2/28 Kelly Letter Topics
Weekly market review
Manufacturing rise
Euro zone risks
State fiscal disaster
China pulling back
Consumer conf.
FDIC bank closures
Bernanke on rates
Greek protests
Falling home sales
Dying bank reform
Oil price trends
Toyota saga
Natural gas trends
Gov killing economy
US rescue bot
Dividend ideas
Japanese women
2010 EDITION
Much has changed; good investing has not
The Neatest Little Guide to Stock Market Investing, 2010 Edition
We've been watching Market Vectors Russia (RSX) since last August, and had a buy price target of $10 on it. Since we began watching, it fell from $40 in August to $10.34 in January when it barely missed our price target, rose to $26 at the beginning of this month, and closed last Friday at $21.31.
Having witnessed that wide range, I asked myself if there was still a chance that Russia would hit newer, harder times to send the ETF down to the $10 level again. In pursuit of the answer, I dove back into our Russia folder for the latest reports. What I found was interesting, as it revealed how Russia will manage its politics and business together to control its energy economy. Remember, it's the "R" in the BRICs, the future of the world economy as defined by Goldman Sachs: Brazil, Russia, India, and China. Its economic strategy is an important one to understand.
Russian President Dmitri Medvedev warned CNBC viewers of "alarming figures" when talking about his economy on June 2. His alarming figures were rising unemployment and falling industrial production -- and those two figures are fairly alarming everywhere we look, not just in Russia.
In Russia, however, they've taken an especially large toll and put GDP on track for somewhere around 7.5% this year, a level not experienced since the fall of the Soviet Union twenty years ago. It fell almost 10% year-over-year in the first quarter alone. Foreign investment plunged 30% and that referenced unemployment figure is on its way to double-digits, as it is in the U.S. as well.
The near term, then, is far from rosy in Russia.
One group that doesn't mind, though, is the Kremlin. Credit has always been hoarded by the Russian government, so private businesses headed by the famous oligarchs turned to foreign sources of capital for funding. When the credit crisis spun out of control last year, private corporations in Russia were more starved than their counterparts in other countries, most notably the U.S. where the credit crunch became a bonanza for the financial industry that found itself swimming in taxpayer capital.
In Russia, the relative balance of power shifted from the private entities, which were already under attack by the government, to the Kremlin. Foreign investors pulled out of Russia en masse, sending the ruble down in value, and bringing the Kremlin into currency markets to buy rubles in an effort to stave off another currency crisis like the one the ruble caused in 1998. The plan worked, the ruble stabilized, but private banks found themselves holding foreign-denominated loans that they couldn't repay.
No problem, said the Kremlin, and it has been merrily consolidating the banking system to its liking and under its influence. The elite business leaders who survive this weeding out process will be pawns of the Kremlin, dependent on credit extended by state-controlled banks and subject to centrally-planned economic directives.
You can be sure that those directives will focus on managing political relationships around the world to maximize Russia's economic benefit. Energy exports as a share of overall exports rose from 50% in 2000 to 66% last year, and the two components are crude oil and natural gas. Europe is trying to diversify its natural gas dependency away from Russia, and Russia is already working hard to limit that diversification through political wrangling.
For example, the Kremlin forced aluminum magnate Oleg Deripaska to give some $33 billion of his personal $36 billion fortune to boosting his aluminum company RUSAL and supporting the Kremlin directly. In return, Deripaska was given management of a state-controlled metals corporation where he can carry out other ideas from the Kremlin. The first was participating in a partnership between state-controlled Sberbank and Deripaska's GAZ auto maker to buy German auto maker Opel. It also involved Canadian auto parts company Magna, and will result in Opel cars being made in Russia.
That kind of business web involving the Russian government, a Russian oligarch with business connections to the West, and Western businesses themselves is precisely how the Kremlin sees itself maneuvering through the coming decades of commodity scarcity and political sensitivity. The Opel buy -- which was a kind of bailout, really -- gave a big boost to German Chancellor Angela Merkel just ahead of her bid for re-election. The timing was no coincidence, of course, and brings both Merkel and Germany closer to Russia and farther from the United States. That will come in mighty handy when Europe discusses where to get its natural gas in the future, Russia or the U.S. At least one powerful voice, Merkel's, will be suggesting Russia.
That type of government is not the type that runs through my blood as a U.S. citizen, but it's one that looks appealing to me as a potential investor. I think the Russia that emerges from this credit crisis will be in far better position than the one that went in. The Kremlin has taken control of its currency, acquired the country's most savvy international business people, and has already used those new assets to begin managing the political connections it will need to get the most out of its natural resources in the coming energy crunch.
Therefore, I doubt we'll again see the $10 level on RSX. There's too much relief in the air, too much anticipation of recovery, and too many smart investors on to the new teamwork happening between private companies and the Kremlin. On the latter, most seem to think the partnerships will be good for business, even if they result in government skimming as much profit off as it wants. That profit will assure that the state-connected businesses will have access to endless credit and a pretty tough partner on the world stage. In any event, there's no longer doubt about government's involvement in enterprise in Russia, and that alone helps investors quantify risks. At least it's not an unknown anymore.
What I think could happen, however, is that the coming dip in oil prices that we expect could lessen the enthusiasm for the Russian economy, giving us a chance to get RSX at around $15. Therefore, I've changed our target price from $10 to $15.
California Rep. Darrel Issa calls the Obama [administration's] economic forecasts a "convenient vehicle for avoiding accountability."
Mr. Issa went over the numbers with me the other day. The stimulus plan was supposed to save 150,000 jobs in the first 100 days, but instead 2.3 million Americans have lost jobs since Mr. Obama occupied the White House. Mr. Issa tells me he believes the administration simply is "making up" such projections. "There is no methodology behind their estimate for creating 600,000 jobs this summer. This is supposed to be the new age of accountability and transparency."
