Dr. John Rutledge Blog

September 1, 2006

Emerging Markets Review

(Greenwich, 9/24/2006) The Internet has bred a proliferation of new journals--especially on emerging market issues that were formerly poorly covered--that is providing researchers around the world with many more outlets for their papers. I am hoping to take advantage of that to help young faculty members at Hunan University reach a wider audience with their work.

The latest issue of the Emerging Markets Review, Volume 7, Issue 3, Pages 191-278 (September 2006) has several interesting articles about investing in emerging markets. You can have the table of contents for each issue of Emerging Markets Review (and many other journals) as well as abstracts of articles emailed to you at no charge (although there is a charge for full articles) by registering at Science Direct at www.sciencedirect.com.

1. Coming to America: IPOs from emerging market issuers, by Robert Bruner, Susan Chaplinsky and Latha Ramchand examines the issue costs of 299 companies from emerging and developed market countries making initial public offerings (IPOs) in the United States between 1991 and 2001. Surprisingly, they find that IPOs from emerging markets experience the same costs on average as IPOs from developed market countries.

The reasons? Emerging market issues tend to be more NYSE, less NASDAQ than U.S. IPOs. They tend to be old economy companies rather than tech companies. They are larger, higher-quality companies--frequently privatizations of state-owned companies with long histories. And they are clustered near the end of bull markets (when investors are temporarily insane and investment bankers are eager to write one more ticket before the door closes.) You can read an abstract of the article by clicking here.

This issue is omportant because we are going to see a lot of very large public offerings coming out of China through the Hong Kong and Singapore markets.

2. Earnings estimates in emerging markets—an update, by George R. Hoguet reviews the availability and timeliness of earnings estimates for public companies in emerging markets. He finds that there are nine earnings estimates per security in Fiscal Year 1(FY1) and 8.7 in FY 2, higher than both the MSCI Japan Index and the Russell 2000 Index. You can read an abstract by clicking here.

3. Changes in the dynamic behavior of emerging market volatility: Revisiting the effects of financial liberalization by Juncal Cuñado, Javier Gómez Biscarri and Fernando Pérez de Gracia shows that over the period 1976–2004 financial liberalization of emerging markets has generally reduced the level of market volatility and its sensitivity to news. You can read an abstract by clicking here.

This is an important issue because this year China is dramatically opening its capital markets as required in the WTO agreement.

JR

Posted by John Rutledge at 7:48 PM

July 18, 2006

Thoughts on Investing

There is so much hand-wringing going on by market watchers that I thought it would be a good idea to haul out a little common sense. Markets have been going down in recent months. I lost money too. But the world rarely ends. When people regain their senses I want to be in the market. Here are 5 things to keep in mind when you watch the news.

1. Don’t be distracted by the daily news. Investors are bombarded daily by a crisis du jour of confusing and conflicting news reports. The positive news on U.S. growth, productivity, and profits, is being drowned out by a tsunami of reports on oil prices, Iran, North Korea, Trade, immigration, inflation, and the Fed. Investors are confused, frightened, and sitting in cash. This is a reaction, not a strategy. The world is not going to end and we still need to educate our children and save enough to retire. This is when an investor needs the discipline to stay focused on long-term objectives, investment fundamentals, tax planning, and a long-term strategy for building family wealth.

2. Long-term investment fundaments are actually very strong. Productivity is rising and the U.S. economy is growing strongly. Profits and growing in double-digits and are at the highest percent of GDP ever recorded. Dividends are rising. The global economy is growing too, led by the reforms in China and India. Japan and Europe are growing too. Capital owners have more choices where to invest at attractive returns than ever before. The Fed and other central banks have shown that long-term inflation will be 1-2%. Bond yields are likely to remain near current 5% levels. Stocks are cheap at only 14 times next year’s earnings. These are great long-term fundamentals for equity markets.

3. Understand and manage risks but don’t let risk drive your investment strategy. Understand strategic risks. China’s growth has fundamentally changed world oil markets; high oil prices are here to stay. High oil prices have brought Iran, Russia, Venezuela and the Gulf back into the headlines. Iran and North Korea’s nuclear ambitions must and will be stopped. The Fed and other central banks have been aggressively raising short-term interest rates—more than 90 increases around the world to date. But tight oil and commodity markets have run their course and the Fed is almost finished tightening. The two big risks are getting caught holding last year’s winners—stocks driven by rising commodity prices—and being out of the market when people come to their senses and stock prices once again rise to reflect the value of the companies.

4. Investment strategy should focus on long-term returns. Defensive strategies—some extra cash, short (2-5 year) bond maturities, defensive sectors--are OK in the short-term. Long-term, focus on high quality U.S. companies with strong cash flow and rising dividends and on countries, sectors, and industries selling products and services to fast-growing Asia. I think U.S. stocks will produce 10%+ returns over the next 5 years, compared with 5% for bonds, 4% for cash, and 0% for real estate. Asian equity markets will produce 12-15% returns. Don’t chase hot commodity prices or Asian IPO’s.

5. Diversification and tax planning still matter. I like to use ETF’s (Exchange Traded Funds) to place small bets on countries, regions, sectors, or industries where policy or technology change has raised after-tax returns on capital relative to the market. I reserve company bets for (rare) situations where I believe I have an information advantage over the market. ETF’s have low expenses and provide at least some level of diversification against adverse company or manager events. Many investors are not aware of the tax liabilities they will face when they ultimately distribute their IRAs. Tax rates are more likely to rise than fall in future years, making tax planning very important.

JR

Posted by Pamela Rutledge at 4:58 PM | Comments (1)

April 26, 2006

Coal is the New Oil

This story from the Asia Times is one of the reasons I have been telling people to invest in tight oil markets by buying coal.

China approves coal-to-oil project. Yankuang Group has received government approval to develop a 5-million-ton coal-to-oil project in northwest China's Shaanxi province.

As I said on Fox News recently, coal is the new oil. As a way to place your bet I like Peabody Coal (BTU) which has more than doubled since I recommended it on Fox News. I bought some more today. I also like the exchange traded fund for Australia, New Zealand, Singaport, and Hong Kong (EPP) which has been very good to me too.

JR

Posted by John Rutledge at 7:35 PM | Comments (1)

Blowout Earnings Reports

This is a HUGE earnings week. So far, 70% of the companies that have reported have beat their estimates and guided earnings estimates higher.

This is the real story. Strong growth, strong profits. Stay in the market.

JR

Posted by John Rutledge at 2:08 PM

Forbes MoneyMasters Video: Investing in China

I made a short video with Vahan Janjigian for the Forbes MoneyMasters series. You can view the video by clicking on this link.

Posted by John Rutledge at 1:41 AM

April 24, 2006

Telecom and Tech Investing

Reuters has an interesting story today, Mergers boost bond sales in US tech, telecom sector, about the recent boom in M&A and financing activity in the telecom and tech equipment sectors.

This is not a return to the 1990;s bubble. This time it is real.

As you now, I whine a lot about the collapse of tech and telecom capital spending since 2001. It is a major factor in making American companies competitive with companies in Asia, where telecom investing is a national priority.

AS you know, I invest by identifying policy events that drive a wedge between the returns on a category of assets relative to others. I have had telecom network as one of the investment storm systems on my economic weathermap on the Rutledge Capital website for some months, anticipating a change in legislation and regulations. Now it looks like it might happen. That's why telecom equipment and service companies have had such good recent performance.

I believe there will be telecom legislation this year that will include national video franchising. That would trigger huge investment in new optical fiber network by telecom companies getting into the video business. The side benefit--it will make the small businesses in those towns able to deliver services to customers anywhere at the speed of light.

JR

Posted by John Rutledge at 4:01 PM

Chinese Currency Not Going Down

The currency market is selling the dollar against the yen and Euro today on stories from the weekend G-7 Whine-Club for Men meeting where the assembled finance ministers complained that China should revalue their currency. Not gonna happen.

As the Wall Street Journal reports today, there are lots of domestic reasons why it makes sense for China to keep the RMB pegged to the dollar. A stable RMB is the key to stable prices and politics inside China, both of which are necessary for continued growth.

I like the yen against the dollar on interest rate grounds--Japan is growing like crazy. But this has nothing to do with China.

JR

Posted by John Rutledge at 3:35 PM

Alcatel-Lucent Bad Governance

This is the stuff that gives corporate governance a bad name.

The Wall Street Journal reports today that prospective merger partners Alcatel and Lucent plan to require votes from two-thirds of the new board to remove either the chief executive officer or the chairman of the combined company.

I thought they only gave tenure in academics where it doesn't matter for the overall economy.

JR

Posted by John Rutledge at 3:23 PM

April 22, 2006

Capital Controls in China

On Saturday I spoke at the Yale China Conference. It was a great opportunity to meet a large number of finance students interested in China. Best of all, when I told them we are hiring four finance professionals to work in our Beijing office I was buried under a mountain of superb resumes.

The conference was hosted by the China Initiative at the Yale School of Management. If you are interested in Chinese capital markets I suggest you visit their website, where they have a number of research papers.

One paper in particular is worth a read. It is a look at the history and prospects for changes in capital controls in China. I have copied the abstract below FYI.

Capital Controls in China: Recent Developments and Reform Prospects by Zhichao Zhang.

Capital controls proved useful for the central planning system, but the growing adverse effects make the reform inevitable. Early reform efforts were focused on relaxing restrictions on foreign exchange availability and embracing for market forces, which led to the establishment of Chinese currency’s convertibility on the current account in 1994. The Asian financial crisis disrupted this process. China recently has quietly re-launched this reform. The new measures are directed at loosening up controls over capital account transactions to achieve so-called “fundamental convertibility” with full convertibility on the current account but conditional convertibility on the capital account that allows free long-term capital flows but restricts short-term capital flows. The recent reforms feature a strategy of selective liberalisation and China is making progress in reducing the intensity of controls, particularly controls on capital outflow. A new regime has emerged under which transactions in most international assets are freed though a number of capital transactions remain regulated. Meanwhile, China has pro actively promoted international use of Chinese currency. These developments suggest the beginning of the end of capital controls in China.

JR

Posted by John Rutledge at 4:42 PM

March 6, 2006

Qatar Market

The real downdraft in the Gulf region is Qatar, where the Doha market is down 22.6% year to date. Same story. Huge increase (500% since January 2000), bubble signs recently, free fall in recent days/weeks.

Investors in America need to pay attention to the local markets in the oil patch. Best way to do so? You can get free daily price quotes from my friends at Global House in Kuwait. And you can get a weekly summary of the business and economic stories from the region's press from MENAFN.

JR

Posted by John Rutledge at 6:21 PM | Comments (1)

Saudi Market Rolling Over

Take a look at the Saudi stock market, where prices fell by 10.37% last week. The worst damage was in the electricity sector, which lost a quarter of market value in one week.

