Stocks versus Commodities: Can the tail wag the dog? - published in the SB News Press in January of 2011

For some time now, stocks and commodities, for the most part, have been moving in the same direction – up.  Historically speaking however, this is not normal.  There are a variety of economic reasons, both for the current relationship between the two, and the historical relationship as well.  Understanding these relationships may provide some insights into the future directions for both markets, and for the economy as well.

The historical relationship between stocks and commodities has been that when stocks go up, commodities go down, and vice-versa.  The primary reason for this is that inflation tends to drive commodity prices up and stock prices down.  Inflation, by definition, means prices increasing, so it makes sense that commodities would benefit from inflation.  Stocks, on the other hand, suffer from inflation, because the profits that companies are making are worth less and less, as inflation increases.  Another way to look at it is that the profits companies earn will buy less as inflation increases.

Inflation can be tricky.  As with most economic factors, inflation doesn’t always affect the economy, stocks, or commodities exactly as expected.  The relative impact of inflation has a lot to do with the rate of inflation.  Also, as with every asset class, prices for stocks and commodities are largely influenced by expectations of future performance, rather than simply by what is happening in the present.  In other words, the future expectation for inflation can and does affect stock and commodity prices, probably much more than the current rate of inflation.

The recent performance of stocks and commodities has not followed the historical relationship between these two asset classes.  In fact, it has been just the opposite – stocks and commodities have both performed exceptionally well.  During 2010, stocks (the S&P 500) gained about 13%, while commodities (CRB Index) gained about 20%.  Gold, which is considered the most effective hedge against inflation, gained about 26% during 2010.  How can we explain why stocks and commodities have been moving together recently, instead of moving in opposite directions, as is their normal relationship?

The answer is complicated, and I’m not sure I have all of the answers.  One thing we do know is that we have experienced a very unique set of economic circumstances over the past two years or so, which provide some interesting information, and which may help explain.  First, stocks were crushed in late 2008 when Lehman Brothers failed, along with several other major financial firms.  The American investing public lost confidence in the financial markets and in banks for the most part.  Stocks reacted immediately and violently to the panic, shedding half of its value from the beginning of 2008 at about 1,450 to the low in early 2009 of 666 (intraday).  From that low, stocks began a slow, but steady recovery that is still in process today. 

At the same time, commodity prices, which also experienced a dramatic decline, falling from July of 2008 through the end of 2008 by about 40%, have also enjoyed an amazing run, gaining almost 80% from the beginning of 2009 through today. 

Both markets suffered extraordinary declines, and have been in recovery mode ever since.  Because both markets were rebounding from such artificially low levels, which were caused by massive shocks to the economy and financial markets, we have seen the two markets move together, in the same direction, over the course of the last two years. 

Returning to our discussion of inflation, the pace of inflation can provide some additional clarity regarding the correlation (both markets moving the same direction together) of stocks and commodities.  Simply put, a little inflation can be a good thing, especially for stocks.  What I find interesting about inflation expectations today is that it appears stock investors see only modest inflation, which commodities investors/speculators see inflation coming at a much stronger pace.  If commodities traders felt that inflation was going to be tame in the coming months and years, they would not have run the prices of commodities up so high, so quickly, especially with regard to gold and other precious metals. This difference of opinion regarding the pace of future inflation could help explain why both markets have continued to rally, even after regaining most of their previous value, which was lost during the market shocks.

Historically speaking, when the stock and commodities markets have moved in unison, one market has been “right” and the other “wrong.”  In other words, the correlation between the two markets has been temporary, and has been followed by one of the two markets reversing to the downside.  More often it is the commodities market that is correct about the direction of inflation.  I believe this is because the commodities market is driven more by professional traders as compared with the stock market, which is increasingly driven by small investors who tend to be unsophisticated and therefore less able to analyze the complexities of the economy and other key factors that ultimately determine market direction.