In a letter to the White House last week, Mr. Issa lays out his complaints in detail. "How can the American people understand what is being accomplished with their money if you do not even attempt to provide information about the employment effects of each stimulus project?" Mr. Issa thinks the administration is guilty of single-entry bookkeeping. It counts jobs created from government spending, but none of the jobs lost from the money taken out of the private economy. What about the negative multiplier effect from the higher interest rates we've seen in the last several weeks?
Meanwhile, the U.S. House Republican Caucus is circulating a chart showing that the unemployment rate of 9.4% is higher than what was projected for May before the stimulus bill passed. "Mr. Obama warned that without the economic stimulus we would have a 9% unemployment rate," says House Republican Caucus chairman Mike Pence. "We got the stimulus and we now have an unemployment rate above 9 percent."
Depletion is one of the most important subjects for anybody interested in the oil industry. Easy oil of the light, sweet crude variety is getting scarcer by the month. The steady disappearance of existing deposits forces oil companies to set their sights farther afield in search of replacing the oil volume lost to depletion. Annually, world oil supply is losing about 4 million barrels per day to depletion.
Where do you to go make up for that if you're, say, ExxonMobil (XOM)? Not to Texas or Alaska anymore, there are no more Ghawars (the world's largest oil field and source of more than half of Saudi Arabia's production), and the Canadian oil sands are a very expensive way to get more supply.
The latter is expensive in two ways: first, because it takes a lot of money to process tons of oil-soaked sand into usable oil and, second, because it takes a lot of energy to do so. Financially, Canadian oil sands oil won't make sense until oil trades for more than $100 per barrel again. Energy-wise, they may never make sense. What's the point of using 8 million Btus of energy to extract one barrel of oil that produces only 6 million Btus?
Then, there's the issue of resource nationalism. There's a reason big oil companies are increasingly state-owned, as in China's Sinopec or Russia's Gazprom: countries don't want to leave something as precious as the world's last oil deposits to the whims of free enterprise. This can get nasty in a hurry, as shown in this excerpt from Why Your World is About to Get a Whole Lot Smaller:
As development costs soar and become multiples of original estimates, tensions have risen between companies and host countries, prompting major changes in royalty agreements or even changes in ownership. Just ask the executives at Shell (RDS-B) about their former Sakahlin-II project, one of the biggest they had going.
The company sunk billions of development dollars into this series of offshore rigs in the frigid waters of the Okhotsk Sea in the North Pacific. When staggering cost overruns were about to cut the Russian government out of its royalty share, the project all of a sudden ran afoul of previously nonexistent Russian environmental regulations, and Shell found itself an unwelcome guest. Under duress, Shell was forced to sell out to Russian interests and walk away from 1.2 billion barrels of oil.
If Shell shareholders were asking their board why the company risked billions of dollars in a both geopolitically and politically challenging environment in eastern Siberia, the answer is simple. That's all that's left.
One place where Exxon shines is in its operational excellence. Its top-tier technology and efficient processes make it a very good partner for a host country's national oil company, or NOC. As the above excerpt shows, the ability to work with countries to help them exploit their oil reserves is critical -- and will become more so as the supply of oil continues shrinking. There's no other company on Earth that can top Exxon's capabilities, so its services will become more valuable as the available oil sources become more difficult to exploit. The world is heading toward an environment where nations will say, "If Exxon can't get it out at a price that makes it worthwhile, then it's a non-viable deposit."
That's a good position for Exxon, made better by its $25 billion cash on the balance sheet and long history of solid operations. You won't find mysterious writeoffs or other accounting gimmicks at Exxon.
The risk of a country pulling a fast one remains real, though. Exxon and other majors, like Shell in the example, can never know for certain that they won't spend billions, work hard, and hold up their end of the bargain only to find a wall of new environmental regulations or similar ploy erected to cheat them out of profits.
Another problem with Exxon and other majors is that they're already so big and new volume is getting so hard to find, that meaningful growth may be hard to create. Just maintaining solid operations with existing supply as prices inevitably soar will help, and Exxon will do so. Also, as oil prices rise over the long term, operations such as the Canadian oil sands should become financially viable, and new technologies may make them viable energy-wise as well.
Yet, we continue to think the best way to benefit from the long-term oil market remains the equipment companies, such as deepwater shops and firms working on the technologies to make hard-access sources viable. The beauty of such firms is that they'll do well regardless of whether their products and services are bought by majors or NOCs or, more likely, both.
Remember the old saying about making money in the Gold Rush? It advised to avoid becoming a miner in favor of selling picks and shovels to miners. Oil is looking a lot like that these days. The picks and shovels of the coming oil rush are more sophisticated than their predecessors in the Gold Rush, but the same idea of everybody needing the same ones applies.
The majors are aware of this situation, of course, as are the NOCs. Both groups are spending their own capital to develop or acquire technologies they think will be critical in the future. Part of our analysis centers on weighing which companies are gaining an advantage, especially a defensible one. So far, the deepwater shops look to hold the best position for the medium term.
We're seeing more and more analyst reports confirming our take, as exemplified by this overview from a report sold by Infield Systems:
Recent years have seen the growth and formalisation of the global deepwater offshore industry. A process that has been driven by increased energy demand stemming from consecutive years of economic growth, the maturing of established hydrocarbon extraction basins, and a growing battle to overcome depleting reserves. Such factors have encouraged operators to invest billions annually chasing this offshore frontier, and across this report we see very few market segments associated with deepwater production not seeing upwards potential.
