Jason Kelly

Off to Oze

noreply@blogger.com (Jason Kelly) — Sat, 19 Jul 2008 07:23:00 +0000

I'll be staying at a mountain lodge in Oze National Park next week, with no access to the internet or telephones. Here's a picture I took on a previous visit:

I'll have fresh articles for you beginning July 29.

To see more photos of Oze with charmingly Japanified English commentary, click here.

I hope you're enjoying summer in your area!

The U.S. May Be The World's First Re-Emerging Market

noreply@blogger.com (Jason Kelly) — Fri, 18 Jul 2008 06:21:00 +0000

Remember how China was the hot emerging market not so long ago? Everybody with an almanac went on TV to tell us that "the story in China is people. Lots and lots of people."

"So, you're saying China has a big population?"

"Big? Not just big. The biggest! All those Chinese need cars and microwaves and razors for their legs and chins. Heh, heh, heh."

Insightful.

Just after that world savvy analyst stepped from the cameras, another guest would appear to warn that China is "an emerging market. One with lots of promise, true, but a relatively unknown quantity. Its institutions just aren't as safe as those in established countries."

From the boob tube, you learned in that span of time that China has a big population but is an emerging market. This is typical of broadcast fare.

The big Chinese population angle is hardly worth paying attention to because the best way to tap it is by investing in companies that make the best products and/or offer the best services which, you'll note, is the same way to invest regardless of how many people we're talking about. The companies that will succeed in China are the same ones that succeeded in Germany, Japan, and the United States.

As for the danger of China as an emerging market, here's an interesting twist: Chinese comprise one of the largest blocks of investors screwed by the Fannie/Freddie blow-up. China is the biggest foreign holder of debt issued by the two GSEs.

According to the U.S. Treasury, mainland Chinese investors owned $376 billion of agency long-term debt at the end of June 2007. That's nearly 33% of total foreign holdings of the agencies.

Economist Brad Setser wrote last weekend:

China, according to the U.S. data, has $422 billion of long-term Agency bonds. That is roughly 10% of China's GDP. It is also almost certainly understates China's holdings. Based on the pattern of revisions in past surveys and the scale of China's foreign asset growth, I would guess that China now holds between $500 and $600b of Agencies -- or about 10% of the outstanding stock.

If -- as I suspect is likely -- the Agencies are too big, too important to the housing market and too Chinese for their debt ever not to be honored on time and in full, that has another implication:

China's holdings of Agencies are effectively holdings of Treasuries, and China's combined holdings of Treasuries total at least $924 billion. In reality, given the pattern of revisions and the scale of China's reserve growth, its current holdings of Treasuries and Agencies now easily tops $1 trillion.

$1 trillion is roughly 25% of China's GDP. That is a rather concentrated position. It shouldn't be a surprise if China thinks it should have a voice shaping big U.S. policy choices.

In some sense, it is remarkable that the system for channeling the emerging world's savings into the U.S. housing market -- a system that relied on governments every step of the way, whether the state banks in China, that took in RMB deposits from Chinese savers and lent those funds to China's central bank which then bought dollars and dollar-denominated Agency bonds, or the Agencies ability to use their implicit guarantee to turn U.S. mortgages into a fairly liquid reserve assets -- hasn't broken down after the "subprime" crisis. The expectation that the U.S. government would stand behind the Agencies is a big reason why.

That allowed the U.S. government to turn to the Agencies to backstop the mortgage market once the "private" market for securitized mortgages dried up, as emerging market governments continued to buy huge quantities of Agencies.

And it now seems that this game will break down on the U.S. end before it breaks on the emerging market end. The Agencies will run out of equity before central banks lose their willingness to buy Agency paper.

Tails are wagging dogs in all directions. The once emerging are now looking fully emerged, while the once emerged are looking submerged again. The U.S. may be the world's first re-emerging market when it comes to finance.

Todd Harrison on Buying Financials

noreply@blogger.com (Jason Kelly) — Wed, 16 Jul 2008 14:16:00 +0000

Don't miss Minyanville's Todd Harrison on why it's good to buy into financials now.

The Iran Factor

noreply@blogger.com (Jason Kelly) — Mon, 14 Jul 2008 08:37:00 +0000

I continue to feel that the biggest threat to the market now is the Iran situation. I wrote about this on May 21 and June 25.

The chances of an air strike keep growing. Iran is almost begging to be attacked, and it may get the holy war it wants.

It would not take more than a few nuclear missiles to destroy all of Israel or finally give Islamic terrorists the weapon they've always wanted to use against the U.S.

The mere threat of those capabilities by a nuclear Iran would change the dynamic of Western relations with the Middle East. One gleaming nuclear missile aimed at Jerusalem would embolden terrorists because their nations would own the oil we need and be able to trump the military edge we currently have.

Negotiations are taking place, but how many hundreds of times have you heard that in regards to the Middle East? Look how they went last week. Iran said it was ready to play nice and then launched missile tests -- in the same week!

The repercussions of a strike on Iran would be huge. Iran already said it would seal off the Strait of Hormuz, through which 40% of the world's oil passes. That would bring the U.S. Navy onto the scene in a matter of hours if not minutes. When a missile test can add $9 to the price of a barrel of oil as it did last week, just imagine what a full-scale naval battle off the coast of Dubai would do.

That's just in the sea. Iran's military would attack Israeli cities, and so would Iran-sponsored terrorist groups. The resistance against U.S. forces in Iraq would intensify, too.

As far as the stock market goes, the oil price spike would be paramount. It could chop 10% off the broad indexes, making all of the technical analysis and timing thoughts moot.

This is one of the areas of stock analysis that's so hard, because it has nothing to do with analyzing anything. What do Iranian nuclear ambitions and Israeli strike plans have to do with the iPhone, Crocs shoes, or Starbucks coffee? Not a darned thing, but the way the situation goes could affect the prices of all stocks.

Do you know if and when Israel and the U.S. will bomb Iran? I don't. Do you know how quickly the U.S. could re-open the Strait of Hormuz if it's closed? I don't. Do you know whether Iran would retaliate with such abandon as to destroy crucial oil reserves? I don't.

What we do know is that this stand-off is five years old, and there's been no war yet. Also:

The Iranian missile test was lame, using old equipment and possibly NOT including the long range missile claimed. ArmsControlWonk.com ran a blog post titled "Same old Boring Shahab 3" in which it compared the diameter of the missiles to their length and found them to be identical to the ones shown in 1998, which have a known range of 746 miles. In sum, there was nothing in the missile tests to alter current U.S. policy.
Diplomacy is still the official strategy. U.S. Defense Secretary Robert Gates said the U.S. is "working hard to make sure that the diplomatic and economic approach to dealing with Iran, and trying to get the Iranian government to change its policies, is the strategy and is the approach that continues to dominate."
Israel bombed an Iraqi nuclear facility in 1981 and the stock market held up fine. (Although oil was cheaper then.)

Thomas Fingar, director of the National Intelligence Council, identified what makes this situation difficult when he explained Wednesday that "Iran has real security needs" and that "we are part of the reason Iran feels insecure."

The Boston Globe noted "President George W. Bush's failure to place a senior U.S. official at the negotiating table and to offer Iran the sort of comprehensive security agreements Iranian officials have hinted they require." It suggested that "until a U.S. president makes an offer that truly tests Iranian intentions, there will be more chest-thumping in the world's most volatile region."

Which doesn't make our job any easier.

In the end, all we can do is base our decisions on what we know. What we know is that oil prices are already high, they've taken a toll on the stock market, good companies are on sale, and MACD and RSI are right where they were before previous market recoveries.

If the talks go south, the bombs start falling, the price of oil spikes, and the stock market tanks, remember that you had no way of knowing ahead of time it was going to happen.

The iPhone Debuts in Japan

noreply@blogger.com (Jason Kelly) — Fri, 11 Jul 2008 14:49:00 +0000

Last night while America slept, Apple's new iPhone 3G hit the ground running in Japan. Here's the most famous TV personality in the country, Mino Monta, putting the device through its paces on the air this morning:

More than 1,000 people waited through the night in front of one Tokyo store to get their hands on the iPhone. In another location, they extended more than half a mile from a store's entrance. People have been talking about the phone for weeks and deciding among friends who would get white and who would get black.

Softbank group president Masayoshi Son, whose company is the exclusive provider of the iPhone in Japan, said that "this year marks the first year when cellphones will become Internet machines."

We here at The Kelly Letter agree, and that's why we own shares of Apple. We're in good company with Mr. Son and John Doerr of Kleiner Perkins who said the iPhone represents a bigger opportunity than the PC.

Go get yours!

Van Knapp Also Likes Banco Santander

noreply@blogger.com (Jason Kelly) — Thu, 10 Jul 2008 13:41:00 +0000

In Tuesday's article, I created a shootout between Dave Van Knapp and Alexander Green on whether Bank of America (BAC) or Banco Santander (STD) is the better dividend-paying stock.

In fact, the only point of disagreement between the two investors is that Dave thinks Bank of America will weather the storm and keep its dividend intact while Alexander thinks BofA's dividend will be cut.

In a follow-up note to me, Dave wrote: "If I were recommending one stock versus the other, I'd probably recommend STD too, given the risk to the BAC dividend."

Furthermore, he clarified: "I did did not write the article from the point of view of 'What's the best bank dividend stock?' -- which is Green's vantage point. I wrote it from the question, 'Has BAC disqualified itself from being a top dividend stock?' Very different questions."

Any misunderstanding is my fault for constructing the article in a shootout format. If you'd like more top dividend-paying stock ideas, be sure to stop by Dave's investing site, SensibleStocks.com.

