Marvell's New Clothes

Marvell (MRVL) is one of the many technology companies that has been under a cloud due to stock option dating issues. The cloud for investors, in most cases, has not been so much the risk of an SEC investigation or related train-wreck scenarios. Rather, while the companies do their accounting restatement investigations they do not release information that make informed investing possible. They do not release earnings; they don't file 10-Q's or 10-K's with the SEC.

On July 2nd Marvell made some of its tardy filings with the SEC. They had already announced the completion of their restatement investigation back in May. The filings included a 10-K covering fiscal 2007 through January 30, 2007. The most recent 10-Q was for fiscal Q3 2007. What we really want to see, of course, are the numbers for the quarter (Q1 2008) that ended April 28, 2007 (See my summary of the May 17 analyst conference for what we know so far).

Still, there is a lot of grist for analysis in the 10-K. For starters, for all practical purposes Marvell made no profit for its year. Out of annual revenues of $2.24 billion (well up from $1.67 billion in fiscal 2006), it lost $12 million, or $0.02 per share. In 2006 it had profits of $199 million, or $0.32 per share.

Time to flee the stock? Sorry, too late. The share price topped out at over $38 back at the beginning of 2006; it ended today at $18.32, and has been as low as $15.25 this year.

Let's try another reality check, since revenues have risen rapidly while earnings have fallen. What happened to cash?

In fiscal 2007 net cash provided by operating activities fell, but not as precipitously as earnings. It was $402 million in 2006, then $337 million in 2007. There was a serious cash outflow, but it was for acquisitions, not for operations.

Marvell made two big acquisitions in 2007: Avago (chips for printers) for $262 million in May and Intel's cell-phone (XScale) microprocessor division for $600 million in November. These acquisitions had serious one-time costs and the Intel division in particular had major ongoing net losses when it was transferred.

Marvell also acquired UTStarcom in February 2006 for about $40 million. According to a neat little chart on page 126 of the 10-K, the acquired businesses, if they had been bought at the beginning of fiscal 2007, would have created an overall loss of $475 million for the year, while bumping up overall revenue to $2.6 billion.

Are these guys stupid? Did the people who created Marvell out of some analog chip designs and built it to a $1 billion business in a few years lose their minds? I don't think so.

They did load up heavily on risk. A good way to get a sense of risk, which is mainly from the Intel purchase, is to use your find function on the 10-K with "Intel" as the search string.

To get back to being heroes for their stock holders Marvell employees have to turn the acquired companies to profitability while continuing to grow their more established business lines. The big bear here is the XScale application processor. Under Intel its revenues were growing, but R&D costs were high compared to revenues, resulting in division losses. Marvell intends to move production from Intel's fabs to its fabless (outsourced) model by mid-2008. That will allow some cost reductions. But mainly Marvell has to rapidly increase sales while keeping prices firm.

These XScale processors go mainly into high-end (3G) cell phones and combine well with Marvell's analog technologies. So Marvell has bought into the cell phone market in a major way. But many other firms, like Texas Instruments and Motorola, are also gunning for the high-margin, high end of that market. The market is expected to grow rapidly, spurred on by the introduction of the iPhone.

Do I know if Marvell can succeed in this market? No, I just don't know. They have a great track record. If they can ramp the XScale business and decrease costs, today's stock price may look way low a year from now. But if XScale tanks, which is a distinct but hard-to-quantify possibility, then today's stock price will seem to have been based on optimism, not solid value.

I own Marvell stock, but I acknowledge the future is hard to see. It would really help if management would break out revenues and costs by division at the next analyst conference.

More data:

Marvell investor relations page
my Marvell page

Akamai Acceleration?

One reason I don't own stock in Akamai Technologies (AKAM) is that the current price assumes very rapid growth; in other words, if you don't like to make assumptions like that, the stock is not cheap. But the company sports some serious business and technological brains. It is the sort of company that two years later, sometimes, makes you feel foolish for not buying it despite the high P/E ratio. Which stood today at 126 (per Nasdaq). In other words, earnings from the past year come to less than 1% of the value of the stock.

Akamai accelerates data exchanges over the Interet (see my Understanding Akamai). Most people who have paid for a broadband Internet connection expect quick downloads; if a page does not download nearly instantaneously, they are on to something else. For a site financed by ad revenue this is bad. For site that serves up such ads, it is very bad. For a site that hopes to sell people something, slow is a disaster.

