assess stocks. Although I know this book is basically about number crunching, my concern is how this book treats the question of timing of the purchase of stocks. In this regard, Security Analysis says:

Timing Consideration in Investment Policy- The old rule for the ordinary investor was that he should buy sound securities when he had funds available. If he waited for lower prices he would be losing interest on his money; he might “miss his market,” even if prices declined, in any case, he was turning himself into a stock trader or speculator. Much of this view retains its validity. However, the time when the investor should clearly not buy common stocks is during the upper range of a bull market.

Benjamin Graham, David L. Dodd, Sidney Cottle. Security Analysis, Fourth Edition. 1962. Page 70.

The first sentence says that a person should buy stocks when they have the money irrespective of values. To this point the word “sound” securities is not clear. I guess that a “sound” security is one that is not expected to go out of business based on “traditional” valuation methods. The second sentence says that a person who “waits” for lower prices would be losing interest on his money even if prices decline. By waiting, the prospective investor would become a trader or speculator. However, Graham and Dodd then go on to say that an “investor” should not buy in the “upper range of a bull market.” By trying to determining the “upper range of a bull market,” isn’t this the same as what they said a speculator or traders does? Anyway, how does one know what the upper range of a bull market is if they aren’t familiar with technical analysis? This suggests that a person must be familiar with technical analysis first and then apply fundamental analysis afterwards provided that the market isn’t in the upper range of a bull market. Strangely, this approach requires an investor to analysis the market at a time when values and earnings are most uncertain. Furthermore, stocks at this point are more susceptible to rumors and hope rather than facts and realistic expectations.

Another challenge is the fact that middle and lower ranges of a bull market is when the fewest individual investors participate. This is the equivalent to the first and second stage of a three stage bull market. The last stage or third phase of a bull market, characterized as the “upper range,” is distinctly known for individual investor activity and participation. For this reason, Graham and Dodd ask the impossible of the individual investor by telling them not to buy in the “upper range” of a bull market. If the recommendation is that timing doesn’t matter then Graham and Dodd should stick to this position. By following up their remark that timing doesn’t matter with a suggestion of times not to buy based on the level of the market leaves a mixed message. They should say, “don’t worry about the market, instead worry about the valuation of the company. Valuation will always suggest when to buy.” This would have re-enforced the message rather than confuse or misinform the reader.

Since I know the book Security Analysis is considered the bible of value investing this issue is certainly secondary but it does point to the overwhelmingly subjective way that the matter of timing of investment purchases is treated. However, the fact that timing is discussed at all, with their own view as to the best time to buy, is an indication that timing really does matter. If nothing else but to determine when not to buy. Interestingly, when Graham and Dodd say that you should avoid buying in the “upper ranges of a bull market” requires that you know where the middle and lower ranges are. So what method do you suppose using to determine this? If, somehow, you can determine the upper, middle and lower ranges of a bull market then why would you necessarily care about valuations? Wouldn’t you just throw all of your money in at the lower end and sell once reaching the upper end?

These may seem like the boneheaded questions of a fool, however Graham and Dodd go further in the next paragraph to suggest that it is impossible for the average investor to time the market. I will give my thoughts about the next paragraph on timing the purchase of a stock in my next post. Touc.

Related article: Graham and Dodd On Market Timing, Part II

Research Rec.: Bard Inc. (BCR) at $71.28

C.R. Bard Inc. (BCR) is the latest Dividend Achiever to reach a 52-week low today. According to Yahoo!Finance, Bard Inc. is "engaged in the design, manufacture, packaging, distribution, and sale of medical, surgical, diagnostic, and patient care devices worldwide."

Bard Inc. (BCR) is one of the most efficient medical device manufacturers that I know. This is represented by both double digit return on equity and return on assets since 2001 as verified by Morningstar.com. The company's low debt position gives it lots of room to weather the future economic turmoil that might be on the horizon. Additionally, BCR has a very low dividend payout ratio of 16%. According to MergentOnline.com, BCR has increased its dividend every year for 37 consecutive years in a row.

According to Dow's Theory, the following are the upside and downside targets for BCR.

Upside Targets:

• $79.83
• $90.72
• $101.61

Downside Targets:

• $60
• $40
• $10
  

On the upside move there is significant resistance at the $85 level. Therefore it is well worth considering your willingness to hold this stock if it reaches $84. On the downside there is significant support at the $60 level. We can only hope that this stock falls further to increase the value component of this stock.

The purpose of my research recommendations is to point out quality Dividend Achievers that have reached a new 52-week low. From this point begins the research to verify the quality of the stock for both short and long-term investing. These recommendations are within the context of the 2nd year of an 18-year bear market. A bear market that I expect to trade in a range between 16,000 and 5,000. The bear market will be considered over when the Dow Transports and Dow Industrials exceed their respective peaks on high volume or the dividend yield on the Dow exceeds 6% or higher. Touc.

