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Financial Sense Newshour

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October 1, 2005

Supply Side Shocks - Inflation on the Rise - Investors Take Warning
The Next Big Thing
Dividends For the Long Run: An Update
Emails

Supply Side Shocks - Inflation on the Rise - Investors Take Warning

JOHN: You know, I was thinking, Jim, here we are at that wonderful segment in the program where we invariably have something to offend everybody. Nobody will be disappointed during this segment. Alright, let's look at where we've come over the past couple of weeks. we've had these couple of hurricanes we're going to have a segment coming up next, a special on global warming we may not be done with really heavy duty hurricanes: October is quite frequently heavy hurricane month when the traditionally heavier storms come in. But having said all that, we have the storms, the refineries are not producing, we've got platforms down, There's now talk of natural gas headed for $20 per cubic unit; in the mining industry, and they don't have enough tires. There is a radical paradigm shift underway in the economy right now about how we're going to have to do business. And by the way, anybody who buys food, goes to the pump, whatever you pay you can't help but notice prices are going up, and that 3% government figure just seems to be well, we shouldn’t say it like a fairy tale, Jim.

JIM: The important thing to understand about how we got here, John, is when money and credit expands in the economy, there are two outlets: one is the money and credit can go into the financial markets, giving us asset bubbles, which is what we saw in the latter part of the 80s, all throughout the 90s, or, for example, what we're seeing now in real estate. So, financial markets are an outlet for money and credit. Another outlet for money and credit is the real economy, and That's what we're starting to see right now. you're seeing the price of food go up, you're seeing the price of energy going up. Just walk into Home Depot and take a look at the prices. All away across the board, things, what I call the real economy, their prices are starting to rise, and people can't help but notice that. And, until this point we've had what I called the good inflation. When Greenspan flooded the markets with money and credit after the stock market crashed in 87, we got a nice bounce, the economy took off. He raised interest rates in 90, 91, we went into a recession, we had a war the first Gulf War he lowered interest rates 24 times, flooded the economy with money, the economy expanded. We had a crisis in 1997 with Asia, he flooded the markets again with money. In 1998 we had a crisis with Russia, and with Long Term Capital Management, he flooded the market with money. In 1999, it was Y2K. In 2001, it was the recession and the events of 9/11.

Now, what has happened is every time that money is injected into the economy the financial markets have taken off, and I think That's one reason that you've seen the market take off after Katrina, because the money supply went up by almost $150 billion, and I think There's this Pavlovian response you get from people in the financial industry, “Aha! Crisis.” Well, we know What's happened in the past when we had a crisis, the Fed floods the market with money. And indeed the money supply expanded after Katrina and Rita. The only difference is the Fed is raising interest rates, while at the same time It's flooding the markets with money and credit. So they are still expanding, monetary policy is still very favorable, but the difference now is when the Fed creates that money, it does not create any supply. In other words, if you have access to money as a company, if you have access to credit as a consumer, well, what does that do? It increases demand. So demand goes up, and we've seen that with the consumer since the recession of 2001, which was a very unusual recession. Instead of pulling back, instead of building up savings, consumers have done just the opposite: They’ve spent money; They’ve gone into debt. And savings, as of latest figures, is now negative in this country.

JOHN: So basically what we're saying is that at this stage of the game, credit or money doesn't really create supply.

JIM: No. It doesn't create supply, it only inflates demand. In other words, if you couldn't get credit let's say if interest rates were so expensive, banks were very tight with lending money, whether It's on home equity loans, or even credit cards then the only way you’d be able to spend money is if you would have to take the money you earned, and you would be limited to that. But if you have access to credit, through let's say, a home equity loan Greenspan just penned his name to a piece that was published at the Federal Reserve last week, where he talked about consumers extracted over $600 billion of equity out of their homes last year. Well, what was that? That was credit. That money that was extracted out of people’s homes was used to maintain consumption. That's creating demand, but what it doesn't do is create supply. Supply comes from what we call real savings, when those savings are invested in what we call “create supply” (property, plant and equipment), then you have a healthy balance from not only demand, but you also have the supply that comes on stream that can balance the demand. The excess demand That's been created with all this money and credit over the last 15 years has been channeled into imports. Which is one of the reasons why the United States is running record trade deficits. [6:20]

JOHN: OK, it would seem then, that this lack of supply would be one of the reasons at least, that we're seeing commodity prices rise, because the demand’s gone up that has been artificially created by the increased currency. But at the same time, now we see product prices are following it up, but That's normal, isn’t it, after monetary inflation?

JIM: Sure, because now that inflation is spilling over from excess demand into the economy and everywhere you look, John, the global economy is supply constrained. Everything! If you just take a look at the energy sector, we don't have enough oil and gas, we don't have enough refineries. One of the problems right now, even if OPEC could magically wave its wand and double its production, is we don't have the refineries, oil tankers, and the infrastructure that can process that oil. And so, we have a supply constraint on the energy sector, not enough energy itself, not enough oil, not enough natural gas, not enough uranium. Look at Uranium and coal prices over the last 2 or 3 years.