The report notes threats to the industry but they're the kind we like to see, such as dayrates having climbed too high and growth being so strong that it's hard to hire enough personnel to keep up with demand.
The trends are clear and give you an important to-do: watch the deepwater subsector of the oil industry.
The Kelly Letter owned shares of Apple stock before I owned an Apple computer. Our thesis was that the internet has unleashed the freedom to work on any computer and that such freedom would lead more people to choose the elegance and power of Apple's products. My research said so and we followed the conclusion in the portfolio, but I didn't immediately follow it in my own life. My office continued using PCs and I personally continued using a PC notebook.
That all just changed when I bought a MacBook Pro 17-inch at the Apple Store in Ginza, Tokyo. Most new Mac users rave about the solidity of the product, the no-bloatware out-of-box experience, and the sheer beauty of Apple's technology. What I want to focus on today, however, is Apple's superb retail experience.
I've always dreaded the PC upgrade cycle. It sucks. A trip to the typical electronics retailer in either the U.S. or Japan involves looking over dozens of machines adorned with stickers and barely clinging to flimsy metal shelves. The staff are usually bored out of their minds and act as if they're doing you a favor to respond to a call for help. Any questions you ask are met with blank stares followed by reading the product box for the answer. That's if you're lucky. If you're unlucky, you'll get a snide comment that it doesn't matter or you should already know the answer. There's usually loud, annoying music overhead, too. I can't get out of the places fast enough.
At the Apple Store, a focused family of products sits proudly atop gorgeous display tables that don't threaten to topple when you touch the machines. Using the machines is encouraged, too, because there's no risk of them blowing up in customer faces or freezing or running through a kaleidoscope of error messages, as happens routinely in PC shops. To be fair to the PCs, many of the error messages aren't their faults but, rather, the fault of the uninspired staff who never took the time to set them up for public display. In the Apple Store, all the machines are online, with correct times displayed, and fully functional. Want to check email? Do it. Want to open a document? Go ahead. Change settings to see if you can quickly set up a good work environment? Have at it.
Such a store shows a great deal of confidence in the products, which gives me confidence as a buyer. I'm not being rushed out the door with a flimsy piece of paper saying I have tech support for a year if I need it -- just call this number in India, but don't under any circumstances bother us here -- but am instead given all the time and freedom to arrive at about the only conclusion anybody can: I want one.
On my first visit, I was still thinking about the big switch from 20+ years of PC history and how much of an impact it would have on my work. Would it take one week, three weeks, two months to get up and running in a whole new way? I wasn't sure. So the reconnaissance mission came first. Right off the street, I was greeted by the pretty setting and settled in to exploring the MacBook Pros. A staff member, a friendly young woman sharp as a tack, asked if I needed any help.
Here's a quick aside that might not be immediately obvious to those who've never lived in a foreign country. There's an art to speaking to foreigners. On the one hand, you don't want to offend their language abilities by assuming they don't speak the local tongue. On the other, you don't want to alienate them by proceeding in a language they can't follow. Over here, I'm the foreigner, and appreciate people who ask me if I speak Japanese and then proceed normally when they find out I do. What I don't appreciate but what is unfortunately the norm, is that even after I say I speak Japanese and demonstrate it in the following conversation, I'm still treated differently, in an air of doubt or as a child.
On this regionally unique point, Apple scored in the top category. Every staff member I dealt with spoke to me politely and informatively, and in precisely the same way they spoke to the store's Japanese customers. Yet, they understood my desire to get a Mac with a U.S. keyboard, and told me that they could have it ready for me in no time. That's right, with no special shipping from the U.S., the Ginza store could install a U.S. keyboard on whatever machine I chose. What great service.
I ran through a list of questions, such as how to right-click, whether I could scroll with the trackpad, the ability to use certain investment services to which I subscribe, and so on. Yuuki, the sharp-as-a-tack woman I mentioned above, answered every question kindly and demonstrated how I could use the Mac my way. Something else I appreciated was the way she never insulted the way I was working on the PC. Her goal was not to degrade PCs or Windows in any way, but just to show me what the Mac could do and let it speak for itself. There's that confidence again.
By the time I left, I was already sure I'd be buying a Mac and went back to the office to start getting ready for the big switch. A week later, I was back in Ginza after making an appointment for personal shopping. Apple offers a private guide to you in choosing what it is you want to buy and then seeing you through the transaction. How's that for service? They call it Personal Shopping. In typical electronics shops, I never see the same person twice. The attitude is always, "yes, he bought it, now get him out the door fast!"
Unfortunately, the day that worked best for me was Yuuki's day off, but she set me up in the hands of her colleague, Takuya, whom she assured me was every bit as knowledgeable and friendly. Takuya was waiting at the appointed time, had the Mac I ordered ready to go, and walked me through several demonstrations. He also offered ahead of time to transfer all of my data from my old PC to the Mac for me, but I said I wanted to do it myself as a way to get acquainted with the new machine. He liked that idea.
He never pressured me to buy more. He showed me all four levels of the store so I'd know where I could get one-on-one technical support at the Genius Bar (again, reservations available online with a click, just like the Personal Shopping), where to see free how-to presentations in the theater, and where to buy accessories and software. We rode a cool glass elevator that enabled us to see each floor as we rode up and down, and he pointed out that Steve Jobs himself had requested that the stainless steel hand rail in the elevator be changed so that the mill lines of the steel went around the tube instead of along its length. "We care about details," Takuya said.
He asked if I wanted iWork software to help with the tasks I said I do at work, and showed me how it would help me. I said sure. He asked if I wanted to try a year of Mobile Me at a discount, and showed me its benefits. I said sure. He asked if I wanted some amazing little Bose speakers, and played heart-shaking music on them. I said no thanks, but made a mental note to get them later.