Dow-Jones Let the Dogs Out...And Got Bit

After considerable pondering on the subject, I have come to the conclusion that the 89% decline in the Dow Industrials from 1929 to 1932 had little to do with the economic state of the nation. In fact, a simpler explanation lies behind the cause of the decline in the Dow which was thankfully never repeated since. A good portion of the blame should rest squarely on the shoulders of Dow-Jones, subsidiary of News Corp.

First, this is not an article to explain away the various levels of overvaluation in the market of 1929. It was clear then, as it is clear now, that the stock market was extremely overvalued. Also, the explanation that follows isn't the only reason for the decline of '29 to '32. We all know that various economic and political events pushed our economy and stock market to the known limits in the shortest period of time. In this article, I'm trying to point out or explain the reason for the extent of the decline in the stock market. I am hopeful that readers of this article will be open to a "different" perspective on this reasonably unique period which might broaden the minds of the reader rather than convince the reader to buy or sell their stocks.

As a person who tries to examine the Dow Jones Industrial Average from every angle, I have often wondered what the impact of the changes to the index would be if the changes to the index were never made. For example, where would the index be if AIG (AIG) wasn't added to the index on April 2004? How about if Bank of America (BAC) was never part of the index? Bank of America was added to the Dow on February 2008. What about if Microsoft (MSFT), Intel (INTC), and Home Depot (HD) weren't added to the index in November of 1999? Where would we be if Citigroup (C) and Hewlett-Packard (HPQ) weren't added to the index in March 1997?

These questions have significant bearing on why the index has fallen so much in the last year and a half. It is worth noting that the selection of these stocks were at or near the peak in the respective industry groups that these companies are members. As an example, when Bank of America was added to the index in 2008 it replaced Altria (MO) and/or Honeywell (HON). Both of these companies, when compared to BAC, fared much better in the time after being taken out of the index. In fact, Kraft (KFT), a successful spinoff of MO when it was taken out of the index, was added back into the index on September 22, 2008 replacing AIG. Unfortunately, once KFT was added to the index it promptly fell from its relatively high price of $34.97 to the current level of $22.55.

The decision to take AIG out of the index and put KFT into the index couldn't have happened at a worse time. After all, the Dow Jones Industrial Average is a price weighted index. This means that the higher the stock price, the greater the impact the stock would have on the overall movement of the index. Essentially, the people at Dow-Jones traded a low priced stock with little impact on the index for a high priced stock that was susceptible to falling during a crummy economy. Furthermore, by choosing KFT, Dow-Jones ensured that the index would fall further because high quality stocks like KFT are the last to go when the market hits the skids. And so, KFT promptly fell 33% after being added to the index. Being a relatively high priced stock in the index, KFT had a much more significant impact on the Dow Industrials than the 90% decline in AIG over the same period.

Effectively, what I am describing is a "buy high and sell low" strategy that Dow-Jones exhibited in recent years. Which got me wondering, how did they manage during the "Great" Crash of 1929? Well, the results were what I would consider to be astonishing. The untimely inclusion of companies like KFT, C, HPQ, INTC, MSFT, AIG, BAC and HD were nothing new. However, what was unique about the period of 1929 to 1932 was the number of changes to the index that took place in such a short period of time. A total of 18 companies were taken in and taken out of the Dow.

Never before and never since has the Dow had so many companies added and dropped as constituents of the index. The only other period that came close was the period from 1899 to 1901, when the index had 9 companies added and dropped from the index. As demonstrated earlier, the timing of the selections were not the most optimal. As one company was added at a relatively high price the outgoing company with a low price, which would have had little impact on the downside, was given the boot. This resulted in a vicious cycle which propelled the index much lower than was otherwise necessary.

I contrasted the period of 1929 to 1932 with other known bear markets like 1906 to 1924, when the Dow languished around the 100 level, and the period from 1966 to 1982, when the Dow traded at or below 1000. In each case, the number of changes to the index was marginal, at best. The 18 year period from 1906 to 1924 had only 13 changes or 1.38 changes per year. The 16 year period from 1966 to 1982 had only 4 changes or 0.25 changes per year. This is contrasted with the 1929 to 1932 period which had 6 changes per year.

If looked at from the perspective that Dow-Jones is always going to "buy high and sell low" then we can reasonable assume that much of the decline in the Dow from 1929 to 1932 was due primarily to the constant changes to the index. Frequent changes to the index causes "the market" to grope about for a bottom (no pun intended) that doesn't exist. It appears that Dow-Jones learned the lesson that "buy and hold" works better than trading in and out. However, the timing of their changes to the index has caused more pain to last much longer than if they just let sleeping dogs lie. Touc.