And the energy sector and the energy sector is just one sector, you have the same thing going on in the mining sector where we haven’t brought a lot of new mines on stream, a lot of the mines in existence are using lower grades of ore because they high-graded it in the 90s when prices were weak. You don't have enough drills out there; There's not enough equipment; the mining industry is short these big tires that go on this big earth-moving equipment. And let's be blunt, in the last two decades, in the 80s and 90s, when the price of oil was coming down, the prices of gold and silver, lead, zinc, copper doesn't matter what you were looking at were coming down, so who wanted to invest in enough production. In other words, who wanted to build a new mine; who wanted to build a new refinery. You couldn't do it economically, it just didn’t make a lot of sense.

So we have not brought a lot of capacity over the last couple of decades. In the meantime, the global economy has continued to grow, world population has continued to grow, and money and credit has been rampant globally, which means there has been a lot of money and credit that has worked its way through the economy, to create this excess demand. And if you subtract $600 billion in home equity loans last year, I don't think we would’ve had a positive GDP in the way that we did last year. $600 billion is a lot of money, even by American standards. [9:07]

JOHN: Yeah, Jim, one of the things That's really important to remember, I would think, is the fact that all this infrastructure we talk about supply, but you can't just flip a switch and have it come online overnight. Trying to turn the economy, you do something and It's like a large ship, it takes forever to make the turn, agonizingly slow, and this would seem the same thing. People say, “well, build more rigs.” OK, That's cool, but that may not happen until xyz years into the future what are you going to do in the meantime. There's your short term crunch.

JIM:Yeah, even if we were to, let's say, go all out and create incentives let's say the oil companies start a major expansion program to go drill and try to find new sources of oil or natural gas. Well, They're going to need drilling rigs, They're going to need oil platforms for deep water exploration. We don't have enough of those. And if we started producing more, then we're going to need more tankers. It takes time to build one of these large tankers. And one of the more important elements in this whole supply equation is a refinery: if you have the oil, or the natural gas, you need refinery capacity to expand, so that you can handle the extra supply that is going to need to be processed, whether its diesel fuel, jet fuel, gasoline, tar pitch, plastic all the products that we use comes out of a refinery. And this is something that takes, I would say, probably a minimum of 3-5 years to build a new refinery. It's going to take from the time of exploration of finding a new source of oil to the time you can bring that on stream, get a platform, you're looking at 3-5 years to bring all this supply on line. So That's a problem. In the meantime, demand continues to go up and we simply don't have the supply, and that supply is not going to be there for quite sometime. [11:10]

JOHN: OK, since we now admit that we have inflation at least we do here on the program, keeping the fairy tale going here, anyone who has to buy gas or heat or even cooler housing in Summer time in Southern climates, which you have to do are rate hikes going to solve this problem? What are the effects of this going to be?

JIM: If we take a look at the problem of Fed policy, the Fed has two tools to rein in inflation, or expand the economy. They can raise rates, making credit more expensive, which can also, by the way, close off speculation in the financial markets. In other words, if the short term rates rise to the point where They're higher than long term rates you virtually kill the carry trade. A second thing that they could do is shrink the money supply. They could start selling government securities to the banking system which decreases their reserves, which decreases their ability to lend credit. The problem is that inflation is now catching up; It's been dormant for many years, and It's been mainly manifesting itself in the financial markets, in the stock market, more recently in real estate, the bond market and mortgage markets. And so, all this money that has been going into financial assets is starting to spill over into the real economy. However, now with the supply imbalance that we have There's nothing the Fed can do. But if the Fed raises interest rates, the only thing that they can do is try to kill off demand. But even then, you take a look at energy, you're still going to have to put gasoline in your car, you're still going to have to turn the lights on, you're still going to have to heat your home, you're still going to have to eat food, all of that requires energy. There's nothing the Fed can do That's going to bring extra supply online. And the other real problem is as interest rates rise, remember, we have to go to a CAPEX cycle of increasing capital expenditures. If we're going to build a refinery That's going to take investment, if we're going build new oil platforms That's going to take investment, if we're going to build new tankers That's going to take investment, and a lot of that investment is financed with credit. So, as interest rates go up you may have some companies and this is one of the problems we've seen in the business sector that are unwilling to invest in plant and equipment. In other words, I think companies at a gut level see this as artificial demand, so as good entrepreneurs they are saying, “wait a minute! this demand is being created artificially, so maybe It's not a good idea to expand, because if It's artificial it could quickly go away”. And especially if the Fed is raising interest rates now, what are you going to do as a company you may be reluctant to tap the bond market to build and bring on new capacity. So rising interest rates are also a problem.

