View 1/2006

The Contrarian's View

Vol. XX, #7, January 15, 2006

The Contrarian's View s published 11 times per year on a mostly-irregular schedule, and the views expressed are those of the author and editor, Nick Chase. Because nobody can predict the future, results of past suggestions or recommendations are no guarantee of future results. My own material in this publication may be freely quoted provided proper attribution is given to its source; quotes from other people are subject to fair-use copyright restrictions. Subscription rate: Selections are free on the Internet. Using your favorite Web-browsing program, open URL http://onashi.org. Mailed paper subscriptions are currently not being accepted (current paid subscribers will continue to receive their paper issues). Unsolicited material sent to us by UPS or by courier other than the postal service is refused and returned to sender! ISSN 1536-4429 Phone: (508) 757-2881

THE INHERITANCE PORTFOLIO

In last month's issue of The Contrarian's View I mentioned that with the death of my stepmother on Thanksgiving 2005, I will be receiving a small inheritance, probably enough to allow me and my wife to make more short trips than we are able to on our current income.

My father and stepmother were always very "close to the vest" about their financial condition, and my siblings and I were aware that there might be this money passed on to us if our parents didn't chew it up on long-term care. But we didn't know for sure until my stepmother's death, and we found out in a most interesting way.

At the reception immediately after my stepmother's funeral service (and before the burial), my wife and I were at the tail of the receiving line for people to offer their condolences. The very last person in that line to greet us introduced himself as my stepmother's executor and I said, "Oh, we probably should talk sometime", expecting to exchange phone numbers and maybe e-mail addresses. But he immediately started dumping on me all of the details about the passing on of this inheritance that I had been wanting to know for about, say, the past 50 years.

I got the feeling he had brought up the subject with my brother, who was near the beginning of the line, but my brother wasn't interested in talking about it right then. By the time he got to me the executor was determined to unload on somebody, and since I'm the kid in the family who inherited the "financial" gene, I was all ears.

He told me (among other things) that our inheritances were mostly in blue-chip stocks. In a subsequent phone conversation I asked him if the stocks were the same ones my father had bought probably a gazillion years ago, or whether the account had been actively managed. Oh no, he said, it's been actively managed. So I was, of course, curious to see just what the managers had been doing with the portfolio.

In early January 2006, even before my portion of the portfolio had been electronically delivered to my brokerage account, I received from the executor a list of the blue-chip stocks, along with their cost bases.

Now mind you, my stepmother was 92 years old when she died, and what I saw there was, shall we say, most unusual for an elderly widow. (Gotta watch that "elderly" stuff; I tell people that I'm "middle-aged" and they laugh at me. "You're old, Nick", they say.)

Would you believe eBay, at a price-to-earnings ratio of 64:1? In a widows and orphans portfolio? OK, scratch the orphans, they will live long enough for the speculative stuff to pan out. But for a widow?

And most of the other holdings were what you would typically find in a "growth" or "aggressive growth" mutual fund. The combined dividend yield was about 1.2 percent, and after allowing for management fees and the capital gains taxes that would have to be paid as a result of the portfolio churning, I would be surprised if my stepmother received more than a minuscule income from this rather aggressive blend of stocks. I surmise that, for reasons unknown to me, my stepmother actually wanted a portfolio of aggressive growth stocks (in a bear market, "aggressive shrink" stocks).

Another surprise was the small number of shares for each company in the portfolio. There were 46 companies or ETFs represented, with 18 shares here, 11 shares there, 21 shares of this, 25 shares of that. Not a round lot in the lot. Of course, this is after dividing by 3, there being three Chase siblings among whom the inheritance is divided, but even after allowing for this, the great majority of holdings (when my stepmother owned them) were lots of less than 100 shares each. My guess is that the portfolio was part of a "group buy", in which it was pooled by the bank with other portfolios to buy (or sell) the stocks the manager(s) desired in much larger quantities, then the stocks were assigned to the individual portfolios.