Keywords:

• delist
• delisting
• delisted
• replaced
• Travelers
• GM delisted
  
• Citigroup
• Cisco
  

The Importance of Dividends

On January 3o, 2006 I bought a stock that was, until recently, a Dividend Achiever. When I bought the stock it was selling for $16.21. At the time, the stock was yielding a little over 5% annually. My only consideration for selling the stock ,as with all Dividend Achievers, was if the company reduced or cut the dividend payment.

Fast forward to April 17, 2009. Today the stock has closed at a price of $9.50. Under normal circumstance this would be calculated as a loss of 41.39%. However, due to the dividend payments over the given period of time the total loss ended up being only 17.84%. All of this occurred during the single worst uncorrected down move in stock market history.

Given the current market conditions, the company has been forced to cut its dividend payment by 33%. The company might be taking the appropriate action at the right time, however the dividend cut means that I will no longer be able to hold this stock.

The key concept that should be gained from this demonstration is the fact that even in the worst of times, a company that has a consistent policy of dividend increases will be better able to sustain your capital through hard times. Had I not selected this (former) Dividend Achiever I would have been out the 41.39%. Instead, I walk away with a relatively marginal loss considering the price and date that I started my investment. This should be the lesson to all investors about practicality and importance of dividends. Touc.

Bear Market Rally Targets

My previous article on November 26, 2008 had projected that the Industrials were expected to go to the 10,836.11 and the Transports should go to 4126.56 by early May and August respectively. Because both indices have fallen further since that date, I need to update my figures to reflect the upside targets and the approximate timing of the targets.

• Industrial Average: 10,360.02 by late August 2009
• Transport Average: 3,748.40 by mid-October 2009

In the same article that I wrote about the Industrial and Transports, I gave my projections for the gold stock index, the XAU. At that time, using Dow's theory, I said that the gold stock index would go to 136.40 by late February or early March. On March 19, 2009 the XAU index hit 136.53. As of the close of market today the XAU sits at 134. My cycle analysis tells me that the trend for the gold stock index is supposed to go down from here. However, if we're in a bear market rally then we could see the XAU go much higher in the near term. So far, I can only guess that the accuracy of my prediction for the XAU gold index is nothing more than luck. Touc.

Unemployment figures compared to Bear market of 1966-1982

As we approach the 2nd year of our 18 year bear market, it is worth comparing the unemployment rate between this bear market and the last most comparable bear market. It is my opinion that the last comparable bear market was the period from 1966 to 1982. If our economy and stock market has a further free fall then I'd have to adjust my comparison to that of the period from 1929 to 1954.


When we look at the Bureau Labor of Statistics data on unemployment we see that both 2007 and 1966 share the characteristic that the respective periods were not all time lows for unemployment. In the case of 1966, the absolute low was in mid 1953 while the absolute low for the period preceding 2007 was in late 2000. The implications of this concept are that thus far everything that we're experiencing in this bear market is going according to planned regardless of the efforts of policy makers.

Next, I'd like to do a side-by-side comparison of unemployment from the low in unemployment in 1953 to the period of the peak in the stock market in 1966. Likewise we will compare the amount of change in unemployment from 2000 to the current date. Then we will observe the commonalities and contrasts between the two periods.

At the lowest levels in 2000, the rate of unemployment has increase by 113% as of Feb. 2009. During the same period of time from the low in unemployment in 1952, the unemployment rate increased 141% in the equal amount of time until 1961.

Research Rec.: Matthews Corp. (MATW) at $29.04

WARNING: The consideration of this stock can only be done with an understanding that we're in a bear market. Please carefully consider the downside risks mentioned in this research recommendation before taking any actions. Despite the possible qualitative attributes of this company, the purchase of this stock should be considered speculative at this point in time.

According to MergentOnline, Matthews International (MATW) is, "a designer, manufacturer and marketer principally of memorialization products and brand products and services. Memorialization products consist primarily of bronze memorials and other memorialization products, caskets and cremation equipment for the cemetery and funeral home industries. Brand products and services include graphics imaging products and services, marking products, as well as merchandising products and services. Co.'s products and operations are comprised of six business segments: Bronze, Casket, Cremation, Graphics Imaging, Marking Products and Merchandising Solutions." Some would think that this business is a "no-brainer" to make money in. However, my experience is that companies in the funeral services industry have a hard time retaining their focus on their core competencies and profitability.

As a Dividend Achiever, MATW has increased its dividend every year for 14 years in a row according to MergentOnline. Yesterday March 30th, MATW eased to a new low after reaching a peak of $58.55 in September 2008. The fact that MATW was able to reach a new high in the middle of September 2008 is an astounding feat. However, the following decline has resulted in a near 50% decline as of March 30th.