The other problem is psychological. Inflation expectations are rising, both at the individual level and the company level, and a lot of companies are now beginning to raise prices in expectation of further price increases. Consumers I've seen public opinion polls you can't fool the guy in the street anymore. He knows when he walks into a grocery store. A husband or wife knows that They're seeing higher prices, they see it everywhere in the price of beef, to milk, to eggs. They're seeing it in their children’s education, They're seeing it in department stores with clothing, They're seeing their utility bills go up; They're seeing it in their service costs I don't care if you use any kind of service if you go to a doctor’s office, doctor’s bills have gone up, medical premiums have gone up, so people are now starting to price in expectations of future price increases, and that is outside the control of the Federal Reserve. [15:19]

JOHN: It would also seem, by the way, that unfortunately the people though are blaming the wrong reasons for the price increases. That's one thing we're seeing in popular mainstream thought. But the second thing as far as the Fed goes, They're playing a game, they went to Las Vegas, They're playing this game and I guess to quote someone else, as far as this game goes, “they are not going to win, They're not going to break even, but they can't get out of the game.” Ultimately, There's a collision coming between the Fed and the financial markets I would think.

JIM: Yes, they are going to burst the real estate bubble. They may not say that formally. They’ve intimated not only with the piece published by Greenspan last week, if you take last week and look at Fed speeches. They're going to burst the bubble, but because this money printing created the demand it never created the supply. So you have all these things on a collision course. You have fiscal policy, which is out of control, deficits are on the rise; you've got money supply expanding at almost 7% or more in the last 3 months. So the financial markets are beginning to look at this and at least the smart people are saying, “Now, wait a minute, we're going to spend $200 billion to rebuild New Orleans, we've got a war going on in Iraq, we've got a drug prescription bill that comes on line next year That's going to start to kick in, fiscal deficits are going to go out of control.” They said “we just passed a $286 billion transportation bill” – which should be called the Bacon bill because There's so much pork in it and nobody in Congress is willing to cut back on their pet programs. you've got the people on the left, of which the typical response is “let's raise taxes” and the funny thing about it is we lowered taxes and tax revenues went up, they never want to talk about that but outside of raising taxes, which causes even further decline in economic activity, which brings in less government revenues when you raise taxes, you get less of what it is that you raise. It's the same thing with prices: raise prices high enough on something and guess what, people stop buying. Well, what happens? You raise taxes and it chokes off and kills the economy. [17:40]

JOHN: But as soon as the thing starts to cut loose, which It's really doing right now, you're going to hear calls for political solutions that really don't take into account economic realities. They're really classic, we've heard them before: price controls; lawsuits against gouging; windfall profits taxes. All of these are temporary. All they do is actually exacerbate the situation, because when it really does cut lose and blow It's far worse than it was.

JIM: That's exactly what we saw. We'd only have to go back to last time we were in this bind, which was in the 70s, we slapped windfall profits tax on oil companies, and they simply said, “OK”. If you found new oil, there was this windfall profit tax that went on and you just stopped drilling. It's exactly what happened in the past, John. We only have to go back to the 70s, they put price controls in, they slapped windfall profits tax and what happened is it took away the incentives for oil companies to go out and find new oil. So as a result, imports were going up because production was also falling as a result of peak oil in the United States, and so when we got into a crisis as we did in 1979, with the Iranian Revolution, you saw oil prices spike and go even higher. We had shortages, we had gas lines, and That's what happens. The states that are going after service stations with price gouging are ones that are experiencing the shortages and higher prices. you've got Congressmen now talking about placing a windfall profits tax on anything over $40 oil. I hate to tell the Congressmen, but if you're Exxon-Mobil and your importing 132 million barrels of oil from the Middle East and you have to pay $65.80 this Friday, That's what you're going to pay.

So this is one of the first things that was amazing when Ronald Reagan became President. One of the first things he did was get rid of price controls, he got rid of the windfall profits tax, companies went on an exploration binge, we brought new production on line, the price of energy went down from $40 down to $20, down to $10. And so, the incentives were there and the extra supply came on line. That's the only way we're going to get out of this crisis is the market mechanism that allows higher prices, number one, creates the incentive to bring more supply on line; and number two, moderates demand through conservation. That's the market mechanism in terms of how it works. That's how you get out of this crisis. If you want to make the crisis worse, put in the price controls, go after these price-gouging lawsuits a lot of these Attorney Generals at the state level are pursuing with no clue, in terms of what is going on economically of how supply and demand work; or even worse put in a windfall profits tax. And watch What's going to happen, John, because in the third quarter now, which ends today, this Friday, you're going to see oil profits at a record, the price of oil has gone up, It's gone up from the $50s to the $60s to $70 which means the world market price for energy has gone up, whether It's natural gas, or its oil, and what that means is prices go up, sales go up, and along with that will be profits. But as a percentage, as we talked about last week, the oil companies are making about a 9% net return on sales after taxes, which is below what technology companies are making; It's below what, for example consumer product companies are making Coca Cola makes 22% net return on its sales, Microsoft 32%, Proctor And Gamble over 20% - and you don't hear anybody talking about price gouging in those sectors. So, we have a tendency as we have in the past to overdo things and come up with policy responses that only aggravate the situation and make it worse, That's the real danger we have right now. [22:04]

JOHN: Jim, since we're all about investing anyway. Well, what are the implications for the investment markets?

