If the market action from Thursday is any indication, investors could be in for a wild ride in the third quarter.  After unemployment numbers were released, the S&P dropped nearly 3% on the day and many growth stocks were hit for much larger gains.  Priceline stock was down on the day but actually held up better than the broad averages.  However, I believe the relative strength will not last and investors might have a great opportunity to short Priceline and profit from a decline in the second half of 2009.

Priceline.com Inc. (PCLN) is one of the primary travel services which offers hotels, flights, car rental, and many other travel services.  The company actually has a very impressive track record with quarter after quarter of growing earnings and sales.  In the first quarter this year, Priceline reported revenue of 462.1 million with EPS coming in at $1.09.  This represented 15% revenue growth over last year and an exciting 43% earnings growth.  The travel business is very seasonal with the first quarter usually representing the slowest quarter so it will be very important to see how the numbers look when Priceline releases second quarter earnings.

As the market traded higher from it’s panic points in October and March, Priceline stock has entertained its share of buyers.  The stock rallied 164% from its October low to peak at $119.14 last month.  Currently the stock sits less than 10% off the high and the company’s solid fundamentals along with the strong stock movement has earned Priceline stock a spot on the IBD 100 roster.  So it may come as a surprise that we are recommending traders short priceline at this juncture in the market.

At this point, Priceline stock is not trading at an enormous or extravagant multiple.  The PE ratio of 16.75 (using 2009 expectations of $6.57 in earnings) reflects a certain degree of investor optimism, but is not close to multiples the stock enjoyed a few years ago during more bullish times.  Unfortunately, we appear to be entering a market period where even just a small amount of investor optimism can be quickly punished with a sharp stock decline.

During positive market and economic periods, we often benefit from the twofold dynamics of increasing earnings estimates, and expanding multiples.  Essentially as companies benefit from the strong economic climate, investors begin to expect profits to grow and the estimates are increased.  At the same time, the stock multiple on the expected earnings expands as investors are willing to pay more for each dollar earned by the company.  The result is often exponential increases in the stock price.

Unfortunately, the opposite can be true during bear markets.  Consider a stock like Priceline trading at 17 times earnings that are expected to be at $6.50.  As high unemployment numbers cause individuals to cut back on vacation plans, and businesses cut travel expenses, analysts could quickly cut those estimates to $4.50 per share which would only be 30% below current expectations.  If investors were unwilling to pay a premium because growth was no longer present, you might see the PE drop to 12 times expected earnings.  The 30% decrease in multiple would actually lead to a 50% drop in the stock (to $54) when you combine both lower estimates and a contracted multiple.

When investing for a few months or a few quarters, perception can be much more important than the actual fundamental numbers.  Over a period of years we will always see stocks trade in a range that represents the fundamentals of the company.  But during shorter time frames it is important to be aware and in front of changes in sentiment and expectations.

It appears after a quarter of rising stock prices which were a direct result of recovery expectations, investors are now set up to be disappointed by a lagging economic recovery.  As this disappointment settles in, we could see many more trading days like Thursday where there are virtually no bids and investors are quickly hitting whatever exits they can find.  Growth stocks like PCLN who are tied directly to the consumer and affected by personal as well as business spending will be most vulnerable.  So I would recommend traders short Priceline with a stop just above $120 and a target near $65 or $70.  If nothing else, long positions should be hedged as the next leg lower could involve significant pain.

FD: Author does not have a position in PCLN

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June employment numbers were released this morning coming in with another monthly decline in payrolls.  According to the release, nonfarm payrolls declined by 467,000 which is a much larger drop than the published 325,000 expectations.  The decline is also much larger than May’s decline which showed 322,000 fewer payrolls.  The official unemployment rate is now pegged at 9.5% inching ever closer to the emotionally significant 10% mark.

The initial reaction in stock futures was a move lower as the report obviously calls into question a widespread assumption that we are experiencing the “green shoots” of economic recovery.  Naturally, bullish investors and pundits will attempt to explain that employment numbers typically lag an economic recovery so we will likely not see job growth until the economic recovery truly is underway and companies have more confidence to hire new employees.

This may be true, but the rate at which we continue to lose jobs has been startling.  Not only are we not improving but employment numbers are actually getting worse! The US economy continues to lose jobs at nearly a half million positions each month and that is using figures that are relatively conservative.  If you factor in less followed but still significant underemployed numbers (workers who took jobs to make ends meet but have accepted major pay cuts) we have a much worse situation than many account for.

Other measures such as average hourly earnings and the average workweek are also very important statistics to be aware of.  In June, the hourly earnings level was flat at $18.53 while analysts had been expecting a slight gain.  The average workweek was 6 minutes shorter as the total number of hours worked was lighter.  This implies that even workers who do not show up in the official unemployment numbers are not seeing any recovery in their income levels and in fact, many are having to take a cut in hours as businesses struggle to meet payroll.  Ironically, many of these workers are having to work harder in order to make up for work done by fellow employees who have been laid off.

As more Americans find themselves out of work, the ripple effect throughout the economic and business world will likely continue.  The banking industry may be one of the hardest hit as loans outstanding continue to be a large problem.  According to a letter by Jim Welsh to investors, FDIC insured banks have recently seen loans 90 days past due increase by $59.2 billion.  Banks have been working hard to beef up their reserves to compensate for loan losses, but despite new capital raised the ratio of reserves to non-current loans has fallen to 66.5% from 74.8% at the end of 2008.  Continued declines in payrolls will likely put even more pressure on these ratios.

Last quarter the market adjusted to the results of the over-hyped bank stress tests.  One of the key assumptions was a “worst case scenario” of 10% unemployment.  Banks were asked to raise enough capital to survive if the economy got so bad that unemployment reached this level, but there was not much consideration given to what would happen if numbers got worse than this 10% level.  Now the number of payrolls lost appears to be increasing instead of moderating and the 10% unemployment level will likely be eclipsed by the end of the year (if not the end of the quarter).

The retail sector will also be affected by an increasingly unemployed consumer.  While there may be some bright spots for discount retailers, the majority of companies in the sector will be fighting against a trend of lower sales.  Specialty shops catering to the affluent may fare the worst as many wealthy customers are now feeling quite pinched and dialing down expensive purchases.  ZachStocks has suggested short positions in various retail stocks like Tiffany & Co. (TIF), CEC Entertainment, Inc. (CEC) and Chipotle Mexican Grill (CMG).  As an alternative to shorting stocks, investors may be able to hedge exposure by buying puts - or simply raising cash levels in order to insulate against a market decline.

Today’s employment report highlights the fact that we are still in a difficult place and not likely to experience a “V shaped” recovery.  Opportunity is still available for flexible and nimble traders, but simply buying and holding a market index may be dangerous in the months ahead.  If you’re worried about your current investment approach, feel free to send me an email and we can discuss options for protecting your wealth.  As we move into the second half of this dynamic year, please use caution and protect your capital.  Remember, the most successful investors gain their edge simply by surviving through difficult markets like these.

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Traders who took advantage of our January 21 article on Shanda Interactive Entertainment have enjoyed quite a ride!  The stock is currently up roughly 100% in less than six months, handily beating market returns.  The sector has been a bright area to invest in, as China Massively Multiplayer Online Role Playing Games (MMORPGs) gain popularity.  For many consumers in China, Shanda games have been a less expensive form of entertainment, so the industry has enjoyed dollars (or more appropriately yuan) that might have otherwise been spent on travel, expensive dinners, or new vehicles.  It’s easy to see why some investors claim that china online game companies are recession proof.

But despite the solid earnings at Shanda, and the recent sharp move in the share price, SNDA stock still appears to be undervalued with significant room to run.  Analysts who follow the company expect earnings to hit $3.39 per share this year representing an increase of 29%, and for 2010, earnings are expected to hit nearly $4.00 per share - another 17% on top of 2009.  The stock is trading in the mid 50’s, setting the PE at 16 compared to 2009 expectations, and just 13.75 compared to 2010 expectations.  Considering the proven track record, and strong financial footing, I find it difficult to understand why this stock doesn’t have a multiple of at least 20 times next year’s EPS.

At the end of  the first quarter, Shanda was sitting on $477 million in cash as well as an additional $207 million in short-term and marketable securities.  That’s quite a war chest for a company that pulled in $569.5 million in revenue over the past four quarters.  A certain amount of cash on hand is important as the company pays to develop new games or even acquire properties from competitors.  But considering the fact that Shanda has no debt to speak of, this cash balance should give investors a strong sense of security as there are very few scenarios which would come close to putting SNDA in a difficult place financially.

One initiative that might help stoke investor enthusiasm is a potential IPO of Shanda Games on the US stock exchanges.  According to the company’s press release, Shanda plans to submit registration documents to the SEC for a possible Initial Public Offering of Shanda Games Limited.  The potential spinoff of the online game portion of the company’s business could help isolate the strong growth area of business from other entertainment business lines run by the company.  At times, this type of strategy increases shareholder value as the new more dynamic portion of the company can trade higher without the baggage of a slower growing business line.  It appears that Shanda Interactive would still maintain a majority position in Shanda Games Limited.

Shanda has also been active on the acquisition front, most recently putting cash to work purchasing Hurray Holding Company which is a music distribution company.  Shanda paid roughly $46.2 million for the purchase and should be able to use its wide distribution and cleint network to make this a profitable acquisition.  It’s encouraging to see the company putting capital to work and taking advantage of its strong financial presence.

The company gave no guidance for the second quarter which has likely had a negative impact on the stock price.  Investors hate uncertainty, so when there is little guidance from management often buyers will step back for a quarter or two in order to make sure the positive trends are still intact.  When the company announces second quarter earnings it is likely that uncertainty will be put to rest and the stock could ramp higher from that point.  I would recommend holding SNDA through the $80 level and possibly further if the earnings expectations are increased.  The stock is dynamic and volatile, but a long-term perspective could put some nice profits in your portfolio.

FD: Author has a long position in the ZachStocks Growth Model

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note: This post is a follow up the the New Year post: Four Stocks for the New Year as well as the first quarter review

We’re halfway through 2009 and the markets continue to be very dynamic.  After a full fledged rout in the first quarter, equity markets have rebounded sharply in the second quarter posting the best market return since the bullish days of the late 90’s.  Despite the strong performance off the March lows, equity markets still appear to have a significant amount of risk.  Unemployment numbers continue to be weak, consumer spending is contracting even with upticks in income levels, and governments around the world are piling on excessive debt.

