Citi Announces Mini Break-Up Plan, But It Should Do More

Today we hear that Citigroup (C) has decided to split its consumer business into two. While not nearly as dramatic as the real break-up plan many, myself included, have discussed, it is a start. Citi will split the consumer business into two parts: consumer banking and global cards. The global card segment will include both U.S. and international credit card lending.

I think CEO Vik Pandit has the right idea here, but for Citigroup shareholders to really see full value realized for the company, they need to split off global wealth management, consumer banking, and corporate banking from each other.

Just my two cents...

Full Disclosure: No position in Citigroup at the time of writing


Related Posts:
Citigroup Break-Up Analysis - Part 1
Citigroup Break-Up Analysis - Part 2
Citigroup Break-Up Analysis - Part 3

One Reason Apple Might Be Hoarding $18 Billion

Today I'm watching the NCAA tournament and trying to lower the stack of unread magazines on my desk. In the March 17th issue of Fortune I came across an interesting article about Apple (AAPL) and CEO Steve Jobs. Some investors in Apple have been disappointed that the company refuses to return any of its $18 billion war chest to shareholders in the form of stock buybacks or dividend payouts. Why haven't they, you might wonder?

Well, when asked how he plans on managing through the economic downturn, here is what Jobs told Fortune:

"We've had one of these before, when the dot-com bubble burst. What I told our company was that we were just going to invest our way through the downturn, that we weren't going to lay people off, that we'd taken a tremendous amount of effort to get them into Apple in the first place - the last thing we were going to do is lay them off. And we were going to keep funding. In fact we were going to up our R&D so that we would be ahead of our competitors when the downturn was over. And that's exactly what we did. And it worked. And that's exactly what we'll do this time."

Interpretation: Don't expect massive buybacks or dividends. Sure, it would be tough for Apple to invest the entire $18 billion even under this mindset, but after the company had cash issues back in the 1990's when they were struggling, Jobs clearly wants to overly cushion the company for whatever the future brings. It makes sense long term, but clearly in the short term investors will be disappointed with the decision to sacrifice short term stock price gains for long term flexibility and stability.

Full Disclosure: Long shares of Apple at the time of writing

Motorola Valuation - Part 1

Following up on my initial Motorola (MOT) post yesterday, here are my numbers on the company's networking and mobility (non cell phone) segment. With MOT shares languishing near multi-year lows at nine dollars, doing individual valuations on both segments that will be spun off next year can help us figure out if there is much downside left in the stock.

My calculation is meant to be realistic, rather than overly conservative or aggressive. I get to about $8 per share for Motorola's non cell phone business, which just shows you how little faith Wall Street has in the cell phone segment right now. Let me know if you think tweaks in my numbers are warranted.















Full Disclosure: No position in MOT at the time of writing

Are Motorola Shares a Bargain at Nine Bucks?

I haven't considered Motorola (MOT) a viable investment opportunity for a long time, mainly due to the overly competitive market environment for the company's core cell phone business. Not too long ago Nokia (NOK) and Motorola dominated the cell phone market and both stocks did well.

In recent years, however, the market landscape has changed. Smart phones like the Blackberry, iPhone, and Treo have taken share. A slew of Asian manufacturers have also played a role, with Samsung, LG, and Sanyo selling far more phones in the U.S. than they ever have before. As a result, MOT has seen cell phone share sag, profits plummet, and a stock price of about $9, down 65% over the last two years.

With the help of activist shareholder Carl Icahn, Motorola has been persuaded to split up the company. The cell phone business is bleeding red, distracting investors from the company's profitable home and enterprise broadband and mobility divisions. In 2007, the cell phone business lost $1 billion on sales of $19 billion. The other business lines (cable modems, set top boxes, etc) actually earned $1.9 billion on revenue of $18 billion. Few people probably realize that cell phones are only half of the story at Motorola. Perhaps a spin off will help with that.