JIM: I would say I would be long things and I would be short paper. [22:15]

JOHN: Well, That's a little cryptic. How about specifically what we should do, Jim?

JIM: I would definitely be in energy. I would be looking at energy alternatives which is where we're going right now, because we think we have a CAPEX cycle which is going to be gearing up. I would be in gold and silver. I would be in essentials such, as food and water. I would also have money in strong foreign currencies right now, because fiscal policy is out of control, which means monetary expansion is taking place right now, the money supply expanding again, credit is still running rampant so the inflationary spillovers...John, you want to look at something that is in short supply, well, you're going to have to be in “things”. [23.00]

The Next Big Thing

JOHN: Reminiscent of Johnny Carson, It's time to take out the great crystal ball and talk about what we see as the next big thing that is going to be coming down the pike. It's interesting how many emails and phone calls we get from listeners, “what do you think about this, where's it going?” I guess That's always the question, where's it going?

JIM: As we talked about in the last segment, you've got supply constraints. And because we have these supply constraints, we've got rising commodity prices everywhere you look; you've got rising energy prices for natural gas, oil, heating oil; uranium prices are on the rise; coal prices are on the rise; gold and silver are on the rise; lead, zinc, nickel, all these commodities are on the rise.

But the thing we're going to have to talk about now the next big part of the cycle is going to be CAPEX spending. In other words, what are we going to do to increase supply? Well, if you're short minerals you're going to have to find more minerals and that means exploration in the mining business. And if you're going to go out and explore for something you're going to need equipment, you're going to need drilling equipment. And if you find something, you're going to need mining equipment, you're going to need big earth moving equipment, you're going to have to build mills to process the minerals so you can turn it into a finished form. So we're going to have to retool, and rebuild. I don't care if It's the energy sector, the mining sector, the timber sector raw materials in general we're going to have to retool. [24:44]

JOHN: Several years ago, you wrote an article by the same title as we're calling this segment, The Next Big Thing. You predicted commodities were going to be the place to be. You were right on, can you give us an update on that, because obviously if you say we should now get into commodities, alright, but do you just sit there or what?

JIM: Well, we've seen energy prices go up, we've seen natural gas prices go up, we've seen coal prices, uranium, all of those things go up, but I think what you're going to see now on the second leg of this commodity bull market and that's where I think we're entering in here this phase is where we're going to need to ramp up spending. If we look at the energy sector, we're going to need more power plants, we're going to need to come up with, for example, clean coal; we're going to have to build nuclear power plants as they're doing in France, India, China, Japan, and we're going to need to bring that on. You can already see politically how we're paving the way for that. we're going to need more drilling rigs for the oil and mining industry. There's a tire shortage. we're going to need to build more refineries. we're going to have to explore and find more oil and natural gas which means more drilling rigs, so what I would be looking at right now we've already seen the commodity producers do well: the uranium companies have gone through the roof; the oil producer companies have gone through the roof I would be looking at companies that are going to build and expand refinery capacity; I would be looking at companies that can supply equipment to the mining industry; I would be looking at companies that can supply equipment and help build the infrastructure in the energy industry. So, John, this next wave of the bull market is going to be a CAPEX spending cycle CAPEX meaning capital expenditures and that's the companies that can do that.

Remember, when prices first go up you've got people a little bit reluctant. I think it was Donald Coxe, who we interviewed in the beginning of 2004, and he was talking in a mining conference and telling the miners, this is going to be the biggest bull market you've ever seen in your lifetime; and at the end of the mining conference, he was at the airport, and one of the top CEOs of one of the top 5 mining companies in the world came up to him and said, “You know, we've seen people like you in the past come and go. You come in, you tell us that the sun’s going to shine and you're right, the sun shines, but It's only briefly and then the clouds come back.”

And what this gentleman was expressing to Donald Coxe was, over the last twenty years, yes, there were some rebounds in the total price of commodities, but then things continued to go back down. So, people in the industry you talk to some of the old-timers in the mining and energy that have lived through this, you see the price go up and It's almost like a resistance, you just go, “Gosh, if I could just get back to the work I used to be doing, I'd be happy.” There's a reluctance to cut lose with the purse strings, because, let's face it, if you want to build a refinery, It's several billion dollars; it takes 5-7 years to build one. And I would say even longer today, to bring a mine on stream, because of the environmental permitting problems you run into. So you have to sit back and think, is this price rise real? Do I really want to take the risk as a company? And as prices continue to break out to new levels, as energy prices head towards $100, I think you're going to be looking at during the next 10-18 months, $100 oil. we're certainly looking at $20 gas. I think you're going to see over $10 dollar in silver, over $500 in gold. As you see these higher prices and if they continue to stay at a high enough level then companies are going to start cutting loose with the purse strings, and they're going to start the spending which is what we're going to need to bring the additional supply on line to meet future demand, whether It's for energy, for food, or its for water. So what this means is, I would look at the companies that can help provide equipment and services to help retooling for CAPEX spending. [29:05]

JOHN: It would seem, by the way, this is going to happen regardless of which political party is ultimately in power, whether they publicly agree with it or not, They're going to go along with it.

