Agora Financial’s Rude Awakening

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Laguna Beach, California

• Where to put your money when more dollars means higher prices,
• The new Group Rude Research Project – a chance to voice your own ideas,
• When demand dries up quicker than an actor in rehab and more… 

Eric Fry, reporting from Laguna Beach, California…

In the early days of the Rude Awakening, your editors conducted several “Group Research Projects.” During these projects, we asked you, the Rude Awakening faithful, to share investment ideas that might capitalize upon a specific trend or opportunity.

In the very first Group research Project, for example, we solicited the names of gold mining companies that might be acquired. In another project, we asked for the names of your favorite oil and gas companies. In another, we compiled a list of your favorite alternative energy companies.

Admittedly, some of these research projects produced better ideas than others. But the exercise always seemed worthwhile, even if the results sometimes left something to be desired. So we think the time has arrived to conduct a brand new research project. Specifically, we’d like every Rude reader who cares to respond to offer a “housing bust pair trade.”

In other words, if the housing bust continues busting and the economy continues slowing, which companies might win and which companies might lose? The housing bust is already well-advanced, of course. So the best pair trades might have already occurred. But we suspect that good pair trades might still remain. To illustrate the types of pair trades that would be of interest, we would refer you to an uncannily prescient edition of the Rude Awakening. On October 3, 2006, we published a Rude Awakening entitled, Buy Spam, Sell Frappuccinos.

Within that column we cited Stephanie Pomboy’s recommendation to “Buy Hormel, Sell Starbucks.” And we also cited the reasons why. “Ms. Pomboy offers up this quirky pair trade,” we wrote, “as a way to play the housing-induced consumer-spending slump. Now that home prices are falling, she reasons, American consumers will not only feel poorer, they will also lose access to the home-equity lines that have been fueling their consumption. As a result, they will become less inclined to buy $5 espresso drinks, and more inclined to buy low-cost foods of various types.”

In the same edition of the Rude Awakening, your editor suggested his own housing-bust pair trade: Sell Countrywide Financial (NYSE: CFC)/Buy California Water Services (NYSE: CWT). “Demand for new mortgages is drying up faster than a movie star in rehab,” your editor observed at the time. “At the same time, delinquencies and defaults are increasing on the trillions of dollars of mortgages that the lenders still hold on their books…

“Countrywide is the largest mortgage lender west of the Mississippi,” he continued. “California Water is the largest water utility west of the Mississippi. But the similarities end there.

“At 24 times forward earnings, CWT would not likely dazzle any value investors. And yet, we would consider CWT a better value than CFC, a stock that sells for a mere 8 times earnings. Why would we shun the statistically cheap CFC in favor of the pricey CWT? In a word, ‘drought’ – a mortgage-lending drought, that is. As the housing bust continues busting, the ‘E’ component of CFC’s PE ratio will atrophy, if not disappear entirely. The housing boom is over…and we suspect the bust will last a very long time.

Coincidentally, ‘a long time’ is also the likely duration of demand for water in California. Water may not be sexy…but it is very profitable.”

Lo and behold, these hypothetical pair trades worked out quite nicely, as the nearby charts clearly illustrate. We got lucky. We admit it. But maybe we’ll get lucky twice…with your ideas. So if you’ve got a pair trade that you think might deliver the goods, please share it with your fellow Rude readers.

In the meantime, our colleague, Chris Hancock, offers his own version of a housing-bust pair trade in the column below.

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Sell the iPods and Buy the Band-Aids!
By Christopher Hancock

The “next big thing” our friends at The Daily Reckoning opine, “will be downsizing, cutting back, making do. Barely on the radar screen now, thrift is coming into focus more clearly day by day. So far, people are a bit embarrassed about it…a bit ashamed that they have had to cut back. But soon, it will be popular…fashionable…and, finally, almost obligatory.”

Hmm…”Prices are rising in Europe as in America. Bread is up 12% in Germany over the last 12 months. Butter has gone up 45%. Milk, 25%.”

Higher prices often stem from printing more dollars. “Force-feeding the rest of the world $2 billion per day (more consumption),” Warren Buffett reminded us recently, “is inconsistent with a stable dollar (more inflation).”We share Mr. Buffett’s concern. Bernanke keeps printing. Politicians keep promising. Bridges keep crumbling. The four branches of the military keep spending.