Down around $9 per share, I couldn't help but want to take another look at the stock. Along with a market value now of only $22 billion, MOT actually has net cash of more than $4 billion, or about $2 per share. I'll share some of my numbers with everyone in coming days, but until then feel free to share your thoughts on Motorola as a value play down here in the single digits.

Full Disclosure: No positions in the companies mentioned at the time of writing

Yikes, California Home Values Drop 26% in February

From the LA Times:

Signs of distress are piling up in the California housing market, where prices are falling at three times the national rate of decline. Statewide, median sales prices fell by a stunning 26% from year-ago levels in February, with home prices dropping at a rate of nearly $3,000 a week, the California Association of Realtors reports. Further, the CAR says the Fed's interest rate-cutting campaign "will have little near-term direct effect on the housing market."

That's right. If you live in California chances are your 401(k) has outperformed your home over the last year. Normally that would be expected, but we're in a bear market for equities!

I am amazed that it has become conventional wisdom that a house is the best way to accumulate wealth in this country. Hopefully a year-over-year decline of 26% in the California housing market will diminish some people's desire to accumulate as much property as possible. Remember everybody, homes appreciate by 3% per year over the long term, so they don't even outpace inflation.

That reminds me. Has anyone seen the television ad currently being run by the National Association of Realtors? It states that homes "nearly double in value every 10 years." I'm shocked they are claiming such a ridiculous statistic.

If we go back to high school math class, we recall the Rule of 72, which lets us divide an annual appreciation rate into 72 to determine how many years it takes for something to double in value. A double in 10 years implies a 7% annual return. That is twice the actual long-term appreciation of U.S. housing. Does anyone really think that homes return 7% per year?

How can the NAR get away with this ad? Because they simply chose a time period where the average return was 7% (yes, it includes the recent housing boom) and implies that was a "typical" period. Gotta love the fine print...

Chesapeake Energy Boosts 2008, 2009 Production Forecasts on New Discoveries

Following up my March 12th post on natural gas producer Chesapeake Energy (CHK) (More on Chesapeake Energy), on Monday the company announced major new discoveries and boosted its production growth forecast for the next two years.

Thanks to a huge find in the Haynesville Shale in Louisiana, in addition to seven other new finds, Chesapeake now expects 2008 production to grow by 21% (vs 20% a month ago) and another 16% in 2009 (vs 12% a month ago). An additional $950 million in capital expenditures will be required between now and year-end 2009 to fund these projects, which will result in CHK tapping the financial markets for capital.

While capital raises were not in CHK's prior plans, the company has already started to increase its hedges (thanks to the recent run-up in natural gas prices), in order ensure that shareholder returns on these new projects are substantial. Chesapeake has now hedged 71% of its 2008 production at $8.77 per mcf, 40% of 2009 production at $9.13 per mcf, and 12% of 2010 production at $9.34 per mcf.

To give you some perspective, CHK averaged $8.14 per mcf of gas in 2007 and $8.76 in 2006. So, CHK's averaged realized price should be around 2006 levels this year, but production will be about 50% higher than it was two years ago. I bring this up because Chesapeake earned $3.61 per share in 2006 and the current 2008 estimate is only $3.54 per share. It appears CHK will earn more than the current consensus estimate in 2008. Analysts' 2009 projection of $3.46 also appears too conservative.

Full Disclosure: Long shares of CHK at the time of writing

Should We Buy the PetroChina Stock Warren Buffett Sold?

First of all, let me say that I think Warren Buffett's investment in PetroChina (PTR) was probably one of the most impressive bets he has ever made. Before China or energy were hot commodities he found a company that was emblematic of both and turned a $488 million investment into $4 billion, an astounding 700%+ return in five years. I'm not sure where that ranks among his all-time best investments (Buffett experts, please let us know), but it is surely his best in recent memory.

Buffett sold his PTR stake in the 150's, after which the stock soared to above $260 per share. China's market has since dropped precipitously, and PetroChina shares now sell for around $120 each. Despite Buffett's decision to exit the stock (20% above current levels), I think PetroChina looks like a good investment today.