Long-time readers of The Contrarian's View will recall that as I approached retirement I shed my portfolio of individual stocks in favor of placing all of my retirement funds with TIAA-CREF so, in case I should be the first to croak, my wife would have to contact only one organization to adjust her retirement income. This move also cut down on paperwork, though it must have led to boredom among you subscribers who, no doubt, have gotten tired of following a handful of TIAA-CREF investment options, most of which aren't even available to the general public.

Now I'd been handed 46 stocks. That's 46 annual reports arriving in March and April, during income tax time. It's 184 quarterly reports and 46 proxy forms. Ugh.

But considering that TIAA-CREF has been exhibiting IRA distribution failures lately and it might be nice to have a source which my wife or I can tap for emergency funds without cracking a CD, and in the interest of not having subscribers die from boredom, I've decided to keep some of this stuff, and build a portfolio of about a dozen stocks which will appear in each issue of The Contrarian's View. Although this will be a "real" portfolio, I will do two things:

(1) I will "normalize" the portfolio as if it begins with about $100,000. That will be way above the real value.... don't I wish it weren't.... but it will make the math easier.

(2) Since I'm retired, I will be siphoning off the dividend income for important living expenses, such as trips to daylily conventions. So I won't make any performance claims because the dividends won't (normally) be reinvested. This will not be an accumulation portfolio in which one compounds earnings with an eye toward retirement, but a distribution portfolio which supports retirement. A portfolio which, hopefully, provides inflation protection for the income it delivers.

(3) The companies whose stocks I retain must generally meet these criteria:

(a) Revenue growth. If a company isn't growing its revenues at or ahead of the rate of inflation (after allowing for growth through acquisitions), then it's really shrinking. Forget it.

(b) Growth in earnings per share. Earnings can be variable, but over the long term (a decade or more), earnings per share should pace or outpace the rate of inflation. Otherwise the company is doing a bad job or diluting itself by issuing too many shares (enriching upper management with excessive stock options).

(c) Dividend growth (if a dividend is paid). A stingy company which is increasing its earnings but fails to share them with its stockholders gets the boot. (Don't forget, studies have shown that stocks are priced for their future dividend streams.)

(d) A reasonable price-to-earnings ratio. Generally speaking, a stock's P/E, after adjusting for the company's growth rate, should be more-or-less in line with its industry peers and not totally out of whack with the general market. (If the industry itself is overpriced, that raises another caution flag.)

(e) A solid balance sheet. Preferably with a cash to-current-liabilities ratio of 1:1 or better, and low long-term debt in relation to assets. Good cash reserves are the fuel which allows a company to grow at a good rate.

(f) Modest institutional ownership. If institutions own 80% or more of a stock's float, then the herd has fallen in love with the company's story line and there's not much room for anything but disappointment. (Who's left to buy?) Low institutional ownership (30% or less) leaves room for the herd to jump on board.

I won't begin to describe the stuff that the supposedly clever money managers bought that I'm in the process of dumping, except to tell you that the eBay was the first to go. As soon as it showed up and was priced, it got sold. Right away, no hesitation. (Maybe I'll say more about my cleaning-out operation in a future issue.)

You should expect a high level of "cash" when I finish structuring this portfolio, because stocks still remain historically overpriced and I am willing to patiently wait for the bargains to pop up in the inevitable recession. (Money managers, on the other hand, are driven to try to outperform short-term, or they lose their jobs. I don't plan to fire myself.)

I will also be entering stop-losses for the stocks I keep to protect against the onset of the next bear market. There's also the possibility I could be wrong about a particular company and/or the behavior of its stock, of course. I do not expect to fall in love with any stock; if its performance doesn't keep pace with inflation, out it goes.

