The U.S. Dollar has to eventually weaken

The U.S. Dollar has appreciated (i.e., strengthened) relative to foreign currencies so far this year. However, in the long term, the U.S. dollar has to weaken. There's absolutely no doubt that this will happen. When it does happen, foreign-denominated assets such as foreign stocks should outperform U.S. stocks for some period of time.

The U.S. has been running trade deficits since the 1970s. However, the trade deficits have been accelerating in recent years. This year alone, the U.S. trade deficit is projected to exceed $700 billion. This means that the U.S.'s imports exceed its exports by $700 billion.

With U.S. dollars in hand, the foreigners can either exchange the dollars for another foreign currency or invest the money back in the U.S. by purchasing U.S. assets. For example, much of the dollars are invested in U.S. treasuries or in the stock market. This is probably because interest rates are higher in the U.S. than they are in other parts of the world. Accordingly, foreign investors are currently getting a good return on their invested dollars.

However, at some point this will have to end. In the nightmare scenario, the dollar begins depreciating (i.e., weakening) until froeign invesotrs decide that enough is enough and start quickly selling off their U.S. assests, accelerating the dollar's depreciation. As the dollar depreciates, the cost of imports will likely rise, resulting in strong inflation in the U.S. and causing either a recession or possibly even a depression.

To hedge one's bets, one can purchase foreign stocks and hope for the best. However, if a depression does occur, foreign stocks and foreign economies would likely also suffer, as the U.S. is a big source of revenue for foreign economies. So a good alternative investment may be gold, the universal money.

Maximize your money market interest income

Anyone who has at least a couple thousands dollars laying around should consider opening an online money market account to maximize their interest income. Emigrant Direct currently pays 4% on its money-market account and requires no minimum balance. ING Direct offers 3.5% interest on its money-market account and also fails to require a minimum balance. Another good thing about these accounts is that both are FDIC-insured up to $100,000. The only real catch is that you have to electronically make deposits/withdrawals to/from the account. For example, you can electronically transfer money between your banking institution and your online account. This is no problem and is similar to the direct deposits that many people make with their paychecks into their bank account.

"Value Investors Flock to Microsoft"

There is an interesting article today in the Wall Street Journal about how Microsoft is now viewed as a good value play.

The "FED Model" theory of equity valuation

The "FED model" is a popular yardstick for judging whether the stock market is fairly valued. This term was coined by Prudential Securities strategist Ed Yardeni after a Fed report to Congress in July 1997 suggested the bank was following it.

The FED model compares the yield of the 10-yr govt bond to the "earnings yield" of the S&P 500. The "earnings yield" is defined as the inverse of the forward P/E ratio of the S&P 500. As of the market close today the S&P 500 is trading at 1230.96 and the projected earnings for 2006 of the components of the index are $78.30. The forward P/E ratio for the S&P 500 is therefore about 15.72 (1230.96/$78.30). The inverse of the forward P/E ratio is E/P, known as the earnings yield. In this case, (1/15.72) is .0636, or 6.36%. As of market close today, the yield on the 10-yr govt. bond was 4.564%.

In theory, the yield on the 10-yr bond is equivalent to the different between the earnings yield and the risk premium (i.e., because stocks are riskier than bonds the earnings yield should ordinarily be less than the yield on the 10-yr bond). In this case, 4.564% = 6.36% - Rp (risk premium). In this case, Rp is 1.796%. Between 1994 and 2003, the average risk premium was 0.11%. Therefore, the current Rp of 1.796% is a very bullish sign and signals that it's probably a good time to buy.

During the stock market bubble, the risk premium was around -2% or worse - i.e., investors bid up stocks to great highs because stocks were actually viewed as being less risky than bonds. Today, on the other hand, investors are completely shunning stocks and invest their money in bonds instead.

CAVEATS

Although the FED model is useful, it does have its flaws. For example, the earnings yield is based on projected earnings, and it's always possible that the economy could go south and those projections will not be met. Moreover, this model only addresses the relative (not absolute) valuations of stocks and bonds. Stocks do not necessarily have to rise for Rp to decrease; instead, stocks could stagnate while bonds decrease in value.