Market cap fell SR 314 billion ($1=3.75 SR) in the SR 3 trillion market.

The market has been on a tear for 3 years. Company performance is terrific but prices have gotten too high. It is not a coincidence, however, that the decline in the Gulf markets began when the lynch mob in the US Congress made the Dubai deal a front page story.

Keep an eye on the emerging markets. They are the canary in the coal mine for shrinking global capital markets.

JR

Posted by John Rutledge at 5:12 PM

January 26, 2006

America's Auto-Immune Disorder

I wrote this piece for subscribers just after the London bombings last summer. With only small changes in the first line, it is as relevant today. As you know, I believe that changes in communication s technology are among the most important drivers in the world today. People from Colombia to Kenya and Buffalo to Bangalore can now watch each other wake up every day.

People in poor countries watch our TV shows. They have determined that 1) we are very rich, 2) it is probably not because we are smarter, work harder, or are better looking than us--it is access to capital. They have learned they are poor and they don't like it. We have to come to terms with the new communications and figure out how to grow together.

Viewers in rich countries can now see just how poor their neighbors are every day. Some choose to ignre it. Some are trying to do things to help poor people become rich. Some react by turning poor countries into demagogs, making them responsible for all our problems. Most of all, people become frightened they will lose their wealth and living standards. That's why this is such a politically contentious time, both in the US and around the world.

As the article below argues, I don't have time to be scared; there is too much to do. And I don't have much patience with people who use their energy being scared. Fortunately, throughout history, frightened people always adapt and go back to their normal activities. When they do, investors will pump the $2 trillion in cash they are sitting on back into the stock market and managers will plow their cash hoards back into capital spending. I want to be there when the price go up.

I hope you enjoy the piece.
JR

News stories from Iran, Venezuela, and other places have a lot of people crawling into their bunkers again. That's a big mistake.

Over the past 40 years I have traveled 15 million miles, wandered around South America, Eastern Europe, Northern Africa, and made more than 100 trips to the Middle East. I have good friends in all those places. I have been searched by 16 year old soldiers with machine guns, I have been detained by officials with stars on their shoulders but no brains in their heads. I have been in air raids and happened into food riots. I have been stopped by tanks. I am still here.

The world has never been safe; it never will be.

There are 300 million of us; whoever is mad at us can’t get all of us.

The big risk is not the risk of dying; it is the risk of not living.

It is not possible to spend enough money to protect people from other people who want to hurt them. The result would be man-on-man defense, just like in basketball. When I was 18 years old I lived for a time in West Berlin. The East German guards on the other side of the fence walked in pairs so they could keep an eye on each other. they were not having fun.

We should not pretend we can deliver total security. People should take more responsibility themselves for being alert to danger.

The real price of delivering excessive imaginary protection is not the money we pay the TSA employees at the airports, it is our loss of identity, which is a form of auto-immune disorder.

Biological Immune systems do not work by having a list of bad guys to look for. They work by being able to recognize “me”. When a healthy immune system encounters a cell, it is able to determine whether the cell is “self”, in which case it allows it to pass, or is “other” in which case it attacks, kills, or repels the invader.

Auto-immune disorders, such as AIDS, are situations in which the immune system loses the ability to identify itself and makes mistakes of both kinds, killing itself as a result. In that senses they are exactly loss of identity.

The most damaging long-term effect of terrorism is that we have become so focused on obtaining order that we are losing our identity.

In the case of America, our identity is to take risks, try things, and welcome strangers. Fear has driven us into our bunkers, behind our TSA guards, and into racism.

The good news is that we can fix this problem ourselves by remembering who we are.

We need to quit whining and get back to work.

JR

Posted by John Rutledge at 3:12 PM | Comments (5)

January 1, 2006

Forbes on Fox Topic: The Hot New Investment Trends for 2006

Hot sectors happen when a policy or technology event materially raises after-tax returns on capital there relative to other assets. Investors move money from low to high return assets which creates capital gains for the guy who got there first. This is precisely the same thermodynamic process as a storm system (a gap between high and low pressures or temperatures) in physics. People can best understand it by looking at a weather map of these storms. (See the weather map on my website for several of these storms.) The reason I like the weather map metaphor is everyone already understandds it, and everyone also knows that a storm is TEMPORARY. The same is true for hot investments, i.e., you also have to know when to SELL them when the party is over.

Last year’s storms were:

1. Oil and commodity prices, both implications of China strong growth;

2. Small cap U.S. stocks caused by the gusher of liquidity for small companies that happened when the banks opened their doors to business loans again 18 months ago; and

3. The turnaround of Japan caused by the end of their 13 year deflation.

In 2006, the most interesting storms will be:

1. Communications technology. Congress will pass a new telecom law next year that will dramatically increase capital spending on new high-speed networks. At the same time, China, Korea, India and others are making massive investments in IT as a strategy for growing their economies without using more oil and gas. This is great for capital owners altogether, but it's especially great for telecom equipment makers and software writers. Best way to play that is EWY,the Korean ETF. (Korea is an important R&D provider for China.) Another is IWZ (the US technology sector).

2. The inflation monster will pull its scary head back into its cave next year and the Fed will back away from tightening (especially if we have a bad event at GM or Ford to prod them into providing liquidity). Investors will realize that inflation and interest rates will stay low so it is safe to buy the companies whose profits are growing more than 10% per year. The market will boom, especially for the small companies who rely on bank liquidity for working capital. Best way to play this is the Microcap stocks (IWC; the Russell microcap ETF) or the small cap ETFs (IWM and IJR).

3. We will get an extension on the dividend and cap gains tax cuts in January. Great for the overall market, but especially great for companies paying dividends (you can use DVY for this), or companies with big cash positions and huge free cash flow (maturing tech stocks like MSFT who can initiate dividends or pay special dividends.)

4. I also have sizable bets still in place on the China Growth stom system (EWY (Korea), EPP (Australia, New Zealand, Singapore, Hong Kong), on coal (BTU), and on Japan (EWJ).

As always, I own all of the stocks I mentioned above. (How could I tell readers I like a stock if I don't put my own money into it?)

JR

Posted by John Rutledge at 12:51 PM | Comments (4)

September 30, 2005

The Cost of Distraction

The Cost of Distraction. I had a great opportunity to talk with investors today in Atlanta where I spoke to several hundred financial advisors. They told me one of the big problems they face is clients that are still scared to invest in the equity markets.

Who can blame them. For weeks now, all we hear on the television is about death and destruction. It's like having the four horsemen of the apocalypse for roommates.

The hurricanes were a big human story. A lot of people were hurt. But they are not a big economic story. Our economy in the US produces about $13 trillion worth of goods and services this year. Private citizens in America own more than $105 trillion dollars of assets and have a net worth of over $50 trillion. It would take more than a hurricane to knock it over.

My main point today, both at the investor meeting and while taping Bulls & Bears on Fox News later this afternoon, is that we can't afford to spend any more time talking about hurricanes. The one thing we know about storms is they do end. Instead, we have to focus on problem number 1. Unless we change course, the US and China are going to knock heads over energy supplies in the not too distant future. Both countries need to take steps to avoid that.

In China last week I learned a disturbing fact from my friend Peter Schwartz at SRI. At current levels of oil per dollar of GDP and projected growth rates, China will consume more oil in twenty years than total global oil production today. It is paramount that both countries find ways of reducing oil and energy consumption per unit of GDP and do what we can to increase supplies of oil, gas, coal, nuclear, and renewable energy.

One reason why is the Arabian Gulf. It will cost more than $750 billion in capital spending there over the next decade to capacity growing fast enough to match demand. Investors won't put up the money unless they believe political risks are under control. That means continued troops in the region.

Another reason is what's happening in China. China is fast privatizing their oil industry, which is going to give rise to massive capital spending in the next few years for new refineries, new LNG facilities, and new exploration. To the extent China can discover new energy sources it will allow them to relieve pressure on global markets. It will also help China burn less coal and improve air quality.

It is going to take a lot of capital to do all this, which makes me b elieve we will see high returns and attractive equity markets for a long time to come. No matter how many hurricanes we see.

JR

Posted by John Rutledge at 10:19 PM | Comments (2)

August 29, 2005

Gulf Stock Markets

Gulf Stock Markets
With all the talk of real estate bubbles in the US, investors should take a look around the world. Nine of the ten top performing stock markets in the world this year are in the oil producing countries in the Arabian Gulf.

It's important to keep track of these markets. They have a direct bearing on what some of the largest and most liquid investors in the world are thinking. And Gulf investors will ultimately finance the rebuilding of Iraq through direct investments in businesses and property.

These markets are hot, hot, hot! According to my friends at the Global Investment House in Kuwait, the Global Index of the top 100 companies in the Gulf increased 15.6% in August, 73.6% year to date, 109.8% over the past 12 months, and 469% since December, 1999. These 100 companies have a current market capitalization of $628 billion. Real estate markets, if anything, are even stronger.

JR

Posted by John Rutledge at 10:13 PM | Comments (2)

August 12, 2005

China Cuts Taxes, Spurs Growth.

Big number from China today. July retail sales there +12.7%, after 12.9% in June. Restaurant sales +17.5%, according to a Bloomberg report, with clothing +16%, appliances +13.9%, furniture +16.9%, cosmetics +16.9%, telecom and mobile phones +21.4%.

What's going on? The government cut taxes for 400 million farmers and raised the exemption level before paying income taxes. Sound familiar?

Big winners? Dell, Adidas, GM, and Wumart (that's right, Wumart Stores).

American's who think of China as a backward, Communist nation, need to take a closer look. The growing Chinese middle class and expanding technology sector are the real stories there.

I like to invest in China by placing chips on China's principal vendors, including energy, technology, and money. That leads me to own EPP (Australia, New Zealand, Singapore, Hong Kong), and EWY (Korea).

JR

Posted by John Rutledge at 12:11 PM | Comments (4)

Japan Growth Strong

Japan's real GDP grew 1.1% in the second quarter. Q1 revised up to +5.4%. Spending was driven by capital spending, government spending fell. Supports my view that Japan turnaround is sustainable. My nameless advisor there, who I refer to as Fibonacci, agrees. Koizumi has called an election for September 11 (coincidence?). I like Japanesse stocks and own EWJ.

JR

Posted by John Rutledge at 11:53 AM

India Growth Accelerates

India Growth Accelerates
Number out this morning that India's Industrial Production +11.7% in June, the biggest number since geometry was invented there before the time of Euclid (he got it from them.) May revised up to +10.9%. Consumer goods +23.7%. Ay Chihuahua.

This number implies India's GDP this year will be 8% or more this year. Their Central bank has decided to NOT increse interest rates to encourage investment . Federal Reserve, please take note of this.

Last month Prime Minister Manmohan Singh made a very impressive pitch to US investors during his talk to the joing session of Congress on his visit here. Singh understands that in today's global economy, we are not competing for jobs; we are competing for capital.

