Green Mountain Coffee Roasters, Inc. (GMCR)

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Peter Lynch deserves a lot of credit for getting people interested in investing. Whether or not he intended to do so, he convinced many people to buy stocks in companies whose goods and/or services they knew and liked. However, indiscriminately buying stocks in companies whose goods and services you like isn't necessarily a good approach to investment management. Just ask anyone who ever bought stock in Boston Chicken or Crocs.

Green Mountain has enjoyed incredible growth in revenue and income over the past several years. From 2006 to 2008, their revenue more than doubled. The Keurig machine is a huge hit and everyone loves their K-cups. I have one. I love it.

But that doesn't mean the stock is a good buy, at least not at these levels. As impressive as their growth to date has been, the market for high-end coffee machines and supplies is saturated. And at 35x earnings and 32x net tangible assets, the stock is richly priced. The stock may continue to move higher, but I expect it to underperform relative to the S&P. I'm initiating a small, short position this morning and will add to that short position if the stock trades over $52 in the coming weeks.

This is a crowded trade. The short interest in the stock is extremely high (over 40%). As such, it's subject to manipulation. If you can hold your short position through any price spikes, you should do well as the enthusiasm for Keurig products levels off.

Dialing Down Leverage After a Rally

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Market events of the past three weeks underscore the incredible gains that can be enjoyed with just a dab of leverage. If you were long the S&P at 700, your portfolio would be up at least 14% now. However, if you had increased your exposure to 1.5x the S&P, you'd be up over 20% for that same period.

I remain convinced that a long-term recovery is in progress. And yet, it's times like these where you dial back your leverage after a rally. If you swapped some index shares to buy the $25 LEAP calls I mentioned in my last blog (symbol: OBMLE), you might want to consider swapping them back. You don't have to go from 1.5x leverage back to 1.0x (unleveraged, but still long), but you might want to at least consider going to 1.2x the index or less.

Stock market recoveries almost never occur in a straight line. You might not get another opportunity to buy at 700 again, but 100 to 120% long the S&P is still a good place to be to enjoy future gains.

Should you use leverage?

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"Leveraging" is nothing more than the act of structuring a portfolio to move faster than some underlying benchmark. You can achieve that effect in multiple ways... by buying on margin, using derivatives like call options, or holding futures contracts. All of these strategies entail a different, and greater, level of risk that merely buying and holding an index product. Be certain you understand those risks before you engage in this kind of behavior.

If anything, the events of the past six months may serve as a lesson for why you should not use leverage. Leverage is a wonderful thing when markets move in the direction you anticipate. Leverage magnifies gains. But when the market moves against you? It's a real bitch. Leverage magnifies losses. As painful as a 50% drop from the market highs of 2007 has been, if you were just holding onto an index fund, you're still in the game and your portfolio should recover over time. Plenty of people who were leveraged over the past year and a half are now wiped out.

Now that you've been warned of the potentially devastating effects of a leveraged portfolio, you need to consider the benefits of taking on some leverage now. One attractive alternative at your disposal is the LEAP call option and the prices for these products right now are very intriguing. A call option is a financial product that gives you the right, but not the obligation, to buy the underlying asset at a certain price [the "strike price"] on or before a certain date [the "expiration date"]. "LEAP" ["Long-term Equity AnticiPation"] merely designates an option with a longer duration. The vast majority of options trading is done in contracts that expire within a few weeks or months. When LEAP's are originally listed, their expirations are typically several years into the future.

I think current market conditions justify a look at the December 2011 LEAP calls on the S&P 500 Depository Receipts [root symbol: "SPY"]. Someone who is currently long SPY could moderately leverage their position with the right SPY LEAP calls. Yesterday, with SPY closing at 71.73, the $25 LEAP calls on SPY for December 2011 [symbol: "OBMLE"] could be had for around $47. An investor who swaps his "SPY" dollar-for-dollar into an "OBMLE" position would end up with a leveraged position of around 1.5. A $1 move in the old "SPY" position would result in a $1.50 move in the new "OBMLE" position. Using the December 2011 contracts affords you over 2 1/2 years to catch a recovery in the markets.

You must have a stomach for risk if you're going to try this. If the S&P (currently around 700) is at or below 250 in December 2011, you will be wiped out. If the S&P is significantly below 700 in December 2011, you will endure severe losses. Your portfolio will be even more volatile if you're holding LEAP call options instead of a plain old index fund. However, if, as I suspect, we enjoy a modest recovery over the next two years, this leveraged position will reward you well for the risk you've undertaken.

Portfolio Management Tasks

I've closed out a portion (less than a third) of my short position in US Treasury futures. There is still plenty of downside on the 30-Year, but the sell off in the S&P has become too tempting. I'm adding more to my S&P positions. Two years from now, people will look back at the first week of March as having been an excellent buying opportunity for stock.

Unfortunately, with the S&P under 710, most will probably fail to take advantage of it.

December's Money Supply Numbers

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Most of the time, the money supply numbers are boring and mundane. However, these days, nothing seems to be boring and mundane. The unprecedented bout of capital destruction we've witnessed over the past year, along with the unprecedented cut of the Fed Funds rate to a level that is effectively zero, has finally made itself felt in the M2 data.

