PHIL TOWN

That 70’s Show (continued)

In my last post I wrote about how there is a parallel between government policies in the late 1960’s and early 1970’s and now.  And that I believe there will be a similar stock market reaction to those policies. And since money to pay for these entitlement and international programs doesn’t come out of thin air, the way politicians try to have their cake and eat it too is predictable: Tax the rich and print the money.  In the last post I tried to show you how taxing the ‘rich’ predictably reduces jobs and stops the stock market in its tracks.  No new jobs and no stock market movement is a bad thing for getting re-elected so politicians will try to reduce the impact of taxation in a time-honored bit of incredible stupidity.  They will go for Door #2 - Print money.

The Federal Reserve Bank can do this legally.  This new money will have a brief positive impact as it rolls through the economy.  It makes people believe for a time that things are okay.   I give it 3-5 years max before the positive impact evaporates and prices begin to rise on commodities like gas and food.  Higher prices in commodities come from less production due to less investment and higher demand due to increased cash in the economy.  So they will print more money to ‘help’ people deal with price increases and that will cause prices to increase even faster.  In Zimbabwe, it only took a couple of years to inflate prices so much it now costs 15,000,000,000 Zimbabwe dollars to buy a loaf of bread because the government policy unintentionally discouraged the producers of wheat while increasing the production of paper money.

But wait!  There’s more! Inflation makes lending on a long term basis very risky.  You lend $1 million of buying power today but are paid back in five years with $500,000 of buying power plus some interest.  That doesn’t work for lenders so they either stop lending or they charge more to make a business loan.  We are seeing the effect now of massive government borrowing essentially mopping up all the bank liquidity and driving up rates to business borrowers.  In five years, expect 20% or 30% or 100% interest per year. Lending stops.  Businesses can’t borrow so they can’t grow.  If they can’t grow, their stock prices go down.

Income taxes and printing money.  What we should do is stop taxing productivity (income and capital gains taxes) and begin taxing consumption (national sales tax – see fairtax.org).  We won’t, but we should. Instead we’ll keep electing people who are all about getting us entitlements and we’ll be stuck in stagflation land until we get so sick of it we elect people who have an economic brain.

Next:  How to profit from the stupidity of our fellow Americans

Now go play.

Phil Town

That 70's Show

The stock market is well on its way to a repeat of the market from 1965 to 1983 – 18 years of an indexed 0% market return.  We have all the ingredients.  Here was the situation by the early 70’s:

-       We were ending an expensive war

-       We were spending massive federal money to create a ‘great society’

-       We were massively intervening in financial markets

-       The stock market was flat after the end of a long bull market

-       Inflation was on the way

These things have a big effect on stock prices.  When the American people forget that the government has no money, we vote for federal government to solve all sorts of problems.  The problem we create when we do that is the problem of finding the money.  The money has to come from somewhere.  There are only two choices of where to get the money: 1) higher taxes and/or 2) print the money.  Both choices are bad for stocks. 

Higher taxes take the money from upper middle class and rich citizens.  These are the people who have enough extra cash after personal expenses to have big bank accounts, big bond accounts and big investing accounts.  Higher taxes mean the money in those accounts goes down to pay the higher taxes. That means some stocks get sold, bonds get sold and cash is withdrawn from banks.

In addition, cash for starting new businesses and investing in growing businesses has to come from the upper middle and rich classes of investors because those investments are riskier than investing in businesses that are established.  Many startups and early stage businesses fail and all of the investor capital is lost.  The cash to invest in those businesses is only available from investors who have plenty of money to burn.  As taxes go up on those citizens, this is the first money that dries up.  Since these are the businesses that can create new jobs, job creation stalls and consumer spending shrinks.  And stock prices go down.

And then what happens?  Well, the politicians react predictably and make it worse.  I’ll tell you about that in the next post. 

Now go play 

Phil Town

Phil Town on Merger Arbitrage

Nick asked me about doing arbitrage on mergers.  His point is that the market has jumped massively since last March when I said to get back in and he's made out well ... but what now?  Is this an opportunity to profit from buying into potential mergers?

So called 'merger arbitrage' is a risky business that Mr. Buffett plays from time to time.  It can be a Rule #1 strategy.  Here's how it works: Rupert Murdoch wants to buy the Wall Street Journal.  It is selling its stock for $36.  He makes an offer and its accepted by the WSJ board - $60 a share.  On the announcement of the deal, the stock price initially jumps from $36 to $59 but then news comes out that a family with pile of WSJ stock doesn't like Mr. Murdoch and doesn't want to sell and the stock price falls to $54.  The gap between the $54 price and the $60 value (the value was defined by a firm and accepted offer) creates a classic Rule #1 opportunity.  We like to buy $10 bills for $5, right?  But if we can buy $60 for $54 and get our $6 profit in a couple of months, that can work out well, too.  

There are two things we have to know: 1) Will the deal happen? and 2) How long will it take?  If we know these things we can figure out our annualized risk adjusted rate of return and decide if its high enough to do the deal.