Before I get into why I think so, let me share what Buffett had to say about his PTR investment in his recently released annual letter to shareholders:

"We made one large sale last year. In 2002 and 2003 Berkshire bought 1.3% of PetroChina for $488 million, a price that valued the entire business at about $37 billion. Charlie and I then felt that the company was worth about $100 billion. By 2007, two factors had materially increased its value; the price of oil had climbed significantly, and PetroChina's management had done a great job in building oil and gas reserves. In the second half of last year, the market value of the company rose to $275 billion, about what we thought it was worth compared to other giant oil companies. So we sold our holdings for $4 billion. A footnote: We paid the IRS tax of $1.2 billion on our PetroChina gain. This sum paid all costs of the U.S. government - defense, social security, you name it - for about four hours."

First of all, the paragraph quoted above tells us that when Buffett says his desired holding period for an investment is "forever," that is not entirely true. He buys a stock that he feels is undervalued, and when it reaches fair value in his mind, as PTR did, he sells it. I think any investor trying to outperform would be advised to do the same.

Now, there are some interesting things about this story to mention. When Buffett started buying PetroChina the price of crude oil was $25 per barrel. He tells us in his letter that at that time he felt the stock was worth about 1.7 times its actual market price, or $100 billion.

If we use his own valuation and simply adjust it to reflect higher oil prices, we can determine an approximate value for PTR right now. Oil trades at $100 per barrel today, so that implies Buffett's valuation model gives PTR an intrinsic value of $400 billion, or $223 per share.

Now, you might ask if that math should be trusted why would Buffett choose to sell last year for only $150 per share? Well, it just so happens that crude oil was trading at $70 per barrel when Buffet sold PTR. Since then oil prices have jumped another 50%, which would imply that had he used a $100 oil price assumption, Buffett's fair value for PTR would be about $225 per share. Pretty darn close if you ask me.

So, did Buffett sell PetroChina too early? Well, that depends on how you view the energy landscape. If you think that energy prices are in "bubble" territory and are overvalued at current prices, then he probably got out at a great time. However, if you are like me and think the bull market in commodities (including energy) has a lot of time left to go which could push crude oil to $150 or more in coming years, then yes, Buffett left a lot of money on the table that investors can now take for themselves. After all, PTR trades at $122 per share right now, about 80% below Buffett's own fair value calculation if you believe oil prices stay elevated long term.

Full Disclosure: Long shares of PetroChina at the time of writing

Fed Finally Showing Rate Cuts Aren't Everything

I know they cut 75 basis points at today's meeting, but the 400+ point gain in the Dow probably isn't in reaction to more rate cuts. Many people have made the argument, myself included, that rate cuts are not the magic anecdote for our economic problems. Sure they're nice, but the structural issues we are dealing with cannot be solved by simply lowering the Fed Funds rate.

Recent steps by the Fed show that they realize they can and need to do more to help. Things like opening the discount window to investment banks, not just commercial banks, and backing the first $30 billion of liabilities to help avert a Bear Stearns (BSC) bankruptcy are doing a great job in restoring confidence to the market. I would not be surprised to see them take another step and start buying mortgage backed securities from the likes of Fannie Mae (FNM) to ensure orderly markets for bonds backed by the U.S. government. Fannie bonds are trading well below par despite the fact that they have no default risk.

Do the Fed's recent actions mean we are completely out of the woods? Of course not. We have gained some footing over the last week or so by holding the closing lows of 1270 on the S&P 500. Even more positive, we are seeing the market react well to bad news, a good indicator that a lot of terrible news has already been priced into stock prices.

Even though JPMorgan (JPM) accounted for the gains (making the feat less impressive), the Dow finished up on Monday, the day the fifth largest investment bank narrowly avoided going belly up. Good news has been hard to come by, but today marks the second 400 point daily Dow gain since last week. Remember, since markets are forward-looking, news itself is far less important than the market's reaction to it. On that front things are looking up, at least for now, although we all know the trend can change on a dime.

