TeraDime NEWSLETTER

 

 

June 2006 TeraDime Newsletter

 

Mid-year Update

 

In October of 2005 I had to come up with the investment theme for the year 2006.� Here is what I have written then:

 

�

So the theme for 2006 should be:

 

�         Overweight on Large Cap Value;

�         Overweight on Short-End Bonds;

�         Underweight on Small Cap Stocks;

�         Underweight on Long-End Bonds;

 

Find companies that will be able to pass increases in price to consumers due to inflation (inflation that does not exists according to our government, but I am a skeptic); Monopolies are bad for consumers and great for your investing portfolios. MSFT will actually be a value company below $22 per share (Something to keep an eye on next year)�

 

Now that we are getting closer to the end of the first half of 2006 I think it is appropriate to look back and see if my investment ideas would make you any money or if you would be better off just sitting in S&P 500.

 

The following represents performance of the above mentioned indexes and performance of the S&P 500.� Results include the reinvestment of dividends and/or interest:

 

ETF

Index Name

YTD Performance

SPY

S&P 500 depository Receipts

0.1%

VTV

Vanguard Large Cap Value

3.3%

SHY

1-3 year US treasury Index

1.4%

IWC

Russell MicroCap Index

-0.2%

TLT

20+ years Treasury Bonds

-5.3%

 

As you can clearly see Large Cap Value stocks clearly outperformed the S&P 500 index and as we have suspected the fear of inflation caused the major sell off of the long end bond.� As you are well aware, money market accounts pay close to 5% right now and it is easy to find 1 year CDs that will actually yield 5%+.�

 

The price of Microsoft Stock moved nicely in the desired/predicted direction (down) and as of yesterday it was trading at $21.88 which is just below our target of $22 per share.� This really presents a great buying opportunity for value investors.� MSFT did absolutely nothing for the past 8 years. If you were holding the stock since 1998, you are exactly where you have started + dividend. So, if you thought that MSFT was a great buy in 1998 with P/E ration of 50 and price of $21 per share, then it is a steal with the current P/E ration of 17 and the price of 21 now.

 

�Microsoft, as a company, is just as great as it was in 1998, the only difference is that it was priced ridiculously high then, and it is fairly priced now.� This clearly shows that even great companies can be bought �on sale� if you wait long enough.� Something to think about the next time you put the buy order for Google at $384 per share and PE of 68! By the way, if you thought that Google was a great buy at $475 per share in the middle of January, then paying $384 per share now should be a no-brainer. That is a cool 19% discount. Note: as you know I like to stay on the value side and Google at $384 is still steep, no matter how you look at it.

 

Economic overview:

 

Interesting statistic: 5 biggest brokerage houses recently issued �research notes� claiming that the price of oil between $60 and $70 per barrel is not sustainable and that we will see major sell off in oil. They claim that 5 years from now oil will cost much less then it costs now and predict that the price will be at around $45 per barrel. The last time all 5 brokerage house had this unanimous consensus is during the year 2000 technology bubble when they had the buy order on anything that had .com in its name.� Remember, �the New economy�!�

 

What does this prediction mean to us, average investors? It means that we will be lucky to still pay $3 a gallon at the pump and that $60 - $70 oil (if not higher) per barrel is here to stay. Consensus among brokerage houses on anything is the best contrarian indicator.� Whatever they say, bet the opposite and you will do just fine.

 

The quick review of the energy component of the S&P 500 that can be easily bought and sold via Exchange Traded Fund (i.e. ETF) called XLE, shows very interesting market expectation and clear proof that investors learn absolutely nothing.� The claim that energy sector is overvalued at these levels cannot be substantiated by looking at the P/E ratio of the XLE as compared to the P/E ratio of SPY (or S&P 500). XLE that holds the following companies: Chevron, Exxon Mobil, Occidental, Valero, etc� has a combined P/E ratio of 10.7.� On the other hand, SPY has a P/E ratio of 15.37.� So, relative to S&P 500 it is cheap. The price already reflects the market expectation of cheaper oil prices in the future, which is probably wrong. On top of it, XLE yields 1.06% and major companies in the index (like Exxon for example) did not cut their dividend even once during the past 40 years. They are earning cash faster than GM is loosing it, and their financial condition is the best in many years. So, when �professional� investors tell me that we are in the energy bubble and that energy companies are overpriced, I would �respectfully� disagree.�

 

Inflation & Gold:

 

In my December 2005 newsletter I have written the following:

 

�As of December 23, 2005 Gold (GLD) is up 18%.� This development makes me happy, since I bought Gold, but it concerns me from a long term perspective (i.e. inflation).� It is really not good news (in the long term) to have Gold moving up in price (or dollar fall in price in respect to Gold), since I am still getting paid in dollars and not in gold.� Unfortunately (for the long term), technical indicators are very bullish on Gold as of today and Gold over many years had been a better predictor of inflation than short term rates that the Federal Reserve controls.�

The �non-existent� inflation forced the price of Gold to move up 7.8% YTD and that includes the recent sell off-of more than 22% since the peak on 5/11/2006 when Gold traded at over $700 per Oz. The major technical support for Gold is $540 per oz. Metals/Commodities are very volatile and many speculators are trading them, so the price of Gold will always be volatile, but if the Gold will hold above $540 and start moving up again, then we may have a great buying opportunity at these levels.

