The S&A Digest: When Things Can't Get Any Better...

Time to sell refiners?... The devil's $15 billion buyback... Unprofitable IPOs & why readers want to buy them... ETF short ratios over 100%... Another reason to avoid taxes... A true secret of barbecue...

On Mondays we give the floor to our quant analyst, Ian Davis. What is a quant analyst? Ian studies the history of the stock market... in excruciating statistical detail. He looks for trading strategies that he can prove worked over dozens of years and under different market conditions. Today, Ian takes on one of the most popular investments of the last few years – oil refiners – and reaches a conclusion I bet you’ll find surprising... See his essay below.

At its annual meeting on Friday, Wal-Mart (WMT) announced it will return more money to shareholders, increasing its share buyback plan by $11.7 billion. The company also plans to cut back on the number of new supercenter stores it will open. Wal-Mart stock is up about 6% since last week. Extreme Value editor Dan Ferris, of course, has described Wal-Mart as the "best stock on Earth right now."

According to unnamed, inside sources, Extreme Value pick American Express (AXP) will sell its private banking business within a matter of weeks.

Signs of a subprime rebound... Citadel, the $14 billion Chicago-based hedge fund, bought subprime lender ResMAE Mortgage for $180 million. Private-equity firm Lone Star also picked up a subprime lender, Accredited Home Lenders, for $400 million in cash.

Signs of a market top... More than 46% of the 89 IPOs this year came from companies that were unprofitable at the time of the offering. This is the highest percentage since the 71% in 2000. (Not surprisingly, we received our first subscriber inquiring about research on IPOs last week... See the mailbag, below.)

As stock markets continue to climb, hedge funds are having a harder time finding individual stocks to short. In order to maintain their short positions, the funds are turning to ETFs – baskets of stocks traded on stock exchanges. The number of short positions in ETFs has risen 85% since the end of 2006. Currently, eight ETFs have short interest greater than 100%. What tops the list? Regional banks.

China will gain an estimated $40 billion a year from the tax increase on stock trading announced last week if trading remains at current levels. The extra tax revenue would equal nearly 7% of the government's annual budget.

New highs: Freeport McMoRan (FCX), Southern Copper (PCU), Raytheon (RTN), Nokia (NOK), Anheuser-Busch (BUD), Petro-Canada (PCZ) Occidental Petro (OXY), Marathon Oil (MRO), ConocoPhillips (COP), POSCO (PKX), American Express (AXP), PowerShares Harvest Currency (DBV), BHP Billiton (BHP), Anglo American (AAUK), McKesson (MCK), Sunoco (SUN).

In the mailbag... Doug Casey continues to incite criticisms, a true secret of great barbecue, and why the latest PSIA recommendation is unique. Add your thoughts here: feedback@stansberryresearch.com.

"I hope you find this of interest: Heinz Stock Deal Rejected as Sham; Step Transaction Doctrine Applied – A multimillion-dollar stock redemption transaction by H.J. Heinz Co. and subsidiaries was an economic sham intended to generate capital losses for tax reasons, the U.S. Court of Federal Claims rules in H.J. Heinz Co. v. United States, refusing to require IRS to refund close to $43 million in taxes on the deal. Judge Allegra says the complex transaction, involving stock sales and transfers between Heinz and its subsidiary, H.J. Heinz Credit Co. [HCC], was designed solely to eradicate HCC's prior-year gains."

– Paid-up subscriber Thomas Popplewell

Porter comment: I know why you sent this... Teresa Heinz (wife of former presidential candidate John Kerry) famously pays next to nothing in personal taxes, thanks to tax-free municipal bond investments. Apparently, the company her family founded has a similar aversion to taxes. But, I don't fault them. I wish it were socially acceptable to avoid taxes here, like it is in most other places in the world. Most Americans don't realize that the "land of the free" is the only major industrialized country that imposes universal taxation on its citizens... or that our top income-tax rate is now three times higher than Russia's top rate. You could spend all day trying to figure out how America – once home to patriots of liberty like Patrick Henry – became a nation of people willing to submit to almost any indignity, as long as their television works, they can afford gasoline, and the pharmacy doesn't run out of happy pills.

"I just realized that [the most recent PSIA recommendation] will make the third PSIA idea I've recently placed in all three client portfolios – Growth, Balanced, and Income. Verizon, another PSIA idea, was the first stock to ever accomplish this feat. I used to think it rare to have good income from dividends and good price upside at the same time. Either I'm recognizing a good thing or you are turning investing on its head... I've never before done this kind of crossover, but it makes a lot of sense in today's market." – Paid-up subscriber Jim Pursley

"An uneducated reader named Warren Heinemann wrote that, 'Doug Casey is so boring. He doesn't like our politics, our constitution or our banks.' Doug Casey is far from boring and there is nothing that he likes more than our Constitution! Like all libertarians, Casey loves the Constitution and only hates the fact that our current government, all three branches of it, largely regard it as a nuisance, or worse they don't regard it at all!" – Paid-up subscriber Ken Mosher

"'Doug Casey is a genius.' I guess if you bought Venezuelan or Zimbabwe land like he recommended you might not think so." – Paid-up subscriber Jeff Araj

Porter comment: Doug has been writing about investments for 40 years. I'm sure he's made his share of bad recommendations. On the other hand, if you want to know which real estate and junior gold stocks to consider buying, I don't know any one more plugged in. (Our own Matt Badiali is no slouch, either. But Doug has about 30 years more experience...)

