Valuation Completed: 8/21/08

Rating: Avoid

Comments:  A classic example of a great stock versus a great company.  AAPL the company is fantastic.  Their products excel, the balance sheet is strong and the operation is very well run.  Management does an excellent job growing sales and earnings.  While doing so they also main excellent margins with nice return ratios.

When it comes to valuation, the stock is stretched as can be.  Their use of options is absurd.  Each year, the employees receive nearly 2% of shares outstanding in the form of new grants.  When you look at the value to AAPL of buying back shares from employees, it constantly runs well over $1B per year,  This phenomenon occurs at many technology companies, but AAPL is among the worst when it comes to transferring wealth from shareholders to employees.

Even if you are unconcerned with the option issue, you should pay notice to the valuation.  I think one could easily justify a 22-23 P/E on these shares.  Currently, AAPL trades near a 35 P/E.  Therefore, you would need to see a 30% drop in share price before you can entertain buying the shares.  Personally, I would like to see a much steeper drop before committing to the stock.  When comparing the stock valuation to the broad market,  I have assumed that AAPL can grow earnings at a 20% rate indefinitely (very aggressive assumption) and that the market will grow at a 8% rate.  If this relationship holds, it will take AAPL 13 years to justify the current stock price.  Simply, aggressive growth is priced into this stock for many years to come.

Given my view that the company is overvalued, what should an investor do?  I have traded this stock frequently over the years.  AAPL shows great volatility and offers traders a nice vehicle to book P&L.  Given their dominant products and market position, I also understand how people would be willing to own these shares as a long term holding.  For each investor a decision must be made as to why and how to hold any position going forward.  While I respect and understand those who stay long of AAPL as either a trade or a core holdings, I cannot own the stock on a valuation basis.  I will continue to rent the shares with the goal of realizing short term gains, but positions will be small and my eyes will always be on the exit. 

Related Stocks:  AAPL

Valuation Completed: 8/20/08

Rating: Neutral

Comments: It is easy to see why the stock price has crashed.  CROX was never prepared for the increase in business they received during 2007.  Internal controls were incomplete and  operational problems surfaced.  As the economy has cooled and discount versions of their product arrived,  CROX is left with a high cost structure, high inventory levels and questions over their future.

The positive for this company are that their core product is better quality than any of the discount versions on the market.  For people who desire the better quality, CROX will be the option (thus creating a permanent client base).  Further, the balance sheet is clean with solid liquid.  Making a series a fair value adjustments, book value is in excess of $3 (vs. a reported book value of $5.40).

When deciding how to manage an investment in CROX, there is a great deal of uncertainty.  The business outlook is opaque.  As quarterly results come in, I see a number of accounting issues that make me uncomfortable.  The lack of comfort raises red flags and suggests extreme caution.  For these who already established a position, the book value of $3.25 should act as a floor.  Coincidently,  this same price is inline with a pessimistic outlook that does not see them reaching their 2005 income level (long before they became a hit shoe company) until  2011.  A more reasonable yet cautious outlook has them losing money this year and not bettering their 2006 EPS until 2011.  With that approach the shares are worth $7.50. 

Therefore, for a current investor I recommend holding the shares, watching the business evolve and determining if fair value increases with improved prospects.  For risk seekers looking to take a position, the current price level offers a reasonable chance for nice gains.  Finally, the cautious should remain on the sidelines and attempt to buy the shares below $3.50.

Related Stocks:  CROX

Valuation Completed: 8/16/08

Rating: Buy

Comments: The stock is incredibly cheap.  The business is well run and management has executed their strategy.  While the cost to produce from the oil sands exceeds more traditional methods, an elevated oil price provides excellent margins.  The stock has dropped nearly 35% since May and I think we are now presented an opportunity to buy oil assets in safe countries at a huge discount.

Assuming a 25% drop in earnings this year, that 2007 will serve as the peak earnings number, and applying a 3% terminal growth rate, I derive fair value of $68.  From an asset value perspective, the stock is worth much more.  I will use fair value of $68 and look to buy at a 20% discount.  Therefore, I am a buyer below $54

Related Stocks:  SU

                When making investment decisions, I consider two distinct time periods.  The first is a long-term view of where I think our economy is headed, what the implications are for the financial markets and what actions can be taken to profit from the events that will unfold.  As mentioned last week, over the next 3-5 years, I expect the general market to show little to no return.  With the economy weak and credit limited, dominant firms with positive cash flow will have the ability to fund innovation and increase their dominance.  Weak companies with limited access to credit will see growth drop, innovation stall and market share lost.  For me, the implication is clear.  Focus on large cap stocks with dominant market share.  Avoid small cap stocks, companies carrying heavy debt loads and those who are struggling in weak industries.

                By constructing a portfolio using these criteria, I search for undervalued companies with large dividend yields and sustainable business models.  When I buy these stocks, I am not sure of where prices are headed over the next 3-6 months.  Instead, I focus upon where the value will be 2-3 years from now.  Having completed my due diligence, I am comfortable knowing that short term volatility may occur yet long term gains will soon follow.  Going forward, I focus upon how the business evolves, what changes have occurred and how that affects the company's intrinsic value.

                While this long term view makes sense to most, the implementation of it is very difficult.  Firstly, exhaustive research is needed to understand both the company and its fair value. The second challenge is to buy the stocks when they meet your valuation threshold.  Since I like to buy at a large discount to fair value, I am often the one picking up shares of stocks that everyone else has discarded.  Consider two of my recent purchases - XTO Energy (XTO) and General Electric (GE).  XTO is down 38% over the past 8 weeks.  GE is 33% off the high reached last October and now trades at the same price it fetched in 1998.  With drops these large most investors begin questioning the logic of buying a stock that has fallen so far.  Instead, I attempt to ignore the market movement, focus on value and act when the price is attractive.  This process is never easy yet yields gains over various business cycles.

                Having implemented a long term investment strategy, we must also focus on what the markets are doing now.  After all, short term volatility can cause one to make long term decisions at the worst possible time.

                With the Dow nearly 3.50% lower over the past 7 trading days, we find ourselves in a dangerous position.  My timing model is currently overbought with 80% of the stocks rated buy.  VIX is trading below 22 and few other sentiment indicators are bearish.   Instead, many pundits are saying the bottom occurred in July and that we will move higher from here.  Personally, I do not buy it.

                As I predicted, the Dow rallied from an oversold condition and bounced nearly 7% over a four week period.  At that time, we quickly approached a long-term downtrend that had been in place since the market's peak in October.  Facing resistance, the market broke down, has violated all support and now trades below all key moving averages.  Looking at my timing model, a further 6-8% down move is needed to restore an oversold condition that could serve as the prelude to a rally.  Such a move would violate the prior lows and add considerable questions about the future path of the market.

                While the rally from mid-July was welcome, it also appears over.  I never believed July represented the low of this bear market.  Instead it was a tradable bottom that allowed for one to rebalance their portfolio and position for the more difficult markets that lie ahead.  While I remain fairly long of stocks, my positions are concentrated in names that I think will prosper over the coming years.  I am using market volatility to generate trading gains and hedge my long positions with selective short exposure.  By doing so, I look to control some of the short term pain while I await the market's recognition of my core portfolio's embedded value.

Related Stocks:  GE, XTO

     Buy 100 shares of NOK @ 25

     Sell 1 NOK September 25 Call for $1.65

Doing this trade lowers your cost basis on NOK to 23.35 - 2.7% below our target entry price.  If NOK closes below $24 on September 20th, you own the shares at a large discount to fair value.  If NOK remains above $24 on that date, you pocket a 2.6% gain on the covered call for 1 month of trading.  The risk is if NOK trades below $23.35 you have paid more than you could by waiting for the share price to decline.

Note: This trade can be scaled, but make sure to byu shares in increments of 100 in order to keep the option trade fully hedged.

Related Stocks:  NOK

Valuation Completed: 8/18/08

Rating: Neutral

Comments:  NOK is a well run company with  a solid balance sheet and good business prospects.  They are often ignored in the cell phone space because their products are not as flashy or dynamic as some competitors.  However, NOK has consistently maintained a dominant mark share and has pushed their presence in emerging  markets.  The result is a predictable growth rate without the risk of financial excess.

The share price has been battered this year as NOK has seen their average sales price (ASP) decline.  Declining ASP leads a to lower margins, but the offset will be new users coming online and higher volume.  All in, NOK should maintain their market share dominance and grow their presence in the emerging markets.  While I forecast operating margins to decline 1.50% from prior years, the long term benefits of having dominant market share will accrue to shareholders in the future.

Personally, I think the sell-off in NOK is overdone.  Investors have become to pessimistic and have pushed the stock down.  Finally, I am seeing a strong company with a dominant market position trading near a price I find attractive.  From an earnings yield perspective, I think the share are worth $28.  Using various other models, I derive fair value between $32-$34.  as always , I will use the lower number and apply a 20% discount.  Therefore, look to establish a position below $24.