Recent CPI numbers show that economy is heating up and inflation is here. Federal Reserve will definitely raise the rates to at least 5.25% by the end of June (markets already priced that in), unfortunately it is not enough.� In order to remove the inflation expectation the more appropriate move would be to raise the rates dramatically by at least 50 basis points or .5% and show the markets that Federal Reserve is serious about fighting inflation.� This move will not help the economy of course, but it will strengthen the dollar (it was loosing its value since 2002), and give people confidence in the �inflation fighting� Federal Reserve.� Two consecutive .50% moves on the short term interest rates will move the short term rate to 6% by the end is August, clearly invert the yield curve and easily put a nail into the coffin of the housing market, which in affect will probably drive the economy into mild recession by the middle of 2007.� However, this move will stabilize the dollar, keep the long term interest rates low and prevent inflation.� The alternative will be to keep raising rates by .25% and constantly stay behind inflation. Sooner or later the dramatic moves up in interest rates will be necessary to prevent inflation, but by that time interest rates will be at 9% vs.6% and recession will be more painful.

Marker Review

 

The S&P 500 (SPY) and Nasdaq 100 (QQQQ) are all trading below their respective 200 day moving average.� Dow (DIA) is still in the neutral market and trades just above its 200 day moving average.� Based on technical indicators QQQQ is already in a bear market.

 

The good news is that stocks are not expansive on absolute basis. The trailing P/E ratio of S&P 500 (SPY) is only 15.37 which is quite reasonable.� The bad news is that as interest rates keep rising and the Federal Reserve keeps tightening the alternatives to stocks will look much better with less risk and earning will deteriorate lowering the (E) components of the P/E ration and moving the P/E ratio higher.

 

Investment strategy for the second half of 2006

 

So, what are the alternatives to stocks at this point? The answer is: Cash and Cash equivalents (CDs, Money market accounts, etc�).� You can easily find a 1 year CD yielding 5.45% with zero risk.� This is a pretty good alterative to volatile stocks.�

 

Second option is a closed end municipal bond funds that trade at discount and provide the tax free dividend yield at around 5.2%.� If you live in a high tax state and have a decent income that is taxed at around 28% federal rate and another 5% state tax rate, then 5.2% municipal bond income will earn you tax equivalent yield of �approximately 7.8%.

 

These are pretty good risk free alternatives.� The rule of thumb is that if you can find risk free investment that can yield you more than 7%, then there is no point to invest in the stock market for the short term (refer to my earlier newsletters for explanation of this theory)

 

Long term investors that follow asset allocation strategy and do not want sell their stock holdings and buy CDs and Municipal bonds funds should consider to keep a bit more in cash equivalents for the next 6 months. Basically, it is OK to not be 100% invested and keep some money in short term cash equivalents if you can get between 4.5% and 5.5% on your cash.

 

Gold sold off dramatically during the month of June and provides us with great technical entry point at around $540 - $560. If you did not get a chance to buy Gold at $720 in May, you have an opportunity to buy it now at around $560.� I think that Gold is in the long term bull market and only very high interest rates and recession will force Gold to dramatically drop in value.� Basically, as I was always suggesting a very small portion of your portfolio should be in Gold as an insurance/hedge against inflation.� Gold can be traded via ETF ticker GLD.

 

If you have to be in stocks, then please concentrate on Large Cap Value stocks that have the power the weather economic downturn, have strong balance sheets, low P/E ratios and ability to pass price increases to consumers if inflation picks up. For example, the Morningstar Large Value Index ETF (ticker JKF) has P/E ratio of 11.59, Price to sales ratio (P/S) of 1.15.� In comparison S&P 500 has the P/E ratio of 15.37 and P/S ratio of 1.41.

 

So, the strategy for the next 6 months:

 

1.                  Cash is OK (CDs, money markets, etc�)

2.                  Closed end municipal bond funds that are not leveraged and trade at discount. This is specially good strategy if you have decent income and live in a high tax state like NY, NJ, CA. Login to www.etfconnect.com to search for these and other closed-end municipal bond funds

3.                  Cut down on risk by investing more into Large Cap Value stocks vs small caps growth stocks.

4.                  Gold and Commodities should represent a small part of your portfolio as a hedge against inflation. Commodities are very volatile and 2% - 3% daily swings in price are not uncommon.� That is why only very small portion of your portfolio should be invested in it.

5.                  Relax and enjoy the roller coaster ride. The stock market will not rally dramatically until Federal Reserve stops interest rate increases and markets stop worrying about inflation.