Thursday, October 06, 2005



As of today’s close, ALL of the indicators the Author follows are negative. And as of this point this year, all major stock market indices are year-to-date negative.

In the September 29th post, the Author shared his defensive portfolio with you. It is now almost fully implemented. It is reprinted below for your benefit and includes some updated information in brackets[].

Author’s Target Portfolio:

20% Gold. This is new territory for the Author. He has never owned gold or a gold fund. And the Author is not sure that gold will continue its run, but the technical charts look good and the Precious Metal Sector has good relative strength. With this investment the author is following one of the key tenets of his investment philosophy. “Never argue with the tape (or chart)”, ala Jesse Livermore.

The Author’s gold holding is IAU, a Comex Gold Index Exchange-Traded Fund. The fund tracks gold prices and, as an ETF, trades on the AMEX exchange.

20% Value Stock. These could be held as individual stocks or through a value stock mutual fund. Avoid value stock ETFs right now. In these markets, you need a fund manager with good value stock picking skills. [The Author holds First Eagle Global Value Fund. Its YTD return is 9.71%. Unfortunately, it is closed to new investors, but watch for it to reopen.]

10% Rydex S&P 500 Inverse Fund. This particular fund is 200% inverse to the S&P 500, so in effect 20% of the portfolio is “shorting” the S&P 500.

10% Rydex NASDAQ 100 Inverse Fund. This particular fund is 200% inverse to the NASDAQ, so this “shorts” the index as 20% of the portfolio.

30 to 40% cash. This component could also include some foreign exposure. [Three ETFs the author tracks, the Latin American 40 ETF (ILF), the EAFA Emerging Markets Index (EEM), and the EAFA Foreign Index (EFA) are falling back. The Author will watch these ETS and will consider buying on pullbacks.]

As always, these are suggestions, not recommendations. Your investments should be based upon your individual needs and analysis. This proposed portfolio is offered only for your study.


IMPORANT DISCLAIMER: This newsletter is offered for informational purposes only. Sources of information provided are believed to be reliable, but are not guaranteed to be complete or without error. Opinions and suggestions are provided with the understanding that readers acting on information contained herein assume all risks involved. The Author may or may not buy or sell securities discussed in this newsletter.



A basic stock market valuation measure is the Price/Earnings Ratio. And the biggest driver in Secular stock market cycles is the change in Price/Earnings ratios from high to low and vice versa.

The post today is from a Desert of the Real Newsletter from last summer. The Author wrote it during the week that the Guild Cinema in Albuquerque had its 1970s Cult Classic Movies Festival. So there is a distinctive 1970s retro-feel to the post. So let’s get down with some valuation rappin’.

Price/Earnings Ratio. What you Pay is What You Hope You Gonna Get, Suckah[1]

Price/Earnings Ratio is a fairly straightforward concept. It is the price of an investment divided by its earnings for a year. For example, if IDISALIE Inc. had $4 in earnings in the last year and the price of IDISALIE Inc. is $80, the P/E ratio would be 20. (80/4 = 20). If the price of IDISALIE went up, buoyed on news of better sales, to $90, the P/E ratio would rise to 22.5 (90/4=22.5). Earnings did not rise, but the price that investors would pay for IDISALIE was bid up.

Similarly, if the price of IDISALIE plummeted upon news that the CEO was caught cavorting with known and still-unindicted felons[2], the P/E ratio would fall. If IDISALIE fell to $72, the P/E ratio would become 18. (72/4 = 18).

The P/E ratio is an expectation of future growth and earnings, also. If IDISALIE ‘s earnings are expected to rise to $5.5 next year and investors bid up the price of IDISALIE, then the P/E will go up based upon the prospect of higher earnings. Conversely, if IDISALIE’s CEO’s legal troubles are expected to hurt the company’s performance, IDISALIE’s price will fall and the P/E ratio will go down.

P/E ratios can also be expressed for market indices or sector indices. The Price/10-year earnings ratio of the S & P 500 is currently at about 27. This is historically high and one of the reasons equity price growth has stalled and we are in the early stages of a Secular Bear Market[3]. Until P/E ratios fall into the low 10s or below 10, the market may not be poised for long-term sustained growth.

Jeremy Grantham is the chairman of GMO LLC, an investment firm[4]. Grantham is one of the top financial and investment minds in the world. He is also an excellent “synthesizer”. He can bring together financial trends or concepts into readable explanations of current conditions. In his July 2005 “Letter to the Investment Committee IV, Explaining P/E”, he discusses the factors that affect P/E ratios, commonly believed factors that do not explain P/E ratio levels, and why the P/E ratio of the market is historically high.

Grantham writes that the factors that have a positive correlation with P/E shifts are factors that relate to “investor psychological comfort”, or economic stability.[5] The three factors that correlate most closely in Grantham (and Ben Inker’s) model are, in order of significance:
1. Levels of profit margins. It is not the increases in profit margins, but the consistently good level of profit margins that increase investor comfort and correlate with high P/E ratios.
2. Stability of inflation around its “sweet spot” of 2.5% per year.
3. Stability of GNP growth.