A year ago, M2 was growing at a rate of around 5.5%, which is generally consistent with a modest rate of inflation. The capital destruction endured by the financial sector as everything mortgage-related collapsed slammed the brakes on M2 growth. By last summer, M2 growth had dwindled to 1.2%... a level that's usually associated with extreme deflationary risk.

The last 3 rate cuts have sharply turned around the M2 numbers. By September, M2 had grown over the past quarter at an annualized rate of nearly 7%. For November, the figure was 13.9%. And now, with the most recent data being release, we see that M2 for the fourth quarter of 2008 grew at an annualized rate of 17.4%

You can probably draw the following conclusions from this data:

(1) The Fed has achieved it goal of avoiding a 1930's style deflationary spiral,

(2) There should be a decent rebound in economic growth this year, probably some time around the 2nd or 3rd quarter, and;

(3) Yields on long-term Treasury Bonds are completely irrational given this surge in the money supply data.

Treasuries have already dropped significantly since I first initiated a position against them. However, there is still a long way for bonds to fall. I now expect to see the yield on the 30-Year exceed 4.5% before year-end and I wouldn't be surprised if they broke the 5% barrier.

Previewing 4th Quarter Earnings

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With earnings season about to kick off, now is a good time to gauge 4th quarter expectations as well as do some forecasting for 2009.

S&P Global has drastically cut back their expectations for the 4th quarter. As recently as September 10th, their forecast for 4th quarter operating earnings for the entire S&P 500 was 24.12. By year end, they had trimmed that number down to 16.19, and that number might still be overly optimistic. Furthermore, 16.19 would represent a 6.4% year-over-year gain compared to 4Q2007 earnings. Given the steep, double-digit drops in y/y earnings for the other 3 quarters of 2007 (-26%, -29%, -24%), forecasting growth for 4Q2008 seems like a stretch. However, the comparable was already low as 4Q2007's y/y was -31%.

The following chart shows year over year operating earnings growth for the S&P 500 for 2007 and 2008. The 4th quarter estimate is from SPGlobal.


To make matters worse for 4Q2008, the yield curve didn't become very stimulative until early 2008. It generally takes about a year for a stimulative yield curve to start generating earnings growth again. So while the 16.19 currently forecast by S&P Global is significantly lower than their September forecasts, we might still see operating earnings that fail to eclipse 15. It's no secret that retail was in a slump for the 4th quarter and the only recent bright spot, energy, did not fare well either.

For 2009, given the rate environment we experienced for all of 2008, I do expect to see a resumption of y/y earnings growth, though I don't expect earnings growth to be quite as robust as it's been with past recoveries. Currently, I expect 2009 operating earnings to come in around 70 to 72 for the entire year. With the S&P closing yesterday at 890, that would give us a forward P/E in the vicinity of 12.5.

Stocks are relatively cheap right now. It takes some guts to hold them at a time like this, but it's times like these where stock ownership is highly rewarded going forward.

What a Bond Market Crash Means for Stocks

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Despite the time and space devoted to the bond market since initiating this blog, I am predominantly focused on stock investing. That bonds had gone bonkers as I was starting this blog was just odd timing on our part. If you're out hunting rabbit and a big, fat squirrel crosses your path, you have to shoot it. They's tasty animals, too. And so it was with our call on the bond market last month.

In the long run, bonds and stocks are only slightly correlated. However, there is an excellent tool for evaluating the investment merits of stocks relative to bonds: the Fed Model.

The Fed Model is not without its detractors and I don't intend to go into great detail in this blog entry about the rationale for, or the efficacy of, using the Fed Model as an asset allocation tool. What is beyond dispute is that over time, stocks have tended to trade at the levels suggested by the Fed Model.

By the Fed Model, it is expected that stocks will tend to trade at a level found by dividing 12 months of forward corporate earnings by the yield of the 10 Year Treasury Note. Arguments about which earnings data to use, whether or not there should be a risk premium added to the equation, or the problem of forecasting future earnings aside, a rise in long-term interest rates tends to make stocks less appealing to investors. And so we would expect a bond market crash to create a drag on future stock returns.

Once again, 1994 serves as an excellent example to review events external to the bond market as the bonds were crashing. At the end of 1993, 10 year Note yields were 5.78%. 1994's S&P operating earnings were 31.75. The Fed Model would suggest that the S&P should trade at 549.30. (On 12/31/1993, the S&P closed at 466.45.) One year later, the 10 year Note was yielding 7.83%. 1995's S&P operating earnings were 37.70. (Fed Model ---> 481.48) The S&P 500 closed the year 1994 at 459.27. So despite a more favorable earnings outlook, against the backdrop of rising long-term interest rates, stocks through 1994 performed poorly.

There are other reasons declining bond prices tend to hurt stocks. Some investors allocate, and reallocate, capital between stocks and bonds in fixed ratios regardless of fundamental valuations. Investors who use an 80/20 asset allocation ratio that rebalance their portfolios quarterly will be taking money out of stocks as bonds decline. Bonds will always compete with stocks for investor dollars, so in the midst of a bond market decline, more attractive bond prices will draw capital away from stocks.

Conditions for stocks should improve through 2009, especially the prospects for forward earnings growth. But the turmoil in bonds this year will probably hamper stock returns. Looking back at 1994 again, the good news is that two to five year stock market performance should be much improved. By the end of 1996, the S&P had risen to 740 and would break 1000 by the first quarter of 1998. We could be setting up for a similar resumption of stock market gains out to the year 2014 or so.