When my tally was finished, he added up the retail prices and then reduced each of them in front of me to get me a greater than 10% discount. Mind you, this was after I'd agreed to buy, so it was just a smart form of customer service. What a way to leave me even happier. They didn't entice me with lowball prices. They sold me on quality products, and then offered me savings as a form of thanks for the business. Very classy.
They put my new Mac in its slim box into a cool Apple bag with straps for my shoulders in case I wanted to carry it like a backpack. Takuya walked me to the door and wished me well, reminding me that I could call, email, or stop by any time.
When I got back to the office, I opened the box to see a beautifully packaged machine, almost beaming with pride at its own design and eager to show me what it could do. I put it on my desk, turned it on, and in very little time had moved my work over to the Mac.
Nothing popped up in my face. No virus software I don't need. No internet service offers. No confirm this, OK that, enable this, disable that, double-check this setting, track down that driver, find old application disks, or dust off the printer software. The machine booted up so quickly I thought it was broken at first. Nope. It really comes up in an eyeblink. Shuts down as fast, too, although just closing it works fine. Hours later, I pushed back my chair and looked at the sleek aluminum shape on the desk in a confident silence without fans or beeps, and joined other converts in wondering what had taken me so long.
You know what else I wondered? What new epiphanies awaited me at the Apple Store. What other little miracles of technology whispered my name? What excuse could I find to visit my new friends in Ginza, and buy something else from them?
As an investor, I can't think of a better result of fine retailing. The customer dying to come back is about as much as we can hope for.
As a customer, I'm just dying to go back. In fact, I will. Tomorrow.
No time for an in-depth article today, but the quick comment is that I think oil is getting overstretched for the short term and is due for a pullback. In preparation for that, The Kelly Letter is shorting the commodity into this week's strength.
Notice that the long ETFs are blinking overbought signals on the charts, while the short ETFs are blinking oversold. It's time to at least get out of long positions, but I think the overstretch is enough to warrant taking short positions -- as we've done.
The Latvian economy appears to be dying. At the end of last year, the EU and IMF cobbled together a $10.4 billion support fund that's doing no good. The small nation says its economy will shrivel by some 18% this year, which means it probably won't be able to meet the 5% of GDP budget deficit limit specified in the EU/IMF package, which means it may not qualify to receive the $2.4 billion due to be lent at the end of this month.
The country is doing so poorly that it may no longer qualify to receive the funds it needs to improve its situation, so it will do worse, so it will not qualify for another package, so the vicious spiral will persist. As with the Federal Reserve's stress tests for U.S. banks, the assumptions used by the IMF proved far too optimistic. Their worst-case scenario called for a Latvian GDP drop of 5%, not 18%.
As you read this, Latvia is going nuts slashing public programs in a frantic effort to qualify for its EU/IMF package. These spending slashes will exacerbate the recession there, and the country may still not qualify for the package. If, after the cuts, the recession deepens and the package fails to arrive, Latvia may default on its obligations and see its currency devalued. Indeed, a slew of beetle-browed onlookers says devaluation is all but guaranteed.
Why should anybody care about that? After all, Latvia is home to just 2.2 million people and is only a $35 billion economy. From the BBC, here's why:
If Latvia is forced to abandon its currency peg to the euro, other countries in the region, such as Estonia and Lithuania, may be forced to abandon theirs as well. The Latvian crisis could also hit European banks invested in Latvia. Swedbank, the biggest lender in the Baltic region, is seen as particularly vulnerable and Sweden's krona has been hit hard in recent days.
If a balance-of-payments crisis occurs in the Baltics and it spills over into other Eastern European economies (please note that this is a big 'if'), then the Eurozone could be affected. The Eurozone's exposure results from Western European banks' heavy exposure to Eastern Europe, via subsidiaries, where they hold 60-90% market share (as a % of assets), depending on the country. Given the [Central and Eastern European Countries'] strong financial linkages with Western Europe, the health of Eastern Europe's economies and its banks could potentially afflict Western European banks.
And here we thought we were out of the economic woods.
This article first appeared in the June 7 week-in-review note to Kelly Letter subscribers.
We've owned shares of Microsoft for almost seven years -- with nothing to show for it. I've been wrong on the stock, and something is wrong at the company. What is it?
Microsoft has been a non-innovator from the start, so to say that its lack of innovation is crippling it is to ignore the strengths that made it a great business for the first two decades of its existence. The company's model has always been to copy the best-of-breed and then defeat the creator of that technology through marketing. It invented none of the applications in its Office suite, nor the main concepts of its Windows franchise. The former came from various innovative firms like Lotus and WordPerfect, while the latter came from Unix and the way Apple elegantly used it in its operating systems. The Xbox copied leading game companies; the Zune copied the iPod; Internet Explorer copied Netscape; and so on. This is not a new observation. It's a well-known part of Microsoft's strategy.
Why isn't it working anymore? Computing is shifting from the local hard drive to the internet, true, but Microsoft is also a big player online. Its IE and Outlook Express software packages remain popular for browsing the web and managing email. Its Office suite is integrated with online applications and offers a limited amount of online file storage and manipulation. The company is not oblivious to the migration to the web.
It appears to me, however, that the wide variety of options presented by the internet make it a much harder beast to control through monopolistic practices. Switching from one website to another is effortless. Most publishing now happens online, so proprietary formatting is gone. As a writer, I used to have to worry constantly about whether the format of my documents would carry over to the recipient. Not anymore. Almost everything is plain text anyway, or rich text, and both of those work anywhere. Blink! Just like that, compatibility with Word disappeared as a reason to keep paying money to Microsoft.