JIM: They're going to be forced to, because once consumers start going without energy and they see the price of energy go to $4 and $5 for gasoline, when they see their heating bills go up 26-50%; when they have to wait in line for gasoline, you're going to have a ticked off voter. The whole paradigm shift takes place because when voters get ticked off these people are not going to tolerate people that are obstructionist; they're going to want something done. They're going to say, “alleviate my pain!” and you better do something. And so I think you're going to see turnover in Congress, just like you see in the Japanese legislature, and also with Japanese Prime Ministers, when they went through their downward cycle in the economy, people were saying, “do something, I want something done.” And It's only when that political pressure is brought on by the voter that you'll see something done. [30:16]

JOHN: It would seem like too it goes in stages, as you pointed out earlier Jim, first of all the first group of “dunners”, so to speak of politicians, they throw group one of rascals out, then they put another group of rascals in, those rascals do the wage and price controls, it relieves the pain temporarily, It's like a painkiller, it doesn't really deal with the issue, ultimately things get worse after that, then they throw that group of rascals out, followed by another group of rascals, that seems to be the pattern historically. Speaking of which, how does peak oil factor into this; we've talked an awful lot about peak oil, how is this going to factor into the whole picture?

JIM: We need to develop alternative sources of energy, John, and we better start doing it pretty fast. Saudi Arabia has trouble right now, There's rumors that their production from their main fields are going into decline, even though They're going to declare their reserves are double what they are, I think that's a PR move. Word on the street is They're trying to buy every oil service company to get them to move their rigs to Saudi Arabia, willing to pay them 3 times the street price with long term contracts because they need to start poking holes in the ground and bring out whatever energy they can, because I think the big fields have now gone into decline. So, we better start looking at clean coal technology. My son wrote an article in one of the wrap-ups this week on a new type of coal technology that can make gasoline from coal waste. we're going to have to look at nuclear that option. we're going to have to expand solar and wind. All these things are going to have to be done, and we're going to have to start expediting them.

we're going to have to start looking at our transportation system and rethink it. we're going to have to rebuild the railroads which are more efficient for transporting goods between the coast. we're going to have to look at mass transit; look at revising fuel standards to allow for diesel which is widely used in Europe you get more energy power out of a gallon of diesel fuel than you do gasoline. we're going to have to look at hybrid cars, fuel cell cars. And this next cycle, CAPEX spending is going to accelerate. So the important thing, John, is peak oil means that everything needs to be put on an accelerated basis, on a priority basis. And we need to act and start doing things and cut out these political debates of “he said, she said”, which the media is still stuck in that road. Turn on a political talk show and That's pretty much it. [32:46]

JOHN: As General Honore said, “you're stuck on stupid.” That was the best comment he made after the hurricane.

JIM:Yeah, That's exactly what it is. The people in the media are idiots. They're focusing on the wrong issues. You don't see them saying, “wait a minute! we haven't built refineries in the last 30 years, maybe That's part of the problem.”

Our oil production in the United States has been declining every year. We have to import more, and where we have to import it from Venezuela and the Middle East is unstable. Maybe we need to start rethinking our energy situation. And if Europe, which is facing higher gasoline prices, use diesel cars, if France builds nuclear power plants, we really need to start thinking about diesel fuel as a more fuel efficient engine, so that we can get more mileage from our cars and consume fewer barrels of oil. you're right, we're still stuck on stupid here. And unfortunately, until we get off the stupid routine, It's just going to get worse. [33:52]

JOHN: Yeah, That's what I meant earlier about wage and price controls as well. Well, what happens is people will get ticked, but because of the media spin that It's the evil producing companies, so we're going to cap what they can charge, That's always the first round isn’t it? You can see this one coming.

JIM: Yes, and I highly recommend, if you can get to the store and pick up a copy of the latest Fortune magazine on Katrina, and the cover story is “government let us down, business picked up.” It talks about Wal-Mart, Home Depot, Federal Express, Valero Energy and what they did in the crisis. They were the heroes, not the villains. The villains in this crisis was government. There's a great picture of when the National Guard needed supplies they went to Wal-Mart, not to FEMA. it'll give you a good perspective of what really went on and why the media is still stuck on stupid. [34:46]

JOHN: I love that term!

Dividends For the Long Run: An Update

JOHN: Now we come back to subject number 3 here: dividends. And Jim, you've made us aware dividends are crucial in determining long term returns with the stock market back to negative territory. It would seem now that looking at dividends once again is really, really crucial?

