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Beware of Investing When Illusion Replaces Reality

The stock market just keeps going higher. The voices of contrarians are being drowned by a chorus of analysts predicting endless growth. Does this sound familiar? If you were paying attention in the late 1990s you heard about how the stock market was now different and that old rules did not apply. Of course then the dot com bubble led to the dot com crash and a lot of money was lost. You would need be more than 100 years old to have been an investor when the market crashed in 1929 but there was the same unbridled optimism running up to the crash that ushered in the Great Depression. Seeking Alpha writes that stocks are in a 1929 style bubble and they quote the famous economist John Kenneth Galbraith from his book The Great Crash 1929.

The pages that follow tell of the greatest cycle of speculative boom and collapse in modern times – since, in fact, the South Sea Bubble. There is merit in keeping alive the memory of those days. For it is neither public regulation nor the improving moral tone of corporate promoters, brokers, customer’s men, market operators, bankers, and mutual fund managers which prevents these recurrent outbreaks and their aftermath. It is the recollection of how, on some past occasion, illusion replaced reality and people got rimmed.”

The basics of stock value do not change. In the short term a rising market will support lower P/E ratios due the expectation of growth. But growth never lasts forever and at some point those with profits will sell. Because the market is often a matter of follow the leader successive investors take profits as they begin to doubt the likelihood of continued growth. Just as the prophecy of unending growth begets a rising market the prophecy of lower growth compounded by big position sellers causes the market to correct or even crash. Beware of investing when illusion replaces reality.

What Should You Do?

Over the long term greed is a profit killer. Investors hang on in hopes of getting the last penny of profits out of a rising stock. The most successful long term investors like Warren Buffett are not market timers. They look at the big picture and buy or sell accordingly. If you have made money on the market rally it may be time to diversify your holdings. Diversify your investment portfolio.

Diversification is a means of reducing risk and increasing opportunity in investing. The chances of having a stock in your portfolio rise significantly in price goes up when you have five well-chosen stocks instead of one. The chances of losing all of your investment capital also go down when you diversify your investment portfolio among several stocks in several market sectors. Likewise, if a part of your investments is in property, a part is in stocks, a part is in bonds, and a part is in offshore investments you can reduce risk and increase the opportunity for profits.

This does not mean you need to sell all of your high tech winners but consider selling some of that part of your portfolio and holding cash, rolling a part into consumer stocks or even looking to European stocks.

Options Are an Option

If you really believe that the high tech FANG stocks you hold will keep going up you can always keep them but buy put options. This way you hold the stock and gain in the event of a continued rally and also preserve your gains if the stock suddenly corrects or crashes. Beware of investing when illusion replaces reality and make plans for protecting your investments.

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Is Fracking Technology Using Up the Last of the Oil?

Four years ago we wrote to invest in oil shale or rather companies that use fracking technology to extract oil and natural gas from these deposits.

We suggested that one look at investment in sustainable fracking technology. Recovery of petroleum from oil shale deposits has allowed the USA to reduce its reliance on foreign oil to the lowest level in more than twenty years. Today the USA imports forty percent of its oil, down from sixty percent just a few years ago. If predictions hold true the USA will continue to increase oil and gas production from fields in both the South and North of the country. All of this is possible because of the technology that allows oil and gas extraction from oil shale deposits. Before you decide to invest in oil shale consider just how to do it. There are exploration companies, drilling companies, big oil companies that refine and sell petroleum products, oil cleanup crews, and companies that make the robots that work a mile down in the sea to fix things. In short there are lots of ways to invest in oil shale and lots of profits to be made along the way.

And despite a supply glut and lower oil prices there are still companies making money by extracting oil and natural gas from oil shale formations. But, there may be a fly in the ointment. The easy supplies of gas and oil were extracted from US formations years ago. Now they are going after hard to extract resources using advanced technology. And they are working on what appear to be the last reserves. Investopedia wrote about this issue and says that oil stocks may gush big losses.

