Friday, March 25, 2011


I did some research on the VIX about fifteen years ago that I subsequently filed away for a later date. This may be good time to bring it forward and get some discussion on it.

The research presents a very simple and quick way to determine when options players are acting “rationally” or “irrationally” about the market; that is, if the VIX implied market volatility actually matches real market volatility (rational), or if the VIX is over- or under-stating it (irrational). It’s based on the idea that the VIX doesn’t really tell you anything by itself. It’s only when you compare it with the market’s actual volatility that it really does say something unique.

What is the VIX?

One major problem with the VIX is that few investors know what it really is. In fact it’s even been given a wrong name. It’s called the fear index although it’s anything but. The entire subject of the VIX and even options themselves starts with something called the Black Scholes equation for options pricing; a thing considered so important it actually won the economist Myron Scholes a Nobel Prize in 1997.

In this equation you insert the option’s strike price, the current stock price, as well as the time remaining before option expires. You also insert a riskless interest rate but don’t ask why; it’s not as critical as these other factors by a wide margin. Lastly, you insert the stock’s volatility number. Like magic, the equation spits out the theoretical price you should pay for that option. What anyone did before this equation is anyone’s guess.

The Volatility Calculation

Of all these inputs the only confusing one is probably the volatility number. How is a stock’s volatility calculated? Essentially you go back five or ten years and do these day-to-day calculations on price and from these you get a number that represents the yearly price variation of that stock. This procedure works fine if the option in question is long term, say six to nine months from expiration. There, any sudden short term change in volatility from a news item dampens out over time. When pricing a long term option you use this stable number; you don’t use any short term volatility number; it won't work well.

However, when pricing a shorter-term option, say one expiring in a month, this long term number doesn’t work well. You must use a shorter term calculation of volatility. You might use a ten or fifteen day volatility calculation. While this calculation will vary widely it will more accurately reflect the market conditions that will apply to that option over its shorter lifetime.

The VIX is 'Implied' Volatility

Now here is where some market technician got ingenious. Someone thought, “Instead of doing this short-term calculation all the time, let’s calculate backwards. From the latest option price let’s figure out the volatility number traders are assuming at that moment.” This backward calculation is the VIX and it's why it’s called “implied” volatility; it’s the volatility number that’s “implied” by the Black Scholes equation using the most recent short-term option prices of the S&P 500 (SPY). The VIX for the last eleven years is shown in this first well-known chart below.
(Click chart to enlarge)

Implied Volatility vs. Real Volatility (almost)

Much has been written and spoken about the VIX, but in my opinion the VIX doesn’t indicate or say anything in itself. Maybe the VIX is simply measuring the real changing short-term volatility of the market and not telling us anything we don’t already know. To see if it is, we could calculate the market’s actual short-term volatility and compare it with the VIX’s implied volatility. However, in doing this I’ve personally found it more useful to do another calculation of volatility over the standard formula. It's also simpler to do. It’s based on the fact that traders are much more alarmed by large day-to-day fluctuations in the market than the actual volatility number that theory might produce.

A Simple Modified Volatility Number

If the market goes up and down 3% a day, but over time doesn’t go anywhere, that will show as a low volatility calculation. Yet we know that investors will not (rightfully) consider it so. Just like a person jumping and going up and down ten feet in the air, they may not get anywhere but they will still cause a lot of commotion. Because of this a more accurate idea, in my opinion, is to simply calculate the average absolute value of the daily percentage change in the market over a short time period. The second chart shows this; it plots the VIX index (blue) against a simple 10-day moving average of the absolute daily price change in the S&P 500 (red). The two numbers are normalized (put on the same scale) by using a simple conversion factor that does this.

The most obvious message from this comparison is that the VIX, at least on a macro scale, simply reflects what is happening short-term in the market itself. In effect it doesn’t tell you anything new that could not be calculated using old standard market volatility measurements of the market itself. You don’t even need options. But as usual the truth is in the details.

The Details

Experience with market psychology or investor sentiment over many years shows what is usually important when expectations get either too one-sided or when they don’t match what is really happening. For example, if the market rallies and investor are doubtful that is usually a good sign; the market is rising against a wall of worry. In a similar vein with the VIX, what should be important is not when the VIX matches real market volatility but when the VIX diverges from what is really happening volatility-wise. It’s when the market calms down, yet investors remain doubtful and jumpy. Or when real volatility rises, but options players ignore it and remain complacent.

Because of this what should be important is not the similarity in the two numbers but when they become widely different. The third chart shows this difference - the difference between the VIX and a smoothed version of the 10-day moving average of the daily absolute changes in the market. High numbers are when the VIX is overstating volatility (probably a bullish indicator) and low numbers the opposite.
It is clear that high overstatement of volatility by the VIX corresponds to major buying opportunities as you would expect from basic theory. There were six periods in the last eleven years; four are shown by a blue arrow, the other two are obvious and are the two times the blue line met or almost met the red line.