According to Dow's theory, MATW has the following upside and downside targets:

Upside targets:

• $31.87
• $40.77
• $49.66

Downside targets:

• $26.19
• $ 10
• $5
  

Again, considerable attention must be directed at the prospect for the downside risk since we are in a bear market. Anyone buying this stock should be willing to accept that this company can easily go down to the $10 or $5 level or a loss of 64% and 82% respectively.

The fundamentals about this company are fair. However, of particular importance is the fact that MATW has an 11% dividend payout ratio. This is instrumental to the success of the company getting through the deepening recession.

Your own research of the funeral services industry will reveal that while death is certain only a few companies have managed to succeed at making money on a consistent basis. It is hoped that MATW is the right company for an otherwise difficult business. Touc.

Research Rec.: Meridian Bioscience (VIVO) at $18.21

WARNING: The consideration of this stock can only be done with an understanding that we're in a bear market. Please carefully consider the downside risks mentioned in this research recommendation before taking any actions. Despite the qualitative nature of this company, the purchase of this stock should be considered speculative at this point in time.

As I mentioned in my sell recommendation of Helmerich and Payne (HP), I have been anticipating the opportunity to buy Meridian Biosciences (VIVO) for over 3 years now. According to Morningstar.com, VIVO, "...manufactures disposable immunodiagnostic test kits used for the rapid diagnosis of infectious diseases. Its products aid in the diagnosis of gastrointestinal infections, mononucleosis, ulcers, urinary-tract infections, respiratory infections, and strep throat."

As a Dividend Achiever, VIVO has increased its dividend every year for 16 years in a row according to MergentOnline. Yesterday March 25th, VIVO plumbed a new low after reaching a peak of $37 in April 2008. According to Dow's theory, VIVO has the following upside and downside targets:

Upside-

• $23.33
• $30.16
• $37.00

Downside-

• $11.29
• $ 5.65

Again, considerable attention must be directed at the prospect for the downside risk since we are in a bear market. Anyone buying this stock should be willing to accept that this company can easily go down to the $11.29 or $5.65 level or a loss of 38% and 69% respectively.

The fundamentals about this company are exceptional like little debt, double digit return on equity and return on assets and an astounding dividend growth rate. Your research of this stock might convince you to buy right away. However, the biggest red flag warning about this company is that the dividend payout ratio is very high at 91%. At some point this has to start going lower or the company may have to dip into it's cash reserves, borrow or cut the dividend altogether.

Aside from all the homework that you have to do before you consider this stock, I would like to draw your attention to the comparison chart below of VIVO's stock price to that of Google (GOOG). While these companies are in unrelated industries both GOOG and VIVO appeal to investors as demonstrated by the eerily similar stock price movement. From the IPO of GOOG back in August 19, 2004 to the most recent peak, GOOG and VIVO appreciated 639% and 665% respectively. However, when the downturn came GOOG fell hard and fast down 67% at the low while VIVO is down 56% from the high. The distinction, of course, is that VIVO will pay a portion of earnings to you the shareholder while it struggles through this economy and GOOG will only promise that things are going to get better as the shareholders hope that the price will go up.

I have bought shares of this company for the long term if the stock falls. While you're doing your research of this company, it is hoped that this stock continues to fall so that you can get a better price than mine. As with my purchase of HP, if VIVO miraculously increases in value, I will consider selling only if my gain has been exceptional and a better alternative presents itself at the same time. If you're unclear about my investment philosophy and approach please review my "About This Site" section. Touc.

SELL Helmerich and Payne (HP) at the Market

The time has finally come to issue a SELL recommendation for Helmerich and Payne (HP.) The stock has performed moderately since the research recommendation was issued on March 10, 2009. It is highly recommended that anyone who bought the stock based on my research should re-read the posting. From the current level of $26.13, HP is poised to reach the $30 level with no effort. However, the returns that this stock has provided in the last 16 days say that it is worthwhile considering alternatives. Later today I will present an alternative Dividend Achiever that I have personally been anticipating for over 3 years.

HP was recommended when it was trading at $22.55. As of Thursday March 26th, HP was quoted at $26.13. This equals a return of 15.88%. Conservatively, on an annualized basis this would equal approximately 380% return. Selling this stock now also generates a return 17.6 times the amount of the dividend yield if the stock was held for a whole year.

It is always recommended that when selling a stock, one should not place an order after hours or when the market is closed. This leaves the seller in the position of being vulnerable to the whims of the market makers. Instead, place your sell orders only as a market order during market hours. Some would complain that a market order during market hours might leave some profits on the table. However, I would rather leave some money on the table rather than have it taken away from me by the trades that are placed by institutions and market makers. Touc.