A true dynamic investment program needs to be able to adapt to market changes in order to protect against new risks, and capitalize on evolving opportunities.  However, picking four stocks at the beginning of the year is a great exercise in long-term planning and evaluating what broad sustainable trends are in place.  This quarter our four stocks have increased sharply from the weak Q1 levels but still leave much to be desired.  By contrast, the ZachStocks Growth Model which is continually adjusted to account for risks and opportunities has outperformed the market by quite a large margin this year.

So here are the four positions we chose at the beginning of the year:

1. JA Solar Holdings (JASO)

Solar energy has rebounded in the past few months as stimulus dollars finally hit the market and are beginning to drive demand for solar power and the components necessary to produce that power.  JASO has traded higher and currently shows a slight profit for the year.  As traditional energy prices increase, the relative competitiveness of alternative energy is boosted.  JA Solar has had trouble keeping up with many of its peers as management has issued relatively weak revenue guidance.  By comparison, our position in Yingli Green Energy in the same sector has yielded triple digit gains.  JASO will likely continue to ride the solar trend higher but it now appears competitors int he sector make for better investments.

2. AECOM Technology Corporation (ACM)

AECOM has rebounded impressively as our second theme for 2009 (infrastructure) finally takes hold.  Over the past weekend, the stock was upgraded by Stearne Agee and the price target was increased to $40.  It appears that this target could prove conservative over the next 12 months as AECOM is quickly proving its ability to convert its backlog of potential projects in to real-for-sure revenue paying contracts.  Througout the recession, ACM has continued to post growth in both revenue and earnings on a quarterly basis.  Analysts are targeting $2.04 as expected earnings for 2010 (fiscal year ends Sept 30) but that estimate may be increased due to strong execution.  Aecom continues to be a strong component of the ZachStocks Growth Model.

3. TBS International (TBSI)

Shipping stocks have been an incredible disappointment this year.  The recessionary environment has cut down on international trade and the corresponding weakness in day rates has caused difficulty even for shipping companies with long-term contracts.  Shippers have also had to deal with the frustrating issue of customer defaults.  So while long-term contracts may have been in place, once the global crisis hit the customers were unable to keep up with their obligations and the contracts were no longer viable.  TBSI is now down more than 20% for the year and we have not held the stock for some time.  A rebounding economic climate could push these stocks higher, but currently there appears to be more risk than potential reward in shpping stocks generally and TBSI specifically.

4. China Medical Technologies (CMED)

ChinaMed is relatively flat on the year despite some difficult and proactive decisions made by management.  The company decided to divest its tumor therapy division and instead concentrate on its diagnosis business.  The strategic move should drive profitability in coming months as the diagnostic business has a recurring revenue stream which is very reliable and has strong margins.  The stock continues to sport a single digit multiple despite expected and historical growth trends.  It is unclear exactly what catalyst will propel the stock higher, but for the time being valuation is very compelling.

The second half will no doubt bring new issues to ponder, trends to follow, as well as risks and opportunities.  Inflation has the potential to eat away at savings and non-performing assets, the current administration appears to be somewhat hostile to free markets, and global economic weakness could spark civil unrest in unexpected places.  So continue to be flexible and alert with your trading and make sure you manage risk appropriately.

Below are links to the other participants in this contest (will be updated as more articles become available)

The Financial Blogger

The Wild Investor

My Traders Journal

Intelligent Speculator

Where Does All My Money Go?

Dividend Growth Investor

Million Dollar Journey

FD: The ZachStocks Growth Model has positions in ACM, YGE and CMED

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Investors in for-profit education stocks are seeing gains this morning after Apollo Group earnings were released.  Revenue crossed the $1,000,000,000 mark this past quarter.  With revenue at a new record high, and growing by 27% over the past year, it truly looks like the company (and the sector in general) is sidestepping much of the economic weakness during this recession.  Student enrollment was 22.6% higher in the company’s fiscal third quarter which includes the final semester of the school year (fiscal year end is August 31).

Profitability was strong so while revenue came in basically even with analyst expectations, Apollo Group earnings beat expectations by 14 cents and came in at $1.26.  Enrollment for the quarter was up 22.6% over last year which is a bit lighter than the 23.1% seen in the previous quarter but still very impressive.  In early trading, the stock is up more than 7% as buyers cheer the report.

Apollo Group (APOL) has an excellent balance sheet with nearly $800 million in cash and very little debt.  Over the past quarter the company used $444 million to repurchase shares at an average price of $61.62.  In June the board approved what appears to be a small increase in the cash available to repurchase shares.  The press release states that the amount increased to an aggregate of $500 million which seems a bit odd considering the majority of that has already been used.  It is likely that the statement was supposed to read “an additional $500 million” but that has yet to be confirmed.

Other uses of cash include acquisitions as Apollo Group recently announced the purchase of BPP Holdings which is a UK company offering educational services for the legal and financial industries.  The purchase will cost $540 million (assuming conversion rate remains steady) and is expected to close in the current quarter.  The acquisition is likely to be profitable considering the ability of the company to leverage back office functions, and management’s strong track record of driving profitability.

The excitement over Apollo Group earnings is pushing other equities higher in the education sector.  It appears that while APOL is relatively fairly valued, some of the company’s peers may be trading at dangerous levels and be worthwhile short candidates.  Strayer Education, Inc. (STRA) and New Oriental Education (EDU) may be particularly vulnerable as the valuations are higher representing more investment optimism and higher expectations.  While neither of these companies have significant debt levels, the lack of liquidity for students may once again become a factor as we move into the fall semester both in the US (for Strayer) and in China (for EDU).

Education companies have typically been strong during recessionary periods as unemployed or underemployed make the decision to further their education order to build earnings power.  However, this time around we are experiencing a much deeper contraction which includes incredible destruction of wealth and corresponding cuts in the availability of capital.  Recent reports on bank loan charge offs and delinquency statistics point to further pain and will likely cause banks to cut back on lending.  This liquidity is necessary for most for-profit schools to maintain growth levels.  Up to now, the government (both US and internationally) has stepped in and filled this funding gap but now governments on the local and national level are finding themselves overextended and may pull back on lending programs.

The bottom line is that while investors are largely bullish on the for-profit education industry, and while Apollo Group earnings have helped to drive this optimism, there could be significant contraction over the coming months.  Investors in education stocks should watch valuation metrics closely and consider hedging against declines associated with lower growth rates.

FD: Author does not have a position in stocks mentioned

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It’s not easy being a banking institution in China.  Often the lines are unclear between national and private interests, and political regulation has a large degree of influence over what loans can and cannot be made.  Most recently, stimulus regulations have required China bank loans to be made to local governments in order to pay for bridges, roads, and other infrastructure projects.  To some extent these loans were backed by an implied guarantee from the national government.  After all, it was the national government who mandated that the loans be made in the first place.

But this weekend an article appeared in the People’s Daily warning that China bank loans made to local governments could face risk of default based on the municipality level rather than holding the full faith and credit of the China government.  According to the Wall Street Journal article, the weekend piece “calls into question the safety of billions of dollars of debt backed by local governments country-wide.”

The possibility of these China bank loans defaulting appears to have been overlooked by lenders for the most part.  Since railroads and highways are largely being sponsored by the central government.  But it now appears that as the projects are completed, the liability will be maintained by local authorities who inherently represent a much greater risk.

China as a whole continues to be a bright spot in the bleak global economic picture.  While growth levels have certainly contracted, China is still increasing its GDP quarter after quarter while most of the other superpowers are shrinking.  Much of the growth in the past two years has been a direct result of the China stimulus measures which have largely been funded by these China bank loans.  If banks are forced to re-price the risk on these loans it will likely mean higher interest rates and potentially less capital available for the projects which are currently helping to prop the country up.

The People’s Daily has historically been a mouthpiece for the central government, reflecting the views of China leadership and the future path policy will likely take.  While some say the paper has lost some of its relevance as China emerges as a free economy, the words are still sobering and worth considering.  From an investment standpoint, there is danger not just in the China financial sector, but also in infrastructure companies with projects financed by these banks.

Currently we have a very positive outlook on infrastructure stocks.  Stimulus measures around the world continue to keep the backlog of projects robust.  And doing business with governments has historically meant that collecting payment for these projects is reliable (if not filled with red tape).  But new concerns with China bank loans coupled with rumors that some G-8 members believe spending has gone too far makes it necessary to take a close look at these investments.

One of the traits of a good investor is the ability to re-evaluate a position or theme when new information becomes available.  It is tempting to be stubborn and stick with a theme that we have worked hard to research and establish positions in.  But at ZachStocks we don’t want to be married to a particular sector if new information proves that there is more risk than we originally accounted for.  So for the time being we are still bullish on infrastructure stocks, and growth in China.  But new information on China bank loans will certainly be worth watching closely and may eventually lead to a change of opinion.

FD: The ZachStocks Growth Model holds positions in China and Infrastructure stocks.

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As markets trade higher to start off the week, underwriters for the new LogMeIn IPO are likely drumming up interest in the latest offering to hit Wall Street.  The IPO market has been relatively slow over the past year as the bear market has reduced the amount of liquidity and made such offerings very difficult.  But the spring rally has made it possible for several new stock offerings to come to market helping companies raise much needed cash for their businesses.

On the block for a possible offering this week is LogMeIn, Inc. (LOGM) which is the primary provider of on-demand remote-connectivity solutions to small and medium sized businesses as well as individual consumers.  Essentially the technology allows users to log onto their home or office computers from any web browser, making sure that all data is easily accessable and yet still providing for secure connections in order to protect sensitive information.  There are several tiers of service offered including a basic free service all the way up to delux permium products.  As of March 31, the company boasted 188,000 premium accounts and continues to grow their subscriber base very quickly.

The LogMeIn IPO is expected to raise about $67 million for the company assuming the stock prices in the middle of the $14 to $16 expected range.  In addition to the 5 million shares being sold by the company, an additional 1,666,667 shares will be sold by existing shareholders which largely include private venture capital firms as well as company executives.  At this point it looks like the executives are selling a reasonably small portion of their holdings which helps investors maintain confidence that the executives have an incentive to continue to grow the business.

