6/28 Kelly Letter Topics
Weekly market review
World Bank's forecast
Durable goods up
Fed's forecast
Rising joblessness
Don't trade Jackson
Too-quick VIX drop
Two months, no action
Selling into strength
Trends within oil trend
America's great highways
2008 EDITION
Much has changed; good investing has not
The Neatest Little Guide to Stock Market Investing, 2008 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.