Related Stocks:  NOK

Valuation Completed: 8/18/08

Rating: Buy

Comments:  XTO portrays impressive profitability and growth.  By focusing on buying wells that others had previously founded/developed, management can reduce costs and increase returns.  Their balance sheet show a trend of improved strength.  While debt is still high, their asset base more than offsets this risk. 

One of their main attractions is that they are an energy play with all of their assets in politically safe areas (most other companies have oil interests in politically sensitive areas).  This fact would lead to a margin of safety with XTO.  Since they hedge a portion of their production, XTO does not show the pure reserve value of others companies.   Discounting their earnings gives a stock price of $60 and discounted reserves show a value of $69.  I will use the lower amount for a fair value estimate , will apply a 20% haircut and look to enter below $48

Related Stocks:  XTO

                The second, more standard approach is to follow the path of compounding.  Under a compounding program, we aim to generate consistent returns, reinvest the gains into our portfolio and then earn income off an ever increasing capital base.  As the capital base rises, the dollar gain increases tremendously.  Running a compounding program for years offers a path that is powerful, predictable and easily understandable.

                This appears to be a simple answer.  All you need to do is pick a rate of return, plug it into a financial calculator, check back in twenty years and start spending your gains.  The average financial advisor will use this approach to manage their client's money.  Using compounding tables and the long-term average of US equity market returns, financial advisors devise plans where a client can earn 8% per year and achieve all of the predetermined goals.  The advisor takes the money, invests in index funds, pockets a fee and hunts for the next client.  That is pretty good work if you can find it.  What most do not realize is the analysis is incredibly sensitive to rates of return.  Any variance to the return number plugged into the calculator causes major differences.

                As an example, assume you invested $10,000 and expected to earn a consistent 8% per year for each of the next 20 years.  At the end of 20 years, your initial investment would have grown to $46,610.  If the return actually was 7%, your investment grows to $38,697 - 17% less than planned.  Most people would not be upset about their investment missing its target return by 1%.  After all, you still made money and the dollar loss in the first year is only $100.  Even if we miss every year, it would only be $2,000, right ($100 per year * 20 years)?  Wrong.  The success of compounding arises because the equity base grows and dollar returns increase.  A seemingly insignificant 1% return miss reduces your expected net worth by 17% at retirement.  For most, this is a material miss that will cause them to rethink their plans, postpone retirement or make life altering decisions.

                If a 1% miss causes so much pain, how about a dramatic miss?  As mentioned earlier, the typical advisor will assume somewhere between an 8-10% annual rate of return based on long term market assumptions.  By trying to get you to focus on the long term, they can use these rates and then explain away poor performance as a need to wait out down periods and focus on the future.  For investors during the 1990s, this approach appeared overly conservative.  As the market routinely generated double digit gains, the 8-10% benchmark was achieved and the advisors appeared brilliant. 

                Recent history has not been as kind.  With the S&P 500 currently trading at 1,289, the index is at the same level as January 1999.  In nearly 10 years, an investor purchasing the S&P 500 index fund for broad market exposure has made no money.  Anyone who invested $10,000 in 1999 with an 8% return assumption would expect to have $21,589.  Depending upon fees, they are most likely in negative territory.  To achieve their initial goal, this investor would need to earn nearly 17% per year for the next 10 years.  While this rate of return is achievable, I do not think a passive index exposure will get there.

                If the long run return is 8% and the S&P 500 has not moved for ten years, won't mean reversion ensure higher return over the coming years?  This argument is logical, yet flawed.  On October 10^th, 1928, the Dow Jones Industrial Average (DJIA) closed at 353.  On September 16, 1954 the DJIA closed at 353.  This was a period of 27 years with no change in the index.  In January 1964, the (DJIA) traded at 785.  In April 1980, the DJIA changed hands at 785 - no return over 17 years.  Looking at history, many years of no movement in the broad market are not unprecedented.  They have happened before and will happen again.  What makes today more risky is that many investors have their futures tied to broad index movement of domestic and international equities.

                With such a sobering view of how missed estimates can derail a compounding plan, two main questions arise.  The first is are we entering a prolonged period of flat market returns (we have already gone 10 years with no movement in the S&P 500) and what can be done to earn return on our money.

                Personally, I think the next 3-5 years in the market will be very difficult.  The world economy has morphed into a mechanism that is highly depended on borrowed money and cheap access to capital.  As the credit markets continue unwinding, interest rates have been lowered.  However, banks have reacted in typical fashion and are punishing today's borrowers for yesterday's sins.  Banks have tightened credit to all and made the ability to fund consumption via new debt extremely difficult.  With the debt spigot off, consumption and investment will drop.  Going forward, it will be hard for the economy to generate incremental growth and for companies to garner the investment that is needed to innovate.  The end result will be strong companies in leading industries will have the internal cash flow and access to capital that is needed to grow.  This will allow these companies to increase their economic moat and dominate their respective industries.  Weak companies will not have access to capital, will see their competitive positions eroded and will fade into history.  Within this environment, some companies do well, others will do poorly, yet the broad market will not move materially higher (in fact I think the more likely outcome is more losses for the broad market).  Therefore, a heavily weighted index position will ensure low growth and high frustration.

                To make money in such an environment, the value of solid research will be accorded a premium.  As markets routinely thrash with no direction, good and bad companies see their stock prices rise and fall in tandem.  By having the knowledge of what each company is worth, we buy the companies who are inexpensive and well positioned in their industry, short the overvalued companies who are destined to fail and reap the benefits.  By actively searching for new ideas, we create a universe of stocks that offer the ability to generate return regardless of market direction.

                Using this thinking, we have made a significant change to our portfolio management approach.  Typically, we focus 50%of our portfolio on our research and then a combination of index funds and various trading ideas to round out our exposure.  Assuming the broad market will be flat for years to come, we are now allocating 70% to our best research ideas, removing index exposure and focusing the remaining portfolio on our best trading ideas.  Taking this approach will allow us to leverage the ideas we feel have the most profit potential and avoid committing capital to parts of the market that will not pay a decent rate of return.

Valuation Completed: 8/3/08

Rating: Avoid

Comments: For years I have described WM as the housing bubble stock.  Their lending standards were poor and the portfolio they acquired shows it.  Their $235B  on balance sheet loans show a strong mix of option ARMs. home equity and subprime products.  Further, the loans tend to exist in bubble real estate markets (50% of the option ARMS are in California).  To make matters worse, many loans were underwritten to high LTV ratios. 

Looking back, we now know that housing markets have collapsed around the country and that WM's core markets have performed much worse.  Making the reasonable assumption that every 90%+ LTV loan originated own has negative equity and that 1/2 of the loans with 80-90% LTVs have negative equity, WM is staring at massive losses.  Not accounting for credit deterioration in the remaining portfolio, the group of loan mentioned above could account for up to $20B of loan losses.  As of June 30th, only $10.6 of future losses were on the balance sheet.  If this dire situation were to unfold, WM would have negative book value.

Given the many uncertainties in this business model, I have decided to rate WM avoid as opposed to short sales.  Am I being too conservative on my analysis?  Perhaps.  Factors that could allow WM to regain strength would be an increase in house prices, their current borrowers continuing to make loan payments despite negative equity or a strategic buyer who is willing to ignore the balance sheet issues in order to acquire WM's branch system.  All could happen and would drive the price of the stock higher.  However, I do not wish to commit capital on pure speculation and the hope that a future buyer will bail me out of my position.  Instead,  I will ignore the shares and focus on stronger banks

Related Stocks:  WM

                In order to grasp the volatility we have witnessed, look at yesterday's activity.  The markets opened higher and stayed at elevated levels.  With the Federal Reserve (Fed) announcing their interest rate decision at 2:15pm, a reasonable expectation would have been for the pre-announcement rally to act as a typical run-up that would be followed by profit taking.  Instead, the market stayed elevated after the interest rate decision and then sprinted higher into the close.  For a market that often failed to maintain bullish momentum, one could argue that the Dow Jones Industrial Average (DJIA) closing 331 points higher (2.94%) on a day when up volume represented 90% of total volume is a sign that we have bottomed and will head higher.  However, when you consider that the DJIA has moved up or down greater than 2% 19 times in 2008(as opposed to large swings 14 times in all of 2007) it becomes clearer that today is an environment where large price changes do not yield immediate trends.  Further with 11 of this year's 19 large moves being down days, one could argue that yesterday's 300 point gain was just a blip in a longer term downtrend.

                As one who studied literature during college, I have always felt I have a grasp over how small subtleties lead to big results.  There is no magic formula that yields consistently strong investment results.  If we have learned anything from the credit crisis, overreliance on black box models leads to disaster.  Initially the outcomes are favorable, but as people put more reliance into methods they cannot fully comprehend, disaster occurs.  From CDOs to various quantitative hedge funds, black box models fail.  The true believers will spin the outcome with the explanation that a billion year event occurred to cause the loss.  In reality, we seemingly experience these statistically impossible events much too frequently for my liking.  Instead of attributing the outcome to a random, unforeseeable event, I find the answer lies in the investment approach.  For me, investing has always been as much art as science.   Granted, hard math is needed to determine how cash flows will develop and what the outcome yields.  However, the choice of growth rates and discount rates has a much larger effect on the ultimate outcome.  By artfully considering multiple scenarios and a range of outcomes, an investor will yield better results than someone who plugs numbers into a model and hopes for the best.