While the remote-connectivity concept is very useful and popular (especially for road warriors and those of us with dual home / business offices), only recently has LogMeIn been able to capitalize on its success and post a profit.  Looking into the financial statements it is amazing to see how much money the company spends on sales and marketing.  In 2006, the company spent 88 cents in marketing expenses for every dollar received in revenue.  But the efforts appear to have paid off with revenue growing by 139% in 2007, 91% in 2008, and 73% in the first quarter of 2009.  As revenues have caught up with high fixed costs, the company is inching closer to profitability with the first quarter actually posting pro-forma EPS of 0.10.

Although the growth is impressive, the price tag on the LogMeIn IPO may be a bit excessive.  Analyst expectations are still hard to come by, but annualizing the first quarter numbers, it is likely the company will earn 40 to 60 cents in 2009.  With the stock price likely to start near $15, the PE will be roughly 30.  When the market is healthy, multiples of 30 on growth stocks are commonplace and often expand to much higher levels.  But in an environment where consumer and business spending is constrained, it is likely that this multiple could prove a bit dangerous.

The company has relatively little debt, so the threat of default is not an issue for investors.  However, the expanded advertising budget could quickly burn through new cash if corresponding revenue does not continue to flow.  The technology sector is highly competitive and LogMeIn believes that it will face threats from similar services in the coming quarters.  There is no guarantee that the company will be able to maintain its leadership in this niche business, especially with companies like Citrix Systems, Inc. (CTXS) and and Cisco Systems, Inc. (CSCO) using deep pockets to develop and promote similar products.

The lead underwriters who handle the LogMeIn IPO are set to be JP Morgan and Barclays Capital which are relatively well respected firms.  Thomas Weisel Partners, Piper Jaffray, and RBC Capital Markets are also on the deal ensuring that there will be a relatively wide distribution for the new stock offering.  With the market starting out higher this week, I wouldn’t be surprised to see the deal come at or above the high end of the range ($16 or above) and possibly trade up from that level on the initial deal hype.  These underwriters often do a good job of creating a perceived shortage of stock on the deal which can lead to more buying pressure on the day the IPO is launched.  But once the hype wears off in the following few days, LOGM will likely be vulnerable to a quick negative move.  At that point, any additional weakness in consumer spending or in the broad markets could push the stock down to the low teens or even single digits.

So while the LogMeIn IPO may generate some near-term buzz and help to develop confidence in market liquidity, the deal appears a bit dangerous and I would not recommend holding deal stock beyond the first few days of trading.

FD Author does not have any positions in LOGM and does not have immediate plans to participate in the deal.

The political and financial message boards lit up late Friday after the House passed the controversial cap and trade bill.  The bloggers have done an excellent job explaining why this bill could be extremely damaging to the economy and despite the rhetoric about creating “green collar” jobs, it will likely put more Americans out of work in the long-run.

While the bill was passed late in the day Friday in what appeared to be an effort to slide it under the radar relatively un-noticed, no one should be extremely surprised by the measure.  The Obama administration has made it exceedingly clear that this would be an important part of his agenda and however misguided the bill may be, it has been expected for some time.  Today I’ll abstain from too many judgments as to the bill’s merits and instead focus on the investment opportunities that will surface as a result of cap and trade initiatives.

Energy is the Obvious First Beneficiary

At ZachStocks, we have been carefully watching the alternative energy sector as stocks have begun to rebound from early 2009 lows.  After achieving rock star status in late 2007 and early 2008, solar energy stocks experienced particular weakness due to overcapacity, falling prices on traditional energy sources like oil and natural gas, and a liquidity crisis which put many expansion projects on ice.  Today, many of those concerns are alleved with prices of oil and natural gas back on the rise and global stimulus dollars pouring into projects to build factories, solar farms, and transmission grids.

Some of the stocks that show the most promise include LDK Solar (LDK), First Solar Inc. (FSLR) and Renesola Ltd. (SOL).  While overcapacity may be the primary remaining concern for the industry, prices are dropping quickly and government subsidies are paving the way for demand to pick up the slack.  The cap and trade bill could go a long way to filling that gap and encouraging (read: forcing) much more demand for clean renewable energy.

Ironically, the cap and trade bill is unpopular with both the left and the right spectrums of politics.  The left has argued that the bill offers too many perks to businesses which takes the teeth out of what is perceived to be a purpose of “punishing business.”  From our standpoint as investors, it is important that legislators realize that in order to create jobs and promote the economy during this difficult time, there needs to be some olive branches extended to business in order to help with employment levels.

Trading Exchanges Overlooked but Full of Potential

I’ve read very little press about the actual “trade” portion of cap and trade, but opportunity to benefit from the businesses that enable the trading of emissions credits could be significant.  ZachStocks readers should be keenly aware of IntercontinentalExchange, Inc. (ICE) which was actually the first stock we discussed when the site was launched back in mid 2007 (hard to believe it has been 2 years now).

ICE had its beginning as an energy trading exchange and has methodically built its reputation as an Over The Counter (OTC) exchange, a futures trading platform, and most recently as a clearinghouse for many regulated and unregulated financial contracts.  The company is one of the front-runners to participate in the trading of these carbon credits and could quickly begin to realize increases in revenue as the trade picks up.  ICE has expertise in launching new trading vehicles so it would be a natural beneficiary of this new trend.

The New York Stock Exchange may be a dying icon of the past, but the parent company NYSE Euronext (NYX) continues to innovate and add new products to trade and new methods of trading.  It would be very unlikely that a new exchange would be developed without NYX having at least some part in the formation or upkeep of the platform or contracts traded on that platform.  As carbon credits gain popularity on an international level, NYSE Euronext’s expertise in Europe, Asia and developing markets could prove very useful.

Engineering and Infrastructure May Play a Key Role

The final area of opportunity I see with cap and trade involves companies who are active in helping retrofit plants factories and engines which are the prime producers of the capped emissions.  We’ve looked at infrastructure in the past as another initiative by this administration has been to support this industry through building of bridges and roads, revamping the national electricity grid, and restoring federal buildings.

As power plants, chemical factories, paper mills and dozens of other industries scramble to cut down on emissions (and  thereby cut down on the tax of buying carbon credits), companies like Fluor Corp (FLR), and Jacobs Engineering Group (JEC) will likely land some substantial contracts.  These big conglomerate businesses may see their stocks increase a bit due to this new business, but smaller contractors like Hill International Inc. (HIL) and to some degree Aecom Technology Corporation (ACM) will have a better chance of yielding strong stock returns due to their smaller, more nimble approach.

So while the cap and trade bill will likely have significant and possibly very negative unintended consequences, there are opportunities for investors who are willing to overweight sectors who stand to benefit from this political move.  I’m interested to hear what action you are taking to protect your wealth and grow investments despite changing political and economical trends.  Please leave your comments and take some time this weekend developing a game plan to pro-actively approach markets based on the information we have today.

FD: the ZachStocks Growth Model holds positions in several of the stocks mentioned.

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When looking for successful growth stocks, China companies have shown up in my screens quite often in the last few months.  One of these success stories is Ctrip.com International (CTRP).  The company operates the largest China based travel portal, offering flight ticketing, hotel reservations, packaged tours and more.  During the market crash in the fourth quarter 2008 and the first quarter this year, the stock dropped to a very attractive valuation in the mid to high teens.  When considering the company is expected to earn $1.13 this year and the growth prospects are relatively good, this was most definitely a buying opportunity.

Investors who took a chance on the company when the economic picture looked the bleakest were well rewarded with a 140% current gain from the 2009 lows.  The company itself has continued to grow revenue and earnings as it captures market share in the difficult consumer environment.  However, despite the company (and the stock’s) recent success, the much higher stock price raises concerns of a potential pullback which could cause investors to give up much of the gains from the past few months.

Investors Current Optimistic Attitude

In general, equity markets move ahead of economic trends.  This is because stock market participants buy and sell based on future expectations.  If I think that the economy will turn higher in 2010, then I will likely begin buying today so that I have my capital in place when that actual turn takes place.  The buying pressure usually pushes markets higher before any rebound in the fundamental picture is recorded.  This is why many economists are not worried about the continued growth in unemployment and lack of economic growth.  They simply believe that this recovery will come in time and that the market has already signaled the change is underway.

But my concern is that the market has fully priced in a recovery and at the end of June we are going to get hard data on just how that recovery has been progressing in the second quarter.  Not all of the market buying pressure has been built around second quarter expectations, but there certainly is some hope that Q2 earnings numbers will show a bit of a stall in the economic decline, or even the “green shoots” of growth.  If the fundamental reported data fails to deliver this improving picture, we could see investors become disenchanted with their holdings and a quick selloff in the market.  Growth stocks with high multiples will be the most vulnerable because they are the companies with the most optimism and therefore the most risk for investor disappointment.

Ctrip’s Potential Disappointment

Ctrip.com fits the “optimistic” category as the stock is currently nearly 40 times the estimates for this year.  The high valuation is largely justified by the expected growth as CTRP continues to capture market share and is expected to grow earnings by 28% next year.  The company also recently made a stock purchase of Home Inns & Hotels Management Inc. (HMIN) to increase its stake in the company from 9.52% to 18.25%.  The purchase was made at a price of $13.31 (Total value of $50 million) which has quickly produced a 24% unrealized gain.  As long as HMIN continues to trade higher, that investment appears to be a wise move.  However, HMIN has some of the same dangers as CTRP and could simply leverage the risks already associated with the company.

During the first quarter, Ctrip realized a healthy if not expected growth in both revenue and earnings.  However, it appears the company is having to work harder and harder in order to manufacture these attractive numbers.  Revenues from hotel bookings account for 43% of total revenues for the company.  While the category saw sales increase by 9%, the total increase in volume was 17%.  This means that margins on hotel bookings were significantly lower as a weak economy resulted in low pricing power.

Similarly air ticketing revenue (which also accounts for 43% of total revenues) increased by 16%.  But in order to outpace the weak pricing, the company actually had to sell 40% more tickets.  The obvious question (although I haven’t hear too many people asking it) is what happens when the company is only able to sell 10 to 15% more tickets and the price continues to drop.  The result could quickly become lower sales which would set off alarms for institutional and retail investors alike.