Full Disclosure: No positions in BSC, FNM, or JPM at the time of writing

Jamie Dimon Steals Bear Stearns

As if JPMorgan Chase (JPM) CEO Jamie Dimon needed to prove himself anymore. The banking giant has already navigated these treacherous waters better than their competitors and now they find themselves in a unique position to be the best situated to take over Bear Stearns (BSC). With a well capitalized bank being the only logical choice for a takeover, JPM was really the only one with a balance sheet strong enough to get a deal done. Without any real alternative bidders, Dimon was able to avoid bidding against himself and named its price: $2 per share, or about half the value of Bear's NYC headquarters.

The Bear Stearns debacle, ending as an orderly liquidation, highlights how important management can be in determining a company's fate. While that seems obvious, it is not always easy to figure out ahead of time that Jamie Dimon is a great CEO and Jimmy Cayne was not. Many investors like to visit management and ask lots of questions of company executives, but that strategy alone fails to really give you an accurate read on management's capability. After all, company executives always will speak highly of their firm's prospects and obviously make the bullish case to investors whenever given the chance.

To shield yourself from management bias, you need to compare what a company says to what it ultimately does. JPMorgan Chase has delivered on their claim of manageable sub-prime losses. Bear Stearns said last week everything was fine and days later they needed a Fed/JPM duo to keep them out of bankruptcy. If companies you follow/invest in consistently deliver what they say they will, you should feel comfortable banking with them. If disappointments become commonplace, be sure to keep that in mind.

So where do we go from here? Well, the investment banks are still vulnerable. They rely on short term funding and their asset base is littered with illiquid, low quality assets. When clients and funders decide to halt business with a firm like Bear, it's game over. Remember, investment banks and deposit banks are not the same. Until the Fed's recent changes, investment banks did not have access to liquidity like the banks did. Although that will change now, the Fed is being forced to accept junk collateral. Companies like Bear made almost all their money on M&A deal fees and underwriting structured products. Those markets are dead, and there is not much else a company like Bear has to prop itself up.

Given recent events, should every financial stock simply be sold? Unfortunately, it's not that simple. As you can see, our markets aren't really "free" markets. Bear Stearns needed help, so the Fed guaranteed $30 billion of Bear's assets to entice JPM to take them under their wing. Whether it is tax rebate checks, Fed backstops, or mortgage bailouts, the government will step in and help curb the problems. As a result, the downside will never be as bad as the fundamentals would tell you they could be because intervention and workouts are always a possibility.

Full Disclosure: No positions in BSC or JPM

Update I (10:00AM CT):
BSC is trading between $4 and $5 per share today. Part of that is short covering and the other part is due to people speculating that someone could bid more than $2 for BSC. Don't count on it. JPM is a logical fit since they are the bank with the closest relationship with BSC. This is not about finding the highest bid. It's about finding the best partner for an orderly liquidation, since without the Fed/JPM plan, BSC goes under due to lack of financing. CNBC's David Faber also just mentioned that JPM has the option to buy the BSC building should investors vote against the $2 per share offer, so they could always just kick BSC out in such a case.

Update II (2:00pm CT):
Lots of talk today about how employees own 30% of BSC and have seen shares worth seven figures last week now worth five figures today, and how much of their net worth has been wiped out. Have we not learned anything from Enron and Worldcom? Did these employees really have the bulk of their net worth in one company's stock? If so, was it really unhedged? I definitely agree that it sucks that most of Bear's employees will lose their jobs, but if some of them had millions in BSC stock disappear overnight because of a lack of diversification and/or hedging, they need to take responsibility for that aspect of this meltdown.

Gift Idea

When I was growing up the gift option of choice was federal savings bonds. When I was old enough to be allowed to make my own financial decisions I promptly sold them and invested the proceeds in the stock market, where my long term inflation-adjusted returns would be much higher. Among both my high school and college graduation gifts were shares of stock and the returns from those have been impressive, but the advantages of such gifts often go beyond dollars and cents.