                Considering the need to look at a wide range of outcomes, what thinking can be applied to the current market?  Are the large move of bank stocks and a 3% rally in the DJIA indicative of a major bottom or just another trap being set by the bears?  With the market, the definitive answers to these questions can only be achieved in hindsight.  The post mortem can be handled by the academics in the years to come.  However, as investors we must act today and use those actions to grow our wealth. 

                The DJIA began its most recent decent on May 20^th.  The prior day the DJIA had battled its way back to 13,028.  While this represented a slight loss on the year and a 10% drop from the all-time high, the May 19^th close was an 11% rally from the low of the year recorded only two months earlier.  As the current decline in the DJIA pushed prices lower and into bear market territory, I was looking to my timing model and various other indicators to see if we had reached an oversold bottom.  My timing model became oversold on June 23^rd and quickly reached an extreme oversold scenario on June 26^th.  History had taught me that anytime my model became severely oversold, quick, material gains followed.  Based on this logic, I went very long of the market and awaited the rebound.  That decision turned out to be correct as my portfolio performed well and added a fair amount of alpha over the following month.  However, this high level view obscures what truly happened and following it blindly would lead to poor decision making.

                While performance was strong since I made the decision to go aggressively long, little of the performance is attributed to the market itself.  When I received the extremely oversold reading, the S&P 500 closed at 1,283.  By the moment my timing model had returned to a normal reading, the S&P 500 was trading at 1,260.  For an investors who saw the oversold reading and went long the broad market, a loss of 2% occurred.  This is the first time an extremely oversold market delivered losses to a bullish investor.  As of yesterday, my timing model is now 67% long and on the verge of becoming overbought.  The price of the S&P 500 - 1,286.  Basically, we have gone from oversold to overbought with no movement in the broad market.  Considering that many stocks would need to drop 5-7% in order to return the market to a neutral reading, extreme caution is advised.

                So if the market was flat, how was I up?  The simple answer is stock selection.  In today's environment, solid proprietary research has more value than ever.  Investors are taking a shoot first; ask questions later approach to investing.  The large price swings are selling off good and bad companies alike.  For someone with patience, discipline and faith in their work, you could buy assets at bargain levels and wait for a quick rebound in price.

                As an example, consider Motorola (MOT).  As has been well publicized, their handset business has been weak as new product development stalled.  However, their balance sheet is strong and their other operating businesses have good margins and wide economic moats.  On July 15^th, MOT closed at $6.76.  Knowing they have over $2 of net cash on the balance sheet, I bought the shares understanding that I was getting their operating businesses for just over $4 per share.  This price was incredibly cheap and would eventually reward patient investors.  Luckily, I did not have to wait very long.  Better than expected earnings and new management has allowed the stock to rally 44% in three weeks.  An investor who had done their homework and had the courage to stand by their conviction realized a large gain very quickly.

                Recognizing today's environment as a stock picker's market has large implications for portfolio construction.  To realize gains in the future, less reliance should be placed upon index funds and sector rotation.  Instead, the focus should be on specific, value-added ideas.  By focusing on core research and risk management, we can build a portfolio that is skewed for long term performance while controlling risk.  The opportunities will always exist to find the next Motorola.  Patience and discipline is the recipe needed to search out good ideas while courage and faith in your work is needed to buy those stocks when everyone else says sell.

Related Stocks:  MOT

Valuation Completed: 8/3/08

Rating: Neutral

Comments:  The stock has had a tremendous rally off crisis lows.  Solid earnings and an increased dividend has driven the price higher.   While management has done an excellent job, I fear that their large home equity portfolio will cause more problems.  For credit loss I have used data as of June 30th and applied the following losses:

  1st Mortgage 2% - 1.5B

   Home Equity 12% - 9B

   Credit Card 5% - 1B

   Other 6% - 3.2B

This implies a lifetime loss of $14.7B versus a recognized loss of $10.2B ($2.7B charge off and $7.5B provision).  The main differencel I have with management lies in the home equity business.  My view is that with a dramatic drop in home prices,  nearly every home equity loan that defaults will suffer massive losses as the equity supporting the loan has been eliminated.  WFC's management has a more hopeful view. 

The beauty of investing is that I could be too conservative and this view will cost me nothing.  To paraphrase Warren Buffet, an investor has the luxury of waiting for the pitch they want before swinging.  I will be conservative on loan losses and decide not to buy until the price of the stock meets my conservative view.

Fair value target is $28 with an entry price of $22.

Related Stocks:  WFC

Valuation Completed: 8/03/08

Rating: Buy

Comments:  They are a solid, well run retailer.  Given the housing debacle and the credit crunch, it is easy to see why these shares have underperformed the past few  years.  Given the large decline, HD is approaching a level I like.

Assuming FY2009 earnings approach a level last seen in 2004, I have developed a conservative valuation of $30.  To get to this point, housing will collapse and take years to recover.  During that time period, HD will continue to operate their core business and buy back shares.  Doing so will allow the valuation to develop and for me to profit.  While waiting, I earn a reasonable dividend yield that is inline with a 5yr US Treasury.  Currently, I rate the shares buy and would purchase  at a 20% discount to fair value, thus implying an entry of $24. 

Related Stocks:  HD

Valuation Completed: 8/03/08

Rating: Neutral

Comments: This is a company I have followed for years.  It has always traded at a premium, but has seen its price decimated over the last year.  Management has been firm and it appears that the Street has lost confidence in their numbers.

By continually reducing guidance, profitability is uncertain.  Although the company says 2009 will be profitable, analysts are predicting a loss.  My models have assumed lossed in FY 2009 with a slight profit in 2010 and a resumption of growth in 2010.  One of my concerns is that all of their growth has been via acquisition because same store sales continue to decline.  They have been able to purchase other companies at small premiums, but I would like to see some organic growth.

Currently, the balance sheet is a mess with a massive level of debt.  This eliminates my typical safety net.  However, the company has also dropped to a very cheap level.  On a pessimistic, low growth scenario BONT is worth $6.  I would like to buy at a 25% discount.  Knowing that risk control is key, I would initiate a position below $4.50. 

Related Stocks:  BONT

Valuation Completed: 8/2/08

Rating: Trading Buy

Comments:  This is an ugly revenue profile.  Most of their businesses have declined or are beginning to decline.  Mtg banking had been a big revenue driver and that is going away.  I don't know how to get any clarity on the revenue front.  The company's stock now sells below the offering price of their IPO five years ago.  Since that time, they have bled money and seen their liquid book value decrease from $11 to $1.50. 

With the lack of clarity, opportunity may exist.  To forecast an income statement using a current run rate approach,  I assume the following:

 Revenue:

   Investment Banking - $150mm

   Institutional Brokerage - $115mm

   Asset Management - $25mm

   Principal Investments - $185mm

 Total Revenue - $475mm

 Less Interest Expense - ($300mm)

 Less Non-interest Expenses - ($565mm)

 Total Operating Loss - ($390mm)

This analysis assumes compensation expense inline with 2007.  If business drops,  that number could be cut sharply and may yield nearly $200mm of cost savings.  With further expense cuts, management may be able to escape the credit crisis near a break even run rate.

If we assume slight losses for the next two years and then minimal profitability, the operating business is worth close to $2.  With the stock trading below $2, I would view FBR as an option on a rebound in the capital markets.  The liquid book value of $1.50 should provide support for the shares.  If the capital markets rebound FBR could easily trade above $5.  If the markets stagnate, $1.50 would be a reasonable downside.  With the potential gain far outstripping the downside, FBR represents a reasonable speculation for risk seekers.

Related Stocks:  FBR

Valuation Completed: 8/2/08

Rating: Neutral

Comments:  The banking industry is shaping up to be the stories of the haves vs. the have nots.  Certain banks are well capitalized, adequately reserved and possess discipline managements.  The others have weak management teams, low credit reserves and are capital restrained.  To me, you would like to buy the strong and either avoid or short the weak. 

JPM is one of the strong.  They possess one of the best management teams in the industry, have ample capital and strong  credit reserves.  As a stress test, I assumed that JPM would suffer a 10% loss on their unrated wholesale lending business and 7% losses on their consumer portfolio.  This would result in a total loss of $19B versus current recognized credit losses of $14B ($4.5B YTD charge offs and $9.5B of consumer reserves).  While the loss would be large, the bank would still be well capitalized.

Assuming a pending $5B write down, I derive a $45 target price based on multiple valuation methods.  With a current earnings' yield of 3.63%, one could make a rational argument that this stock should trade closer to $55.  For me, I will use $45 as my target price and would like to buy the stock at a 20% discount to fair value.  Therefore, I would look to initiate a position near $36.