Options for Dealing with CTRP

Depending on your situation and risk profile, there are several ways to protect against, or even take advantage of a decline in the stock.  Each of these strategies offers different advantages while including certain drawbacks as well.  When investing there is rarely ever a “free lunch” (chance for return without some corresponding risk), but many of the financial tools at our disposal can shift those risks and returns to be more favorable for your individual situation.  If you would like a second opinion on how YOU should approach investing in this or other investment opportunities, my direct line is always open.  So let’s take a look at some of the CTRP options:

1. Short Stock - The first and most obvious opportunity if CTRP were to decline would be to short the stock.  This means that you profit directly in line with how far CTRP drops.  However, if investors continue to be optimistic and the stock climbs, a short position has unlimited potential for losses.  For this reason many IRA accounts are not allowed to short stocks.
2. Buy Puts - A put contract is simply an options contract which gives you the right but not the obligation to sell the stock at a particular price.  You can buy this contract (most IRA’s and qualified accounts allow for this trade) and the contract will increase in value as CTRP declines.  The benefit is that if our analysis is wrong, you are only out the amount you paid for the put contract.  However, the drawback is that prices on puts include extra premiums for volatility and for the duration (time remaining on the contract).  The stock would have to drop significantly or quickly in order to make up for the premium you pay for the put.
3. Covered Call - If you own the stock and like the company long-term, but are worried about the potential for a short-term drop, then selling calls against your stock position could be an option.  For instance, you could sell the September 45 calls for roughly $4.40 per share which is yours to keep.  If the stock drops between now and September, the premium you accepted for these calls will help offset your losses.  However, you give up the potential for a strong run as shorting the calls gives you the obligation to sell the stock at $45 if the buyer of the contract so desires.  Essentially when you include the $4.40 for the option your selling price would be $49.40 which is better than the current market price.
4. Sell Naked Calls - Another aggressive (and potentially dangerous) way to take advantage of the call premium would be to sell the calls naked (meaning without owning the stock).  The danger is that for every dollar CTRP trades above $45, you would be on the hook for when and if the owner of the call exercises his right.  Until the stock trades above $49.40 you will likely end up with a profit.  But above that price your risk is the same as being short the stock.

So you can see that there are several ways to profit from or protect against a decline in this stock.  Difficult markets don’t always mean losses for smart investors.  I would be interested in hearing your success stories from the last six to 12 months.  What moves did  you make against conventional wisdom which allowed you to profit while many others were losing?  Leave a comment on this post or send me an email (growth@zachstocks.com).  Hopefully we can all learn from the aggregate experiences and put more profits into our investment accounts.

FD: Author does not have a position in CTRP

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UBS AG (UBS) issued a press release today with results for trading so far in the second quarter.  It appears that even with the majority of equity markets rising, and liquidity seeping back into the economy, the company will still report a net loss for the second quarter.

The majority of this loss will be due to write downs and restructurings which have already been made public.  As far as the operating business is concerned, the company will actually post an improvement compared to the first quarter (not exactly a high hurdle to overcome).

Probably most concerning is the difficulty the company is having in attracting new capital.  Since UBS was one of the hardest hit banks during the liquidity crisis of late 2008 and early 2009, clients have largely lost confidence in the firm.  That confidence is incredibly important for a company built on trust and client loyalty.  Without net new assets brought in by the company’s advisors, there is little hope for a sustainable rebound in long-term profits or in the stock price.

UBS is working hard to get its capital base to a stronger place which should help with confidence and in turn increase marketability and new assets under management.  Along with the second quarter pre-announcement, the company also said it would sell 293.3 million shares to “a small number of institutional investors.”  If the company is able to privately place these shares instead of selling to the broader market that will probably have less of an immediate effect on the stock price.  However, the new shares certainly dilute existing shareholders who have too accept the fact that they own a smaller piece of a (hopefully) stronger bank.

Ironically, while UBS is still in poor shape financially and having a difficult time gaining traction in growing earnings, it may be a great speculative buy at this point.  Now please hear me - this is not a safe investment that you can put a significant portion of your capital into and sock it away.  The UBS trade is fairly risky as the company still has to deal with some very difficult issues.  However, the market may already be pricing these risks into the stock price which means that if any positive surprises occur the stock could jump substantially.

Currently analysts are projecting anemic earnings of $0.36 per share for 2009.  But in the following year if the Swiss bank gets its act together, it could earn $1.50 (or even more if the expectations prove conservative).  Currently, the stock is just below $13 which means the stock is just 8.6 times next year’s earnings.

Up to this point we have seen very clearly that the world governments have a vested interest in keeping the banks in business.  Now there is no guarantee that UBS won’t stumble and fall into receivership.  But if that were going to happen it most likely would have occurred in the past year.  At this point UBS is taking the difficult but necessary steps to repair its balance sheet and build a sustainable business model.  If they are successful, the $1.50 in expected earnings will likely be understated.

It appears the two forces of increasing earnings expectations and a rise in the stock multiple could both come into effect over the next 6 to 12 months.  If expectations were increased to $1.75 and the multiple rose to a still conservative 12 times earnings, the stock would hit $21 which is more than a 60% gain from current levels.  Investors may be able to use the additional supply of stock coming to market as a chance to buy this stock on the cheap and hold as the recovery story becomes common knowledge.

Now I don’t believe the banking industry will return to its former glory and UBS will probably not see the $4.56 in earnings we saw in 2006 for a decade or more.  But at this point with expectations so low, a small fundamental improvement could go a long way towards pushing the stock higher.

FD: Author does not have a position in UBS

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Markets closed mixed on Wednesday after economic issues gave both bears and bulls food for thought.

Early in the session stocks rallied broadly after a positive durable goods report.  While analysts were expecting a 0.8% decline, the numbers actually came in with a gain of 1.8%.  Now there are many different ways to examine the numbers, ex-transportation the report was up 1.1%, and ex-defense orders grew by 1.4%.  Lower inventories was also an encouraging sign as it means that when the economy turns stronger, there will be an immediate need for new orders instead of companies working through levels of inventory already built up.

The Organization for Economic Co-operation and Development (or OECD) did its best to offset the negative World Bank report which sent stocks spiraling on Monday.  The OECD raised its estimate for global economic growth from 0% to 0.8% growth.  An expectation for the US economy to bottom this year was certainly a contrast to the World Bank’s dour expectation of continued recession for the US and the global economy.

But the FOMC statement at 2:15 threw cold water on the rally as Bernanke and company stated that they are making no change to current policy.  According to the statement released, the FOMC sees the rate of contraction slowing which is relatively small comfort especially when the Fed later stated that they believe the economy will stay weak for a time.  It appears that the target rate for fed funds will remain near zero “for an extended period.”

Probably the most important part of the statement was the Fed’s continued commitment to buying treasuries and mortgage backed securities to add liquidity to the market and keep rates lower.  This is a less traditional policy method which was instituted in December and has been a key avenue for pumping cash into the economy.

While the official statement on inflation showed little concern, some of the governors have begun to express their concern about the long-term danger of loose policy.  Thomas Hoenig, the Kansas City Federal Reserve Bank President has been outspoken regarding the possibility of inflation and the historical tendency to leave monetary policy too loose when coming out of recessions.  We have begun to see rising commodity and fuel prices which are more volatile but certainly could be the precursor to a more widespread inflationary environment.

At the end of the day, the Dow was down 0.28%, the S&P 500 was up 0.65% and the ZachStocks Growth Model actually gained 1.80%.  Strength was relatively broad, but strong moves in our China Gaming positions Netease.com, Inc. (NTES) and Shanda Interactive Entertainment Ltd (SNDA) were of particular help.  Precious metals were higher as inflationary fears began to creep back into investors minds.  It will be interesting to see if the recent pullback in gold and silver will find support and regain its positive trend.  For our part, we are protecting client accounts against inflationary pressures and holding cash levels larger than normal in order to protect against market declines and broad volatility.

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The Blackstone Group, LP (BX) received an important endorsement on Friday which could go a long way towards building confidence with investors and partners.  According to Reuters, the China sovereign wealth fund China Investment Corp (CIC) plans to invest $500 million in one of Blackstone’s hedge fund units.  China has been watching the decline in global markets and is now anxious to put some of their capital to work at historically low prices.  The ZachStocks Growth Model currently holds a 3% position in BX and has unrealized gains north of 50%.

While $500 million is a small investment compared to a potential $80 billion which is estimated to be earmarked for hedge fund investments, any investment at all from China is significant for Blackstone.  Back in 2007 when Blackstone was preparing its Initial Public Offering, China committed billions in buying a pre-IPO position in the company.  The timing couldn’t have been worse and as Blackstone traded off sharply due to the global economic slump, China saw its billions evaporate.  So a new $500 million investment in one of Blackstone’s funds is a meaningful gesture.

Throughout the recession, Blackstone has been relatively successful in attracting new capital for its private equity funds, real estate funds, and other alternative opportunities.  However, the challenges have mounted as debt financing has been difficult to find in any significant size.  The company will typically raise capital from investors for its funds (for example $5 billion).  The business strategy is to then leverage that capital by borrowing another $10 billion and investing the entire amount.  Leverage can increase returns for investors and for the company as long as investment decisions are profitable.  But if $15 billion is invested in a losing venture, a 10% loss would actually cause the initial investors to lose 30% (and more due to interest on the loan).

Debt financing is a great tool for Blackstone when working well.  That is because the company usually gets to keep a portion of the gains on hedge fund assets.  So not only is the company collecting a management fee, but for every $1 billion investors make in gains, $200 million is siphoned off the top as Blackstone’s incentive allocation.  Gains have been hard to come by in recent quarters, which has hurt profits.  In some quarters the company has actually reported negative revenue as incentive allocations booked in previous quarters were wiped out by losses.  However, the picture appears to be improving for hedge fund returns which should result in profits for Blackstone in the form of investment management fees as well as incentive payments.

In a separate piece of news Friday, the supreme court ruled in favor of Blackstone, upholding a lower court’s dismissal of a lawsuit brought by ADS.  ADS had taken action against Blackstone after Blackstone backed off an agreement to buy out ADS.  As the economy turned lower, ADS’ prospects diminished, and Blackstone ran into funding issues, the deal could no longer complete the transaction.  ADS wanted Blackstone to pay a breakup fee, but obviously the dynamics changed materially which was cause for termination of the deal.  With this court case in the rear-view mirror, hopefully management will be able to spend more resources towards driving profitability for investors instead of playing defense against the lawsuit.

Analysts are calling for earnings of 31 cents this year and 81 cents in 2010.  These expectations are very fluid and dependant on both market conditions as well as the skill of managers running the investment programs for Blackstone.  I believe after the difficulty during the last year, analysts are overly cautious with their expectations.  Blackstone is obviously able to attract capital as alternative investments become more attractive to pension funds and other large institutional investors.  Managers are more aware of the risks of the markets and will likely handle investments more conservatively.  This means that incentive allocations per $1 billion of investment capital may be lower, but with significantly higher balances in their various funds, the total amount of fees should be attractive with any positive investment performance.

