Is the Tail Wagging the Dog?

USG has emerged from Chapter 11 bankruptcy in part through the issuance of rights that will recapitalize the company. Shareholders received one right to buy a share at $40 for each share they owned on July 3. The rights expire at the end of July. The new capital will help USG fund a trust that will eliminate any asbestos liability. Then why has the stock fallen off of the cliff, given that:

1. USG had been able to accumulate over $1 billion in retained earnings through bankruptcy;

2. The asbestos litigation and bankruptcy proceeding are soon to be in its past; and

3. Management will be able to focus on its operations while having the incentive of equity compensation;

The stock peaked at $94.64 (rights-adjusted) three months after the bankruptcy plan was approved (on 1/30/06); creditors will be repaid in full with accrued interest. It is now trading at $46.95 and, combined with the rights, at $53.94 for a 43% drop. The only fundamental news affecting it are a housing construction slowdown, but that slowdown had already been priced into other housing related stocks long before USG peaked on April 26 and it had been priced into USG's, too. USG is currently trading at approximately six-times this year's "normalized" earnings (minus bankruptcy and asbestos expenses which have already been charged) and its competitors trade at around thirteen-times earnings. Besides, housing only accounts for about half of USG's business.

Perhaps more importantly, why has the stock dropped 17.5% (rights adjusted) since the rights were issued? One theory is that the tail is wagging the dog. Investors looking to shed some housing exposure--or at least unwilling to pay another $40 per share to take on more housing exposure--may be selling the rights at approximately the difference between the stock price and the $40 strike (the "Gap"). An excess supply of rights could force the price of the rights to drop below the Gap, which creates an arbitrage opportunity for someone willing to sell the stock and buy the rights.

That selling of stock for technical reasons--not fundamental ones--results in a drop in stock price and a downward spiral, which should disappear once the rights expire. That should create an opportunity to own the shares at a low price. When investors refocus on fundamentals, the price should go back up.

Housing Markets: Beliefs and Anecdotes Constitute Academic Research

12/07 03:52PM =DJ Homebldrs Biggest Losers Following Bearish Housing Report
By Janet Morrissey
Of DOW JONES NEWSWIRES

NEW YORK (Dow Jones)--Homebuilding stocks were the biggest losers among 100 sectors of the Dow Jones index Wednesday as jittery investors appeared to react to an academic multi-report study that offered a bearish outlook for the group.

The UCLA Anderson quarterly report, released Wednesday, predicts U.S. housing construction will start declining in early 2006.

"Evidence is accumulating that the great housing boom of the past decade is coming to an end," said visiting scholar David Shulman, in the three-report study. "Higher interest rates and declining affordability are exacting their toll..."

...UCLA Anderson senior economist Michael Bazdarich admits his his group thought the decline would start in mid-2005, and it didn't. As a result, he now expects the slide to begin in early 2006. "We think the logic for this coming decline is powerful, and we strongly believe it is going to occur." Still, the indications are "mainly anecdotal" at this point, making it "too early to call the turn.

Now I know why contrarians usually outperform momentum investors.

Meanwhile, Centex Corporation, a homebuilder with 127.7 million shares outstanding, announced at 4:01 pm today that it completed a five-million share repurchase and authorized an additional five-million share repo plan; 1.5-million of those shares will be bought before the end of January. This comes after Beazer Homes, Inc., with forty-two million shares outstanding, authorized a ten-million share repurchase plan at the end of November.

It is almost always wiser to do what the owners are doing. I trust owners more than I trust academicians. Follow the money.

The FOMC Minutes

The Fed might finally be coming around to the conclusion that inflation is less worrisome than it previously thought. The media will catch up much later. The most important parts of today's FOMC minutes are paragraph 21 and a portion of paragraph 22:

Paragraph 21

While participants noted some recent favorable data on core inflation and labor costs, upside risks to the outlook for underlying inflation remained a key concern. Wage gains had remained modest relative to continued strong productivity growth, suggesting that labor costs were not putting much upward pressure on prices. Indeed, core inflation continued to be subdued, and in recent weeks gasoline prices had unwound a significant portion of their steep increases. Nevertheless, there was a risk that the large cumulative rise in energy and petroleum product prices through the summer would be transmitted to core consumer prices. A number of firms had been reporting a greater ability to pass through increases in energy and other costs to customers, though evidently more so to other businesses than to consumers. A survey measure of the near-term inflation expectations of households had risen notably, but intermediate- and longer-term inflation expectations implied by Treasury security yields had remained fairly stable. It was noted, however, that longer-term expectations of inflation remained contained in the context of an increase in the extent of additional monetary policy tightening expected in financial markets.

Paragraph 22

...Some members cautioned that risks of going too far with the tightening process could also eventually emerge. Nonetheless, all members agreed to indicate at the conclusion of this meeting that a continued measured pace of policy firming remained likely...

