CarMax, Inc. (KMX) will announce earnings next week as their fiscal first quarter ended on May 31.  Despite sagging sales the last three quarters, investors appear optimistic that this report will be a bit stronger.  The stock is currently trading near $13 after hitting a low of $5.76 on November 21.  Unfortunately, while KMX has been a great success story for 2009, the current stock price appears vulnerable to a sharp decline if the news is anything but spectacular.  Analysts are expecting the current year (fiscal 2010 ending February 28) to generate earnings of 23 cents per share leaving the stock with a current PE of 57.  Now to be fair, I should also point out that 2011 is expected to generate earnings of $0.49 so the multiple on earnings 2 years out is only 26.5.  However,  that is still fairly high for such a speculative growth story.

Much of the recent strength has been due to increasing expectations of used car sales, and positive financing data.  The logical argument is that as the consumer deals with lower employment and reduced balance sheets, he or she will more likely buy a used car instead of springing for that shiny new set of wheels.  And the high profile bankruptcies of the US car manufacturers has certainly not hurt the trend towards buying used cars.

Financing has also gotten a bit looser in past months, but not as much for individuals as it has for KMX lending facilities.  It is expected that the financing unit will be able to securtize more of its loans and sell them, leaving more available capital to lend to KMX customers.  That certainly could have a positive effect on demand, although standards for making these loans will still be much tighter than we have seen in past years.

One of my major concerns with  CarMax is the potential for sharply increasing competition.  First, you have many independent dealers who used to traffic in new GM, or Chrysler cars who may now enter the used car market.  These guys have the property, staff, and expertise to sell cars but no longer have the privileges associated with the manufacturers.  It’s likely that these resources will be used to sell used cars, and compete directly with CarMax.

Secondly, the auto manufacturers will come out of bankruptcy leaner and fighting for their lives.  This means a sharply reduced cost structure which will trickle down to significantly reduced prices on new cars.  So consumers who may previously have decided to stick with a used purchase may find that the cost of a new car is incrementally attractive.

Currently, the gross profit for the average unit sold at CarMax is about $1,850.  It will be interesting to see where this number comes in next week, and which way it is trending.  Investors could quickly sour to the company if this gross profit number is not improving.

While CarMax will certainly stay in business, and may in fact benefit from the current automaker debacle, the stock price just seems to reflect too much optimism.  I wouldn’t be surprised to see the stock trade back down to 15 times the 2011 estimate of $0.49.  That would bring the price to $7.35 – which would be quite a shock to investors.

Shorting the stock is likely the best way to profit from a drop over the period of several months.  However, aggressive accounts could consider buying the KMX June $12.50 puts.  It’s a very risky play, but you can pick up these contracts for 40 cents as I write.  The options expire at the end of the day next Friday, but if KMX announces very poor earnings and the stock drops to $10, you would realize a 525% return on the option.  However, if the stock does not trade down sharply, know that you would then lose the entire $0.40 used to purchase the puts.  The risk / reward ratio on this trade looks appealing to me for a very small part of your trading portfolio.

FD: Author does not have a position in KMX

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Much has been made about the potential for “green shoots” or signs of new life in the broad economy.  Zero Hedge offers a unique perspective on the opportunity costs of these green shoots – what we are giving up in order to “manufacture” this emergence in economic activity…

The Opportunity Costs of Green Shoots

As we’ve been saying, it’s not the change in the trajectory of the global economy, but the cost of engineering it, that clouds the outlook. One example: the cash-for-clunkers program that drove German auto sales higher may cost German taxpayers at least $3.5 billion, even after the sales tax and foregone unemployment cost benefits. Such programs simply pull forward future demand, and displace other non-auto purchases. The world has never relied before on a coordinated avalanche of fiscal and monetary stimulus, and financial guarantees. I find investment commentary that hails the arrival of better data without acknowledging its potential costs to be incomplete.

The Ultimate Fighting division of heavyweight economists has been active, with Paul Krugman and Allan Meltzer exchanging sardonically-worded “history lessons” with each other. Here’s a chart I pulled together to try and grasp the fireworks. Today’s “output gap” (a theoretical measure of spare capacity) is around 2x the 1970s version. That should give the Fed ample room to keep monetary policy easy for a long time. But how easy? The expansion of the monetary base is already 4x greater than its 1970s counterpart, and heading higher. So far, the money multiplier (which drives inflation) has been weak, but the Fed is making a huge bet they can control all of this. The size of the monetary and fiscal expansion reminds me of that giant boulder at the beginning of “Raiders of the Lost Ark”; recent increases in commodity prices and Treasury/Agency yields suggest it may be gaining on us.

Read the entire article including remarks on residential real estate and the US dollar…

Solar Stocks have been drawing attention over the last several weeks with many stocks posting impressive gains reaching into triple digit percentage points.  The move has come after solar stocks were pummelled late last year and in early 2009.  The action over the past 18 months is an excellent example of how investors’ outlook can move from overly optimistic, to overly pessimistic, to eventually a rational view of the long-term prospects for an industry.