It's in the same trap regarding almost everything online. Outmarketing Lotus 123 with Excel worked to snuff out 123 because as more people started using Excel, more people needed to remain compatible with its files. People began saying "send me your Excel file" instead of "send me your spreadsheet" or even "your 123 file." With online search, for instance, it can't work that way. Google's dominance doesn't mean I can't prefer Ask.com just because I like it. I don't have to worry about my way of searching being compatible with your way of searching. The compatibility issue no longer drives users into the arms of Microsoft.
It's the same with the OS. I mentioned in the past that the freedom to switch to any computer that could get online would give Apple a leg up and cause Microsoft trouble. I also said that my firm would migrate to Apple over the next few cycles. That began two weeks ago when I replaced my own PC notebook with a MacBook Pro, and was able to start working differently within a week. Apple's ads don't lie. Its technology is gorgeous, powerful, and easy. For me, there was a little adjustment period as I unlearned old habits and learned new ones, but it's been more fun than stressful. I love not caring whether Microsoft can do a better job with Windows 7 than it did with Vista, because it no longer matters to me. I've moved on.
Will the rest of the world move on, too? The longstanding argument in Microsoft's favor is that while one guy with one notebook might be able to convert to another way of working, entire corporations with proprietary apps built on PC platforms won't. Therefore, Microsoft will always thrive as a giant among giants, supplying the framework within which serious business gets done.
Is that true, though? Databases run on other platforms. Browsers increasingly handle more of our workload. Text has ceased being proprietary. Email works the same way anywhere. People seem more concerned with whether the home office works with their mobile appliance of choice than the other way around. The parts of business that people use and personalize have moved past Microsoft, it seems, and that leaves the company vulnerable to losing the other parts behind the scenes.
Every analyst report I read on Microsoft stresses that incremental revenue from Windows and Office upgrades will keep the company afloat, but it seems I've read that same report for seven years with no change in the stock price. I don't think Windows and Office forever are enough to keep Microsoft a compelling business.
To be sure, it's good at milking them. To assure a better adoption of Windows 7 than Vista, for instance, Microsoft stopped enterprise support of Windows XP. Many businesses stuck with XP because there was no compelling reason to upgrade to Vista and plenty of reasons to avoid upgrading. The ability to keep working fine without the upgrade shows how mature computing has become, and how increasingly stretched the constant upgrade path to profitability has become. These days, beyond just not wanting another upgrade, users fear them. That's a pretty sketchy situation.
It's made more so when you realize that Windows, Office, and Server/Tools comprise 80% of Microsoft's revenue. That much of the cash depends on upgrades that need to be forced on people through planned obsolescence and support rationing. In the past, such measures worked because people knew less about computing than they do now, and had fewer options. These days, with most personal users doing almost everything online and most business users having everything they need already in place or migrating online, it's not guaranteed. There are many non-Microsoft options, some cheap or free, and the Microsoft brand is taking on the tarnish of old school. Who wants a Microsoft-powered mobile phone? Who searches online with Microsoft sites? What power user opts for Internet Explorer over Firefox, Opera, or Safari? Why send a Word document via email when you can just share effortlessly with an online productivity suite like Acrobat or Google Docs or ShareOffice or Zoho?
Unlike Apple, Microsoft has created few ongoing service revenue streams from individual users. Apple's iTunes store, Mobile Me online storage and data sync service, and photo album printing service are all good examples of how Apple keeps getting money from its users after the initial sale. It does so in a way that doesn't make the user feel bad. Nobody wants to pay for software they don't need, but they don't mind paying for songs they want, renting movies they want to see, managing their data conveniently, and printing the pictures they want to share. These are all great ideas that give people what they want at prices they don't mind -- the essence of business, really. One problem with monopolies is that they lose that drive to make customers happy, and when the monopoly power falls away, the unhappy customers are quick to make a switch. The former monopoly is slow to adapt, in most cases, and we're witnessing that with MSFT 2.0.
Exhibit one is the new Microsoft Bing. Have you seen it yet? It's the company's latest attempt to gain market share in internet search, where it just can't get any traction. Its inability to make headway in online search shows that it's stuck with the desktop, the very real estate that's declining in relative value because people spend less time there than before. Nobody is going to stop Googling stuff in favor of Binging it.
It's so lopsided online that Yahoo isn't interested in doing any kind of deal with Microsoft. Remember a little over a year ago when Microsoft tried to buy Yahoo, and Yahoo snubbed it? That's still going on. Yahoo feels more confident in its battle against Google without Microsoft on its side. Yahoo CEO Carole Bartz said last week at Bank of America's 2009 Merrill Lynch tech conference, "I personally think we would be better off if we never heard the word Microsoft." That's a pretty clear repudiation.
Bing is a convenient case-in-point for what ails Microsoft. It calls itself a "decision engine," which is already lame. When I search online, I'm no more making decisions than when I drive my car and "decide" at an intersection whether to turn or keep going straight. Sure, life is a series of decisions, but what I'm doing online with search is searching. I may be finding information to help me make a decision, but the main thing I'm doing is searching. So, already, the attempt to differentiate falls flat.
Beyond that, Bing is no better at helping me make decisions than the search results at Google and Yahoo. Besides, its real game becomes clear with its focus on buying things and enticing me with its garish cashback feature. That part is inelegant and transparently against my interests. Cashback pops up from the most expensive options, and tempts me to get a 5% rebate by paying 25% more on the price. This is straight from the playbook of discredit cards and the worst retail practices. Once I wised up to cashback being a con from Redmond, the entire set of search results from Bing became suspect. If it's skewing the shopping results toward expensive items so it has a profit margin that enables it to give me 5% back and still retain a slice for itself, why wouldn't it skew search results in some way?
