There is an interesting Barrons' article this weekend that highlights the difference between reported and operating earnings, including their overall effect on P/E ratios (which are used to make bull and bear cases). In a nutshell, operating earnings exclude write-offs, while reported earnings do not. In the past, the two were nearly the same for most companies, and certainly the market on average, but recently there has been a divergence given the level of housing and credit write-offs that companies are now taking. As reported in Barron's, with data from Comstock Partners:

"Reported earnings for the S&P 500 for 2007 were just over $66. The operating earnings for 2007 were $84.54. The estimated numbers for 2008 are about $69 for reported earnings and about $90 for operating earnings."

This of course will affect your view of whether we are in a bull or bear market, or somewhere in-between. The article goes on to mention how:

"If you are a bull, you will say that the market is trading at a very reasonable 16 multiple on the $89.44 of earnings in 2008 and 13 times the 2009 estimate of $110.44. On the other hand, if you are a bear or just a reasonable person you can see the market is trading at 24 times trailing earnings and about 21 times the estimate of 2008 reported earnings."

Given that markets tend to peak at P/E ratios around 20 and bottom at P/E ratios around 10, your earnings estimate, whether using operating or reported earnings, is important. Of additional interest is how earnings typically will only grow at about 6% per year over the long-term, a trend that reflects growth in real GDP plus inflation, with real GDP constrained on average by increases in the labor force and the level of productivity of those same labor force workers. When the earnings of the market rise above this 6% number, we see reversion to the mean. Given the current market multiples, it is expected that the market will not only go lower, but that it is likely to overshoot and fall below the 6% average trend line earnings, as it often does in corrections.

The old saying "Sell in May and Go Away" has not worked much in the last few years. Maybe this is the year we revert back to the actual mean ..... or meaning of the old saw.

A recent WSJ article highlights a commonly overlooked effect or consequence of commodity trading - that of bad hedging or speculation bets causing buying pressure, driving prices higher. As for speculators, we often assume that they are just following the short-term trend, which is currently up, adding further momentum buying pressure. Sometimes the buying pressure comes from speculators and hedgers that are simply exiting out of a bad past position, either due to margin calls, or simply because they can no longer take the pain.

Many producers entered into contracts to sell crude oil in the future, locking into higher prices for future delivery. While the future prices were higher than the spot price at the time the contract was written, some of the contact prices are now as little as half the current spot price, even for contracts with a delivery of less than one year. As a result, companies and traders are being forced to close these deals by buying back existing contracts that were wrote just months ago.

Longer-term trading has increased over they years, with Nymex oil futures contracts tripling over the last four years, with much of the growth coming from futures contracts that expire more than one year out. This form of long-term hedging and speculation was relatively rare in the past and is certainly contributing to some of the current increase in trading activity and price movement as these trades, which were probably not expected to be as speculative, are now needing to be unwound.

A recent Bloomberg article also discusses the impact of speculators selling out their contracts, but focuses more on short-term speculators that have recently closed out short positions after making bets that the price of crude oil would decrease after the recent run-up. The closing of these contracts has put further buying pressure on the commodity. As evidence, open interest has been falling for months. The CFTC list how "non-reportable" small-size speculators have been closing out their short positions, which were 47% higher than long positions. Any time you have a rising and shrinking market (open interest is decreasing, while prices are rising), it is usually a good indication that speculators are closing out positions and leaving the market.

As recently reported in a WSJ article, the International Energy Agency IEA is apparently preparing a downward revision of its oil-supply forecast. An analysis of the top 400 oil fields is expected to show that future supplies of crude oil will be tighter than previously thought. As seen in the WSJ chart below (source: IEA World Energy Outlook, 2007), a November 2007 analysis found that there needs to be 12.5 million barrels of oil added each day to keep the supply-demand balance in order out to 2015. Over the last 6 month the situation has probably stayed the same, at best, even with higher crude oil and gasoline prices.


While the IEA has predicted over the years a steady increase in supply to keep up with rising demand, even assuming the increases would continue out until 2030, there is now worry that the world will have a difficult time over the next two decades supplying a level of demand much above 100 million barrels a day. Demand is currently at about 87 million barrels, with supply about 85 million barrels. As of now, the lack of supply is being made up by some reduced demand (from higher prices), as well as pulling from inventories, but inventories will eventually be drawn-down too much and will be unable to make up the difference.

Many note that the data is always somewhat suspect. The IEA is funded by the oil consuming countries and is sometimes thought to be used as a way to encourage the countries flush in oil to supply more, thereby driving the price down for consumers. Furthermore, given that the major oil producing countries are secretive as to the real level of reserves left and available for production, it is also difficult to get an exact reading on the supply number.