LDK Solar Co., Ltd. (LDK) is not a new name to ZachStocks as we have looked at the stock multiple times in the past 2 years.  Subscribers to the ZachStocks Growth Model are currently sitting on 81% gains in the name as our March purchase proved very timely.  Wednesday the stock shot up 21% in active trading.  The move came after the company updated investors on its progress in ramping up a polysilicon plant which is expected to increase production in the third quarter.  While the news was not necessarily a deviation from previous releases, investors were relieved to see that the company was indeed on schedule.

Polysilicon is the raw material for most PV solar modules and is very difficult to produce efficiently.  In the past the cost of poly has been a major issue for solar energy as a category because high priced poly made it difficult for solar energy to be cost effective.  But advances in technology are finally paying off as the spot market price for poly is falling.  LDK is circumventing this process by developing a large scale plant to produce its own raw material.

While LDK continues to perform well on the company level, the macro picture is also showing strength.  Recently there have been several announcements of new solar energy projects from both the public and private sector.  These types of news releases are driving optimism in the market which is bolstering what have been depressed multiples on solar stocks.  On Wednesday a Chinese official said that the country intends to produce 20% of its energy from alternative sources by 2020.  While this is certainly an aggressive timetable, the statement helped investors to have confidence that alternative energy truly is a priority for this growing country.

Another force driving solar energy is the rising price of traditional energy sources.  Oil has risen more than 100% from its low of $32.40 late last year to a current price near $72.  Natural gas has followed a similar pattern making electricity more expensive to generate using traditional means.  Higher prices on traditional energy simply makes solar more competitive as projects work with a more attractive cost benefit timeline for how long it would take for a solar installation to become profitable compared to existing solutions.

Some investors have been afraid to get into solar names recently because prices are so much higher than they were 2 months ago.  However, looking at valuations for particular names, there still appears to be plenty of attractive investment opportunities.  LDK currently trades near $13.50 per share while analysts are expecting the company to make $1.63 in 2010.  Historically, high growth solar companies have enjoyed multiples of 30 to 40 times earnings.  Now this may have been unreasonable, but at the same time, the current valuation of 8.3 times future earnings seems to be ultra-conservative.  And that’s after the stock has already experienced a 260% rise from its March low.

Analysts expectations should be taken with a grain of salt.  After all, it is very difficult to predict exactly how pricing dynamics will play out, and what kind of demand will be generated with worldwide stimulus programs.  But applying a conservative 15 times expected earnings still gives us a stock price of $24.45 – not a bad return from current levels.  If you want to get a bit more aggressive and use a multiple of 20, the price could reach $32.60 which is another 141% above current prices.

Solar stocks will certainly experience volatility as new information becomes available in coming weeks and months.  However, the trend is definitely for higher prices, and this is an area which could continue to experience economic strength even with a weak consumer (due to government projects).  I would recommend aggressive accounts take at least a modest amount of exposure to solar stocks and LDK particularly as the gains could offset potential losses in other areas.

FD: Author has a long position in the ZachStocks Growth Model

By Don Miller
Associate Editor
Money Morning

Could the U.S. economy be looking at a “jobless recovery?”

After the worst financial crisis since the Great Depression reached its apex late last year, the U.S. economy has shown signs of life in recent months. Stock prices have soared. The housing market – once in veritable freefall – seems to be bottoming out in preparation for an eventual upsurge. And just last week, the government said that businesses cut jobs in May at the lowest rate in six months, a report that offered encouragement both to investors and to the millions of U.S. workers who have lost their jobs.

But U.S. Federal Reserve Bank Chairman Ben S. Bernanke threw cold water on hope for a full-blown economic rebound when he hinted that the U.S. labor market could well be facing a jobless recovery – an upturn in which the economy and corporate profits advance, but virtually no new jobs are created to compensate for years of layoffs.

Just this week, economists at the Federal Reserve Bank of San Francisco said they see signs that the current turnaround could mimic the aftermath of the 1990-1991 recession – a wheezy, drawn-out recovery with little hiring that means years of additional problems for U.S. workers.

“This projection indicates that the level of labor market slack would be higher by the end of 2009 than experienced at any other time in the post-World War II period, implying a longer and slower recovery path for the unemployment rate,” the Fed economists wrote.  “This suggests that, more than in previous recessions, when the economy rebounds, em

ployers will tap into their existing work forces rather than hire new workers. This could substantially slow the recovery of the outflow rate and put upward pressure on future unemployment rates.”

Unemployment Damage Widespread

Alongside other economic indications of a stabilizing housing market and rising consumer confidence, the unemployment figures offered a glimmer of hope that we may be on the cusp of an economic turnaround and the end of job destruction.

But it’s highly unlikely this economy will produce meaningful job creation anytime soon.  The financial fallout from the biggest recession in 60 years is likely to be so costly and so pervasive that new-job creation is likely to be virtually nonexistent for years to come, particularly in the manufacturing and construction industries.

The U.S. Labor Department reported that the economy lost “only” 345,000 jobs last month, significantly lower than the 520,000 that analysts expected and the first time since October that job losses didn’t increase.

But even though the latest report may be an improvement, the fact is that companies slashed jobs during the latest recession at a rate that’s been rivaled only a couple of times since the Great Depression. Indeed, the Labor Department said that:

• The U.S. economy has lost more than 6 million jobs since the recession began in December 2007 – meaning nearly one out of every 20 jobs was eradicated.

