Agora Financial’s Rude Awakening

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Laguna Beach, California

• Oil powers up $4, the dollar crumbles and other “good” news,
• Ominous headlines and the jubilation on the Street,
• Corn Crop 101 from Kevin Kerr and one last housing bust pair trade…

Eric Fry, reporting from Laguna Beach, California…

America’s financial news continues to disappoint, but its stock market continues to dazzle…if not also amaze, bewilder and perplex. As one miserable news story after another crossed the wires yesterday, the Dow Jones Industrial Average soared to its largest one-day gain in almost two months – up 214 points.

Why the sudden jubilation on Wall Street?

It’s anyone’s guess, but don’t look to the financial headlines for answers. The top headlines of the day included gems like, “Oil Rises More Than $4 After Dollar Falls Against Euro” and “MBIA, Ambac, $1 Trillion of Debt, Lose S&P AAA Rating.”

But the stock market ignored these troubling tales – focusing instead on the exhilarating news that consumers continued to spend more of the money they don’t have. Same-store sales at Wal-Mart and Costco increased more than expected in May.

As yesterday’s trading session drew to a close, Fitch downgraded the credit ratings of two other mortgage insurers, MGIC and PMI. To justify its downgrade, Fitch explained:

“On further review of the U.S mortgage market and its impact on the financial and insured portfolio performance of the MI industry, Fitch has grown considerably more pessimistic on the outlook for the sector. This relates greatly to Fitch’s view that 2007 will likely prove to be one of the worst underwriting years in the modern history of the U.S. mortgage industry, and recognition that 2007 was a year of rapid growth for a number of key mortgage insurers. Fitch notes that 2007 vintage mortgages are turning delinquent at a significantly faster pace than the 2006 or 2005 vintage years; an early indication in support of Fitch’s growing concerns with exposures underwritten in that year…

“Adding to the strain seems to be an increasing willingness for borrowers to ‘walk away’ from mortgage debt when estimated home values are below their current mortgage balances…The deterioration in the U.S. mortgage market has led to continued sharp increases in delinquencies for all the MI companies, particularly for loans originated in the 2005-2007 vintage years.”

Hmmm…If this kind of news can’t generate another 200-point rally tomorrow, we don’t know what can.

The stock market is notoriously capricious, of course. So its recent bizarre behavior should surprise no one. Like a Greek god, the stock market delights in foiling the ambitions of mortals. And yet, it also bestows good fortune upon OTHER mortals. In both cases, the market does what it wants, not what anyone necessarily expects.

So it’s during times like these that pair trades can make some sense, or can at least lose money more slowly than many conventional investments.

In yesterday’s edition of the Rude Awakening, we featured a handful of pair trades that you, the Rude Awakening faithful suggested. Today, we’re back with more. But this one comes from your editor…just to be sporting.

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All About Silking and Tassling
By Eric Fry

Sell Visa (NYSE: V), Buy agricultural commodities.

This pair trade seeks to capitalize upon two important facts:

1) Debt-financed consumption is not an essential bodily function.
2) Eating is.

Therefore, if the U.S. economy were to slow down a bit, Visa purchases might also slow down. U.S. grain consumption would not. But this pair trade is not just a “macro story.”

On the micro level, Visa is a very expensive stock. In fact, it would be a very expensive stock, even if economic conditions were robust, which they are not. The stock has nearly doubled since its IPO on March 18. So at the current quote of $87.24 a share, Visa sells for a lofty 43 times estimated
2008 earnings – or nearly three times the estimated earnings of the S&P 500!

Visa’s luxurious valuation, along with its skyrocketing share price, bears no resemblance whatsoever to any of the stock market sectors that reflect the American consumer’s ability to consume. For example, the nearby chart tracks the recent price trend of Visa compared to homebuilding stocks and bank stocks. The Visa share price has clearly decoupled from the trend of the other two sectors. Admittedly, the time frame under review is quite short. Nevertheless, this particular picture is worth at least 500 words.

Homebuilding stocks are tumbling because home prices are falling. Banking stocks are tumbling because credit is contracting. Both of these trends are very bad news for a company like Visa that relies heavily on consumer spending.

However, the many fans of Visa stock would argue that Visa is merely a “transaction processor.” It does not originate or carry loans. That’s true and that’s certainly a virtue. But a transaction processor still needs transactions to process. Which brings us back to the stock’s valuation. How high a valuation does a “transaction processor” deserve? Something less than 43 times earnings would seem reasonable…much less. Remember, three months ago, 25 times earnings seemed like the “right” price to pay for Visa.

We have no idea if Visa will return to the mid-20 PE ratio from which it vaulted, but we would not be surprised to see buyers become a bit less enthusiastic at current prices. Lastly, we would note that cash-hungry financial firms like Bank of America and Citigroup own millions of Visa shares. Therefore, these cash-hungry firms might be eager to sell some of their billions of dollars worth of Visa stock. Despite all of these various concerns, however, Visa stock continues to flirt with new highs.

