A look at America’s largest book sellers will reveal some stark contrasts. On one hand we have Barnes & Noble (BKS), the steady and familiar “brick and mortar” bookstore and on the other there is Amazon (AMZN), the popular internet retailer. Looking at these two companies and their stock prices brings you back to the heady days of 1999, when companies were neatly divided into “old economy” and “new economy” companies and the latter were given absurd valuations in the stock market. Now, ten years later, Amazon’s stock price has reached new all-time highs and Barnes & Noble is trading near the low end of its range for 1999.

In reality, many things have changed in the last decade. Companies are no longer worth hundreds of millions — or even billions — of dollars by virtue of a dreamy business plan and references to the internet in their names. Amazon is one of a handful of companies that has lived up to its hype of the dot com boom. It has consistently grown revenues well in excess of 20% per year and has been profitable every year since 2003.

However, when comparing these two distant relatives it seems that their valuations have drifted too far apart. Care to guess what the ratio of their market capitalizations to one another is? The answer is 56:1 in Amazon’s favor. That would be understandable if Barnes & Noble were in a situation like its smaller competitor Borders Group, which is headed for a fourth straight year of losses and whose survival is in question. But that is not the case with B&N. Barnes & Noble has remained profitable throughout the downturn, although revenue and EPS in the last twelve months are off 7.5% and 41% from their respective peaks in 2007 and 2006. Considering that the company’s trailing P/E ratio is around 13, the market consensus would indicate that the decline of Barnes & Noble is secular rather than just cyclical.

As for the digitization of books, this is by many perceived as an opportunity for Amazon and a threat to B&N. It is premature to declare a winner in this battle. EBooks should cut into physical book sales at Amazon just as much as at B&N, and the latter is coming out with an eBook reader, nook, which is by many accounts superior to the Kindle from Amazon. This new reader is coming out just in time for the holiday season and will have the advantage of being on display in stores where shoppers can handle the product, as opposed to seeing a picture of the Kindle on Amazon’s web site.

Other potential positives for B&N include its purchase of Barnes & Noble College Booksellers (which was previously a separate privately held company) at the end of September. While the acquisition will have a negative impact on earnings in fiscal 2010 (the fiscal year ends in April), the college bookstore business is stable with some growth potential. Additionally, if Borders Group were to go under, an event whose odds I am not in a position to estimate, B&N would most likely be the largest benefactor.

The Tyranny of high P/Es

If Amazon and B&N had similar valuation ratios, there would be no question that Amazon would be my preferred investment. However, the valuation ratios differ widely. To give its investors a satisfactory return on their investment, Amazon will have to keep growing rapidly for a long time.

As a little thought exercise, let’s assume Amazon earns 2 dollars per share in 2009 and grows sales 25% every year while maintaining a constant profit margin. Further let’s factor in a required rate of return of 11% per year (not a very high rate considering the risk). In 2019, annual sales will have grown to 238 billion dollars and earnings to 18.6 dollars per share. Amazon’s stock price will be 340 and after all this, the P/E ratio will still be over 18.

Let’s think about what this means. Amazon has been an incredible success story over the last fifteen years. It is now a household name and the largest online retailer. Is it likely that sales will grow from 22 billion to 238 billion in the next ten years? Given how Amazon is already beginning to butt heads with the likes of Wal-Mart and Target, the price wars are moving from books to DVDs, you can imagine how hard and successfully Amazon will have to fight to reach that level of sales. My example is simplistic for illustrative purposes. Amazon could for instance start paying dividends instead of reinvesting all its cash flow. But the fact is that Amazon is in a low margin business and unless it can grow sales to 200 billion or so by 2019, its current P/E of 70 is not justified.

It is dangerous to short stocks on valuations alone as they can always go from unreasonable to more unreasonable, but it is worth remembering that ultimately prices are determined by fundamentals and not the other way around.

Disclosure: Long position in BKS and short position in AMZN.

The stock market’s rebound from the lows of March has been amazingly strong and is beginning to make many wonder whether stocks have become overvalued again. Without doubt, the lack of desirable alternatives to stocks continues to fuel the rally. Stocks may no longer be such a bargain, but with cash yielding nothing and 10-year treasury bonds yielding 3.4%, what are the options?