Related Stocks:  JPM

Valuation Completed: 8/2/08

Rating: Neutral

Comments: As a long standing  owner of PFE, I have suffered as the company continues to disappoint and the share price sinks.  Since 1999 the shares have been going from the upper let to the lower right as the shares dropped from above $45 to the current level.  During this time, there has been business reorganizations, changing management and a failing pipeline.  Since 1999, PFE has spent over $55 Billion on research and development with very little to show for the effort and money spent.   Also, the level of R&D spending has been increasing sharply over the last few years.  For a company with a $125B market cap, this is a stunning amount of money.  Instead of pouring the funds into R&D management could have either retired almost half of this shares outstanding via share buybacks,  bought 50% of Genentech or purchased  80% of Amgen.  Further, with AAA credit rating PFE borrows at a spread of 50bp over treasuries.  If management wishes to continue with the R&D investment, why not borrow in the credit market and use the proceeds to buyback shares at the current low levels?  With only $7B of long term debt, opportunities exist for financial engineering.

Given my frustration with management, what approach does an investor take?  For me, I maintain my position and would encourage others to become buyers.  The pending patent expirations have weighed on the stock.  If you make the assumption that drugs losing patent protection provide no income after the patent expires, the operating business is still worth $25.  If PFE either retains some sales via the generic market or replaces the drugs with new product, the price could easily trade into the $40s.  Also, with a dividend yield over 5% we are paid to be patient.  I have always said that fair value will eventually be recognized by the market.  In time we should see the market recognize the value of this business or await management to realize the steps they could take to enhance shareholder value.

Related Stocks:  PFE

Valuation Completed: 8/2/08

Rating: Neutral

Comments:  Technology stocks rarely pass my value test.  When they do, I pay particular attention.  With MOT, we see a stock where momentum investors rushed in during 2005 as some hoped the handset business would overtake Nokia.  As time passed, the stock fluctuated between $15-20 while Carl Icahn battled the board and attempted to extract value.  As shares passed from momentum traders to short-term traders looking to piggyback on Icahn, MOT has been left with a shareholder base that was more interested in short-term fluctuations than long-term value.  Therefore, when the handset business began to falter, short-term investors went to the exit and the price collapsed.

Within the price collapse is where I find opportunity.  I agree with all who bemoan the problems of the handset business.  For years, MOT has not been able to create  a follow-up to the Razr.  This has caused MOT to morph from  must-have phones into another commodity phone producer.  With this transition, margins and sales drop.  When you have a large internal infrastructure that can not be redeployed quickly, this margin drop creates the losses we witnessed in 2007.

While I agree with the markets pessimism over the handset business, Mr. Market has ignored that MOT's other businesses are profitable, growing and have strong economic moats.   Assuming the handset business remains troubled for the next 2 years and then resumes growth, the operating business is worth $10.  Further, MOT has a liquid book value of  $3 and net cash of $2.  I will use the net cash and operating valuation to derive a fair value target of $12.  As always, buy at a discount to fair value in order to provide a margin of safety.  In this case, I will use a 30% discount and would add to the position below $8.50.

Related Stocks:  MOT

Valuation Completed: 8/1/08

Rating: Buy

Comments:  This a disciplined bank with a strong balance sheet.  However over the past few years, management has done a poor job.  There has been little growth, high expenses and no true focus on corporate strategy.  The share price has been supported by the fact that STI has a banking footprint that would be attractive as a takeover target. 

As the credit crisis unfolds, the takeout premium has vanished.  STI now trades nearly a 50% discount from last year (a few weeks ago it was trading down 65%).  At current prices, STI either represents an ideal investment or is another example of a poor quality bank that was propped up on false takeover expectations.  Which is it?

STI avoided most of the toxic practices that hurt national banks.  Instead, STI is a regional lender who focuses on their core competencies.  This makes the analysis easier as they key variable is assessing the loan portfolio and determining a range of expected future losses.  As of December 31st, STI had a credit reserve of $1.3B.  I think the future loss will be closer to $3.6B,  My loss calculation is based on the following assumptions:

   Residential Mortgage - 10% frequency and 20% severity for 2% loss - $656mm

   Credit Card - 20% frequency and 25% severity for 5% loss - $42mm

   Home Equity - 30% frequency and 40% severity for 12% loss - $1.8B

   Construction - 10% frequency and 40% severity for 4% loss - $550mm

   Commercial - Double current reserve  - $400mm

   All Other - Double current reserve  - $200mm

As of June 30th, STI has recorded $619mm of credit losses and built a credit reserve of $1.8B.  Together, they have recognized future credit losses of $2.4B.  While this is a step in the right direction, it is still short of my expected loss of $3.6B.  Although more credit losses may arise, the bank has created a risk profile where capital ratios are adequate and the dividend should be secure.

Even though STI does not represent the ideal trade I would search for, compelling value exists.  From a valuation perspective, I think STI is worth $60.  This number is consistent across 4 different pricing techniques.  Given my desire to purchase an asset at a 20% discount to fair value, I would look to establish a position at a price below $48.

Related Stocks:  STI

Valuation Completed: 8/1/08

Rating: Buy

Comments: In uncertain markets, we rely upon management to make the proper decisions.  A management team who executes will exit the crisis strong while those who fail will see their competitive advantage drop.  BAC's core strengths are impressive.  They maintain the largest percentage of interest free deposits of any national bank, have a large branch presence and now are the largest mortgage company in the county.  What about management's decisions?  The events of the past year do not paint a pretty picture.  BAC did a terrible job in the investment bank and overpaid for both MBNA and LaSalle.  To be fair, the investment in China Construction Bank was tremendous and I think the purchase of Countrywide will pay large rewards over the years to come.  With the conflicting data, I will judge BAC management as above average, but not superb.  Therefore, I expect the core banking franchise to deliver the bulk of the stock's performance.

Looking at the baking franchise, a few items grab my attention.  First, the business continues to operate well and all new activity is being done at very profitable levels.  While new business is profitable, the looming question surrounds their risk profile and expected future losses.  As of 12/31/07, I find both their credit loss assumption and capital levels to be too low.  The year end credit reserve reflected future expected losses of $12B versus what I think will be future losses of $23B.  I derive my loss number as follows:

   Residential Mortgage - 10% frequency and 20% severity for 2% loss - $5.5B (mgmt at 1%)

   Credit Card - 20% frequency and 25% severity for 5% loss - $4B (inline with mgmt)

   Home Equity - 30% frequency and 40% severity for 12% loss - $11B (mgmt at 1%)

   All Other - Double current reserve  - $2B

While this is an ugly picture, the positive news is that BAC management has addressed the issue.  Through June 30th, BAC has charged off $6.3B and increased their credit reserve to $17.6B.  Therefore, credit losses recognized and reserved for are $23.9B versus my estimate of $23B.

So how do we distill all this data?  BAC has positioned their business where the credit losses on the balance sheet are a fair view of future expected losses.  From here, any additional losses will reflect changes in the credit environment.  With Tier 1 capital over 8%, BAC should be able to avoid issuing new equity or reducing their dividend.  From a valuation perspective, a dividend discount and P/E approach yields fair value of $45.  An earnings yield approach delivers fair value near $60.  I would like to buy at a discount to the lower number and will initiate a position below $40.  At current levels, BAC represents a solid company with a high divided selling

Related Stocks:  BAC

                Having called a market turn and being positioned for it is very gratifying.  However, we must always look forward.  Prior gains have been reflected in our accounts and now we must focus on where the markets go from here and where the opportunities exist.  Only by developing a view of the future can we arrange our portfolios for future gains.

                People use a variety of tools to make investment decisions.  Technical traders and value investors look at a myriad of data to determine what they think is the most likely outcome for the market.  Having developed a view, actions are taken, positions are monitored and various steps implemented to make sure that the investor is comfortable with the risks they have taken and the opportunities that exist.  At a high level, this approach is sound and logical.  However, I would also apply my own twist.

                As a value investor, I am extremely concerned with the long-term business prospects of the companies I own.  Believing that a superior business will ultimately yield long-term benefits, I allocate capital based on which companies I think have a high margin of safety accompanied with outstanding return potential.  While a long-term focus allows me to look past volatility and noise, I realize that we all live in a world of short-term goals.  Within this short term world, business prospects take a backseat to market psychology.

                The severely oversold market we faced over the past few weeks had pushed the market to an extreme where a quick decisive rally was needed.  Having seen that rally, we must assess where prices go from here.  Two weeks ago, every market expert called for a 500-700 point rally on the DJIA that would work off the oversold level.  We have received that move and now many are taking the view that gains will be consolidated with a retest of the prior lows.  Intuitively, this argument has merit.  My timing model was 4% long at the extreme and now sits at 34% long.  VIX has spiked toward 30 and now trades below 22.  The S&P 500 moved sharply and now hovers just above the January and March lows.  All this data argues for people to monetize their gains, move to the safety of cash and await the market's direction.  As I said, it makes perfect sense.

                There is just one problem I have with this scenario - it makes perfect sense.  If I have learned anything over the years it is that the consensus view is often incorrect.  Further, following the consensus view will never allow one to achieve superior long term results.  Instead, I must develop a view, compare it to the consensus and determine if opportunities exist for a contrarian to profit.