Bank of America v. Banco Santander for Dividend Yield

noreply@blogger.com (Jason Kelly) — Tue, 08 Jul 2008 06:54:00 +0000

From dividend investing expert Dave Van Knapp:

Picking Dividend Stocks: Dividend Safety

It is axiomatic in dividend investing that the best dividend stocks score highly on dividend yield, consistency, and growth. When you are focusing on dividends (rather than exclusively on price), you obviously want to own companies that
have a decent initial yield (more than a bank deposit),
pay their dividends without fail, and
increase their dividends regularly.
As with every form of stock investing, all you have to go on in selecting individual stocks is history and conjecture.

As to history, you want to find stocks that have a demonstrated record of paying dividends consistently (never missing a payment) and raising them often. In my e-book, The Top 40 Dividend Stocks for 2008, I present a scoring system for rating stocks along these two scales (plus several others) in a scoring system I call the Easy-Rate™ system.

A company's history of dividend payments tells you a few things that you can reasonably project into the future. For example, if a company has paid a dividend every quarter for ten straight years, and raised the dividend in seven of those years, that suggests that the company is run in such a way that dividend-paying is the norm. Management expects to continue to pay the dividend every quarter, and they manage the company's money accordingly. They know they have a constituency of shareholders who expect that dividend and periodic increases, and they "play to" that constituency. Skipping a payment or cutting the dividend would probably cause many shareholders to abandon the stock, bringing a disastrous fall in the stock's price.

But any projection into the future is conjecture, isn't it? There is risk in any prediction, from weather forecasting, to picking your fantasy football team, to selecting the best stocks. Even if the "odds are with you," or "all signs point in that direction," there is risk that any prediction will be wrong.

And so it is with dividend stocks. Even if we take the utmost precautions to pick only stocks with a good yield, great dividend history, and the strongest signs of continuing that history, we can be wrong.

The financial sector in the past 12 months provides some vivid examples of such risk. Many retail banks, commercial banks, investment banks, and mortgage lenders have been pummeled by the sub-prime mortgage crisis, which became a full-blown credit crisis. The iconic Bear Stearns failed (it was bailed out by the government). The iconic Citigroup slashed its dividend along with more than 10,000 jobs. Countrywide Financial, the country's largest mortgage issuer, nearly went out of business, "saved" only by being purchased at a fire-sale price by Bank of America.

In my e-book, I selected Bank of America (BAC) as one of the Top 40 dividend stocks. It had a 6.6% yield, good valuation, and had raised its dividend for more than 25 straight years -- a select club with only 59 members. But BAC has been hit hard by the credit crisis, and it is hard to tell whether the acquisition of Countrywide, even for a song, is good or bad in the short term. (It is probably very good in the long term.)

BAC, like a lot of banks right now, needs money. One way to get money, of course, is to cut its dividend. So BAC's dividend is "at risk." So far, BAC has resisted that temptation. It paid its first-quarter dividend, even though the payout exceeded its profits. It paid its second-quarter dividend on June 4. Its next dividend (not yet declared) is scheduled for September 28 -- and this is normally the quarterly payment in which BAC increases its dividend each year. Its CEO, Ken Lewis, "views the dividend as safe," as reported by MarketWatch on June 11 (notice that is after the second-quarter payout).

Because of a significant price drop, BAC is now yielding a sky-high 11.4%.

Is BAC still on my Top 40 list? Yes.

Other than the peril of the dividend being cut, BAC satisfies all my requirements for a top dividend stock. One could argue that this is a once-in-a-lifetime opportunity to get a world-class company -- which will now become the nation's largest mortgage lender -- at a yield of more than 11%. Chances like that do not come along often. Notice that if the dividend is not cut, that 11% yield to a new purchaser will never go down in relation to the original investment. In fact, it will go up if and when BAC increases its dividend.

Should BAC still be on my Top 40 list? Maybe. Do you believe Lewis when he says the dividend is "safe"? What would you expect him to say? Do you think BAC will raise its dividend this year? I don't, but that alone does not disqualify the company. Do you believe that at some point in the future, the financial segment will recover, and stocks like BAC will return to former prices? I do, although it will probably take a few years. Remember the savings and loan crisis of the 1980's and 1990's? Banks recovered from that, albeit with a lot of government help and a number of bank failures.

As an investor, you can make up your own mind about Bank of America. For my money (and I own it), it looks like a good long-term investment. Short term, it is likely to lose more value. But the chance of it failing is near zero. Its dividend is in the stratosphere. And I think it's going to weather this storm, turn the corner, and begin re-appreciating in price. I'm focused on the dividend, so I am not as concerned with how long that takes as I would be with a "growth" stock. In the meantime, I will happily collect my checks each quarter.

That's my conjecture.

However, over at The Oxford Club, investment director Alexander Green thinks Bank of America is not nearly as enticing as Spain's Banco Santander:

Many investors have been searching for higher dividends in the beaten down financial sector. This makes sense at first blush since bank stocks have fallen so far that many sport double-digit yields.

But beware. Many of these dividends will be cut sharply. Some will be eliminated altogether.

That doesn't mean that banks aren't a decent contrarian buy right now. But tread carefully.

Reeling from the rise in foreclosures and the ensuing credit crunch, earnings at many banks are quickly evaporating and, in many cases, disappearing. For example, Citigroup has already lopped its dividend by 41%. National City, a major regional bank, cut its payout in half. And Washington Mutual slashed its quarterly dividend to a mere penny.

Seventeen of 20 financial companies in the S&P 500 have cut their dividends so far this year, more than in the past five years combined.

These banks didn't take this step lightly. Most blue-chip banks have a long history of not cutting dividends. Management wants to keep shareholders happy. But if the money isn't there to cover the dividend, it will not be maintained. It doesn't make sense to borrow money -- or dilute equity holders -- to continue a payout.

Still, you can get a good idea which financial stocks will maintain or increase their dividends -- and which ones will not -- by taking a close look at the underlying business.

Consider Bank of America (BAC), for example. Here's one of the nation's top banks, down so far that it is yielding a mouthwatering 11.4%.

Is this dividend secure? Almost certainly not. Quarterly revenue is down 35%. Earnings have slumped 77%. And analysts have slashed future earnings estimates 20% over the last 90 days. It's just a matter of time before this dividend gets whacked.

On the other hand, take a look at Spain's biggest bank, Banco Santander (STD).

The bank has more than 13,000 branches worldwide, the most of any bank. It has virtually no exposure to sub-prime mortgages.

First-quarter profit rose 37% on revenue of $11.63 billion. And while many major banks are reporting record losses, Santander just reported its tenth consecutive quarter of double-digit profit growth. Management is sticking to its forecast of 15% annual earnings growth over the next two years.

This 8.8% dividend yield will almost certainly rise over the next two years. Banco Santander is a far superior choice for the dividend-oriented investor.

Close To A Near-Term Bottom

noreply@blogger.com (Jason Kelly) — Mon, 07 Jul 2008 11:29:00 +0000

Technicians have been telling us the market is oversold for a couple of weeks now. It looked especially ripe for a relief bounce last week, but instead became more and more oversold as more and more people sat waiting for the bounce.

I like to look at MACD and RSI to get an idea for technical conditions, and neither said two weeks ago that we were ready for a bounce. They're pretty convincing now, though.

Let's look at the year so far for patterns. I'll go through the January low, March low, spring high, and last Thursday's close for the S&P 500 index of large companies, the S&P 400 index of medium companies, and the Russell 2000 index of small companies.

Remember that for RSI, 70 and above is considered overbought while 30 and below is considered oversold.

On the S&P 500 index of large companies:

January low on 1/22

Closed at 1,311
MACD was -36
RSI was 26

March low on 3/10

Closed at 1,273
MACD was -19
RSI was 31

Spring high on 5/19

Closed at 1,427
MACD was 15
RSI was 63

Last Thursday 7/3

Closed at 1,263
MACD was -29
RSI was 27

The index is sitting at its lowest point yet in the series and just under the 1,265 level that unemployment rate analysis three weeks ago suggested as a bottom. However, that assumed an unemployment rate of 6.7%. We're at only 5.5% and many analysts expect it to reach 6.0%.

Overall, the index level says nothing, the MACD says buy, and the RSI says buy.

On the S&P 400 index of medium companies:

January low on 1/22

Closed at 753
MACD was -26
RSI was 24

March low on 3/10

Closed at 745
MACD was -10
RSI was 31

Spring high on 6/5

Closed at 897
MACD was 11
RSI was 69

Last Thursday 7/3

Closed at 787
MACD was -16
RSI was 24

The index is in a strong downtrend aimed right at the 750 level that supported it in the past. That implies another 5% drop until it bottoms.

Overall, the index level says wait, the MACD says buy, and the RSI says buy.

On the Russell 2000 index of small companies:

January low on 1/22

Closed at 672
MACD was -23
RSI was 29

March low on 3/10

Closed at 644
MACD was -13
RSI was 29

Spring high on 6/5

Closed at 763
MACD was 8
RSI was 67

Last Thursday 7/3

Closed at 666
MACD was -14
RSI was 28

The index is in a strong downtrend aimed right at the 650 level that supported it in the past. That implies another 3% drop until it bottoms.

Overall, the index level says wait, the MACD says buy, and the RSI says buy.

Two-thirds of the evidence in this small piece of the market puzzle says buying is the move to make now. The other one-third shows that even if buying now is early, it's probably not terribly early.

The old mantra is that oversold can become more oversold. It can't stay that way forever, though. Eventually, the market gets as oversold as it's going to get in the near term and then moves higher. To be sure that point has been reached, a lot of technicians wait for washout days to be followed by strong buying as a signal that the sellers are done.

Doing so back in March, however, would have had you buying in after the bounce was well underway. That's common and what brings us to how this kind of overview must always end.

