Connecting the Dots

By: Tony Sagami | Tue, Aug 2, 2005
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4 straight months of falling construction spending
Rising fuel costs kills profits at AMWD
Another company signs the inflation blues
Proctor & Gamble complains about commodity prices
Japan slaps tariffs on U.S. steel

There were several economic news releases today, but all of them dwarf the news of King Fahd's death, which sent oil prices sharply higher today.

Saudi Arabia is the largest oil producing country in the world and King Fahd was extremely friendly to the United States and often the lone Arab voice of support.

Despite loud criticism from other Arab countries, Fahd permits hundreds of thousands of American troops to be stationed in Saudi Arabia at the beginning of the first war against Iraq.

On the surface, the line of succession is clear, as Fahd will be succeeded by half-brother Abdullah bin Abdulaziz Al-Saud, who has been effectively running the country for several years since Fahd suffered a major stroke in 1995.

U.S. officials, oil companies, and Wall Street have their fingers crossed that Saudi Arabia will remain an American friend. I have low confidence that it true, but only time will tell.

King Fahd's death wasn't the only news to roil the oil markets.

BP shut down a gasoline-producing unit at its giant Texas City refinery for maintenance, likely a result of last Thursday's fire. That refinery is the third largest in the U.S. and the source of 3% of our country's gasoline.

Even more troubling was the news on Sunday that Iran is pushing forward with its nuclear initiatives. Iran insists that they are only interested in nuclear power for electricity generation, but the European Union and the U.S. suspect Iran of building a nuclear arsenal. I don't know about you, but the idea of anything nuclear in Iran scares the heck out of me.

All that angst about oil translated into a record prices over $62 a barrel.

The hear-no-evil crowd essentially ignored the surge in oil, gave the Dow Jones a gentle nudge downward, and amazingly sent the Nasdaq higher by 10 points, which shows that the bulls are only interested in plowing into four-letter stocks with big betas and paying almost zero attention to risk management.

I'm not sure whether to call it arrogance or ignorance, but that throw-caution-to-the-wind strategy is a recipe for investment heartache. I hope you aren't following it.

4 straight months of falling construction spending. The Commerce Department reported that spending on construction projects in June dropped by 0.3% in June.

Not only is that well below the 0.8% gain Wall Street was expecting, it is also the fourth consecutive monthly drop in construction spending.

Even the 0.3% drop hides the severity of the spending slowdown. If not for a 4.9% jump in federal construction spending, the numbers would be even worse.

Like water off a duck's back, the real-estate-can't-go-down crowd pays zero attention to numbers like this. And they also ignore the dramatic increase of the yield on 10-year Treasury bonds, which are now up to 4.32%.

Rising fuel costs kills profits at AMWD. How would you explain?

American Woodmarket (Nasdaq:AMWD) makes kitchen cabinets and has been riding the real estate boom. Business is booming -- sales jumped by 15% in Q2. But profits dropped by 11%? What gives?

According to CEO James Gosa, the answer is simple:

"It's those fuel prices. The run-up in crude oil prices has affected us in a number of ways."

"Petrochemical costs account for a substantial portion of all of our costs. A lot of what we do, after all, is move material. We are moving materials constantly between our plants and then ultimately to the consumer."

Those weren't the most alarming comments though. What really caught my attention was:

"We are back in an inflationary world where prices will go up from year to year. "So we all need to reset our brains."

If you can remember the cost-push type of inflation that caused President Nixon to install a wage/price freeze in 1971, you know how hard inflation is to kill once it becomes entrenched.

Watching oil zoom past $62 dollars today get us that much closer to the danger zone that Mr. Gosa is warning us about.

Another company signs the inflation blues. Ducommun (NYSE:DCO), a maker of aircraft and helicopter parts, is growing its top line just fine...but profits aren't so hot.

Q2 sales hit $62.0 million, a nice 8% jump from the $57.4 it did last year. However, profits fell from 42 cents in 2004 to 40 cents this year. What's up?

The problem is falling profit margins, which dropped from 24.6% last year to 22.8%. As with American Woodmark, the problem is higher costs.

"The gross profit margin decrease was primarily the result of higher operating costs."

Ducommun's problem isn't so much energy costs, but increases in the cost of aluminum, steel, plastic composites, and sheet metal.

Yet, Alan Greenspan and his Fed buddies continue to claim that inflation is under control.

Ducommun, by the way, receives about 45% of its sales from Boeing.

Proctor & Gamble complains about commodity prices. This is getting to be a broken record. Sales at Proctor & Gamble rose by 10% from $12.96 billion last year to $14.26 billion in Q2.

Guess what? Profit margins fell by 1.1% because of higher commodity costs, which P&G described as "significant challenges."

"We delivered another year of strong top and bottom-line results despite significant challenges from higher commodity costs."

Rising sales, shrinking profit margins, and falling problems. That is a lament that I predict you'll hear form a lot more companies.

Japan slaps tariffs on U.S. steel. Japan took a retaliatory step against the American steel industry Monday and announced it will impose 15% levies on U.S. steel imports starting on September 1.

This tariff is in retaliation on U.S. tariffs on Japanese steel products under the 2003 Byrd amendment, named after Senator Robert Byrd, a West Virginia Democrat who sponsored the bill.

Don't think Japan is alone in this action. The World Trade Organization has ruled the U.S. tariffs to be illegal and 25 countries from the European Union plus Canada have already imposed retaliatory sanctions against the United States.

While I wouldn't characterize these actions as a trade war, anything that discourages free trade depresses economic growth and contributes to inflation.


 

Tony Sagami

Author: Tony Sagami

Tony Sagami
Harvest Advisors.

Tony Sagami

Tony Sagami is the owner and founder of Harvest Advisors, an investment research and money management company. Sagami has been managing money for more than 20 years and is one of the early pioneers in the application of technical and quantitative analysis to mutual funds and stocks.

Tony is a man that wears several hats. In addition to Harvest Advisors, he has launched several successful technology companies. Tony is the owner of Monocle Systems, a popular investment analytical software program that has been used by thousands of professional money managers and sophisticated individual investors. Tony is also co-owner of AdvisorSquare, one of the largest web design and hosting companies in the world.

Tony is a frequently quoted expert, appreciated for his frank and unconventional view. Tony has appeared in publications such as the Wall Street Jouranl, Barrons, Kiplingers, Smart Money, Business Week, New York Times, Washington Post, Investors Business Daily, Bloomberg, Financial Planning Times, Mutual Funds Magazine, Chicago Tribune, LA Times, and many others.

A graduate of the University of Washington, Tony enjoys coaching youth sports, serving his community as an active Rotarian, and exploring the all the beauty that Montana has to offer. Tony is a Paul Harris Fellow, an Eagle Scout, and married to his first-and-only wife and father of 4 wonderful kids.

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