QUOTES FOR THE MONTH

Can anyone still believe Keynesian quackery works, or that the key to reviving prosperity is to get consumers to spend yet more borrowed money? - Rick Ackerman

With a high level of optimism to start the year in the face of numerous uncertainties, it isn't difficult for me to remain bearish for yet another year. I still firmly believe that we have not yet seen the worst of the bear market. Folks are nuts if they think that it will be back to the glory days of the 80s and 90s after just a few years of losses. It has never worked that way throughout history. Periods of exuberance are always followed by periods of despair. With the extreme excesses seen in the last decade I expect an equivalent amount of despair.... The sentiment just reeks of major long term top. - Marc Sexton

Two million jobs 'created?' Who did all this? Government? Yes, because of Homeland Defense, Iraq, Afghanistan, and of course those tens of thousands of jobs 'created' to check your shoes and baggage before you board the planes, plus an air marshal on most flights. Government stooges check out and examine every train wreck, plane crash, truck accident, and anything else they can conjure up on which to spend money. Government grows as if it were fertilized and in rich soil with ample water. Sort of like bamboo, which can grow 18 inches a day. Government is growing so fast...naturally to protect us...that we should all be glad; correct? Uh huh, but I don't think so. - Don Stott

Almost everyone thinks that the Fed will do anything -- including tolerating a much more rapid decline in the purchasing power of the dollar -- to mitigate the risk of a deflationary outcome. And Fed representatives never miss a chance to bolster this line of thinking because such thinking is necessary in order to keep the game going. After all, who would invest in 30-year US Treasury debt yielding 5% if it were known that there was no chance of deflation and that an additional large decline in the purchasing power of the dollar was all but guaranteed? The Bank of Japan might, but no private investor in his/her right mind would. The truth of the matter, as we see it, is that the Fed has the tools to keep the inflation going and it KNOWS it has the tools to keep the inflation going. The Fed's biggest fear is that everyone else figures this out. - Steven Saville

Energy prices will fall. Higher interest rates will not dent consumer spending. What's more, higher interest rates will not deter businesses from borrowing either. Quite the contrary. Businesses will spend! Spending and consuming rather than saving and producing will be vindicated as the surest way to wealth in a competitive world. People who think like this are the same kind of people who took videos of the 2004 Boxing Day tsunami as it rolled toward them. They are doomed. - Dan Denning

We have had a global asset bubble in real estate, stocks and some commodities. That bubble will have begun to pop in earnest by the end of '06 and will engender global economic contraction and overcapacity resulting in falling wages and prices, falling interest rates, falling stock prices, and quite probably a falling dollar. There is no reason to believe that the global asset bubble collapse will bring anything different to most world markets than past bubbles brought to other markets in other times and places. - William Hecht

While the United States still has a surplus in its balance on service, this surplus has in recent years been declining - suggesting a loss of competitiveness even in high-profit intellectual property and services. Moreover, the surplus in the United States balance on services is tiny and shrinking as a percentage of GDP when compared to the bulging and (as a percentage of GDP) increasing deficit in the balance on goods. - Marc Faber

Data mining is the key technique for nearly all stockbroker economics. There is no claim that cannot be supported by statistics, provided that these are carefully selected. For this purpose, data are usually restricted to a limited period, rather than using the full series available. Statistics, it has been observed, will always confess if tortured sufficiently. The greatest single triumph yet achieved by data mining is the invention of the bond yield ratio. This claims that equities can be valued by comparing bond yields and earnings yields. These ratios showed a strong correlation in the US from 1977 to 1997. But the exact opposite relationship ruled from 1948 to 1968. It is, of course, possible to use all the available data, thereby flattering the prejudices of economists but offending the key principle of data mining. If this is done, it shows that there is no relationship at all between bond yields and earnings yields. - Andrew Smithers

Bernanke considers himself to be an expert on the Great Depression and the 1929 Crash, and he evidently has Wall Street convinced that under his watch the Fed will not repeat the monetary mistakes that supposedly triggered the deflationary collapse of the 1930s. I would argue that merely by harboring the belief that the Fed will be able to manage a global debt bubble amounting to hundreds of trillions of dollars, Bernanke has disqualified himself for the job. - Rick Ackerman

We have a full-fledged monetary quack about to take the helm at the Federal Reserve. - Doug Noland