Nobody ever knows the exact bottom. You're always going to be a little early or a little late, depending on how you approach the analysis. In other words, the best you should hope for is to get close.

The numbers now say that we're close for the near term.

Your Take On The Crocs Brand

noreply@blogger.com (Jason Kelly) — Thu, 03 Jul 2008 09:00:00 +0000

There's a debate raging as to whether Crocs, maker of the famous Croslite clog, is a dead fad or a value at its current stock price just over $7. The stock is down from $75 last Halloween, but the business sports an operating margin of 23%, revenue growth of 40%, insider ownership of 11%, and an impressive line of footwear beyond the original clog -- it even includes women's shoes with heels. Look at all the styles at the Crocs website.

Here at The Kelly Letter, I began building a position in Crocs last month to howls of protest from some and cheers of encouragement from others. Those protesting said the original Crocs clog was a fad killed by cheap imitations. Those cheering said the original clog itself was no fad because it's very comfortable and, furthermore, the expanded line of styles speaks to the company's long-term plans and prospects.

I decided to start buying shares because it looks like Crocs is making strides towards establishing its name as a desirable brand. There will always be knock-offs, but are they as good as the original?

Where I live and work in Japan, the knock-offs have shown up from China but they feel different. People who've gone on comparison shopping trips for me reported that true Crocs are softer both in terms of pushing down on them with one's feet and in terms of rubbing their surface with one's fingertips. The Croslite material is better.

Too, teachers and mothers at schools near my office report that mothers do not want their children seen in knock-offs. They buy for them either real Crocs or an entirely different kind of shoe, not an imitation. That's branding at work.

These are anecdotal observations, but they're useful. I'd like to know the word on the street from other parts of the world as well. If you have access to a shopping area and can compare Crocs with imitations that are available, please send in your impression. I'd also like to hear what people say in your neighborhood. Is there value in the Crocs brand, or is it just a maker of a fad shoe that's now been flanked by knock-offs?

Email me your two cents.

Rising Money Supply Is Bad For Workers But Maybe Not Bad For Stocks

noreply@blogger.com (Jason Kelly) — Wed, 02 Jul 2008 05:16:00 +0000

In early 2006, a friend of mine named Mike wrote to me saying he was worried about the Federal Reserve's decision to stop publishing M3 money supply statistics. He thought it could be a prelude to inflation and trouble for the stock market.

The M scale is a way of measuring money, proceeding from M0 on the narrow end of cash to M3 on the wide end including foreign deposits. Here's how they stack up:

M0: This is the most liquid measure, and looks at just the actual cash sloshing around the economy.
M1: Includes M0 and checking accounts.
M2: Includes M1 and small time deposits of less than $100k, savings deposits, and individual money market funds.
M3: Includes M2 and large time deposits of $100k or more, institutional money market funds, repurchase agreements, and dollars held at banks in Canada and the United Kingdom.

In March 2006, the Federal Reserve stopped publishing M3 data, saying that doing so would save it money and that M3 added no additional useful information about the economy beyond what M2 already showed.

But, is that true? You don't have to be an economist to see from the list above that M3 is the broadest measure of money in the economy. For more than two years, we've had no official data for deposits of more than $100k, institutional money market funds, repurchase agreements, or dollars stashed in Canada or the U.K. The worry voiced by Mike and others was that by hiding the growth of big money, the Fed made it easier for itself to inject billions of digital dollars into the economy without anybody noticing.

They wouldn't do that, though, would they? Sure they would. Even back when M3 was tracked, the Fed grew it at a rate of 8% per year. A chart showing 8% annual growth jumps off pages to even uneducated eyes, so away went the chart. Growing the money supply by so much is bound to have an impact on inflation, so the consumer price index was replaced in 2000 by "core inflation" as the way the government reports inflation. Core inflation checks the price of everything except energy and food.

Of course, that makes sense, because only people who turn on lights, drive cars, and buy groceries are affected by energy and food prices. Surely you're not part of that odd bunch.

So, by hiding the rising cost of energy and food, and not reporting the growing supply of dollars each year, the Fed cleared a nice path toward opening the money spigot to full blast. Corporations are all for this recipe because they award salary increases based on the cost of living which now does not include energy or food, so they can freeze or even lower wages. Higher prices for goods and services sold, coupled with lower employee wages equals more profitable companies, which must mean a healthy economy. Ta-da! Just like that, the economy is a gem again, thanks to the working stiff.

As investors, we're supposed to think like corporate management in the pursuit of all profits all the time. We're not supposed to care about workers. To hell with them. The less our companies can pay for their productivity, the better. You know the old saying: pay them just enough so they won't quit.

In theory, then, the rising money level combined with fudged inflation stats to create more profitable companies should lead to higher stock prices. It hasn't, though.

Since M3 stopped being tracked in March 2006, it has gone parabolic. You can't get data from the Federal Reserve anymore, but other organizations have pieced it together from weekly Fed reports. For example, the key stats section of nowandfutures.com provides charts showing that M3 was $10.25 trillion in March 2006 and has risen 32% to $13.50 trillion now. That's a big expansion of the money supply in just 27 months.

By chance, have you noticed anything getting more expensive during those 27 months? You have to look carefully, so let me help.

According to the Energy Information Administration, the average price of a gallon of regular grade gasoline in the U.S. was $2.25 when M3 data disappeared. Today, it's $4.10 and approaching $4.50 in some areas.

According to the Bureau of Labor Statistics, a pound of white, all-purpose flour cost 33 cents when M3 data died. In May of this year, it was 53 cents. A dozen grade A large eggs went from $1.30 to $1.93.

Inflation is here. Another way to put it is that a dollar is worth less today than it was a couple of years ago. That's true at gas stations and stores, as shown above, and also at the currency exchange where 27 months ago one euro bought $1.20 and one dollar bought 119 yen. Today the euro buys $1.58 and the dollar buys only 106 yen.

Which might explain what the Federal Reserve was really up to. The dollar is still the world's reserve currency. We pay for imports with dollars. Those sending us the goods and collecting the dollars as payment, such as China, deposit the dollars in central bank coffers or convert them to local currency. The central banks take the dollars and buy U.S. Treasuries. The U.S. government wants to pay that debt back with dollars as cheap as possible, which has been arranged.

What are the practical implications for individuals?

One is that this financial engineering may mean little to the stock market. On the one hand, rising profits from an inflated money supply and stagnant wages should get stock prices moving higher. On the other, higher energy prices could offset the savings from low wages.

Indeed, when we look back at the history of M3 in America, we see it rising steadily from about $0.80 trillion in 1970 to $4.00 trillion in 1995, then taking off to its current $13.50 trillion. During that time, we've seen bear markets, flat markets, and bull markets in stocks. We've also seen runaway inflation in the 1970s and benign inflation in the 1990s.

So, while Mike was right about the end of M3 data kicking off a race higher in the money supply, it's not clear that it's an automatic stock market killer. What is clear is that the situation is not good for American workers.

Canada Stole The American Dream

noreply@blogger.com (Jason Kelly) — Mon, 30 Jun 2008 09:04:00 +0000

Courtesy of Martin comes a Macleans article from which I took the following excerpts:

While [Americans have] been out conquering the world, here in Canada we've been quietly working away at building better lives. While they've been pursuing happiness, we've been achieving it.

Believe it or not, we now have more wealth than Americans, even though we work shorter hours. We drink more often, but we live longer and have fewer diseases. We have more sex, more sex partners and we're more adventurous in bed, but we have fewer teen pregnancies and fewer sexually transmitted diseases. We spend more time with family and friends, and more time exploring the world. Even in crime we come out ahead: we're just as prone to break the law, but when we do it, we don't get shot. Most of the time, we don't even go to jail.

The data shows that it's the Canadians who are living it up, while Americans toil away, working longer hours to pay their mounting bills.

The wealth numbers, in particular, are shocking. As of 2005, the median family in Canada was worth US$122,600, according to Statistics Canada, while the U.S. Federal Reserve pegged the median American family at US$93,100 in 2004.

Those figures, the most recent available, already include an adjustment for our higher prices, and thanks to the rising loonie Canadians are likely even further ahead today. We're ahead mainly because Americans carry far more debt than we do, and it means that the median Canadian family is a full 30% wealthier than the median American family.

Here in Canada, the average amount of personal debt per person is US$23,460. In the U.S. it's a whopping US$40,250. And all those numbers are from 2005, just before their housing market slipped into a sinkhole. If you looked at the numbers now, you'd find that Americans are even further behind, because their largest asset -- their home -- is worth less.

Meanwhile in Canada, not only are we wealthier, but we don't even have to work as hard to make that wealth. In 2004, the average Canadian worker put in 35 hours of work per week, while our American counterparts put in 38. Only 30% of Canadians work 45 hours a week or more, compared to 38% of Americans. We also get -- and take -- much more vacation time. Employed adults in Canada get about 17 vacation days a year, and we take 16 of those days, leaving just one on the table. In the U.S., they get 14 days of vacation, but they only take 11, making them the world leader in yet another category: the working drudge.

While Americans are putting in overtime to pursue the American dream, we're at the pub having a few pints with friends. They may have bigger cars and bigger homes, but they're living under a mountain of debt. They look richer, but the numbers prove that they're not. The truth is that all of that competition, all of that keeping up with the Joneses, can take its toll.

Way to go, eh?

Using Dividend Yield to Find Bargains

noreply@blogger.com (Jason Kelly) — Fri, 27 Jun 2008 05:58:00 +0000

With the financial sector still under pressure and the broader market following it lower, lots of people are looking for bargains. It never hurts to review one of the most basic ways of finding bargains among large companies: dividend yield.

For that, I suggested to frequent site contributor Dave Van Knapp that he write an article on the subject, which he did:

Question: Can dividend yields help you find bargains in the financial (or any other) sector?