For those who are not eager to accept the low yields offered by cash and bonds and are nervous about enduring the volatility of the stock market, I propose an alternative: selling call options against stock holdings (also known as writing covered calls). This strategy generates income and reduces the risk of the portfolio, while giving up some of the upside of holding stocks. I consider this a particularly attractive strategy for those who are retired or near retirement and need to derive an income from their investment portfolio. As stocks are called away (when their price is higher than the strike price at expiration) the equity part of the portfolio is reduced and stocks are sold at prices that have been determined to be acceptable.

Following are the 12 largest companies in the S&P 500 by market capitalization, all of which are widely held stocks. In each case calculations are based on call options expiring in January 2011 with a strike price ranging from 5-20% higher than Thursday’s closing price. “Return if exercised” does not include dividends, which in some cases can be significant, especially when compared to current bond yields.

In spite of a bleak outlook for consumer spending, many retailers have seen their stocks explode upward in recent months. Some of this can be attributed to a reversal of the excessive pessimism around the March lows in the market, but the price action in recent weeks suggests that some investors (who may have missed the rally) are indiscrimininately getting into the market and that heavily shorted stocks are rising due to short covering. A stock that exemplifies this is Dillard’s Inc. (DDS), which is a regional apparel and home furnishing retailer.

Declining sales and lacklustre earnings

Dillard’s did not need a major recession to experience declining sales. In fact, sales contracted more than 10% between 2000 and 2007. Since then, the decline has accelerated. Sales were down 5.5% in fiscal year 2008 and down 16% in the quarter ended May 2, 2009 (same store sales were down 13%). The most recent data is sales for July, during which Dillard’s sales declined 15% compared to July last year (same store sales declined 12%).

The story isn’t any better if we look at the earnings. In the last ten years, Dillard’s cumulative earnings per share amount to a measly $1.16, or less than 12 cents per share in an average year.

Rigor mortis

The one positive point is that Dillard’s managed to have positive net income ($0.10) per share in the most recent quarter, which is an impressive turnaround, given the ongoing sales decline and considering that the loss for 2008 was $3.25 per share. This was achieved through cost cuts and by drastically reducing inventory. While management should get credit for doing what it can in a difficult environment, the outlook for Dillard’s in coming years seems to indicate further sales contraction. Considering the fundamental change that consumer spending is undergoing and the lack of differentiation Dillard’s has from its competitors, it is hard to see how the next ten years will be better than the last ten.

At first glance, Dillard’s seems cheap by one measure: Price/Book, which currently is around 0.4. However, realizing this book value will not be easy. Most of Dillard’s assets consist of inventory (29%) and the stores themselves (property and equipment accounts for 63% of assets). Most of Dillard´s stores are located in suburban shopping malls. The decline of shopping malls is well documented. It is hard to imagine Dillard’s assets being realized near book value anytime soon.

Source of financial statement information: Gridstone Research.

Disclosure: Short DDS call options at time of writing.

The president’s weekly address from August 1 contained the following statement:

“Now, I realize that none of this is much comfort for Americans who are still out of work or struggling to make ends meet.  And when we receive our monthly job report next week, it is likely to show that we are continuing to lose far too many jobs in this country.  As far as I’m concerned, we will not have a recovery as long as we keep losing jobs.  And I won’t rest until every American who wants a job can find one.”

Apparently, the president is aiming for 0% unemployment. This absurdly unrealistic goal can be attributed to ignorance of economics, demagoguery or delusions of grandeur. Whichever it is, the president’s economic advisors must have cringed.

The problem with Keynesian economics

While we can only hope that empty rhetoric is at work here, there is not much to inspire confidence in a new era of fiscal responsibility in 2010 or anytime soon. At the heart of the problem is what I consider the main flaw in Keynesian economics: it only seems to work in one direction. Politicians who seek reelection have an incentive to give their voters instant gratification. Since people do not feel the pain of fiscal deficits as immediately as they feel reductions in government benefits or a general slack in the economy, it makes political sense to roll the problems forward and let someone else deal with them. When times are good, there is rarely much talk of reducing government expenditures to cool the economy down and reduce the public debt.