Interestingly, because both the stock and commodities markets have increased in value so much, so fast, I believe it is highly likely that both will reverse to the downside in the short-term.  In fact, we have already seen gold and some other commodities losing value in recent weeks.  Gold, for example, has fallen from a high of $1,433 in November 2010, to around $1,360 this week, or by about 5%.  Stocks have yet to roll over and begin to decline, but given the sizable gains, especially within certain sectors of the market – Consumer Discretionary stocks up 26% in 2010; Industrials up 24% in 2010 – I would not be at all surprised to see a healthy correction in the near-term.  In fact, we have already witnessed some companies reporting fantastic earnings results for the fourth quarter, such as Intel this past week, suffer sizable selling pressure and stock price declines as a result.

So the big question is: Will the tail wag the dog?  Can stocks continue to perform well in the face of increasing inflation (assuming that the commodities market is correct in its prediction that the pace of inflation will be robust)?  One thing is certain; both markets cannot be correct.  Either inflation will remain contained, or it will accelerate.  Tame inflation could provide the foundation for continued positive stock price performance and a sustainable economic recovery with solid GDP growth for several years to come.  On the other hand, high inflation would tend to drive commodity prices up, but could (and most likely would) result in downward pressure on stocks and a challenging economic environment.

The Fed definitely has its hands full.  I feel that the coming few years will likely be the most challenging in the Fed’s history.  The Fed governors will have to navigate the treacherous waters of the economic environment they have created, with trillions of dollars pumped into the economy, lots of downward pressure on the dollar, a mounting budget deficit and a national debt of around $13 trillion (and climbing rapidly), and very challenging global economic pressures.  If the Fed can find that magic balance between raising interest rates enough to combat inflation without stifling the economy, they might just be able to preserve and sustain the recovery.  However, it is a tall order.

Retail Performance and the Risk of Over-optimism - published in the SB News Press in January of 2011

This past week, we were able to see the financial results for many of the major retailers.  While most did exceedingly well, many suffered sizable stock price declines when they reported their fourth quarter results.  In this week’s column, I will discuss the performance of the Consumer Discretionary sector, and the key differences between historical (actual) performance and expected future performance, and more specifically why investors must understand these differences to help them make better investment decisions.

The past two years (2008 and 2009) were dismal for retailers.  For 2008, overall retail sales declined by 1%, and 2009 holiday retail sales increase a lethargic 0.4%.  After the stagnant 2009 holiday season, MasterCard Advisors’ SpendingPulse™ reported a much better than expected holiday season for retailers with overall season-over-season growth of 5.5 percent.  Excluding auto sales, holiday shopping in the 50 days before Christmas totaled $584 billion, again according to MasterCard SpendingPulse. The 5.5 percent increase over 2009 is the highest year-over-year increase since 2006.

The National Retail Federation had initially estimated growth of only 2.3 percent, which is the long-term, historical average annual growth rate for holiday sales.  The group stated that recent stock market gains, income growth and personal savings built up during the recession helped boost consumer confidence and led to more sales.

Unfortunately, although estimates for retail sales for the holiday season have been surprisingly positive, a December 26^th blizzard on the east coast put the brakes on what was expected to be brisk after-Christmas sales.  Despite the blizzard, after-Christmas shoppers boosted sales at stores open at least a year 3.6 percent in the week ended Jan. 1, the International Council of Shopping Centers said in a statement on January 4^th.

Most experts believe that spending that was expected for the after-Christmas period will not be lost, but instead will be pushed into January, as shoppers look for bargains.  In fact, with total holiday gift card spending estimated at $24.78 billion, consumers still have plenty of buying power, and most experts believe they will continue to spend in the short-term.  Retailers also expect gift card purchases to lead to additional spending during January.

U.S. retail e-commerce spending for the entire November – December 2010 holiday season reached $32.6 billion, a 12 percent increase versus 2009 and an all-time record for the season, (comScore, Inc.).  By comparison, foot traffic increased over the previous year, but only by 1.8 percent for the season and 4.1 percent in the week ending January 1^st, (ShopperTrak’ National Retail Sales Estimate (NRSE), based on the Department of Commerce data).  Comscore reported that spending in November and December of 2010 totaled $32.59 billion, up from 2009's $29.08 billion.  Black Friday (the Friday after Thanksgiving) and Cyber Monday (the following Monday), two of the biggest online shopping days of the year, had sales increases of 8.9% and 16%, respectively.  Cyber Monday was the first billion-dollar spending day in history, and the first time Cyber Monday ranked as the heaviest online spending day of the year.