Absurd talk continues of US economic robust strength. It is really robust philandering corruption distortion and deception in the calculation of all major economic statistics. A mere 12-year-old kid can unmask the lies on the statistics. Gee, wages will rise to catch up to strong productivity! Well, the benefits of this imported productivity are in Asia. Gee, robust performance with "full employment" is the mindless manipulated mantra. Well, such a boast requires not counting those who no longer receive jobless insurance benefits. Gee, low price inflation has returned to our shores. Well, let's stop driving, shipping, heating, and eating for that matter, and ignore asset bubbles.... Anyone who truly believes the Q3 GDP of 4.3% growth is an infant and naïve at best, a moron or a hustler at worst. It was mostly price inflation, not removed properly, then labeled as growth, aided by hedonic lifts to technology spending, compounded by chain weighting. - Jim Willie

STOCK MARKET OUTLOOK

One of the things I noticed while constructing the "Inheritance" portfolio was that the great majority of stocks I inherited were purchased on November 9, 2005. In the following two months those November 9 stocks rose about 7% in value overall (with the greatest gains in energy and commodity-industry stocks), but the consumer/retail stocks had hardly budged. As far as I am concerned, this is a BIG RED FLAG that the consumer is tapped out and the next recession.... this time led by a slump in consumer spending.... will be upon us within the year, and it will start being discounted by the stock market any time now, but this discounting could hold off until after the spring.

OK, Nick, you say, Pick one! Yeah, yeah, I am mindful that January is the most popular of the months for a major market top. But a market which surges in January usually coasts into March or May. So, I give 50% odds for a major top in January, and 50% odds it will occur in the spring. Regardless, the second half of 2006 will be ugly for the bulls.

The risk of systemic failure is currently about 20%, where it will likely remain until the spring (or whenever the major market top is in place).

PORTFOLIO REVIEW

Prices shown are as of January 15, 2006.

A. "Inheritance" - real (normalized) portfolio, under construction:

SUMMARY - "Inheritance":
Original cost: $100,000.00E
Present value: $ -
Increase: $ - [+ %]

COMMENT on "Inheritance": UNDER CONSTRUCTION.

B. "Professors' Investment Group (PIG)" - investment club portfolio.

SUMMARY - "PIG":
Original cost: $10,699.00
Present value: $20,574.04
Increase: $ 9,875.04 [+92.30%]

COMMENT on "PIG": Another 3-month T-bill was bought on January 3, 2006, and the Prudent funds reflect the reinvestment of year-end distributions.

TIAA/CREF 403(b) retirement plan; I switch between indexed stock/bond/money funds:
(No transactions since June 30, 2004 due to my retired status. Update soon, I hope!)
A portion of my TIAA-CREF funds are currently in the process of being transferred to Fidelity Investments.

Values, 13Jan2006: stock, 214.31; equity-index, 85.46; MM, 22.70; bond, 76.78; inflation-indexed bond, 46.58; real estate, 241.03; TIAA current yield in SRA, about 4.92%. Current money-market yield is 4.06%.
Gain, 1988: 18.91%; 1989: 14.48%; 1990: 8.28%; 1991: 27.93%; 1992: 10.20%; 1993: 3.08%; 1994: 4.07%; 1995: 4.80%; 1996: 5.28%; 1997: 5.38%; 1998: 5.72%; 1999: 5.12%; 2000: 9.99%; 2001: 1.11%
Gain, January 1 through March 31, 2002: 0.97% (3.86% annual rate of return)
Total gain since January 1, 1988 (14.25 years): 223.43%
Compound annual rate of return: 8.59%
Gain shown excludes the impact of additional monthly cash contributions.

(Please note that I have not had the time to calculate my rate of return beyond March 2002, and may not get the time until 2006)
Buying CREF stock on January 1, 1988 and holding it gained 422.38%, for a compound annual rate of return of 11.46%.

COMMENT on NYSE "Timer's Trend": We are currently on a BUY signal of November 18, 2005.

COMMENT on NASDAQ "Timer's Trend": We're on a BUY signal given January 6, 2006.

NEXT ISSUE - will appear near the end of March 2006. (11 issues per year, February is the "skip" month.)

BONUS THIS MONTH: In cleaning out my father's old files which were in storage, I came across this 1933 letter (shown on the next page) in which he was told there were no openings in a firm where he was an intern the previous summer. Imagine entering college in 1928, when the economy was really booming, then graduating from business school in 1933 with a masters degree, right at the bottom of the greatest depression the country has ever seen (so far). How discouraging.