I own a position in IIF. Down about one percent today; think I will buy some more.

JR

Posted by John Rutledge at 11:42 AM

August 10, 2005

India Profits Screaming

The headline story in today's (actually tomorrow's; you know, the time zone thing) Economic Times published by the India Times is incredible. 118 companies in the India stock market have earned more profits in the past three months (the first quarter of the fiscal year) than they did in the entire previous year.

I own IIF, the Morgan Stanley exchange traded fund for India, to capture some of this growth. Like China, India is driving world growth.

Be a little careful though. A separate story yesterday warned there are rumors the Prime Minister is thinking of resigning out of frustration over lack of success in selling state-owned companies.

And, by the way, The Economic Times, along with the Shanghai Daily (where today's headline reveals the currencies in the central bank's new currency basket, but not their weights in the basket) make pretty good breakfast reading. I have both with my oatmeal every morning.

JR

Posted by John Rutledge at 11:35 PM | Comments (1)

August 4, 2005

I Lost Money Today in the Stock Market

I Lost Money Today nthe Stock Market
Sometimes I write about investments that have gone up, so I thought it would be a good idea to confess that almost every stock I own went down today when the stock market went down. Bummer.

What happened to cause today's declines? Absolutely nothing. The fundamental factors that make me believe stocks are very good investments today--low inflation, low interest rates, rising productivity, rising profits, and the storm watch themes like dividends and telecom reform that you see on our website--are just as true tonight as they were before the market opened this morning.

Reminds me of the joke I remember from long ago about there being two kinds of life insurance you can buy in Beirut, minutely and hourly.

Sometimes I think we would be much better off if we only got to see stock prices once a year on our birthday. Equities are for making money over years, not days.

In response to today's declines I sold exactly zero shares of stock. Hope it goes down again tomorrow so I can buy some more good stuff cheap.

The S&P 500 is up 13% over the past year. The Dow closed at 10,610 today; it was 7500 a little more than 2 years ago. Hang in there investors. It's going to be fine.

JR

Posted by John Rutledge at 10:12 PM | Comments (2)

August 2, 2005

Whoops! Japan ETF ticker is EWJ. My bad.

Whoops! Japan ETF ticker is EWJ. My bad.
A loyal subscriber who reads a lot more carefully than I type has poined out that I referred to the Japan Exchange Traded Fund as the ticker EWY. I was wrong, of course, it is EWJ. My response below.

Thanks for finding the error. You are right of course, EWJ is the Japan ETF.

It was a Freudian mistake; Korea (EWY) has been so good to me (up about 50%) that my fingers just typed the letters. I own both stocks, but for different reasons. Korea is the best way to place a bet on China technology growth. Japan is a great turnaround and dividend story.

Thanks
John

Posted by John Rutledge at 11:48 AM

August 1, 2005

Bonds and Real Estate Prices

For those of you who are worried about home prices, I don't like what I am seeing in the bond market.

The ten year bond yield has increased by almost half a percent in the past 2 weeks, from 3.88% to 4.32% today. That's worth 12-15% on home prices.

We saw this movie on the way up; now we may see a little on the way down. Home prices have increased by more than 50% over the past 3 years, driven primarily by lower mortgage rates. Mortgage are bundled and sold by the container load in the bond market, where they price off Treasuries.

The right way to think about home prices is like a bond, as the securitized value, or present value, of the stream of housing services they will provide in the future. Buyers in the commercial property market go through this analysis explicitly, using estimates of future rents to determine expected cet cash flow each year in the future. A proxy for residential housing is expected rental yields.

Worth noting. More construction and completions means more houses relative to people and incomes. It lowers expected rental yields, therefore depresses the value of existing properties.

Bond guys do this work all the time. Stock analysts don't do it but should do it. Home buyers should do it too.

The duration of the S&P 500 at today's interest rate levels is 26 years. that means it will take 26 years for the owner of the S&P 500 to "earn" half the present value of the index if he collected all the free cash flow. That means a 100 basis point rise in the after-tax cost of capital for the index would reduce its value by 25%.

The duration of the housing stock is not far off. It is shorter to the degree that rental values grow more slowly than cash flow, and longer to the extent that the cost of capital for housing is somewhat lower than for equities due to the yummy tax breaks on housing. On net, I would use roughly the same number.

That's why a half percent move in the bond yield worries me. It equals about 13% on home prices.

Don't get crazy and sell your house. But don't stand in line to buy one either. This housing boom is just about over.

JR

Posted by John Rutledge at 2:49 PM | Comments (3)

Coal is the New Oil

Coal is the New Oil
Peabody Energy (BTU) definitely has the coolest ticker on the stock exchange; it also has the hottest stock. People have figured out that they own tons (really) of coal, that the stock price undervalues their coal reserves in the US, and that rising oil prices caused by Asia's growth have made coal the new oil.

My good friend Jacques Berghmanns in Brussels told me he likes the company. Last week we saw why. BTU increased iought its dividend by 27% and announced a share buyback program. Looks to me like a 10-12% grower for a long time. My only concern is price. (I bought some 3 weeks ago; it's up 22.5% since then. Up 3.7% just today! Too fast for my tastes.) Still, it is just 16 times next year's (2006) earnings. Be nice if it would drop some so I could buy more.

JR

Posted by John Rutledge at 2:01 PM | Comments (1)

July 27, 2005

Asia doing well today too.

Asian stocks are very strong today. China has been a storm system on my weather map for a while. I am not a fan of the forced revaluation last week. Fixed rates were much more stable for both China and the U.S.

I do like the way China has managed it, though. It left the currency not convertible--still capital controls in pace--which makes speculating much more difficult and costly for a speculator who wants to move big money into the RMB. The Chinese central bank also engaged in open-mouth operations yesterday saying no more revaluations. And moving to a currency basket shifted some of the political pressure from the U.S. to Japan and the EU, both of which trade more with china than we do. If you look closely, you will see the shadow of Robert Mundell in the press release. Bob is an advisor to Chinese officials there. There is no one better.

I like placing the China bet through EPP (the exchange traded fund for the Pacific Rim excluding Japan.) Is holds the stock markets of Australia, New Zealand, Singapore and Hong Kong. I have an EPP position that's up 22% since October; another is up 39% in 18 months. I am not selling either one.

I also like EWY, the ETF for Korea, China's major technology source. Korea (EWY) is the epicenter of telecom-equipment R&D and is the driving force behind mobile-phone production in China, where 300 million cell phones will be sold this year. I own some EWY up 42% since last September and still like it. I also like Japan (EWJ) where companies are just beginning to pay dividends.

JR

Posted by John Rutledge at 3:28 PM

Telecom Stocks Strong Today

I posted a comment over at TheStreet.com's RealMoney today on the market's reactions to today's telecom bill.

I have been tracking the telecom reform storm system on our website rutledgecapital.com for some time. I saw the building pressure for a new telecom law from people all around the country who want broadband access to compete with companies in Asia. That new law would raise the return on network-building assets relative to the market, establishing a high-low return weather front, in the same way high and low pressure systems create thunderstorms on a weather map. That return differential would then drive investors to rebalance their holdings toward the favored asset class, which would move prices.

The prices are moving today. I have been holding a position in telecom sector stocks via (IYZ), the Exchange Traded Fund for the Telecom Sector betting that congress will get telecom reform more right than wrong this year. The sector is up sharply across the board today since the new bill was announced.

Getting the law right will trigger big investments in high-speed networks. That would be great for the equipment makers like Lucent (LU), Nortel (NT), Cisco (CSCO), and Corning (GLW) -- all of which are up big today. (Corning is up more than 5% so far today.) It's also good for telecom service companies like Verizon (VZ), BellSouth (BLS), SBC (SBC), Qwest (Q), AT&T (T) Sprint (FON) and Nextel (NXTL). They, too, are up today; Sprint and Nextel are up about 5% at this point.

Keeping my fingers crossed and holding on to my IYZ position.

JR

Posted by John Rutledge at 3:10 PM

July 26, 2005

Housing Prices Continue Up

June prices of existing homes rose 6.3% from May, and are up 14.7% over a year ago. This was triggered by the June drop in long-term rates below 4% that drove the 30 year fixed mortgage down with it.

The housing market is not a bubble; this is an interest rate story. The drop in interest rates has caused a massive one-time repricing of the housing stock. The housing market will not collapse because U.S. inflation and interest rates will stay low. U.S. inflation is anchored by prices in India and China.

This housing game is in the ninth inning, though. The recent revaluation of the Yuan triggered a sharp rise in Treasury bond rates. Mortgages will follow. Expect a final patooie of activity as people race to buy and refinance fearing the end of low rates. I expect the run-up of prices to stop. Don’t leverage yourself into real estate, but don’t sell your house either. (By the way, stocks are a better long term investment than houses anyway; they have out performed housing 3 to 1 over the last 25 years.)

JR

Posted by John Rutledge at 12:28 PM

July 19, 2005

Guest Blog Topics & Sector Bets

Had a great time yesterday as the Guest Blogger for the CNBC Squawk Box’s blog (squawkblog.com). In case you missed it, here are the topics and sector bets I blogged about:

1. Rubber Boat CEOs
Maria Bartiromo interviewed Ed Gallup, Immucor Chmn. & CEO. It is so refreshing to see a CEO who not only knows every number about his business and has specific, numerical objectives for his company’s sales objectives. The kind of guy you’d like to have with you when you invade China in a rubber boat. Very impressive.

I’m interested in your opinions about other Rubber Boat CEOs you have seen on Squawk Box or elsewhere. Who do you think does an especially good job explaining their company to investors, as well as operating their company?

2. On Citigroup & BofA Results

I think the contrast between weak Citi and strong BofA results today is partly a reflection of the different markets they have targeted. As Marc Oken, BofA’s CFO, said on the show this morning, they are mainly a U.S. bank. The U.S. economy is very strong and credit risk is declining sharply. BofA is a good way to bet on the U.S. growth story.

Also, as I have been writing recently, the big story lately has been the strong performance of the U.S. small caps, driven by a dramatic acceleration of business loan availability to private, middle market, companies in the U.S. BofA is a big lender to this market; their middle market loans grew 12% in today’s numbers. In that sense, BofA is a proxy for the small cap bet.

Finally, Citi talked about the lousy trading and capital markets last quarter. This reveals something I worry about. Since Gramm-Leach in 1989, big banks have generally shifted capital out of lending, into capital market activities, which have a much higher ROE (when things go right). But trading and capital market revenues are not sustainable; neither are the earnings they generate. This shift toward capital market strategies, to me, makes bank earnings less sustainable, and over long periods shold weaken multiples. That makes me like the small banks more than the large ones while this is going on.

I do not own either stock personally, but I but own DVY - which has shares of both

3. The Next iPod - Hearing Aids For Boomers

Boomers are aging, losing their (our) hearing, are vain and insecure. How about an IPOD that doubles as a hearing aid so a n Old Boomer can look cool and hear what people are saying at the same time?