Garnering interest in the markets was never a problem with me, but that was clearly the exception. Giving children shares of stock not only gives them a valuable financial asset, but it also allows one to expand the financial education process with them at an early age. At some point (perhaps not at first depending on how old they are), recipients are going to ask what that framed share of Disney stock is, and at that point you can explain it to them. Such a conversation might, at the very least, start them toward a path of being very educated when it comes to the responsibility of managing their finances.

Pulse of the Housing Market

Given that the housing market malaise is the prime culprit for our economic and market adversity, I decided to post some charts showing key indicators such as delinquencies, foreclosures, and inventories. Sources for this data are Countrywide Financial (CFC), which has the nation's largest mortgage servicing portfolio ($1.48 trillion), and the National Association of Realtors, which tracks home sales.

First up, Countrywide's mortgage delinquency rates and pending foreclosure rates for the last twelve months:

As you can see, delinquency rates have stabilized the last few months, with foreclosures still headed higher, but not severely. While certainly a good sign, we can not call it a trend just yet. After all, last summer we saw a leveling off, only to see another spike shortly thereafter.

The next chart is home inventories, I believe a key proxy for the future direction of home prices. We will not see stabilizing home values (and eventual gains again) until we work through very high inventory levels. Typical inventories levels are about 50% below current levels.

Again we see a curtailment of rising inventories in recent months, but I still do not think we can call it a long lasting trend of stabilization as of yet, given that we will not pass the peak in ARM rate resets for the next quarter or two.

But let's assume for a moment that these indicators do stop getting worse in coming months. Does that mean the housing market will stabilize also? Probably not. Inventories need to come down. The only way we get that is to increase demand. With home buyers now needing the "trifecta" to get a mortgage loan application approved (good credit, proof of steady income, and money for a down payment), demand won't outstrip supply unless prices come down further to get qualified buyers to pull the trigger in greater numbers.

More on Chesapeake Energy

"madhatter" writes:

After reading your old post, I'm just curious as to why you personally like CHK out of the bunch? Based on fundamentals alone, it seems like DVN or SJT might be a better play on nat gas (even though I realize the latter is a trust). Does CHK have something that I'm missing? Because their fundies seem to put them in the middle of the pack as just 'average' in terms of nat gas players. Thanks for your thoughts.

I neglected to expand very much on Chesapeake Energy (CHK), since I've written about it before (to read prior posts simply do a search for "chesapeake" from the left sidebar of this blog), but it has been a while so let me go into more detail. Here are four main reasons for my bullish stance on CHK:

1) Chesapeake is the largest independent domestic natural gas producer

This is beneficial for several reasons. They have a very large, diversified asset base from which to grow production and reserves. When you are such a big player and have extensive experience drilling in different areas of the country, it gives you an advantage that should lead to very high success rates with future drilling programs. Also, it means Chesapeake would be an ideal acquisition target for one of the big oil giants at some point in the future if and when management decides to consider an exit strategy.

2) Industry leading production and reserve growth

Indeed, the numbers back up the points made above. Chesapeake's organic production and reserve replacement rates are among the highest in the large cap natural gas sector (they might be the highest, but I do not have data in front of me to prove that, so I will include the "among" qualifier). In 2007, CHK increased gas production by 24% over 2006 levels and the company's reserve replacement rate was a staggering 369%. Company guidance for 2008 is for 21% gas production growth, followed by another 13% in 2009.

I think you will be hard-pressed to find large natural gas producers that are posting organic growth rates much higher than that (clearly small firms can have large growth rates due to a small starting base). As a result of past growth and the expected continuation of it for the foreseeable future, I feel Chesapeake's fundamental outlook is as strong as, if not stronger than, the competition.

3) Extensive Hedging Program

Chesapeake has the most extensive gas hedging program in the industry. The company has 70% of 2008 gas production hedged, as well as 33% of 2009 production. I like the hedging program because it reduces the commodity price risk the company faces, so its earnings stream is very predictable. The gas market is very volatile, and as a result, Chesapeake doesn't get hurt too badly when prices fall, but when markets are strong (or weather patterns cause temporarily sharp increases in prices) the company steps in and increases its hedges to lock in high prices that might not be realized otherwise.