Answer: A qualified yes.

You all know (I hope!) what dividends are: Cash payments by companies to their shareholders out of company profits. Paying dividends is one of the four principal things that a company can do with its profits -- the other three being (1) building a war chest, (2) reinvesting in the company (organically or by making acquisitions), and, (3) buying back its own shares.

Dividend yield is a simple calculation from two pieces of information: Total dividends over the past twelve months divided by the stock's current price. So, if Dividend Co. pays $1-per-share annual dividend, and today's stock price is $40, its current yield is 1/40, or 2.5%. Every stock's current yield is readily available on every financial website and in the newspaper.

Current yields change daily, that's why they're called current. The yield changes any time either of its two components changes. Most dividends are paid quarterly, so most changes in that piece -- the annual dividend -- happen just four times per year. But the stock's price changes continually whenever the market is open. If Dividend Co.'s price goes up to $41 today, its current yield drops to 2.4% (1/41). Just for a benchmark, as I write this, the current yield of the average stock in the S&P 500 is 2.6%. Companies in certain sectors -- such as finance and energy -- have become known for paying healthy dividends. Other sectors -- such as technology -- generally pay few dividends, if any.

So, can dividend yields help you find bargains? Well, there is an entire investment strategy -- the Dogs of the Dow -- based on the proposition that the highest-yielding stocks in the Dow Jones Industrial Average at any given time represent the best bargains. The theory, popularized by Michael O'Higgins in 1991, is that large, well-established companies (such as those in the Dow) do not alter their dividend payout policies very much, so therefore their dividends reflect management's long-term outlook for the company -- that is, they can spare the money rather than plow every cent back into the company. Therefore, if the yield is high, it must be because the price is "low" (compared to the stock's real value), and so the stock is a bargain whose price is likely to rise.

A popular technique is to invest in the ten highest-yielding Dow stocks (the "dogs"), hold them for a year, then sell them and buy the new ten highest-yielding stocks. Repeat annually.

One site devoted to this strategy (dogsofthedow.com) claims that the strategy has generally outperformed the Dow itself over many years by several percentage points.

In researching my e-book, The Top 40 Dividend Stocks for 2008, I did not follow this strategy. It's too mechanical.

I found that in using dividends to identify bargains, you must look beyond the yield itself. You must be able to achieve high confidence that in addition to being substantial, (1) the dividend is reliable, and, (2) the business model itself is sound. This takes some old-fashioned fundamental analysis -- otherwise the best stocks to buy would always be the highest yielders. You can find these on any stock screener, but yield alone does not tell the whole story.

It so happens that financial stocks right now illustrate the point perfectly. Citigroup is the poster child (aka whipping boy). At the end of last year, it had a sky-high yield of 7.3%. It was The Top Dog of the Dow. Say you bought it on January 1, 2008. As Dr. Phil would ask, "How'd that work out for you?" As of yesterday's close, Citigroup is down 40% for the year, and to add insult to injury, it slashed its dividend earlier this year. It simply couldn't afford it. (For comparison, the Dow itself is down 13.7% on the year.)

We know the reason, of course. Citigroup has been one of the hardest-hit banks in the subprime mortgage and credit mess. It turned out that it failed both of the criteria: Its dividend was not reliable, and its business model was not sound. The end of Citigroup's story is not yet in sight.

But Citigroup, you say, is an extreme -- perhaps unrepresentative -- example. And I would agree with you. Most of the time, a high-yielding stock suggests a good bargain. But you can't stop there. The key is making sure that the other criteria -- reliability of dividend and soundness of business -- are in place too. In Citigroup's case, by the end of last year, both could be seen to be in jeopardy by anyone who did just a little research. But other high-yielding financial businesses, such as JP Morgan Chase (which largely sidestepped the subprime mortgage disaster), or high-yielding businesses outside the financial sector, such as Kinder Morgan Energy Partners or McDonald's, have sailed along pretty smoothly. The latter two have delivered both high yields and decent price appreciation, while JP Morgan Chase has suffered much less than many other financial stocks.

Bottom line: High yields can be a good starting point in locating bargains. But look beyond yield alone. Ask yourself if the dividend is in jeopardy: For example, is it way high compared to what the stock normally yields? (Citibank was.) And take a look at the stock's business: Does the company have a good story? Are its numbers trending in the right direction?

Questions such as these will help you decide whether the high yield itself is a good omen or a flashing warning of high risk and decay.

Thanks to Dave for good work as always. To read more about his methodical approach to dividends, take a look at the review I wrote of his new book last month.

America's Pathetic Energy Policy

noreply@blogger.com (Jason Kelly) — Thu, 26 Jun 2008 09:32:00 +0000

Did you read Thomas L. Friedman's Sunday column in The New York Times yet? He referred to President Bush as our oil "addict-in-chief" and said of Mr. Bush's new plan, "It is hard for me to find the words to express what a massive, fraudulent, pathetic excuse for an energy policy this is."

What A Strike On Iran Means To Oil Prices And The Global Economy

noreply@blogger.com (Jason Kelly) — Wed, 25 Jun 2008 06:50:00 +0000

Raymond wrote:

About a month ago you wrote an article looking at geopolitical risks, and identified a strike on Iran as the most pressing current situation. Any updated thoughts on that?

Yes, I wrote to subscribers last weekend about what an Israeli strike on Iran could mean to oil prices. I concluded that it would probably bring a spike higher, but that such a spike might finally be the blow-off top needed to get the price moving lower again "once everybody sees that no barrel of oil was harmed in the making of this movie."

Also over the weekend, Barron's agreed with the general idea that the price of oil is near a top. In his article "Bye, Bubble? The Price of Oil May Be Peaking," Andrew Bary wrote:

In the next decade, oil indeed may hit $200 a barrel. But prices could fall to $100 a barrel by the end of this year if Saudi Arabia makes good on its pledge to increase production; global demand eases; the Federal Reserve begins lifting short-term interest rates; the dollar rallies, and investors stop pouring money into the oil market. China raised prices on retail gasoline and diesel fuel by 18% Thursday, in a move that is expected to curb demand.

Keep in mind that neither Mr. Bary nor I were discussing the longer-term trend in oil prices, which is higher for the simple reason that rising demand is meeting static or declining supply. We were discussing the potential for medium-term price relief.

Others are not nearly as sanguine. The BERR Assessment made clear to The Oil Drum Europe that current high energy prices and associated inflation are not "a transient blip when the UK seems to be in a terminal dive towards insolvency" from an accelerating deficit in oil and gas surpluses. Euan Mearns wrote:

We should hopefully by now have reached a point where all stake holders in UK, European and Global energy are able to grasp the simple fact that we are now in the early stages of a full blown global energy crisis. The focus is currently on oil but this will soon turn to concerns over natural gas and coal supplies.

This crisis has been turned into a state of emergency by the indifference of political leaders in the UK (and throughout the world), fluttering in the wind of poorly informed public opinion while they have prevaricated about expanding renewable energy resources and building new nuclear power stations. All warnings of this pending energy crisis have been ignored in favor of pursuing popular policies that created the illusion of prosperity whilst the fundamentals of our nation's security and well being have been draining away.

That's the fragile backdrop against which we need to consider the impact of a strike on Iran.

The worst case scenario is that a strike would finally push the needle firmly to stagflation, the poisonous pairing of stagnant growth with rising inflation.

On that front, perhaps nobody has written more pointedly than Nouriel Roubini:

Stagflation requires a negative supply-side shock that increases prices while simultaneously reducing output. Stagflationary shocks led to global recession three times in the last 35 years: in 1973-1975, when oil prices spiked following the Yom Kippur War and OPEC embargo; in 1979-1980, following the Iranian Revolution; and in 1990-91, following the Iraqi invasion of Kuwait. Even the 2001 recession -- mostly triggered by the bursting high-tech bubble -- was accompanied by a doubling of oil prices, following the start of the second Palestinian intifada against Israel.

Today, a stagflationary shock may result from an Israeli attack against Iran's nuclear facilities. This geopolitical risk mounted in recent weeks as Israel has grown alarmed about Iran's intentions. Such an attack would trigger sharp increases in oil prices -- to well above $200 a barrel. The consequences of such a spike would be a major global recession, such as those of 1973, 1979, and 1990. Indeed, the most recent rise in oil prices is partly due to the increase in this fear premium.

Mr. Roubini concludes that without such a jarring negative supply-side shock, global stagflation is "unlikely" because of robust growth from Chindia and other emerging markets.

That leaves us with speculating on the odds of a strike against Iran.

The Jerusalem Post reported yesterday that former U.S. ambassador to the U.N. John Bolton said that Israel is likely to attack Iran in the time between the November presidential election in the U.S. and the inauguration of the new president. Mr. Bolton also said that he does not believe the U.S. will participate in the attack.

That's not the tone struck by CBS. It reported yesterday:

Israelis are mounting a full court press to get the Bush administration to strike Iran's nuclear complex.

CBS consultant Michael Oren says Israel doesn't want to wait for a new administration.

"The Israelis have been assured by the Bush administration that the Bush administration will not allow Iran to nuclearize," Oren said. "Israelis are uncertain about what would be the policies of the next administration vis-à-vis Iran."

Israel's message is simple: If you don't, we will. Israel held a dress rehearsal for a strike earlier this month, but military analysts say Israel can not do it alone.

"Keep in mind that Israel does not have strategic bombers," Oren said. "The Israeli Air Force is not the American Air Force. Israel can not eliminate Iran's nuclear program."

The U.S. with its stealth bombers and cruise missiles has a much greater capability. Vice President Cheney is said to favor a strike, but both Mullen and Defense Secretary Gates are opposed to an attack which could touch off a third war in the region.