4. Economy Stronger Than Dirt

Maria interviewed Kevin Kliesen, National Association for Business Economics, about the NABE Survey of the U.S. economy. The NABE survey is right on the nose. The U.S. economy is stronger than dirt. That’s why the broad market (SPY) is doing well and the small caps (IWM, IJR) are on a tear.

5. Genentech Blindness Drug Plus Viagra = Happiness

Here’s another aging baby boomer play. Genentech is announcing a new cure for aging blindness today. This is great news for the guys who have been taking Viagra. Seems to me that you should be able to take both together; then you could have sex and see what you are doing at the same time.

PS: A recent poll of all the men who went blind from taking Viagra showed that 100% of them said that it was worth it!

6. On Capital Flows

What we can do that might turn around the flow of capital out of the U.S. to China?

That’s exactly the right question. Yesterday I told the governors at the National Governors Association annual meeting that we are not competing for jobs with China, we are competing for capital.

The dirty secret most Americans don’t know is that the core of the impact on the U.S. trade accounts is not cars or shoes, it is technology. U.S. regulatory policies have shut down capital spending in telecom while China has made telecom capital spending a priority. China is also targeting incentives for our best technology companies to relocate there. Not good. U.S. technology and telecom equipment companies are moving to China at a record pace.

To stop that we need to first repair our policies so we are not driving companies to leave. Congress is rewriting telecom laws now; hope they get it right.

7. China Investing—Will China Stay Strong?

Fundamentals for China growth are still very strong, and should be 8-9% for next year or two. The risk is that political pressure within the U.S. is making our government do things that cold interrupt China’s growth. Last week the Commerce Dept. embargoed Chinese cotton goods, for example. Another example is U.S. talk of tariffs, and our pressure to revalue the currency. If China growth stopped, even for a short while, commodity prices would drop like a stone. So, while China still looks good, I think we should be a little careful not to have too much exposure there today.

8. Sector Mix & ETFs

Sam Stovall’s interview on Squawkbox (7-18) recommended a sector allocation based on a strong U.S. economy. Reminder that asset allocation across security classes, countries, and sectors may be responsible for as much as 90% of total portfolio returns. I like the ETFs as a way to place those bets.

9. Maytag Deal

The bidding war for Maytag is continuing. Things to watch for. A board of directors will have a hard time turning down a bid from a strategic acquirer (Whirlpool) in favor of private equity bidders. Their main concern will be the risk of a busted deal, where they pick a buyer then the buyer either fails to close or re-trades the price lower at the last minute. Both are easier with a strategic buyer. Deal issues and shareholder value will dominate xenophobia in the directors’ minds.

10. Little Screens, No Engineers

Music videos on iPods with tiny screens? One squawkblogger suggested that the next generation would be better off reading a book or newspaper so they might learn something.

The point is well taken. Education is THE issue for the country. This year China will graduate 350,000 engineers, more than the U.S. + Japan + Germany. The U.S. will graduate just over 50,000.

FYI, there is a Korean government agency, ETRI, that has 1500 engineers working on those little screens Joe Kernan talked about. They have also developed a wireless standard called WIBRO that will allow a commuter to watch a real-time TV broadcast on a train going 60 miles per hour.

Time for us to quit whining and get back to work.

11. Index Composition

One commenter wondered if it time for the Dow Jones to do a major rebalancing since all the names added in the recent years have been losers.

That’s right-- which points to a weakness in all the top-size-tier index portfolios. A company gets put into a top tier index because it went up LAST YEAR. So it is a momentum buyer’s portfolio. May be one of the reasons madcap and small cap indexes have done so well.

Here’s an idea. Why don’t we create an index based on the intrinsic value of the stocks in the Dow or S&P. That way we would not put a stock in just because its price has gone up.

12. Big Exit Packages - What Do You Think?

Good FT article this morning (7-18) on Morgan Stanley exit packages. Co-president Stephen Crawford got $32 million when he quit. David Sidwell will get $21 million if he is terminated as CFO or resigns for good reason, according to the Financial Times. Mitch Merin and John Schaefer have also been given new guaranteed packages.

I think big parachutes for executives suck; they are a sign the board is not doing its job. Would love to hear nominees for the Exit Package Pig of the Year prize.

I will start by nominating Gilette.

13. I own SPY, IWM, IJR as well as call options on IWM.

Want to close with two bets I like. My two largest positions are small cal U.S. stocks (IWM) and dividends (DVY).

I like small caps because they are the epicenter of the turnaround in bank lending. From November, 2000 banks loaned businesses minus $230 billion, From a year ago, bank loans have increased by $120 billion. Increased loan availability is dramatically improving the performance of small companies and will continue to do so for the next year. I own both IWM and IJR.

Dividends will dominate total returns over the next decade, due to tax law changes two years ago, due to changing capital structures as managers adapt to the new tax rates, and due to investor hunger for income. There are also signs this is starting to happen in Japan. I own DVY.

JR

Posted by John Rutledge at 12:57 PM

July 14, 2005

Markets Discover Korea Too

The other big number on my screen today is Korea. The Korean exchange traded fund is EWY, it is up 2.3% today, with Hong Kong (EWH), and Pacific Rim ex-Japan (EPP), an ETF owning the markets of Australia, New Zealand, Singapore, and Hong Kong. Australia and New Zeealand are supplying resources to China (coal is the new oil); Singapore and Hong Kong are windows China is using to import capital as well as regional centers of advanced technical education.

Korea is interesting for several reasons. First, you can throw a rock from Korea to the high-tech manufacturing plants in China (can't wait til Wall Street discovers that Korea is located close to China). Second, Kiorea is kicking butt on technology investments, our butt actually. They have an state-run R&D agency called the Electronics and Telecommunications Research Institute (ETRI) in Daejon manned with 1500 engineers developing high-speed communications devices for Samsung, LG, SK Telecom, and other Korean companies to bring to market. ETRI has an annual budget of $345 million.

And the Korean government has a program called IT837 (stands for 8 services, 3 infrastructure projects, 9 new devices) that you are going to be hearing about. Projects include a telecom network 50 times faster than what we call broadband, RFID tracking devices to track everything from military grenades to imported beef products, and a wireless broadband standard that will allow commuters to stay to computer networks even while travelling on high-speed trains.

And by the way, China will sell more than 300 million cell phones this year to its own citizens--almost all of them have Samsung innards.

I own EWY, but not as much as I wish I did. The stock is up 38% since last September.

JR

Posted by John Rutledge at 1:07 PM

Shocking Truth Revealed! Market Discovers US Economy Growing, Inflation Low.

NASA was humbled today when the US stock market lifted off faster than their missile launch. The cause? Wall Street has discovered, once again, that the US economy is stronger than dirt, that it is growing strongly, that inflation is low, and that in spite of recent warnings the world is not going to end just yet.

I will write more on this later, but for now a few factoids to chew on:

1. Today's June CPI report (+0.1% in June, +2.5% over year ago) is OK. Translation, no big interest rate increases coming.

2. Today's June Real Earnings Report (average weekly earnings rose by 0.2% from May, 3.0% from year ago) is OK too. Incomes are growing.

3. Today's May Retail sales (+1.7% from April, +9.6% from year ago, are better than OK. Even excuding automobiles--remember the price cuts, they are giving away cars now--retail sales were +0.7% from April and +8.3% from May 2004).

4. Yesterday, the May trade report showed a smaller deficit than people anticipated.

5. Analysts are revising their Q2 profit estimates up, especially for small companies.

6. Yesterday, the White House announced this year's budget deficit will be about $100B smaller than they thought. Big increase in tax collections.

More growth, more profits, less inflation, less interest rate pressure. Shocking! Stock prices are going up.

Thing is, unless you just like to watch the green ink run across the screen you have to get your bets on the table for this sort of thing before the game begins if you want to make money.

My best two investments lately have been the dividend bet (DVY), and the small cap bet (IWM). DVY is $63.70 today, up from about $56 last August, and you get a 3% dividend yield to boot. And IWM, at $66.50, is up about 20% in the past two months (I bought a whack of out-of-the-money August 65 call options at $0.50 in April. Last trade today was at $2.80).

Don't bet against growth at this time.

JR

Posted by John Rutledge at 10:10 AM | Comments (1)

July 9, 2005

Anti-Terror Stocks

I’m always tempted to recommend BUD (beer always calms me down), LLY (Prozac), or GSK (Paxil), but enough with the jokes. I think everybody will have the idea to buy security companies, x-ray companies and the like.

I like to throw in Symbol Technologies (SBL), a $2B company that dominates the market for hand-held scanner equipment (their old business) and is going to dominate the future market for RFID (radio frequency identification) technology. Security is about knowing where stuff and people are. RFID chips are the answer.

Wal-Mart has mandated their vendors to use RFID by next year so they can track the shipping and sales process from start to finish no matter what vendor’s involved. Brittan Elementary School, north of Sacramento, had to abandon its plan to monitor attendance and prevent vandalism using mandatory RFID badges for students when parents and the ACLU got involved, and California legislators got excited about passing laws to restrict their use. But you can also put them on kids on nursery school playgrounds to avoid kidnappings like they do in Mexico. In Japan, they not only use RFID bracelets on school children but on hospital patients so they get the right dosages of drugs. Symbol CEO Bill Nuti is a former #2 at Cisco; he is a winner. I own the stock and know the management.

Another is Peabody coal (BTU). Besides their cool ticker symbol they own a ton of coal reserves (well, actually many tons). Terror equals oil prices. Coal is the new oil.

JR

Posted by John Rutledge at 10:30 AM

July 8, 2005

Real Estate Sucker Bet

I was on CNBC’s Closing Bell with fellow guest and old friend Brian Westbury to discuss the housing market on Monday, July 5. Brian and I have known each other since the Reagan White House. He’s a great guy and first class economist--one of the most prolific writers I know. Our topic was real estate prices. Brian reminded us tht the income, growth, demographic, and tax fundamentals behind housing are still strong. While I agree with Brian on the fundamentals, I am more worried that recent price increases are not sustainable. We both agree that stocks are a better place to invest than housing.

I think the easy money made in housing is over. Residential real estate is a sucker bet today. Real estate today reminds me of the late 1970's, when Trammel Crowe was building skyscrapers all across America funded by inflation-hedging investors, over-reaching Savings and Loans, and high tax rates on securities.

Today, we're riding a tiger. The economy is very strong—and I think it's getting stronger which makes me like the stock market a lot. Housing is up more than 30% over the last year in some of the hot markets. That’s just too much for me. Demographics were there 2 and 3 years ago. I think a lot of the appreciation came from the housing markets repricing for lower interest rates. It repriced upward one more time again in the last couple of months when bonds came down to 4%. But I don't think these price increases are sustainable. There are too many expectations of price increases in the transactions and not enough attention to cash flows and rent.