While the blizzard on December 26^th and 27^th certainly contributed to the shortfalls in sales reported by some retailers, the reality is, from an investor standpoint, expectations were extremely high for the sector. 

Analysts continually increased their expectations for sales and earnings for stock within the Consumer Discretionary sector leading into the end of the year, which drove stock prices ever higher.  In fact, the Consumer Discretionary sector was the top performer in the S&P 500, gaining 26% in 2010. 

Some of the largest retailers, such as The Gap, Macy’s, Target, and American Eagle Outfitters did not meet analyst expectations, and their stocks paid a heavy price.  Gap, the largest U.S. apparel retailer, showed a decline of 3 percent in same-store-sales, compared with the 2.4 percent average increase indicated by analyst estimates compiled by Retail Metrics Inc.  Target, the second-largest U.S. discount chain, reported a same-store sales gain of 0.9 percent for December, compared with the 3.9 percent average estimate. American Eagle’s sales dropped 11 percent, versus the projection for a 1.8 percent decline.  Gap’s stock dropped about 7 percent when they reported their sales figures this past week.

There were some noted winners for the holiday season as well.  Abercrombie & Fitch Co. reported a sales increase of 15 percent, beating the average estimate of 10 percent.

Despite the impressive increase in retail sales during the holiday season overall, and despite strong same-store-sales (sales from stores open at least one year) for most retailers, many companies are falling short of analyst’s estimates.  As a result, the stock prices of these firms, in most cases, are getting hammered when they report their sales figures.  This underscores a key difference between actual, historical performance and future (analyst) expectations.  

The reality is that analysts are human beings, with the same flaws as the rest of us. They get overly optimistic about the stocks that they follow, and can get caught-up in the hype and excitement, just as investors do.  The term “herd mentality” certainly can be applied to the analyst community, meaning that those who follow a certain sector or industry group often follow the same exact line of thinking, all recommending the same companies with equal levels of enthusiasm and conviction.  In these cases where every analyst is 100% convinced that the group will perform well, as happened with the Consumer Discretionary stocks this holiday season, it is next to impossible for any single analyst to publish anything other than stellar predictions, much less something outright negative.

One thing many investors have a hard time understanding is how a stock can sell-off significantly when they report seemingly fantastic news, such as strong sales and earnings.  The reason this happens (quite often in fact) is that stocks trade on future expectations (usually supplied to the market by analysts) of performance, and not on actual, historical performance. 

For example, analysts write and publish reports on a given industry or a specific stock that paints a rosy picture of the future.  Based on the report, investors buy the stock (or stocks within the industry), driving the price up.  As more and more analysts jump on the band wagon, publishing glowing reports on the stock (or industry), more and more investors also jump on board, creating a strong up-trend.  Sometimes prices are driving up to such lofty levels, that even if the company reports exactly the performance that the analysts expected and wrote about in their reports, (sometimes even if they exceed those expectations), the stock will sell-off dramatically when the company reports their performance.  If the company disappoints—reports performance that is anything less than what the analysts stated they should report—the stock, as we saw with The Gap and others, will get hit.

The tricky part is understanding what the longer-term expectations are for the company as well.  If, for example, analysts expect the company to do really well this quarter and also expect them to do well (or even better) for the next quarter or two, and if the company meets or exceeds the current expectations, the stock may go up even more when the company reports results.  In other words, we can’t automatically expect the stock to sell-off when results are reported.

If all of this sounds more like science fiction than science, believe me, you are not alone.  I have been in the investments business for over 20 years, and I am still surprised on occasion.  The key takeaway should be that investors should not place their faith in analysts or their reports.  Instead, stocks should be bought and sold based on a combination of the fundamentals of the company and how, based on an analysis of those fundamentals and the expected long-term performance of the stock that should result from those fundamentals, fits within the risk tolerance and long-term investment objectives of the specific investor.  In other words, stocks should only be bought if they are a good fit in the investor’s portfolio and are priced attractively, based on their true fundamentals, and should only be sold if they are no longer attractively priced, based on future expectations for long-term performance, and/or if they no longer fit within the investor’s long-term investment strategy, risk tolerance, and objectives.