Fears that the Permian Basin is drying up sooner than anticipated has sent the stocks of major U.S. oil producers tumbling. Concerns over America’s fastest-growing oil field, where almost half of the rigs currently drilling in the U.S. are located, arose as one of the Basin’s major players unveiled some disconcerting news at the beginning of this month.

The news is that oil wells in the Permian Basin are producing higher and higher percentages of natural gas and propane and lower percentages of oil. This typically happens as the reserves in an oil field are running out. Companies whose stocks were hit by this news were Pioneer Natural Resources Co. (PXD) whose earnings report contained this information and both Parsley Energy Inc. (PE) and Concho Resources Inc. (CXO) which are also major players in the Permian. Is fracking technology using up the last of the oil? If so this is a major blow to investors in fracking operations. That is because this is a higher tech and more expensive way to recover oil and natural gas and thus these wells need to have a decent life expectancy in order to eventually turn a profit. If these were the only supplies in the world the law of supply and demand would kick in and drive the price up as supplies dwindled. But there is currently a worldwide oil glut and lots of producers waiting in line to sell oil even at today’s low prices. When to buy oil stocks is when prices are down and in advance of a greater demand for oil. But if fracking technology is using up the last of the oil investors need to be careful which companies they buy based on their prospects for recovering oil into the long term future.

Is Fracking Technology Using Up the Last of the Oil? DOC

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As the North Korea Situation Escalates What Should You Buy and What Should You Sell?

Tension is increasing on the Korean peninsula as North Korea races to perfect nuclear arms and the means to deliver them by missile as far away as the United States. As the North Korea situation escalates what should you buy and what should you sell? First a little background.

What Is Going On in Korea?

Ever since the Korean War fighting ended with an armistice in 1953 troops have lined both sides of the demilitarized zone, ready to resume combat. Meanwhile the South has become a democratic country with an advanced economy. The North has remained under dictatorial rule of the same family unwilling to share power and fearful of overthrow. Their goal has been to build such a powerful military deterrent that their family would be safe to rule the north forever. That goal has advanced to the development of nuclear bombs and the missiles to deliver them.

Successive US presidents have stated that North Korea will never be allowed to accomplish that task but no one has moved beyond talks and sanctions. The problem is that for a small country North Korea has a large army and long range cannons as well as rockets aimed at Seoul, the capital of South Korea and the ability to strike other neighbors such as Japan. North Korea would certainly lose in the event of a full scale war. But no one has risked military strikes to knock out their missile and nuclear production facilities for fear that their apparently crazy leader would be willing to go down in flames rather than give up dictatorial power that his family has had over the country since the middle of the last century. But now North Korea is on the verge of accomplishing its goal and there is the possibility that the USA will intervene militarily to prevent that from happening. As these events play out what should you do with your investments?

Defense Stocks

As the winds of war blow defense stocks are always a good bet.

As many US defense contractors only devote a small part of their business to defense an investor who believes that the nature of the world and the US response will always reward defense stocks will want to stick with companies that are largely if not primarily defense contractors. However, when investing in defense stocks there are different types of stock. Northrop Grumman, for example, is the world’s largest builder of naval vessels whereas Raytheon Company is the world’s largest producer of guided missiles and Boeing not only provides the military with many aerospace products and services but was the contractor for maintaining the Space Shuttle fleet. A smaller company such as L-3 Communications holdings provides primarily technical expertise and very high tech products involved in intelligence gathering and, more importantly, processing. The big names in defense are the kings of a high cost of entry business and primarily compete among themselves for large government contracts.

And if a real war breaks out, how will that affect the economy and stocks in general. We have a hint as global markets wobble following Trump’s fire and fury comment. CNN reports the story.

Major European and Asian indexes dropped Wednesday after Trump ratcheted up the war of words with Kim Jong Un’s regime, saying it will “face fire and fury like the world has never seen” if it keeps threatening the United States.

If real fighting breaks out it will be devastating and stocks will fall across the world. Those who have profited from the current rally may wish to buy puts to protect their positions or simply take some money off the table and hold cash. And, of course, gold prices are up and will remain there until this situation is resolved. If you want to retreat to gold read our article about gold investments.