Looking at recent administrations, a clear pattern emerges. The Clinton administration, while it had the decency to return a budget surplus when tax receipts were growing handily, was benefitting from one of the great stock market booms in history. The Bush administration, inheriting a popping bubble, was quick to patch up the bubble and reflate it with a little help from its friends at the Federal Reserve. In that instance, a budget surplus was not even attained during a boom. The Obama administration faces the same problem as the Bush administration did, except both the problem and the solution are on a larger scale. A continuation of this pattern can only lead to declining wealth and influence in the long run for the U.S. and other countries going down the same road. Unfortunately, there is nothing to suggest that this cycle will be broken in the coming years. For things to change, the U.S. government will most likely have to max out on its credit limit in the bond market. It is hard to live beyond your means when you can no longer borrow more money.

To be fair, it is not only politicians who have an unhealthy interest in fiscal stimuli. Some economists think that increased government spending is the solution to most problems, this 2002 article from Paul Krugman being an embarrassing case in point.

What does this mean for your portfolio?

It is not clear what this means for the stock market – it rarely is. There are two counteracting forces at work here: the first being that higher taxes and slow growth are on the horizon, which does not bode well for corporate profits and stock prices; secondly, people are increasingly realizing that cash, which has no inherent value, is not all that safe under inflationary circumstances.

The best thing an investor can do in terms of reducing risk in a portfolio might be to increase the weight of emerging market assets over the token 5-10% mark. Investors are often reluctant to invest large amounts in emerging markets due to political risk, even though it is quite easy to invest in a diversified portfolio of emerging market stocks spread out over the world. Many less developed countries have shown fiscal discipline and have significant budget and current account surpluses. As things stand, political risk in the Western world should not be overlooked.

Leveraged ETFs have gained a lot of popularity, and some scorn, in their relatively short history. They are popular because they allow retail investors to take aggressive positions without using margin or buying options. Inverse ETFs, whether they are leveraged or not, allow investors to short indices without a margin account. These funds are disliked because they do not accomplish what some might expect them to, which is to double the returns of the underlying index over an unspecified time period.

This is not what they were designed to do, as a visit to a website for a leveraged fund will quickly reveal. What they do is double (or in some cases now, triple) the return of the underlying index on a daily basis. The arithmetic behind this is simple. Let‘s say the underlying index drops by 20% one day. To reach breakeven in the following day, it will have to rise 25%. The leveraged fund, however, will go down 40% on the first day and up 50% on the second day, leaving it at 90% of its original level. The numbers are unrealistic, but this is the kind of erosion you can expect over a long period of time. These funds accomplish their stated goal of tracking daily movements pretty well, although not perfectly. I agree with David Fry, that people should familiarize themselves with what they invest in and stop the whining. These funds can be used to catch strong short term moves, but are much less suitable for long-term investing.

The S&P 500 vs. its leveraged and inverse leveraged funds

Let‘s look at how two of the most popular leveraged funds, SSO (2X leveraged S&P 500) and SDS (2X short S&P 500), have fared since July 13, 2006, when SDS first started trading. Since then, the S&P 500 is down 26%, SSO is down 58.1%, and SDS is down 3.4%. The fact that SDS is down over the entire period, while the underlying index is down more than a quarter underlines how hard it is to make money on long term positions in these funds. Over shorter periods, as witnessed by the performance of SDS from September 2008 – March 2009, leveraged funds can be spectacularly successful.

Selling bear call spreads on the leveraged funds

As we have seen, for leveraged funds to do well over long periods of time, they need a sustained trend in one direction. I, for one, do not have much faith in such a trend in the next couple of years. Instead, I am expecting range-bound trading with occasional sharp moves up and down. For that reason, I think it is unlikely that either SSO or SDS is going to be much higher a half a year from now than it is currently. In an effort to capitalize on this belief, I intend to trade bear call spreads on both the SSO and SDS. That entails selling near the money calls and selling deep out of the money calls to limit the downside. As I am somewhat pessimistic about the market‘s outlook, I would sell calls deeper out of the money for SDS than for SSO.  As an example, I will take a bear call spread with expiration on December 18, 2009. At the end of today, SSO is trading at 24.16:

Sell a call option with a strike price of $26 for $2.9 per share.
Buy a call option with a strike price of $35 for $0.65 per share.