Putting all of this together, Grantham and Inker’s model calls for the high P/E ratios we are presented with. The market is still over-priced and when the market falls to normal (and will almost certainly overcorrect, as markets usually do), stock prices will fall in value. And Grantham reminds us that his model “explains high prices, it does not justify them[6].” (Original Emphasis)

Reversion to the Means. Or the Maddening Götterdämmerung of Most Mortal Men[7]

Just as some men are Ford men, some kids are “Toy’s R Us” kids, Grantham is a reversion to the means guy. Grantham succinctly states:

“[E]conomic trends mean revert because there is a powerful and persistent normal return toward which capitalist competition strives, competing down handsome margins and P/Es and avoiding low returns until shortages develop.”

That’s the Fact, Jack.[8] If only Alan Greenspan could explain things that effectively. High P/E ratios will come down and stocks will become cheap again. And that is when the smart money should put all four feet and snout into the market trough. Grantham backs this up with some statistics.

Many studies show that the key to generating a good (or poor) long-term stock return is to consider when you initially invested your money. If you threw it all in March 2000, yuh been pimped. However, if you invest when P/Es are low, you’re in the Jack. Grantham and Inker divided the 10-year returns from all monthly starting points into five quintiles. If investors invested their money when investor comfort levels where low they have netted an 11% return. If they invested when comfort levels were highest (like today’s market), the compounded 10-year return was 1%. That’s not a typo, 1%.[9]

And Mr. Grantham has brought us full circle. Invest at the end of a Secular Bull Market and the following Secular Bear Market will devour your returns and maybe even some of your capital. Keep your picnic basket in the cabin until the Bear finally gives up and walks away, and there will be a banquet in a few years.

Finally, remember that there are opportunities in all markets, Secular Bulls and Bears, and Cyclical Bulls and Bears. Keep reading this Blog and the Author will share them with you as best he understands them.


[1] You must forgive the Author. The Guild Cinema is showing Cult Classic Films from the inimitable decade of the 1970s. The 1970’s was the last decade in which Walther Mathau wore a purple hat with a white feather or Cloris Leachman wore a halter-top. Perhaps it is best that way.
[2] Jack Abramoff and a yet-to-be indicted congressional leader from Sugarland, Texas, who shall remain nameless, or in a more Rovian sense, “unidentified”. FLASH UPDATE: This congressional “leader” from Sugarland, Texas has since been indicted.
[3] Please refer to the May and June 2005 editions of Desert of the Real for a discussion of the Secular Bear Market.
[5] “Letter to the Investment Committee IV”, p. 1
[6] Letter, p. 2.
[7] The Author means no offense to his female readers. It is just that the phrase “most mortal men” has good alliterative qualities. He has seen the film “Who Framed Roger Rabbit” enough times to appreciate good alliteration in a work of art.
[8] There’s that 1970’s cinema stuff, again. We all remember the 1970s, don’t we? Good times, guitars heavy with fuzz and wah, big cars, tight halters with big natural . . . uh, better not go there. This is a family blog. But there was something else in the 1970s. Recessions, a poor stock market, and double-digit INFLATION.

Many of us were and are still schooled to believe that prices of input materials (remember the oil crisis) are the drivers of inflation. The Author managed to show up for economics class one day when he was told that there were two types of inflation: Cost-push inflation (cost of oil goes up, so does the price of goods shipped by truck) and demand-pull inflation (everybody wants to buy a Cabbage Patch Doll so the price of the doll goes up). But subsequent reading and study is telling the Author that inflation is not an economic event, but a monetary event. This is probably a story for another newsletter, but the Author will cram it into this footnote as a farsightedness vision test.

The means reverting statement Grantham makes provides guidance on why inflation is not an economic event. When oil prices go up, markets and entrepreneurs react. They seek more oil sources, look for petroleum alternatives and make engines more efficient. Rational consumers also react, driving less and buying more efficient vehicles. Except in America, of course, where oil prices have not caused an economic behavioral reaction. In the inimitable American tradition, Americans use their credit cards to fill their tanks. Americans are deferring, and financing at usurious interest rates, the gasoline price increases. As a 1970’s loan shark film character might say, “If yuh gonna drive it Big, yuh gotta pay the Vig”.

Inflation is the monetary event where there is excess liquidity or stimulation in the economy. Monetary officials, like Alan Greenspan, hold vigil over inflation and try to limit inflation with a tightened money supply.

So back to the 1970s. Some among us may remember Paul Voelcker, the cigar-chomping Fed Chairman that President Jimmy Carter installed. Voelcker began an aggressive money-tightening policy that cut inflation, induced a recession and ended the 1970s. Alas, that was the 1970s. And as good-hearted tough-guy cop Baretta (played by Robert Blake) would say, “And dat’s duh name ‘uh dat tune.”
[9] Letter, p. 2.