Diversification Doesn't Matter

The idea of a diversified holding of stocks is often said to save many investors from losing large amounts of money. However, the concept of diversification often is misunderstood in its most basic context. Diversification only matters when an investor is spread among completely different asset classes such as real estate (real property and not in the form of primary residence), business ownership, gold and silver (bullion), and stocks. All other notions of diversification are often just that…notions.

For do-it-yourself investors who wish to buy stocks, the mantra has been to diversify your risk. I guess this means, the more stocks you hold the less you’ll lose. Along these lines, diversification is supposed to reduce downside movements while participating in upside action. The fewer stocks you have the more you’ll lose. The more stocks you have the less you’ll lose. Unfortunately real life suggests that the more stocks a person holds the greater the risk of loss. How is this possible? I have my suspicions as to the reasons. However, I would like to provide the evidence for my claim that diversification isn’t all that its cracked up to be.

Many people who follow the stock market know that the Dow Jones Industrials Average is the most widely quoted index. However, most people “know” that the best index to follow for a broader understanding of how the entire stock market performed rely upon the Standard and Poor’s 500 (S&P 500) index. After all, the S&P 500 contains 500 diversified companies in many different industries. This is contrasted by the Dow Jones Industrials, which only contains 30 companies.

However, did you know that the top 43 companies in the S&P 500 comprise 50% of the movement of the index? The top 131 companies comprise 75% of the movement of the index. By the time you get to company number 258, you have reached 90% of the movement of the entire S&P 500 index. This means that the remaining 242 companies in the index only contribute 10% to the movement of the index. It’s as if those companies on the bottom half don’t even exist.

How is it possible that the S&P is so strongly influenced by the top 258 companies? The answer is that the S&P 500 is considered a market value weighted index. This means that, “…movements in price of companies whose total market valuation (share price times the number of outstanding shares) is larger will have a greater effect on the index than companies whose market valuation is smaller.” Basically, larger companies have more influence on the index. For this reason, most people who invest in an S&P 500 index fund or ETF are really investing in companies that have the largest valuation rather than a “well diversified” portfolio.

It wouldn’t be enough to simply say that the S&P 500 index isn’t as diversified as most people think. We need better evidence to show that the concept of diversification can’t stand on its own. Using the Morningstar.com database of various domestic indices, I compared the 1-year, 3-year, and 5-year performances to see if there are any distinguishing characteristics. Because this has been a declining market of the last 2 years we should see the indices with fewer stocks with the greatest losses. If there were any gains then the least diversified index should have the highest percentage gains.

Unfortunately, the reality is quite sobering. When comparing Morningstar’s 37 domestic indices in the 1-year category:

• Ranked #1 was the healthcare index with a –20.55% loss with 178 companies
• Dow 30 was ranked #17 with a loss of -35.05%
• Russell 2000 (2000 companies) was ranked #20 with a loss of -35.27%
• S&P 500 was ranked #23 with a loss of -36.47%

In the 3-year comparison:

• Ranked #1 was the energy index with a 11.92% gain with 121 companies
• Dow 30 was ranked #8 with a loss of -9.3%
• S&P 500 was ranked #21 with a loss of -12.31%
• Russell 2000 was ranked #29 with a loss of -15.44%

In the 5-year comparison:

• Ranked #1 was the energy index with a 11.92% gain with 121 companies
• Dow 30 was ranked #14 with a loss of -2.66%
• S&P 500 was ranked #23 with a loss of -3.61%
• Russell 2000 was ranked #27 with a loss of –3.78%

It seems as if the more diversified the index, the worse it performed. The only time the Dow 30 came at the bottom of the list was when we compared the 1-week, YTD, 4-week and 13-week ranges. Remember, a truly diversified index is supposed to overperform other indices on the downside (go down less) and underperform on the upside (go up less). If you’re investing for the “long haul” then the data tells us that you shouldn’t be invested in the S&P 500 or any other index that is “truly diversified.”

Another way to test this assumption of diversification on your own is to eyeball the different periods of time using the interactive comparison chart at Yahoo!Finance.com. First, pick the S&P 500 or any other “diversified” index and compare it to the Dow Jones Industrial Average. Then select the timeframe that you’d like to compare (5 years or more is best). Once the timeframe has been selected you can slide the timeframe backwards to any period you want. You’ll see that the Dow frequently overperforms on the upside and overperforms on the downside from 1980 onward. Prior to 1980, The Dow and S&P go back and forth in either underperforming or overperforming. The point being, diversification really doesn’t matter when it comes to spreading your risk. Touc.