4) Superior Management, Insider Buying

CEO Aubrey McClendon has been one of the most aggressive insider buyers of his company's stock that I know of. Given his superb track record of producing strong financial results, this is not surprising. McClendon has long been singing the praises of his company's stock, but unlike most executives who do so, he has been putting his money where his mouth is (and he's been right). He is the largest individual shareholder in the company he co-founded. In 2008 alone he has purchased more than 1.63 million shares of CHK on the open market at prices between 35 and 46 per share. That is ~$70 million of his own money! Investors should feel comfortable that they are investing right alongside him. Plus, with such a large stake in the company, you can bet that when he wants to retire, the company will be up for sale to maximize shareholder value.


The reader mentions Devon Energy (DVN) and San Juan Basin Royalty Trust (SJT) as other, potentially more attractive natural gas plays. I am actually a big fan of Devon. However, it's not really a pure play on natural gas (they are 50/50 between gas and oil). If you are looking for a well balanced domestic energy exploration and production company, I agree DVN should be near the top of your list.

Royalty trusts are interesting plays, given their high yields, but they tend to be less geographically diversified and have less financial flexibility. SJT, for instance, focuses on New Mexico, so their asset base is not diversified and they are much smaller than Chesapeake.

Also, while the high dividends of trusts are attractive, they really do not allow company management to be flexible in how they grow the business. When you pay out most of your income out as a dividend, you don't have much capital available to grow faster organically or make acquisitions. Rather, you are forced to sell debt to raise money, which isn't always an ideal funding mechanism (like now when credit markets are shaky).

So those are my thoughts on Chesapeake. Although I am a big fan of the company, there are definitely plenty of very good energy companies from which to choose from. Do you have other favorites? Let us know which ones and why you prefer them!

Full Disclosure: Long shares of CHK at the time of writing

Natural Gas Update

In July of last year I wrote that the United States Natural Gas Fund ETF (UNG) looked ripe for gains after a 30% drop from $54 to $38 per share. In recent weeks natural gas has become a hot commodity, with prices hitting $10 last week, up from under $6 last year. UNG shares have jumped 25% to $47 each and I think some profit taking is in order. Long term I still like energy in general and gas specifically, but at this point I think owning hedged exploration and production stocks makes more sense than owning the gas ETF after such a large increase in underlying commodity price.

Which gas stock would I point readers toward? Long time readers will be bored with this company, but Chesapeake Energy (CHK) continues to be my favorite domestic natural gas stock (newer readers can refer to my September 2006 piece entitled An Attractive Entry Point For Chesapeake Energy). Like UNG, CHK too has risen sharply (from $29 to $44 since that bullish article), but they have the advantage of being able to hedge prices for their ever-growing production, so they will get hit much less than UNG during the next natural gas sell off, which will surely come despite the recent renewed enthusiasm for the commodity.

Full Disclosure: Long CHK at the time of writing

Browsing the Sale Rack for Technology

One of the great things about blogging about the market is that while I can't possibly buy every stock that looks attractive, I can post some ideas online and readers can make money if any of them spark their interest. With the technology sector among the worst performers so far in 2008, I thought I would present six stocks that look awfully cheap for long term investors who have no problem waiting out current economic conditions. All of these names have extraordinarily strong balance sheets, so there is even more value than the P/E ratios indicate. Feel free to make the case for any favorites you may have on this list.











Full Disclosure: Long DELL and MSFT but like the entire list to some degree

Differentiating Between Trading and Investing

John writes:

Hi Chad,

How do you differentiate between "trading" and "investing"? I'm always curious to hear what people think is the difference.

Thanks for the question, John. I don't think there is too much of a debate over the difference, and my views likely aren't much different than most, but I'm happy to give my personal thoughts on the topic.