                Using this approach, I believe the current rally has more room to the upside.  There are a handful of factors to support my thesis.  Key among them are that sentiment indicators have come down from the extreme fear readings we saw a week ago, yet have not approached levels showing complacency, too many investors are looking for reasons to sell any rally and the market's reaction to news has shifted dramatically.

                The reaction of the market to information is of particular note as it describes how investors are processing information and making decisions.  In environments where the markets are heading lower, all news is viewed bearishly.  When prices trend higher, all news is seen as support for stock prices.  Currently, the market has put a bullish spin on each piece of data and has allowed for prices to head higher.  Key examples of this dynamic are the reaction to bank stocks and Apple's earnings release.

                Virtually every bank has reported sharp declines in earnings and credit quality.  Dividends have been cut, assets have been sold yet prices move higher.  The market has treated each earnings report as a reason to take the sector higher.  When Apple reported a strong quarter with tepid guidance, the stock sold off dramatically.  Having closed Monday above $166, Apple traded as low as $147 before the market opened Tuesday.  By the close of trading Tuesday, Apple was above $162 and is now trading at a price that is higher than Monday's close.  In 48 hours, Apple saw 10% of their market value erased and then recovered.  In bearish markets where prices are heading lower, stocks do not react to news in this fashion.

                Having profited from the initial move, I am faced with a market where I am long of stocks that are trading at higher prices than a week ago.  How do we approach this situation?  My policy has always been to maximize gains while controlling risk.  With that mandate, I have been selling stocks I have held for a quick rebound yet do not planning on keeping for long periods of time.  Further, as my core holdings have grown in value, I have systemically sold shares to maintain a proper risk balance.  Over the coming weeks I will continue this policy.  By harvesting gains and managing risk, I can profit from the long term potential of my core holdings as well as benefit from a short term rally.

Related Stocks:  AAPL, WFC

                An analogy I have often used is that the markets behave like rubber bands.  Normally, we fluctuate within a range where minimal stress pulls the rubber band in either direction.  At times, normality ceases and the rubber band becomes tightly stretched in one direction.  Eventually the tension is released and the rubber band violently snaps back in the opposite direction.  With the market severely oversold, we are clearly stretched to the downside.  Knowing that markets never go in one direction indefinitely, we will eventually see a sharp rally in stock prices.  The only question is when the rally occurs and for how long and how far it takes us.

                Over the past week, no action has occurred to alter my view.  In fact, as the market has deteriorated many conventional sentiment indicators show that fear is beginning to dominate.  The VIX has moved sharply higher and is approaching 30.  New lows on the New York Stock Exchange (NYSE) are expanding and equity mutual funds are beginning to see increasingly large outflows.  All said, when hope is finally abandoned the market will bottom and begin the sharp rally I expect. 

                Given these conformations of my oversold thesis, why not become longer?  I have two large concerns.  The first is that everyone is expecting a sharp rally that takes us 5-7% higher, stalls and then resumes the primary bear market decline.  While the thesis makes sense, the fact that everyone expects it is unnerving.  Experience has taught me that the consensus view is rarely correct.  Therefore, we need to see some deviation from this view before a short-term rally can occur.  Hopefully the signs of retail investors pulling money from equity mutual funds indicate the capitulation needed to form a bottom.  Only when I see the majority of investors abandon the idea of a quick, tradable rally will I expect that rally to occur.

                My second main concern is the calendar.  This week we have a series of key economic reports, many important earnings reports and options expiration this Friday.  Next week we will see another slew of earnings reports with most of the S&P 500 disclosing how they did in the prior quarter and what they expect to see in coming quarters.  With such key fundamental information becoming available, the market has the ability to react strongly.  Decent earnings with reasonable forecasts should push us higher.  Confirmation of the perceived economic and credit market tightness would drive us lower.

                So should we view the next two weeks as decisive for the market direction?  Clearly I think so.  After the next two weeks pass, company specific news will be sparse and stock prices will react to non-specific news.  The absence of a strong catalyst will eliminate the ability for prices to push higher based on business fundamentals.  Without that catalyst, investor psychology will dominate fundamentals.  While this could produce a rally, psychology based moves are not sustainable over long periods of time.

                Considering these competing factors, how do you position yourself in this environment?  For me, the answer had been to maintain core positions I find attractively valued, realize gains on short-term trading opportunities and attempt to capture some of the excess volatility that is priced into the market.  Following this strategy, I have closed a number of short positions, applied option strategies to capture the high level of implied volatility and maintained my core holdings.  With 30% of my portfolio invested in financials, the bank sell-off and constant battering of the brokerage sector has taken a toll.  However, I firmly believe that the stocks I hold are sound institutions selling at hugely discounted prices.  A few weeks of volatility and market-to-market losses can be hard on the psyche, but if the intent is to grow wealth over long periods of time, occasional adverse outcomes must be expected.  The key is to hold positions you believe in and position yourself for when the market turns.  If history teaches us anything, it is that a disciplined investment approach which focuses upon value and long-term prospects will yield results far in excess of what the general market indices can deliver.

                An analogy I have often used is that the markets behave like rubber bands.  Normally, we fluctuate within a range where minimal stress pulls the rubber band in either direction.  At times, normality ceases and the rubber band becomes tightly stretched in one direction.  Eventually the tension is released and the rubber band violently snaps back in the opposite direction.  With the market severely oversold, we are clearly stretched to the downside.  Knowing that markets never go in one direction indefinitely, we will eventually see a sharp rally in stock prices.  The only question is when the rally occurs and for how long and how far it takes us.

                Over the past week, no action has occurred to alter my view.  In fact, as the market has deteriorated many conventional sentiment indicators show that fear is beginning to dominate.  The VIX has moved sharply higher and is approaching 30.  New lows on the New York Stock Exchange (NYSE) are expanding and equity mutual funds are beginning to see increasingly large outflows.  All said, when hope is finally abandoned the market will bottom and begin the sharp rally I expect. 

                Given these conformations of my oversold thesis, why not become longer?  I have two large concerns.  The first is that everyone is expecting a sharp rally that takes us 5-7% higher, stalls and then resumes the primary bear market decline.  While the thesis makes sense, the fact that everyone expects it is unnerving.  Experience has taught me that the consensus view is rarely correct.  Therefore, we need to see some deviation from this view before a short-term rally can occur.  Hopefully the signs of retail investors pulling money from equity mutual funds indicate the capitulation needed to form a bottom.  Only when I see the majority of investors abandon the idea of a quick, tradable rally will I expect that rally to occur.

                My second main concern is the calendar.  This week we have a series of key economic reports, many important earnings reports and options expiration this Friday.  Next week we will see another slew of earnings reports with most of the S&P 500 disclosing how they did in the prior quarter and what they expect to see in coming quarters.  With such key fundamental information becoming available, the market has the ability to react strongly.  Decent earnings with reasonable forecasts should push us higher.  Confirmation of the perceived economic and credit market tightness would drive us lower.

                So should we view the next two weeks as decisive for the market direction?  Clearly I think so.  After the next two weeks pass, company specific news will be sparse and stock prices will react to non-specific news.  The absence of a strong catalyst will eliminate the ability for prices to push higher based on business fundamentals.  Without that catalyst, investor psychology will dominate fundamentals.  While this could produce a rally, psychology based moves are not sustainable over long periods of time.

                Considering these competing factors, how do you position yourself in this environment?  For me, the answer had been to maintain core positions I find attractively valued, realize gains on short-term trading opportunities and attempt to capture some of the excess volatility that is priced into the market.  Following this strategy, I have closed a number of short positions, applied option strategies to capture the high level of implied volatility and maintained my core holdings.  With 30% of my portfolio invested in financials, the bank sell-off and constant battering of the brokerage sector has taken a toll.  However, I firmly believe that the stocks I hold are sound institutions selling at hugely discounted prices.  A few weeks of volatility and market-to-market losses can be hard on the psyche, but if the intent is to grow wealth over long periods of time, occasional adverse outcomes must be expected.  The key is to hold positions you believe in and position yourself for when the market turns.  If history teaches us anything, it is that a disciplined investment approach which focuses upon value and long-term prospects will yield results far in excess of what the general market indices can deliver.

                An analogy I have often used is that the markets behave like rubber bands.  Normally, we fluctuate within a range where minimal stress pulls the rubber band in either direction.  At times, normality ceases and the rubber band becomes tightly stretched in one direction.  Eventually the tension is released and the rubber band violently snaps back in the opposite direction.  With the market severely oversold, we are clearly stretched to the downside.  Knowing that markets never go in one direction indefinitely, we will eventually see a sharp rally in stock prices.  The only question is when the rally occurs and for how long and how far it takes us.

                Over the past week, no action has occurred to alter my view.  In fact, as the market has deteriorated many conventional sentiment indicators show that fear is beginning to dominate.  The VIX has moved sharply higher and is approaching 30.  New lows on the New York Stock Exchange (NYSE) are expanding and equity mutual funds are beginning to see increasingly large outflows.  All said, when hope is finally abandoned the market will bottom and begin the sharp rally I expect. 