Sources:

• IndexArb. Index Component Weights of Stocks in the S&P 500. accessed online March 24, 2009.
• EDinformatics. Investor Education: S&P 500 Index. Accessed online March 24, 2009.

Fannie and Freddie Break the Buck

Both Fannie and Freddie finally made it to the big leagues. What is it that both of these companies have managed to do? They both have closed above the fabled $1 a share mark. as I mentioned in my February 21st article the threat of delisting was upon the companies and that something had to happen. Either the companies get delisted or the miraculously go above $1.

Regular reader Ron wondered aloud whether or not some sort of trickery would the explanation for the continued propping of these otherwise dead companies. As I said in my comments following in the article, this is "one of the biggest speculations in history." No sooner said than done, the stocks fell promptly by 40% and bottomed on March 6th. From that ridiculously low level the stocks rose at least 185%.

We finally got the answer that I suspected but only time could tell. The government, lacking the barest sense of fiscal responsibility, has triumphed again. It is well worth watching Fannie Mae and Freddie Mac for a sense of what is to come next. I find it interesting that both companies bottomed on March 6th while the Industrials and Transports bottomed on March 9th. Maybe, just maybe, these government entities are on the inside track. I'll be following them as you could imagine. Touc.

The Common Refrain, To Our Detriment

The problem with our markets and economy, as a "capitalistic" society, boils down to the fact that every mechanism set up to avoid failure and disruption (counter to a capitalistic system) has failed. Not only has failure remained in the system, the very features that have been instituted to save us have actually contributed to a slow and methodical breakdown of a system that is supposed to thrive on change. The following is a short list of ideas, institutions or laws previously thought to bring stability to our financial system:

• 
  
  Fannie Mae
• 
  
  Freddie Mac
• 
  
  Circuits breakers
• 
  
  Federal Deposit Insurance Commission
• 
  
  Government seizure of AIG
• 
  
  National Association of Securities Dealers
• 
  
  FINRA
• 
  
  Securities and Exchange Commission
• 
  
  Generally Accepted Accounting Principles
• 
  
  Uptick Rule
• 
  
  Ban on Short Selling
• 
  
  Sarbanes-Oxley (Sarbox)

After all, look at some of these concepts and see what their impact has been. Circuit breaks were instituted after the stock market crash of 1987 to prevent a similar one-day decline of 20%. Since then the only circuit breakers to ever kick in are those that happened during the largest rise in stock market history from 1990 to 2007. On the way down however there is not a peep of a circuit breaker being tripped. The most recent orderly declines have contributed to the largest singular decline in stock market history. Worse still, we don't even know if the carnage is over.

How about the Securities Exchange Commission and FINRA? Out of all the crimes that have been committed on Wall Street the only person to go to jail was Bernard Madoff and his associates. Come on!!! The guy turned himself in...and if it wasn't for the market decline who knows how long the scheme could have gone on. Do you want financial security? Don't rely on the SEC or FINRA to provide it.

As quiet as its kept, one law that keeps being violated but hasn't landed anyone in jail is Sarbanes-Oxley (Sarbox). What is Sarbox? Oh, that's the law that came out after the Enron and WorldCom accounting and executive frauds of the 1990's. One provision of Sarbox says that executives can't publicly say that their company is financially safe and sound when they knew otherwise. This was a tactic that Enron executives used to prop their price up while they were selling at the same time. I have heard too many executive from Fannie, Freddie, Lehman, Merrill, B of A, Citi and others do what is a clear violation of the letter and intent of the law. Any of those guys in jail yet? Naw, no one is likely to go to jail for outright lying because if the executive says something to prop the company stock between the quarterly reports but not specifically on the audited quarterly report itself then it's cool. The Sarbox legislation reads like a "how to guide" on ways to avoid getting caught. Either let Skilling and Ebbers go or back the intent of the law and put the most recent offenders in jail.

After the Enron and WorldCom debacle Sarbox was supposed to address the issue of off-balance sheet items. Among other things Sarbox says that it's purpose is:

"...to identify areas of reporting that are most susceptible to fraud, inappropriate manipulation, or inappropriate earnings management, such as revenue recognition and the accounting treatment of off-balance sheet special purpose entities." (emphasis mine)

What about Fannie, Freddie, Citi, and Merrill using off balance sheet entities or GE using earnings management to cover their losses or produce profits? Is anyone going to stand tall and call these Enronesque tactics out?· Not likely, whoever has the guts to bringing these issues up would be accused of kicking an opponent while they're down. Unsportsman like conduct would be the charge.