Despite the strong run from the panic-driven lows in March, the stock still appears to be an attractive investment which could be strong regardless of the market direction.  The company’s real-estate portfolios may still be subject to write downs, but the hedge fund businesses should help offset that weakness.  Bottom line, if China is making investments with Blackstone, this is a ringing endorsement and should go a long way towards helping the funds raise more capital, and creating confidence for BX shareholders.

FD: Author has a long position in the ZachStocks Growth Model

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Another insigtful article from my friend and Colleague Justice Litle - Editorial Director for Taipan Publishing Group.

A Raging Bull Market in Organized Crime

The most profitable business in the world isn’t big oil. It’s organized crime. And the global financial crisis has unleashed more opportunity for the kings of crime than ever before…

“The Mafia isn’t part of the past, it’s part of the future.”
– Roberto Scarpinato, Sicilian prosecutor

Just how heavy is a million dollars cash?

If you’re trying to smuggle that kind of dough in old-school $100 bills, you’ll be lugging a little over 22 pounds. But if you’re rolling with banded, manicured bundles of the highest denomination euro notes (a cool €500), then the same amount only weighs you down by 3.5 pounds – and takes up a lot less space.

This is the kind of thing it’s good to know when you’re in the most profitable business in the world.

Ask a Wall Streeter to name a line of business that produces endless gushers of cash, and big oil probably comes to mind. The oil majors have certainly been known for record-busting profits these past few years. But the mafia’s profits are far bigger.

The mighty Exxon Mobil, for example, booked a profit of a little over $45 billion last year. That’s a whopping $10 billion per quarter or more. And yet, in comparison, the top three organized crime outfits in Italy – just the top three, mind you – more than doubled Exxon’s profit for the same calendar year.

And of course, where Exxon has to pay taxes, the mafia mostly avoids such hassles. So when you take the tax-free aspect into account, the mafia leaves big oil in the dust. And of course, the “big three” in Italy are just the tip of the iceberg. The powerful tentacles of organized crime extend all over the world…

Meet the Octopus

During my time at Oxford University in the mid-1990s, one of the best things about the experience was the speakers who came and talked to us. The Oxford Student Union (which has nothing to do with unions as Americans know them) would regularly bring in fascinating people to come and speak.

One of the speakers who made a real impression on me was a man named Brian Freemantle. An organized crime expert who has worked in more than 30 countries, Freemantle is the author of a book called The Octopus: Europe in the Grip of Organized Crime.

The book is nearly 15 years old now, and so many of the statistics are way out of date. But the basic outlines of the organized crime “octopus” Freemantle describes still hold true. And if Freemantle were to update his book with numbers for the new millennium, they would no doubt be mind-boggling.

As Freemantle writes in the opening pages of The Octopus,

Crime pays. It always has done. Not, of course, for the street people or the amateurs. They are swept up, like the disposable dross they are, as much victims as those upon whom they prey. The people for whom crime pays are the professionals, the men and women who operate it as a business, conducted through structures closely resembling legitimate multi-national corporations and conglomerates, their boardroom-like hierarchies serviced by accountants and financial advisors.

Freemantle then goes on to describe the eight tentacles (i.e. money-making activities) of the octopus: “the illegal arms trade, the illegal drugs trade, money-laundering, computer crime, prostitution and pornography, illegal immigration, terrorism, and fine art.”

One might think the octopus, too, has been hit hard by the global financial crisis (just like everyone else). One would be wrong though… instead, the crash of 2008 may turn out to be the biggest coup in decades for organized crime.

Cash in Hand

So why is the mafia set to wax, even as the whole world wanes? In a word, cash. We have all heard many times by now, in various guises and forms, that when times get hard, cash is king. And nobody keeps more cash on hand than the kings of crime…

Banks everywhere are afraid to lend their precious reserves. Fears of a fresh downturn, combined with the heightened credit risk of battered borrowers and toxic assets still weighing down bank balance sheets, have all but turned off the credit taps.

Many businesses, including well-run, profitable businesses that simply need access to capital in the normal course of operations, are suffering. At the same time, the most sophisticated players in the criminal underworld are sitting on tens of billions – no, make that hundreds of billions – and have a pressing need to launder those funds.

One of the most important tasks for any self-respecting crime boss is white washing the ill-gotten gains… turning “dirty” money into “clean.” This money laundering process is often handled by channeling funds through legitimate businesses. (I experienced this firsthand during my time in Olomouc, a charming little town in the Czech Republic, where the puzzling proliferation of clubs, restaurants and jewelry stores served mostly as mafia fronts.)

So now, with banks more or less out of the lending picture and businesses facing a dire need, the mafia has a once-in-a-generation opportunity to go “legit” on a bigger scale than ever.

As Giorgio Napolitano, the president of Italy – not to be confused with flashy Prime Minister Silvio Berlusconi – observed in May: “There’s a risk that Mafia organizations can profit from the current crisis by buying control of struggling businesses, infiltrating all regions of the country.”

A “risk?” More like a guarantee…

“The Mafia is ramping up its investing,” prosecutor Antonino Di Matteo tells Bloomberg. “The Mafia’s financial managers are trying to invest now, while the time is right, so that they can launder their fortunes once and for all.”

The Tony Soprano Full Employment Act

It isn’t just Europe where crime pays. In the United States, scores of less than savory characters are salivating at the new opportunities created by Washington.

We already know that the alphabet soup of acronyms dreamed up by Turbo Timmy Geithner and Helicopter Ben Bernanke are borderline criminal – TARP, TALF, PPIP and so on – but I’m talking straight-up Goodfellas type stuff here. For instance…

Two weeks or so ago, I sat next to a paving contractor in a local poker tournament. (Just as in Las Vegas, in Reno/Tahoe you can find a tourney on any given weekend.)

“Business is very good,” my fellow poker player reported. “Amazingly good actually. That stimulus cash is really starting to flow.” Apparently he was doing some heavy construction work on a nearby Indian reservation. Big road upgrades, courtesy of a check from Uncle Sam – and the backlog of work was piling up.

Now, I imagine this paving contractor’s business is probably 100% aboveboard and legit (even though he wears enough heavy gold to fall somewhere between Liberace and Mr. T). But if he wanted to cut a few corners, how hard could it be?

Or, heck, maybe he’s the victim in all this. Plenty of aboveboard businessmen in the construction trade wind up greasing a palm or two on their way to a finished project… sometimes it’s just what you gotta do…

The scale of opportunity, er, corruption, is bigger than one might think.

According to fraud consultant David Williams of the Deloitte Financial Services advisory, a whopping $50 billion worth of stimulus cash could be siphoned off the top for fraud (above and beyond the legally fraudulent activities of a venal and corrupt Congress).

“The rule of thumb typically,” Williams reports, “is that of the about $500 billion worth of money that’s going to run through the procurement process, somewhere between 5% and 10% of that usually finds it way into potential problems.”

The FBI is aware of the danger. As FBI Director Robert Mueller recently warned, “These [economic stimulus] funds are inherently vulnerable to bribery, fraud, conflicts of interest, and collusion. There is an old adage, that where there is money to be made, fraud is not far behind, like bees to honey.”

Of course, being aware of the danger and being able to do something about it are two different things…

Call it the Tony Soprano full employment act. With the government anxious to throw bales of taxpayer cash at “shovel ready” projects, the organized crime element will be standing by with a “shovel” too… “ready” to haul away veritable garbage trucks of loot.

Eyes Wide Open

So what can you and I do about this? Realistically, not very much. (Okay, let’s be honest… not a damn thing.)

But at the same time, I would rather go about my business with eyes wide open than eyes wide shut. The strong and growing presence of organized crime is something that ordinary citizens don’t have much day to day contact with (most of us anyway). But it is a reality we all pay for… like an extra form of goods and sales tax, paid to a de facto shadow government operating behind (and sometimes in direct cahoots with) the official one.

Think about the difference between undertaking a new business or investment venture in a low-corruption Western country, like the United States, versus a high-corruption “frontier market” country, where the rule of law is still only vaguely formed.

In the more advanced Western country, you can rest in peace knowing that the laws will be upheld and everything is completely above board. Right?

Not quite. That bit about the United States being “low-corruption” was a touch of sarcasm. As the global financial crisis continues to unfold, one of the side effects could be the gradual disappearance of the brightly drawn dividing line between high-corruption and low-corruption nation states.

This reality will make following conventional, business as usual, “eyes wide shut” investment advice all the more dangerous in the years ahead… just as it would be dangerous to open an import-export business in some far-flung outpost without having a clear handle on the risks present.

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Monday was an ugly day on Wall Street.  Stocks had the sharpest decline we have seen in two months with the S&P dropping a full 3% by days end.  Headlines pointed to concerns over the economic recovery and skittish investors after such a strong run from the March lows.  This is a critical juncture in the market as a decline in investor confidence could quickly snowball into a much more significant decline in the market.  Estimates of a potential decline range from a few days of selling, to a test of the March lows, to dour pictures of new lows and great depression style calamity.

While my estimate is for a month or two of weakness with the markets holding above the March lows, it is important to respect the potential for a much bigger decline if the economy continues to show anemic signs of recovery.  In particular, stocks with excessive speculation could be vulnerable to decline as investors flee to safer opportunities and place a larger portion of their account in cash.

Baidu, Inc. (BIDU) more than doubled the market’s loss Monday with a loss of 6.6% on heavy volume.  It appears institutional investors are quickly liquidating positions in the “Google of China.”  The concern is that if the economy is weakening, BIDU will not be able to grow advertising revenue as quickly.  With the stock trading at 48 times 2009 expected earnings, there is very little room for disappointment.

Bullish investors point to the fact that BIDU has seen strong historical growth despite the tough market environment which is certainly true.  However, the year-over-year revenue growth has slowed in each of the last four quarters.  Q1 2008 saw revenue growth of 130%.  In subsequent quarters, the growth declined to 122%, 103%, 69%, and in the first quarter of 2009 revenue growth was only 45%.  The execution is certainly impressive, but may not justify such a high multiple on the stock.