The main difference between "trading" and "investing" is time horizon. Investors are long term players. They are investing in a business and are making an optimistic bet about the fundamentals of that business in the future. If they pay a reasonable price, and their analysis of the business prospects are correct, they will make money over time (regardless of overall market environment) because over the long term both valuation and earnings determine the value of a business, and thus the per share price of a company's stock.

Furthermore, since investors are willing to take a long term view (years rather than days, weeks, or even months) on an investment, they are likely to buy more shares as a stock drops in price. The main goal is to minimize one's cost basis in order to maximize profits over time. Temporary drops in share price aren't likely to change an investor's opinion of a stock's long term investment merit, unless of course the fundamental outlook changes in a meaningful way.

Conversely, traders are short term oriented. They tend to care very little about valuation or the long term earnings power of a business. Since they won't own the stock long enough for future business fundamentals to influence share price, they are more likely to use chart patterns and follow the momentum when buying stocks.

Since traders are more like speculators (making educated guesses as to short term price movements) than investors are, they are likely to use stop loss orders to limit downside risk. If a trade goes against them, they cut their losses quickly and look for other opportunities. Even if the market reaction in the short term is illogical and unsubstantiated, since they aren't willing to hold the stock long term and wait for the inefficient market to correct itself, they can not afford to wait things out until cooler heads prevail.

Here is an analogy for you; investors are the casinos, whereas traders are the gamblers. Investors have the odds stacked in their favor, just as the casinos are guaranteed winners over time because the games they offer have a win percentage built-in. Over time, the economy grows and corporate earnings grow, hence stock prices rise over long periods of time. Thus, investors (who by definition are long term players) have the odds stacked in their favor.

Traders, on the other hand, are trying to win big on short term trends, much like a blackjack player hopes for a hot shoe and then cashes out his/her chips. The gambler knows that they don't have a statistical advantage but they play nonetheless, trying to make some money and getting out before they give it all back. Now, I grant you that traders aren't at a statistical disadvantage, so the comparison isn't perfect, but whether or not the market goes up or down tomorrow is pretty much a coin flip, so traders' odds are about 50/50, although they try and boost those numbers with technical analysis, momentum trading, etc. Much like a trader's stop loss order will limit losses in the market, many gamblers will come to a casino with a certain amount in their wallets, to ensure they don't incur severe losses.

Casinos and investors know very well that in the short term they might lose money to a hot table or an analyst downgrade, but over time they feel comfortable because they know the odds are in their favor to make money. They are patient enough to wait for their payout, whether it comes from the 5% edge at the roulette table they operate, or long term earnings growth generated by a publicly traded company they have invested in.

Traders Bracing for Retest of January Lows

Regular readers of this blog know that I am a fundamental-based investor. As a result, over the long term the two key determinants of future stock price performance that I focus on are earnings and valuation. Although I strongly believe that technical analysis only works over short periods of time, in the absence of new material information, enough people read charts (especially traders, as opposed to investors) that they can predict near term market movements due to thousands of people acting on them in the same manner simultaneously.

I bring this up because when we got the huge leg down in January, which served as a short term bottom after the Fed temporarily rescued us with an emergency rate cut, traders were adamant that we did not see capitulation (Bernanke didn't let that happen) and would have to retest the lows after an oversold bounce. Sure enough, we got a bounce up toward 1,400 on the S&P 500, moved along in a narrow 1300-1400 band for a little while, and now are moving back down to the lows, as the chart below indicates.











Let's give the chartists credit for their call. Market bottoms often look like the letter "W" on a chart, a pattern I have noticed since I started following the markets. The next step is to see if we in fact retest the lows (we are a few points on the S&P away from the closing low of 1310 as I write this, but still a few percentage points away from the intra-day lows of 1270).

If we get a retest, followed by buying interest sparked by all those chartists salivating at a potential double bottom formation, we could certainly have another bounce in coming months. Depending on the economic and earnings picture at that point, it could very well give investors a chance to take some chips off the table. That is only one possible scenario, but it is the one bulls should be hoping for.

