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2007: Look Out
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This is Edition 1 of 2007,Volume
VIII. This means it is the beginning of the ninth consecutive year of
publishing the OTC Journal, and what a journey it has been. I have
been patiently slugging it out for the past five years, hoping to return
to the kind of market we had in the 1990's.
2007 is setting up to be the best
of times and the best of times. The market is simply ready to blast off.
There are several factors leading us to what could be a great year for
the stock market- in everything from the micro cap stocks to the largest
of the large caps.
The stars are aligned for stocks
in the coming year. The environment is perfect for the first time this
decade. Here are some of the major contributing factors:
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Stabilzed energy prices- lowering
inflation expectations
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Low bond yields- making stocks more
attractive
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Strong earnings and reasonable earnings
growth amongst large cap companies
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Strong balance sheets
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low inflation
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the collapse of the speculative real
estate market, bringing aggressive investors back to the stock market
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A number of long awaited new mega
trends in technology
In fact, we are going to get something
in 2007 we haven't seen this decade: Multiple Expansion. Yes, over the
past several years stocks have, in general, done ok. However, stocks have
gone up commensurate with corporate growth. There was no multiple expansion,
meaning PE Ratios have remained extremely low and about at the same level.
For example, in 2001 the PE Ratio
on the S&P 500 for the trailing 52 weeks was about 14.5- it was 20
for the forward 52 weeks. Currently, the trailing PE for the S&P 500
is about 15- 16.1 for the forward 52 weeks. This means valuations are actually
a bit weaker at the end of 2006 vs 2001 relative to earnings.
There's a clear and easy argument
for the market to be 30% undervalued presently. If you were
to buy one share of every S&P 500 company, and save the profits and
dividends in a separate account, do you know how long it would take you
to double your money?- approximately 13.7 years.
If you were to clip every coupon
from the 30 year US Treasury at 4.6%, do you know how long it would take
to double your money? - yes, that's right- 29.6 years.
Well, you might ask how about income
property? The average income property in the US today costs 23 times rentable
income. Therefore, it would take 23 years to double your money,
or get your capital back from income property.
Averaged out over many years, the
difference between stock values and bond yields has been much closer- in
fact 30% closer. Therefore, in order for the markets to return to
equilibrium, stocks must either be 30% undervalued, or bond yields have
to go up 30%. The only factors that could push bond yields up 30% are an
overheated economy or raging inflation- neither of which seem to be in
outlook for 2007.
After surviving the Dot Com demise,
911, Enronitis, corporate scandals, rocketing energy prices, and capital
flight to real estate, the stock market is ready to return to its former
place at the top of the investment pedestal.
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What
Could Go Wrong |
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There's plenty of scary things out
there that could derail this scenario and flush the market down the toilet.
Foremost is, of course, the ever present geopolitical risk- which is politician
speak for terrorism.
Terrorist activities, short of cataclysmic
events like the World Trade Center, do not derail the economy. However,
they do cause oil prices to rise, which is public enemy #1 for the markets.
Rising energy prices equal inflation, which in turn equates to higher interest
rates, a slower economy, and lower stock prices.
In my view, another major risk factor
out there is the massive and unprecedented growth of hedge funds. Hedge
funds are now responsible for trillions of dollars in trades every day,
and have a major impact on the market.
2006 was a year of extremes- The
May to August sell off was one of the most continuous and relentless sell
offs I can remember. The Mid August to year end bull market was likewise-
one of the longest and most sustained rallies I can remember. In my view,
this is due to the trading practices of hedge fund manager. Here's how
it works, and here's why they are so dangerous:
You start a hedge fund and raise
$100 million. You take the $100 million and leverage it into $1 billion
in trading capital. You charge a 2% annual management fee, and keep 20%
of the profits. You only get $2 million of the $100 million to run the
fund, but if you can make 5% on the $1 billion you trade with, that's $50
million, or $10 million for you. Now you understand why hedge fund managers
are reluctant to take any risk.
Now, if you are leveraged 10 for
1, and the market goes against you, the losses can add up quickly. If you
perform poorly, and your investors want their money back, you have to dump
shares rapidly to meet the redemption demand.
This massive slew of capital is leading
to a new generation of investors that buy and sell more on price movement,
and less on fundamentals. However, the pendulum is swinging back, and the
more successful managers are now starting to invest in value for the longer
term.
A collapse in hedge funds could be
very negative for the markets.
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Why
I Love 2007 Already |
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Want some good reasons to be optimistic
about 2007- especially in the tech space? Here you go:
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The Vista Upgrade Cycle: Every
dollar spent upgrading to the Microsoft Vista operating system creates
$12 or more in related IT spending. This will result in a worldwide spending
cycle of at least $200 billion.
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The IPv6 Upgrade Cycle: The U.S.
government is kicking off this $125 billion upgrade (at least) staring
with the military to a new network Internet protocol that allows electronic
devices to exchange data over a packet-based network. In short, it's a
major cycle upgrade in networking. The entire US Government is spending
$125 billion to go 100% digital in phone systems over IPv6 equipment. Asia
and Europe will follow suit to the tune of $200 billion in PCs, routers,
and switches.
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High-Def/Digital TV Transition:
Finally analog broadcast will come to an end by 2009. This means that within
about two years every tv in the US will have to be digital and hi def.
Expect 150 million TVs to be replaced in the next two years.
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IPTV is coming (TV over the internet).
There is a major fight brewing between ATT and Verizon over digital content.
Worldwide telecom providers will enter the fray with IPTV systems featuring
300-plus channels - most with high-def 1080i or 1080p signals. Cable systems
will fight back with 100% digital cable boosted to 1080i bandwidth, too.
This will be great for consumers.
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The Real Broadband Wireless Cycle:
Oh yeah- you can still make a phone call on your cell phone. The mobile
revolution called WiMAX does not use a cell tower. GenX doesn't care whether
they get their messaging, TV, movies and Web sites over WiMAX or 3G or
whatever ; they just want it and they want it now. The cell phone evolves
along with mobile internet access.
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Clean Energy Technology: Mandates
and subsidies from 46 countries and 23 U.S. states puts energy technology
spending on a 30% annual growth rate for the next 10 years and a 50%-plus
ramp for the next 36 months. Green is cool, and it will stay cool for the
next 5 years.
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Bio Pharma Advancement: $68 billion
of branded pharmaceuticals go off-patent in the next three years. Big Pharma,
which has evolved from innovative to giant marketing companies, will need
to replace those blockbuster drugs by looking to smaller, innovative companies
for new products.
And, there's one, last, big reason to
be very optimistic in 2007 that is microcap specific, compliments of the
SEC. There is a new SEC rule which went into effect in 2006.
It severely limits the number of shares small companies can register on
behalf of investors. Therefore, financiers of microcap companies will not
be able to engage in the aggressive "death spiral" type financings of the
past.
For microcap investors, it means
the following. Less companies will be able to get capital, but the ones
that are able to will be of higher quality than microcaps of the past.
There will be less toxic supplies of stock hitting the market, and floorless
convertible securities are behind us. Fund managers who engage in these
kinds of financing will have to be prepared to take risk. Therefore, they
will have to put their money in better companies.
Less microcap companies will have
their shot, but the ones that do should trade much better.
Medistem (OTC BB: MDSM) will no longer
be covered due to lack of performance and lack of interest. Callisto (AMEX:
KAL), Advanced Cell (OTC BB: ACTC), and Auriga (OTC BB: ARGA) will be covered
on a limited basis.
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