In a market environment like we are experiencing today, perception can much more of an effect on stocks than reality.  This is why we often see stocks pushed above what many would consider to be a “fair value” as investors become excited about a growth story and buy at any price.  Conversely, there are times when investors perceive more risk and will sell stocks down to a level that is fundamentally cheap and offers incredible bargains.  As traders, picking up on these subtle changes in perception can yield impressive gains over time.

The sentiment appears to be changing for well-followed and generally accepted growth stocks.  The change similar to the overall market’s concern over a potential stall in the accepted economic recovery theory.  But in the case of individual stocks like BIDU, the change is magnified.  We can see that the beta (rate of change compared to change in the market) is very high with BIDU.  But more than just a statistical measure, it appears that fear in the general market will be magnified for BIDU as the stock is leveraged toward the future growth of this well known company.

Now to be fair, Baidu is an excellent company with a strong management team.  The balance sheet has no debt, and a healthy cash balance.  So the fear of a complete business failure is totally unfounded.  Growth will likely still be relatively strong despite an economic downturn simply because of the demographics in China.   But that growth may come in below expectations.

The first quarter is understood to be a seasonally weak time due to dynamics surrounding the Chinese New Year.  So while revenues and earnings were above the year ago levels, the first quarter revenue and earnings figures came in well below fourth quarter levels for a sequential decline.  It will be very important to see how the second quarter numbers come in.  If the company is able to show seasonal and year-over-year strength, the numbers will go far towards propping up the stock even in a declining market.

However, if those numbers show growth continuing to slow it could be very difficult for investors to swallow and the stock could drop to a more reasonable multiple of 25 to 30.  A lower multiple coupled with lower 2009 and 2010 earnings expectations could be devastating to the stock.  Consider a multiple of 30 on lowered 2009 estimates of $5.00 would leave us with a price of $150, a 44% drop from current prices.

In the current market it pays to be cautious.  I would recommend considering BIDU as a short opportunity to offset risk in other long positions.  One could use a stop at $315 which would be a new recovery high for the stock.  If this level is breached the short should be closed as BIDU would obviously be stronger than we anticipate.  But if correct, this short could yield strong gains in a rough environment.

FD: Author does not have a position in BIDU

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Investors Business Daily had a front page article regarding a “discussion draft” bill released by the house Ways and Means Committee on Friday.  The bill is very generous with plans to subsidize healthcare costs, but does little to explain just how these subsidies would be paid for.  Amazingly, democrats believe that this bill will cover about 95% of Americans with some sort of healthcare benefits.

So far, it has been difficult to get any sort of comprehensive health plan through both the House and Senate due to the huge expense of such a measure.  Originally, Obama had a July 31 deadline for Congress to get a bill to his desk, but it now appears that the president will back off this aggressive time table as a viable plan still has not begun to emerge.

As of yet, there is no official word from the Congressional Budget Office as to how much this new proposal would cost, but the pricetag is expected to be above the $1 trillion estimate placed on earlier proposals by Senator Ted Kenneday and Senator Max Baucus.  Not to be discouraged, Henry Waxman from California promised that the bill would be paid for through cutting expenses on existing programs and with additional revenues.  Of course additional revenues means higher taxes.

And higher taxes will certainly be a problem if enacted.  The current economic recovery is still in question, so raising taxes to pay for such an expensive program as universal healthcare would be very unpopular and potentially economically dangerous.  Unemployment levels continue to trend higher with the expectation now set firmly in double digits for the coming months.  There is speculation of additional taxes on soda which seems absolutely rediculous but may end up helping to pay at least a portion of the costs for such an expansion.

As an investor and taxpayer, the thing that is most concerning is seeing an industry be completely nationalized as would be the case if 95% of Americans were covered by the new healthcare program.  The US government is notorious for being inefficient with programs because it is not designed to take the place of the free market.  A nationalized healthcare program would reduce much of the incentive for medical advances and would eventually lead to sub-standard care for the majority of citizens.

A free market where consumers bear some or all of the costs of their own health costs would go far in eliminating waste and weeding out physicians who overcharge for treatment.  However, if the government program places regulated pricing on payments for particular procedures and treatments, there is no free-market mechanism to encourage innovation, cost savings, or even better treatment.

Farther down the road, the healthcare profession will likely be characterized by relatively low wages and high degrees of regulation.  Hardly the type of industry a bright student would aspire to.  So it wouldn’t be surprising to see talent diverted to other fields (as has been the case with the financial industry) or even for aspiring doctors and nurses to set up practices in more business friendly countries.

Eventually, in order to receive the best care, wealthy consumers may travel internationally in order to receive first-rate care while those not in a financial position to do so are stuck with less at home.  Medical technology and drug development companies could go out of business due to lower government reimbursements, or choose to move their operations to countries with a more “pro-business” approach.

Now I don’t want to sound too capitalistic and harsh.  Obviously we need to be humane in our distribution of healthcare regardless of the economic status of the patient.  But if I am able to afford a healthcare program for my family, it should be my responsiblity and not the governments to provide for the necessary care.  So for people living below the poverty level a national healthcare plan is certainly necessary.  But in my opinion, this plan should not include citizens who are 400% above the poverty level or crafted to cover 95% of Americans.

One of the things that would make healthcare more affordable and competitive would be to create limits for malpractice litigation.  I’m not sure what the exact portion of healthcare cost can be attributed to malpractice insurance, but I’ve talked to enogh doctors to realize that this is a serious portion of the cost of medical treatment.  Litigation reform and a safety net for those who truly cannot afford basic healthcare would be much cheaper than the proposed legislation, and would promote competition, innovation and healthy business practices for the broader medical sector.

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Focus Media Holding Limited (FMCN) has been devastated by the recent economic downturn.  In late 2007, the stock topped out above $65 per share, but currently trades at roughly $7.50 - down roughly 88% from its former glory.  The Chinese advertising company spent considerable capital to develop a network of outdoor advertising monitors which held promise to generate huge revenues due to exposure to the Chinese masses.

But as the economy weakened and advertisers pulled back on spending, Focus Media found themselves leveraged and without the necessary revenue to keep up with expenses.  Finally, the company had no choice but to sell the majority of its assets to rival Sina Corporation (SINA) in a stock deal that should close in the next few months.  Focus Media will still continue to trade as a stand-alone company, but after selling its best assets, it is unclear just how the company will survive.

While the long-term concerns surrounding Focus Media are still very difficult to overlook, there is an interesting opportunity to lock in a profit from the proposed merger.  Focus Media has said that it will receive 47 million shares of SINA as compensation for the outdoor advertising assets.  The company plans to distribute these shares to holders of FMCN once the transaction is complete.

Focus Media has roughly 128.6 million shares outstanding and will be receiving the 47 million SINA shares to distribute.  At this point it looks like each share of FMCN will have rights to 0.365 shares of SINA.  So if you own 1,000 shares of FMCN you can expect to receive 365 shares of SINA.  Using today’s market prices, it looks like the value of these SINA shares actually represent $10.71 for every FMCN share.  However, FMCN is currently trading at just $7.60.  So in theory, you could buy 1,000 shares of FMCN at the current price, short 365 shares of SINA at $29.00 and expect to make about $3.00 once the deal is complete.

Another alternative for this trade would be to buy 1,000 shares of FMCN and then sell 3 calls SINA September 30 for $2.70  If SINA trades flat to lower from current prices, you will be able to keep the premium and eventually sell your SINA shares at the market.  However, if SINA trades higher, you will be obligated to sell 300 shares at $30, but you should benefit from a rise in FMCN because the payment for its transaction will be worth more.

While the transaction appears riskless on paper, one should realize that no profit comes completely free of risk.  The wild card in this scenario is two-fold.  First, there could be some regulatory resistance to the deal and if SINA were blocked from purchasing these assets, FMCN would likely trade even lower and it’s possible that SINA could trade higher as investors no longer fear dilution from the deal.

The second risk is that FMCN could accept the shares and then fail to distribute them to investors.  While there would certainly be a large public outcry against this, it wouldn’t be the first time executives changed course mid-way through an important transaction.  If FMCN were to continue to hold the SINA shares, the value would still be available to investors, but the spread could still remain wide as investors fear the company will sell the SINA shares instead of turning them out to investors.  This would be bad news since Focus Media is bleeding cash without these assets and could quickly burn through the proceeds from the SINA sale.

So the opportunity to profit from this transaction is very attractive and could be a lucrative opportunity.  But investors need to be aware of the risk and keep the size of this trade at a reasonable level in case the deal falls through.

FD: Author does not have a position in FMCN or SINA

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Alex Fotopoulos is the editor of My Traders Journal as well as the Chart Analysis blog which analyzes trends for stocks and ETFs.  Recently Alex and I shared lunch together and I was impressed by his take on the market and his passion for investing.  I hope you will find his opinion on CVS helpful.

In the June 15th edition of Barron’s Kopin Tan made some bullish comments about CVS Caremark Corp (CVS). One of his suggestions for suggesting CVS as a good stock pick is the historically low P/E ratio it has right now. I pulled the following chart of CVS’ historical P/E versus its current price to earnings ratio from one of the free Ford Equity Research reports offered by TD Ameritrade.

I like to use these reports and charts that show stocks’ P/E ratios in the low historical ranges. My next step is always to chart the stocks I’m considering. The chart showed potential support close by, either close to the current price from early in Monday’s trading near $29.80 or next at $29.00.

I started my trade as a naked put order with a $30 strike, but decided I should target a lower strike to give myself a better chance of the option finishing at a full profit for me. Before I placed an order for the $29 strike I double checked myself to see how I could hedge it which is something I’m trying to do more after learning my lesson too harshly last year when some of my picks went the wrong direction. I noticed the vertical put spreads at $30/$28 offered the same net premium as the naked puts at the $30 strike. I figured hedging my trade was smarter in this market than taking the full downside risk since the upside potential gain was the same. The only difference is that I took away a full dollar from the cushion I had from the options finishing out of the money. If the options I was selling were set to expire this week I wouldn’t have taken the chance with this trade, but I think that even if CVS dips, it shouldn’t be for long and I’ll ride out my position.

While CVS was trading at $29.81 my limit order hit. I sold five CVS July 30 puts (CVSSF) at $1.25 and received $611.24 including commission and bought to open 5 CVS July 28 puts (CVSSO) at $0.50 and paid $253.75 including commission as a hedge. Since I entered the order as a vertical puts spread instead of separate legs in different orders I only paid commissions on one order and then on each option contract. I put my order in for a $0.75 net credit. I came away with a total after commission net credit of $357.49.

