Talk about getting kicked when you're down! Did we really need another hurricane? Rita's damage is still being assessed, but the energy boys have sure been having a good old time gunning the price of oil and natural gas.
With nat gas hitting intra day highs of $13 and oil seeing the high 60's, the brainiacs in DC have pulled out their trusty slide-rules and have started floating talk of price controls and 'windfall' taxes against energy companies.
First of all, this is America, not socialist Europe. We do not penalize people for making a lot of money. Someone needs to remind the politicians of that one. Where were they when the oil industry was getting decimated by $10/bl oil in 1998? The survivors of that bear market have earned every penny in profit that they are now making. But let's put all that aside for a moment and examine the economic side of it.
Any attempt to initiate price controls or punitive (what I call 'shake down') taxes will be absolutely disastrous and will have the exact opposite effect. That is, they will lengthen this bull market in energy and drive prices even higher.
Every commodity boom carries within it the seed of its own destruction; higher prices lead to overdevelopment of capacity which ultimately leads to lower prices. The way to lower prices is to incentivize INCREASED PRODUCTION. Price controls and windfall taxes simply PROLONG commodity price booms, because you remove the profit motive needed to entice greater exploration and the entry of new players to the space.
It's basic supply and demand, and as such governments need to ask themselves, 'How do we encourage greater energy exploration and production?'
You want to see sparks fly? Provide MASSIVE tax breaks that are linked to increased energy exploration and production, and you will see energy prices TANK!!! Of course that will never happen. It would be political suicide, and I also think that the E&P majors would be completely against it. They would immediately recognize how much competition it would bring into their business. These guys aren't stupid; instead of focusing on drilling new wells, they've been spending their money buying each other out. What this does is simply reposition ownership of EXISTING oil reserves but does nothing about ADDING new oil sources.
They are in no rush to derail their own gravy train. During the last oil bear, there was tremendous consolidation in the energy space, and as such I won't say the word 'cartel,' but these guys are pretty chummy with each other and learned a lot from the 1970's oil boom. They will not quickly repeat the same mistakes of over production that killed them the last go round.
Wily Wal-Mart being fed to the Wolves?
Any one here own Wal-Mart? Boy, they've been taking a beating. And the terrible thing is it has nothing to do with how they run their business. There are two major drags on the company right now that are completely beyond their control.
The first is Natural Gas and Heating Oil prices. If that seems odd, let me explain. This winter, Americans are going to be faced with some very tough choices. Some will have to choose between heating their homes and paying the MasterCard bill; other more fortunate souls will be faced with less harsh choices. Like whether to pay the heating bill or go spend money at their local retailer.
Wal-Mart is the largest retailer in America (and the world,) and as such, any slow-down in consumer spending due to skyrocketing heating bills will negatively affect them. In and of itself, this is the milder of the two issues because it's temporary in nature. The far more disturbing situation is the strengthening of the Chinese Renminbi.
Here's the problem: Wal-Mart spends tens of billions of dollars buying goods from China, and because of China's artificially depressed currency, it's been party time in Bentonville. They've been making money hand over fist playing the price spread between buying wholesale in China and selling retail in America.
Right now the official exchange rate for Renminbi to dollars is approximately 8.3 Renminbi for $1. So if you have $100, you can convert it into 830 Renminbi and buy 830 Renminbi worth of Chinese goods and services. Similarly, the Chinese can take 830 Renminbi and buy $100 of American goods and services.
Now here's where it gets sticky for Wal-Mart. The currency wizards estimate that the Renminbi is artificially undervalued by as much as 15%. As you probably know, Congress has been 'Jaw Boning' the Chinese to revalue their currency in an effort to lessen our trade deficit and make our goods more attractive in foreign markets. Let's assume for a second that the Chinese let the Renminbi 'float;' that is, they let it trade without any interference or manipulation from Beijing and it appreciates by 15%.
Here's what happens; the exchange rate would fall from 8.3 Renminbi to 7 Renminbi for one American dollar. So $100 would only buy 700 Renminbi instead of 830 Renminbi. That means Wal-Mart would have to pay 15% MORE for the same unit volume (amount) of goods!!
Now times 15% by the tens of billions that they spend annually on Chinese goods, and you can see why institutions are dumping the stock. Wal-Mart works on razor-thin profit margins. Imagine for a second that your largest supplier of goods for your business suddenly jacked up prices by 15%. The effect is DEVASTATING to your profits. Sure you can raise prices, but as we all know, higher prices lead to declines in demand, and declines in demand lead to declines in profits, and declines in profits lead to declines in STOCK PRICES.
Now the other thing to bear in mind is that Wal-Mart employs over a MILLION people and sells over a QUARTER TRILLION dollars of goods each year. If they start jacking up their prices, how long do you think it will be before it starts showing up in the INFLATION numbers? How long do you think it will be before they start laying off THOUSANDS of employees in an effort to cut costs and shore up their stock price? The ripple effect will be felt every where.
Now the flip side of this is that US goods will become more attractive to the Chinese, because for the same 830 Renminbi that used to buy $100 of American goods, they can now buy $115 worth of US products because of the strength in their currency. So while Chinese goods become 15% more expensive for us, our products become 15% cheaper to them.