But Brian is right about the imoprtance of tax rates. Two of the hottest states in the markets are the states with 0% state income tax. People are flocking to Florida and to Nevada for just that reason. And both are also well known to be warm in the winter.

But I think it's a dangerous time to short the home builders because when the market gets a run like this, we don't know when it will stop. Short-term prices increases could bury you if you have a leveraged short position.

But stay away from REITs. The best investment I’ve ever made was turning $1 into $3 by selling a real estate investment to a REIT at the top of the 1990's REIT market. REIT accounting is opaque. I think REITs are vastly overpriced right now. But REITs at least have a big dividend yield, unlike most home builder stocks. Now we're seeing home builders using options to purchase land and home buyers using options to buy new homes. This smells a lot to me like the end of the bubble at the end of the ‘70s and again at the end of the '80s. So I’m a little worried. I don't want to have people risk their money by buying into the market right now, but I don't want it people to sell their houses either.

JR

Posted by John Rutledge at 4:40 PM

Going Global

I joined Dylan Ratigan on CNBC’s Market Hour on July 4 to talk about the best places internationally to place money in the next half of the year. First, I like the U.S. markets; I think they are in very good shape and have a very good core foundation.

But on top of that, I like to add international exposure. Not in Europe--Europe is not growing and not going to grow. But Asia is a great bet. A risky bet but very high return one for sometime to come. I like both South Asia for the commodities that feed China and North Asia as a manufacturer and producer of products. I think ETFs (exchange traded funds) are a good way of adding international bets to your portfolio. What I like about all these ETFs is that they have 50 to 100 stocks in each one. Although watch out, they have quite a heavy concentration in the banks which is the core of the market in most of these countries. Some examples:

There is an ETF (ticker, EWJ) which is a way to bet on Japan. Japan is having a turnaround that is partly driven by exports of capital goods into China and partly driven by changes over the last few years in their own monetary policy. But as an investment, that’s not a homerun. That’s a single.

You can buy South Asia with an ETF (ticker EPP) that is an index of the Australia, New Zealand, Singapore and Hong Kong markets. Think of that as the coal going from Australia up into China, feeding the industrial boom there and the capital markets of Singapore, and Hong Kong that are supplying China with the funds to grow their businesses. There are also exchange traded funds for Taiwan (ticker EWT) which is the home of the semiconductor business--but that is riskier because of the political issues with mainland China. The government of Malaysia just announced that they are bringing broadband through the power lines to every home in Malaysia starting this summer, so I expect some growth from that. The ticker for Malaysia is EWM.

India has had phenomenal growth, but most American investors have difficult time investing in India. One way is by investing indirectly through U.S. companies doing direct investments in India. Most technology and professional service companies are now using it as an outsourcing base. China is growing 9% a year, but India is growing 8% and will for sometime. India will pass China in size of their economy in the next 20 to 30 years. And inside India, they're doing things to make this growth sustainable. What have they been doing? They made a law that foreigners can own land. Foreigners can own bank. They have increased the share of telecom companies that foreign investors can own from 49 up to 74%. India has also lowered corporate taxes and made big infrastructure investments in telecom, fiber-optics and wi-fi. They’re hard wired up to us with fiber-optics. They will grow like crazy.

JR

Posted by John Rutledge at 4:29 PM

May 10, 2005

Hedge Fund Collapse Rumors

Stocks are being kicked around today by rumors of a possible hedge fund collapse. Given what I have seen lately in credit management, I don't think it is out of the question.

But to repeat what I wrote last week, the more you worry this will happen, the more you should buy small cap stocks when prices retreat.

There is nothing like a good financial panic event for unclenching the buttocks of the Federal Reserve.

JR

Posted by John Rutledge at 1:01 PM

May 5, 2005

GM/Ford Downgrade

The stock market got it wrong today. The stock market fell sharply when S&P announced their downgrade of GM and Ford bonds to junk status. Should have gone the other way. I have been through enough of these crises to know that any event of this size which threatens to impair liquidity will make the Fed significantly more accomodative. (Bank Herstatt or LTCM) A benign Fed and the huge profit growth being posted for Q1 are very positive for the stock market.

JR

Posted by John Rutledge at 9:54 PM

May 1, 2005

Investor Beware: Bank-Loan Funds are not Money Market Funds

Investor Beware: Bank-Loan Funds are not Money Market Funds
The WSJ referred to bank loan funds as a safe haven that investors are buying to protect themselves from rising rates. Bad idea.

Yield-starved investors have stuffed about $4 billion this year into bank-loan mutual funds, also called senior-loan funds or loan-participation funds, in which funds buy short-term loans that banks and other lenders make to companies. That's a nearly 10-fold increase from a year ago.

Many investors are even using bank-loan funds, which distribute payments monthly and are currently yielding as much as 7%, as a stand-in for sedate money-market accounts...The risk with bank-loan funds: They are generally noninvestment-grade debt, meaning they have ratings of double-B or lower on the Standard & Poor's credit-rating scale. That is in the junk-bond neighborhood. While not terribly troubling in an improving economy, low-rated debt is more likely to default in a weak economy.

Based on recent conversations with friends of mine--the guys who are actually making these loans--there is less diligence being applied to leverage lending today that during the last drunken brawl we had in the late 1990s, and certainly less than is applied when issuing a junk bond. I see serious default risk down the road.

Moral of the story: If you have money that you want to keep as cash, rather than invest for long'term income and gains, keep it in a money market fund--a real one--collect the 2-3%, and relax. Funds that pay you 5, 6, or 7% are paying you for the risk you will lose some or all of your money.

JR

Posted by John Rutledge at 5:18 PM

Stock Market Up 1651% Since 1980, More Than Half Dividends.

Stock Market Up 1651% Since 1980, More Than Half Dividends.
We spend so much time whining about what the market did yesterday that I thought it would be helpful to remind you about the longer-term numbers.

During the nearly 25 years (97 quarters) between January, 1980 and March this year, the S&P 500 index delivered a total return of 1651% (12.5% annually) to investors who re-invested dividends. Of that, just under half (46.6%) was in the form of capital gains; 53.4% was in re-invested dividends.

The S&P 500 Index (SPX) was 135.8 on 12/31/80, when Larry Kudlow, Jerry St. Dennis, and I were scrambling to put together President Reagan's economic plan. It hit a low of 109.6 in June, 1982, when Dr. Doom and Mr. Gloom were whining about the twin deficits. It is 1158.5 today.

Many investors today bought their first stock in 1999 when you couldn't lose money buying tech stocks. They are sitting in cash today earning 2% per year. (3% if you are willing to lock your money up for 6 months in CDs or T-bills).

Stocks are up 26.3% just in the past 2 years since the dividend tax cut. I remember doing a press conference with John Snow in March, 2003 when the S&P was 7500, saying the dividend tax cut would boost values by 10-20% and change corporate payout policies. Since then the market has added $3 trillion in value.

There is no better place for long-term investors than the stock market. That is as true today as it was in 1980.

JR

Posted by John Rutledge at 3:05 PM

Q1 Earnings Up 18.7%, 2.5x January Estimates!

Q1 Earnings Up 18.7%, 2.5x January Estimates!
As of today, 382 out of the 500 companies in the S%P 500 index have reported their Q1 earnings. Weighted by market cap, the average company reported earnings 18.7% higher than in the in the same quarter last year. (Share-weighted, +17.4%, Non-weighted, +20.7%)

These are blowout numbers, folks, up 2.5x the 7.6% expected for the quarter by analysts in January. Two-thirds of the companies (255/382 so far) beat estimates. Of course, we can thank Mr. Sarbanes and Mr. Oxley for that--in a world where optimistic CEOs, CFOs, and analysts get to go to jail and be a bad man's girl friend, estimates have become rather subdued.
Here is how the share-weighted numbers break out by sector:
-18.9% Consumer Discretionary
+ 6.4% Consumer Staples
+42.0% Energy
+18.6% Financials
+11.8% Health Care
+25.1% Industrials
+18.4% Information Technology
+66.0% Materials
+ 5.4% Telecom
+ 7.3% Utilities
+17.4% Total for S&P 500

In some cases the big increases represent higher energy and commodity prices and, as such, are somewhat dependent on continued growth in China and India. But revenues were up more than 9% overall. And behind all the sectors you can find the driving force of rising productivity. The catch: continued productivity gains depend on huge impending investments in high-speed communications networks, yet Telecom sector earnings (+5.4%) are not growing fast enough to attract the capital to fund them. Mergers in the sector will help. Congress's intent to reform telecom law this year is badly needed.

With all this good news you'd think analysts would b e excited about Q2. Not so. Business Week reports current Q2 earnings estimates of just +7.2%. I think the number will be +12-15%. Look for more good surprises.

JR

Posted by John Rutledge at 2:11 PM

April 28, 2005

Private Equity Irony

Does anybody else see the irony in this story in today's WSJ about the prospect of private equity firms going public so widows and orphans can get in on the action?

In recent weeks, investment bankers from Morgan Stanley and Goldman Sachs Group Inc. have approached top private-equity firms including Carlyle Group, Texas Pacific Group and Kohlberg Kravis Roberts & Co. with a novel idea: taking their partnerships public.

I know these guys. They are very smart. These are great business--for them. They make great investments--for their partners. But rest assured, if they think it's a good idea to sell a piece of their own companies to you, it's a really bad idea to buy it.

It is evidence, though, that the markets have gotten silly again. Yield-starved investors have crammed tons of money into hedge funds (just wait; they'll be the next IPOs), who have been exhibiting the type of gaping behavior toward lenders that baby birds show mother birds returning to the nest with a worm. Only today, hedge funds are gobbling up anthing with current yield, most notable (relatively) high-coupon leveraged loans. Banks and mezzanine lenders are as aggressive today as they were in 1999.

This is great for short-term growth--today's wimpy GDP number notwithstanding. But it's loading the pipeline with paper that's not going to look so good in 2 years or so.

Warren Buffett tells us don't ask the barber if you need a haircut. Don't buy the barber shop either.

JR

Posted by John Rutledge at 11:12 AM

April 25, 2005

Existing Home Sales Up Again. Bubble Signs?

The March Existing Home Sales report released today by the National Association of Realtors shows big price increases. No bubble here, but the party is about over.

In March, 6.9 million homes changed hands at a median price of $195,000. To the delight of my real estate broker friends, that's +4.9% more transactions at an +11.9% higher price, than one year ago, which means real estate commissions increased by +17.4% in the past 12 months.

The biggest increases were in the West, +5.9% in March and +19.9% year over year ago. The Northeast, although +11.4% over last year, were down -3.2% in March. Guess the Wall Street bonuses aren't looking so good.

I am always more interested in existing home prioces than new home prices for three reasons. There are a lot more old houses than new ones, which makes the numbers more reliable. Existing home sales are less distorted by variations in lending terms in the fickle construction loan market. Finally, the total expected return on existing homes is a very important driver for the level of interest rates.