With regret, we read last week that the projected total cost of medical care for U.S. veterans of the Iraq and Afghanistan wars will top $500 billion, a figure on par with the total military spending to wage these wars to date.And speaking of military might, Defense Secretary Robert Gates estimated in
testimony before the Senate Armed Services Committee that the Pentagon will spend upwards of $685 billion next year alone. That’s $170 billion more than the $515 billion the president proposed in his first-ever $3 trillion budget.

If that weren’t enough, Gates doesn’t even expect that number to stick. “I have no confidence in that figure,” he admitted. You can expect the estimate to rise in the near future.

A hundred billion here…a hundred billion there. Who’s counting?

Apparently, no one.

But that’s not to say the S&P can’t weather the storm. The companies representing the Standard & Poor’s 500 index now derive 49% of revenue from foreign markets, up from 30% in 2001. Meaning, those folks with money to burn (Southeast Asian consumers) should keep earnings reports strong. Stronger repatriated currencies should only bolster this trend.

Unfortunately, many Americans believe a strong S&P equals a strong American economy. We tend to see another American economy. We see an economy riddled with debt, more debt and even more debt. We see the American consumer eerily close to tapping out. Thirty-four percent of Americans now believe they are among the “have-nots.”

It serves to reason. More than 405,000 homeowners lost their homes to foreclosure last year.

Most middle-income Americans, the ones driving our buy-now, pay-later economy, have spent well beyond their means. Americans currently perpetuate a negative savings rate. That can’t last forever.

Cheap oil and cheap credit have fueled this era of consumption…this gilded age of instant gratification.

But the days of ultra-cheap oil are firmly behind us. “The U.S. Navy, for example,” says our oilman Byron King, “is currently designing future ships using $225 per barrel as a baseline for the price of fossil fuel. The days of ultra-cheap credit look to be waning, as well.

The endgame: Americans will be forced to consume less and less. It seems to us that cutbacks are the only option.

So investors should be very cautious on stocks that rely on American consumers. We suggest you take special note to exercise caution regarding companies like Apple Computer, Starbucks or P.F. Chang’s.

We have no particular prejudice against any particular one of those companies. In fact, we could have easily picked three different businesses.

Simply put, if John Q. Public lost his house and credit card, we imagine he’d use his last $20 to buy toilet paper, Folgers and a pack of smokes well before he made another dinner reservation on his 2008 iMac while sipping a $3 cup of joe. Furthermore, these companies aren’t cheap.

As for what to buy, ask yourself: What companies can raise prices in this environment?

Think of things you need. Beer and cigarettes come to mind. Well, you may not need these items, but I’ll use them to illustrate a point.

When’s the last time you actually looked at the price of one beer versus another? I’m not talking Heineken versus Pabst Blue Ribbon, mind you. I’m talking about Heineken versus Corona…or Bud Light versus Miller Lite. Customers in this sector buy on preference.

One could make the same case for shampoo and bandages. The point: When times are tight, we’ll still continue (hopefully) washing our hair and staunching our wounds.

You also want to ask yourself: Can a business control its basic costs? When grain, beef and poultry prices are surging, can P.F. Chang’s easily pass on its input costs (higher meat prices) to a cash-strapped consumer? Will margins suffer?

You get the idea. So for those readers blindly loyal to the American economy, we believe the best American equities right now are top-quality blue chip stocks that provide staples to the American and foreign consumer. Stocks like Exxon, Johnson & Johnson and the Altria Group come to mind.

Which stocks come to your mind?

[Joel's Note: Er…seriously. Which stocks come to your mind?

Now that you’ve read a few ideas about how one might profit from the coming housing/consumer spending-bust, we like to hear from you, the faithful readers of the Rude Awakening.

If you’ve got an idea about how to secure a personal economic upturn during the broader economic downturn, please fill us in.

Specifically, we’d like to hear your suggestions for a “housing bust” pair trade. Pick one stock to sell short and one stock to buy, as a way of benefiting either from the housing slowdown or the consumer spending slowdown…or both.

Send your Rude Housing Bust Pair Trades to the address below.

Until next week…

Cheers,

Joel Bowman
Rude Awakening

aussiejoel@the-rude-awakening.com