That order went through on Monday June 15th. During my lunch on June 16th I charted CVS while it was trading at $29.92. This is a summary of the notes I took then.

The trend lines of higher lows and lower highs are on the path to converge soon - This is setting up to a symmetrical wedge. Recent lows for CVS show support just under $29.00 possibly. Although CVS broke below its 50 day moving average last week the 100 and 200 day moving averages show support not far below the current price which is in line with the previous lows I mentioned. The Williams %R 14 and 28 day indicators show no real push for direction for either side. Volume has been lighter than average recently possibly suggesting the latest dip might not have too much staying power.

I expect the wedge drawn in my chart is going to be the catalyst for a new run up for CVS soon if I’m right and if I’m off by some I think CVS will come back down to touch its earlier low close to $29.00 and then will fight back strong. The break below the 50 day simple moving averages made me feel I should hedge my position along with the 10 and 20 day averages (not shown in this chart) breaking support too. I think the 100 and 200 day moving averages will cross soon which is a bullish indicator and that will help lift CVS even more.

On Wednesday, the day after I charted this view of CVS it broke above the trend line I drew of lower highs and made it up to $31.23 before settling down some by close. I still expect CVS to have room to run and hope to keep my bull put spread in place through July options expiration.

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I’m on vacation with my family this week.  While I’m still on top of markets and am staying in touch with trends, I’m trying to spend a bit of time recharging the batteries and enjoying the kids.  So today I’ll share some interesting videos from my friends at Ino - interesting information on the current S&P trading, Gold, and the debate over inflation versus deflation.  I hope you find the videos worthwhile and helpful for your trading…

S&P 500 - A Correction or Major Turn?

With the S&P 500 falling to a fresh two-week low, the big question is this a correction, or the start of a major trend on the downside?  The video is free to watch and there is no need to register.

Gold Update: June 15

Will the long-term support line stop the hemorrhaging in the gold market?  The video is quite short, but it will lead you step by step into the detailed analysis of this not so precious metal.

The #1 Predictor of Inflation or Deflation

There is an indicator which has been around since 1957. It has accurately forecasted every inflationary and deflationary cycle since.  Take a few minutes to watch this short video and see how you can benefit from this indicator.

Please let me know what you think about these videos.  I’ll be back to you tomorrow with market insights.  And don’t forget to sign up for the ZachStocks Newsletter - our next issue comes out tomorrow with some important reading on critical investment trends.  Use this link to sign up for the newsletter.

The seeds of economic recovery have been planted.  Over the last 9 months, governments across the globe have poured more stimulus packages into the economy than any of us could have imagined just a year ago.  But like the biblical parable of the sower and the seeds, new growth is anything but guaranteed.

Monday the markets were down sharply as investors worried about rhetoric from the G-8 meeting.  Specifically, comments about cutting back on stimulus programs weighed on the markets.  One prominent report likened this potential decline in stimulus measures to planting seeds and then deciding not to fertilize.  While we have been skeptical about the long-term benefits of excessive spending, it seems illogical to generate a market recovery based on the expectation of spending, only to back off this plan before the fundamental picture gives significant evidence of a rebound.

Commodities were especially hard hit due primarily to strength in the dollar (which makes everything else less expensive on dollar terms).  These comments should be taken with a grain of salt, especially when considering the motives behind the speakers.  It is in the best interest of nations who have significant dollar reserves, to see the dollar stronger.  So as nations that the US relies on to purchase debt state their confidence in treasuries and in the dollar, it is similar to a trader “talking up his book” or boosting confidence in positions he has already taken.

While the decline in commodities was disconcerting, it does not appear to be a fundamentally justified move.  I believe over the coming months we will see a robust trend towards higher prices of hard and real assets.  While the dollar may not fall in comparison to other currencies (remember other governments can print currency too), the purchasing power of the dollar will likely fall sharply.  This could correspond with a sharp rally in the dollar price of commodities.

One company that could benefit greatly from this trend is Potash Corp. (POT).  The company makes fertilizer and feed products for use in the US and Canada.  These products are obviously in strong demand regardless of the economic cycle as few would consider basic food to be a discretionary item.  There is a relatively finite supply of potash available for fertilizer and since POT owns rights to a significant amount of this resource, it should benefit from strong pricing power in the coming months.

The stock traded lower well ahead of the financial slump for much different reasons.  Potash had been trading at an unsustainable level when biofuel was considered to be a viable alternative for our energy issues.  Investors bid POT higher in expectation that the company would enjoy high prices due to the inordinate amount of corn being produced for ethanol.  As this alternative became less popular, and traditional energy prices dropped, Potash pricing dropped as well.

Today the dynamics are much different with a lower stock price, significant expected growth, and the demand being driven by true agricultural consumption and not as much by biofuel speculation.  When added to the inflation scenario we spoke about earlier, Potash Corp begins to look like a very appealing investment.

From a valuation standpoint, POT currently holds a PE of roughly 11 times earnings.  That number is less helpful when you look at the volatility in earnings over the past two years.  In 2008, the company made $10.95 per share as commodity prices spiked higher.  In 2009, the company is expected to earn only $6.89 due to lower pricing power and the biofuel headwinds.  But looking to 2010, analysts expect the company to make $11.29 and I expect that estimate to be relatively conservative as most analysts still have some deflationary biases.

Potash Corp has a relatively stable balance sheet with debt adequately covered by cash flow.  The company pays a small dividend which is not really that important as an investor, but it appears that management has confidence in its ability to generate free cash flow enough to pay investors on a quarterly basis.

The stock should likely be priced more in line with the assets underground than with the earnings on any given year.  As potash pricing picks up over the coming quarters, those reserves will become more valuable and the true net equity of this firm will be supported.  Over time, this will likely be reflected in the stock and could push prices past $200 in the next 6 to 9 months.

FD: Author does not have a position in POT

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An interesting perspective on consumer confidence from Bob Blandeburgo.  While I’m not sure that the consumer is feeling as robust as these measures suggest, it is interesting to speculate which retailers will be able to move merchandise in the coming quarters…

BlackRock, Inc. (BLK) made headlines late last week as the company announced a blockbuster acquisition.  The firm will pay roughly $13.5 billion in cash and stock for Barclay’s Global Investors (the Barclays division which includes the ETF platform known for its iShares products).  The deal is a cash and stock offer with BlackRock ponying up 37.8 million shares along with $6.6 billion in cash.  Impressively, despite the huge investment, BlackRock was only down a bit over 3% on the news.  For large transactions like this, typically the acquiring company trades down sharply on the news as investors fear dilution of their investment.

The deal is likely to go through although there is a third party who had originally made an offer for the iShares platform and now has 5 days to match BlackRock’s offer.  Shareholders will also be required to approve the deal and the company’s do not expect the deal to close until the fourth quarter.  It will be interesting to see if the government steps in to review this deal.  Since Barclays could certainly use the capital, it would seem prudent to let the deal go through, but at the same time, global regulating bodies are carefully watching financial firms to make sure that we do not build up systemic risk similar to the scenario which brought the financial industry to a screeching halt late last year.

Financing for the deal appears to be in place with BlackRock raising a significant amount of cash thfouhg offering securities to institutional investors (an agreement is already in place) as well as drawing from a new credit facility which has been established with a syndicate of banks.  While the company is confident that it can raise this necessary capital, we have seen how quickly financial firms can renig on agreements especially with the changing industry dynamics.

Following the deal, Barclays will own roughly 20% of BlackRock which could present interesting synergies for the two companies to work together.  It is assumed that Barclays will be able to leverage the relationship between the two firms in order to offer BlackRock’s financial products and investment services to both institutional and retail clients.  It will take several years to determine if these business lines are compatible, but it appears to be a sound strategy in the early stages.  One wildcard will be financial regulation for the entire industry.  With Obama making it very clear that financial institutions will not be allowed to grow to a level where they have the potential to bring down the financial system in a manner similar to AIG, growth of large firms in this area could be hampered.

BlackRock is currently trading in a healthy pattern after rallying from a support area around $90.  While the firm has certainly not escaped the economic difficulty over the last few quarters, the stock has been stable compared to many of its peers and looks to be in good shape.  The company is expected to earn $7.65 next year which puts the PE at roughly 23 times future earnings.  It is unclear exactly when synergies from the acquisition will kick in, but these estimates could prove to be conservative if BlackRock is able to create value from this announcement.

While a PE of 23 is a bit higher than I would normally be comfortable with, the conservative nature of the estimates appears to support the stock price.  Debt levels are currently very attractive and while the company will increase those liabilities, their ability to raise capital quickly in this type of market is certainly a positive.  Over the next year we should see estimates increased and the potential for a higher stock price.  At this point, BlackRock looks like an attractive, stable option for investors wanting to participate in the financial industry.

FD: Author does not have a position in BLK

An Interesting Read from Peter Schiff…  Hope you’re having a great weekend.  I’ll be vacationing this week with my family but will do my best to keep ZachStocks rolling with useful information througout the week.

Peter Schiff: Why this Money Should Replace the U.S. Dollar

There’s a new universal currency, backed by solid gold. You can use it to make online purchases anywhere in the world. Converting some money to the new currency takes just 5 minutes. You can start with as little as $10… or as much as $10 million.

According to CNBC star analyst and Euro Pacific Capital President Peter Schiff, this money could double the value of your savings - automatically - in just 6-9 months.

For Schiff’s full analysis and recommendations, please go here.

How China Could Rescue General Motors

By William Patalon III

And Jason Simpkins

Money Morning Editors

For anyone who still disputes that we’re operating in a global economy these days, consider this bit of business irony: The long-term survival of America’s biggest car company could depend on how well it does in Mainland China.

As it works its way through bankruptcy and crafts a corporate turnaround plan, General Motors Corp. (OTC: GMGMQ) – derisively referred to as “Government Motors” by critics – has five factors on its side. The first four are pretty predictable fare for a U.S. auto company that finds itself on the ropes:

• First, bankruptcy will turn GM into a company whose smaller size is better suited to the diminished size of the post-financial-crisis U.S. auto market.
• Second, the bankruptcy process will also allow the company to turn billions in liabilities into equity, freeing up cash it can use to invest in its future.
• Third, even with the sale of Saturn and Hummer – and with the elimination of additional models and nameplates – General Motors has a stronger stable of products than most observers realize.
• And fourth, the consumer backlash against the bankruptcy likely won’t be as damaging as had been initially feared – meaning sales won’t just “fall off a cliff.”