As the North Korea Situation Escalates What Should You Buy and What Should You Sell? DOC

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Time to Reallocate Your Investments as Trump Agenda Weakens

You may have been one of the lucky ones who jumped into the market with both feet the day after Donald Trump was elected president. If so you have probably made money. Investors were excited about the prospect of economic stimulus from infrastructure spending, lower taxes, deregulation and a mountain of offshore corporate cash coming back home. After spiking downward the night of the election the S&P 500 has gone up 400 points or 20%. And if you picked your stocks well you have done even better. But, it is apparent that despite lots of hype that the Republican president and Republican congress are 1) not getting much done and 2) unwilling to work across the aisle to negotiate, pass legislation and govern effectively. Thus the Trump trade is fading. CNBC reports what one billionaire hedge fund manager is doing about it.

Third Point, the hedge fund managed by billionaire Dan Loeb, said it reduced investments in the “fading ‘Trump Trade'” during the second quarter, according to an investor letter obtained by CNBC.

The firm is instead repositioning the portfolio toward investments in companies that “benefit from low inflation,” the letter said.

Third Point reduced investments in bank financials and exited reflationary macro trades. The firm also has been lowering its exposure to credit strategies.

While in a previous letter Third Point said 2017 would be characterized by the Trump administration’s push for increased fiscal spending and tax reform, neither has yet to play out.

Companies with lots of cash are waiting to see what happens in Washington. This hedge fund manager has decided to reallocate his investments as the Trump agenda weakens.

Focus on a Weak Dollar

The focus for investors has shifted from benefits of Trumpism to the fact that the dollar is weak and getting weaker. CNN Money about how the US dollar has plunged during the Trump presidency.

The greenback has been shut out of the summer party on Wall Street. Just as the Dow cruised above 22,000 on Wednesday, the dollar tumbled to a 15-month low against its rival currencies.

That’s not all bad: The weaker dollar has helped power stocks to record highs, and it helps American companies make money overseas.

But the conflicting messages from the currency and stock markets are dramatic, especially considering that the dollar initially spiked after Trump’s victory. His promises of big tax cuts, infrastructure spending and deregulation sent it to a 14-year high in January.

Everyone believed that having the same party holding power in the both houses of congress as well as the presidency was a recipe for jump starting the economy and driving the dollar as well as stocks sky high. The stock market has rallied despite an inept congress and bumbling president but the dollar has gone into reverse. There is no clear path to fixing any of this so investors will be well served by reallocating their investments to focus on the demise of the Trump agenda and a weakening dollar.

Time to Reallocate Your Investments as Trump Agenda Weakens DOC

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Are Banks Ready to Break Out?

Hopes of deregulation are part of why financial stocks are up. And investors may be moving some money out of an overvalued tech sector. The bottom line is that US bank stocks hit a post-crisis high according to The Financial Times.

US financial stocks closed at the highest level in nearly 10 years on Tuesday as hopes for deregulation of banks grow and investors ditch technology stocks for the previously unloved banking sector.

Shares of some of the country’s largest lenders, including Citigroup, Bank of America and JPMorgan, climbed more than 1 per cent on Tuesday, pushing the S&P 500 financial index to 419.54 – a level it last touched in December 2007 before the financial crisis had fully taken hold.

The gains came ahead of a move by the Office of the Comptroller of the Currency, which oversees national banks, to start the process of amending the Volcker rule, which bans banks from speculating with their own capital. On Wednesday, the OCC will formally seek public comment from banks and others on how the rule is working, people familiar with its plans told the Financial Times.

Banks passed the Federal Reserve stress test in June and since that time have outperformed the broader stock market. Interest rates are not going up all that fast which would normally put a damper on financial stocks but the promise of deregulation has raised these stocks. So, are bank stocks ready to break out?

Upside Potential

Both Barron’s and Investor Place argue that banks have a lot of upside potential. Their arguments are based on the deregulation argument. Does that translate to higher intrinsic stock value? If you think that financial stocks will break out for a year or so you will plan on investing short term and if you believe that their return on equity invested will continue over the years due to the benefits of deregulation then you will be in for the long haul. But, why is there deregulation in the first place. Weren’t there problems that nearly demolished the US and global economy? If congress and the president go ahead with deregulation will there be problems again down the road?