• The unemployment rate now stands at 9.4%, the highest since 1983.

• A total of 14.5 million Americans are now unemployed. The number of long-term unemployed (those without jobs for 27 weeks or more) increased by 268,000 to 3.9 million and has tripled since the start of the recession.

But even those statistics – as grim as they seem – don’t tell the whole story.

As reported previously in Money Morning, the “official” employment rate doesn’t account for workers that have been switched from full-time to part-time jobs. And it also doesn’t include “marginally attached” workers – people who have given up job-hunting altogether.

If you added those unfortunates to the government’s jobless tally of 9.4%, the “real” unemployment rate would stand at a staggering 16.4%.

That’s the worst showing since the 1981-1982 recession when the official jobless rate peaked at 10.8%, which was the worst to hit the labor market since the Great Depression.  A total of 2.8 million jobs disappeared in that downturn, but the labor market was much smaller back then.

Unfortunately, the nature of this recession makes it likely things will get worse before they get better.

As two of the so-called “Big Three” U.S. automakers – General Motors Corp. (OTC: GMGMQ) and Chrysler LLC – attempt to navigate their way through the Chapter 11 bankruptcy process, they are set to close more than a dozen manufacturing plants and to cut another 32,000 jobs. Any moves that GM and Chrysler make will likely also have to pass muster with the Obama administration, which made loans to both of those carmakers.

Other major U.S. employers are likely to follow suit as they continue to reduce inventories and cut back on capital investment. That leaves most economists predicting that even the official jobless rate will top 10% by year-end.

An Economic Recovery May Not Bring New Hiring

So what happens to the labor market when the layoffs end and the economy starts to grow again?

All indications are that the road to recovering the millions of job lost during this recession will be a bumpy one.

Employers remain skittish as they slowly recover from the biggest economic upheaval since World War II and are already saying they will be cautious about replenishing payrolls anytime soon.  And just the sheer numbers of people on the street dictates that it will take some time to bring even a portion of them back into the work force.

But to get to the heart the matter – the one factor that will keep the job market moribund for some time – analysts point to the bubble-bursting events that let the air out of the gigantic auto and housing sectors, the economic engines that drive manufacturing.

“It will take a recovery in automobiles and housing for the manufacturing sector to once again prosper,” Norbert J. Ore, chairman of the Institute for Supply Management Manufacturing Business Survey Committee, toldThe Kiplinger Letter, noting those sectors have shed more than 1.5 million jobs in the past two years.

And despite the government’s monumental stimulus program to create 3 million jobs in the next two years, those critical sectors are likely to face moribund prospects until at least 2010 – and perhaps even longer.

“It’s going to take five or six years for homebuilders and automakers to fully recover from this recession, and it may take longer,” says Martin Hutchinson, a Money Morning contributing editor who has written extensively about the current downturn. “You’re not going to see aggressive hiring in those industries for a good while.”

Hutchinson says the automobile business is in particular difficulty from outsourcing.

“A great deal of the cutting-edge technology associated with the U.S, automobile business is currently being outsourced to other countries, which will further hinder product development and sales for that sector and constrain future hiring,” Hutchinson said.

Federal Chairman Bernanke also says that the labor markets may continue to suffer for some time.

In a speech to Congress on May 9, Bernanke pointed to lack of consumer spending and weakening demand for commercial and industrial loans as constraints on future hiring.

“Even after a recovery gets under way … we expect that the recovery will only gradually gain momentum and that economic slack will diminish slowly,” Bernanke told U.S. lawmakers.  “In particular, businesses are likely to be cautious about hiring, implying that the unemployment rate could remain high for a time, even after economic growth resumes.”

2001 Recession – Déjà vu All Over Again

This won’t be the first jobless recovery the U.S. economy has experienced.

In the 2001 recession, 1.6 million jobs were slashed. Unfortunately, the end of that downturn didn’t bring an end to the job cuts: In the year that followed the recession’s conclusion, another 562,000 workers lost their jobs. And in the 12 months that came after that, 193,000 more workers lost their jobs.

It wasn’t until 2004 that more than 2 million new jobs were finally created.

In fact, the only job growth we’re seeing now is in healthcare and education where a paltry 44,000 jobs were added in May.  Meanwhile, more than 9.5 million jobless workers took temporary employment last month, a category that’s seen its ranks grow by 5.8 million since the recession started, the U.S. government reported.

But it’s the jobless recovery of the early 1990s – which followed the recession of 1990-1991 – that may offer the best insight into what we can expect to happen next, the Federal Reserve Bank of San Francisco economists say. That admittedly pessimistic view is based on two factors:

• First, of all the jobs that have been slashed, a miniscule number are classic “layoffs,” where workers are actually expecting to be called back to their jobs when economic conditions improve. From July 1981 to November 1982, the share of unemployed workers on temporary layoff rose from 16.1% to 20.7%. From December 2007 to April 2009, however, the share of unemployed workers on temporary layoffs decreased from 12.8% to 11.9%.

• And second, the number of people who are involuntarily working in part-time positions (when they want full-time jobs) is at a historical high. In December 2007, about 3% of the work force had taken part-time jobs for economic reasons. By April of this year, that number had nearly doubled, reaching 5.8%. What’s more, more than half of those workers had reported that their weekly hours had been cut by at least five hours.