There is one point this comparison made very clear last week. The recent surge in the VIX last week in response to the market decline and the Japanese catastrophe was a rational investor response. The increase in the VIX implied volatility pretty much matched the actual increase in market volatility.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

A Fresh Look At Auto Part Stocks

We took a look at the auto part stocks back in February and noted how they were stalling out and could be either faltering or beginning to correct. While this group was in fact tired, it has held up quite well as it transitioned to more of a sideways correction. Many traders associate the word correction with lower prices, but there are times where a stock will correct through time as it works off excess bullishness. The auto part stocks have fallen somewhere in between with a pullback from recent highs, but also pretty solid respect of support levels underneath.

Tutorial: Technical Analysis

Advance Auto Parts (NYSE:AAP), for example, backed off from new highs late in 2010 and suffered a sharp decline toward the $60 level. It started to stabilize in this area before pulling back again in late February. However, the $60 level brought back buyers and is now forming the bottom of a larger base. AAP has now started to trade back above its 20- and 50-day moving averages as it hovers in the middle of its base. While AAP may not quite be ready to break out, the overall picture is starting to become more positive.


AutoZone (NYSE:AZO ) is another stock that appears to have managed staving off a deeper correction. AZO also took a big blow after hitting new highs late in 2010. It failed miserably, dropping toward the $250 level in January and hovering at support for weeks. After a brief shakeout later in the month, AZO stabilized and attempted to move back higher. It didn’t last long as AZO pulled back toward the $250 level. This time buyers rushed in and pushed AZO back higher. AZO is now pretty close to the late 2010 highs and could be close to a breakout. (For further reading, check out AutoZone Not Sputtering.)


Following the same pattern, Stoneridge (NYSE:SRI ) has been trading sideways for months as it corrects the rally that occurred through the second half of 2010. Things were looking tenuous in early February as SRI dropped under its 50-day moving average and hit new lows, but buyers defended the $14.25 area. Buyers continued to defend this area and SRI is now testing the top of the ascending triangle that has formed throughout the consolidation. A close above $16 could signal an end to the current consolidation.


Tenneco Common Stock (NYSE:TEN ) also looked tenuous at best in early February as it entered a freefall on high volume. However, it rebounded just as sharply and reclaimed its 50-day moving average a few sessions later. From there it has continued to meander sideways as it narrows in range. TEN is currently at the apex of the triangle pattern it has been forming and should be close to a move in one direction or another.


The Bottom Line
While things looked bleak a couple of months ago, time does heal wounds in the stock market. The auto part stocks have taken a much needed break as they consolidate some of the outsized gains from the last two years. The group is not out of the woods yet, but many stocks have now revealed clear support levels for traders to monitor. If these stocks can emerge from the bases they have been building, they could provide a great opportunity for patient traders.

At the time of writing, Joey Fundora did not own shares in any of the companies mentioned in this article.

By Joey Fundora

Oil Sands: Fueling the Future

For many years, trying to tap an oil sands deposit accomplished about as much as sipping molasses through a straw, but that is changing. So do oil sands companies make a good investment now?

Humans and bacteria share a surprising number of features, not least in what they consider good food. In general, the smaller and simpler the molecule, the easier it is to digest. So, about 50 million years ago, when and where bacteria had a chance to chow down on some of the rich hydrocarbons we call oil, one might expect them to start on the smaller, tidier mouthfuls, and indeed they did.

What’s left today of these bacterial banquets are deposits of oil molecules so big and cumbersome that they flow like molasses in winter, if at all. At the extreme end is bitumen, which looks rather like sticky asphalt:

The oil sands that contain this heavy oil and bitumen have long posed an intriguing “what-if” for the industry. heir potential is staggering. One of the world’s largest deposits, in the Canadian province of Alberta, spreads over the size of Wisconsin and may hold two trillion barrels of oil – eight times the reserves of Saudi Arabia.

For just about as long, however, oil sands have been minor players at best in the world’s energy picture. The very qualities that native peoples have exploited to seal their boats make these heavy oils and bitumen tough to suck out of the ground and shove down a pipeline. And that’s before they even get to a refinery.

Two developments in recent years have brought oil sands in from the cold: rising oil prices and new technology to pry bitumen out of deposits and make it run, not walk, to the nearest processing facility.

So let’s take a look at how oil sands came about and what we can do with them.

The Tale of Two Oil Deposits

We’re back to millions of years ago, this time to the hundreds of millions, when algae and the simple organisms that fed on them died, drifted down to the seafloor, and were gradually buried under sediments and subsequent generations of ancient life.

As the ages passed, the pressure of layers above and heat from inside the earth broke down and reassembled these simple plants and animals into chains of carbon atoms bristling with hydrogen. Under pressure, these hydrocarbons squeezed through grainy, porous sedimentary rock until blocked by nonporous rock, known as capstone. There accumulated the first of our tale, a deposit of what we now call conventional oil.