It's easy to see why I still consider the Iran strike issue to be the most pressing geopolitical concern for investors.

Should You Trade For A Living?

noreply@blogger.com (Jason Kelly) — Tue, 24 Jun 2008 04:56:00 +0000

At some point, most of us wonder if it's possible to quit our day job and become a full-time stock investor or trader. That moment comes usually after a big win or, more often, a string of big wins. The first time my annual investing income exceeded my business income, I thought about re-orienting my life to focus on managing my money.

Recently, a reader named Michael wrote to both Dave Van Knapp and me asking our advice on whether he should make the plunge to full-time management of his money. Both Dave and I replied to him separately, Dave in more detail than I. Below are all three notes plus a follow-up from me.

Michael wrote:

During the dot-com crash, I lost 100% value in most of my investments, and I forgot the stock market completely for many years.

For some reason this past February something sparked in me (maybe turning 50 did it), and I dove back in head first. I started a learning frenzy -- buying books, reading articles and such, watching CNBC, Bloomberg, etc. Wow, what a hodgepodge of information! There is a lot of conflicting information and nonsense, but also some really good stuff.

I opened two brokerage accounts and started investing again. Unfortunately, prior to some of my investment decisions, I was not aware of my now two favorite sources for investment information (Jason Kelly and Dave Van Knapp). I made some really bad decisions and some good ones along the way. In each portfolio I have some stocks that are up a bunch and some that are down a bunch.

I have just completed reading one of your books, and I am reading a second on dividend investing. I really enjoy this stuff, and if I could would be a full time trader (do you think that it is possible to do stock investing/trading as a full time career?).

My biggest concern now is a way of backing out of some of my bad decisions and not losing my shirt. I am using margin heavily and wish to eliminate this and to start using sensible techniques to manage my portfolios. Any thoughts would be appreciated and I look forward to many years of profitable investing.

Dave replied:

Hi Michael,

Thanks for writing.

There is a lot in your letter, and it leaves me with the impression that you are caught in a variety of modes of investing, particularly as to how much risk you take on and how you manage that risk. I was struck by the fact that you expressed interest in both dividend stocks and living the life of a trader. Those two modes of investing are very different in terms of their goals, time horizons, amount of activity, and the like. I am glad that you find Jason's and my books and newsletters helpful, because while our tactics differ, we both advocate a sensible, realistic, risk-aware, and methodical approach to stock investing.

This will sound like a pain, but I suggest you take a step back and think about, and then write out, your investment goals, both long range and short range. Once you have your goals firmly in mind, write out the strategies you think would help achieve them. I consider this exercise a foundational step for any sensible stock investing, and I refer to the documents as "constitutional documents." Just as with our nation's constitution, yours can be amended from time to time. The exercise need not be long -- I bet you can boil it down to a page. Review it often (to remind yourself of your investment policies), but keep changes down to about once a year.

The point is, I do not want to see you go off in 50 investing directions at once. That's not to say that someone might not trade "risky" stocks with part of one's money and invest another part in "safe" dividend stocks. But you should do so with your eyes open as to the benefits and risks of each approach, what percentage of your "stock money" you want to devote to each, how much time you have to spend, and so on. Any investments you make along the spectrum of high-risk to high-safety stocks should strive to reach your investment goals. Only you can articulate your goals.

In general, the shorter your average holding period, the closer you are to being a "trader," and the longer your average holding period, the less you are a trader. In my higher-risk investments, I use sell stops to protect myself on the downside. My holding time for a stock may be anywhere from a few days (for a mistaken pick) to many years. My approach focuses on Buffett's Rule #1, not losing.

In my dividend-stock investing, on the other hand, I do not use sell stops, relying instead on a semi-annual review of my portfolio for suitability and the continued dividend-paying ability of the stocks. In "pure" dividend investing, one is far less concerned with what the portfolio is worth at any given time than with the reliability of receiving continually increasing dividends. The dividends can be reinvested or used as current income.

I applaud and encourage you to continue to move away from using margin, especially since you have suffered deep losses in the past. Margin simply amplifies everything, the bad as well as the good. In all of the hedge fund "blow-ups" that I have ever read about, and in things like the recent collapse of Bear Stearns, excessive use of margin has always been involved. I have never used margin. That said, many successful investors do. I know that Jason is a proponent of leverage. He buys funds that are themselves leveraged rather than using margin (borrowing directly from a broker to fund investments).

As to backing out of your bad decisions (by which I think you mean mistaken investments), I have two suggestions: First, conduct a portfolio review. Examine each stock and decide whether it advances your investment goals or not. That will be relatively easy after you have written out your goals. You will probably conclude that some stocks were mistakes and should be sold. Second, you must sell them. You may find it psychologically difficult to sell stocks at a loss. Many people do. Selling at a loss is a well-known but self-defeating hang-up for many investors. But you must sell the stocks that do not fit your investment strategy.

As a technique, you might consider setting a very tight sell-stop, like 2%, under each stock you intend to sell. That way, if they catch a temporary updraft, you can squeeze every last nickel out of each one. Keep re-setting the sell-stops just under the stock's price. Before long, they will hit their stops and sell. Many investors find that psychologically easier, because it takes some emotion out of the transaction. The sale takes place "automatically" according to the rules you set up when you are emotionally detached.

Again, thanks for writing, and best of luck in your investments!

I replied:

Hi Michael,

I think it is exceedingly hard, but possible, to make a living as a trader. I also think it's not a very fulfilling life, but some people swear by it. My friend succeeded at it financially but returned to work because he felt so isolated in front of his computer all day, nobody to talk with, and without anything in common with people anymore.

As for margin debt, I would eliminate it and never use it again. Warren Buffett said that if you're smart you don't need it and if you're dumb it'll kill you. I don't know what your positions are, but I would think carefully about what you can do to get rid of that debt for good. Maybe selling the losing positions makes sense because then you can get a tax write-off even as you use the cash to pay down the debt. Every little bit helps.

Even though Dave offered clarification between margin debt and leveraged products, I want to expand that a bit here. You won't amass margin debt using leveraged funds or ETFs like the ones offered by ProFunds and ProShares. You won't have to pay interest on borrowed money with leveraged products because all of the leverage happens within the funds and ETFs. You hold them the way you hold any other investment bought with cash, and there's never a margin call.

That being understood, the dangers of leverage still apply because the investments themselves change price with greater force (usually 200%) than their underlying target index. If that index gains 10%, the 200% leveraged fund or ETF will gain 20%. If that index loses 10%, the 200% leveraged fund or ETF will lose 20%. The tracking won't be that precise in practice, but that's the idea.

Leverage is risky. Those using it believe that the risk is more than counterbalanced by the potential for a higher return. For instance, if a sector or the broad market has sold off hard and an investor has enough time to wait, buying a leveraged long fund or ETF at cheaper levels can be a great way to ride a recovery to stellar performance. For the chance at that, some investors like me are willing to expose themselves to the downside risk of leverage.

One way that leveraged funds and ETFs are better than margin for using leverage is that you can't lose more than 100% of your investment in the funds and ETFs. You can lose only what you put in. With borrowed margin money, it's possible to lose everything you invested, plus what you borrowed, and still need to pay interest on what you borrowed. That situation can be a life wrecker.

Hats off to Dave for a nice technique to back out of losing positions. I like the 2% stop-loss ratcheted up daily to squeeze as much money as possible out before selling. Longtime readers know that I'm a big fan of limit orders precisely because they take a lot of the emotion out of this emotional business.

Before making trading your career, be sure to read some books on the subject such as Alexander Elder's classics Trading for a Living and Come Into My Trading Room and his newest, Entries & Exits.

Finally, understand that trading is extremely hard. Even well-known pros get it wrong from time to time, as this recent gaffe by Jim Cramer illustrates:

What Morningstar Thinks of Financials

noreply@blogger.com (Jason Kelly) — Mon, 23 Jun 2008 09:20:00 +0000

One way to help yourself decide whether to put money to work in the beaten-down financial sector is to see how its individual stocks are rated by analytical firms. I did exactly that in yesterday's note to Kelly Letter subscribers. I looked at Morningstar's analysis of the top ten components of the Dow Jones U.S. Financials index.

With the news around subprime, capital raising, write-downs, the still struggling housing sector, and stagflation being so bleak, you might be surprised at the results.

If you'd like to take a look at yesterday's note and to see my suggestion for how to position money now, come on board the letter. It's only a penny for the first month and then just $5.48 per month thereafter, and you can cancel at any time. You probably won't, though. A full 85% of people who try it for a month stick with it. From the information page:

Why the high satisfaction? Because it's cheap, it works, and it's pleasant. So many investment services are unapproachable or mysterious about their methods, as if they're doing something that ordinary folks wouldn't understand. Don't fall for it. They're not doing anything that's beyond anybody else. Just look at their results to see.

Now's a great time to give the letter a spin, at least if you have an extra penny to spare. We'll roll out the welcome mat when you click here!

Kind regards,

What Roman History Means To America

noreply@blogger.com (Jason Kelly) — Wed, 18 Jun 2008 08:41:00 +0000

This is my last article this week. I'll be away from the free site until next week, but will be sending The Kelly Letter to subscribers this weekend, as usual.

More on our current theme of America's future comes from historian Jonathan, who wrote:

Your reader [Marcel from Monday's article] evidently doesn't understand what became of the Roman Empire. It split in twain, and (excepting my folk hero Julian the Apostate's brief efforts) remained that way.

The western portion could certainly be considered to have fallen in a sense, given that Alaric the Visigoth and his homies sacked Rome (by which time the administration was at Ravenna anyway) when hardly anyone could be bothered to defend it. Later that century it fell to a Scirian barbarian king, then became an Ostrogothic kingdom, and in general we watched the rise of Germanic-speaking people -- Franks, Goths, Vandals, etc.