According to Akamai, of the top 100 Internet retailers, over two-thirds use Akamai to accelerate their web shopping experiences. Akamai has quantified the value of this acceleration: an 11% increase in revenues after Akamai's acceleration technology has been installed. One customer, Motorcycle USA, saw an over 15% improvement in conversion rates (completed sales once a customer has reached a stage of interest). Revenues increased 30%. Best of all their call center volume dropped, allowing them to save money.

Watching my wife try to shop on the Internet is instructive. She browses, but about one-half the time ends up calling in her order rather than finishing it online. She can spend several minutes of employee time finishing an order. Akamai claims customers typically abandon a site after a 4 second wait. Paying Akamai to decrease the wait pays off.

This particular Akamai product is called Dynamic Site Accelerator. "The Akamai solution not only enables retailers to accelerate their dynamic transactions and interactive content, but has also increased browser to buyer conversion rates and reduces infrastructure costs by offloading traffic from customers' Web infrastructure."

For all that, Akamai's revenues were only $239 million in Q1 2007, with net income of $19 million. Even with a continuing ramp 2007, GAAP earnings are unlikely to top $105 million. At today's $7.9 billion in market capitalization, that gives a forward P/E ratio of 75. If the stock price stays the same for about a year and earnings do grow rapidly, today's price may seem reasonable in June 2008.

You might also want to view my summary of the April 25, 2007 analyst conference covering the results from Q1 2007. Management guided to $610 to $620 million in revenues. Management likes to project "normalized earnings," which is a lot higher than GAAP revenue. For instance in Q1 GAAP earnings were $19 million, but "normalized" earnings were $50.7 million. They are guiding to possibly $215 million normalized net income for the year 2007. If the GAAP to normalized ratio holds, GAAP full year net income will be only $70 million. A nice chunk of change, but not one that justifies the stock price.

So we have a rare current-day example of a great technology company that seems to be overvalued by investors. Akamai has great promise, but in my view it requires a couple of years of revenue and profit growth to justify today's stock price.

Adobe's New Products Roll On

Adobe (ADBE) stock recently made it back up to its year-2000 highs. It is not a cheap stock; its PE ratio is about 47. But it is in an enviable position. It has virtually a monopoly in its chosen field of graphics development software for professionals.

Almost all professional graphics designers prefer Adobe Photoshop. While free and lower-cost photo-manipultion programs abound, they are used almost exclusively by amateurs. While any file format, such as Microsoft Word, can be posted in a web link, some how Adobe made the PDF/Acrobat file format the ubiquitous alternative to HTML pages. Now Flash is becoming the favorite for posting Web videos.

My regular web pages at Openicon.com are laid out in Dreamweaver, created by Macromedia but now a part of the Adobe empire. At the low end competitors, including Microsoft, basically have to give away programs to compete with Abobe. Once people get to a point where they are willing to pay for professional software, Adobe goes to the cash register.

I think Microsoft's Silverlight initiative is very intersting, but it is no immediate threat to Adobe.

This year Adobe is in a product renewal cycle. Professionals everywhere will groan as they are milked for their upgrade money, but they have learned through bitter experience they have no choice. They must pay for the upgrades or fall behind their peers.

Management, of course, is proud of itself and feels it is doing fine. The new products will be great and sell. To get last quarters results and insight from management you can read my summary of the March 20, 2007 analyst conference.

This week Adobe launched a public Beta of ColdFusion 8 Software. This is more esoteric than Photoshop. It allows software teams to build dynamic Web sites. It even supports sites requiring integration with Microsoft .NET products and enterprise Java.

A full Version 8 of Acrobat 3D was also released. This allows professional CAD/CAM designers to share designs, including over the Internet.

Creative Suite 3 has been introduced and will be the big money generator for most of 2007. Depending on which version you buy, it includes such products like Photoshop, Illustrator, Flash, Dreamweaver, or Acrobat.

With design for Internet, including Internet video, still being a growth area, Adobe's revenues and profits are almost certain to continue to grow over the next few years. That said, 2006 revenues were $2.58 billion. There was a bit of an end-of-year pause as some customers delayed purchases until the new products were released. And because of development costs, net income in 2006 was down from 2005. Expect it to be up again in 2007.