Uncle Sam to The Rescue?

It’s not all gloom-and-doom on the hiring front, however.

The government’s $787 billion stimulus package is slowly working its way through the federal bureaucracy to local government coffers with promises to create or save more than 3 million jobs over the next two years.

And on Monday, President Barack Obama announced 10 projects aimed at speeding up stimulus spending to create or save more than 600,000 jobs, Bloomberg News reported.

Calling it a “summer of accelerated Recovery Act activity,” President Obama said the effort includes new services at health centers in all 50 states; work in 107 national parks, airport improvements, and highway construction.  They will also provide funding for schools to hire more teachers.

In the first three months of the Obama administration’s stimulus plan, the government doled out about 11% of the stimulus funds, according to a progress report released by Vice President Joe Biden’s office on May 13.

The report said that most programs and projects were running ahead of schedule and under budget and 70% of the funds will be allocated in the next fiscal year – enough to make a major impact, even though it’s less than the 75% allocation promised by the White House.

Of course, there’s a great deal of political debate over how effective the stimulus program will be.

U.S. Rep. John A. Boehner, R-Ohio, and the House Republican leader, said last week the stimulus “isn’t producing jobs immediately, as the administration promised.”

And Money Morning’s Hutchinson says the net long-term effects of the stimulus program may be a wash for taxpayers and businesses anyway.

“U.S. businesses and consumers will be paying for all this anyway with higher taxes and interest rates,” Hutchinson said. “Any job creation from that will be neutral for the economy.”

In late October, investors in The Brink’s Company (BCO) received a spinoff of the company’s home security division.  The new stock listed as Brink’s Home Security Holdings, Inc. (CFL) has performed very well over the last 8 months, rallying as much as 50% above the closing price on its first day of trading.  The transaction was designed to unlock the value of the home based business which may have been overlooked due to the larger secured transportation and cash logistics side of the parent company.

It is a bit baffling how well this strategy worked.  Investors in BCO received one share of the new CFL for every share of the parent company they owned.  And now 8 months later both stocks are well above their levels from when the spinoff occurred.  Now both companies are certainly strong firms with positive cash flow and a well respected brand name.  But economic weakness which has pressured growth rates does not appear to be showing up in the stock price.

For Brink’s Home, this is especially confusing since the company relies heavily on consumers and to a lesser degree on new construction for its future revenue growth.  During the first quarter revenue came in just a bit higher than last year at $136 million.  Adjusted Earnings were $0.40 per share, a sharp 43% increase over the first quarter 2008.  A good bit of this increase in profitability was due to the fact that the division did not have to pay hardly any royalty to the parent company.  This type of earnings growth is nice, but not necessarily repeatable since next year there will be little comparable difference in the royalty payment.

Management noted that growth is being pressured by a weak economy in general, and specifically the portion of the business that protects new construction is slow.  It’s hard to imagine this business line getting much better in the near future with the likelihood of rising interest rates, a deeply entrenched consumer, and employment continuing to be weak.  Logically, it seems that home security could be an opportunity for some consumers to cut back on expenses and lower expenses.  This may be to blame for the fact that net new subscribers were lower than the growth seen in previous quarters.

CFL looks especially vulnerable after a failed breakout attempt last week.  The $30 level has proven to be resistance twice now, and a weakening market picture could take the wind out of optimistic investor’s sails.  The stock is currently trading at 22 times expectations for this year, and earnings are actually expected to decline in 2010.  It’s very hard to justify a growth multiple on this company if growth turns out to be non-existent.

Brink’s Home currently has no debt and adequate cash on hand to fund its capital expenditures.  The company will spend a good bit of marketing costs in the third quarter as it launches a new brand image.  It will be very interesting to see if a new campaign can jump-start growth even during a difficult economic environment.  If the stock market begins to decline again and home values do not pick up, it is unlikely that consumers will be easily convinced to spend more on security systems.

It wouldn’t surprise me to see analysts set a stock target for this stable company at $14.75 or so.  That would represent a multiple of 12 on future earnings of $1.23.  While it sounds a bit pessimistic to expect a 50% drop in the stock, I don’t see why investors would currently pay 22 times earnings for this company.  My recommendation would be to consider opportunities to short this highly priced stock while keeping a tight stop just a bit above $30.

FD: Author does not have a position in CFL

My friend and colleague Adam Lass wrote a great piece for Taipan Daily last week.  Adam is one of the two brains behind Wavestrength Options Weekly (or WOW as we call it) – an options trading service which relies both on fundamental reasoning and chart reading to determine attractive opportunities and the correct timing.

I enjoy Adam’s witty observations and hope you will as well…

Investors in Green Mountain Coffee Roasters Inc. (GMCR) are waking up to an unfamiliar stock price today.  For the second time in 2 years, the stock has split – this time investors are receiving 3 shares for every 2 shares previously owned.  The move causes no economic change for shareholders, but does potentially make the stock more attractive to individual investors who may shy away from buying a stock priced at more than $90 per share.

GMCR has seen its stock price appreciate more than 300% over the last year as investors cheer the robust growth in the midst of one of the deepest recessions in history.  The growth in revenues and earnings is certainly impressive as consumer spending drops, but not nearly as impressive as the appreciation in the stock price.  Based on expectations for 2009, the stock is now valued at more than 60 times earnings – quite a hefty multiple for a consumer driven niche coffee company.