The Roots of Borders’ Troubles Run Deep - published in January of 2011 in the SB News Press

Borders started as a two-room used bookstore in the college town of Ann Arbor, Michigan, by two brothers - Tom and Louis Borders. The company’s first superstores offered more than 100,000 titles at discounted prices, but sales advanced rather slowly until 1992 when it was acquired by Kmart.  The Kmart acquisition marked the beginning of Borders’ problems.

Kmart already owned Waldenbooks, which was doing poorly at the time.  They thought by purchasing Borders and combining the two companies, they could gain some economies of scale and increase sales and profitability.  Unfortunately, the acquisition caused a mass exodus of executives, which effectively gutted the management team and left Kmart holding the pieces of two disorganized and troubled companies.  It took Kmart three years to get the combined companies stabilized.  Facing their own problems, and after only three years of operating the combined firm, Kmart decided (under pressure from their shareholders) to spin-off their book assets in an IPO (initial public offering).  This IPO basically created what is Borders Group today.

Borders could have been investing in an online bookselling website during that lost three years.  Had they done so, they might have crushed the fledgling Amazon.  In the late 1990s, while Amazon built momentum toward becoming the dominant player in the online bookselling space, Borders was busy opening stores overseas, in the UK, Ireland, New Zealand, Australia, Singapore and elsewhere.  Completely missing the boat, Borders didn’t launch its e-commerce site until 1998 - three years after Amazon, and a year after Barnes & Noble (which also totally missed the boat in comparison to Amazon).

The Borders online business was a complete bust, generating only $5 million in sales its first year after launch, while Barnes & Noble generated $70 million the same year, and Amazon garnered $610 million in sales that year.  Just three years after establishing their Internet business, Borders gave up and closed their e-commerce site.  Borders paid Amazon an undisclosed amount to develop a cobranded site, and although Borders was a partner and received a percentage of the sales, Amazon did all the work, providing fulfillment, content, customer service, and inventory management.  Borders finally decided to take another shot at running their own site in 2007, when they created their e-commerce division.    

In 2000, Borders hired Merrill Lynch to “explore strategic options,” which is code for “we want to get bought.”  Unfortunately their timing was poor (again), and after no one came forward with an offer, they quickly backpedaled and took the company off of the market. 

Starting in the late 1990s and resurfacing several times, (including just recently), rumors of a merger between Borders and Barnes & Noble have been widely circulated, although nothing has, to-date, come of these rumors.  It isn’t clear whether this would help either company, both of which are suffering at present, and both of which just closed their Santa Barbara locations.  One would think the experience Borders had with Waldenbooks would inform their thinking, but the rumors persist.

After a reorganization that involved a round of layoffs, Borders announced, in October 2000, plans to open 55 new stores each year over the next six to eight years, essentially doubling its store count from 350 superstore locations to about 700, with a cost of about $130 million annually.

For the ten-year period, from 1992 through 2002, Waldenbooks nosedived from 9.5% of the market to an anemic 4.8%.  Lighter mall traffic was blamed for this decline, although many other retailers did not suffer the same fate.  In 2000, there were 869 Waldenbooks stores, but by 2002, that number had dropped to 778.  By 2004 Borders had begun converting some Waldenbooks locations into “Borders Express” stores.  By 2007, Waldenbooks stores had dwindled to just 300 locations, with even more closings in 2009, chopping the number of locations (Waldenbooks and Borders Express combined) to just 150 or so.    

During Borders’ efforts to stop the bleeding at Waldenbooks, in 2006, a very highly respected hedge fund manager, William Ackman, through his Pershing Square Capital fund, bought 11% of Borders.  The stock was trading around $20, and Ackman made the rounds with all of the typical media stations extolling the growth potential of Borders and his expectation that the stock could (and would) trade as high as $36 per share.  Unfortunately for Ackman, Borders’ stock price never moved above about $25 per share, and quickly began a long, slow retreat from about March 2006. 