The big killer, though, is that even if Bing gets something really right and really cool, Google and Yahoo would just implement it at their own much more heavily trafficked sites and Bing would fall from whatever little perch it had managed to attain.
Microsoft is trying hard, with a $100 million ad campaign, to get you to switch from Google to Bing, but it won't succeed. It's trying to convince you that you need better search results when:
A) You don't think so, and, B) It doesn't deliver them.
Other than that, it's off to a great start.
I give it points for presentation, though. The site is nice looking. As for functionality, comparing the news section to Google's news section is all you need to do to understand why Bing is a bust. Bing's news page looks like somebody's blog with pictures, not at all an up-to-the-minute feed from the best sources online. Google News, by contrast, has an official feel, comprehensive coverage, and many options for customization to follow the news you want the way you want.
While Microsoft embarks on another lost year against Google and Yahoo, it's losing the cloud computing war. That's where it should be focusing its efforts. It will continue snubbing open standards, clinging as it does to its monopolistic practices that served it so well during the desktop phase of computing, so users will not embrace Microsoft's own cloud computing initiatives. Why? Because they'll require access from Windows and installation of Microsoft's server software in companies, and will somehow always work best with Internet Explorer. By the time it gets its cloud services model doing anything interesting, it will be in the same situation it faces in online search today: up against entrenched competitors and offering no compelling reason to switch.
Permit me to step outside my bounds a little and tell you an idea I have for Microsoft. The company owns a well established operating system, industry standard office software, and the most widely used internet browser. Combine those with its deep pool of development talent, and I think it has all the ingredients needed to make the most powerful virtual desktop on the market.
Call it World Windows, for now. It would be built into every new copy of Windows and offer the option of complete replication online of a user's computer desktop by incorporating two existing technologies: remote PC access and online backup. Investing in a server farm to handle everybody's hard drive impression would be smart, as it would provide everybody with data back-up and convenience when they travel. With World Windows, from any internet-connected computer in the world, I would be able to pull up my precise desktop with all of my software usable via a browser-based emulator that could be maximized to fill the screen. Any net-connected computer could become my computer exactly as I see and use it at home or work.
Once that was in place, it would provide Microsoft with plenty of new opportunities to place smart ads and add-on services, such as more deluxe back-up for a price. Bing or another Microsoft search service could be built in to gently show people a different way to search, with maybe some kind of customization like saved searches to make it stickier so they don't run right back to Google.
It's possible that if such a platform took off, Microsoft could charge online ad placers like Google and Yahoo a percentage of click revenue that happened via the virtual desktop that spreads like wildfire.
This approach would accomplish several goals:
A) Keep Microsoft at the center of the computing experience B) Get everybody cloud computing with familiar MS software C) Provide ad revenue to MS without needing search D) Entrench Microsoft in a new way -- online
So far, we've seen nothing so visionary from Redmond. Instead of pulling together something big and bold like World Windows, it continues trying its method of copying and outmarketing. It has not yet adapted its business to a changed business climate.
In the meantime, the company is managing its cash cows well for the short term. Senior Vice President Chris Liddell said in the March conference call: "Over the next 18 months, we will be delivering updates to our core franchises, namely Windows 7, Windows Server and Office 2010, as well as bringing new services like Windows Azure to market." That's all the optimism, the core franchises. They're fine today, but what kind of future do they have?
Judging by the stock's performance this decade, investors don't think much of one. As MSFT's revenue per share has increased every year since 1993, the stock has been a loser this whole decade. Its value has become better because the same share price buys more revenue and earnings, but the lack of share price appreciation is troubling.
We'll hold for now to see if the company can't get back over $30 just on economic recovery prospects alone, and the fact that almost nothing positive is priced into it at $22. For the long term, though, Microsoft has lost its presumptive status as a buy-and-forget holding.
It's hard to miss the long-term supply and demand pressures that will push oil prices higher. Almost every investor is aware that oil supply is getting harder to find, while oil demand from growing economies is rising. Furthermore, underinvestment in oil industry infrastructure leaves open the door for an energy shock if a global economic recovery sends demand through the roof and the oil industry has trouble delivering.
Some say that long-term dynamic is what's driven the price of oil up this spring. Benchmark crude closed yesterday at $68.81, it's highest settle since early November. Others doubt that, however, and say that the recent spike has more to do with the declining value of the U.S. dollar than with the economics of oil. Barrels are priced in dollars, so as the value of dollars fall, the price per barrel will rise.
The purpose of this article is not to explore what's driving oil prices now, but rather to look at what type of oil investment is best for the eventual rise in prices for any reason. Is it best to buy an investment that tracks the price of oil, a broader energy sector tracking vehicle, the stocks of large oil companies, or the stocks of oil service companies?
To get an idea, let's compare how representatives from each of those categories fared from July 1, 2008 to February 1, 2009 as oil declined precipitously, then how those same investments fared from February 1 to yesterday's close.
From 7/1/08 to 2/1/09, here's how oil price tracking vehicles performed:
-90.9% PowerShares Oil 2x (DXO) -65.7% PowerShares DB Oil (DBO) -75.4% United States Oil Fund (USO) -77.9% iPath S&P GSCI Crude Oil ETN (OIL) -56.0% ProShares Oil 2x (UCO) [from Nov.]
From 7/1/08 to 2/1/09, here's how various energy-sector tracking vehicles performed:
-56.6% iShares Dow Jones U.S. Oil & Gas (IEO) -49.7% Vanguard Energy ETF (VDE) -47.9% Energy Select Sector SPDR (XLE) -82.1% iShares S&P Global Energy (IXC) -78.1% ProShares Dow Jones U.S. Oil & Gas 2x (DIG) -31.0% Direxion Russell 1000 Energy 3x (ERX) [from Nov.]