The other deposit was in for a second ride. Geological forces lifted these oil-bearing rocks up toward the surface of the earth, within reach of water and bacteria. You know what happened next.

Because of this additional history, oil sands differ in structure as well as content from conventional oil deposits. The bitumen coats the grains of sand like a film and is in turn surrounded by water. Scraping the bitumen off the grains is the first step in extraction.

The uplifting also means that oil sands deposits are relatively shallow: some can even be surface-mined like coal.

This geological process happened in places like Venezuela and the United States, and particularly in Canada. In the province of Alberta are three major oil sands areas: the Athabasca (the largest), Peace River, and Cold Lake. Current estimates put the combined bitumen in these deposits at 1.7 trillion barrels, and some geologists believe more field work will jack that number up a fair bit further.

The catch is that, at present, only 10% or 170 billion barrels of that bitumen is considered economically recoverable, that is, worth a producer’s considerable effort to bring it to market. Even so, 170 billion barrels places Alberta second only to Saudi Arabia in terms of proven oil reserves, and ever-developing technology is likely to bring more in reach.

We’re going to focus on Alberta because it’s home to the largest and most developed oil sands deposits in the world.

To Market, to Market: Step 1

Surface mining operations dig up and crush the oil-soaked rock, then mix it with water heated to 50-80°C. In such conditions, the bitumen floats off. All told, bitumen recovery from strip mines approaches 90%, and the mining and processing costs come in at about US$8.00 per barrel.

However, only about 20% of Alberta’s bitumen is shallow enough for surface mining. The remaining 80% requires drilling and in-situ methods that extract the oil from the rocks in place. There are several methods to do this, and more in development. What they generally have in common is pumping down steam to heat the trapped oil, making it less viscous. Then a producer can actually pump the bitumen to the surface.

Many oil sands companies use this in-situ method, called steam-assisted gravity drainage (SAGD).

Another factor in-situ methods have in common is the large amounts of energy required to generate the steam. At present that energy usually comes from natural gas, which comprises 65-80% of total operating costs.

According to government statistics, Alberta is host to 91 producing oil sands projects as of 2009. Of these, only four are mining projects, while the remaining 87 use various in-situ recovery methods. In 2009 those projects produced an average of 1.49 million barrels of bitumen per day (bbpd), which represents more than 40% of Canada’s total oil production. That 1.49-million figure is projected to reach 3 million bbpd by 2018.

To Market, to Market: Step 2

However it’s recovered, this stiff black glop needs further work in order to sell it. An oil sands producer has two choices: to upgrade it and make synthetic oil, or to dilute it with lighter hydrocarbons so it can run down a pipeline to a refinery.

Upgrading usually requires two steps. First the bulky hydrocarbon chains are broken into smaller ones in a process called hydrocracking; upgraders may also remove carbon to produce the smaller chains along with coke. The second step adds hydrogen to “fill out” the new carbon chains and to remove impurities like sulfur. Currently five upgraders in Alberta churn out a bit over 1 million barrels of synthetic crude oil each day, and there are plans for more.

Bitumen that’s not upgraded is blended with diluents that make it runny enough to pipe to refineries throughout North America. The diluents are usually a mixture of light hydrocarbons, such as light crude oil and naphtha. Companies can recycle diluents that stay within Alberta, a significant consideration in project planning.

The investment to get the industry to this stage has been massive. Between 1999 and 2009, an estimated $91 billion was pumped into developing Alberta’s oil sands. In 2009 industry invested another $10 billion, and almost $170 billion worth of oil sands projects are currently underway or proposed in the province.

Environmental Issues

Environmental groups have labeled bitumen “dirty oil” and are calling for an end to oil sands operations. They have three main complaints: that ugly mines and tailings ponds destroy habitat, that projects gulp energy and emit significant emissions for every barrel of oil, and that the whole process uses a significant amount of water.

The groups are certainly right on some fronts. In-situ operations cause minimal disturbance, but surface mining – even though it represents only 20% of oil sands operations – does make an unsightly mess of boreal forests and marshlands. And in-situ projects have their own issues. The roughly 30 cubic meters of natural gas and three barrels of water consumed to produce one barrel of bitumen are indeed high.

Well, oil sands aren’t going away. Their potential is too vast, global demands for energy too high, and for governments like Alberta, they contribute too much to the coffers.

But more encouraging yet, industry is developing less intensive techniques. Quick-drying tailings ponds can be returned to nature faster, for example. And companies have a double incentive to develop in-situ methods that require less energy and water: they would lower operating costs as well as mitigate complaints.