Why Are Banks Regulated?

The Federal Reserve Bank of St. Louis posts an article, Why Are Banks Regulated?

Banking regulation has existed in some form since the chartering of banks and its goals have evolved over time. Today, banking regulation serves four main purposes.

Financial Stability: Instability in the financial system can have material ripple effects into other parts of the domestic and international financial sectors. Supervision that is focused on financial stability (often called macro-prudential supervision) looks at trends and analyzes the likelihood for financial contagion and the possible impacts across firms that pose systemic risks.

Protection of the Federal Deposit Insurance Fund: Since Jan. 1, 1934, the Federal Deposit Insurance Corp. has insured the deposits held in U.S. banks up to a defined amount (currently $250,000 per depositor per bank). The federal government serves as a backstop to the insurance fund.

In exchange for this insurance guarantee, banks pay an insurance premium and are also subject to safety and soundness examinations by state and/or federal regulators.

Consumer Protection: Since the creation of the Federal Trade Commission in 1914, the federal government has had a formal obligation to protect consumers across industries. Since that time, numerous laws and regulations have been crafted by various agencies to protect bank customers and promote fair and equal access to credit.

Competition: A competitive banking system is a healthy banking system. Banking regulators actively monitor U.S. banking markets for competitiveness and can deny bank mergers that would negatively affect the availability and pricing of banking services.

One only needs to remember the fraudulent lending practices that preceded the 2008 financial meltdown to hope that any deregulation is done carefully and oversight is maintained. Banks may indeed breakout to much higher levels if substantial deregulation occurs but investors will be wise to pay attention to the health of banks and the economy thereafter.

Are Banks Ready to Break Out? DOC

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Do Technical Signs Predict a Crash?

The stock market keeps going up despite what would appear to be overpriced stocks. But eventually every rally ends, sometimes with bang and sometimes with a whimper. Market Watch writes that a technical flag indicates the market may just have entered a danger zone.

The S&P 500 keeps closing just short of a critical level in the high 2400 range. This is similar to what happened going up to the 2000 dot com crash and the 2007 crash that ushered in the Great Recession.

This is investing via technical indicators. And if you are buying into an index fund that tracks the S&P 500 you may want to pay attention and even convert some of your market gains into cash. But another view is that fundamentals in the form of higher earnings are what are driving the market higher. CNBC calls this a melt up that could push stocks to new records.

Veteran market watcher Edward Yardeni believes investors who succumb to stock market jitters could miss out on another wave of big gains.

Yardeni noted the most recent record highs for the Dow Jones, Nasdaq and S&P 500 indices aren’t being driven by a surge in valuation multiples. Rather he says the activity is “more like a melt-up in earnings.” And, that’s a bullish sign for the rally.

“The fundamentals are just cranking along at a decent pace here. Earnings are doing remarkably well given that the economic data looks kind of slow. But somehow or another, companies are generating good revenues and good earnings. I think that’s because the global economy is doing reasonably well.

When there is money to invest it will go somewhere. Investors like safety and they like the prospects of growth as well as dividends. Because it is easier to get reliable information about the US stock market than markets outside of the USA investors stick with the NYSE and NASDAQ. The fact that stocks have been going up does not hurt either. But, as we said in the beginning every rally comes to an end. Will this one just level out on a higher plateau or will it overshoot and collapse?

A Rude Awakening?

Business Insider writes that there are huge warning signs that investors should pay attention to.

To a growing chorus of strategists and investors across Wall Street, the stock market looks like it’s headed for a rude awakening.

Their mounting pessimism comes at a time when US equities are looking healthy, at least on the surface.

Their concern stems from a lack of volatility.

Baupost Group, a $30 billion fund, recently highlighted the lack of price swings as a harbinger of pain to come, calling it a possible “accelerant for the next financial crisis.” Meanwhile, Highfields Capital Management, which oversees $13 billion, said this past week that low volatility is giving people the false impression that the market is risk-free.