In 2007, Borders had suffered steady mediocrity in its sales, prompting them, no doubt under intense pressure from Ackman and other investors, to undertake additional measures to try and jump start their sales.  They put their international operations on the block, but eventually were forced to simply shut them down.  They also remodeled stores, reworked their customer loyalty program, launched the new website (ending their partnership with Amazon), and continued their dismantling of Waldenbooks, (as stated above).  By this time, Walmart, Costco and other discounters had either entered or ramped up their book business, increasing the competitive pressure on Borders. 

Around this same time e-readers were introduced, and once again, Borders missed a huge opportunity to get out front with their own device.  Instead, they offered the Sony e-reader.  Unfortunately (yes again), their deal with Sony was not an exclusive, as Sony’s e-reader was also available through a host of other retailers, such as Best Buy, Circuit City, and even discounters like Target.  Barnes & Noble didn’t immediately jump on the e-reader band wagon, but they did introduce their own device, called the Nook, around the end of 2009, which became their best-selling item of all time.  

Borders did partner with Sony to co-brand their e-book website, and later also offered the Kobo e-reader, rolling out the device in stores in June 2010. But, it wasn’t until the summer of 2010 did Borders launch their own e-book site.

All of the remodeling, store closures, new websites, and the like seemed to only make things harder for Borders and worse for their shareholders.  Even before the financial markets imploded in late 2008, after the Lehman Brothers failure, in the first quarter of 2008, Borders was already experiencing credit problems.  They were forced to suspend their dividend, and begged a cash injection from Ackman’s fund of $42.5 million to keep the doors open.  They also, once again, put themselves up for sale, and Barnes & Noble was once again rumored to be interested in merging.  Yes, once again Borders took themselves off the market, so nothing happened.

Throughout 2008 Borders aggressively closed stores and cut employees to reduce costs and try to preserve cash flow.  In January of 2009, they replaced George Jones with Ron Marshall as CEO, a turnaround specialist.  At the same time, their stock cracked the $1 level, generating a delisting letter from the New York Stock Exchange.  Marshall resigned after only one year on the job, sparking another round of top management departures. 

During this time, Borders was able to repay the Pershing Square loan, but only because they were able to arrange for a $700 revolving Line of credit and another $90 million term loan (replacing debt with more debt).  Also another equity investor, Bennett LeBow, bought a 15.5% stake in the company for $25 million around this same time, which made him their largest shareholder (Lebow became CEO a few months later). 

Late last year, Ackman championed a deal for Borders to buy Barnes & Noble for $16 per share, or a total of almost $1 billion (Barnes & Noble had put themselves on the market earlier in 2010).  While the ink wasn’t even dry on this offer, Borders announced that they were, once again, out of cash. 

Borders just announced, even after the holiday season, (which should have been a time of strong sales for them), that they did not have the money to pay some of their vendors.  This of course was followed by these same vendors (and others) announcing that they had ceased all shipments to Borders. 

Scrambling to stem the tide of negativity, Borders met with all of the top brass at the major publishing companies, presenting their game plan for getting things back on track.  They also announced more layoffs, a closed distribution center, and more executives walking out the door. 

The latest news from Borders is that they are working on a $500 million credit facility from GE Capital, $200 million of which they desperately need to pay-off existing senior debt that is due.  So far, there has been no announcement from GE as to the status of this loan. 

Can Borders survive?  Does anyone care anymore?  I think the bigger and more interesting question is: What is the future of the book industry?  The trend seems to be pointing to more e-books, blogs, discussion boards, etc.  Do people even have the patience to sit down and read a nook anymore?  I hope so, but in our current world on texting, multitasking, high energy, fast-paced video games, and multiple conduits for information and entertainment, it’s anyone’s guess as to whether or not the hardcover and soft cover will survive.

Stocks in Free-fall

The Dow is down 280 and accelerating to the downside.  Japan, the Middle East, and even Europe with Portugal's downgrade, are all contributing.  We have violated several key support levels for stocks on a technical basis.  Last year, the 1,250 level on the S&P was a strong resistance level, and once we pushed up through it, stocks drove quite a bit higher.  Now we are right at that 1,250 level, so it will be interesting to see if we drive down through it.  If that happens, we could see another 100 points plus come off of the S&P 500.