9 Stocks George Soros Is Buying : C, DAL, F, GM, MSI, MT, PBR, UAL, WMT

Investment Underground took a look at a few promising picks that George Soros' funds are buying. Here are our noteworthy favorites to keep an eye on that may impact your portfolio:

General Motors (GM): When coming from such lows, mega highs are needed to get back up. EPS estimates for this year are thus, understandably hyperbolic: 574%! (For some leveled perspective, GM is looking at a much more reasonable five-year EPS projection of 24%.) We’ll see this week if we’re on track. The leader of the U.S. car market, with 19% of it in its pocket, GM has fought a very rocky battle over the past few years. With new leadership that has an eye on a clean debt book, a condensed and somewhat diversified product portfolio and healthy North American operations it looks like GM, dependent on consumer behavior of course, might be able to take off its boxing gloves for a bit, or at least get itself out of the corner and land some punches of its own.

Petroleo Brasileiro (PBR): This massive Brazilian producer has been boosted recently by the major discovery of reserves off the Brazilian coast. This type of extraction is more costly than traditional extraction, so, as prices for oil rise, the justification and margin son this type of extraction grows. Libyan instability leads to spike in oil prices which leads to increased value of PetroBras’s reserves. That said, this type of extraction is also known for its long-term nature. That means that investors are aware that the benefits of the reserves will be elongated over a period of time so momentary shakes to the oil market can have less of an effect on the stock. This is a double-edged sword.

United Continental (UAL): United overpaid for Continental Airlines, and the company will face a tough job continuing to integrate the airline over the next few years. Competitors, both established and new, as well as significant fuel price increases will hamper this company. UAL can grow revenues with higher ticket prices and we expect mid margin expansion due to synergies developing, albeit at half the $1 billion figure offered by management. We value shares at $23 apiece using a 12% discount rate. Events in Japan are not helping the company, though operators like Delta (DAL) are bearing the brunt of reduced air traffic to and from the island.

Motorola, Inc (MSI): In January the mobile telecommunications and technology giant had broken up into Motorola Solutions and Motorola Mobility. IU’s information is dedicated to Motorola Solutions (MSI), a company with 51,000 employees. Its market cap stands at 14.02B with a return on assets at 2.54%. The revenue is 19.28B. Its trailing annual dividend yield is 3.78. We recently highlighted that Dodge & Cox funds have a significant ownership stake in the company.

ArcelorMittal (MT): has a market cap of $53 billion. It trades under a P/E of 20.66, and with a PEG of 0.80, but with a dividend yield of 1.8%. In 2010, MT made $78 billion in revenues, which is an increase of 19.84%. Net income is up to $2.9 billion. This is a jump of 2371%. EPS also went from $0.08 to $1.72. The ROE is 4.72% and ROA is 2.26%.

The EBIT and profit margins are 2.38% and 8.9%, respectively. The current ratio is 1.39 with a D/E of 0.31. 52 week trading range is $26.28 - $47.25. The 30 day put/call ratio is 0.8.

Walmart (WMT): While present in Japan, it is far from its most crucial market and in the words of a Moody’s analyst, it won’t a have material impact on the company’s operations. Currently trading at $51.52/share, it hasn’t deviated by more than 2% from this price in the past 20 days. Its forward P/E of 10.6 lends itself to the view that it should climb higher to reach fair value in the $60/share range.

Citigroup (C) has shown four straight quarters of profit, after being squarely embroiled in the financial meltdown of 2008. In sum, the company made $10.6 billion in profits in 2010. The company also grew revenues by 7.87% in 2010, and 52.08% in 2009. The EBT margin in 2010 improved to 15.22%. In its heyday, Citigroup traded with P/S multiples in the 3’s. Now, it is 1.5, and the industry average is 1.3. EPS came in at $0.35 in 2010, recovering from -$0.80 in 2009. Analysts expect 2011 to produce an EPS between $0.32 and $0.55. Shares trade under $5. This is a long-term play.

Delta Airlines (DAL): Delta should be able to grow revenues at a 7% clip and keep margins around 6%. Fuel prices will hamper any real growth for the company, however. Periodic battles for market share with other established and newer players in the industry will keep a lid on Delta. We value shares at $10 apiece using a 12% discount rate. Delta recently announced that its revenue losses due to the crisis in Japan would amount to $400 million, a significant chunk for the company.

Ford (F): Ford is trading at a very low $14-15 per share, well below fair value of $23 per share, on a discounted cash flow basis. EPS for 2011 are forecast at 113% with a five-year projection of nearly 13%. Broad trends suggest that it is stealthily improving its position in the competitive landscape: a consolidation of brands, a gain in market share over the past year and the shedding of debt. On this last point, it was just announced that Ford will redeem, in cash, all 6.50% convertible trust preferred securities, effectively taking off $3 billion in debt from its books and reducing total debt to $16 billion. As earnings announcements loom, these dual events could act as a catalyst to bring its stock price nearer to fair value. We use an 11% discount rate for the company.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The Dollar Will Collapse Within 3-4 Months

The US Dollar's inflationary death spiral continues. We've now taken out the 2010 low leaving only two more lines of support before we're in completely uncharted territory.