As Truman said: "Give me a one-handed economist." The Fed needs to present boths sides of the argument to keep the financial markets from going overboard, but this is the first time in this tightening cycle that the risk of tightening too much has been raised.

Merrill Thinks Monetary Policy is Already Neutral

That is, inflation isn't the threat that everyone is making it out to be and the real danger to the economy is policy overreaction.

11:42 (Dow Jones) "The key to next year's economic and financial market performance hinges upon the Fed not overreacting to the perceived inflation threat," Merrill Lynch says. "We do not share the view that policy is still accommodative." The firm's David Rosenberg says the tea leaves - from a flat yield curve to range-bound equities to a cooling housing market - spell out that the funds rate is already at neutral, but he's not sure the Fed sees it that way. "Not only has the Fed never ceased a tightening campaign with the funds rate at an 'accommodative' level, but it has never stopped at 'neutral' either." (PJV)

Energy Prices

Two recent populist rants have been making the rounds and both concern energy prices. Gasoline prices and natural gas prices are so high, these rants go, that the average consumer will be hard pressed to fill his tank and heat his home.

The following are some data on the central New Jersey market price for a gallon of premium gasoline:

Immediately after Katrina: $3.35 (When my station attendant asked if I was paying by cash or credit I said "bank loan." I heard nothing but crickets, which to me was evidence that he either had no sense of humor or couldn't speak English.)

One Week Ago: $2.80

Today: $2.53


It looks like the tank-filling fear mongering might be a little off. Well, what about the folks that will not be able to heat their homes because natural gas prices are going to be outrageously high?

( DJ ) 11/01 10:15AM DJ US Oil Sector Down On Decline In Gas Prices
By Lisa Sanders

NEW YORK (Dow Jones)--Another decline in natural-gas prices spilled over to the oil sector and sent stocks into an early slide Tuesday. Natural gas for December delivery, which lost 6.5% on Monday, picked up where it left off, falling 51.5 cents, or 4.2% (today), to $11.69 per million British thermal units...

...Warm weather forecasts are behind the drop in energy futures."

(END) Dow Jones Newswires
11-01-05 1015ET
Copyright (c) 2005 Dow Jones & Company, Inc

So, the wholesale price of natural gas in the futures market is down more than 10% in two days. I guess we should all calm down.

So, Besides in Energy, Where's Inflation?

By Campion Walsh and REBECCA CHRISTIE
Of DOW JONES NEWSWIRES

WASHINGTON -

...Within the advance GDP report, the personal consumption expenditures, or PCE, price gauge excluding food and energy rose 1.3% in the third quarter, down from 1.7% in the second quarter and well below the first quarter rate of 2.4%. Federal Reserve policymakers closely watch the core PCE as an inflation indicator...

By Campion Walsh and Rebecca Christie; Dow Jones Newswires

Inflation is decelerating, not accelerating. Remind me again why the fear of it is rising? Is filling up the tank once or twice a week really having that much of an impact on the psyche? (by the way, premium gas cost me $3.35 a gallon about six weeks ago and it's $2.80 today.)

Ten-year Treasury investors seem to believe that inflation is under control based on the prices they pay and the yield they are willing to accept. Low long-term rates are good for economic growth in most cases. There is one scenario, however, that low long-term rates will not boost the economy: When short-term rates rise enough to make the yield curve flat or inverted, banks have little incentive to lend and capital providers have little incentive to provide capital. That leads to slower growth.

The Fed's action to increase short-term rates, while long-bond investors keep long-term rates low, has flattened the yield curve. Given the diminishing evidence of core inflation, the Fed runs the risk of causing a recession. Then, inflation will be last on everyones' list of fears.

Time to Short Papa John's (PZZA)?

On Mondays during football season Papa John's Pizza offers one free topping to pizza buyers in the Washington, DC area for every touchdown the Redskins score, and they double that if the Redskins win. This Sunday the Redskins scored SEVEN touchdowns and won. Pizza buyers got FOURTEEN free toppings.

From the Washington Post:

...business apparently was brisk. One deliveryman brought 20 pizzas to Redskins Park and said: "We're getting slammed today. . . . Everybody's happy."

Given that the Redskins are second in the entire NFL in offense, their quarterback--Brunell--is the top rated passer in the NFC, their top rusher is fourth in the NFC and their top receiver is on pace for 2,000 yards in receiving, which will blow away Jerry Rice's single-season receiving yards record of 1,848, it might be time to short the stock. Pizza margins are ridiculously thin and I've got a hunch that the amount of meat on Monday's pizzas could have fed a city in China for a month. And, think of the worker's compenastion suits when the delivery folks try to carry 50-pound pizzas.