Adobe is not a bargain stock, but it is one that is highly likely to pay off in the long run. The company has $2.3 billion in cash in the bank, too. With low risk and high long-term potential, this is a good stock for certain types of portfolios.

I don't own the stock.

See also:

My Adobe (ADBE) page
Adobe corporate web site

Rackable (RACK): Playing with the Big Guys

Today Rackable (RACK) had plunging stock price syndrome after the company announced that Q1 2007 earnings would be below expectations, that is to say, negative. How negative, we will have to wait until the earnings release.

At the analyst conference for Q4 2006 (see my summary) guidance for Q1 2007 was revenues between $70 and $75 million due to seasonality and lumpiness in largest accounts. They said to expect gross margins at low end of range. There are lots of details about why Q4 worked out the way it did and what Q1 might be like in the answers to analyst questions.

What did the press release say? "Total revenue for the first quarter of 2007 is expected to be in the range of its previous projections of $70 - 75 million." No change there. But "the company anticipates a net loss for the first quarter of 2007, on both a GAAP and non-GAAP basis," because "gross margin for the first quarter [is] to be approximately 30% lower than previously communicated." The details: price competition, a cancelled order, a severance package, and some tax obligations.

Management leaves some bright looking crumbs for investors: a greater than one book to bill ratio, the strongest backlog of orders ever, and cash balances improving to $170 million at the end of the quarter.

So how much is the stock worth today (which is to day, should you buy it because it is beneath that price, or should you sell it if you own it above that price)? It was at $55.75 per share within the last year; today the stock is below $15. What changed?

Rackable is in a position that is common in all industries, including technology. It had a good idea and executed well on it. It grew rapidly, from $53 million in annual sales in 2003 to $360 million in 2006. Investors (including me; I own the stock) got overly enthusiastic by projecting a straight line of increasing sales and profitability.

Sales revenues had not been bad, continuing to increase through Q4 2006. But Q1 2007 revenues will not only be sequentially (and seasonally) down; they will be below Q1 2006. In addition, starting with Q3 2006 earnings have taken a beating.

Rackable was noticed by the big guys because it was becoming a big guy. It was taking out full page ads in Infoworld; it was winning big contracts from YouTube, Microsoft, and other Internet search/portal players who liked Rackable's innovative approach to server farms. Sun, IBM, HP and Dell took a look and said: this has got to stop. Any one of these companies has the financial resources to take some losses in order to underbid Rackable. And reports are that this has been happening lately.

In order to keep its customers Rackable has cut its prices in specific situations. But it does not sell servers one at a time. It sells systems on a large scale. A few price cuts in a few specific situations and it is in the red.

Just as when the stock was bid up high based on future expectations, the pricing of the stock today depends on your model of future sales and earnings. No one actually knows what will happen; but some of us will guess right, and will at least guess in the ballpark, and some will be way off.

I think Rackable will pull through, but I see plenty of downside danger. To a fair extent they should be able to meet anything Sun, Dell, or HP can throw at them because Rackable has a superior (and patented) technology. They have the advantage of being a niche player: the other guys might be willing to underbid for a while, but they have other distractions and no one wants to be the head of the division that is bleeding money within a company that has many divisions.

The need for the type of server installations that RACK sells is growing rapidly. I think management was right to do what it took to keep their market share. They have enough cash that they can't be forced out of the game easily.

Rackable is not, today, a stock for short-term investors. It is a risky stock for long term investors. But today it has cash equal to 42% of its market share; the immediate downside is limited. I admire the guys at IBM, Sun, Dell, and HP, but I think Rackable may be the nimble running back that dodges the heavy defenders and makes a good run.
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See my summary of the Q4 2006 Rackable analyst conference

Altera (ALTR), FPGAs and CPLDs

At its November 6, 2006 analyst conference Altera reported revenues of $341.2 million for its 3rd quarter ending September 30th. It predicted 4th quarter revenues would decline 2 to 5%. Then when it reported Q4 revenues at $317.4 million at the February 13, 2007 conference, they were down a whopping 7%. A further decline of up to 4% in revenues was given as guidance for the first quarter of 2007. Should we panick? Is Altera sliding into oblivion? Is this 2001 all over again?