The net credit for this trade is $2.25 per share and the breakeven is $28.25 on the SSO, 16.9% higher than it is currently. Maximum loss for the trade is (35-26) – 2.25 = $6.75 per share.

You can do this for both SSO and SDS and be almost certain that you will make a profit on one of the trades, have a decent chance of making a profit on both, and have a limited downside. If you think there is a high probability of a strong, sustained move in one direction in this time period, this is not the trade for you.

Disclosure: No position in the securities mentioned in this article.

On July 30 of last year, I recommended taking a long position in the market as I considered it oversold on a short-term basis (using the CRB Stock Market Momentum Indicator) and was anticipating a bear market rally. As it turned out, the market was just in the beginning stages of a massive collapse and the trade turned out to be a miserable one. A closing signal for this trade finally came after the close on June 17. During the 323 days the trade lasted, the S&P 500 fell 27.4%. A graph with entry and exit points for this trade is shown below as well as a table with historical results from this momentum trading strategy.

Time to play defense

We now have two consecutive unprofitable signals. To keep that in context, these signals have come during what has been one of the most vicious bear markets in the last hundred years. I have not lost faith in the usefulness of this momentum indicator as a timing tool, but to avoid blunders of this magnitude in the future I will be using a stop-loss rule for the trade. Furthermore, given the current overbought conditions, I think this is a good time to close some long positions or perhaps sell near-the- money call options on existing long positions with expiration anywhere between July and October.

With all the ranting going on everywhere these days, I feel entitled to indulge in a rant of my own. My beef is with people who are unwilling to take responsibility for their actions. I will use as an example Jon Stewart’s public flogging of Jim Cramer about a month ago. Stewart is in the habit of engaging in serious discussions while hiding behind the cover of being a comedian. It would be just as ineffective if someone serious, such as Larry Summers or Alan Greenspan, were doing stand-up comedy while regularly reminding the audience that he is an economist and should therefore not be expected to be funny.

First of all, the notion that the financial media could somehow have saved people from big investment losses in this bear market is ridiculous. Let’s say Jim Cramer and his colleagues had been more prescient and warned retail investors about the fragile balance sheets of financial institution and impending market collapse – all that would have accomplished is to speed up the decline. Someone is inevitably left holding the bag. Besides, if Cramer’s crazy antics are not disclaimer enough about the seriousness of his show, I don’t know what would be.

Who is to blame?

But what I took the greatest issue with was the notion that somehow Jim Cramer or the financial media is responsible for people’s retirement savings. Stewart brought his 75 year-old mother into the discussion and said that she had bought into the idea of long-term investing, suggesting it was obviously a bad idea. As I don’t know much about Stewart’s mother’s situation, I will use an average 75 year-old as an example instead. This person might be expected to have started saving in the early 1960s when the S&P 500 index was around 60. The individual would have enjoyed an enormous bull market in the 1980s and 90s. With age, exposure to equities would be gradually reduced and retirement at age 65 would have come at a good time in 1999 – almost at the very top of the market. What better time to start drawing down on one’s savings? What is more, a person of that age has lived through another sharp bear market (’73-’74) and does not need to be an expert in financial market history to know that occasionally stock prices fall a lot. To make such a person look like a victim suggests that stock markets should be able to give predictable 10-15% returns, a dangerous idea in itself. The alternative is simply that the person did not save enough for retirement.

That is not to say that I am blind to the flaws of the financial industry. It has been an unnecessarily self-serving industry in recent decades, where an army of people has reaped rewards out of proportion with their talents, contribution to society or personal risks taken. That problem appears to be taking care of itself very rapidly, however. For those interested in a good critique of the financial industry and modern business ethos in general, I recommend John C. Bogle’s recent book “Enough.”

It was lack of personal responsibility that got us into the mess we are in; let’s not make matters worse by continuing that trend.

One of the many unusual things in the financial markets these days is the relationship between the growth in the money supply and inflation expectations. At the same time, as unprecedented growth in the balance sheet of the Federal Reserve is taking place, inflation expectations, as witnessed by the narrow yield spreads between inflation indexed treasuries and regular treasuries, are extremely low.