Nonetheless, the hand-writing is on the wall, causing many firms on Wall Street to begin raising estimates for the price of crude (Goldman predicting $200 a barrel next year) as more data suggests that supply will not be able to keep up with demand. It looks like the volatility and movement in crude oil prices will continue until they reach a level where real demand destruction begins.

During a recent post I made a case for the steel stocks, along with a follow-up article. During the original article I mentioned how "steel companies themselves are also taking steps to reduce costs. This is becoming more of a worry as iron-ore prices have risen 71%, while prices for coking coal and scrap steel have more than doubled. To meet the problem head-on, some companies are attempting to purchase iron-ore mines, coal mines, and deposits, as well as hording scrap steel in an attempt to hedge against higher raw material prices."

We are now beginning to see more of this phenomenon being played out. ArcelorMittal (MT) has agreed to pay $631 million for a 14.9% stake in Macarthur Coal, a move that not only provides a source of coal for ArcelorMittal, but also makes it less likely that Macarthur will be taken over by Xstrata PLC. The purchase was made from two large shareholders agreeing to sell for $19.96 a share, or an 8.5% premium to Macarthur's last trade. Macarthur is the world's largest exporter of pulverized coal, the coking coal used when making steel. ArcelorMittal has traditionally purchased more than 20% of Macarthur's output. This move insures that ArcelorMittal can continue to receive this raw material. They has also recently signed new long-term contracts for iron ore and pellets with Vale, and a off-take agreement with Coal of Africa Limited.

To help possibly fund this stake and others, ArcelorMittal had recently completed the pricing of a $3 billion bond issue of 5 and 10 year notes. Interestingly, Nucor Corporation (NUE) just recently started a secondary offering of 25 million shares of common stock, and also plans to raise up to $1 billion in the debt capital markets. Press releases state that the secondary offering funds will be used for "general corporate purposes, including acquisitions, capital expenditures, working capital needs and repayment of debt." Don't be surprised if an acquisition or stake in a coal company ends up being considered by Nucor and other coal companies as coal prices continue to rise in price and the commodity becomes more in demand. Many steel companies are already considering similar secondaries and bond offerings to remain flexible for such moves.

As for coal companies, these stocks have also been doing well. Popular and widely held companies to begin looking at include Arch Coal (ACI), CONSOL Energy (CNX), Massey Energy (MEE), Alliance Resource Partners (ARLP), and Peabody Energy (BTU). Each have had nice runs this year. Other plays also exist. More about coal in a later post.

The WSJ has an interesting article that describes a situation of how even the best intentions for hedging risk do not always work out exactly how you had hoped. In an effort to stem the tide of losses resulting from bad real estate and leveraged loans, many firms on Wall Street began shorting vehicles that would allow them to profit as these markets collapsed. Unfortunately, tracking error raised its ugly head, and now many are finding that not only were they not getting close to 1-1 back ($1 loss in assets followed by a $1 gain in the hedge - often unrealistic, but a high goal nonetheless), many are getting much less, with a 70% efficiency being a relatively good recovery. To add insult to injury, some are finding that their assets are continuing to fall in price, even as the tracking index they shorted against has been rallying - causing a double loss on both the falling long asset and the rising short index.

It looks like the company with the worst hedges in place is Lehman Brothers, which is expected have write-downs on BOTH assets and ineffective hedges somewhere in the range of $1.5-2 billion. Morgan Stanley will have about half this amount of losses, with both Goldman Sachs and Merrill Lynch being less effected, so far - Goldman in particular has less real estate, but more leveraged loans than its competitors, and may eventually post some losses from these hedges.

As highlighted in the article, it looks like Wall Street has a long way to go in the area of risk management.

As recently reported in a Bloomberg article and elsewhere, the TED spread has been shrinking, and a number of analysts are stating this as evidence that the economy is getting back on firmer footing. While the spread does get mentioned when it starts spiking, and correcting, it is not as widely followed as some of the other more popular indicators.

In short, the TED spread is the difference between the yield on 3-month Treasury bill interest rates and the 3-month Libor. It was originally the spread between the 3-month Treasury contract and the 3-month Eurodollar contract represented by Libor before the CME quit offering T-bill futures contracts - thus giving the name TED (Treasury - Eurodollar) spread. The current quote is around 0.8. The normal range is usually between 0.1% and 0.5%. The spread has been over 2% on three different occasions in the last year, and has been elevated above it normal range since August of last year. The combination of investors looking for the safety of Treasuries (driving prices up and yields down), while incurring higher borrowing costs due to credit issues (driving 3 month Libor yields up), have increased the spread over the last year.