Now I understand that Green Mountain currently tops the Investor’s Business Daily 100 list and has been a main staple in this elite group for several months running.  I find this list to be very helpful in finding growth companies with excellent track records and more than once I have found opportunities that have offered chances to double or triple my investment.  However, the list is also an excellent source for finding potential short opportunities because of the fact that optimism can often drive stock prices to unsustainable levels.

The current optimism in Green Mountain stems from the many distribution deals the company has signed over the last few months.  Most importantly was an agreement with Wal-Mart which puts the company’s products in more than 3,000 locations – a move which is certain to drive sales in coming quarters.  On a smaller scale, the company has also signed agreements with Cuisinart and Conair.  Coffee is distributed using the Green Mountain brand as well as under the Newmans Own and Tully’s brands.

Analysts are currently projecting earnings for 2009 to reach $1.52 per share (pre-split) plus an additional 40% in 2010 to a level of $2.13 per share.  If you take the stock split into account, the expectations move to $1.01 in 2009 and $1.42 in 2010.  This type of growth rate is very impressive and partially justifies the high price for the stock.  Despite the fact that this coffee trend may be a “fad” approach, it is difficult to argue with the success in terms of both sales and earnings.

However, looking at the balance sheet, Green Mountain has accumulated a significant amount of debt in order to finance its growth.  Currently long-term debt sits at $118.7 million after the acquisition of Tully’s brand.  The company has also increased its guidance for capital expenditures in the coming year which will likely lead to higher debt levels. The majority of the company’s current assets are in the form of accounts receivable and inventories with very little in cash.

Now it is unlikely that debt will be a significant issue for the company due to the robust sales levels and positive cash flow.  But the leverage adds a degree of risk which could cause investors concern if we enter another stretch where liquidity is an issue.

Over the next few quarters I expect analysts to begin to develop longer-term forecasts, guiding investors to view the 5 to 7 year growth rate near 25%.  After all, it’s going to be tough to find an encore to the Wal-Mart deal.  Looking at the stock price, I would think investors would eventually look at a 25 multiple as being reasonable – and if applied to the 2010 estimate of $1.42 per share, this would yield a stock prece near $35.50.  At this point investors have raised the price on nothing but good news and it will be interesting to see how they react to anything that could be considered less than optimal.

Shorting runaway stocks can be dangerous and anyone who shorted outright when ZachStocks offered a cautionary note back in April is definitely under water right now.  One way to benefit from a potential decline would be to buy puts on the stock.  While these contracts are a bit expensive due to the volatility of the stock, this type of approach allows a trader to cap his risk while still participating in the downside.  If GMCR begins to drop it could move very quickly because of the fickle nature of the current investor base.  For those long, I would urge caution and recommend at least hedging the position by selling calls or buying protective puts.

FD: Author has a short position in GMCR

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It’s finally beginning to happen…  After spending the last three months mounting some of the most impressive single stock rallies seen in decades, a few retail stocks are beginning to roll.  And that roll could lead to some impressive profits for ZachStocks traders willing to take the unpopular side of the upcoming trend.

The Rise and Fall of Retail Stocks

Much of the recent rally in retail stocks stemms from the bargain basement prices many of these stocks started out with early this spring.  As investors fretted over the “end of the economy as we know it,” stocks of all colors shapes and sizes were liquidated at just about any price.  This mass selling actually set the table for a sharp rebound in many sectors once the situation began to stabilize.

Rallies from the march lows were not necessarily based upon the fact that “things were getting better” as much as a relief from investors that the financial system did not completely fall apart.  As the economic picture continued to function (although one could certainly argue that we are limping along instead of making strong strides), opportunistic investors began to search for good values among the wreckage of retail stocks.

These stocks were not too hard to find as there are plenty of companies that continue to operate profitably despite reduced growth estimates and a generally weak consumer.  As these bargains were picked up by investors in March and April, the buying soon resembled a feedback loop where strength in the names reinforced investor confidence and drove further buying.  But while buyers in March had legitimate fundamental valuation on their side, buyers in many names today seem to be simply piling on to the momentum with little regard for valuation.

Fundamental Spending Changes

It is abundantly clear that all retail stocks rely on consumer spending to varying degrees.  While different types of consumers frequent different classes of retail companies, the bottom line is that all are dependant on at least one subset of the population to take out the checkbook or credit card in order to make purchases.

Unfortunately at this point it is becoming harder and harder to find those consumers with the ability or willingness to make the same level of purchases seen earlier in this decade.  There used to be a relatively sound argument that the high end retail stores would survive a recession due to the fact that the rich always have cash to spend.  However, the current recession has been difficult for all classes of spenders as evidenced by layoffs from Manhattan to Detroit.  In fact, it now appears that retail companies catering to the affluent are in more dire straits as the wealthy clients “trade down” to more modest clothing, restaurant, or leisure offerings while lower-end customers are simply learning to do without some purchase that normally would not be considered discretionary.

Recently, an economic report came out showing that while personal income had begun to tick just a bit higher, consumers spending continued to decline.  The result was an increase in the savings rate and we are likely seeing only the beginning of this trend.