The key term above is expected. The expected capital gains yield (the expected increase in the price of a home the next year divided by its current price) plays the same role for investors managing wealth as does the expected capital gains yield on their stock portfolio.

What matters, of course, is comparisons of expected total returns on real estate, stocks, bonds, and the other assets people can own. These include estimates of their respective current yields; the service yield of the house (roughly the value of living in the house divided by today's price), the dividend yield of the stock, and the current interest yield of the bond. All sorts of other things matter too, including transactions costs (for fellow geeks, like my friend Paul Davis, transaction costs create a kind of arbitrage threshold for transactions, identical to the role played by Boltzmann's constant in the numerator of the exponent in Boltzmann distribution, which measures alternatively the probability of two particles crashing into each other or to a chemist the speed of a chemical reaction), tax rates on each asset, and liquidity.

Of these, expected price increases and changes in tax rates are the stars in the show. Not because they (analytically) matter more; because they happen more.

This is the analytical root of the link between expected inflation and interest rates, and explains why we should NOT measure that link using CPI inflation rates, as I wrote about the other day.

So why are interest rates so low today in the face of such huge home price increases? Mainly because the increases of last year don't imply they will go up gain next year. The big increases were caused by falling interest rates when owners capitalized future rental income streams at lower rates. Their behavior next year will depend on rates then too.

There are many people who think rates will rise a lot next year. They will be proven wrong. They get excited when they see a big CPI number, like the one we saw last week, and they sell the stock market. I think we will see very soft inflation numbers next year, which will keep long bond yields roughly where they are now. Stable bond yields should allow housing prices to come in for a gentle landing, maybe up 3-5% next year with slower increases after that, but still with huge variations across the country driven by income fundamentals.

The private equity market gives us another piece of evidence that the big price run-up is over. I have been seeing a big increase in the number of businesses for sale in the construction and building materials sectors. I saw a residential construction business for sale today, for example, with $10 million in profits last year on $30 million in revenues. That 30% pretax profit margin is too high for a construction business, reflecting the builder shortage in today's hot market.

JR

Posted by John Rutledge at 3:25 PM

April 21, 2005

March CPI Spooked Stock Market; Bond Market Got it Right

Stock and bond market investors reached totally different conclusions today when they read the March CPI report released by the BLS.

Prices were up +0.6% in March, 3.1% over a year ago, a 4.3% annual rate of increase for the first quarter. The big number spooked the stock market; the DJIA (-115), S%P 500 (-15.9) and Nasdaq (-18.6 were all trashed. But the bond market yawned. The ten year treasury yield closed at 4.18% for the day, just where it opened, as did the 30 year Treasury at 4.55%. What gives?

In this case the bond market got it right. There is nothing in the CPI report to suggest that demon inflation is back. The big culprits were energy (+4.0% in March, +12.4% for the year), and Transportation (i.e., energy, +1.9% in March). Taken as a whole, it still looks like CPI inflation will remain 2-3% for some time.

Communication prices continued to fall (-0.2%) across the board, in spite of all the whining going on in Congress this week about mergers and too much concentration in the telecom sector. The communications and IT sectors are incredibly competitive today.

The reason people are continually spooked by the monthly price reports is they don't have a clear understanding about how and why inflation expectations impact interest rates. Too much textbook; not enough thinking.

I have been interested in this subject for 35 years. I wrote my Ph.D. dissertation on the subject. It was years later, after I had written a book on the subject as well, that I figured out I didn't have a clue how it worked.

The textbooks today all tell you the nominal interest rate is equal to the real interest rate plus the expected rate of inflation. They refer to this as the Fisher equation, after Irving Fisher, who supposedly invented it. Most economists believe Fisher meant that changes in inflation expectations drive nominal rates up and down, leaving real rates--hence the real economy--unchanged.

The truth is very different. In 1972, while writing my dissertation, I read every single work Irving Fisher had published, then I corresponded with his son and read his unpublished manuscripts and notes as well. (OK, call me anal.) What Irving Fisher actually believed was that changes in inflation expectations had an even bigger impact on real rates than on nominal rates, and that they had important effects on the real economy by creating credit cycles. In this sense Fisher's work was essentially Austrian, closely tied to Wicksell's natural rate and, somewhat later, Keynes own rate of interest.

I finally worked out the linkage between inflation expectations and interest rates on a train while travelling to give a lecture to the GE Pension Fund, run by my friend Dale Frey. Dale was so smart and such a perfectionist in his own work that I wanted to get it just right.

The connection between inflation expectations and interest rates works through the prices of storable tangible goods. If a person wants to transfer purchasing power from this period to next period, he must do so by holding something that lasts longer than one period. We call such things assets. The investor has a lot of choices. He can hold a stack of $20 bills. He can hold a bond (IOU) promising a fixed number of dollars next period. He can hold shares of stock. Or he can hold existing real goods, which he can sell or use next period.

Asset markets will force asset prices to the levels that make these alternative strategies for transferring wealth have roughly comparable results. In particular, abstracting from credit risk and tax considerations, the total return on holding the bond (the nominal interest rate) should be about equal to the total return on holding quantities of real goods, which is equal to the sum of their service value (you can live in a house or drive a car), less depreciation (goods wear out), plus appreciation, less storage and maintenance costs (rent on a garage). The appreciation term is where inflation expectations come in. If people expect the price of their holdings of houses, cars, and other tangible assets to increase by 10% next year, then the nominal interest rate must be that much higher for bondss to remain competitive with real goods as an asset.

Note that we are referring to the appreciation of the stock of existing goods, because that is what people can actually hold. The CPI does not measure this, nor does the PPI, the GDP deflator, or any other price index measuring the price of new products.

59.76% of the CPI is comprised of service prices--haircuts and guitar lessons. Services are inherently unstorable; their depreciation rate is too high. For that reason, real interest rates calculated from CPI data misrepresent inflation pressures on interest rates. For the same reason, the yield on TIPS, inflation-indexed Treasuries, tells us very little about inflation expectations or pressures on nominal rates, because the Treasury uses the CPI, not storable tangible goods prices, in their adjustments of principal.

What really matters for interest rates is sustained increases or decreases (think Japan) in the prices of land, commodities, and long-lived structures. Not one-time increases like we saw last year, sustained increases. This requires the support and cooperation of a central bank. That is not going to happen in the US today.

When the stock market gets spooked by a CPI report, like today, think of it as a going back to school sale and load up on the stocks of your favorite companies and sectors. That's what I did today.

JR

Posted by John Rutledge at 5:21 AM | Comments (1)

March 15, 2005

Geek Think: Housing Boom Phase Diagrams

Warning, this article may only be interesting to geeks. If you are not a geek, the DELETE button is on the upper right hand corner of your keyboard.

Thought it would be useful for some readers to give you a more formal statement of the property market analysis in the previous entry.

As my old friends know, I am a big fan of making sure you distinguish between asset markets and flow markets when thinking about the economy. The reason is pretty simple. GDP is a number of about $12 trillion, chump change in comparison with our $155 trillion asset market, including $105 trillion in financial assets and $50 trillion in real estate and other tangible (George Carlin) stuff, according to the most recent Fed Flow of Funds reports.

Bottom line: if a policy does not impact the asset markets it does not matter.

Aside: This is no different than asking whether the earth orbits the sun or the other way around. Most people know the sun is the big dog in this story, therefore the earth orbits the sun. Actually this is not true. You can get a free drink at a cocktail party by telling people that actually both the sun and the earth rotate the center of mass of the sun-earth system, which is a point inside the sun but not its center. The end.

This is important because almost all of what passes for macroeconomic analysis today is simply descriptions of who is spending how much money in the GDP accounts. That analysis leads these thinkers to make big mistakes, which gives us great opportunities to make money.

Regarding real estate, take a look at the following diagram.

In this diagram, the graph on the upper left represents the asset market in which the price P of the existing housing stock, K, is determined.

The graph on the upper right represents the new construction (flow) market in which the price of an existing home interacts with the marginal costs of contractors to determine the number of homes or buildings they are willing to build, which we denote by lower-case k.

The lower right graph is simply a device for bringing big K and little k together on the same graph, which I have placed in the lower left. That is where all the action takes place.

Start with housing stock K(0) and demand for homes D(0) which determine the initial price of a house at P(0) in the upper left graph. A drop in interet rates increases the number of homes demanded at each price, creates an excess demand for homes, and pushes the price of an existing home up to P(1).

In the new construction market in the upper right graph, the higher home price results in more homes being built per year, k(1), than was the case at higher interest rates.

Now the hard part. The graph in the lower left is a phase diagram, a concept we can use to help think about dynamics. The critical concept is the stationary state line descending from the origin downward and to the right. That line represents combinations of K(t) and k(t) that leave the existing housing stock unchanged. This will happen when the construction of new homes, k(t), is just big enough to replace the number of homes that have worn out through depreciation (you know, like when your teen-agers come home). I have assumed that delta percent of existing homes die each year through depreciation. For example, if a home lasts 50 years, then delta would be 2% per year.

Assume we start at K(0) and k(0), which is a point on the line described above, i.e., we start in a situation where the housing stock is neither growing now shrinking. I can do this--it is my chart!

Now lower interest rates. The higher demand in the upper left graph increases the price to P(1), which increases housing construction in the upper right to k(1). But at k(1), we are building more houses than needed to replace the ones wearing out. Therefore the housing stock is growing. In fact, a little thought and 2 glasses of wine will convince you that all the points downward and to the left of the line in the lower left graph represent situations of a growing housing stock. In fact, the distance from the line indicates how fast it is rising or falling. Conversely, all points to the right of the line represent a shrinking housing stock. The housing stock will continue to grow until construction and depreciation are once more equal and the housing stock is in a new stationary state. (Geek note: Ludwig von Mises would have referred to such points as evenly rotating. Richard Dawkins would call them ESS, or evolutionary stable systems.)

A drop in interest rates will make a permanent increase in housing prices but, over time, the growing housing stock will mitigate some of the price and construction pressure, which means the initial burst of activity, and possibly of price, are likely to moderate somewhat over time. To an information theorist, the initial spike in price is a way of amplifying the initial information signal that housing is now scarce in order to get everybody's attention so they get out their hammers and build more houses.

So interest-rate induced housing inflation is largely a one-time event. It is not property inflation. It is not a housing bubble.

Housing inflation, as opposed to one-time increases in home prices, happens when there is a continuous increase in demand caused, for example, by systematically inflationary monetary policy. We do not have that today.

Housing bubbles pop when a sudden reversal of interest rates, or a sudden reduction in the availability of mortgage financing, causes a sudden, one-time, drop in demand. I don't think that is going to happen either. Inflation today is likely to remain low for some time.