At its current rate of collapse, the US Dollar will do this within the next 3-4 months. This means the greenback will break into a new all-time lows by 2H11, which will precipitate the coming inflationary collapse.

Small wonder then that both Gold and Silver recently hit new highs for their current bull markets. With the greenback dropping like a rock, and rumors of QE 3 swirling around the financial community, what sane investor would bet against inflation?

On that note, now is the time to be shifting capital into inflation hedges. Those who buy Gold and Silver will likely do very well in the coming months (my personal view is Gold will clear $1,500 and Silver $40 this year).

We’re also going to be seeing an increased wave of buyouts in the natural resources sector as larger firms look to increase their resources via mergers and acquisitions rather than spending the money to find and develop new mines.

The natural resources sector will also benefit as large institutions (pensions, mutual funds, etc) finally begin piling into inflation hedges across the board. Given how little exposure the Big Boys have to inflation hedges even a small percentage of assets under management, shifted into these sectors, could result in sharp price spikes.

In other words, buckle up, cause things are about to get REALLY interesting.

BNN: Top Picks

Paul Harris, Partner & Portfolio Manager, Avenue Investment Management, shares his top picks.

click here for video

How to Get a 9%-Plus Yield on the Dow Large-cap stocks are the safest place to be right now

I always love to find a strong-paying income investment that just so happens to be right where the upside action is. It’s no secret that large caps have been the go-to stocks for the first three months of 2011, at least from the vantage point of professional fund managers. The lower U.S. dollar does wonders for companies with more than 50% of their business done outside the United States, and I don’t see this theme changing anytime soon.

Large-cap stocks are the safest place to be at a time when the dollar is weak, corporate profits are booming and, yet, we have soaring domestic budget deficits and geopolitical issues in the Middle East.

For those looking for income investments, one way to capture a fat 9%-plus dividend yield and own the biggest U.S. multinationals is to own the Dow 30 Enhanced Premium & Income Fund (NYSE: DPO). It’s a closed-end fund that invests in all 30 of the stock components of the Dow Jones Industrial Average while applying aggressive swaps and covered call options strategy.

The Dow has easily been the most resilient of the major averages when the dark clouds of uncertainty lift, and I think you would be well-served to have a portion of your assets in the index — while simultaneously collecting some hefty dividend income and option premiums.

The chart of DPO below shows a very constructive breakout from a “golden cross” in October. This occurs when the 20-day (green) and 50-day (yellow) moving averages move up through the 200-day (black) moving average, signaling a new uptrend. Currently, the market is in a period of consolidation, thanks to the front page of the daily newspaper showing havoc in the global oil patch.

DPO Stock Chart

This close-end fund will purchase other securities or financial instruments, primarily swap contracts, designed to provide additional investment leverage to the return of the Dow stocks.

Managers of the DPO fund also will engage in certain option strategies, primarily consisting of writing (selling) covered call options on some of the Dow stocks. The options will be written on approximately 50% of the portfolio. As a result, the other 50% of the fund’s total holdings will not be hedged — and have the potential for full capital appreciation.

The current 9.4% yield on DPO is easily accomplished when the Dow index is incurring triple-digit swings on a weekly basis. It’s the very stuff option sellers live for to bring in premiums, and as a result, a greater percentage of the portfolio can be left open for pure upside.

At this juncture, I like the risk/reward ratio associated with the Dow Jones industrials, and recommend purchase of the DPO up to $11 per share.

Grain stocks to dip further despite record harvest

World grain stocks are set to fall again in 2011-12 despite a record harvest, as increased feed and food consumption more than account for increased production, the International Grains Council said.

The influential intergovernmental group, in its first grains forecast for the forthcoming season, estimated grains output jumping 4.6% to an all-time high of 1.805bn tonnes.

"The biggest increases are forecast for Russia, the US and the European Union, with sizeable gains also expected in Canada, Kazakhstan and Ukraine," the council said.

However, even this estimate, which assumed a 4% rise in sowings to a 13-year high of 537m hectares, would be insufficient to restore production above demand.

World consumption of grains - defined as wheat and coarse grains including corn – will rise by 1.1% to 1.808bn tonnes.

'Continued tightness'

"The first comprehensive analysis covering all grains points to continued tightness in the global market unless output exceeds current projections," the IGC said.

"A significant upturn will be required in production in 2011-12 to prevent another fall in end-of-season inventories."

Their analysis implies stocks falling to a four-year low of 338m tonnes in 2011-12, and a stocks-to-use ratio – a key measure of the readiness of supplies, and therefore of price potential – of 18.7%, down 0.4 points, albeit still looser than in 2006-07 and 2007-08, whose tightness spurred the previous rally in grain prices.