For years consumers had many choices when it came to funding purchases.  Credit cards sere usually the liquidity option of choice as teaser rates and high available balances made spending painless and easy.  Even consumers who borrowed above their means were usually bailed out by the ability to refinance their house pulling equity out to reset the system and begin accumulating credit card debt again.

However, now that many of these channels are no longer available, consumers are first of all forced to stop spending beyond their means.  This trend is easy to understand and accepted by most thoughtful investors.  However, a less visible trend will be for consumers who no longer have access to a “safety net” of home equity or available revolving credit to begin building emergency funds in the form of savings accounts, CDs or other short term deposit instruments.  The result will likely be that even if employment begins to turn higher (which has not happened yet), the level of spending will remain low.  That’s not good news for an economy that has typically relied heavily on consumers for growth.

Investments Poised to Fall

The positive feedback loop we mentioned earlier is now in danger of stalling.  Friday we received an employment report which was supposed to be “good news” in that it was less dire than economists had been expecting.  The market gapped higher initially but failed to hold any of its gains into the closing hour.  Overbought markets failing to rally on good news (especially on Fridays) can often spell doom for a positive trend.

Not all retail names are vulnerable at this point, but there are several relatively high-priced stocks which should decline and offer sharp gains for traders who are willing to step against popular opinion, and who have the ability to time their trades correctly.

Tiffany & Co. (TIF) has seen declining earnings the last two quarters as sales have dropped by more than 20% on average.  The weakness was primarily due to tough spending in the North America region.  The company is seeing inventory levels increase which could spell trouble down the road.  Expensive inventory sitting idle while the company manages a high debt level is certainly not a recepie for success.

Chipotle Mexica Grill (CMG) has climbed significantly while sales growth has actually been stalling.  The stock holds a growth stock multiple but at the same time that growth is being called into question.  If inflation becomes an issue in future quarters, it could sharply compress multiples and the multiple on the stock would also see weakness.

Green Mountain Coffee Roasters Inc. (GMCR) has bucked the trend so far but may be running out of steam.  The specialty coffee retailer is trading at more than 60 times this year’s earnings and while growth is expected to be positive in the years to come, that multiple leaves investors vulnerable to any disappointing news.

There are plenty of other names which could be vulnerable to an upcoming decline in retail stocks.  One of the most important issues to look at is whether the stock is trading at a high multiple relative to the expected growth.  A more difficult but equally important measure would be to determine whether growth expectations are truly legitimate or not given the macro picture for consumer spending.  When a good target has been identified, timing is important as the stock should begin trading lower and the broader market should be following a similar trend.  Shorting stocks in this market can certainly be risky but the potential returns are quite attractive.

FD: Author has a short position in GMCR

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The Middleby Corporation (MIDD) is another company tied to the retail sector which has seen its stock improve significantly over the past few months.  In March investors were panicking and selling stock as fast as they could pushing the price to a low of $20.45.  Since that time the stock has rebounded to reach a high of $50 – nearly a 150% return in a few short months.  That’s quite an incredible gain for a boring company which makes ovens for restaurants and food processing customers. 

Despite the sharp rise in the stock, earnings for the current year are actually expected to come in below last year’s levels with an expected EPS of $3.40.  While operating profitably in this market is certainly positive for any company, the stock currently trades at nearly 14 times earnings which is a bit rich for this company which has limited growth capabilities.

One metric that investors may have been excited about is the latest sales figures for the first quarter.  Middleby actually saw its sales increase by 13% to a total of $181.5 million which initially looks fairly bullish.  However, the sales increase was largely due to an acquisition of TurboChef.  So essentially Middleby paid $116.1 million in cash, plus another $45 million in stock in order to generate that bit of additional revenue.

Acquistitions can certainly be beneficial especially during difficult economic times because the purchasers are often able to get a good deal for the company they purchase.  However, Middleby is making what I consider to be a fairly risky bet by financing this acquisition with a significant amount of debt.  At the end of the quarter the company had total debt of $346 million which is well above the book value of $284 million.  This leaves Middleby in a heavily leveraged position which certainly implies risk.

During the early part of the second quarter Middleby made an additional two acquisitions and while they are not on the same grand scale as TurboChef, they still required more debt financing to complete.  Currently the company is drawing on a revolving credit line in order to fund the purchases.  This credit line has a variable rate which has been helpful for the company in the current era of low rates, but could prove to be challenging if the prevaling interest rates begin to rise.  There is plenty of economic evidence that rates are ticking higher – a trend which could crip profitability for Middleby in future quarters.

This credit line actually has an issue more concerning than the variable rate.  The entire line actually matures in December of 2012 – a bit over three years away.  While three years may seem like an eternity, the economic recovery is expected to take some time and will not likely be very robust in the early stages.  If we get a few quarters farther down the road and financing for companies like Middleby is not readily available, institutional investors could become uncomfortable with this debt level and begin to pair back or liquidate positions.  The result could be a sharply lower stock price.

Middleby stock recently broke out of a consolidation just below $50.  That breakout is now in question as the stock moves lower with this weak market.  Investors who bought on this new high are more likely to get cold feet than investors who bought earlier this spring.  While stocks must follow economic and fundamental measures over the long-term, patterns like a false breakout can often drive sharp short-term moves and give traders an opportunity for quick profits.