Conclusion: There were good reasons why home prices increased over the past two years. But don't get caught in either the trap of believing they will continue to rise, or that there is an unavoidable housing bubble. Prices will be relatively flat over the next year.

Final geek note--I promise. The construct of present values, which underlies the construction of the stock demand curve in the upper left quadrant of our story, and we use all the time in finance, is weak stuff. Usually done by using the discount rate, a single number that is supposed to represent the opportunity cost of alternative assets during the life of the house. What we should use is estimates of the rental value of the house for each future year, each discounted by the relevant expected discount rate for that period, which you can approximate by calculating expected forward interest rates rom adjacent bond yields. When the shapes of the cash flow streams we are analyzing (here determined by the choice of depreciation rate) are different from the shapes of the cash flows of the bond we are using to measure interest rates, this causes problems. Especially true for the housing stock, which certainly has a duration longer than any government bond today.

JR

Posted by John Rutledge at 8:16 PM

Real Estate Prices

I received a comment from my good friend Jim Copley on my recent post about sizzling property markets. Jim is the CEO of the CROM Corporation, the nations's leading maker of highly-engineered municipal water storage systems. Jim is the kind of manager I would be proud to go to war with. (If you are in need of a 2 million gallon water tank please let me know.) I am proud that Rutledge Capital has an investment in Jim's company. Here is my response.

The abrupt drop in interest rates over last couple years has led to the complete re-pricing of residential and commercial real estate, as owners re-financed mortgages at the lower rates.

Essentially, we have re-capitalized the future stream of rental value embodied in the current housing stock at lower interest rates. The securitization of the US mortgage market allowed this to happen.

This leads to two sorts of problems. Some people look at the rising prices of the past year and think they will rise forever. They are the buyers lining up to draw straws for new developments today. We have seen this movie before in 1990. If you have been infected with this disease, best thing is to lie down until it goes away.

Recent price increases reflect lower interest rates, not rising future rent values (not higher future income streams), so are one-time events. In fact, the most recent report on existing home prices from the National Association of Realtors shows that prices peaked last June and have fallen since then. It is important not to get swept up in the excitement today.

The second thing I hear is talk about a real estate bubble. I don't find that worry credible because I believe interest rates will not rise much from current levels. Interest rates are ultimately determined by inflation, which I believe will remain in the 1-3% zone for a long time, both for domestic reasons (Fed, productivity growth) and global reasons (professional service price arbitrage with the countries in Asia that have fiber-optic connections with the US.) Cash returns on commercial real estate, although much lower than 2 years ago, are still somewhat attractive relative to bond yields. And both the economy and employment are rising, which will keep cash flow growing.

JR

Posted by John Rutledge at 6:16 PM

March 1, 2005

Household Balance Sheets are OK

We hear so much about the overburdened consumer that I thought you would like to see the actual numbers showing household assets and debts.

As of Q3/2004 (most recent data) US households and nonprofit organizations owned $21.7 trillion in tangible assets, like homes, and $35.3 trillion in financial assets for a total of $57.0 trillion is assets. Against that they owed $10.7 trillion, mostly in the form of mortgages. Their net worth was $46.7 trillion.

This is a big country. Our balance sheet is in very good shape.

Posted by John Rutledge at 2:54 PM

February 23, 2005

The Economy Will Grow More than People think in 2005

In my WSJ op-ed in November 2001, and many other places since, I argued that in spite of sharp reductions in Fed funds rates, monetary policy was actually very tight. Because banks has systematically withdrawn from lending to business customers. Between then and May, 2004 bank business loans totaled minus $230 billion. How? By collecting $230 billion from business customers than they loaned to business customers every week for three and a half years.

This is why we had a slow, jobless recovery over that period. Big companies borrow money from the bond market; small companies have to borrow from banks. Small companies make up more than half of GDP and create 3 of every 4 new jobs.

Over this period we had a half a recovery, because only half the companies in America had access to credit.

As a result, the Fed had to push market rates much lower than would have been necessary. The result was a recovery dominated by large companies and the mortgage market, both of which are driven by fed funds and T-bill rates.

Since last May this is all changed. The mortgage refi game is over. Banks are lending to businesses again. Loans have increased by $63 billion since May. This is giving small companies a dramatic increase in working capital and drop in cost of capital that is not being reflected in (rising) fed funds rates.

Implications.
GDP, employment, and profits will grow faster than economists think this year, the mirror image of the jobless recovery that preceded it.

Fed funds rates could increase a great deal without stopping the recovery.

The surprising productivity gain of the past 5 years has been accomplished by big businesses alone. Now small companies are getting the working capital they need to make the IT investments to duplicate those gains. Add increased availability of broadband (new telecom act this year; I am on the working group) and cheaper, more scalable technology; the result is a small business led productivity jump.

Together, these factors mean small company profits will grow faster than big company profits. Small cap stocks will outperform large caps this year by a wide margin. (This is why I have a long position in US small cap stocks at the moment.)

Moral of the story:
is it is misleading to make judgments about the economy and investing, or to set monetary policy, by thinking about big public companies alone. When you dig under the numbers, the US is a two-cylinder economy. They both need to work for us to really grow.

John

Posted by John Rutledge at 3:00 PM

February 1, 2005

Business Loans, Growth, Small Cap Bet

Why growth will be stronger in 2005 than people think.

Why I have a bet on small cap stocks

Banks loaned businesses minus $230B between November 2000 and May 2004. That means banks collected about $1 billion more from businesses than they loaned to businesses ever week for three and one half years. As you can see in the chart, and at the FRBSL website, this was the sharpest contraction of bank credit since the Great Depression.

I wrote an op-ed about this subject in November, 2001 warning that non-price credit rationing would hit small businesses very hard, that small businesses make up more than half of GDP and 3 out of every 4 jobs. This was the reason we had a jobless recovery for so long.

Last May banks opened their doors to business borrowers again, as you can see in the chart. This corresponded to the end of the refi boom. Since then business loans have increased by about $40 billion. To date, this increase in lending has been restricted to small banks—large banks are too busy being investment banks to bother with business loans.

Doesn’t take a genius to figure out what that means for growth. Both GDP and job growth will be surprisingly strong in 2005, just as they were surprisingly weak in 2001-2003. Profits will be stronger than people think too; double digits for the year.

This explains why I hold a bet on small cap stocks today. As you know, I manage my equity portfolio by tracking storm systems—situations where an abrupt policy change has produced an after-tax yield differential. Yield gaps attract the attention of arbitrageurs. If you put your bet down early they will give you a free ride as they create capital gains by driving returns into line.

Large companies don’t borrow money from banks; small ones do. This story means small companies are enjoying a sharp drop in their effective cost of capital. They will grow faster; faster than before and faster than big companies. I think small caps will outperform the overall market in 2005.

How to place a bet? There is an exchange traded fund (ETF) that owns the S&P small cap index. It’s ticker is IJR.

Posted by John Rutledge at 9:20 PM

Geek Think: Housing Boom Phase Diagrams

Warning, this article may only be interesting to geeks. If you are not a geek, the DELETE button is on the upper right hand corner of your keyboard.

Thought it would be useful for some readers to give you a more formal statement of the property market analysis in the previous entry.

As my old friends know, I am a big fan of making sure you distinguish between asset markets and flow markets when thinking about the economy. The reason is pretty simple. GDP is a number of about $12 trillion, chump change in comparison with our $155 trillion asset market, including $105 trillion in financial assets and $50 trillion in real estate and other tangible (George Carlin) stuff, according to the most recent Fed Flow of Funds reports.

Bottom line: if a policy does not impact the asset markets it does not matter.

Aside: This is no different than asking whether the earth orbits the sun or the other way around. Most people know the sun is the big dog in this story, therefore the earth orbits the sun. Actually this is not true. You can get a free srink at a cocktail party by telling people that actually both the sun and the earth rotate the center of mass of the sun-earth system, which is a point inside the sun but not its center. The end.

This is important because almost all of what passes for macroeconomic analysis today is simply descriptions of who is spending how much money in the GDP accounts. That analysis leads these thinkers to make big mistakes, which gives us great opportunities to make money.

Regarding real estate, take a look at the following diagram.

In this diagram, the graph on the upper left represents the asset market in which the price P of the existing housing stock, K, is determined.

The graph on the upper right represents the new construction (flow) market in which the price of an existing home interacts with the marginal costs of contractors to determine the number of homes or buildings that will be built, which we denote by lower-case k.

The lower right graph is simply a device for bringing big K and little k together on the same graph, which I have placed in the lower left. That is where all the action takes place.

Start with housing stock K(0) and demand for homes D(0) which determine the initial price of a house at P(0) in the upper left graph. A drop in interet rates increases the number of homes demanded at each price, creates an excess demand for homes, and pushes the price of an existing hime up to P(1).

In the new construction market in the upper right graph, the higher home price results in more homes being built per year, k(1), than was the case at higher interest rates.

Now the hard part. The graph in the lower lef is a phase diagram, a concept we can use to help think about dynamics. the critical concept is the stationary state line descending from the origin downward and to the right. That line represents combinations of K(t) and k(t) that leave the existing housing stock unchanged. This will happen when the construction of new homes, k(t) is just big enough to replace the number of homes that have worn out through depreciation (you know, like when your teen-agers come home). I have assumed that delta percent of existing homes die each year through depreciation. For example, if a home lasts 50 years, then delta would be 2% per year.

Assume we start at K(0) and k(0), which is a point on the line described above, i.e., we start in a situation where the housing stock is neither growing now shrinking. I can do this--it is my chart!

Now lower interest rates. The higher demand in the upper left graph increases the price to P(1), which increases housing construction in the upper right to k(1). But at k(1), we are building more houses than needed to replace the ones wearing out. Therefore the housing stock is growing. In fact, a little thought and 2 glasses of wine will convince you that all the points downward and to the left of the line in the lower left graph represent situations of a growing housing stock. In fact, the distance from the line indicates how fast it is rising or falling. Conversely, all points to the right of the line represent a shrinking housing stock. The housing stock will continue to grow until construction and depreciation are once more equal and the housing stock is in a new stationary state. (Geek note: Ludwig von Mises would have referred to such points as evenly rotating. Richard Dawkins would call them ESS, or evolutionary stable systems.)

A drop in interest rates will make a permanent increase in housing prices but, over time, the growing housing stock will mitigate some of the price and construction pressure, which means the initial burst of activity, and possibly of price, are likely to moderate somewhat over time. To an information theorist the initial spike in price is a way of amplifying the initial information signal that housing is now scarce in order to get everybody's attention so they get out their hammers and build more houses.

So interest-rate induced housing inflation is largely a one-time event, not property inflation, not a housing bubble.

Housing inflation, as opposed to one-time increases in home prices, happens wehen there is a continuous increase in demand, caused by systematically inflationary monetary policy. We do not have that today.