Altera makes semiconductor chips and specializes in FPGAs (Fully Programmable Gate Arrays) and CPLDs (Complex Programmable Logic Devices). All these devices can be contrasted to ASICs, which are Application Specific Integrated Circuit. Supose you have an application, perhaps processing some information inside a cell phone or a hard disk drive. You decide what the semiconductor chips have to do (what their logic structure is) in order to achieve your goals. With an ASIC you then design the layout of the logic that will be in silicon. To create the ASIC chips you go through the standard manufacturing process of using masks, doping, and etching to create batches of chips incorporating your design. FPGAs and CPLDs approach the same problem by giving engineers sets of general solutions that are arrays of possible logic states. You program the FPGA to have the same logic that you would build into an ASIC. So the end products should function identically. Why not use all FPGAs, or all ASICs? There are cost advantages to ASICs once a design is nailed down and if production is on a large scale. But when an engineer sits down to design an ASIC, she could just reach into her parts box, pull out an FPGA, and program it instead. So FPGAs go from idea to finished product much faster. If you want to fix an error, or do an upgrade, often all you have to do is reprogram the FPGA. With an ASIC you have to redesign the circuits, make new masks, etc. Speed and flexibility are what FPGAs are about, but they are also great for prototypes and specialty products with low production runs.

Because of this Altera's competitors are not just other FPGA and CPLD manufacturers; they are ASIC manufacturers as well.

While prices of all stocks fluctuate, there is no way a company like Altera, in the price range it has been in lately (52 week high $22.32, 52 week low $15.54), can be compared to the revenueless Internet stocks of yesteryear. In fact even in the relatively lousy 4th quarter Altera had net income of $99 million, up 43% from its Q4 of 2005. It is in a competitive business, but not that many companies are competing in programmable silicon, so profit margins are healthy.

Altera constantly invests in the future: its R&D runs about $60 to $65 million per quarter. Part of the recent revenue decline is due to customers reducing inventory, getting into cautious positions for 2007 sales. 39% of revenue was in sales to the communications industry, which continues to deploy not just new models of cell phones, but whole new types of products like WiMax and 3G phones and their attendant base stations.

Who competes head-to-head with Altera? Actel, Atmel, Lattice Semiconductor, NEC, Quicklogic, and Xilinx. Actel had $48.2 million in Q4 2006 revenues and has FPGAs as its principal products. Atmel primarily makes microcontrollers, though it does have several FPGA lines; it has been struggling the last few years. Lattice Semiconductor is focused on FPGAs and had revenues of $61.8 million in Q4 2006. NEC is a huge company which derives only a small amount of revenue from FPGAs. Quicklogic’s web site is worth a look: they openly and cleverly challenge Altera and Xilinx on their home page. Their Q4 revenue was $7.7 million, plunging 25% year-over-year. And then there is Xilinx, the main competition. You can find out more about XLNX in my analyst conference summary for this company, which claimed 70% of the global FPGA market in 2006.

The only real short-term threat to Altera’s profitability is a global recession. In the long run their competitors are a threat, but Altera also has the potential to eat into Xilinx's market share. Overall PLD (programmable logic device) usage is certain to grow.

Applied Materials on 45 nm

Intel, locked in a battle-to-the-death with AMD, recently announced it had won the 45 nm war. Within hours the same day IBM announced that Intel's accomplishments, even if real, were no big deal because IBM has the same capabilities. That is good for AMD, which is partnering with IBM.

45nm means that semiconductors are constructed on a grid with cells 45 nanometers wide. Right now the most advanced silicon actually being sold is 65 nm, which Intel started selling mid-2006 and AMD started selling in January 2007. Smaller sizes mean more gates and computing power in a given area. You can, of course, waste those extra gates with a bad design.

Applied Materials executives, in the February 13th analyst conference (see my summary), gave their perspective on the transition to 45nm. They make much of the equipment used in fabrication plants to make semiconductors. They sell that equipment to just about everyone, including AMD, Intel, and IBM. They should know a thing or two about it.

They claim to have the best process. Whatever process they have they will license to anyone who will pay for it. They have worked with both IBM and Intel on the issue.

What does this mean for investors? It probably means 45 nm won't be an issue. One company or another might get an edge, but that is unpredictable right now and won't be the main determining variable. Every time process size shrinks there is a lot of handwringing; some day further shrinking either will be prohibitively expensive or just won't work.

Winners will be those who use 45 nm most effectively and are most effective at marketing. Intel is the long-reigning champion, but looks punch drunk and ready to fall. Intel fired thousands of engineers last year while AMD was hiring.