                Given these conformations of my oversold thesis, why not become longer?  I have two large concerns.  The first is that everyone is expecting a sharp rally that takes us 5-7% higher, stalls and then resumes the primary bear market decline.  While the thesis makes sense, the fact that everyone expects it is unnerving.  Experience has taught me that the consensus view is rarely correct.  Therefore, we need to see some deviation from this view before a short-term rally can occur.  Hopefully the signs of retail investors pulling money from equity mutual funds indicate the capitulation needed to form a bottom.  Only when I see the majority of investors abandon the idea of a quick, tradable rally will I expect that rally to occur.

                My second main concern is the calendar.  This week we have a series of key economic reports, many important earnings reports and options expiration this Friday.  Next week we will see another slew of earnings reports with most of the S&P 500 disclosing how they did in the prior quarter and what they expect to see in coming quarters.  With such key fundamental information becoming available, the market has the ability to react strongly.  Decent earnings with reasonable forecasts should push us higher.  Confirmation of the perceived economic and credit market tightness would drive us lower.

                So should we view the next two weeks as decisive for the market direction?  Clearly I think so.  After the next two weeks pass, company specific news will be sparse and stock prices will react to non-specific news.  The absence of a strong catalyst will eliminate the ability for prices to push higher based on business fundamentals.  Without that catalyst, investor psychology will dominate fundamentals.  While this could produce a rally, psychology based moves are not sustainable over long periods of time.

                Considering these competing factors, how do you position yourself in this environment?  For me, the answer had been to maintain core positions I find attractively valued, realize gains on short-term trading opportunities and attempt to capture some of the excess volatility that is priced into the market.  Following this strategy, I have closed a number of short positions, applied option strategies to capture the high level of implied volatility and maintained my core holdings.  With 30% of my portfolio invested in financials, the bank sell-off and constant battering of the brokerage sector has taken a toll.  However, I firmly believe that the stocks I hold are sound institutions selling at hugely discounted prices.  A few weeks of volatility and market-to-market losses can be hard on the psyche, but if the intent is to grow wealth over long periods of time, occasional adverse outcomes must be expected.  The key is to hold positions you believe in and position yourself for when the market turns.  If history teaches us anything, it is that a disciplined investment approach which focuses upon value and long-term prospects will yield results far in excess of what the general market indices can deliver.

- Warren Buffett

                When writing this article each week, I am often confronted with an environment where little is clear.  Markets rarely exist in a world where things are black and white.  Instead we must make sense of shades of gray in order to determine the future.  Today is a little different.  Anyone who has not been heavily short for the past 8 weeks knows this has been a brutal market that is characterized by relentless selling, widespread damage and vanishing safe havens.

                To review, on May 19^th the Dow Jones Industrial Average (DJIA) closed above 13,000.  Since then, a steady stream of selling has chopped 14% from the index as we now sit below 11,300.  During this process, the previous market lows were quickly breached and the DJIA has officially entered bear market territory.  In fact, the DJIA currently trades at a level that was last reached in August 2006.  In 8 weeks, two years of performance has evaporated.

                Within this decline a few interesting developments have occurred.  First, the DJIA has led the other major indices lower.  Typically, the DJIA shows strength.  Currently it shows weakness.  While this difference may be subtle, I believe it is important.  As the DJIA represents a broad-based measure of business, its weakness shows how pervasive the economic slowdown and credit crisis have become. 

                Another interesting factor to the current decline is the steady, relentless nature in which it has occurred.  Usually, a 14% drop in eight weeks would be accompanied by a washout where investors purge themselves of stocks and show clear signs of capitulation.  With a clear reading from various fear indicators, one could be comfortable taking action.  Today many of the sentiment indicators are mixed.  While certain metrics indicate a bottom, others do not.  This has made reading the tealeaves more difficult than usual.

                Three common sentiment indicators I use are the VIX (a measure of investor fear based on option prices), the NYSE Bullish percentage (the percent of NYSE stocks who have bullish patterns on a point and figure chart) and the NYSE new highs - new lows (an indicator of how many stocks are reaching new highs versus those reaching new lows).  Using these three, we see some clear patterns but also some level of disagreement.

                The VIX currently trades near 26.  While this is high in relation to where it traded before the selloff began in mid-May, it is below where prior reversals have occurred.  When the market temporarily bottomed in January and March, the VIX spiked above 30 and quickly reversed.  During these spikes in January and March, the VIX traded nearly 10 points above its 10 day moving average (MA) and nearly 15 points above its 200 day MA.  Today, the VIX is 2 points over its 10 day MA and 3 points above its 200 day MA.  While fear has increased in the market, it has not reached the point of capitulation we would expect from major market bottoms.

                For those searching for a quick bottom, the NYSE bullish percentage offers more comfort.  At the current reading below 28%, less than 28% of all stocks traded on the New York Stock Exchange (NYSE) show bullish patterns.  This reading is below the extreme reached in January when only 16% of stocks were bullish yet is in line with the level from where the March rally began.  For me, this leads credence to the view that the markets may be scratching out a short term bottom that leads to a quick, powerful rally.

                Finally, the new highs versus new lows offers further confusion.  The current reading of -544 means that the sum of all new highs minus all new lows equals 544.  Therefore, many more stocks are breaking lower than are heading higher.  For some perspective, this indicator reached -850 at the January low and -650 at the March low.  Therefore, stocks may be breaking down, but we have not reached an extreme that mandates a significant bottom.

                The three indicators mentioned above are just some examples of data any investor can glean from the market.  If we expanded our discussion from these three indicators to fifteen indicators, the same pattern would hold.  Certain pieces of information point to an immediate rally while other show a lack of true fear.  With such a mixed signal, you could argue a bearish, bullish or neutral view.  While these arguments are interesting, I am more interested in being neither a bear nor bull.  Instead I prefer to be correct.  With that mandate there is a need to cut through the fog and develop a clear view of how to profit over the coming weeks, months and years.

                Until now, I have focused upon general tools any investor could use.  While these tools offer insight, they offer little competitive advantage.  With thousands of profit seeking investors using the same information, you can reasonably expect your chance of gaining a true competitive advantage to diminish.  Instead, I will turn to a proprietary model to guide me.

                For years I have been using a timing model to both manage clients' portfolios and to gain a sense of market sentiment.  Over the years it has served me well in both regards.  Using the model, I assume a normal market environment to be one in which less than 80% of stocks in the model are either bullish or bearish.  When a market goes beyond that 80% threshold I consider it to be an extreme movement (i.e. - 80% of stocks showing bullish signals would be an overbought market and 80% of stocks showing bearish signals would be an oversold market).  Further, a market that goes 90% in either direction would be considered severely overbought or oversold. 

                So where are we now?  Currently, my timing model is 96% short - the most severely oversold it has ever been.  Since we are so oversold, shouldn't the market rally?  While I am inclined to say yes, an oversold market can remain oversold for some time.  However, it is important to consider what this reading of the timing model means and to think about what we can expect to happen over the coming weeks.

This past weekend, I used the long holiday to back test the timing model to 1998.  Over the past ten years we have experienced many booming bull markets where prices went straight up and vicious corrections when it appeared the pain would never end.  For this reason, I think the period tested offers a proper view of how the markets behave in very different environments.

Looking at the results, I found the outcome of severely overbought (greater than 90% bullish) and severely oversold (greater than 90% bearish) markets interesting.  Over the past 10 years, my timing model has been severely overbought 9 times.  During that period, the market remained overbought for an average of 35 days with the longest period being 65 days and the shortest period being 17 days.  More importantly, from when the market became severely overbought until when it returned to a more normal reading, the S&P 500 returned an average of 3.72% with the maximum gain being 12.31% and the lowest gain being a loss of .88%.  Therefore, an investor buying a severely overbought market stood an excellent chance of realizing gains in the future.

Conversely, the market has been severely oversold 4 times (not including the current severely oversold signal).  In those environments the average time was 13 days with a maximum of 17 days and a minimum of 9 days.  Interestingly, the S&P 500 returned an average of 6.18% with a maximum gain of 9.65% and a minimum gain of 4.03%.  While severely oversold markets initially continued lower, buying in this environment eventually led to quick and significant gains.

So how do we distill all this data?  The current severely oversold reading occurred on June 26^th when the S&P 500 was trading at 1,283.  We are now 8 days into this environment and have dropped over 3%.  As of now we are approaching a price decline and day count where the market should begin to bottom and head higher.  I admit this prediction at a moment when the markets are lower appears odd, but the tendency is for oversold markets to behave like rubber bands.  The harder one pulls on the rubber band, the quicker is the snap back.  We are approaching the rebound and need to position ourselves accordingly.

To navigate this market, I have become longer than at any point in the past two years.  Over the past three weeks I have realized large gains on a number of my short positions.  At the same moment I have been adding positions I view as inexpensive with the expectation of reaping profits in the future.  Once my anticipated rally occurs, I will have the opportunity to reduce my net exposure and move to a more defensive posture.  With little clarity on the true fundamentals of many industries and no clear example of investor capitulation, any rally we experience should be viewed as a temporary bounce in an ongoing bear market.  At some point, a rally will be sustained, the bear will be vanquished and a new bull market will emerge.  Unfortunately that day is still in the future.  Until it arrives, sell strength, be cautious and capture whatever gains the market presents.