"I purchased this course and find it to be above reproach. It has to do with currency trading and is very, very complete. An honest product. It is ongoing with live interaction with a professional currency trader with many years of experience... Not for every one. Just us high-risk livers. My personal investment. Keep up the great work." – Paid-up subscriber Peter Stephens

"I have enjoyed reading PSIA, True Wealth & Penny Letter. Have you considered starting a newsletter [that] deals with IPOs & recently listed IPOs. I have observed that many of the good ones keep going up in price." – Paid-up subscriber Joe Appaya

Porter comment: Buying IPOs is a fool's errand, if you don't get the broker price – which you can't unless you've got tens of millions of dollars in your account or unless you're plugged in. Market studies show that, on average, buying IPOs on their first day of trading is one of the worst ways of investing.

"Okay Porter, I have come to the conclusion that I have been petty and childish for not sending this sooner in the vain fantasy that my grilling secrets, if revealed, would render me less of the god of outdoor cooking that I am... My secret is the only, repeat only, way to add weight to a cut of meat, and the only way to season it to its core. It's called brining. If you're not entirely familiar with the technique, I refer you to Alton Brown's cookbook (he may have more than one, but I think the title is Good Eats). Simply put, soaking a piece of fowl or pork (it cannot be done to red meats or fish) in a brine solution of some salt, a bit of sugar, and a seasoning, has a molecular effect upon the meat. The brine time is a minimum of 8 hours and maximum of about 48 hours. As I said, don't try it with beef, or other dark meats. It will absorb the moisture, but it will also bleed out the red blood... Blech!" – Paid-up subscriber Mike Rollins

Porter comment: I have brined many times. It's the secret to my beer-can chicken recipe. If you're new to brining, caution: You can overdo it. I'd recommend starting with a very small amount of salt (say, half a cup) to a big bucket of water. I don't like to brine for more than two or three hours, either. You don't want to chemically cook the meat, which can happen if you use too much salt or if you leave chicken in the brine for too long.

Regards,

Porter Stansberry

Baltimore, Maryland

When Things Can't Get Any Better...

The basic idea behind an oil refinery's business is simple. A refinery converts crude oil into usable products like diesel and gasoline.

A refinery's profits come from the "crack spread," which is the difference between the cost of oil and the price of gas or diesel. When the crack spread is large, these companies can sell their product for a large amount relative to the fixed costs of refining, or "cracking" in industry terms, the crude oil.

To get a rough gauge for the economic situation for oil refiners, I created my own crack spread using the ratio of diesel prices to crude oil prices. I like looking at a ratio between diesel and oil rather then a spread, since it's the clearest way to track the performance of diesel relative to the performance of crude oil. Specifically, the indicator I'm using is the price of diesel (in ¢/Gal) divided by the cost of crude oil (in $/Bbl).

Last month, this ratio reached 3.23, a level that is 1.64 standard deviations above the average ratio (2.84). To give you a sense of how rare this level is, the ratio has exceeded 1.64 standard deviations only 4.7% of the time since 1994.

Since a high ratio is good for refiners (higher earnings relative to costs), you'd expect refiners' stocks to perform well when these situations arise. But, surprisingly, this turns out to be false.

A Contrarian Indicator for Oil Refiners

When the diesel-to-crude-oil ratio is high – when the ratio hits 3.2, or 1.5 standard deviations greater than the average – Valero Energy (VLO), the largest independent oil refining company in the U.S., performs poorly over the following six months.

Look at the numbers.

The following table shows the performance of Valero six months after it reaches a high diesel/crude oil ratio extreme and the company's average six-month performance for comparison.

The next chart shows the stock price of Valero Energy compared with the diesel-to-crude oil ratio. (In the table, the ratio in this chart has been normalized, which means that 0 represents the historic mean. A value of +1 or -1 means the ratio is one standard deviation above or below its mean level.)

As you can see, peaks in the ratio often correspond to peaks in the company's share price.

Valero Tends to Peak When Conditions Are Most Favorable

Conclusion

Conditions for oil-refining companies became unusually favorable last month. As the outlook surrounding these oil refiners becomes less rosy, their share prices will likely suffer. Refiner stocks have soared in the last three months. So if your thinking about investing here, you may be late to the party. Tread carefully around these refiners over the next six months.

Good investing,

Ian Davis

June 4, 2007

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