From 7/1/08 to 2/1/09, here's how various oil company stocks performed:
-63.7% PetroBras (PBR) -40.3% BP (BP) -41.2% Royal Dutch Shell (RDS-B) -13.4% Exxon Mobil (XOM) -50.5% ConocoPhillips (COP)
From 7/1/08 to 2/1/09, here's how various oil service company stocks performed:
-66.2% Pride International (PDE) -65.1% Transocean (RIG) -24.6% TEPPCO (TPP) -55.9% Diamond Offshore (DO) -59.1% Noble (NE) -71.0% National Oilwell Varco (NOV) -66.9% Ensco International (ESV)
Now, for the rally from February's lows.
From 2/1/09 to yesterday, here's how those same oil price tracking vehicles performed:
+79.5% PowerShares Oil 2x (DXO) +37.3% PowerShares DB Oil (DBO) +32.5% United States Oil Fund (USO) +31.5% iPath S&P GSCI Crude Oil ETN (OIL) +33.1% ProShares Oil 2x (UCO) [from Nov.]
From 2/1/09 to yesterday, here's how those same energy-sector tracking vehicles performed:
+22.7% iShares Dow Jones U.S. Oil & Gas (IEO) +16.8% Vanguard Energy ETF (VDE) +14.4% Energy Select Sector SPDR (XLE) +22.2% iShares S&P Global Energy (IXC) +17.8% ProShares Dow Jones U.S. Oil & Gas 2x (DIG) +13.7% Direxion Russell 1000 Energy 3x (ERX) [from Nov.]
From 2/1/09 to yesterday, here's how those same oil company stocks performed:
+72.8% PetroBras (PBR) +23.7% BP (BP) +18.6% Royal Dutch Shell (RDS-B) -4.1% Exxon Mobil (XOM) -1.7% ConocoPhillips (COP)
From 2/1/09 to yesterday, here's how those same oil service company stocks performed:
+60.7% Pride International (PDE) +54.3% Transocean (RIG) +20.7% TEPPCO (TPP) +40.5% Diamond Offshore (DO) +36.5% Noble (NE) +52.4% National Oilwell Varco (NOV) +49.2% Ensco International (ESV)
Remember all that talk about contango back in February, and the astute onlookers who said anybody dabbling in the leveraged long funds would be screwed to hang on? Nice tip that proved to be. DXO is up almost 80% since then.
Moreover, the oil price tracking vehicles that so many scoff at for failing to track precisely have been just as good as the major stocks involved. Compare the losses and rebounds of the price tracking vehicles with the oil service company stocks. They went way down and then came way back. For all the talk of contango and slippage and the uselessness of daily tracking vehicles, none of it prevented the ETFs and ETNs from doing what they were supposed to do over the medium terms involved. Remember that the next time some part-timer tries to sound wise by pointing out that the leveraged ETFs are calculated on a daily basis -- as if you didn't know that by now, and as if it means they can't work for periods beyond a single day.
For longer periods, though, against the backdrop of rising oil as demand outstrips supply, oil service company stocks look to be the place to be.
Thomas asked, "Are you guys worried about rising interest rates?"
Yes, very. Wednesday of last week saw a rough 5-year bond auction that sent 10-year yields higher, to 3.70%. That was the high of the year, and it got traders talking about whether the government had lost its ability to keep rates down. Remember, the Fed has been working hard to drop rates via its buying of Treasuries. If that isn't working anymore and rates are in the hands of the free market and the free market wants to take them higher, well, you can see why people are worried that we're about to re-play That '70s Show.
From last weekend's Kelly Letter:
One of the biggest risks remains runaway inflation from rampant government borrowing and the flood of money put on the street in the last year.
Historian Niall Ferguson wrote last Friday in the Financial Times about this subject, as it came up in his recent debate with Paul Krugman:
"'The only thing that might drive up interest rates,' [Krugman] acknowledged during our debate, 'is that people may grow dubious about the financial solvency of governments.' Might? May? The fact is that people -- not least the Chinese government -- are already distinctly dubious. They understand that U.S. fiscal policy implies big purchases of government bonds by the Fed this year, since neither foreign nor private domestic purchases will suffice to fund the deficit. This policy is known as printing money and it is what many governments tried in the 1970s, with inflationary consequences you do not need to be a historian to recall."
He concluded that, "In the absence of credible commitments to end the chronic U.S. structural deficit, there will be further upward pressure on interest rates, despite the glut of global savings."
There are, of course, no such credible commitments on the horizon. Indeed, there have been none in the past three decades. About the only bipartisan theory in Washington is that spending solves all -- and the more borrowed, the better.
The New York Times picked up on this theme yesterday, noting that "in the last three weeks, the pace of the increase in the 10-year Treasury note's yield has quickened." True, and it wasn't exactly rising at a snail's pace before that. From the article:
Since the end of 2008, the yield on the benchmark 10-year Treasury note has increased by one and a half percentage points, rising to 3.54% from 2%, the sharpest upward move in 15 years.
Increased rates could translate into hundreds of billions of dollars more in government spending for countries like the United States, Britain and Germany.
Even a single percentage point increase could cost the Treasury an additional $50 billion annually over a few years -- and, eventually, an additional $170 billion annually.
This could put unprecedented pressure on other government spending, including social programs and military spending, while also sapping economic growth by forcing up rates on debt held by companies, homeowners and consumers.