But an interesting thing happened there. When those successors finally produced a new empire, they called it the Holy Roman Empire. I am not contending that the HRE was any form of direct descendant of the Empire of Vespasian and Diocletian, of course. I am contending that in one form or another, the western Roman Empire hung on quite a long time -- even if only as an idea.

But that was the weak side of the split.

The eastern portion could not be considered fallen at all at the same time as the western. It became the Byzantine Empire, a thriving place, and endured for a millennium after Odovacar the Scirian contemptuously told the last western Emperor: "You can run along now, son."

Of course, it's not good enough to just tell the history; part of the task is to draw lessons and inferences. I think your British example is a reasonable one; I think it's a worthy topic of discussion which former major power we resemble more.

I am greatly fond of pointing out to Americans that our Francophobia is ironic in light of the fact that we so resemble the French. We are unilingual, we overrate ourselves, and we're often insufferable about both facts. We ought to view the French as kindred spirits, because they're the only other people in the world as abrasive and difficult and annoying as we are. (Then there's that little part about us probably losing the Revolution without them, us helping Napoleon, a big statue, then two major wars together. If ever two nations were meant to be friends it is us and France.)

I do not think that the U.S. faces the fate of the western Roman Empire, or even the eastern. I do think that the world contains a finite number of resources, an issue Americans have often been able to ignore for domestic purposes but which was enough of a deal-breaker for Japan to lead her to war against us. The Japanese know (because, so far as I know, they have almost no natural resources).

I also think that the underdeveloped world wants to live like the developed world. Chinese and Indians want to live like Japanese and Americans. So do Bolivians and Botswanans. The rest of the world is hurrying to catch up, and that means significant amounts of infrastructural and consumer spending as homes get their first indoor plumbing, water faucet, phone line, microwave, electric socket to power a microwave, etc. Therefore, we will see them grow at a faster rate for some time -- probably into my retirement years (I'm 44 now).

But that doesn't mean America is in decline. It may mean that America's growth slows; it may mean that other nations grow faster. If someone wants to consider that relative decline, I suppose they can, but they're applying too much spin by putting it that way.

What it does mean is that Americans will have to get over their Suite Madame Blue [lyrics and live performance] delusions and realize that our national military and economic power has limits. What it means for the American investor is that there's profit to be had investing overseas, at least for those few Americans who understand or care what's going on overseas.

The rest are the mullethead in the flag do-rag and shades we've all seen in the pic holding a sign that says, "Get a Brain Morans." They're the same Americans who think that because fuel prices have now finally reached equivalent levels to the early 1970s, death and destruction will rain upon our land. Odd. I was a boy in the early 1970s. I remember long gas lines but I don't remember death and destruction. (Watergate, yes.)

As for those who don't realize that a portion of the Roman Empire survived intact for nearly a millennium after the exile of Romulus Augustulus in the west, it might profit them to check their analogies before using them.

A great history lesson, and consistent with the main message of Fareed Zakaria's new book, The Post-American World: It's not so much that America is declining, but rather that other countries are finally catching up. Zakaria calls it the rise of the rest.

America will remain the sole superpower for a long time yet to come. Will it use that position to its advantage, or get sidetracked and become the buffoon in the room that everybody else is snickering about?

There's been a lot of snickering so far this century. Some fine statesmanship would be a pleasant change of pace.

Immigration And America's Future

noreply@blogger.com (Jason Kelly) — Tue, 17 Jun 2008 06:29:00 +0000

Yesterday's article on why I think America is not in decline prompted thoughtful replies from readers.

John wrote:

I found your article particularly interesting as I am British, and agree somewhat with your opinion, but remain skeptical about America's future.

One topic you and many others constantly overlook is America's appalling immigration blunder. This is not a minor problem, as it's going to affect the US's future. This nation is where it is thanks to immigrants from western Europe, primarily Germans. In the 18th and 19th centuries, 50 million Germans came to the USA. They were the most industrious, qualified immigrants any nation could have welcomed, and this country should be eternally grateful to that group. It's also interesting to note that it was Wernher von Braun (a German) who was the brains behind the US space programme.

The current crop of immigrants does not come anywhere near the desirability of the people who came here during the period I mention. This is the ultimate reason the US will not compete in this century.

I understand you live in Japan. Have you been here recently to take a close look at the infrastructure? The shocking condition of the road-railway systems is straight out of the 1890s -- worse, in fact. There's no public transportation of any note, a failing school system, and political correctness has been taken to the point of absurdity.

The US enjoyed a power surge after World War II as it was the only industrialised nation standing. I am 73, and lived through the war in the UK, and will be eternally grateful to the US army and the USAF for their tremendous effort -- that's the America I remember and liked.

I felt compelled to write this letter because many Americans are still under a degree of denial about their country. As an ex airline guy who has traveled and lived extensively abroad, I was aware of the decline that was taking place several years ago.

You appear to be an interesting young man, Jason, and are no doubt living in Japan for your own reasons. Whatever they are you must be very aware of what is happening in that part of Asia -- I think we are going to be very surprised at the events that occur in the next 10-20 years.

Discussions with my grandparents and others of their age have instilled in me the respect for the World War II generation that John conveys in his note. There was something almost magical about the greatest generation, and comparing their handling of WWII with nearly every U.S. conflict since then is a sure path to frustration. Who would you rather have in charge, Franklin D. Roosevelt or George W. Bush? It's a rhetorical question.

On that score, I share John's point of view. Ditto the poor quality of the U.S. transportation system, which I wrote about on May 22.

Regarding immigration, however, I don't find the current situation quite as grim as John does. Every country would prefer that most of its immigrants be highly educated geniuses cut from the von Braun cloth. That's not a reasonable preference, though. The current crop of immigrants to the U.S. may not bring the same contributions brought by the Germans and other European immigrants, but it does get America around the declining demographic problem faced by other developed nations.

By 2030, according to Nicholas Eberstadt at the American Enterprise Institute, the U.S. population will grow by 65 million people. Europe's, however, will remain stagnant and end up with twice as many seniors over 65 than children under 15. Developed populations around the world have either already stopped replacing themselves or are near that point, leaving immigration as the primary way of keeping demographic trends healthy. Too few children today means too few workers tomorrow.

The UN reports that a native-born American woman bears 1.9 children, less than the 2.1 rate needed for replacement. Without immigration, the American population would not be growing today.

Also, we should keep in mind that at any point in history the most recent wave of immigrants is viewed with suspicion. The newest newcomers somehow never stack up to our retrospective view of the prior newcomers. Part of that is due to the prior newcomers now considering themselves natives and looking with disdain on the next wave of people doing precisely what they once did.

Recall the "No Irish Need Apply" signs of the 1850s and 1860s in England and America to realize that the impression of European immigrants as being high quality people wasn't always dominant.

From the Opposing Viewpoints book on Immigration, edited by Mary E. Williams: "By high margins, Americans are telling pollsters it was a very good thing that Poles, Italians, and Jews emigrated to America. Once again, it's the newcomers who are viewed with suspicion. This time, it's the Mexicans, the Filipinos, and the people from the Caribbean who make Americans nervous."

That said, I think it's easy to support John if we restrict our dislike to illegal immigration. Nobody opposes immigration when we're talking about Indian software developers, Japanese automotive designers, German rocket scientists, British journalists, French engineers, and Brazilian business leaders. Let's be honest: the problem is illegal aliens who sneak into the country, produce a litter of children supported by social programs, and never generate enough economic value to offset their drain on the country.

John wondered if I've been back to America recently to see its current state. Yes, I get back two or three times a year. One of my most frustrating experiences has been accompanying a group of Japanese visitors to Los Angeles International Airport where they were eager to begin using the English they'd studied so hard, only to find that half of the "Americans" they met didn't speak English. One of them asked me why she couldn't catch any of the words the man on the street was saying to her.

"Is it an English dialect?" she asked.

"No, it's Spanish," I answered.

The image that Japanese people have of Hollywood is left over from the days of Marilyn Monroe and Audrey Hepburn, whose pictures still adorn brand new movie theater walls in Japan. That impression is gone by the time the sun sets on the first day in Los Angeles.

Is it so shocking, though? Look at the name of the city.

Even the hard line against illegal immigration can run up against second thoughts the first time you get to know a good person who came to the U.S. illegally. A friend of mine in Los Angeles owns an office equipment store, is married to a white American woman, has a son in the military, and would do anything in the world to help me. He came illegally to the United States from Honduras, with the help of a "coyote" (smuggler). He spoke no English. To learn, he joined a Toastmasters club. That's where I met him, and I've enjoyed listening to his speeches in perfectly good English.

I know his story is anecdotal to the national discussion, but it's not to me. Even as we form national policy, it wouldn't hurt to keep compassion close at hand.

As a thought on whether the U.S. is in danger of being swamped by immigrants, keep in mind that the foreign-born share of the population in 1900 was 20%, twice as high as the 10% share it sits at today.

I agree with the spirit of John's note. The U.S. needs to get smart about immigration, not to cut it off. The country needs to decide who's going to improve the national situation and who's going to make it worse.

Here in Japan, I have to periodically prove to the country that it's worth letting me stick around a while longer because I'm writing something of value about the culture. I didn't sneak in, nor do I stay surreptitiously. The authorities know where to find me and I have every document required to be here.

Is it too much to ask that immigrants to America show the same respect?

America Is Not In Decline

noreply@blogger.com (Jason Kelly) — Mon, 16 Jun 2008 08:29:00 +0000

Marcel wrote:

Shame on you for directing your readers toward mostly American stocks. You should be gravely concerned about America's inevitable decline, and attentive to what it means to a portfolio of American stocks. Like Rome before it, the American empire is headed for extinction. The Iraq War will bankrupt the United States and usher in that much more quickly the Chinese century.