The Author got you with motorcycles, right. Come on, admit it. No breathing adult would want to read about microeconomics, but many folks long for the open road and a wound-out bike.

Motorcycles are ubiquitous. They are cheap transportation in crowded international cities, workhorses in many rural areas in developing countries, and objects d’art and desire in the developed world. They range from the ultra-utilitarian scooter to the unapologetically obsolete American Cruiser. And for the sporting breed, today’s sportbikes produce more horsepower than small cars and run at the speed limit cubed.

So if we look at motorcycles in terms of their utility, almost any motorcycle will fill a basic transportation need. The Author could go to the classified ads and get a working motorcycle for a little as $300-$500. It probably wouldn’t look very nice nor go very fast. But it would go from point A to point B. And the Author is not ashamed to admit that riding even a lowly 125cc “beater” is fun.

But motorcycles are confounding[i] things. Many motorcycle owners are deeply devoted to one brand of bike, one type of riding (dirt, touring, slow group rides), or extreme performance. And many motorcycle owners lavish attention and spare parts in copious quantities on their bikes. So it can be safely said that many people own motorcycles for reasons beyond their base utility. Here is where the economics come in.

Economists are dudes and dudettes that work on the margins.[ii] Two important definitions are set out below:

Marginal utility
The change in total satisfaction as a result of consuming one additional unit of a specific good or service.

Marginal efficiency of capital
The percentage yield earned on an additional unit of capital. [iii]

If you have ever taken an economics course, the definition of marginal utility is often cast in terms of junk food. One Doublestuff Oreo is a nice treat. You eat another, and another. But then at some point, you will get less satisfaction out of eating the next Oreo. In economic terms, the marginal utility of the next Oreo will diminish and each additional one will have even less marginal utility. Finally, there will be little if any marginal utility in an additional Oreo. You have had enough cookies.


One way to look at the marginal utility of motorcycles is to consider a person who owns several motorcycles. Some people like to have LOTS of bikes. A sportbike, cruiser, a dirt bike, a track bike, maybe an antique or classic. But let’s say that this person has a collection that contains several bikes for different rides. She owns three cruisers-a Harley-Davidson Soft Tail, a Victory, and a Yamaha V-Max. She has most of the cruiser world covered. She thought about picking up a Honda Valkyrie, but she recognized that she was not very excited at putting one more cruiser on the paddock. So she foregoes the purchase. In other words, the marginal utility of getting one more cruiser motorcycle is declining.

The Author is not a cruiser person, however. He likes sportbikes. He formerly owned a Ducati. And he recently put his money down for a Ducati 999, an expensive high-performance motorcycle. Ducati Superbikes like the 999 have been called the Ferraris of motorcycles. There are a handful of bikes that go even faster than 999s, but power-to-weight ratio, suspension characteristics, braking ability, and handling place them at the pinnacle of sportbikes. And they are drop-dead gorgeous motorcycles.

The Author’s 999 is a yellow monoposto. Monoposto is Italian for one seat. No place for a passenger. It is not comfortable and has no place to store anything. It does one thing. It goes very fast, stops very quickly, and corners well. There are many sportbikes that cost far less and are nearly as good. But getting from good to better to ultimate works on a declining curve of marginal efficiency of capital. Each additional dollar of components and engineering produces a correspondingly lower yield in terms of performance[iv]. And at some point, the marginal efficiency of capital spent to build a better bike will decline to almost nothing and finally to nothing. Not even Bill Gates could outspend you to go any faster.

These concepts, marginal utility, and marginal efficiency of capital, are common sense ideas that find expression and quantitative expression in the field of economics. And these concepts work in the world of motorcycles, chainsaws and power lawn mowers.


[i] Almost Conundrumous things.
[ii] They never seem to talk about the big things, just the marginal things. Perhaps this why economists are on few A-lists.
[iii] These definitions come from Campbell R. Harvey's Hypertextual Finance Glossary. Mr. Harvey is an investment and finance professor at Duke University and hosts an excellent web site:
[iv] Using marginal efficiency of capital in the context of marginal increases in race bike performance is a little unusual. Using marginal resource cost compared to performance costs would be a little more traditional. (Comparing each additional dollar spent to each performance gain). But this is an investment newsletter and the Author thinks in more in financial terms than production models and microeconomic. (If you call this thinking!)

But if I am the owner of the motorcycle company and I only race bikes to increase sales and earnings, then I want to know when my marginal returns on the money I spend on racing maximizes and then just begins to decline. That is where I will stop spending any more money on racing. This is called the profit maximization point. Most say that the profit maximization point is where marginal resource cost equals marginal revenue cost. But using the point where profits just start to decline is a way to actually test where the profit maximization point actually is