But now the spread is decreasing. Does this imply that all is clear in the economy? Maybe, but maybe not. A decreasing spread is a sign that liquidity is increasing, reflecting at least in part the success of the recent unconventional Federal Reserve actions to increase liquidity. The overnight Libor rate has dropped to around 2.11%, the lowest value in three and a half years. The 3-month rate has also declined to around 2.66%. Yet lenders still continue to hold cash, given that the Libor-OIS spread, the spread between the 3-month loans and the overnight indexed swap rate, is still around 0.66%, compared to an average rate of about 0.11%.

In fact, when you dig deeper, as discussed at the WSJ marketbeat blog, the recent narrowing of the TED spread is due mainly to an increase in T-bill yields which have risen by about 1.25% in the last few months. This has had a bigger impact than a drop in Libor, which has only fallen about 0.25% in the last month. As a result, traders are not as impressed, at least not quite yet. If the situation was reversed, where Libor was falling by 1.25%, this would imply that the liquidity issue and credit problems were abating, but this is not yet being indicated by the action in Libor. Instead, the T-bill supply is above average, putting pressure on prices and raising the yields, thereby lowering the spread. Things are improving, but it may still be too early to assume the credit and liquidity problems are behind us.

Reuters has an article this morning that continues the story we have recently discussed regarding rising steel prices. The story begins with a qualifier of how steel prices, currently around $1,100-$1,150 per ton, may drop to $800-$900 a ton in the near future, but will probably not fall back to the $400 a ton that was priced last year. Nonetheless, pricing power remains. ArcelorMittal (MT) raised prices by $186 per ton, a 20% increase, raising prices $40 to $60 per ton for June and July, and has notified customers to expect the same increases in August. AK Steel Holding (AKS) raised spot prices for carbon steel products $150 per ton. The CEO of U.S. Steel Corporation (X) sees flat-rolled steel prices in Q2 rising as much as $300 per ton higher, or 50% higher than the average Q1 price of $646 per ton.

Yet, not all analyst see blue skies. Peter Marcus of World Steel Dynamics believes that eventually steel makers will be unable to pass along raw material price increases, and that banks will begin refusing to finance inventories at these prices. Ironically, this may be a plus for U.S. steel makers since rising steel prices, and dollar issues, have made them more cost effective while making foreign imports less attractive. This is good news for U.S. steel. For additional information on U.S. companies, seekingalpha.com has a nice article written a few weeks ago by William Ellard that discusses a few of the smaller steel companies. It is worth a read. You can also check out my original article here or here.

As reported by the WSJ, Microsoft and Yahoo! are apparently talking again. In the statement provided by Microsoft, the company highlighted that it is "considering and has raised with Yahoo an alternative that would involve a transaction with Yahoo but not an acquisition of all of Yahoo." This is certainly a change of approach from the recent "take it or we will go hostile" strategy. Interesting indeed.

For Yahoo! this new discussion makes sense, given that it would allow Yang and the Board to potentially save face and give Yahoo! the strategic partnership it needs, while also maintaining control of their company (depending on the stake). For Microsoft, the motivations are less clear. In the short-term it does show that once again they are willing to negotiate, moving further away from the hostile disposition that did not go over well with some investors. As for strategy, it would make Yahoo! pullback on its talks with Google, at least in the short-term, as the potential partnership/merger between Microsoft and Yahoo! progresses. A partnership with Google was always an unwritten poison pill for Microsoft, and Yahoo! had certainly been playing its card. Whether Google wanted to partner or not really did not matter. It served both of their needs as it continued to distract each company while helping Yahoo! fend off a hostile takeover. If a deal with Google has fallen through (which some suspected after the Microsoft merger talks fell through), then it would also allow Yahoo! to save face, once again.

Still, on first read it is difficult to tell whether a merger or partnership would be better for Microsoft. A partnership would allow both companies to remain intact (for the most part), maintaining the two diverse corporate cultures. It may also prevent talent at both companies from bolting out the door, or Googling for jobs at, well, Google. Of course without a merger, Microsoft would certainly have less input on Yahoo! search and advertising, making integration slightly more difficult. The WSJ article also stated that the deal "... would involve Yahoo carrying search advertisements from Microsoft." This seems hard to believe considering how Yahoo! was testing and considering farming out aspects of its advertising to Google. This alone makes me think we have not heard, or are being told, the whole story.