Many agricultural commodities are also flirting with new highs. But the similarities end there. Agricultural commodities are very unlike Visa. They do not merely facilitate commerce, they facilitate human existence. Everybody on the planet is hungry and they all want to eat. This fact does not make commodities a buy, but it does highlight the imbedded long-term demand component that underpins grain prices.

Demand is only one half of the bullish case for ag commodities, however, and maybe not even the best half. Grain supplies are thin…very thin. Worldwide supplies of all cereal grains combined have dropped to 25-year lows. Wheat stockpiles are especially lean. Global stockpiles of wheat have plunged to 30-year lows, while U.S. stockpiles have plummeted to 60-year lows.

Not surprisingly, grain prices have been rallying sharply for the last year or so. But recently, grain prices have been slipping a bit. In fact, since the day of the Visa IPO, agricultural commodities, as a group, have FALLEN. Therein lies an opportunity…perhaps.

Grain supplies do not increase as easily as credit cards. Grains only spring from the ground when farmers plant and fertilize them, and when weather conditions permit. Lately, the weather conditions have not been permitting as much corn-growing as they usually do. In fact, our resident agricultural commodity expert, Kevin Kerr, reported yesterday:

“More bad news. I am hearing about 10% losses here and there in each major state for corn. Add it up and it is very significant. Let me explain why.

“Here’s my version of Corn Crop 101,” Kevin wrote. “It’s still wet and ugly all over the Midwest…It’s June 4th…Bad news if this rain keeps up and then the searing July heat sets in…You can forget about this crop if the corn isn’t tasseling and silking before then.

“So how far along is the corn, not very far at all. A very rough estimate can be made by counting the leaves developed or by measuring plant height, which I did last year. However, the first solid indicator of crop progress is the average silking date.

“Begin looking for silks soon after the tassels appear. Under normal conditions, 20% to 25% of the plants in a field will silk each day. When approximately 75% of the plants show silks, we record that date as the silking date. In a typical year, the average silking date for Iowa for example, falls between July 20 – 25…Not this year, not a chance…

“So that means late harvests and a greater risk of damage from frost…Frost is a factor because harvest will be later this year and an early hard freeze can be the final nail in an already fairly well sealed coffin for corn yield.

“In case I lost you at tasseling, it’s when you start seeing the stringy stuff coming out of the corn husk. Late silking is associated with lower yields and wet grain…Since farmers planted (and are still planting) late, the problems are magnified when a killing frost comes early. I think the story is growing even worse for soybeans.”

Kevin probably provided more information than most of us care to know about tassling and silking. But such are the detailed, first-hand observations that enable Kevin to provide so many successful trades to the subscribers of his trading service, Resource Trader Alert.

For us non-traders, Kevin’s observations add one more important ingredient to the bull case for ag commodities: There’s no room for error on the supply side.

Therefore, we repeat: Sell Visa, buy ag commodities. (There are many ways to “buy ag commodities,” but buying a one of the many ETFs and ETNs that own agricultural commodity futures is probably the easiest way. “JJA” on the NYSE is one example. For more details click here.

But please don’t get carried away with this pair trade. Visa is still a great company, even if its stock is overpriced. And ag commodities are still vulnerable to gut-wrenching selloffs, even in the midst of a powerful bull market.

All we’re really saying is that we’d rather invest in grain than plastic, especially during the economic slowdown that might soon begin.

[Joel's Note: Another difference between the Visa story and that of ags, we might be so bold as to suggest, is the gaping spread between the excess of intangibles and an alarming shortage of tangibles. In other words, we have plenty of credit cards in circulation and, with them, companies making profit as “transaction processors.” At the same time, the world is in the throes of
a drastic food shortage. In many places, people are literally scraping at the bottom of the rice bowl just to grab a grain.

Kevin and I spoke quite a lot about this difference when he visited the UAE recently. He was here to speak at a mega-fund investment conference in Abu Dhabi and I took the opportunity to ask him why he chose resource trading as his specialty.

“The fact that you can touch and feel them makes a big difference to me,” he said. “It’s why I go out west every year to visit the farmers, to see the crop progression and get the lay of the land. It’s measurable and, provided you know what you’re doing, you can make relatively accurate predictions.”

Actually, the success of Kevin’s predictions was precisely the reason he was in the UAE in the first place…to educate an elite group of mega-fund managers on how to play the resource market. These guys run tens and sometimes hundreds of millions of dollars and coughed-up ten grand a head
just to hear Kevin’s presentation.

However, as a Rude reader, Kevin’s offering you a special “Guest Pass”program. If you’re interested, here’s a link.

Be sure to keep an eye out for your 5-Minute Forecast, en route to your inbox shortly. The guys have been monitoring one Wall Street fat cat that is about to announce some very embarrassing earnings shortly…could be a great short for your own housing bust pair trade.

Until tomorrow…

Cheers,

Joel Bowman
Rude Awakening

aussiejoel@the-rude-awakening.com