                Knowing there is a subtle difference, I will use an example to illustrate the point.  Imagine we are sitting inside our homes during a blizzard.  As the snow stops falling, we decide to go outside.  Most people would wear layers of warm clothes to protect themselves from the harsh weather.  Even though this would be the consensus view, it would be the correct approach.  Someone trying to be different and viewing themselves as a contrarian thinker would go outside in sandals and a bathing suit.  Obviously, this person is not an individualistic, contrarian thinker, but a stubborn person making unwise decisions.  Being exposed to harsh weather with little protection results in discomfort, sickness or worse.  The same logic can be applied to the financial markets.  Taking a stance that is wrong and maintaining that stance against all odds is foolhardy and stubborn.  All that can be expected from such action is swift and frequent losses.

                Considering the slight subtlety above, we must understand what the group consensus is, how groupthink could be wrong and what the potential profit actions would be.  Along those lines, I would like to discuss two major topics, what the consensus opinion represents and how a contrarian investor would position and profit from them.

                The first area to discuss is commodity prices.  Beginning in 2004, I took a 20% portfolio allocation in commodities.  My investment decision focused on both the future expected gains in commodities themselves as well as the diversification benefit received from a commodity investment.  In January 2004, the CRB Commodity Index stood at 258.  Today it trades at 455 - a gain of 76%.  My view has always been that the increase in prices reflects the supply and demand of the world's markets.  As emerging economies industrialize, the need for commodities increases.  China has shown that building booms drive the need for iron ore and coal.  Populations who had lived in poverty begin to acquire wealth and want to upgrade their lifestyles.  Among the first goals for this group of people is better quality food.  This desire increases the cost of wheat, soybeans and other foodstuffs.  The dynamic of commodity demand continues as oil is needed to for transportation and precious metals are acquired as a symbol and store of wealth. 

                Seeing China, India, Brazil and numerous countries grow rapidly; the demand side of this equation is large and growing.  Unfortunately, supply has not kept pace.  Worldwide, oil is becoming harder to find and more difficult to extract.  Droughts in Australia and floods in the United States have shown the fragile nature of agriculture markets.  Despite high gold prices, producers have not brought much supply to market.  Limited supply coupled with rising demand drives higher prices.  Until the laws of economics are invalidated, this relationship will hold.

                As we all know, prices can rise and fall beyond the true value of any good.  The consensus opinion on commodities is that the current price rise has outstripped the supply/demand relationship and that current prices represent a bubble.  The bubble view has gained such prominence that Barron's has published two cover stories in the last three months (March 31^st and June 23^rd) describing how we have reached bubble status and must prepare for the bubble to burst. 

               Knowing that most are calling this price increase a bubble that will collapse, what should a contrarian investor do?  I remain a believer in the long-term fundamentals of the commodity markets.  While the increase in prices has accelerated lately, the story is intact.  Demand is growing and supply is limited.  As the emerging markets grow, they will demand fuel and food to satisfy their populations.  The demand pressures create inelasticity where prices can remain high even after supply grows. 

              As I learned years ago, the best way to invest in a bull market is to maintain your position.  Recently, I have used the Powershares DB Commodity Index ETF (DBC) as my commodity investment vehicle.  Looking at a chart, we see many instances of quick, painful declines.  Had an investor panicked at each decline, they would have surrendered their position and missed the next move higher.  A better approach is to live with some volatility, hold your position and let the fundamentals works in your favor.  Having said that, it is also prudent to maintain your position in a size that confirms with your portfolio goals and risk tolerance.  Starting with a 20% portfolio allocation to commodities in 2004, I have scaled that back to a current weighting of 10%.  As commodity prices have risen, I have consistently sold pieces of my position to maintain a risk profile that I am comfortable with while still benefiting from the increase in prices.

             A second topic of key interest is the ability of the Federal Reserve (Fed) to manage the economy.  During the tenure of Alan Greenspan, investors became enamored with the ability of the Fed to cure all economic ills.  Inflation was low, productivity was growing and asset markets behaved well.  Whenever turmoil occurred, the Fed would devise a way to quickly cure the pain and allow investors to prosper.  Over nearly 20 years of consistent medicine, the investment community became convinced that central planners can adequately manage a capitalistic economy.

             As Greenspan passed his role to Ben Bernanke, investor faith remained largely intact.  When the credit crisis began unfolding during the summer of 2007, Fed interest rate reductions led to stock market rallies that allowed the Dow Jones Industrial Average (DJIA) to reach an all-time high of 14,164 on October 9^th, 2007.  Even though that peak was short lived, the Fed has taken increasingly aggressive and creative actions to bolster the stock market and the economy.  Recent proclamations from various Fed governors indicate that they are now focusing on the value of the dollar.  From there, many are pushing for greater influence for the Fed to oversee investment banks.  It seems that faith has been put in one central organization to increase its grasp over all aspects of the economy and financial markets.  Sadly, few have questioned this expanded mandate and continue pushing for more intrusive regulation.

            Considering that the DJIA has retreated 16% over the last nine months, you would expect investors to question the Fed's ability to cure all ills.  Investors have not taken that step.  Having seen the Fed avert the financial meltdown that would have accompanied the collapse of Bear Stearns, many believe it is a matter of time until growth resumes and the markets push higher.  The relative strength of the NASDAQ and the particular strength of some high profile technology companies (i.e. - Amazon.com, Research in Motion) over the past few weeks show that investors are not prepared to abandon high beta, volatile stocks.  If investors truly believed bleaker times were ahead, they would abandon high beta stocks for the safety of diversified, strong dividend paying companies.  Instead, risk profiles remain high as investors buy what is working instead of what is cheap.  If the Fed does anything to stabilize the markets, these risk seeking investors are looking to position themselves for the eventual rebound. 

             As a contrarian, we must ask ourselves what would happen if the consensus' faith in the Fed is incorrect.  Personally, I see very little the Fed can do.  They have expended a great deal of their ammunition in reducing their overnight lending rate to 2%.  With future interest rate reductions unlikely, a different path would be to raise interest rates to boost the dollar, deflate commodity markets and make US assets more attractive.  In an election year with a weak economy, this approach is unlikely as well.  Instead, the Fed will maintain the current level of interest rates, provide liquidity to financial firms and help avert any further disasters.  What we are left with is an economy that struggles for growth while dealing with persistently high inflation.  From an investment perspective, I expect strong companies to get stronger, innovation to decline and marginal competitors to be merged out of existence.

             In the two examples above, I have illustrated how a contrarian can develop a non-consensus view and apply that thinking to investment decisions.  When investing, innovative thinking is needed to develop profitable ideas.  Look at what most think, consider contrary views and determine ways to profit.  However, you must also remain flexible in your thinking.  Maintaining a losing position because you want to be different is a path to ruin.  Giving up a losing position because the market disagrees with your logic leads to frustration.  Instead, develop a thesis, constantly reassess conflicting data and adapt as needed.  The nimble, flexible investor will be the one who can let correct, contrarian views grow into profitable positions.

Related Stocks:  AMZN, DBC, RIMM

                Most investors receive information from a few different sources.  Whether it is television, newsletters or some other medium, knowledgeable investors seek information that will allow them to prosper.  With many different ideas swirling in the air, you can always find someone who has an idea that resonates with your thought process.  Think housing has bottomed?   A professional investor can supply reams of data to justify your view.  Think the economy is headed for a depression?  A different investor can share information to support your thesis.  As ideas conflict, people enter into investment transactions that reflect these various views.  In theory, the mass conflict of ideas arrives at a point where stock prices are efficient and reflect all known information.

                So what happened last week?  To review, the Dow Jones Industrial Average (DJIA) dropped 429 points (3.4%) on the week.  Within that drop we saw a 101 point decline, a 214 point rally and a 395 point decline.  During this process, positive information on retail sales and the Federal Reserve's (Fed) decision to defend the dollar offered reasons to drift higher while an increase in the unemployment rate and an $8 spike in oil justified the decline.  While the explanation for the price swings is simple, it is more difficult to determine if enough had changed in the underlying economy and business fundamentals to justify such swings.

                As one who never put much faith in the idea of efficient markets, I will leave it to others to determine if last week's increased volatility is justified.  For me, I am more interested in determining what we have learned from the events and how to profit in the future.  With lower stock prices, a few things are clear.  The first is that investors are feeling less optimistic than a week ago.  The second thing we know is that the cost of buying ownership positions is lower now than it was a week ago.  Both of these facts are key in creating a long term strategy to create wealth.

                Whether or not you believe in market efficiency, the presence of millions of profit seeking investors makes following consensus views a difficult approach to achieve success.  The best opportunities arise when you can develop an idea that is contrary to the majority yet is also correct.  The need to take a contrarian view is essential to profit.  This is where a lower market helps.  As investors were throwing stocks out the door, an opportunity arose for a contrarian to step into the void and buy companies others did not want. 