Housing bubbles pop when a sudden reversal of interest rates, or a sudden reduction in the availability of mortgage financing, causes a sudden, one-time, drop in demand. I don't think that is going to happen either. Inflation today is likely to remain low for some time.

Conclusion: There were good reasons why home prices increased over the past two years. But don't get caught in either the trap of believing they will continue to rise, or that there is an unavoidable housing bubble. Prices will be relatively flat over the next year.

Final geek note--I promise. The construct of present values, which underlies the construction of the stock demand curve in the upper left quadrant of our story, and we use all the time in finance, is weak stuff. Usually done by using the discount rate, a single number that is supposed to represent the opportunity cost of alternative assets during the life of the house. What we should use is estimates of the rental value of the house for each future year, each discounted by the relevant discount rate for that period. When the shapes of the cash flow streams we are analyzing (here determioned by the choice of depreciation rate) are different from the shapes of the cash flows of the bond we are using to measure interest rates, this causes problems. Especially true for the housing stock, which certainly has a duration longer than any government bond today.)

JR

Posted by John Rutledge at 7:15 PM

December 14, 2004

Forget the Fed, Bank Loans are Back. Buy Small Caps

The Fed raised the Fed funds rate one-quarter percent again today, which took the inflation worriers by surprise; pushing 10 year Treasury yields 19 basis points lower, and turned my screen completely green as stock prices responded. The real isue is business loans, and they are heading up.

This is one of those stories you can use over and over again. It seems like investors talk themselves into believing inflation is rising every six months. When they do, take their bet. This economy is driven by productivity growth, which means lower costs and prices and rising profits. Inflation is not a problem.

Most important point about monetary policy is not the Fed's rate move today. It is the fact that banks, which had shut their doors to business lenders from late 2000 til this May, have opened for business loans again. Loans were down $230 billion from December, 2000 to May, 2004, the sharpest decline since the Great Depression. Since then business loans have increased by about $30B, as you can see below.

It's small banks, not the big ones, that are lending as you can see in the chart below. That's very important for growth and hiring in small companies, which make up more than 50% of GDP and 75% of new jobs. This economy is going to grow by 4% or more next year.

The return of banks to business lending creates an interesting opportunity in the market. Large companies never borrow money from banks; small companies only borrow money from banks. This should make small cap stocks outperform large caps as small companies respond to the sharp implicit drop in their cost of capital as banks become more friendly. They have increased by nearly 20% since their August lows.

Collateral evidence in the middle market buyout business, where lenders are lining up for meetings and sending huge boxes of candy to private equity sponsors again (and it's about time; I was getting hungry.) Today's market, with small caps (IJR) up big relative to large caps (SPY), is an illustration. And you are going to hear a lot of we love small business talk this week from the White House meetings this week. I am staying long small cap stocks.

JR

Posted by John Rutledge at 4:16 PM

December 9, 2004

Asian Markets

Markets are selling Asian ETF's today; Korea (EWY), Pacific ex-Japan (EPP), Japan (EWJ) all down. It's a head fake.

Reaction to soft Q3 growth stories in Japan, failure of Korean central bank to lower rates to restore weakening growth. Also a striking op-ed in the Japan Times today about the string of recent peasant and worker violence in China. Exception is Hong Kong, where real estate is firming. There is reason to worry about China. Our government is leaning on them to revalue the RMB, which would further tighten credit. NOBODY knows how to estimate what would happen. I believe the Japan growth story is very solid. "

Posted by John Rutledge at 6:38 PM

December 7, 2004

Gulf Market Press Summary Source

I got a lot of emails from people asking me where they can track news on the Gulf markets I mentioned in my RealMoney article (posted to blog last night.)

There is a website you can access which will send you an email with links to the financial press in all the Arab newspapers. You can see it at . It's a great way for US investors to see the Iraq, oil, and other news stories from a different perspective.

Posted by John Rutledge at 6:42 PM

December 6, 2004

Invest in a Chinese Airline? I don't think so.

Any investor contemplating investing in a Chinese company needs to read this article in today's WSJ.

Air China, which is trying to raise as much as $1.1 billion through an initial public offering of shares in the Hong Kong market, is telling investors that it plans to upstream as much as $1 billion with a finance company controlled by its parent, China National Aviation Holdings Co. Investors will get to ride in the back seat.

You are going to see a lot more of these. Chinese leaders have decided that the only way to deliver the rising living standards their people expect is to import massive amounts of capital. That means enticing foreign direct investors and selling securities of domestic Chinese companies in foreign markets.

Warren Buffett once described investing in an airline as temporary insanity.

Investing in an airline in the Hong Kong market owned by a Chinese parent is permanent insanity.

Posted by John Rutledge at 6:57 PM

Measuring Progress in Iraq

If you want to know what the outlook is for Iraq you need to ask the guys who know--the investors who set the prices in the Gulf stock markets.

My friends at Global Investment House in Kuwait--in my judgment the most astute observers of Gulf capital markets--tell me that local investors like what they see. Their overall index of the Kuwaiti stock market is up 14.2% year to date (YTD), and 18.7% last 12 months (LTM). That's about double the year to date performance of our S&P 500 (7.1%), and NASDAQ (7.2%). The Dow Industrials are up only 1.3% YTD.

Real estate stocks in Kuwait are up 15.4% YTD and 19.5% LTM. Stocks in Gulf countries other than Kuwait are up 37.2% YTD, 41.0% LTM. Islamic stocks (companies that run their businesses in compliance with Islamic principles) are up 25.8% YTD, 35.1% LTM.

These prices are meaningful because they represent the present value of the free cash flow that listed companies will generate within the period governed by current regimes, current law, and current property rights. Investors will seriously discount the expected cash flow of a company located in a country with an unstable government because that cash flow stream would be abrogated by any change of government. Increased stability, therefore, translates into a longer expected cash flow stream and higher stock prices.

This is especially so for real estate investments, which are completely immobile and, therefore, a perfect barometer of local investor expectations of the likely duration of their current government. This is one case where an increase in the duration of a security means less risk, not more risk.

My current bet is that Iraqi elections will be held on schedule in January

Posted by John Rutledge at 4:00 PM

November 14, 2004

It's Not Kansas Out There: Stay Away from China IPO's

There is one question that is sure to come up every time I speak to a group of investors. "How can I invest in China?" I always tell them the same thing.
"You already are invested in China."

Everyone knows that China is knocking the lights out, growing two or three times as fast as the US. And everyone knows that it was China's incredible growth that drove up oil, steel, aluminum, copper, and coal prices last year. Can't blame them for wanting a piece of the action.

Problem is, the headline investments are sucker bait. As you can read in this CBS MarketWatch article, China is the force behind a huge wave of IPO's that are hitting western stock markets. China's leaders have figured out that the best way to deliver rising living standards to their people is to tap our capital markets for the money to buy the tools and technology to make their workers productive.

Japan leads global IPO's this year with 141 new issues that have raised a total of $9.3 billion. Japan's Electric Power Development company (J-Power) (JP:9513: news, chart, profile), for example, distinguished itself with a $3.4 billion offering - second only to Belgacom (BE:000381027: news, chart, profile), the Belgian telecom giant, which raised $4.1 billion in the largest issue so far this year.
China is runner-up to Japan in the IPO market, raising $4.4 billion via 95 new issues, according to PricewaterhouseCoopers. For instance, leading fixed-line telecom operator China Netcom (CN: news, chart, profile) (HK:906: news, chart, profile) took in $1.1 billion ahead of its scheduled Nov. 16 U.S. listing and a Hong Kong listing the following day.
Next month, Air China is expected to debut in both Hong Kong and London after moving its IPO plans forward from 2005, according to The Syndicate Source, ECM Monitor, which tracks global IPO's.

That's great for them, and a good opportunity for knowledgeable, on-the-ground, China insiders. But it's no place for part-time investors.

Most investors already have more exposure to China growth than they realize. Big US companies like Intel, Ford, GM, Johnson & Johnson, and Procter & Gamble exposed you to China because they have investments there. Commodity price sensitive companies like Exxon, Alcoa, USX, or Phelps & Dodge expose you to China because their revenues respond to commodity prices. And companies in Japan, Korea, Taiwan, and Hong Kong expose you to China because they do so much business there.

You don't need to buy a Chinese IPO to make a bet on China.

I have had a modest direct bet in place on China's growth for some time by owning a strip of Exchange Traded Funds for the Asian countries most exposed to China business. So far, so good. But I am keeping the bet small. I suggest you do the same.

Posted by John Rutledge at 7:02 PM

November 11, 2004

The Russian Bear is Waking Up

There is a cloud on the horizon that we should keep our eyes on. It is the end of the Russian experiment in democracy at the hands of Vladimir Putin.

I track the major economic and financial storm systems in the Storm Watch section of our website. They identify situations where policy change has opened a gap between returns on different assets, which attract the attention of global investors. My weather map today is tracking storm systems dealing with Iraq, telecom, China, tax policy, and business lending. Each one poses a risk. Each creates an investment opportunity.

I recommend that you read Gasparov's op-ed piece, Putin's Appeasers, in the European edition of Thursday's WSJ, which takes western governments to task for not objecting to recent Russian events:

Under the direction of Mr. Putin, Russia is well into its transition into an authoritarian state. The costs of this change for the Russian people and the world are high and getting higher.

We have grown used to seeing Russia as poor and powerless. That is going to change. Just as commodity deflation in the 1980's dried up Russian revenues, last year's commodity inflation has turned Russia into a money machine. Russian oil and gas reserves are the only real alternative to the Arabian Gulf in the next decade. And they still own all those nuclear warheads.

Ten years ago I asked a friend and former cabinet member in the first Bush administration why they did not simply purchase Russia's stock of nuclear weapons in 1989-1992 in exchange for food during the first long winters after the fall of the USSR. He said they couldn't afford it; the budget deficit would have been too big. I think it would have been our best bargain of all time.

Posted by John Rutledge at 7:17 PM

November 6, 2004

Post-Election Economic Storm Watch

Jobs - Banks are lending again, big job gains coming, Fed tightening worry.
A Second Dividend Tax Cut- Potential for +10% stock gains, $1 trillion.
The Deficit- Improving growth will increase tax revenues, reduce deficit.
Telecom- Telecom Act of 2005 will trigger massive network investments.
China- China is driving world growth but near-term slowdown is a risk.
Iraq- Elections will take place in January but violence will continue.

SHIFT HAPPENS

Major economic change is almost always the result of a change in government policy that drives a wedge between the after-tax return on one type of asset relative to others. This leads to a SHIFT in asset demands as investors attempt to rebalance their portfolios to take advantage of the return differential. The rebalancing drives asset price changes, and ultimately shows up in the creation or destruction of assets.

Formally, these asset market disturbances are identical to the temperature and pressure differentials that drive the storm systems on a weather map. It is worth remembering that economic shifts, and the risks and opportunities they represent, are always transitory.

Posted by John Rutledge at 4:31 PM