I would recommend traders who are uncomfortable with the current retail environment to consider MIDD as an attractive short opportunity.  The stock could easily trade back to the $30 area where it was consolidating before the fear began at the beginning of this year.  A tight stop above $50 would help to cut risk in this short position.  The company does not pay a dividend which likely makes it even more vulnerable to a drop as value investors usually prefer to be paid a yield while they wait for the stock to move in their favor.  In short, the picture looks risky and I would advise against investing in the name right now.

FD: Author does not have a position in MIDD

Keith Fitz-Gerald is the editor for the Geiger Index trading service.

Five Wall Street Whoppers And Why You Need To Know Them

By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report

If you’re like many investors, you are probably sitting on the sidelines right now, unsure of what to do. If you want to buy, you may be thinking “let’s wait a little longer.” If you want to sell, you might be concerned about “missing out.”

 

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Either way (and even if you don’t plan on making either move anytime soon), having a sense of what got us here can keep you from repeating the same mistakes and even help you make smarter financial decisions – particularly when it comes to repairing your portfolio and even growing it in the years ahead.

When it comes to understanding exactly “what got us here,” I find it helpful to review some of the key bits of advice that Wall Street kept pitching to retail investors, a series of widely accepted investment adages that somehow became gospel and that I refer to as “Wall Street’s Biggest Whoppers.”

Let’s take a couple of minutes to look at the Big Five – the five worst offenders from a list that I assure you is actually quite a bit longer:

Wall Street Whopper No. 1: Buy and Hold - It was supposed be a simple proposition. Consistently put money to work in the markets, let it ride – and laugh all the way to the bank. The thinking was that you couldn’t go wrong because the markets would go up 10% to 12% a year – each and every year (It’s actually more like 4% to 6% – on average – but that’s another story for another time.

What’s important to understand is that “Buy and Hope” is the greatest myth foisted upon the American public in the last 200 years – the need for American International Group Inc.’s (AIG) retention bonuses, notwithstanding. As millions of investors have found out the hard way, the markets can – and do – frequently go through tremendous periods of readjustment.

This means that timing, as they say, really is everything. And “they” – the brokerage firms, hedge funds, ratings agencies and others that together make up “Wall Street” – don’t want you to know that. Wall Street wants you all the way into the game all the time. It doesn’t care whether you win or lose, just as long as you keep playing. So the collective “they” work together to pitch you whatever’s hot, and then move on when that investment has run its course.

And don’t even get me started about the conflicts of interest. The supposedly independent ratings agencies that rubber stamped everything from derivatives to high-grade debt have been in bed with the companies they’re supposed to be regulating for years. Consequently, millions of investors thought they had the “green light” to invest in supposedly safe institutions that have proven to be anything but during the past 24 months.

Where the rubber meets the road – especially during the down years like we’re living through now – is that the risks of outliving your money go up dramatically if you have to get out. In fact, if you achieve annualized returns of zero or less for the first five years after you retire, your odds of running out of money in the next 30 years more than double from 26% to 57%, a study from T. Rowe Price Group Inc. (TROW) reported recently.

And that’s proving to be a tough reality for millions of investors who thought they had this handled. Which is why I was not surprised to see data from the Employee Benefit Research Institute quoted in Money Magazine showing that more than 30% of near-retirees, or those in the early years of their retirement, had more than 80% of their money invested in stocks at the onset of this crisis.

Many of those investors have undoubtedly sold off assets to finance living expenses while waiting for the market to reverse. And that’s created a “double whammy” of sorts: Not only did they lose money on the way down; but those losses and the subsequent forced sales could well mean that their portfolios won’t be big enough to benefit from the next upturn when it does arrive.

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What to Do Now: As I have long espoused, the notion of being able to take on more risk simply because you have more time isn’t what it’s cracked up to be. Instead, it is far more appropriate to make choices based on the certainty of returns, especially now.

And that should start with how you think about dividends and reinvestment. In short: Boring never looked so good. Data from Wharton’s Jeremy Siegel and Yale’s Robert J. Shiller - not to mention from my own research - shows that dividends and reinvestment can be far more stable contributors to overall wealth creation than capital appreciation.

Looking ahead in uncertain times, the best choices remain those businesses with solid management, plenty of free cash flow, and an increasing dividends that are backed up by unstoppable global trends. Not overpaid, arrogant Wall Street executives who engineer risk under the guise of safer returns.

There are still plenty of choices available if you do your homework. And it’s not too late to begin buying them selectively right now. In fact, as I wrote recently, history suggests we’re nearing a once in a lifetime buying opportunity so the odds of an upside move could arguably outweigh additional downside…even if you don’t quite get the bottom right.

Wall Street Whopper No. 2:  Some Debt is Good (aka: The Careful use of Debt is an Appropriate Wealth-Building Tool) - This is one of Wall Street’s biggest and most dangerous whoppers, and yet I almost hesitate to include it because of the e-mail I know it’s going to generate. But at the risk of sounding like a broken record, if you owe somebody money, you’ve still got to pay it off one day. That means any growth you attribute to debt until it’s paid off in full exists only in fantasyland. Ask General Motors Corp. (GM), Lehman Brothers Holdings Inc. (OTC: LEHMQ), or any one of the dozens of world banks that are now coping with the aftereffects of growth through the supposedly “intelligent” use of debt.