Today's article comes courtesy of frequent contributor Dave Van Knapp. His site, SensibleStocks.com, is chock full of clear-headed ways to pick stocks and explains the oft-unappreciated role of dividends.
The blogosphere is full of pundits trashing the current stock market rally. I wrote an article several weeks ago making a case for the sustainability of the rally, and I got flamed by commenters. Sentiment ran about 10-1 against me.
The day that article ran, the S&P 500 finished at 884. It closed yesterday at 943, up 7%. Altogether, the current rally, which began on March 10, is now almost three months old. During it, the S&P 500 has risen from 677 to 943, a 39% increase. The climb started fast, then slowed somewhat but has still kept going generally up. Each month since the rally began, the S&P 500 has gone up: 9% in March, 9% in April, and 5% in May. The largest drawdown during the run has been 5%. I have been investing into the rally via a series of purchases of SPY (SPDRS, an ETF that tracks the S&P 500), using tight 8% trailing sell-stops. None of the stops has been hit. All positions are in positive territory.
So is the rally sustainable, or is it a "sucker's rally," a "dead cat bounce," an unsustainable secondary bullish period within a primary bear-market?
By one measure, a definition used by Ned Davis Research, it already is a bull market. They declare a bull market occurs whenever there is a 30% rise in the stock market over a 50-calendar-day period. That's already happened.
The same organization uses an alternative definition of a bull market: a 13% rise after 155 calendar days. That has not happened yet. It has been 84 days since the rally began on March 10. But note that the increase required by the second definition is just 13%. The market could go backward from here (to 765) and still satisfy the second definition. But we're interested in future sustainability. So for purposes of discussion, I arbitrarily tacked on the second definition to the first to arrive at a definition of "sustained" from the time of the first article. The bottom line: Will the S&P 500 reach 1050 by October 12, 2009? That would certainly be a sustained, investable rally in most people's minds. It would comprise a total increase of 55% since the March 9 low and a total duration of about seven months.
I think this is possible, perhaps even better than a 50-50 chance. Those who guffawed a few weeks ago have already witnessed the market achieve almost half of the additional rise needed. At 943 today, the market is less than 12% short of the 1050 target, with more than four months to get there. Will it?
There are plenty of articulate, intelligent commentators making the case that the market is heading for a major fall, and soon. But there are arguments to be made on the other side. Here are the ones I consider to be the strongest:
Bull markets usually begin during, not after, recessions. In talking about the market, I am emphatically not talking about the economy. The economy is staggering, with more shocks still to come. Unemployment will undoubtedly rise, perhaps to 10% or more. But unemployment has always been a lagging indicator. Charts of the last nine recessions (available here) show clearly that eight of them had bull markets begin prior to the end of the recession, about six months on average.
There are signs that we may be nearing the end of the recession. If bull markets start a few months before recessions end, the question becomes, are we nearing the end of the recession? There is evidence pointing in both directions, but here I am making the case for the sustainability of the rally, so I'll focus on positive signs:
The Institute for Supply Management monthly survey of new orders bottomed in December, with a positive trend since then.
Initial unemployment claims appear to have flattened out, even as the total number of unemployed still rises.
We are seeing stable and rising commodity prices, with oil up more than 40% from its low and copper up more than 50%, both indicative of improved demand.
There are some positive signs in the still-bleak housing sector: The inventory of unsold single-family homes peaked last summer at 4.5 million units and has subsequently declined to 3.7 million. (A more typical inventory level is 2 million units.) Affordability (the ratio of median house payments to median income) is improving, and the $8,000 first-time-homebuyer tax credit is beginning to impact the market, at least at the low end.
The University of Michigan Consumer Sentiment Index, which fell to a low of 55.3 in November 2008, rose in March to 57.3, in April to 65.1, and in May to 68.7. The indicator has now been up five of the last six months.
Bernanke and the Federal Reserve are pulling out all stops to stimulate the economy. Since September 2008, the money supply (M2) has been growing at a 13% rate, one of the highest in the post-World War II period.
Measures of banks' willingness to lend each other money have shown substantial improvement. The rate premiums demanded for unsecured lending between banks fell by more than 80% from their 2008 peak to mid-May. In the past couple months, several banks have successfully floated secondary stock offerings, raising capital to get out from under TARP restrictions and/or to strengthen their capital positions.
The Index of Leading Economic indicators rose in May for the first time in seven months.
Post-recession rallies can be powerful. According to Navellier and Associates, the five most recent recessions before the current one (all shown in the previous charts) each spawned powerful rallies. Working backwards in time:
Recession: March, 2001 to November, 2001. Market bottomed in October, 2002, then gained 50% in 17 months. (Note: This is the only one of the bull markets that did not begin during the recession.)
Recession: July, 1990 to March, 1991. Market bottomed in October, 1990, then gained 45% in 19 months.
Recession: July, 1981 to November, 1982. Market bottomed in August, 1982, then rallied 66% in 15 months.
Recession: January, 1980 to July, 1980. Market bottomed in March, 1980, then went up 35% in 12 months.
Recession: November, 1973 to March, 1975. Market bottomed in October, 1974, then gained 76% in 21 months.
To repeat, the strongest argument that this rally is sustainable is the historical pattern that bull markets start about 6 months before the end of recessions, backed up by growing evidence that the current recession is in its final months.
Anybody who claims to know whether this is a bear-market rally or the end of the bear market is blowing smoke. Nobody knows at the time it is happening. What I've tried to do here is make the best case for the sustainability of the rally in the face of a continuing bad economy. The jury -- the investing public -- will make the final call.
DISCLOSURE: Long SPY, IBM, and FDS, having moved from an all-cash position at the beginning of March to about 52% invested now. If the market continues to go up, I will continue to buy into the rally.