                To buy when others are selling sounds simple, but there are a few nuances that most be noticed.  At times, investors are justified for selling.  An example would be if the markets have experienced an increase in value that is not justified by the fundamentals, you do not want to buy on dips.  In this case, the drop is justified and buying it will results in losses.  A generation of investors during the 1990s was taught to buy every dip and sell every rally.  As a bull market moved higher, this strategy produced predictable profits.  However, as the bull turned into a bear buying dips led to large losses and investor frustration.

                Therefore, you do not buy when others sell, but buy when the selling is not justified by the market environment.  So was Friday's selling justified and should we be buying at these levels?  For me, this answer is less clear.  As I have written over the prior weeks, the rally off the April lows were based on the hope that the Fed would save the economy, housing would soon bottom and that escalating commodity prices would either stop rising or not harm the economy.  Never believing any of these arguments, the recent drop in the DJIA looks more like justified selling than a contrarian buying opportunity.  Also, not all dips are the same.  As the DJIA peaked above 13,000 in mid-May we saw many drops followed by rallies.  During this time, price drops were occurring as stocks were consolidating gains.  In that environment, buying dips led to profits.  Recent market information indicates that the current declines have accompanied stocks that are breaking down.  Buying these dips will often lead to losses.

                Before we reject this selloff as an opportunity to buy stocks, we must also examine the values the market presents us.  As mentioned above, stocks are clearly cheaper now than they were a week ago.  If we want to buy long term positions in strong companies, is now the time to do so?  Again, this answer is unclear.  Looking at my research universe, nearly 15% of all stocks I follow are selling at prices where investors are being compensated for the risks they take.  This is the highest number of cheap stocks I have seen in almost 5 years.  Unfortunately, most of these companies have exposure to the credit crisis.  One thing we have learned during the credit crisis is most banks do not have an accurate view of what they hold on their balance sheet or the true value of those assets.  Therefore, we must ask ourselves at what point financial stocks evolve from investments to speculation.

                So as I asked at the beginning of this article, where do we go from here?  Despite last week's large drop I am not convinced we have reached bottom.  Over the past two days, the market foundation has started eroding as price declines are met with higher volume, more stocks breaking to new lows and negative breadth.  A market that had shown signs of consolidating gains is now showing signs of breaking down.  Without compelling values to justify increasing my equity exposure, I would rather rent stocks than own them.  Eventually, this market will offer an excellent opportunity to buy strong companies at low prices.  We are not there yet.

                At the time, my concerns seemed unfounded.  The DJIA closed that day at 12,392.  Over the next seven weeks, the Fed would reduce interest rates an additional 25bp and the DJIA would close above 13,000.  Most continued to ignore escalating commodity prices and a weakening dollar.  After all, the Fed had managed to boost the DJIA nearly 5%, prevented a market meltdown by arranging for JPMorgan to acquire Bear Sterns and taken increasingly creative actions to unlock the credit markets.  Having accomplished these goals, why worry that oil prices had increased 25%?

                As I have identified many times, the key when evaluating any investment decision is to look at things over proper time periods.  What initially seemed like an unnecessary concern was actually a prudent assessment of the risks in the marketplace.  The Fed's easy money policy had increased inflation risk.  Eventually the market realized this risk and began pricing in the possibility.  As a result, the DJIA currently trades at a price below where it closed 11 weeks ago.  Despite a break in prices, oil is still 15% higher and the dollar remains relatively unchanged versus other currencies.  More worrisome, the KBW Bank Index is 11% lower and the Dow Jones Broker Dealer Index is unchanged.  Further, if we look back to when the Fed began reducing interest rates in response to the credit crisis (9/17/07), the DJIA has dropped 8%, the Broker Dealer index has lost 23%, the Bank index has declined 31% and the CRB commodity index has risen 28%.

                Having pushed their overnight lending rate to 2%, we are now in the position I feared.  The Fed has expelled a great deal of ammunition and creativity in addressing the financial crisis, yet has accomplished little.  The US economy is reliant on borrowed money to grow yet credit is unavailable to most borrowers.  Further, the weak dollar and higher commodity prices that have gnawed at consumers have finally drawn the attention of Fed chairman Ben Bernanke.  With yesterday's acknowledgement that a weak dollar is leading to inflationary pressures, the likelihood of further interest rate reductions has diminished.  One must remember that the value of the dollar is under the leadership of the US Treasury, not the Fed.  Bernanke, by mentioning his concern over the dollar, has injected himself into a discussion that prior Fed chairman avoided.  It is hard to imagine how Bernanke could have made these comments and still plan to reduce interest rates in the future.  The logical assumption is that further rate reductions will not be forthcoming and that the next move from the Fed will be to push rates higher.

                As I asked in my article on March 18^th, the key question is, "where we go from here?"  The immediate reaction to Bernanke's comments has been a stronger dollar and weaker commodity prices.  While short term volatility will remain in those markets that have become most reliant on easy money (i.e. - the banks and brokers which continue to selloff), we must also consider the long term ramifications of the Fed's actions.  Personally, I have never been comfortable or advocated the current approach to managing interest rates.  By constantly reducing interest rates in the wake of every financial crisis, the Fed has prevented the economy and asset markets from ever reaching equilibrium.  The result has been one bubble after another.  As we are now learning, when the bubbles stop blowing the cleanup can be painful.

                Assuming the Fed leaves interest rates constant, we should see a steep yield curve and slower growth.  Banks will have the ability to lend money at larger spreads which allows them to rebuild their balance sheets.  Capital will begin flowing to the businesses that are strong and produce returns for shareholders.  Marginal players in weak industries will see their access to funds diminished and will be merged with stronger partners.  Dominant players in strong industries will grow the value of their franchise as barriers to entry increase.  Consumers will begin focusing on restoring their creditworthiness and strengthening their personal wealth.  All in, a movement away from slashing interest rates to prop up the stock market will result in a stronger economy that will create wealth and efficiently allocate capital in the future. 

               Unfortunately, the transition in that direction will be painful.  Even if the recession is over and the worst behind us, the lack of lending will result in subpar growth over the next few quarters.   This lack of growth with no true catalyst will make it difficult for the markets to move higher.  When this transpires, expect the calls for Fed action to be loud and constant.  From there, we will see if Bernanke has the persistence to create an economic environment where risk is priced and returns are reasonable or if he will bow to the pressure, follow Alan Greenspan's lead and provide a short term solution with serious long term consequences.

                When interpreting information, many people use mental short cuts.  Doing so allows us to process vast amounts of data quickly and arrive at informed decisions in short periods of time.  Knowing this, people who present information often frame it in a way to influence the recipient.  By influencing a person's perception of information, the conclusion reached will support the message being delivered.

                For years I have believed that companies use their financial reports to frame a story they would like to present to the investing public.  To most people a company's annual financial statements are bland documents filled with facts and figures.  Since a company presents hard data, there must not be any latitude in what we see.  After all, facts are facts, right?  The question is straightforward yet the answer is a more nuanced yes and no.

                As an example of how different companies frame their finical results, examine the annual reports from Amazon.com (Ticker: AMZN) and Whole Foods Markets (Ticker: WFMI).  AMZN offers us an in-depth look at their operating business, many non-GAAP metrics they use to manage and evaluate their business performance and a thoughtful discussion of the risks they face.  Turning to the financial statements, AMZN starts with the Statement of Cash flows.  Since the entire report has discussed how cash flow is a better measurement than earnings, the financial statements are consistent with the message that has been delivered.  While I am not in favor of AMZN's reliance upon non-GAAP financial performance, I can appreciate the fact that their message focuses upon their operating business and is consistent throughout the report.

So what do we find with WFMI?  Within the management discussion, little attention is given to their operating business and why shopping in their store is better than buying organic food from a larger supermarket.  Instead, we are treated to pages of descriptions detailing how they have shaped the organic industry, benefited local farmers and created a positive environment for their employees.  Far less attention is given to how 67% of all inventories are perishable, their prices are higher than competitors and how a slowing economy may alter consumer behavior.

Turing to the financial statements, WFMI leads with the balance sheet.  This is an interesting choice.  When you bring off-balance sheet liabilities into the equation, WFMI has a negative book value.  Also, as a growth stock most of their investor base would rather look at an income statement or cash flow statement to discern future growth and the ultimate stock price.  Could it be that management would rather not have us look upon diminishing growth prospects?

Given the mixed message in the report, what are the investment implications?  Looking at the numbers, WFMI has some great attributes.  Cash earnings have outperformed GAAP earnings the last 3 years and the cash conversion ratio has remained steady.  Operating margins have been improving and turnover metrics remain strong.  All together, the business is well run and efficient.

Now we turn to the negatives.  By financing the purchase of Wild Oats with cash as opposed to stock, interest expense is set to increase from $4mm to $35-40mm.  At the same time, growth is slowing as consumers have less discretionary income to purchase expensive, prepared organic food.  Since 67% of WFMI's merchandise is perishable, any fall in sales caused by an over strapped consumer will lead to increasing shrinkage and lower margins. 

The market has started to recognize this fact as the shares have dropped from a high of over $74 i