JIM:You know, John, if you take any long-term period of time, a 5-year period, a 10-year period, decades, the compounding effect of dividends is unmatched. I don't care: any study that has ever been done about investment returns, dividends have proven to play a crucial role. In fact, one of the key roles in producing returns for investors and this has worked across all markets, across all centuries. There was a book called TheTriumph of the Optimists and I've referred to it off and on over the last couple of years, but even more recently, there was a study done on stock market returns in the top ten major markets Germany, Canada, Italy, Japan and Singapore and the rate of return from dividends, in other words, total returns in the stock market which is appreciation, plus dividends is almost in many markets, like in the French market, almost 3 to 1, in the British market it was almost 3 to 1, in most European markets 3 to 1, Hong Kong it was almost 3 to 1, in Japan less so. But in most markets dividends have played the key role of producing investor returns, and now that the markets are going through what I call mean reversion, any time you go through a period of where you have above average returns, as we saw from 1982-2000, when the stock market was producing 15% returns a year, those periods, historically, without fail, have been followed by an extended period of lower returns. And we've certainly seen that if you look at from the year 2000 going forward: the Dow isn’t where it was in 2000, in January; the S&P isn’t there; nor is the NASDAQ. we've had a rally since 2003, but if you look at last year, most of the returns in the stock market came in the last six weeks after the election. If you look at this year, we've alternated back and forth, between negative returns and positive returns. On the day that we're speaking, this Friday, the Dow is down over 2% for the year, the NASDAQ is down over 1% for the year, and only the S&P which gets reshuffled so many times, It's hard to keep track, but It's up a little over 1%. Well, if It's up a little over 1% isn’t it nice if you could be invested in 3,4,6,7 percent returns or as high as 10% returns from dividends. So, in this kind of mean reversion type market, dividends are going to be the key to investment success, if not investment survival. [38:09]

JOHN: What looks attractive out there, and when you look, by the way, you have to think globally, dividend returns are higher in what, Europe, Asia, Latin America, places like that?

JIM: Yes, I think you have to think globally today, because the dividend yields for example in the S&P500 and let me just give you an example here we're almost looking at 1.6% return on the S&P is 1.6% - and this just gives you an idea. In France, the dividend yield is about 3.9%, Australia 3.7%, Italy 3.7%, Britain 3.1%, Hong Kong 3.1%, Singapore 2.6%, Canada 2.1%, and the US 1.6%. So, if you think of dividends, most countries have international companies today. So, there are big food companies in Switzerland, there are big food companies in Europe, there are big energy companies in Europe. One of the Asian energy producers we own has a yield of 4.9%, plus It's growing its reserves. So, if you look globally there are companies like this out there, and you can find a lot more of them overseas. [39:28]

JOHN: Are there any sectors that look attractive to you?

JIM: Here is a great thing about it, if you look back historically, natural resources have been one of the best dividend producing areas of the market, and I don't need to tell anybody that owns a major energy company What's happened to your dividends. Some of these oil companies are increasing dividends 25%. Some of the mining companies are doing the same, that are producing. So natural resources look very attractive. I think non-cyclical type industries like consumer goods companies that have a franchise that aren't impacted as much by economic events, in other words whether we're in a recession or a recovery, those seem to have the best history of raising dividends.

I love healthcare. Two or three of the healthcare companies that we own, one company in particular has increased dividends 43 years in a row, they just increased their dividends to 15.8%, wouldn't that be nice with costs going up to get a 15-16% increase. Some of the royalty trusts we own have seen their dividends double in the last year and I think a couple of ones we're looking at right now will double again based on what we see going forward in the 4^th quarter. Utilities are another area of steady dividends and not a bad place for rates of return, especially water utilities, that look attractive, though some of them are overpriced a bit right now.

But I would say 4 areas that look attractive right now: natural resources; non-cyclical consumer franchise companies; healthcare; and utilities. [41:05]

JOHN: Can you give us some examples of both countries and industries since you are talking about thinking globally?

JIM: Right now, for dividends, I like Europe, It's a very stable area of the world, they have good producing companies, international companies, the dividend payout as I mentioned is over 3%. we're in some international utilities that pay between 8 and 9%. So, utilities look attractive, non-cyclical consumer product companies I think are a good defensive place to be right now. Many of these companies range between 2.6-3%. The energy sector believe it or not. we're still getting between 8% and 10% in the royalty trust area, and also I think with energy companies themselves you can still get 3%, if not more in dividends. And with the markets down this year, getting a 3% or 4% dividend, or a 5% or 6% dividend, I think that is the way to be playing this kind of market. And I think of all the stuff, with the Fed saying basically They're going to keep raising interest rates, until something breaks you might want to think of something defensive because if your stock doesn't go up, wouldn't it be nice to be cashing dividend checks. [42:27]

JOHN: That's a good question, though. How do you relate your dividends to what the inflation rate is, too? Because obviously, one of the reasons people move out of paper in times of high inflation is the returns aren't that good.