But the fifth factor – the wild card – is still China, where GM has established a surprisingly strong and successful presence. That should allow General Motors to capitalize on a market that’s the world’s fastest-growing right now, and that will one day be the world’s biggest market, too. Eventually, GM will be able to use that low-cost market to build cars and trucks and ship them back to the United States for sale at competitive prices. China’s big carmakers are already planning to do just that. So why shouldn’t GM?

The bottom line: China’s car market could be GM’s savior.

Why China Could Save “Government Motors”

The good news for General Motors is that its Asian operations will be unaffected by the bankruptcy.

“Our operations are separate, they are profitable, they are well-funded, and we generate our own funds for future investment,” GM China President Ken Wale told reporters. “We do not see any change to our growth activities.”

GM China is trying to drive home this point by emphasizing to its Asian customers that it isn’t an extension of General Motors, but is actually a joint venture between GM and Shanghai Automotive Industry Corp. Each company owns 50% of the venture.

GM China has actually been one of the bright spots in General Motors’ operations. While U.S. sales have plunged, sales in China have advanced at a stunning rate. In the first five months of this year, GM China sold about 670,000 vehicles – a 33.8% increase from the same period a year ago. May sales surged 75% from last year.

“Shanghai GM is a brand name here by itself and its Wuling minivans and mini-trucks are selling like hot cakes all over the country,” Zhang Xin, an analyst with Guotai Junan Securities Ltd, told Reuters. “I think it will be business as usual here, as whoever is calling the shots at GM eventually would make sure that its China business remains on the right track.”

And while worldwide auto sales continue to plunge, sales in China are expected to grow between 8% and 9% this year. China actually overtook the United States as the world’s largest auto market for the first time in history in the first quarter.

“Within 10 years, this will be our largest market in the world,” Wale, the GM China president, told Time magazine.

GM China plans to double its sales in China to more than 2 million vehicles and introduce at least 30 new or updated models over the next five years. Meanwhile, General Motors will close or idle 14 U.S. plants and warehouse operations, shedding up to 20,000 workers.

As part of that streamlining effort, GM is looking at ways to roughly double the number of cars it builds abroad for sale in the U.S. market. Currently the company imports the Chevrolet Aveo and Pontiac G3 from South Korea. The Saturn Vue and Chevrolet HHR sport utility vehicles come from Mexico. And the Pontiac G8 comes from Australia.

The company could export small vehicles such as the Chevrolet Spark from China to the United States. That fuel-efficient mini car is to debut in 2011, GM’s Web site says.

But GM has been so successful in China that it is reportedly negotiating with U.S. lawmakers to send a greater proportion of the carmaker’s production overseas, the U.K.’s Telegraph reported.

No matter how those discussions go, GM will start shipping cars to the United States from Shanghai in 2011. While many carmakers import components from China to save on labor costs, this would make GM the first carmaker to actually import whole cars from Mainland China. But those numbers will be small – at least initially. The company plans to export slightly more than 17,000 vehicles in the first year, before ramping up to 50,000 cars a year by 2014.

In fact, GM sold more vehicles in Asia in the first quarter than it did in the United States. Only 26% of GM’s first-quarter sales came from the United States, a 36% decline from a year ago.

The Wild Cards that Could Cause GM to Crash

Of course, the plan doesn’t sit well with unions.

“GM should not be taking taxpayers’ money simply to finance the outsourcing of jobs to other countries,” Alan Reuther, a Washington lobbyist for the United Auto Workers (UAW) union wrote in a letter to U.S. lawmakers.

Indeed, the UAW and others argue that the whole point of bailing out the U.S. auto industry was to save American jobs and help prop up the sagging economy.

“I think that’s wrong,” Keith Pokrefky, a Michigan autoworker, told WILX, the Lansing TV station. “I think that’s wrong for America. I think it’s wrong for American jobs. It’s un-American.”

For its part, GM argues that it is only logical to produce cars where they’re going to be sold.

“GM’s philosophy has always been to build where we sell, and we continue to believe that is the best strategy for long-term success, both from a product development and business planning standpoint,” GM’s China office said in a written statement to the The Associated Press.

Harvard Business School professor Clayton Christenson – who was also a consultant to G. Richard Wagoner Jr., the former GM CEO who was also the architect of GM’s China strategy – told Time that inexpensive, Chinese-made Chevys, exported to the United States, could be the “disruptive” force the company needs to resuscitate its North American vehicle sales.

“It’s exactly the right thing for [GM] to do,” Christenson said.

While China keeps its data on labor costs under lock and key, analysts estimate that wages and benefit payments per factory worker are less than a tenth of what they are in North America, Time reported.

And as Ballard, the Michigan State economist notes, if GM fails, there are no jobs at all.

And perhaps that’s the reality on which everyone should focus. There was a time when what was good for GM was good for America. But somewhere along the line, the interests of the country and the carmaker diverged.

Even now, with the Obama administration having anted up with taxpayer money, the near-term steps that GM needs to take to survive may not be very popular with the “Buy America” crowd. In fact, having ponied up billions of dollars worth of federal assistance, U.S. President Barack Obama now finds himself trying to balance the competing interests of all the stakeholders, even as his administration tries to save GM – a balancing act that may prove impossible to pull off.

President Obama might be better served by focusing his energy on saving GM – allowing the company to employ the five factors that favor a turnaround to its own maximum advantage.

In fact, we’ll make this statement: These five factors could save GM. For the company to achieve long-term success, however, two specific things must occur.

• “Government Motors” must employ those five factors to their fullest potential.
• And the Obama administration must allow the company to do so.

Only time will tell if either or both of these happen.

• Decline in personal wealth near $5 trillion last 2 quarters
• All social classes are feeling the pinch
• Few places to hide that offer real protection
• Dollar strong ahead of G-8 Meeting
• Japan with positive comments on treasuries
• Long-term inflation picture intact

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CarMax, Inc. (KMX) will announce earnings next week as their fiscal first quarter ended on May 31.  Despite sagging sales the last three quarters, investors appear optimistic that this report will be a bit stronger.  The stock is currently trading near $13 after hitting a low of $5.76 on November 21.  Unfortunately, while KMX has been a great success story for 2009, the current stock price appears vulnerable to a sharp decline if the news is anything but spectacular.  Analysts are expecting the current year (fiscal 2010 ending February 28) to generate earnings of 23 cents per share leaving the stock with a current PE of 57.  Now to be fair, I should also point out that 2011 is expected to generate earnings of $0.49 so the multiple on earnings 2 years out is only 26.5.  However,  that is still fairly high for such a speculative growth story.

Much of the recent strength has been due to increasing expectations of used car sales, and positive financing data.  The logical argument is that as the consumer deals with lower employment and reduced balance sheets, he or she will more likely buy a used car instead of springing for that shiny new set of wheels.  And the high profile bankruptcies of the US car manufacturers has certainly not hurt the trend towards buying used cars.

Financing has also gotten a bit looser in past months, but not as much for individuals as it has for KMX lending facilities.  It is expected that the financing unit will be able to securtize more of its loans and sell them, leaving more available capital to lend to KMX customers.  That certainly could have a positive effect on demand, although standards for making these loans will still be much tighter than we have seen in past years.

One of my major concerns with  CarMax is the potential for sharply increasing competition.  First, you have many independent dealers who used to traffic in new GM, or Chrysler cars who may now enter the used car market.  These guys have the property, staff, and expertise to sell cars but no longer have the privileges associated with the manufacturers.  It’s likely that these resources will be used to sell used cars, and compete directly with CarMax.

Secondly, the auto manufacturers will come out of bankruptcy leaner and fighting for their lives.  This means a sharply reduced cost structure which will trickle down to significantly reduced prices on new cars.  So consumers who may previously have decided to stick with a used purchase may find that the cost of a new car is incrementally attractive.

Currently, the gross profit for the average unit sold at CarMax is about $1,850.  It will be interesting to see where this number comes in next week, and which way it is trending.  Investors could quickly sour to the company if this gross profit number is not improving.

While CarMax will certainly stay in business, and may in fact benefit from the current automaker debacle, the stock price just seems to reflect too much optimism.  I wouldn’t be surprised to see the stock trade back down to 15 times the 2011 estimate of $0.49.  That would bring the price to $7.35 - which would be quite a shock to investors.

Shorting the stock is likely the best way to profit from a drop over the period of several months.  However, aggressive accounts could consider buying the KMX June $12.50 puts.  It’s a very risky play, but you can pick up these contracts for 40 cents as I write.  The options expire at the end of the day next Friday, but if KMX announces very poor earnings and the stock drops to $10, you would realize a 525% return on the option.  However, if the stock does not trade down sharply, know that you would then lose the entire $0.40 used to purchase the puts.  The risk / reward ratio on this trade looks appealing to me for a very small part of your trading portfolio.

FD: Author does not have a position in KMX

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Much has been made about the potential for “green shoots” or signs of new life in the broad economy.  Zero Hedge offers a unique perspective on the opportunity costs of these green shoots - what we are giving up in order to “manufacture” this emergence in economic activity…

The Opportunity Costs of Green Shoots

As we’ve been saying, it’s not the change in the trajectory of the global economy, but the cost of engineering it, that clouds the outlook. One example: the cash-for-clunkers program that drove German auto sales higher may cost German taxpayers at least $3.5 billion, even after the sales tax and foregone unemployment cost benefits. Such programs simply pull forward future demand, and displace other non-auto purchases. The world has never relied before on a coordinated avalanche of fiscal and monetary stimulus, and financial guarantees. I find investment commentary that hails the arrival of better data without acknowledging its potential costs to be incomplete.

The Ultimate Fighting division of heavyweight economists has been active, with Paul Krugman and Allan Meltzer exchanging sardonically-worded “history lessons” with each other. Here’s a chart I pulled together to try and grasp the fireworks. Today’s “output gap” (a theoretical measure of spare capacity) is around 2x the 1970s version. That should give the Fed ample room to keep monetary policy easy for a long time. But how easy? The expansion of the monetary base is already 4x greater than its 1970s counterpart, and heading higher. So far, the money multiplier (which drives inflation) has been weak, but the Fed is making a huge bet they can control all of this. The size of the monetary and fiscal expansion reminds me of that giant boulder at the beginning of “Raiders of the Lost Ark”; recent increases in commodity prices and Treasury/Agency yields suggest it may be gaining on us.

Read the entire article including remarks on residential real estate and the US dollar…