Ethanol use curbed

The IGC's forecast of a further tightening in inventories echoed comments from fertilizer group PotashCorp made hours before, and came despite a 1m-tonne upgrade to the council's forecast for world wheat production, taking the estimate to 673m tonnes.

In the council's first estimate for 2011-12 corn production, the world harvest was pegged at 841m tonnes, a rise of 4.1% on this season's result.

However, increases were also forecast both food and feed use of grains, if not for industrial use of corn.

"Continued tight [corn] supplies and resultant strength in prices will likely restrict growth in industrial use, particularly in the fuel ethanol sector," the IGC said.

"After several years of strong growth, industrial use of [corn] is expected to level off, with starch use a little higher, but an easing in the US ethanol sector is likely."

Goldbug Sprott Bets On Continued Upside For Gold, Silver Amid Uncertainty

Canadian firm Sprott Asset Management hasn't been shy about betting on precious metals over the past several years. Mining stocks make up the bulk of Sprott's top equity holdings and the firm said it believes continued global uncertainty, perhaps including a double-dip recession, will further boost gold and silver prices.

With about $9 billion in assets under management, Sprott has performed well over the past couple of years as gold and silver have surged. Gold is currently trading near its record high and silver is pushing another 31-year high as the Gold and Silver Stocks Index is up 1.5% today, but Sprott sees more gains on the way for the metals.

The firm said gold prices could reach $1,800 an ounce this year and $2,000 an ounce early next year. Sprott is similarly bullish on silver, saying the white metal could reach $50 an ounce in the next 12 months as it makes its way to $100.

Of course, those scenarios would benefit mining companies such as Barrick Gold (NYSE: ABX - News), Eldorado Gold (NYSE: EGO - News), IAMGold (NYSE: IAG - News), Yamana Gold (NYSE: AUY - News) and Silver Wheaton (NYSE: SLW - News), all of which could be found among Sprott's top holdings at the end of 2010.

10 Sins Of Inflation

While my comments last month (see 7 Reasons Investors Should Embrace Inflation) focused on the positives of inflation, at least from the governments perspective, its long term and overall effects are always negative. The only reason it gains any traction in government is because it has various positives in the short term for bureaucrats and politicians, which I detailed last month. Aside from the fact that last month’s inflation positives are negatives for other than government and debtors, let’s review some more negatives:

  1. It discourages investment and erodes savings thereby making planning and budgeting by individuals and industry hesitant and uncertain.
  2. It causes an allocation of more capital into non-productive assets such as gold, collectibles, land, etc.
  3. It causes hoarding and speculation which leads to price distortions, i.e. it is self- perpetuating.
  4. It erodes peoples’ pensions and retirement savings so they cannot afford to retire. Those already retired face a reduced quality of life or becoming Wal-Mart greeters.
  5. It leads to tax bracket creep for individuals increasing their tax rates in addition to the total tax amount.
  6. It increases labor strife and disruptions as wage negotiations make unions more importance to workers.
  7. It causes an inefficient allocation of resources resulting from the constant need to raise prices, which is also costly, e.g. restaurant menus.
  8. It leads to speculative borrowing which increases investors’ risk as well as overall systemic risk for the financial system.
  9. It invariably leads to an economic contraction when government decides the negatives outweigh the positives. They do this through raising interest rates and shrinking the money supply.
  10. As inflation drives up interest rates, the cost to the federal government of financing a $14 trillion debt at say 6% becomes $840 billion a year – the amount of the entire budget not so long ago. This alone would be a $350 billion increase in federal spending over the cost today, which shows just how marginal is the current debate over getting $100 billion in annual budget cuts.

The consequences of inflation for the federal government are a host of new problems, usually involving the spending of more money to counter the economic contraction they caused in the first place. But then, this is the history of government actions, a high percentage of which are directed at remedying past policy mistakes.

Individual investors need be pro-active if they wish to avoid the consequences of inflation.

My recommendations for asset allocations are:

  • 25% in adjustable interest rate debt securities
  • 30% in stock market sensitive issues, i.e. convertible stocks and high dividend paying blue chip stocks
  • 20% in energy securities and master limited partnerships
  • 15% in high dividend paying special purpose closed end funds, i.e. commodities, energy, adjustable rate debt and stocks
  • 10% in gold, silver and platinum ETFs

We follow this strategy for our managed accounts and attempt to achieve this diversity in the Multi-driver Portfolio.

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We left this story last month with the happy expectation that Fed Chairman Bernanke was going to be deflating the carry trade bond bubble, bring long term interest rates in line with inflation expectations, stimulate bank lending and thereby create economic growth.

As this plays out monetary velocity, i.e. the frequency money turns over, will increase giving us the moderate inflation Ben is hoping to induce. The problem with this hopeful scenario is that the rate of inflation will likely be much higher than desired.