Other analysts are simply concerned about the continued and perhaps excessive optimism of those who are still throwing money at the market. Perhaps it is time to consider Buffett’s advice to be greedy when others are fearful and fearful when others are greedy.

Do Technical Signs Predict a Crash? DOC

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Are Coal Companies a Good Contrarian Bet?

Despite the conversion of many electric plants to natural gas and away from coal, the USA still consumed 800 million tons of coal in 2015, the last year for which totals are available. We wrote recently about the bleak future of coal.

Electric companies have been switching plants from coal to natural gas and closing coal plants. Big consumers like GM and Toyota insist on clean energy and won’t use coal even if environmental regulations are relaxed. That is the bleak future of coal.

Peabody Energy is the largest coal producer in the USA as well as in Australia. The stock sold for $27 a share in 2013 and then steadily fell down to $2. It spiked briefly in late 2015 to $24 and then fell again. The company entered bankruptcy in early 2016.

That having been said the market currently prices coal stocks accordingly. Considering all the negativity with coal, are coal companies a good contrarian bet? Market Watch refers to coal stocks as the ultimate contrarian bet.

“Coal-mining companies are among the most out-of-favor companies in the stock market today,” says George Putnam. “As contrarian investments, these stocks have real appeal.”

First, coal stocks look darn cheap. “Prospects are not nearly as grim as most investors believe,” says Putnam. So the stocks now trade at “enticing” valuations. All of the six coal companies he suggests, below, trade either below book value or for price-to-earnings (P/E) ratios of 8 or less. The benchmark S&P 500 Index’s P/E ratio SPX, +0.14% is about three times higher.

Next, since many coal companies have gone through bankruptcy, they’ve shed debt. “Coal companies are healthier now than they’ve been in a long time,” says Putnam. Stronger balance sheets and lower interest payments enable them to produce better earnings, pay regular dividends and special dividends, and use cash flow to buy back stock. This is one reason why Eric Green, director of research at Penn Capital, owns Arch Coal Inc. ARCH, +1.38% on behalf of his investors.

These are the coal companies that he is talking about.

  • Arch Coal Inc., emerged from bankruptcy in October 2016
  • Peabody Energy Corp., emerged from bankruptcy in April 2017
  • Alliance Resource Partners LP, avoided bankruptcy
  • Foresight Energy LP, avoided bankruptcy
  • CNX Coal Resources LP, majority owner is a natural gas company
  • Cloud Peak Energy Inc, produces low sulfur content coal but has quite a bit of debt

Warren Buffett started in the stock market by purchasing companies that were doing poorly but could be reorganized and made more profitable for a short term thus increasing their share price and providing Buffett with profits. This was referred to as getting one more puff out of the cigar. There is no question that coal as it is now used is not going to make a huge comeback. But the USA and the rest of the world need energy and there will always be a place for coal. And, as technology advances, coal may become a cleaner way to generate energy. The point is that considering their extremely low prices coal companies may be a good contrarian bet for the near future.

Are Coal Companies a Good Contrarian Bet? DOC

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Are Coal Companies a Good Contrarian Bet? PPT

Three Potential Black Swans

Despite concerns about stocks being overpriced the markets keep going higher and higher. And that means stocks all over the world are going up. Every time this sort of market euphoria occurs it is eventually followed by a day or reckoning. Market Watch writes that the recent breakout in stocks should not be trusted and cites three potential black swans. Black swans, by the way, are unpredictable or unforeseen events. They discuss this issue after nine global stock indexes have topped out at the same time.

There have been 39 times when each of those nine indexes has closed at multiyear highs at the same time, according to Lyons. On several of those occasions, we saw the market top out and retreat.

Will this be another one of those times? Obviously, Friday’s session showed some weakness, though the damage was slight. This week, the Fed and a full calendar of earnings will play a part in where investors take the market from here. The IMF got the ball rolling Monday with a downgrade of U.S. economic growth forecasts, which could dent stocks in the early going.