JIM: I would take a look at companies and industries that are going to have pricing power, because for those industries that have pricing power, it means that they can increase the price of the product they sell to consumers and with that increased pricing power is going to come the ability to increase earnings. And with increased earnings, and with increased cash flow are going to come increased dividends. And so That's one thing you have to understand with the industries that you're investing in, when you're looking at these companies, you need to look at not only what the dividend is, but you also have to look at what their capabilities are of raising that dividend. In other words, What's the business model, how will they be impacted by the economy if at all? What will be their ability to pass on price increases to consumers in the goods that they sell? And that is something you have to factor in when you're looking at these companies. But That's what I would look at. [43:35]

Emails

JOHN: Here he is with the first email of the day, Chad in Denver, Colorado says,

“Jim, with energy being the stellar performer last week, I thought I heard you mention in the Joe Duarte segment that you're cutting back on energy, or were somewhat hesitant. Are you getting out of energy? Or if so, should I be selling my energy stocks?”

JIM: What I was saying was is there is a lot of hot money That's coming into the market, That's looking for $75-100 oil, and I think a lot of these people who are coming in could be disappointed if we get a pullback, but one thing we're doing right now is something that we mentioned in the Big Picture segment, is we see a CAPEX cycle That's going to be taking place in the energy sector. And so, another thing That's going to happen is alternative energy, so we're moving on and looking at alternative energy, which I think is going to come to the forefront as we start getting in these energy bottlenecks, as we see the price of gasoline go up, and as we get to shortages because invariably I think politicians would make the wrong kind of decisions. But we are looking at alternative energy, so we pared back some of our energy positions to, number one, take advantage of what I think will be a natural gas and heating oil crisis this Winter, because we are following weather patterns, and we think we're going to see an abnormally cold Winter. Even if we just have a normal Winter we're going to have problems in heating oil and natural gas. But if it gets colder than normal, then we could have a crisis. So we are looking at how to play the rising prices we see coming in heating oil and natural gas, and then also we repricing and taking a look at alternative energy which I think will be the next part of the next big thing. [45:37]

JOHN: Mark is saying,

“What do you expect to happen to rents in the future, relative to the housing bubble and its potential bursting?”

JIM: I think you're going to see rents go up. Rents have lagged because vacancies have gone up in this country, because anybody and his mother and brother could be buying a home, because we've never seen interest rates this low. The other thing, with the advent of modern creative financing, you know, the option ARMs, the interest only loans, what you've seen happen is the segment coming into the home buying market that shouldn’t belong there. In other words, there are the marginal buyers, these are the people that really couldn't afford to buy a home if you had normalized interest rates, if you didn’t have these creative products. But What's going to happen is when the tough times hit and as interest rates go up, as these mortgages are reset, as the bankruptcy bill goes into effect next week, you're going to see pressure on these people, there credit card payments are going to go up, there mortgage payments are going to go up, you're going to start seeing a lot of bankruptcies and foreclosures, and you're going to see another segment have to move back into the rental market, where we haven’t been bringing in a lot of supply of rental properties because if you are a home builder you want to build a home, you don't want to build an apartment. So I think you're going to see rents go up. [47:02]

JOHN: Alex writes from Burlington, Ontario, Canada and he's talking about a hedge fund error and a US dollar collapse,

“Could you explain a bit how a hedge fund error could cause this, I've read a lot lately saying this is very possible?”

JIM: If you take a look at a lot of these hedge funds, the strategies they use are very aggressive, they concentrate in a sector and they tend to be highly leveraged. The best example I could give you is the famous Long Term Capital Management, where they borrowed $125 billion from the banking system, and they only had $3 billion in equity to back that up. On top of that, they had leveraged bets in derivatives over $1 trillion in derivatives with only 3 billion that was backing up any price changes in that area. And I think what you have right now is you've got a lot of players going in, playing credit-default swaps, the credit derivative market, the CDO market which is collateralized mortgage obligations and what you have there is you've got a lot of companies that tend to dominate those mortgage pools. So one of those companies gets into trouble, they go under and what happens is the whole system of derivatives is immediately repriced, and remember a lot of these derivatives are illiquid. Over 90% of them are illiquid, so you don't know what the price is until you go into the open market place and try to dispose of them. And that was the problem with Long Term Capital Management where they had derivatives that when they went to sell them, they could only get 50 cents on the dollar. So a lot of these derivatives right now are priced by computer models, not by the market, and with the Fed raising interest rates you've got a collision course coming between those that are speculating in the carry trade, and in these derivative products and what might happen to these derivatives, if interest rates head much higher than most people expect, or you start running into financial problems with many of these financial players that are doing all of this creative financing. These companies doing all of these option ARMs or negative amortization loans, they're booking profits that they haven't collected. In other words, if you aren't making your complete mortgage payment, the part that you aren't paying gets added onto your mortgage, your mortgage just gets bigger but the company that loaned you the money is booking that as profits, even though they haven't received it yet.