The Fed’s plan would be that once the desired inflation level is reached, they will begin selling off the $600 billion in treasuries they acquired under QE2. Such sales will decrease the money supply, the first shoe to the inflation equation. This will also have the effect of driving long term interest rates even higher in the search for buyers. It will also have little effect on the velocity of money, which should actually increase even more as the increase in interest rates fuels even more inflation angst.

The Fed has little or no influence on the velocity of money short of raising short-term interest rates to a level that causes an economic slowdown or recession. Even then, if they don’t play it right, they can get their economic slowdown and still have inflation (better known by the term ‘stagflation’.)

Even those who try to protect themselves against inflation by buying TIPS and other adjustable rate securities find their refuge is limited by the fact that government decides how much inflation to report. By excluding such essentials as food and fuel from the CPI (called core CPI) they miss much of the real cost of living. This is especially so since housing is 42% of the overall CPI index, but becomes 51% of the core index when food and energy is stripped out. Given this distorted percentage for housing which continues to decline, don’t expect core CPI to give a realistic reading anytime soon. It has been reported that if inflation today was measured as it was in the 1980’s we would be reporting a rate of 9% rather than 1.4%. Hint, you may want to avoid treasury TIPS, which are tied to core CPI.

To make matters worse, through what is termed hedonic adjustments, the government makes subjective judgments about product equivalents (i.e. a computer today may cost more but, is 4 times better than one sold five years ago; ergo in their calculation, the price actually declines! The fact that you don’t use or need the snazzy new features is irrelevant.) It is such data manipulation which allows politicians to have inflation while by-passing mandated budget cost increases tied to the CPI.

This big-name stock is now cheaper than 99% of the companies in the S&P 500

Sprint Nextel Corp.'s shares are so battered after AT&T Inc.'s $39 billion offer for T-Mobile USA that investors are valuing the third-largest U.S. mobile phone carrier at a discount to its net assets.
Sprint's 11 percent slide to $4.49 since the T-Mobile USA deal was announced March 20 through yesterday left its stock trading below the company's $4.87 a share in assets minus liabilities. That means investors can buy Sprint for 92 cents on the dollar, cheaper than 99 percent of companies in the Standard & Poor's 500 Index excluding financials, according to data compiled by Bloomberg. Sprint's licenses from the U.S. Federal Communications Commission, which give it the right to operate its network in specific regions, alone are worth $19.9 billion, 46 percent more than its market capitalization of $13.6 billion.

AT&T's purchase of T-Mobile USA from Deutsche Telekom AG will give the combined company more than double the customers of Sprint, while Verizon Wireless has almost twice the market share. To boost value, Overland Park, Kansas-based Sprint may buy the remaining stake in partner Clearwire Corp. or another carrier such as MetroPCS Communications Inc., according to Dan Hays, a director at consultancy PRTM. It may also become a target for Verizon as carriers that run on the same network technology are forced to combine, he said.

"Someone, whether it's Sprint or Verizon, is going to have to serve as a catalyst for the consolidation," said Washington- based Hays, who specializes in telecommunications. "What's clear is that they can't all afford to remain independent."

Today's Trading

Cristi Allen, a spokeswoman for Sprint, declined to comment on potential acquisitions. Marquett Smith, a spokesman for Verizon Wireless, declined to comment, as did Clearwire's Susan Johnston and Jim Mathias of Richardson, Texas-based MetroPCS.

Shares of Sprint rose 0.5 percent to $4.51 at 10:07 a.m. on the New York Stock Exchange today. Clearwire slid 1.9 percent to $5.25, while MetroPCS climbed 0.4 percent to $15.56.

Sprint had held discussions with Bonn-based Deutsche Telekom about buying T-Mobile USA prior to the AT&T announcement, people with knowledge of the matter said this month. Talks had been on and off, and the companies disagreed on the value of T-Mobile USA, the people said. Sprint's shares had surged 19 percent this year before the AT&T deal was announced.

With the purchase of T-Mobile USA, AT&T will surpass Verizon as the largest U.S. wireless carrier, in a deal the company said may take a year to close. Dallas-based AT&T anticipates having to divest some network assets and subscribers as a condition for regulatory approval, a person with knowledge of the situation said this week.

'Odd Man Out'

Chief Executive Officer Dan Hesse, 57, said Sprint plans to submit its concerns over AT&T's proposed acquisition of T-Mobile USA to Congress because the combination hurts the wireless industry and will have "tremendous" power.

"They got stood up at the altar," said Kevin Smithen, a New York-based analyst at Macquarie Group Ltd., who rates Sprint "underperform." "Without that transaction, we believe that Sprint is the odd man out."

Sprint gained 0.5 percent yesterday, leaving it valued at 0.92 times net assets, data compiled by Bloomberg show. That's cheaper than all the other 420 non-financial stocks in the S&P 500 except for three utilities: Princeton, New Jersey-based NRG Energy Inc.; Constellation Energy Group Inc. in Baltimore; and St. Louis-based Ameren Corp.