Meanwhile consumers benefit from the intense price competition. Short term investors probably want to avoid Intel and AMD, despite historically low stock prices. Long term, any letting up in the price wars will mean big bounces for both the companies.

Semiconductor Inventories and Demand

I am fascinated by technology, by the businesses that create, manufacture, and sell it, and by the human factors in management. Listening to executives from Atmel, Linear Technology Corporation, Microchip, Maxim, Texas Instruments and Xilinx at their analyst conferences explaining Q4 results, all these factors converge. Q4 2006 was not the best quarter for the semiconductor industry. While most companies had year-to-year improved revenues, most were sequentially down from Q3. Many predicted further deterioration in revenues for Q1 2007. The down trend was widely attributed not to decreased demand, but to reductions of inventories at customers. To some extent seasonality is involved, as when end-products are aimed at consumer holiday buying and had to be produced in Q3 in order to be incorporated into products and shipped back across the Pacific to sell to spendthrift Americans.

So what investors want to know is whether this is the beginning of a downward trend, or just a temporary adjustment of inventories. It is also important to consider how companies are competing and may buck any trend.

Atmel (ATML) was down 5% sequentially and up only 2% year-over-year. They have never really recovered from the 2001 bust, so don't indicate any kind of trend.

Linear Technology Corporation (LLTC) did worse, down 8% sequentially but up 1% from the year-earlier quarter. They expect revenues to fall another 4% to 7% in this March quarter.

Microchip (MCHP) was down 6.3% sequentially, but up 6.9% year-over-year. They are optimistic that Q1 2007 will be the bottom of the cycle and are predicting that revenues will be flat sequentially. [I own MCHP stock]

Maxim (MXIM) escaped relatively unscathed, with revenues down only 1% sequentially but up 11% from Q4 2005. However, they are predicting that Q1 2006 revenues will be down 3% to 6%.

Texas Instruments (TXN) revenue was down 8% sequentially but up 4% from year-earlier.

Xilinx (XLNX) revenue was down 3.5% sequentially, but flat from the year earlier. They guided to flat to down 5% sequentially for Q1.

I think there was some tightening of end-user inventory because of uncertainty over the 2007 economy. Since the 2007 economy looks rosy at the moment, I think that when demand holds up the end users (electronics device makers) will have to start rebuilding inventories. But remember that each company produces chips in multiple categories. Slack or robust cell-phone demand will not impact all companies equally. Defense spending or cutbacks hurt some companies more than others.

When we get Q1 2006 results I'll be looking back to see which executives gave good guidance. Of course unfounded optimism is now suspect: it seems like an attempt to manipulate share prices upward.

Petsmart Poodles and Wolves

The fact that the markets in a particular stock are only technically in equilibrium is easy to observe, economic fundamentalism to the contrary.

Some time in the last 24 hours demigod Jim Kramer said to buy Petsmart (PETM) and a bunch of people must have because over 1.7 million shares changed hands today and the closing price was up $1.14 per share to $31.36, a rise of 3.77%. The market capitalization of the stock shot up $159 million.

Now does anybody really think that the fundamental value of the company changed $159 million in 24 hours? Maybe if some fundamental news came out. But this was a comment by a commentator on a TV show. The same is true of most upgrades and downgrades from brokerage houses. They often site trends or ideas that were publicly known well before the changes in ratings.

But I bought Petsmart (PETM) back on 4/15/2005 when it was at $26.60 per share. At the time I realized all my stocks were either software or hardware; I was looking for diversification. I know a little bit about the retail trade, plus anyone can take a trip to the mall and see how stores appear to be doing. The closest Petsmart is a 2 hour drive from my house, but then the closest stores of most national chains are as distant. I had shopped at Petsmart, I liked their strategy of building new stores, and I liked the price of the stock. But I never expected a big runup. You have to buy into a company when it is smaller, usually, to get that. I bought three retail stocks, using the same criteria.

Is Petsmart fairly valued at $31.36? To me it looks within the range. It is still adding stores, but at some point the pet-superstore market will be saturated. Rival Petco is also still opening stores, and they are way bigger than the older Petcos. PETM's trailing price/earnings ratio is 24.89, which is pretty bullish. Forward PE is 19.24, which is more reasonable. The holiday quarter's results will be the lynchpin of true value. Did people pamper their pets? Were costs kept under control? If Jim Cramer is right and this is a turnaround, wouldn't it have been nice to have figured that out when the price of the stock was lower? It has been as low as $22.07 in the past 52 weeks. Why was it worth $22.07 then but $31.36 today?