This is patently untrue. It shows a lack of historical grounding and ignorance of current facts.

The only reason Rome is cited often by those making predictions of America's demise is that Edward Gibbon's The Decline and Fall of the Roman Empire was so popular. The memorable title became part of the common lexicon so that even those who've never read the book think they know the whole story by just pointing out that the Roman empire declined and fell. There were a few details, however, and those details make the comparison to America's current situation too simplistic.

In short, Gibbon thought Rome fell because its citizens lost their civic virtue, entrusted their empire's protection to barbarian mercenaries who turned on them, and fell so under the trance of Christianity that they cared less about worldly affairs and more about the rewards of the afterlife. There are other theories as well.

To me, the decline of Britain's dominance is a more appropriate focus of study when considering America's situation as other countries rise. The primary reason that Britain declined on the world stage is economic. Its economy could not keep up with the economies of France, Germany, Russia, or the U.S. The British politician Leo Amery said in 1905:

"How can these little islands hold their own in the long run against such great and rich empires as the United States and Germany are rapidly becoming? How can we with forty millions of people compete with states nearly double our size?"

That should seem a familiar sentiment. It's what many people in America say when considering whether the U.S. can compete with a rising China and India. It's why I prefer to consider Britain instead of Rome when looking for precedents to America's situation.

Happily, I find that America is not an economic lightweight, nor anywhere near extinction. The Iraq War, blunder though it's been and critical though I am of it, will not bankrupt the country.

For evidence, let's turn to Fareed Zakaria's new book, The Post-American World. The following appears under the subhead "America's Long Run" on pages 180-182:

First, however, it is essential to note that the central feature of Britain's decline -- irreversible economic deterioration -- does not really apply to the United States today. Britain's unrivaled economic status lasted for a few decades; America's has lasted more than 130 years. The U.S. economy has been the world's largest since the middle of the 1880s, and it remains so today. In fact, America has held a surprisingly constant share of global GDP ever since. With the brief exception of the late 1940s and 1950s -- when the rest of the industrialized world had been destroyed and America's share rose to 50 percent! -- the United States has accounted for roughly a quarter of world output for over a century (32 percent in 1913, 26 percent in 1960, 22 percent in 1980, 27 percent in 2000, and 26 percent in 2007). It is likely to slip but not significantly in the next two decades. In 2025, most estimates suggest that the U.S. economy will still be twice the size of China's in terms of nominal GDP (though in terms of purchasing power, the gap will be smaller).

This difference between America and Britain can be seen in the burden of their military budgets. Britannia ruled the seas but never the land. The British army was sufficiently small that the German chancellor Otto von Bismarck once quipped that, were the British ever to invade Germany, he would simply have the local police force arrest them. Meanwhile, London's advantage over the seas -- it had more tonnage than the next two navies put together -- came at ruinous cost to its treasury. The American military, in contrast, dominates at every level -- land, sea, air, space -- and spends more than the next fourteen countries put together, accounting for almost 50 percent of global defense spending. Some argue that even this understates America's military lead against the rest of the world because it does not take into account the U.S. scientific and technological edge. The United States spends more on defense research and development than the rest of the world put together. And, crucially, it does all this without breaking the bank. Defense expenditure as a percent of GDP is now 4.1 percent, lower than it was for most of the Cold War. (Under Eisenhower, it rose to 10 percent of GDP.) The secret here is the denominator. As U.S. GDP grows larger and larger, expenditures that would have been backbreaking become affordable. The Iraq War may be a tragedy or a noble endeavor, depending on your point of view. Either way, however, it will not bankrupt the United States. The war has been expensive, but the price tag for Iraq and Afghanistan together -- $125 billion a year -- represents less than 1 percent of GDP. Vietnam, by comparison, cost 1.6 percent of American GDP in 1970 and tens of thousands more soldiers' lives.

American military power is not the cause of its strength but the consequence. The fuel is America's economic and technological base, which remains extremely strong. The United States does face larger, deeper, and broader challenges than it has ever faced in its history, and the rise of the rest does mean that it will lose some share of global GDP. But the process will look nothing like Britain's slide in the twentieth century, when the country lost the lead in innovation, energy, and entrepreneurship. America will remain a vital, vibrant economy, at the forefront of the next revolutions in science, technology, and industry -- as long as it can embrace and adjust to the challenges confronting it.

That's the macro picture. The micro picture as it relates to our stock portfolio is that many of the companies we own will thrive no matter which countries dominate the global economy, because they operate everywhere on the globe.

Quick case-in-point: Apple's new iPhone 3G. It's launching on July 11 not just in the United States, but also Australia, Austria, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Italy, Japan, Mexico, the Netherlands, New Zealand, Norway, Portugal, Spain, Switzerland, and the United Kingdom. It will eventually get to more than 70 countries, if not more.

So, for two reasons I feel no shame for holding a stock portfolio dominated by American companies:

America is not in decline.
American companies can thrive regardless of which individual economies dominate.

Happy Father's Day

noreply@blogger.com (Jason Kelly) — Sun, 15 Jun 2008 09:31:00 +0000

Happy Father's Day! If you're lucky enough to be a father, be a good one. If you're lucky enough to have a father, love him while you can. Nothing lasts, and the best we can do is appreciate what we have before it's gone.

Joe Saitta wrote about his regret in a piece called I Should Have Been There:

I was no different in my teen-age years than teen-agers today. I thought I knew it all, had seen it all and done it all. I married young and fathered you two beautiful girls. Innocent to what lay ahead, my duties fell short. A part-time parent, in a full-time world.

I wasn't there when you took your first steps. I should have been there to catch you when you fell. The first time you said "Daddy," I should have been there to see your smile. The first day of school, the important questions -- "Daddy, why do boys pull my hair?" -- I should have been there to tell you why. Your first boyfriends, your first date -- I should have been there. I can't bring back those days in time when your first was also mine. I wasn't there. I should have been.

Now you have families of your own and, as always, make my Father's Day special. I realize what I've missed and taken for granted. So this Father's Day, I give to you my heart, my love, my all.

I should have been there.

Life Without Microsoft

noreply@blogger.com (Jason Kelly) — Fri, 13 Jun 2008 13:33:00 +0000

Wrapping up this week's look at why Microsoft's business has grown while its stock price has not, CJ sent along the story of how Mike Kavis worked for one year without Microsoft products in a Microsoft office environment. He has "not used a single Microsoft product at work. It has been one year now and I have survived with Thunderbird and Evolution, Open Office, Firefox, and many other open source replacements for Microsoft products."

The open source experiment was a success, "nearly flawless" in his words. He was especially enthusiastic about Open Office, which "worked remarkably well both receiving Microsoft Office files and creating files in Office format. I exchanged literally thousands of documents between Microsoft Office and Open Office. I never encountered a single issue with Word and Excel and occasionally encountered minor formatting issues with Power Point files. The formatting issues were nothing more then some minor placement issues which probably occurred less than 5% of the time."

That led CJ to say that, more than Google Docs, "the compelling threat to MS Office's revenues to me is your argument that users can easily convert between file formats these days."

CJ is not worried about Google Docs yet: "My first inclination is to think that until Google Docs has a strong off-line story, they will not put much of a dent in MS Office's revenues. Licenses with businesses is where the MS Office suite makes its recurring income, and I don't believe many businesses are going to get on board with the cloud computing concept anytime soon. Many businesses have their own in-house variations of cloud computing using a VPN connection. I have a hard time understanding how businesses will justify trusting third-party vendors with their vital data when they can do it themselves."

That last point is probably valid, but notice the hints at the idea that it might change in the future. This is not a criticism of CJ's point, just a confirmation in my mind that what investors are unsure of is Microsoft's future -- and have been for the past eight years. Its currently installed base of products is still growing revenue and profits, but the what-ifs are adding up:

What if cloud computing keeps growing in popularity and becomes as accepted as online shopping and online payments? I remember when people hesitated to buy from Amazon.com because it required using a credit card online. Then people said PayPal had no future because it wasn't a real bank. Online money? Who would ever trust that? How quaint those early concerns seem in retrospect, and we're only talking ten years ago. Now that Amazon.com has been hassle-free for so long and PayPal is bigger than American Express, nobody talks that way anymore. It could well go the same way for cloud computing. If so, the MS Office franchise looks shaky indeed.
What if people realize that they're finally free to use any operating system they want because they can use any applications they want online or freely downloadable ones offline? What if Mike's one-year experiment becomes the norm, not the interesting case study? Then, the Windows franchise looks shaky.
What if Google really does have the internet permanently locked up? It could keep growing revenues as its search share grows and leave Microsoft with no online business model because it has no serious advertisers to tap for an ad-supported online application environment and can't charge because all its competitors make their apps available to users for free.

This week has been a search for the reason investors have refused to pay up for Microsoft's growing earnings, a trend that has left the price of MSFT stock flat for the past eight years. I think the best answer is that Microsoft's business model is still working, so it hasn't changed. Pro-Microsoft investors would say, "Don't fix it if it ain't broke." Doubters would say, "It is broke but you just don't know it yet."

For the past eight years, the doubters have dominated in the market. We'll see down the road whether the pro-Microsoft gang is right that the company's business model is not broken.

Van Knapp's Take On Microsoft

noreply@blogger.com (Jason Kelly) — Thu, 12 Jun 2008 09:31:00 +0000

Continuing our recent look at why Microsoft has grown its business but not its stock price under Steve Ballmer's leadership, here's an installment from Dave Van Knapp of SensibleStocks.com:

After I read your article on Ballmer, and your readers' responses to it, I looked up MSFT's numbers...revenue growth, profit growth, P/E, all the usual stuff. Blended together, they seem to make a case for SCREAMING BUY! But then, as I always do, I asked, "How's it doing?" And you had already answered that: MSFT has been dead money for eight years or so.