And the other thing you have to understand is in the derivative market, all these derivatives are written and concentrated in a few major players. That is, if one of them gets into trouble, it starts a daisy chain, or a domino of defaults because you may have a position, let's say you are short something, maybe short energy, or you could be short interest rates in one form, you're going to hedge that bet with somebody else, so that if it goes against you, you've protected yourself by hedging that position with let's say another financial company, and if that financial company gets in trouble then your hedge collapses, and you become fully exposed to the position you're in. I mean this whole thing could domino. [50:28]

JOHN: Jim is writing from Kalispell, Montana. He says,

“What the heck is hyperinflation? I know the big debate for the future is whether a depressionary deflation or an inflationary period occurs. I understand the concept of a depressionary deflation well enough, however you seem to believe that a hyperinflation occurs at some point in the not so distant future, as the government essentially runs the printing presses to pay its bills. here's my problem, what is a hyperinflation, is it an inflation of 20%, 50%, 100%? What is the definition of hyperinflation as separate from inflation or stagflation? And finally, should a hyperinflation occur, what will the overall economy look like, during such a scenario? Thanks, and keep up the great show.”

JIM: let's define hyperinflation. I would define hyperinflation as double-digit inflation. When you start getting into the teens, it could be 15%, 12%, it could be 20,30,40 and then when you start getting in triple digits you're really in hyperinflation. And in a hyperinflation, the government creates money, and as we talked about in the first half of this segment, it doesn't create supply, they can't create a new factory, they can't create an oil well, they can't create a mine, they can't create a refinery, they can't create a power plant, they can't create a farm. Those things aren't created when the government prints money. All it does is put the money in the hands of independent individuals which creates the demand, and they can print all they want, but if you don't have the supply that comes on stream to meet that demand, then what happens is prices inexorably go up, and that's what you get in a hyperinflation. And you can have these hyperinflations and depressionary type economies, just take a look at Argentina, Russia, or Turkey in the past, and you'll have a glimpse of what could come here. [52:24]

JOHN: You know, speaking of which, in the same line as that one, the Fed say loosens credit, nothing is created until such time as somebody borrows something, do we ever get to that point where they can loosen the credit all they want and the consumer says, “I'm up to my eyeballs in debt, no more, that's it!”, and then what happens?

JIM: Or they borrow the money as they did in Germany and they invest in speculation, which is exactly what your spec community is doing today. [52:33]

JOHN: So everybody gets in on the game in other words, is what you're saying?

JIM: Yeah, in other words instead of investing in property plant, and equipment you invest in speculative instruments, whether It's derivatives, investing in futures contracts, or tangible type goods. So the money goes into speculation, instead of the real economy, therefore you don't get supply. [53:13]

JOHN: Well, Jim we're going to have a segment in the next hour, a special round table discussion and It's probably going to generate more controversy but we're not strangers to that, about the issue of global warming. One of the things that some listeners have been emailing us is the fact that the overwhelming majority of atmospheric scientists around the world agree that global warming is a fact, that It's man-made etc.. Well, I did some checking around, It's very hard to even get a total of the number of atmospheric scientists, or meteorologists, and no one to the best of my knowledge has ever taken a poll, examining exactly how many believe it is, and how many believe it isn’t. Which means statements to that effect are totally bogus.

JIM: And the other thing is, as we talk about these decadal cycles, that come in like 30 year periods, a 30-year period of cooling, which is what I saw in the 70s when I was in graduate school and they told us we were going to global cooling, and we were going to freeze to death. And then the weather cycle pattern changed in 1995, and now we're going through a heating cycle. And by the way, these decadal cycles have been with us since man was around. we've had them and so we go through these weather patterns and I think most people would agree we are in warming cycle now. But in terms of whether this is global warming and It's manmade, There's too much controversy over that, that leaves so much of that in doubt. And if you look at the solutions, which are always to come up with an international tax, which leaves half the globe unaffected by whatever treaties you're going to have and raise taxes. But It's not handled from a scientific basis, It's handled from a political basis, if you take a look at these hurricanes and They're saying, “well, these are all caused by global warming and had we signed the Kyoto Protocol we wouldn't have had these hurricanes.” Well, I mean that is just balderdash. And some of the people you're going to hear in the panel were on the UN commission that looked at environmental issues. So we're going to bring that up to a debate and the importance of this is, too, John, as it relates to the food cycle. We always have a problem with food, with growing population, but secondly we have a problem with food, meaning demand, in the sense that our agricultural processes are very energy intensive from the combines, to the tractors, to the fertilizers, so peak oil is going to impact that, but also a changing weather pattern is also going to affect harvesting, and crop outputs. So this is why this is a very important subject, and we wanted to at least look at it from at least a scientific point of view, bring a scientist, people who have studied the area, a climatologist, and rather than accept the blather...you've got to remember, the media’s still stuck on stupid, and that's where it is when it comes to the global warming issue. [56:07]