Putting technical analysis aside, our call of the day (see below) paints a pretty unsettling picture of what’s to come for this relentless market. But so far, investors don’t appear to be all that concerned.

The three potential black swans that they are concerned about are these.

Yellen overshoots, hiking rates too much and too soon
The European Central Bank runs out of bullets
China experiences a debt meltdown

One thinks back especially to the period before the dot com crash when conventional wisdom was brushed aside and people bought anything with .com in the name. It was argued that the nature of the market had changed and stocks would simply go up forever. There is some evidence of the same sort of thinking before the 1929 crash that ushered in the Great Depression. But this is not an isolated opinion. CNBC writes about two big forces that could affect the market come August.

While the overall breadth of the market has been sturdy, with more stocks rising than falling on a consistent basis, sectors have moved in and out of leadership in a kind of “immaculate rotation” that has refreshed and supported the broad indexes while keeping strong segments from getting over-extended and preventing weak areas from buckling the tape.

This has been the market’s character and will remain so until these patterns shift. The market, for many investors, has been too quiet to trust fully, yet too strong to fight with much conviction.

They argue that August is historically a tough time for stocks and note that the sort of complacency that goes with a continued bull market is likely to keep investors in the market even when warning signs suggest pulling out some cash. That being the case, when the market does correct there could be a monumental rush for the exits which would magnify losses and convert a correction into a crash. Beware of the three potential black swans.

Three Potential Black Swans DOC

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What Investments Do You Want to Own Next Year?

When you follow stocks in the news there is an element of breathless melodrama. Nellie has been kidnapped and is tied to the train tracks. The train is coming. Will the hero get there in time? One moment the answer is yes and the next moment it is no. If you fall for the melodrama of stock reporting you are caught in a gut wrenching never-never land of worry about next month, next week or even tomorrow. A healthy alternative is to pick investments based on a longer term view. What investments do you want to own next year and for years to come? Business Insider writes about recommendations from Morgan Stanley for stocks to own in 2018. These are based on expected performance over at least the next two years. Here are the first dozen on their list.

  • Alexion Pharmaceuticals (AXLN), Current price: $126, Target price: $141
  • Bank of America (BAC), Current price: $24, Target price: $26
  • Cisco Systems, Current price: $31, Target price: $39
  • Citigroup, Current price: $67, Target price: $73
  • Constellation Brands (STZ), Current price: $197, Target price: $218
  • HP Inc. (HPQ), Current price: $18, Target price: $23
  • Jack in the Box Inc. (JACK), Current price: $96, Target price: $126
  • Johnson Controls (JCI), Current price: $44, Target price: $51
  • Schlumberger (SLB), Current price: $67, Target price: $90
  • T-Mobile (TMUS), Current price: $61, Target price: $72
  • Viacom (VIAB), Current price: $35, Target price: $48
  • DXC Technology (DXC), Current price: $78, Target price: $85

Read the article for the rest of list. Last year’s list came in with an 11.38% return which was one percent less than the S&P 500. The point is to pick solid investments which follow Buffett’s rules of investing one and two, both of which are not to lose money. How can you pick stocks that are likely to at least hold their value and more likely appreciate with perhaps a dividend thrown in? Pick stocks where you know how the company makes money and will continue to do so into the longer term future. And learn to do the intrinsic stock value calculation to pick stocks to buy, hold or sell.

Does It Have a Viable Business Plan?

When a new technology emerges it can cause spectacular profits. And when the next technology comes along the first can be relegated to the dust bin of history. A famous example of a business plan that died due to changes in technology is Eastman Kodak. They invented the personal camera and were the king of film until digital came along and demolished their business plan. Understanding how a company makes money and how it will continue to do so is critical to knowing what investments you want to own next year and beyond.

Intrinsic Value

To know what investments you want to own next year you need to pick companies where you have a clear idea about their future cash flow. Then you can calculate intrinsic stock value. The end goal is to determine the relative Graham value which is the intrinsic value divided by the current stock price. When the value is greater than one the stock will likely hold its value or go up in price. Thus it is a buy or hold. If the opposite is the case this is not stock that you want to be owning next year.

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