Take a look around and see how many of the items in your home and office are made in China and you tell me if you think inflation is coming or not.
Long story short, this potential Renminbi revaluation is a major CYCLE TRIGGER that will spark a repositioning MONEY CYCLE out of retail stocks into companies that garner the bulk of their earnings from overseas as well as companies that are big exporters (steel, mining, agriculture, heavy equipment etc.) These companies will have a double earnings effect working in their favor. The first will be the increased demand for their products stimulated by a weaker US dollar, and the second will be the currency boost they get from earning profits in a foreign currency, because they can convert it into more US dollars giving them what I call a 'double bubble' of increased profits.
This new Money Cycle will ravage companies that rely predominantly on buying Chinese products that they then sell into the American market (retailers!!) Those companies are going to underperform to put it mildly.
I'm not suggesting that a currency shift of this magnitude is going to happen overnight (it doesn't mean that it couldn't!) What I'm saying is that as investors we need to remember that the market is a leading indicator and is a discounting mechanism and typically discounts events a year to eighteen months BEFORE they happen. We need to be positioned for these events before they are splashed all over the front pages of the financial media, because by then, it will be too late and the opportunity to profit from it will be greatly diminished.
Those of you long Wal-Mart and looking to protect your investment may want to think about initiating a 'cashless collar' to protect your position. Here's how it works. Let's keep the math simple and say you own 100 shares of Wal-Mart. You don't want to sell it but you also don't want to see your stock price get cut in half (which could very easily happen under the above scenario.)
Here's what you can do. Wal-Mart closed Friday at $43.20. You could sell one January 2007 $45 CALL option for $420. You would now have $420 deposited into your brokerage account. You can then take that $420 and use $245 of it to buy one January 2007 $40 PUT option at $245.
When the dust clears you now have a hedged position where you bought your insurance (PUT option) for free and made an additional $175 in cash. So let's say that Wal-Mart gets slammed to $27 a share, your PUT option allows you to sell your Wal-Mart stock at $40! Isn't that a thing of beauty? Now let's say the opposite happens and the stock is running and gunning to $52. Under the terms of the CALL option you sold you are obligated to sell your stock at $45; not so beautiful.
Here's what you do; you simply buy back your Jan '07 $45 CALL option and sell a Jan '07 $55 CALL option. The premium you receive from selling the $55 CALL option will in most cases (but not always) offset the extra money you had to pay to buy back the Jan '07 $45 CALL. This is a terrific way to manage your position and something the pros do all the time.
Why it makes sense to read this weekly
You'd have to be living under a rock not to notice that the markets have been getting kicked around of late. Last week was especially painful with a 2% drop in the indices.
On 8/1/2005, we sounded our first warnings saying, 'One thing to bear in mind this week is that cash levels at mutual funds dropped to 4%. That is the lowest level since hitting an all-time low in March 2000. This market's starting to look very overbought in the short term.'
On 8/15, we again said, 'we are MASSIVELY overbought here with bullish sentiment getting RIDICULOUSLY high.'
And on 8/22/2005, we once again strongly urged caution writing, 'For the last couple of weeks now the entire Tycoon Research team has been urging caution. When the value guy (Dylan), the options guy (Chris) and the technician/hedge fund guy (yours truly!) are all advocating caution, do yourself a favor - listen to the voice of over 50 years of market experience.'
Since then, we've seen the Dow go from approximately 10,713 to as low as 10,328; the NASDAQ has gone from 2,201 to as low as 2,093; and the S&P has declined from 1,239 to as low as 1,205. That's a 3%-5% hit to the indices which means that the average stock is doing a whole lot worse than that. More importantly than that, though, my single most important technical indicator just flipped bearish. I have made more money off this one indicator than any other technical tool I use.
The long and the short of it is we must remember that markets move in step-wise fashion; they rarely drop off a cliff. The strategy for this market is to short weak stocks on rallies; sell calls on rallies and buy them back on re-tracements; have tight stops on all new buys or think about substituting CALL options instead of buying the stock. (Just remember, don't over-leverage. If you're normally a 500-share buyer of stock, only buy 5 options. Don't get greedy and buy 25 options. That sort of trading results in financial ruin!)
Another call we made was on Gold. On 8/8/2005 we wrote - 'for all you gold bugs out there, keep an eye on gold stocks as we see some very positive technical improvement in the underlying commodity.'
Additionally on 8.15/2005 we wrote - '. . . with the commodity breaking out of a four- month consolidation to over $444 an ounce from $431 an ounce just over a week ago. This is a HUGE technical breakout for gold and matched with the recent breakdown in the US dollar, it could portend a major move in gold prices.'
Since that time we've seen a terrific move in gold, up as high as $474 an ounce!! We've seen strong moves in gold stocks, up 30% in Rangold Resources and up 23% in Newmont Mining, all in little more than a month, not to mention the monumental gains we've seen on the actual commodity itself, up a stunning 74%!! (We just love the fantastic leverage that the commodity markets provide us.) FYI - The easy money on Gold has already been made and the metal is starting to look very overbought right now. Look to take profits here and re-enter on a pullback.
'Let the Game Come to You'
Chief Investment Officer
ETF Master Trader