UPDATE: 12:20PM CT
The S&P 500's closing low was 1310.50 on January 22nd. Today the index hit an intra-day low of 1310.49 and has since bounced about 4 points.

Sifting Through Buffett's Annual Shareholder Letter

Warren Buffett's annual letter is always a good read and the recently released 2007 version is no different. There are a couple points that Buffett mentions this year that I think are worth pointing out and commenting on regarding the current market environment; corporate creditworthiness and sovereign wealth funds.

Buffett is often criticized for speaking out against the widespread use of derivatives and at the same time, initiating derivatives positions for Berkshire. However, just because certain derivatives are extremely risky and may pose a serious threat to our financial system, that does not mean that every single derivative contract is bad. There are many derivatives that do not use tons of leverage and pose little threat, and those are the ones Buffett is using.

In the letter, Buffett points out that Berkshire has entered into 94 derivative contracts which fall into two categories; credit default swaps and long term short put positions on several equity indices. The former is interesting because corporate credit spreads have widened dramatically recently, and investors are worried that default rates are set to spike in coming years.

Buffett has decided to insure bondholders against default over the next five years, and in return has received more than $3 billion in premiums for these contracts. He is betting that actual corporate defaults are less than the rates currently implied by the market prices of credit default swap contracts. Given that current prices are artificially high for credit protection, due to the unstable credit markets, the implied default rates right now are well above typical historical loss rates at the end of an economic cycle.

What does this mean to individual investors? It means that high yield bonds are extremely depressed right now and many smart investors are betting that the market for corporate debt has swung too far into the pessimistic camp. If you agree and believe that although earnings might fall in coming years for certain companies, they will still be able to repay their debt, then high yield bonds and credit protection are interesting areas for investment. Investors can play this two ways.

First, you can simply buy high yield corporate bonds or bond funds. High quality managers are salivating at some of the yields currently available in the corporate bond market and are more than willing to wait out this economic downturn, collect interest payments, and get repaid several years down the road if their financial analysis proves accurate.

You can also invest in a company like Primus Guaranty (PRS), a small publicly traded writer of credit default swap contracts. Essentially, Primus is doing exactly what Buffet has done, but they do it for a living. As credit spreads widen and premiums rise for selling credit protection, Primus will do more business at more lucrative prices.

Another point Buffett raises in his letter that I think is interesting is the rise of sovereign wealth funds. For those of you who are unfamiliar with the term, these are simply government owned investment funds of foreign countries. As the global economy has expanded and the developing world sees increased economic prosperity, foreign governments are flush with cash, and like anyone else in that situation, are looking for places to invest it.

As the world's biggest market, it is not surprising that the U.S. has seen China buy a 10% stake in the Blackstone (BX) IPO and Abu Dhabi invest in Citigroup (C). Of course, some on Capitol Hill are worried about foreign money being invested in U.S. companies. Although these are passive investments, and bring with them no control of operations, national security concerns are being voiced by many.

Buffett makes the point that this trend is largely the product of our own doing. The U.S. is racking up huge deficits, issuing debt to any foreign country who will buy it, and the resulting weak dollar is prompting foreign investors to invest in U.S. equities. They are simply diversifying their investment portfolio. After a while, you can only buy so much U.S. debt without getting a little worried about our country's financial health. Many U.S companies, although navigating through tough times, look more attractive than the government does for investment dollar allocations.

As a result, foreigners want to buy equities as well as bonds. Buffett points out we certainly can't blame them for buying stocks rather than more bonds. And it is much easier for them to do so now because so many financial institutions are trying to raise capital after sub-prime mortgage blunders. In my view, as long as these remain passive investments, we really can't complain. When operational decision making becomes as issue, as it was when an Abu Dhabi firm wanted to run our ports here in the U.S. (the deal was squashed), then it makes sense to talk about national security threats, but only when a real threat is apparent.

Full Disclosure: No positions in the companies mentioned at the time of writing