The price-to-sales ratio of 0.41 for Sprint was also the cheapest among 50 companies in the MSCI World Telecommunication Services Index, according to data compiled by Bloomberg.

'Destroying Value'

Sprint's shares traded as low as 0.18 times book value in November 2008, two months after New York-based Lehman Brothers Holdings Inc.'s collapse deepened the worst financial crisis since the Great Depression, the data show.

"It's a reflection of their weak performance for a number of years," said Kevin Shacknofsky, who helps manage $7 billion in Purchase, New York, for Alpine Mutual Funds. "When you trade below book, it means that you think management is destroying value. They are not getting returns on investments they are putting in the network in building the business."

Sprint listed net assets of $14.5 billion at the end of 2010, according to a filing with the U.S. Securities and Exchange Commission. Total assets amounted to $51.65 billion, while it had $37.11 billion in liabilities.

Property, plants and equipment were valued at $15.2 billion, after depreciation costs, and intangible assets were $22.7 billion, mostly made up of $19.9 billion in FCC licenses.

Market Share

AT&T's absorption of T-Mobile USA and its 34 million customers will leave Sprint further behind with 16 percent of the U.S. wireless market. The new AT&T will have 39 percent and Verizon Wireless has 31 percent, according to data from research firms EMarketer Inc. and ComScore Inc.

Sprint will likely consider buying other companies that use the same network technology, known as CDMA, said Michael Nelson, a New York-based analyst at Mizuho Securities USA Inc. The standard is shared by Verizon Wireless, MetroPCS, Leap Wireless International Inc. and U.S. Cellular Corp. of Chicago. AT&T and T-Mobile USA are on the GSM standard, used more worldwide.

"They were in the bidding for T-Mobile. Therefore, they are clearly looking for acquisition candidates to help them grow their capacity," said Peter Jankovskis, who helps manage about $2.7 billion at Oakbrook Investments in Lisle, Illinois. "They are further behind the curve than their competitors are. So, they are facing higher costs to upgrade and keep pace."

Leap Wireless

Sprint may consider acquiring MetroPCS, which has a market value of $5.5 billion, and Leap Wireless, a $1.2 billion company, said Nelson, who recommends buying Sprint shares. Purchasing both would still leave Sprint with less than 21 percent of the wireless market, the data from EMarketer and ComScore show.

Greg Lund, a spokesman for San Diego-based Leap Wireless, declined to comment. The company's shares retreated 0.7 percent to $14.62 today.

Sprint may also buy the 46 percent of Kirkland, Washington- based Clearwire that it doesn't already own, said PRTM's Hays and Macquarie's Smithen. The cost to buy the stake, meet Clearwire's funding needs for its construction and update the network to a more commonly used technology standard may reach $4.5 billion, Smithen said.

Sprint had $20.2 billion in debt at the end of last year, while cash and near cash items totaled $5.17 billion, data compiled by Bloomberg show.

Credit Ratings

The wireless carrier is currently rated B1H, four levels below investment grade, according to Bloomberg's Company Credit Ratings, which analyze borrowers based on indebtedness, market capitalization, profitability and other financial ratios.

If Sprint's long-term debt were to climb by $6 billion in an acquisition, its credit ranking would drop one level to B1, Bloomberg's ratings show. An increase of $4.5 billion, Smithen's estimated price tag for Clearwire, would not change its rating.

Verizon may also consider acquiring Sprint to regain its title as the largest U.S. carrier, PRTM's Hays said. Verizon Wireless is co-owned by New York-based Verizon Communications Inc., which holds a 55 percent stake, and Vodafone Group Plc of Newbury, England.

Shares of Verizon Communications gained 0.6 percent to $37.20 today, while Vodafone was little changed in London.

"In the past few years, Verizon has been satisfied to let Sprint hand over subscribers on its own," Hays said. "If we're now faced with a race to be the biggest, Verizon has to look at Sprint."

'Don't Know How'

Verizon Wireless Chief Executive Officer Dan Mead has said the company isn't interested in buying Sprint, according to Verizon's spokesman Smith.

Sprint has lost money every year except one since acquiring Nextel Communications Inc. in 2005 for $45.9 billion including assumed debt. Customers abandoned the carrier after complaints about call quality as Sprint struggled to integrate the Nextel network into its operations. The company wrote down most of the acquisition, and the stock has retreated 81 percent since the deal was completed in August 2005, Bloomberg data show.

"We don't own Sprint. There's a reason we don't own it," said Michael Cuggino, who oversees more than $11 billion at Permanent Portfolio Funds in San Francisco. "AT&T and Verizon are taking the right steps to remain competitive and achieve growth, whereas Sprint appears to be falling behind. I don't know how Sprint deals with that."

Overall, there have been 5,295 deals announced globally this year, totaling $539.4 billion, a 21 percent increase from the $444.3 billion in the same period in 2010, according to data compiled by Bloomberg.