As far as I can tell, not that much has changed. Petsmart is well managed. Their stores look like they are staffed with people who care about your pets. That was true long before I bought the stock.

Anesiva 4975 Plan Revealed

Anesiva (ANSV) announced today that it completed a successful meeting with the FDA. Based on FDA feedback, they released a plan for Phase 2 and 3 trials for their 4975 compound, which is a long-term, non-opioid pain reliever.

But first, be aware that I own stock in ANSV and think investors should consider all stocks in biotech companies that have not actually brought drugs to market to be very risky investments. Also, at least short term, ANSV stock price is much more dependent on whether the FDA approves Zingo, a local anesthetic that has completed its Phase 3 trials, than on 4975.

4975 is a formulation of capsaicin, a TRPV1 agonist that blocks pain transmission in nerve cells. It acts for weeks without the ugly side effects of the current drugs of choice, opioids. During surgery it is dripped into a wound. Other than that the surgery is completed as usual. Because of the way drugs are approved at the FDA, companies can't just apply to have a drug approved for surgeries in general. So after doing a series of Phase 2 trials on different types of surgical pain, Anesiva guys met with the FDA and came up with this plan to get approval for four indications, involving 4 Phase 2 trials: hip replacement surgery, knee replacement surgery, arthroscopic should surgeries, and for osteoarthritis (in absense of surgery).

But clearly they are concentrating on knee replacement surgery, the only indication for which they announced a planned Phase 3 trial, beginning in the second half of 2007. Phase 2 trials in all four indications are to begin in the first half of 2007.

This is great news for current investors. At the same time FDA approval is not guaranteed. If the trials are successful it would be 2008 before approval could be granted. There were 470,000 knee replacement surgeries in the USA in 2005, and if that program goes well then getting approval for other types of surgery and long term pain should be relatively easy.

Meanwhile we anxiously await approval on Zingo, which provides immediate, skin level anesthetization and is designed to reduce pain for needle insertions. My understanding is that thumbs up or down from the FDA should come in the first half of this year.

To learn more see my summaries of Anesiva's quarterly analyst conferences.

2007 Economic Outlook

What will the economy do in 2007? While there are some dangers, and unexpected events may change things, I think the U.S. economy will do just fine in 2007. The world economy will do better.

I have followed the statistics and the predictions of government agencies, investment banks, and assorted pundits. In 2005 I made a pretty good prediction (read it). For 2006 I was busy and wrote nothing down. If you are an investor you want to know not just how the economy will do overall, but how individual sectors will fare. Though I am a math guy and like to make models, I think the human brain, mine anyway, is still best for modeling complex systems like the economy. So this is what I think:

China and India will continue to boom. With increasing domestic consumption they will continue to be positive drivers for the manufacturing and intellectual property side of the U.S. economy. Electronic chip makers who can produce the best technology and get good prices for their chips will continue to do well.

The commodities boom as a whole is not so much over as adjusted to the market. New mines and processing facilities that were created in response to higher prices will keep a lid on commodity prices overall. Only specific goods where their are genuine global shortages that are difficult to rectify with new investments will see significant price increases. That said, petroleum is a wild card. Capacity seems adequate for now, but purposeful production cutbacks will probably keep oil well above $50 per barrel. A major war could send prices far higher.

The housing market in the U.S. is going to recover in 2007, but more slowly than predicted because prices have not, and probably will not, drop enough to accelerate the demand side. I would not look for significant increases in new house construction until the second half of the year.

Retail as a whole will have a modest year. One good thing about people not buying houses is that they tend to have more cash around to spend on other things, which will offset in part the decreasing wealth effect from people using their house appreciation as income.

Interest rates will stay in a narrow range. If housing does pick up in the second half and manufacturing and services stay strong, which is likely, look for rates of 6% and higher by the end of the year.

I think the bond market is wrong, at least for the short run. I am not known for being overly optimistic about the economy, but that is based on realism. I called the imbalances of the late 1990's. Now that things are more in balance, the fools who told you that the stock market had nowhere to go but up in 2000 are overestimating the chances of recession in 2007. Bond rates are mostly too low, not because inflation is likely to heat up significantly, but because the Federal Reserve will eventually raise rates to keep inflation at bay.