Low inflation expectations

Inflation expectation for the coming 12 months, as measured by a University of Michigan survey of consumers, have been coming down rapidly, from 5.1% last July to 1.7% in December. Given the current weakness in the economy and falling commodity prices, it is perhaps not surprising that people are expecting low inflation in the near term (although deflation fears seem to have diminished recently).

For inflation expectations further into the future, my preferred measure is the spread between Treasury Inflation-Protected Securities (TIPS) and regular, unindexed treasuries. Currently, 5-year TIPS are yielding 1.44%, only a quarter of a percentage point lower than regular treasuries. 30- year treasuries are yielding 3.4%. Unfortunately, TIPS are no longer issued in maturities longer than 20 years, but the 20-year inflation-indexed yield of 2.5% indicates that long-term inflation expectations are quite low.

One argument I have seen against using this spread as an indication of inflation expectations is that in times of financial crisis, investors seek liquidity as well as certainty of repayment. As TIPS are less liquid than regular treasuries, a small spread may say more about a preference for liquidity rather than low expectations for inflation. I would dismiss this argument for the following reason: TIPS have only been available since 1998. The only financial crises since TIPS were first issued are the collapse of Long-Term Capital management in 1998, and arguably the stock market bust of 2001-2002. These are not enough data points to base generalizations on. Besides, trading volumes in TIPS have not remained constant during this period. In 1998 the average daily trading volume of TIPS was USD 900 million. In 2008 it was 8.7 billion, having risen every year in between. The discount on TIPS, for this reason, should be steadily diminishing.

In any case, inflation expectations appear to be low in the short-term as well as the long-term. Recent developments in the money supply make those expectations implausible.

The money supply

For those of us who agree with Milton Friedman’s statement that “inflation is always and everywhere a monetary phenomenon,” recent growth of the money supply suggests unequivocally that it is only a matter of time until inflation will start to kick in. M1 (see Wikipedia entry for further explanation of terminology) has grown by 17% in the last twelve months and almost 40% in the last three months (on an annualized basis) and M2 has grown by 9.9% and 18.4% by the same measures, respectively. However, it is not until we get to the narrowest measure of the money supply, M0 or the monetary base, that things get really crazy. From September to December of 2008 the monetary base expanded from USD 905 billion to USD 1.65 trillion. This is mostly due to banks accumulating excess reserves with the Fed, where they can earn an interest rate equal to the fed funds target rate. Of course, there is little reason for banks to lend to each other when they can more safely lend to the Fed at the same rate. This has served to more than double the Fed’s balance sheet in the last year (for a more thorough discussion of this, see this article). Given current economic conditions, it seems likely that sooner or later banks will be discouraged from hoarding their cash with the Federal Reserve (for instance by not paying interest on those reserves).

Flight to safety…but safety from what?

It is clear that aversion to risk is currently very high and risky assets are being sold in favor of those that are perceived as being safe, such as cash and treasury securities. These assets are safe, if safety is measured in terms of avoiding large, negative numbers in one’s account statement. However, the fear of losing money can quickly be replaced by the fear of money losing purchasing power. If, and I consider this scenario very likely, inflation sets in, yields on treasuries can be expected to rise quickly. The same is true for the inflation premium on TIPS. Mispricings in the markets should not be seen as intellectually irritating, but rather as a profit opportunity. In this case, shorting unindexed treasuries, buying TIPS, or both, could be appealing. This is all easy to do with ETFs. For TIPS, there is iShares Barclays TIPS Bond (TIP), which has a duration between 6.5 and 7.25 years. For shorting non-indexed treasuries, Proshares has ultrashort funds for intermediate (7- to 10-year) treasuries (PST), and for long (20+ year) treasuries (TBT). As is often the case, timing is tricky and I would advise caution with the ultrashort funds.

Disclosure: No position in securities mentioned in this post.

Recently, many people have been denouncing buy-and-hold investing. Among phrases heard: “long term investment died as a thesis” this year. Of course, these voices are featured most prominently after a huge fall in the market, when the outlook for returns from long term investments has actually improved.

The best example of this is a Business Week front-page story titled “The Death of Equities,” published in August of 1979. Then, as now, investors were weary of a long, painful bear market. The story didn’t mark an exact bottom in the market, however in the two decades that followed the S&P 500 increased more than tenfold.