Why 'risk adjusted'?  Well, no one knows for sure the deal will happen because this family has the power to block the deal and they seem intent on doing so.  On the other hand, Mr. Murdoch is an intense guy who usually gets what he's after.  So there is some risk here that the deal won't go through.  What we do to determine whether this is a good deal for us is to apply a specific type of risk evaluation that creates a kind of Margin of Safety (MOS) analysis.  You have to know these five things: 

1.  Probability the deal goes through (Prob%): 

2.  Probability the deal fails to go through (Fail%)

3.  Potential profit (Prof$):

4.  Potential loss (Loss$)

5.  Time to realize profit (Time%):

The 'risk adjusted' formula is: (Prob% * Prof$) - (Fail% * Loss$) = Risk Adjusted Profit

Here's how that looks for the Dow Jones deal:

1. Prob% is 95% because Murdoch is intent on it and the WSJ CEO wants a payday

2. Fail% is 5% (100%-95%)

3. Prof$ is the $60 offer minus $54 current stock price.  Prof$ = $6

4. Loss$ is $54 price we have to pay minus what the stock sells for if deal fails - say back to where it was - $36.  So $54-$36=$18.  Loss$ = $18

5.  Time% is the Time for deal to go through: best guess based on news from board or completion date.  2 months. 2 months / 12 months = 17% of a year.

Do the formula: (Prob% * Prof$) - (Fail% * Loss$) = Risk Adjusted Profit

(95% * 6) - 5% * 18) = RAP

5.7 - .9 = 4.8

$4.80 is the Risk Adjusted Profit

Now calculate your Risk Adjusted Return (RAR):  $4.80 / $54 equals 8.9% RAR.

Time% is 17% of a year so the Annualized RAR is the RAR divided by the Time%.  8.9% / 17% = Annualized RAR = 52%

We're looking for an Annualized RAR of over 20%.  This is 52%.  Therefore we can do the deal.

That's how it works.  Kind of cool, huh?

Now go play,

Phil Town

How the Rich get Richer

I wanted to share a recent comment from Markus and my reply:

"Hi Phil Town, there are two points I still have not yet understood: 

1. If I only buy stocks at the MOS price I calculated using your tools, when should I rebuy, after having sold them (because of 10-days-line, MACD- and stochastic indicated to sell)? Should I wait for the stock's price fall again to the MOS-price? This might take a long time of being solely in cash and waiting for Mr. Market to turn crazy again... 

2. Should I buy a stock which has gained 50% and more during the last 6 months in a perfect stable trend but which hasn't yet reached its MOS price? I fear to buy it at the top at the end of a trend. Thank you for any reply."

Phil Town's response:

A stock is rising in price and has moved in just 6 months from $20 to $40 per share.  It is easily worth $150 a share.  Should I buy more if I have more money (assuming the indicators or FACs don't show a big down trend on the way)?  Let's check the Payback Time (more on that in my new book) because its a great check to see you're getting a true bargain but assuming that's okay and you're still below the MOS (in this case about $75) with the price at $40, of course we're buyers. This is stockpiling at its most elemental.  You buy.  You buy more.  As long as I'm selling you $10 bills for under $5 you just keep buying.

This is exactly how the rich get richer.  They have the money to buy when things are on sale.  If you are careful with your money, you will also have the money to buy when things are on sale.  And if you save some each month and Mr. Market cooperates, your wonderful business will still be on sale in a month and you can buy more.

Now go play.

Phil Town

Phil Town recommends website

As you guys know, I almost never blog about someone else’s blog, but you know the old saying about the apple falling not so far from the tree?  Well, this person’s writing is phenomenal.  Really.  The fact that the blog is written by my daughter, Danielle, has nothing to do with praising her work.  Nah. I can’t be bought for love or money….. Well, make that, I can’t be bought for money.  Love is another story altogether.  I love my daughter and I do whatever I can to help her go forward in her life, including subjecting you guys to a brief blog on her new website, BrownButterandBourbon.com . 

First, the name of the website itself is compelling, isn’t it?  Brown Butter & Bourbon?  Doesn’t the title pull on you to find out what it’s all about?  Well, a quick trip to the site will get you to the answer but I’ll spare you the trip.  It’s about Danielle’s unique style developed from her life in Jackson Hole and Wellesley, Mass and Oxford, England and New York, applied to her home dinner parties.  

I mean, seriously, you’ve got to be coming from a different place when you can make something really cool and really beautiful out of an image of a dead salmon lying on an iceberg.  That’s not the first thing that comes to my mind when I’m thinking about having a dinner party.  Of course, the first thing that comes to my mind in that situation is which caterer I should call to take this thing off my hands.  

And maybe that’s the point of her blog – giving us some pretty (if strange and different) ideas of how a little get-together can be easily put together without the caterer.  And maybe that would actually be cool to do.  You know, actually do the dinner ourselves. 

But you guys do that already – do it yourself, I mean.  So for you, her blog will just be another set of cool and unusual ideas for doing it yourself.  Not a bad thing at all.  And her writing style is pretty good reading, if I do say so myself. Perhaps, in spite of her reluctance to admit it, the apple really doesn’t fall far from the tree.

Now go play.

Phil Town