It's as bad as it gets

Japan's reactors are melting down.  They have consistently lied to us, letting precious time pass and now it appears it is likely too late for anyone to do anything about it.  Tokyo is reporting radiation, the PM of Japan is now admitting radiation is leaking badly (after he lied and said it wasn't just this morning), and they are telling people to stay in doors (as if that will help).  The Japanese stock markets are in free-fall, down over 12% today after more than a 6% drop yesterday.  Dow futures are off 275 points and falling.  I realize that Japan is facing a huge earthquake, Tsunamis, and now a nuclear disaster.  I understand, but I can't forgive this blatant disregard for the truth and the safety of billions of people.  Call it ego, pride, embarrassment... whatever.  I just call it unforgivable.

Dow craters more than 200 points

Several economic reports this morning have pushed Asian markets, then European markets, and now U.S. markets down hard.  China reported a trade deficit in February, with monthly exports growing by only 2.4% from the year-earlier period, while imports grew 19.4%, after soaring 37.7% and 51%, respectively, in January. Although this takes a bit of pressure off of China in terms of the external political pressure to allow their currency to float freely against other currencies, it indicates that global demand may be weakening.  


The news from China spanked Asian markets, which spilled over into Europe.  Spain was downgraded by Moody's to Aa2 from Aa1, based on concerns that the restructuring of their banking system will cost much more than the government is predicting.  


Here at home, we had 26,000 new jobless claims for state benefits last week, which was higher than expected, . and our trade gap widened unexpectedly and sharply.  The U.S. trade deficit widened by 15.1% in January to $46.3 billion, reported by the Commerce Department.  The deficit is the largest since June 2010 and came despite a record level of exports. The trade deficit was well above the consensus forecast of Wall Street economists of a deficit of $41.5 billion. Imports rose 5.2% in January, the biggest gain since March 1993, easily outpacing a 2.7% gain in exports. The U.S. trade deficit with China widened to $23.2 billion in compared with $18.3 billion in the same month last year. The trade deficit had added an impressive 3.4 percentage points to growth in the fourth quarter. But the wider deficit in January suggests trade will be a drag on first quarter growth, which is exactly what we don't need.


Stock futures were weak early, prior to the market open, and the Dow plummeted 200 points right off the bat. The S&P 500 is down 22 points, and the NASDAQ is off 53.  Commodities are also down, with oil giving up about 3% and gold down $23 per ounce.  The only stock in the Dow that is up is McDonald's.  In short, it's ugly out there today.


Although the combination of news items today is certainly negative, the fundamental issue is the rich valuations in stocks and commodities.  Anytime valuations are extended, it doesn't take a lot to knock prices down.  Investors are looking for any excuse to sell and lock-in profits, and also don't want to give back what they have fought so hard to earn over the past year.  Tax season is upon us as well, so we could see selling to raise cash for tax payments also. 


Yesterday was the one-year anniversary of the start of the bull market (March 9th, 2010) and we have seen impressive gains in stocks over the past 12 months.   The real question is; Where do we go from here?   

Stocks spanked again

The Dow lost 168 points today, as oil prices continue to advance.  As I wrote about in Saturday's column in the News Press, gasoline futures trade on Brent, North Sea Crude futures prices, which have been rising dramatically over the past few months.  While WTI (West Texas Intermediate) is trading just under $100 per barrel, up $2.66 today, Brent is pushing $114 per barrel.  I filled-out yesterday at $3.75 a gallon.  I think we could easily see $5 or even $5,50 per gallon this summer.

Although Bernanke spoke today and stated that he feels that gasoline prices could spike and the economy could still continue to grow, and that inflation would not be a serious concern, I don't buy it.  If gas prices break through $5 a gallon this summer, the economy is going to suffer.  For every penny that gasoline rises, it costs consumers $1 billion.  That is $1 billion that comes right out of consumer spending that would occur in other areas of the economy, but is gone forever.  Gasoline prices rose 17 cent a gallon last week alone, which means that $17 billion of spending was taken out of the economy.  A one-dollar rise would take $100 billion out of the economy, and would continue to take money out of the economy for as long as prices stay elevated.

There is a lot to worry about with all that is happening with oil.  Add to this the possibility of deterioration in the Middle East and a possible closure of the Suez Canal, or worse, a revolution or even a war, and we have the makings of a serious threat to our economy.