How this will play out for each stock is yet to be seen. It really depends on the type and size of the deal, as well as how much control Yahoo! retains. Whether Icahn and numerous other investors and speculators will get paid is also yet to be seen. Any formal predictions on a final outcome? Not from me. At this point it seems foolish to predict that we might be near the end game when the game keeps changing.

We often hear a lot of discussion, and rightly so, about the prices of crude oil and the agricultural commodities. Their moves over the last year have in some cases been parabolic. Their effect on produced gasoline and food prices are also well documented. Less talked about, but increasingly visible and important is steel. Steel price are continuing to rise, with the alloy's average composite weighted price for all carbon-steel products around $1,000 per metric ton (see chart below, from the WSJ article, by way of MEPS International).


Stock prices of related steel companies have also seen a similar rise in the last few months. The SLX exchange traded fund (see below, chart from stockcharts.com) contains various industry companies that are weighted based on their exposure to the price of steel. The daily chart of the SLX has recently broken out over $100 and is in a nice uptrend. The weekly chart (not shown) has also recently broken out from resistance that was a little below the $90 price.


How are some of the big players in the industry holding up? In a word .... great. Below are the charts for US Steel (X), ArcelorMittal (MT), and Nucor (NUE). Many smaller, less well known players have similar looking price trends. As seen in the charts, the price patterns all look very similar, and also mimic the recent price pattern in the SLX, as to be expected.




While the charts certainly look nice, you have to wonder how long companies can continue to increase prices - not only in response to demand, which could decrease, but also with regard to raw material cost, which have been rising. Will costs get so high that demand destruction will occur? Will raw material cost increase faster than companies can increase product prices, thereby reducing profit margins? Both customers and companies are beginning to take action, but in some cases they are at the mercy of the markets.

In Turkey, a number of construction companies are going on strike, protesting price increases. In India, transportation and housing projects have been put on hold. Other countries are limiting the amount of steel that can leave the country as exports, while at the same time freezing prices and reducing tariffs to increase imports. Even oil companies are beginning to worry that they cannot build or obtain the equipment they need to extract the oil that is in such high demand.

Steel companies themselves are also taking steps to reduce costs. This is becoming more of a worry as iron-ore prices have risen 71%, while prices for coking coal and scrap steel have more than doubled. To meet the problem head-on, some companies are attempting to purchase iron-ore mines, coal mines, and deposits, as well as hording scrap steel in an attempt to hedge against higher raw material prices. Many are worried that the higher raw material costs, which are forcing them to raise their own prices, will in fact reduce demand as customers start looking for cheaper substitutes, such as aluminum and higher strength plastics.

As it turns out, all is not bad for the steel companies. Construction is still strong in many places outside the U.S., and demand for oil is causing a need for increased production for the capital assets used by the oil drilling, exploration, and services industries. Many of the oil service companies do not have an adequate supply of machinery to service their industry, and many of the machines they do have are wearing out and need to be replaced. This replacement cycle could take a number of years to unwind. Given the profits that crude oil companies are generating, it is likely that these companies will continue to spend to upgrade and add to their current assets. This of course is good news for the steel makers.

Car companies, another user of steel, also need to keep their supply up to meet international demand, yet they too are at the mercy of the steel makers. One such example is Toyota Motors, who is expected to agree to a steel sheet price hike exceeding 20,000 yen per ton from Nippon Steel. The demand is also not just coming from oil services, automotive, or commercial construction, but from all corners of the globe. This is even forcing changes within the industry. ArcelorMittal is set to increase prices for its flat carbon products that are sold in Europe. The Russian company OAO Severstal is buying the Ohio steelmaker WCI Steel. Nucor has applied for permits to build an iron-making facility in Louisiana that will produce 3 million tons/year of iron, and has reached a joint venture with Sidenor for the production and distribution of long steel products and plate in the Balkans, Turkey, Cyprus, and North Africa. The story goes on. The international growth and level of demand are exciting.

So what is an investor to do? While raw material cost are increasing for steel companies, they are currently able to raise steel prices to keep up with cost, and in some cases, raise steel prices beyond their current cost increases, generating higher profit margins. Given that demand is strong, and inventory levels are low, it is likely that demand will continue to stay strong for the near future, probably through this year and into 2009. The capital expenditures by the oil service companies, automotive industry, and aerospace industry (with its huge backlog) is also likely to keep demand steady, if not growing.

As for an entry point, it is always hard to buy right after a stock has run up so far and so fast, but looking at the charts of X, MT, and NUE, it is hard to argue that these stocks are not in a strong uptrend. Pullback are likely, but given the recent price action, global demand story, and current shortages, it is more likely than not that pullbacks to the uptrend line (but not breaking it) present buying opportunities, and not a reason to head for the exits.