Valuations finally looking good

Robert Shiller, in his perfectly timed Irrational Exuberance, (published in March 2000) made a strong case for stocks being wildly overvalued. That was a good time to question the wisdom of buying and holding stocks regardless of valuations. Shiller used a chart of P/E ratios that tracks a 10-year moving average for earnings to dampen the effect of earnings fluctuations on P/E ratios. At the time Shiller’s book was published, this adjusted P/E ratio was a record 43. This methodology of tracking the market has since been popular and is updated on Shiller’s web site.

As Shiller’s data has a lag of a couple of months, I decided to update his graph with the recent market action. By this measure, the market is cheaper than it has been since 1985. Rather than questioning stocks as viable investment vehicles, it seems to me that stocks are looking better than they have looked in over twenty years.

Earnings cycles

Many investors have raised doubts about P/E ratios as earnings have been unusually high in recent years, but now it seems clear they are destined to fall in coming years. When this happens, they say, the P/E ratio will rise again. The graph below shows earnings as a share of GDP since 1948. The earnings numbers are based on data from the Bureau of Economic Analysis (BEA), which is designed to be consistent over time and excludes capital gains and losses, for instance. We can see that corporate profits were a relatively small component of GDP in the 70s and 80s, with a fair amount of time being spent in the 6% – 8% range. Recently, corporate profits have fallen from a peak of 12.9% of GDP in the third quarter of 2006 to 10.2% in last quarter. It is not hard to imagine profits falling further. How far this fall will be is anyone’s guess, but barring a Marxist revolution or a complete breakdown of the U.S. economy, 6% seems like a reasonable floor.

An earnings history for the last sixty years (from the same BEA data set as above) shows that overall corporate profits (shown here on a logarithmic scale) are not all that volatile. Besides, the value of stocks represents claims on their future earnings into perpetuity, so one very bad year should have a limited impact on valuations.

No reason to shy away from the market

The extreme volatility that has been prevalent in the market in recent months is disconcerting for those hoping to turn a quick profit on their stock purchases, but should not cause long-term investors much alarm. As discussed above, stocks are cheaper than they have been for decades. What makes the market even more attractive now is that interest rates are low, in stark contrast to the very high rates of the 1980s. Far from being dead, the buy and hold investment approach is in good health.

As simple as “buy low, sell high” sounds, events and sentiments seem to conspire to get us to do just the opposite. Stocks are cheaper than they have been for a long time. The S&P 500 index, currently at 930 points needs to climb 18% to reach the closing price of October 30, 1998. Yet, as high as stock valuations were in 1998, people were generally very eager to buy stocks then, just as people cannot seem to get rid of stocks, or any risky assets, quickly enough now. Given the uncertainties ahead it is understandable that many investors are waiting to see clear signs of a bottom — there is nothing to keep cheap stocks from getting cheaper. However, bottoms are only visible in hindsight. For those who are fortunate enough to have some cash on the sidelines, there are some enticing opportunities for deployment.

There is no shortage of stocks that look attractive at first glance – those with low P/E ratios for instance – but at this stage in the cycle I think it is prudent to buy shares in companies with relatively little financial or operational leverage (i.e. those that can withstand some revenue declines without getting in trouble) and reasonably predictable cash flows. My plan is to start investing in the lower risk companies now and gradually buy into more cyclical companies next year as opportunities present themselves. I envision being “all in” around this time next year.

Following are a few examples of stocks with good cash position, relatively little or no debt and high dividend yields:

· Pfizer (PFE): While facing stiff competition from generics, this big pharmaceutical has a diverse portfolio of drugs and many more in its development pipeline to sustain its cash flows. With a dividend yield of 7.7% and 26 billion dollars in cash, this looks much better to me than 5-year Treasury bonds yielding 2.7%.

· Analog Devices (ADI): While this semiconductor company is not invulnerable to the looming cyclical downturn, it certainly helps to be virtually debt free and sitting on $2 billion in cash. The forward dividend yield is 4.1%.

· Chevron Corp. (CVX): Barring a prolonged weakness in commodity prices, this large, integrated oil company should perform well. With minimal debt, a strong cash position and a 4.2% forward dividend yield, Chevron is worth a consideration.

Disclosure: Author has a long position in PFE.