Alright, so what's my beef with FDIC? It sounds like a wholesome institution. After all, it protects the deposits of everyday citizens like you and me, right? Thanks to James Grant's book Mr. Market Miscalculates, here is what National City Bank (today's Citigroup) had to say about the legislation bringing FDIC into being:

"The element of character in the choice of bank is eliminated, and the competitive appeal is shifted to other and lower standards, such as liberality in making loans. The natural result is that the standards of management are lowered, bankers may take greater risks for the sake of larger profits and the economic loss which accompanies bad bank management increases."

Now, don't get me wrong, I like keeping my money in an institution that passes on the cost of deposit insurance. However, it is the FDIC protection that allows the banking institutions to run amok when times are good and the public has to pay when times aren’t so exciting. Is there any coincidence that we had the S&L crisis (FSLIC backed) to begin with? Is it any wonder that the costs associated with the S&L crisis are still part of our government's off-budget items. At the same time we're still paying for the S&L debts, the Resolution Trust Corporation (RTC) is called a success. Prophetically, Citigroup is among the largest offenders of the very system that their forerunner was against and for the very same reasons. There is little wonder the FDIC is petitioning congress for an additional $500 billion backstop "just in case." The FDIC is moral hazard reincarnated. After all, a bank can put a FDIC sticker on their door and have instant credibility as a business and if it fails the FDIC swoops in to legitimize the sticker.

The government seizure of AIG is now a hornets nest. But it never had to be. If we didn't bail out AIG we wouldn't have to worry about bonuses being paid in the first place. The near $10 trillion of bailout money could have gone to better uses like bailing out the FDIC, something that people have expected to be there for over 60 years. Or buying up 90% of all mortgages in the nation...no, no... better still, insuring against any defaulted mortgages up to $10 trillion. By insuring against loss, no money has to go out at all until there is a real, honest to goodness foreclosure. And like every good insurance company, the government could selectively decide to pay up.

The outlandishness of getting rid of these organizations certainly gets folks riled up. How could a simple two-year decline in the stock market and economy call for the dissolution to such important entities? To which I say, show me the evidence that these rules and organizations have done their job. What good comes from letting a company like AIG stay around when so many well run insurance companies are waiting to take their place. Ah, but the common refrain is, "if we let AIG go then the alternative could be worse." Touc.

Sources:

• 
  
  Department of Justice. “Former Enron chairman and chief executive officer Kenneth L. Lay charged with conspiracy, fraud, false statements.” July, 8, 2002. accessed online March 22, 2009.
• 
  
  Colvin, Geoffrey and Benner, Kathy. “GE Under Siege.” Fortune Magazine. October 15, 2008. accessed online March 22, 2009.
• 
  
  Grant, James. Mr. Market Miscalculates. Axios Press. 2008. page 202.
• 
  
  DioGuardi, Joseph. “Enron Fraud Small Change Next to U.S. Accounting Gimmicks.” World Tribune.com. May 4, 2003. accessed online March 22, 2009.

Book Review: Trouncing the Dow

The results are in on my 8-year survey of the investment method that is in the book Trouncing the Dow by Kenneth Lee. As with most investment books, there is the promise of rich rewards if you follow the author's secret to investment success. The only problem is that in order to really know if an approach is useful you need to see how the process would work over an extended period of time. Upon buying any investment book, it is impossible to find meaning in what the book contains. After years of passive study Trouncing the Dow proves to be a book that is worth examining.

Naturally, this book drew my attention because of its focus on the Dow Jones Industrial Average. By choosing stocks that are in the Dow Industrial average, Lee is trying to convey the idea that quality should be a priority when deciding which stocks to buy. However, the strength of this investment approach is found in the author's ability to recognize that stocks cannot and should not be held for the "long run." Instead, Lee says that, after determining the price range for a particular stock, you would consider buying at the low and selling at the high end of the range.

In theory an investment approach either works or doesn't. However, there is the real world to bear upon the actual outcome of any investment style. In the case of Trouncing the Dow, I have the benefit of starting my analysis in the middle of major bull market correction in May of 2001. This starting point takes away the illusion that all stock will go up forever as demonstrated by the Dow Industrials falling 37% and the NASDAQ falling 70% during the period from January 2000 to September 2002.

This review was done as a real-time experiment rather than an investigation based on looking back (backtesting) on what the performance would have been. From May to December 2001, I started my investigation of the benchmark investing method using 19 companies that were on my list for possible investments. As mentioned earlier, the benchmark method indicates what the range of a stock price should be in order to buy or sell. Trouncing the Dow uses Value Line Investment Survey as the sole source for deriving the data necessary to come to a conclusion.