And this is just as true on a personal level as it is on a professional and governmental level. I wish our leaders understood this, although – in their defense – they finally seem to be getting the picture in recent weeks. Better late than never, although I would just as soon not have seen millions of investors taken on a white-knuckle ride to begin with.

Perhaps the saddest thing of all – and one of the most important lessons we can learn – is that the lessons we grew up with no longer seem to apply. We were taught that if we worked hard and acted responsibly, we would flourish. But now, even if we were responsible, we’re finding out that we’re now liable for the “other” guys’ debts, too.

What To Do Now: From an investing standpoint, confine your choices to those companies with little or no debt. Steer clear of the ones that are on the U.S. Federal Reserve’s IV drip. Yes, those companies probably have upside, but the real test will be what happens when they are forced to wean themselves off their Fed-administered drugs and operate without the crutch of government financing. History suggests that many will fail – despite the government’s unprecedented efforts to save them.

On a personal note, borrow conservatively and only if you have to. Pay off your credit cards each month or shift to a cash-only, “pay-as-you-go” spending plan if you can’t keep that spending under control. Refinance your house before interest rates begin rising dramatically to cope with the almost-certain after-effects of current stimulus spending. And by all means make sure that whatever debt you take on is debt you can afford to pay off.

Wall Street Whopper No. 3: It Pays to Diversify - The conventional wisdom used to be that if you spread your money around, you’d somehow be safer. This is no more effective than rearranging the deck chairs on the Titanic. It’s better to get off the boat.

In uncertain times, it’s how you concentrate your money that matters. This is an important adjunct to “investing with certainty in uncertain times,” and I’ve long advocated the benefits of stability and consistency as a means of getting ahead of the game – and staying there.

The proprietary 50/40/10 (Base Builders/Global Growth & Income/Rocket Riders) portfolio structure we utilize in our monthly newsletter, The Money Map Report, is a terrific example of what I mean. Not only does this portfolio strategy instill a discipline that forces investors to adhere to a “safety-first” philosophy, it has also proved itself to be far more stable than the broader markets since the credit crisis began. It kicks off higher-than-average income, demonstrates lower-than-average volatility – and still generates all the upside you can handle.

This safety-first discipline, with its dual emphasis on high current income and long-term appreciation, has generated some truly impressive returns.

And t his brings me to a key point: Far too many investors don’t understand how the game must be played right now. They think that investing in rocky times is an all-or-nothing equation.

It’s not.

Instead, it’s about the continual adjustment of positions to reflect changing assumptions related to risk – especially now that the risks of stock ownership have changed.

What To Do Now: In an era of simultaneous collapse, when then stock, bond, housing and credit markets have cratered at the same time, there’s simply no excuse for not hedging your portfolio at all times, not just when it’s popular to do so. Nor is there any reason why you shouldn’t be thinking safety first. That way you have the freedom to screw up on speculative bets instead of being dependent upon them to regain what you lost on foolish moves made during the downturn.

And by all means, learn how to use any of half a dozen specialized tools – like inverse funds, or options – to make low-risk, but-often-spectacularly-profitable choices, even under current market conditions. That way you can plan for the worst , yet still obtain the best of what’s out there.

Wall Street Whopper No. 4: Your Home is an Investment - No, it’s not. At best, it’s a roof over your head that keeps you from being priced out of the local rental markets. At worst, it’s a money pit that provides you with the illusion that you’re doing something sensible with your hard-earned money – despite the fact that an entire industry would have you believe otherwise.

Research from Shiller, the Yale economist, shows that, since 1900, home prices have run sideways or even declined for long periods of time. That means that – except for two steep run-ups – one after WWII and the other as part of the late 1990s lending binge – real estate hasn’t been the winning investment everyone claims it to be. And millions of people are learning the hard way that real estate can, and does, lose value. Seems they’ve conveniently forgotten the lessons Texans in the oil patch learned in the early 1980s or that Japan experienced in the 1990s.

Wall Street Whopper No. 5: Shop ’till You Drop and Save the Economy - The U.S. government wants you to spend money. And Wall Street, together with the credit card companies, want you to save their sorry hides by helping you do just that. That’s why so much of the stimulus planning – if you can call it that – revolves around tax cuts and handouts. It’s all window dressing.

Nothing – and I mean nothing – will matter until the banks start lending again.

Period.

What To Do Now: Keep your powder dry. History shows that the ebb and flow of money has never been smooth. Ever.

So to talk as if what’s happening now is an enigma is to ignore the past. We’ve been here before. There was the Panic of 1873 (sometimes calledthe “real” Great Depression), the Great Financial Crisis of 1914, and the B anking C risis of 1931, for example. The reason what we’re living through now feels different now is that those events are simply beyond the living memory all but a precious few people.

But take heart, for there are some bright spots to look to.

America’s safe-haven mantra – misguided though our policies may be – is an important indicator that savvy investors should plan for an eventual rebound – even if we’re destined to test new lows in the months ahead, and even if we have to look outside our own borders as a part of that process.