The S&P 500 index is undervalued

The P/E ratio of the S&P 500 is near a 10-year low. According to Standard & Poor's, the total reported earnings through 9/30/05 for the sum of the components of the S&P 500 was about $67/share. As of today, the S&P 500 index trades at about 1220. Accordingly, the trailing P/E ratio of the S&P 500 index is about 18.21 (1220/$67). The last time the trailing P/E ratio was this low was 10 years ago, at the end of 1995 when it was about 18.14 at the end of the Dec. 1995 quarter.

While the trailing P/E is attractive right now, the forward P/E looks even better. Standard & Poor's projects the earnings on the index for 2006 to be about $78.30, giving a forward P/E ratio of about 15.58 (1220/$78.30).

Is this a "buy" signal? I sure think so. Stocks have recently been weighed down by high energy prices and a FED that has been steadily raising short-term interest rates. However, consumer price inflation is still relatively low by historical standards. Moreover, relative to bonds, stocks look extremely attractive. The yield on the 10-yr US bond has recently risen sharply to 4.67%. In other words, despite the recent rise in bond yields, they are still priced as though there is no heavy inflation on the horizon.

Accordingly, I am led to the conclusion that stocks are due for a strong rally. Although corporate profits have been strong for several years now, stocks haven't done much since their strong surge in 2003. So I think that a rally is long overdue. It would not surprise me to see a 30% year-over-year rally in the S&P 500.

Selling stocks short

I first became interested in investing when I attended college during the mid-1990s. I read such seminal classics as One Up On Wall Street and Beating the Street by legendary Fidelity mutual fund manager Peter Lynch. During the course of my recreational reading on the subject I learned all about long and short positions. A long position in a stock is one in which the investor owns the shares themselves. A short position, on the other hand, is one in which the investor borrows the shares from another investor and then sells them, making money if the shares drop in value.

Although the concept is not difficult to understand, I had to do some sleuthing on my own before I really figured out what takes place during a short sale, as I discuss below.

(1) The investor must initially instruct his brokerage house to sell short shares of a stock.

The investor can only sell stock short if the investor has a "margin" account. A margin account is one in which the investor can borrow against his current holdings to purchase addition shares of various securities and sell short. A "cash" account, on the other hand, does not permit such borrowing or selling short.

(2) The brokerage house borrows the shares from another investor's account.

This is the part that isn't straightforward. That is, why can a brokerage house borrow shares from another investor's account? The brokerage house can only borrow shares from another investor's account that are held in "street name," i.e., in the name of the brokerage house. Most stock purchased nowadays is held in street name. This makes it much easier to sell the shares. If the stock were held in the investor's name instead of in street name, the invesotr would have to physically deliver the corresponding stock certificates to the brokerage house before selling such shares. However, if held in street name, the shares are already at the brokerage house's disposal.

The reason why the actual borrowing takes place is because a settlement must occur three days after a trade is made. This is known as the "T+3" rule. That is, three business days after a trade is made, the seller must deliver the shares being sold and the buyer must deliver the corresponding money for the shares.

The investor from whom the shares are borrowed can still sell his shares, and the investor's will reacquire the shares and the short selling investor's brokerage house will borrow the shares from a different investor.

(3) The investor buys back the short shares to "cover" the position.

After selling shares short, the investor has to eventually repurchase the shares to close his position in that stock. An investor with a long position makes money by first buying shares at a low price and then sell the shares at a higher price. A short seller makes money, on the other hand, by first selling the shares and then buying back the shares at a lower price at a later date.

CAVEATS

There are some caveats to short selling. First, if the price of the shares sold short keeps rising the investor can quickly lose a lot of money. Second, the investor's short position may be closed at any time such as, e.g., if the investor loses too much on the position relative to the investor's other holdings in the account. The short position may also be closed if the investor from whom the shares were borrowed decides to sell and the shorting selling investor's broker cannot find another investor from whom to borrow the shares.

Anyone considering selling a stock short also needs to be aware that the investor is responsible for paying dividends to the investor from whom the shares were borrowed. For example, assume that investor A borrows 100 shares of MSFT from investor B, and then sells the 100 shares to investor C. In the event that MSFT declares a dividend, investor C will receive the dividend directly from MSFT. However, investor A will have to pay investor B an amount of money equal to the value of the declared dividend.

Hello

Welcome to my blog. This blog is directed to finance and investment-related topics. Feel free to leave comments and I will respond accordingly.

- Jim