Because there is no such thing as a perfect approach to investing, I consider a successful approach one that gets me close to the high and the low price but above the range on the downside and below the range on the upside. If a stock was predicted to reach a high of $45 but peaked at $40 then there is no value in that prediction since I would have been waiting for a price that never materialized. Conversely, if the prediction was that the stock was supposed to reach a low of $10 but only went as low as $12 then I would have never considered buying the stock until it reached $10 therefore this would have been considered a false or inaccurate prediction. Some stocks that had a predicted low of $10 but actually hit bottom at $8 were considered accurate and an acceptable trade-off given the fact that the selected stock paid a dividend compensating for the wait on the way down and up. In general my findings about this investing approach are as follows:

First, the accurate observations (11/19):

• The average decline after the predicted low was 22%
• The largest decline after the predicted low was 47%
• The smallest decline after the predicted low was 12%
• All 11 stocks exceeded the predicted high price, in some cased by 3 times
• Prior to 2001, 9 of 11 stocks had a history of increasing the dividend every year for the last 10 years

The inaccurate predictions (8/19):

• 1 company filed bankruptcy
• 1 company was bought
• Prior to 2001, 2 0f 8 stocks had a history of increased dividends
• Benchmarking was way off the mark when predicting transportation companies
  
  

In a proposition that is 50/50 in terms of the outcome, Trouncing the Dow method seems to be an effective way to increase the odds in your favor. Again, I only considered the benchmark approach to be effective if the stock price went below the predicted low. Why? Because we're only interested in what the worst case scenario is or might be. The upside will always take care of itself.

Combining the benchmark method, in Trouncing the Dow, with the non-banking companies in the Dividend Achievers Index may be an effective way to increase the quality of the stocks you choose to buy as well as when you decide to buy the stocks. I recommend that you at least check the book out at your local library and apply the approach to the non-financial components of the Dow Jones Industrial Average. Keyword search the title of the book and you'll find plenty of backtested analysis for this investing approach all over the internet. Touc.

Financial Panic Chronicles

After the most recent banking drama that we've been having, I thought it would be interesting for us to turn back the clock and revisit a bygone era of prior financial panics. This will be the beginning of a series of posts from various news sources. The purpose of this exercise is to see, that despite the passage of time, how we make some fundamental mistakes over and over again.

The first financial panic that I'm examining is the failure of Bodenkreditanstalt which later became CreditAnstalt. The following excerpt is from the New York Times dated November 15, 1929:

"The president of the bank employes' association demanded that the fortune of $7,000,000 which Herr Sieghart is alleged to have obtained, despite the collapse of the bank be confiscated for partial reparation of the losses of employes and shareholders in accordance with the bank's articles of incorporation."

Wow, leaving aside the way they spelled 'employee' back in 1929, you'd think this was straight from an article on the bonuses being doled out by AIG. By the way, $7 million in 1929 is the equivalent of $84 million in 2007. The more things change the more they stay the same. Touc.

Source:

• "Austria Bank Head Scored In Failure." New York Times. November 15, 1929.

Industrial Production Index Fence Sitting

The news just keeps coming in. Today the Federal Reserve announced the Industrial Production Index (IPI) figures for the month of February. The IPI fell to the level of 99.7298. This is 1.93% above the December 2001 level of 97.8399. Falling below the Dec. 2001 level would bring economic activity to the dark ages for all intents and purposes.

Warning: the following charts may cause severe and/or permanent eye damage. Avert your eyes if you start to feel the signs of fatigue, drowsiness, or nausea.This blog is being featured on www.condron.us, I hope you find this useful.

For all I know this is do or die for the U.S. economy. Because the IPI is a lagging indicator as part of Dow's Theory, we can only guess that as the Dow Industrials and Dow Transports have bottomed on March 9th we might be in the midst of a temporary bottom. How do I know? I don't know. However, the economic data that is coming out recently isn't worse than what would be expected as the "experts" have baked in much of what is known to be on the horizon.

My opinion is that we aren't out of the woods but we are well on our way to a natural reaction to the oversold conditions in the market and the economy. However, be prepared for new and unforeseen realities that the market has to offer. As an example, what would happen if a medium sized holder of treasuries decides to sell all of their holdings? The shock to the financial system would be profound and unexpected since everyone is waiting on pins and needles for China or Japan to pull the trigger.

Usually it is the unexpected and smaller players that can disrupt an entire system like what occurred in Thailand in 1997 or Austria in 1931. As the prevailing logic goes, China and Japan have too much at stake to actually sell their U.S. treasuries, therefore it is fitting that they wouldn't engage in the activity as readily as, say, ______________________(fill in the blank).

As with every snowball, all it takes is a small player to get things started. The rest becomes a matter of flooding the exits. The last thing we need in this economy is rising interest rates due to the forced selling of treasuries. This would be the final blow to the perception that the economic "crisis" can be contained. However, it is this scenario that has the highest probability of occurring as a sort of "black swan" event. Touc.