You personalized that with Ballmer's tenure, concluding "no innovation, no growth, and Google's eating their lunch." But MSFT's growth numbers don't lie, there has been strong growth. However, as you pointed out yesterday, the P/E has shrunk, with the net result that the stock price is about the same as it was eight years ago.

I'd like to offer some points that have been overlooked in the discussion so far:
When MSFT was growing as fast as Google is now, let's not forget that they were cheating. I'm not referring to taking others' ideas and marketing them better, that's not cheating. No, they were breaking antitrust laws left and right. They made an art form of anticompetitive practices. They have been convicted by the U.S. government, several states, and Europe. I think (after years) they finally have settled everything on this side of the Atlantic, but I believe they may still be trying to settle a few charges in Europe. That's how they built their huge moat. As long as a significant part of the game stays the same (i.e., business software), they are going to continue to grow, because they dominate that sector and are essentially impregnable within it.
Their cheating -- along with some innovation, more copying, and great marketing -- gave them an essential monopoly in business software. Their operating system, Internet browser, and essential office products (like Word, Excel, and PowerPoint) all became industry standards. Except in a few niches such as graphic design and education, they completely swamped Apple. That gave them huge network-effect advantages. It doesn't matter that people don't line up overnight to buy Vista. What matters is that Vista is installed on all new PCs except Apple's.
MSFT out-maneuvered Apple in another way, and it was brilliant: They made their systems available to all computer makers. Remember when "PC" meant only the personal computer made by IBM, and all others like it were called "clones"? That's because IBM hooked up with MSFT first. Apple (except for a brief flirtation) closed themselves up and did not allow clones. They insisted on forcing users to buy their computer if they wanted Apple's (superior) OS and other programs. Apple boxed themselves in for years with this fundamental strategic mistake.

I worked in huge companies, and there was never a question about buying Apple products. We had to have the business standard. The only question was who made the best/fastest/cheapest computer, and there were lots of choices. They all worked together. None worked with Apple. The IT choice was a no-brainer: PCs with MSFT software. This also contributed to MSFT's moat, and they deserve credit for a masterful strategic move.
Another area where MSFT out-strategized Apple was in their partnership with Intel. Remember "Wintel"? It's only in the past couple years that Apple has used Intel processors, and it has been one of the keys to their resurgence in PCs (a term that is now generic, not referring only to IBM products).
Meanwhile, MSFT was beaten down by Google in paid search, not just in search. MSFT tried (as did Yahoo and many others), but Google hit on the winning formula, tying ads to search results in an appealing and effective way.

It's Google's strength and also their greatest vulnerability. I think more than 95% of Google's revenue comes from paid search (AdWords and AdSense). Google essentially did an end run. While others were trying to become "portals" to the Internet (which usually meant keeping you on their own site for as long as possible -- AOL, MSN, Yahoo, etc.) -- Google recognized that a simple search of the Internet was what most users wanted. That allowed them to take advantage of a ridiculously simple interface, which many found superior to the portals' hodgepodges. Google gets huge innovation credits for that, although it can be argued that appealing paid search is their only successful commercial innovation to date.
Google ideas that you are touting -- such as Google Apps -- have been around for years. (They were formerly called ASPs...application service providers). Google has no lock on winning that race, if indeed there is a race.

Just in the past couple of days, I have seen Microsoft ads for their version of Internet-provided workspaces, just like Google Apps. Adobe has been doing it for a long time. There is no guarantee that working on the Internet will supplant working within one's own PC...although I personally think that will happen. I do know that there are many professions -- doctors and lawyers come to mind -- that have yet to come close to the trust needed that they would place their clients' confidential information "out there" on the Internet.

Every time Google (the inaptly sloganed "do no evil" company) pulls a stunt like scanning and publishing copyrighted material, or publishing "geographic" photos so detailed that men can be identified walking out of strip clubs, they hurt their own cause in regard to Web-based applications.
What's the bottom line? I sold my MSFT 8-9 years ago when they were adjudicated to have violated antitrust laws...I happen to have strong feelings about things like that. I've never been sorry. I think the stock was about $31 when I sold it, and I don't believe it has ever re-attained that level.

Maybe it's paid its debt to society and is worth a look again. As I said earlier, it's a cash machine that apears to be a screaming buy. But I wouldn't buy it until it turns upward. As you said, there's something the market doesn't like about the stock or its prospects. Maybe it is Ballmer. (Those clips were priceless!)

It may be as simple as the realization that the monopoly power behind Microsoft's early success is waning. It's not gone yet as the business results show, and I suppose the company could post respectable numbers on just the fumes of its earlier achievements.

But when the future of computing is seen to be Internet-based, and Microsoft is seen as having bungled and continuing to bungle the Internet, then Microsoft's future appears cloudy.

For instance, while many people are not eager to put confidential information online yet, the fact that more and more people do it every day for free is itself a cause for concern. Between Acrobat.com, Google Docs, OpenOffice.org, ThinkFree, Zoho, and whatever else is in the works, there are a lot of ways to get work done without paying through the nose for MS Office. Perception: users don't need Microsoft to do work anymore.

Browsing the Internet is best handled by Firefox, and that just gets better every year -- for free. Perception: users don't need Microsoft to get online.

The Internet has quickly rendered compatibility issues moot (unless you're still tethered to Microsoft's proprietary formats), which means that more people are for the first time free to choose Apple's elegant products for their computing needs. That makes Apple's non-open platform strategy finally sensible because if you want an Apple computer you have to get one made by Apple. Perception: users don't need Microsoft Windows on their new computer.

And on and on. So far, even though people don't need Microsoft across these and other categories, they're still ending up using them or choosing to use them. For investors, though, the lack of need means that eventually Microsoft will need to prove that its products stack up to the competition, and win loyalty on merit rather than monopoly -- and it has a poor track record there.

Microsoft is not known for its innovation or quality, it's known for its business acumen at boxing users into having only one choice: Microsoft.

When that list expands to include others, Microsoft loses its edge. The perception that the list of alternatives to Microsoft is growing in all categories and that Microsoft's edge is dulling may be the dim future that has investors hesitating to pay much for the company's business results.

Can Microsoft's R&D Efforts Save It?

noreply@blogger.com (Jason Kelly) — Wed, 11 Jun 2008 09:44:00 +0000

Jack is back with further commentary on Microsoft. For background, read the most recent two articles under the MSFT label. Here's Jack on the free cash flow margin of safety:

From Reuters, we find that Microsoft has produced:

12.50% 5-year avg revenue growth
24.16% 5-year avg earnings growth
20.26% 5-year avg ROE

The interesting thing is that growth has accelerated in the last two years. How come? Perhaps because of the $6 billion for research and development spent in 2006 and $7 billion in 2007. These items compromise earnings in the short run but are a mechanism for this relentless growth. At this rate (24%), earnings currently double every three years, and in 13 years the company will earn as much as its current market capitalization in a single year. If the P/E were to remain the same, this means the share price will go up 17 times in 13 years. If Steve Ballmer keeps doing what he is currently doing, I have no doubts about MSFT reaching that level of earnings.

When Bruce Berkowitz invests in a stock he likes to think "of the worst things that could happen. What if a natural disaster, an attack, a dirty bomb, what if financing dries up, etc.". So what happens if Microsoft is incapable of growing forever? Thus Microsoft is essentially producing free cash flow (FCF) at the rate it earns at the present time, to eternity. Its current FCF yield is approximately 7%. But hold on, what is the point of R+D and growth CAPEX when there is no more future growth?
So adding back the R+D into FCF, we add the after tax R+D (7Bn * 0.7) = 4.9Bn back into earnings. What is the picture now? FCF yield doubles to a little more than 14%. That's a neat package to have every year.

Of course Microsoft faces intense competition in the market it is in. However the lack of erosion in its incumbent business (for 25 years!) means that its core earnings are very unlikely to change. Growth may be compromised in certain areas (such as search marketing, etc.) however, Ballmer has shown that he is still capable of increasing earnings at an increasingly rapid rate.

The only problem in my mind is MSFT generates too much cash and management does not know how to allocate it. (This is why ROE has fallen from historical averages of 50+% to 20+%.) I gave a great sigh of relief when MSFT cancelled its bid for Yahoo.

This looks like a pro-Microsoft day here, so I'll pass along comments from Justin, prefaced with his caveat that he thinks "Microsoft is a dinosaur" and that they "may have made a fatal mistake in not doing enough with the internet." Nonetheless:

But there are a few business segments in which Microsoft is still innovating. They are beginning to introduce a surface computing device that is simply awesome:

And in the long Microsoft tradition of stealing ideas from Apple, they are beginning to introduce multi-touch technology into other consumer devices. I think multi-touch -- along with voice recognition -- will be the next major revolution in user interfaces, the same way the graphics user interface replaced text-based inputs. Look at this:

And as you pointed out, the X-box is doing really well. There are actually a lot of young kids who think of Microsoft as a really cool company that makes games like Halo.

If all this planning for a better future has a good chance of delivering a better future to Microsoft shareholders, why then hasn't the share price risen to reflect the strengthening business? Jack is right that earnings have been growing. Because the P/E has been shrinking, however, the share price hasn't budged.

Is everybody just wrong about the glorious days ahead for Microsoft, or are they onto something? If the future is Apple stealing Microsoft Windows share with its computers and Microsoft Exchange share with MobileMe, and Google stealing Microsoft Office share with Google Docs and preventing Microsoft from ever gaining any meaningful hold in internet search, then investors are onto something. If Microsoft can innovate into new markets or keep its existing market dominance relevant and growing as Jack contends, then investors are missing a great bargain.

Which do you think is the case?