The stock market as a whole is not overvalued right now. Of course some individual stocks are. But there are plenty of stocks that are undervalued, too. This is an ideal field for picking individual stocks.

Construction Workers and the 2007 Economy

I am not as worried about the 2007 economy as some, despite my reputation for gloom and doom. I acknowledge the downside risks, of course. In one particular, construction worker employment, I think the risk is typically overstated.

No doubt that the construction of new housing has slowed down and is not likely to perk up significantly in 2007. But did you or any of your friends try to get a contractor to do major repairs, additions or alterations in 2005 and 2006? Everyone was busy; pricing verged on extortion; projects started months behind schedule and sometimes ended years behind schedule.

So while there is not pent-up demand for new homes, I think there is plenty of pent-up demand for construction workers. Overtime will be cut back (if it has not already been) so many workers will have smaller paychecks. In California many overworked Mexicans may simply take a nice vacation back to their hometown, where many are building a house of their own. There will be increased competition in the repair, alter, and addition market, which will be great for frustrated home owners.

Real estate workers (dirt pimps, my friend John calls them) are seeing smaller paychecks, but that is just part of the game. Many new real estate agents who came on board in 2004 and 2005 would never have survived under normal positions. It's disappointing to have a real estate license and be lining up for a job at WalMart or Target, I'm sure, but good times will come again and at least you'll already have the license. Smaller paychecks should remind people of the importance of saving during good times, a lesson much of America seems to have forgotten.

I believe it is a bit early to be buying stock in home construction companies, given the uncertainty going forward, but if you do buy now at least you'll be buying the stock for way less than what people were paying for it back in 2004 and 2005.

Live and learn. A down cycle is just a good time to mentally flip the chart and see it as a rising inverse. Laid off by a big construction company? Hopefully you saved some money during the boom. Get your contractor license, print up some business cards, and knock on some doors. Do good work, put your customers before yourself, and soon people will be knocking at your door. Adapt and thrive.

I'll be on vacation a few days, then back to share more with you in 2007.

Humans, Chess Computers and Black Box Traders

On December 5, 2006 it was announced that a computer, Deep Fritz, beat the world champion human chess player Vladimir Kramnik, in a six game tournament. Four of the games were draws and two were won by Deep Fritz.

It is also believed that over half (estimates vary) of the trading volume in stock markets is now made using machines, often called black boxes. And let me be clear: these are machines that are programmed to evaluate stocks and make trades without human intervention.

Given that, would individuals be best off turning over their investments to mutual fund managers or hedge funds that can make use of these AI (artificial intelligence) computers?

Well, some individuals clearly were not up the the task of competing in the markets even before machine trading started. For the rest of us, so far at least, I think that if you take a look at the nature of machine trading, you can avoid being hurt by it and might even take advantage of it, at times.

What are the machines doing? Their strategies mainly fall into four categories: momentum plays, arbitrage, covariance, and news analysis. All of these strategies were developed by humans, but computers can be better at them.

Momentum plays are the simplest strategy: if a stock is going up, bet that it will continue to go up. If it is going down, bet that it will continue to go down. Be ready to bail out of a position the moment momentum changes. This simple reality used to be the main advantage of having a "seat" in a trading pit. What are the advantages for a computer here? At best humans work in tenths of seconds. Computers can work in millionths of a second; in a second a computer to look at the entire range of stocks to see which ones make the best momentum plays any given moment.

The result of course, is amplification. Some people say stocks are always in equilibrium, the latest price representing a balance between the buyers and the sellers. But it is just as true to say that stock prices are always out of equilibrium. If a stock is going up it attracts momentum players, human and computer alike. It goes up until it is so out of touch with fundamentals that other computer programs and humans start selling it in quantities sufficient to flatten the curve and then send it heading down. The same process in reverse runs on the downside.

Are you thinking about buying a particular stock today? You know if it is falling you are inclined to wait and see if you can get it cheaper. If it is going up, you buy quickly because time is money.

You don't have to worry about the machines too much if you are an intermediate to long-term investor. Ultimately stock prices depend on fundamentals. While some machines are throwing prices out of equilibrium, others are executing trades that tend to bring prices back to fundamentally sound levels.

So do your research, delve into the future, and try to buy at a good price.

I'll be looking at the other three strategies (arbitrage, covariance, and news analysis) in future blogs.