To be honest, I figured General Motors would be in bankruptcy by now. With a monthly burn rate estimated to be between $2 billion and $6 billion (depending on source) it would seem this money hole would have imploded sooner rather than later.

But with the stimulus package signed and the goal of creating or saving 3.5 million jobs (on a side note, if anyone knows how you calculate "saved" jobs please let me know it seems if 3.5 million people are still working by the time the next election rolls around, this will be a "success") and hundreds of billions of dollars ready to be handed out to anyone who earns a prevailing wage, the government may have revealed their plan to save GM and Chrysler.

This time, they're actually addressing the real issue at hand. After all, it's basic economics. It's all about supply and demand.

The Supply Side

In a week when GM's market cap fell to below its 1938 valuation (yes, lowest since the Great Depression) and announced 47,000 layoffs, it still felt it somehow deserves more taxpayer money to stay afloat, GM and Chrysler handed in their recovery plans.

The plans called for layoffs, restructuring, and more cash much more cash. GM and Chrysler asked for an additional $7 billion in "loans" immediately and more than $21 billion down the road. This was on top of the $17.4 billion the companies received last year.

But this cash won't address the real problems GM and Chrysler are facing which we identified when they got their first round of handouts:

At the end of October, GM North America reported it has 799,000 vehicles in stock consisting of both cars and light trucks. That's about five months worth of inventory (when measured against the 166,000 sold in October), which is 15% below last year's inventory, but it's only getting worse.

At current sales rates, inventory will start to grow. GM expects to produce an additional 567,000 (875,000 total for Q4 minus 318,000 October production) over the next two months. If the October sales rate holds up, despite rising unemployment and falling consumer disposable incomes, GM's total inventory will increase to 1,234,000 vehicles.

Since then, sales have only gotten worse and thanks to government life support they're still making more and more cars. But here's where the government is making its most ridiculous move yet to address the overcapacity problem and cover more of the automakers cost.

The Demand Side

This is the big question I had a few months ago. During an interview with BNN , we identified there were a total of 250 million cars, trucks and motorcycles registered in the United States. But there are only 203 million drivers. That's an average of 1.23 vehicles for every driver.

At the time it seemed everyone was focusing on debating the morality, but there were much, much bigger questions at hand whether it was right to bail out these companies or not. For instance, where all the demand would come from? Does everyone who wants a car already have one? How many people would choose to upgrade to a new model in the middle of an economic downturn?

So the government devised a solution: they'll create demand.

One big part of the stimulus package is for the government to purchase $300 million worth of new cars. Sure, it's for hybrid cars (which I guess makes it a bit more marketable to the public who wants to say hybrid cars are bad), but it's clearly aimed at making a dent in the overcapacity problem.

So now the government is not just subsidizing supply, it's also creating artificial and unsustainable demand.

Ballooning Backdoor Bailouts

On top of that, there are plenty more "backdoor bailouts" for the auto industry. The Detroit Free Press reports there is:

- a tax deduction on auto loan interest which consulting firm R.L. Polk says works out to about a $1,250 subsidy per car purchased (good idea! Especially since the tax policies and implicit Freddie and Fannie guarantees which help create a "house for everyone" bubble worked so well)

- An income tax deduction for purchase of hybrid vehicle worth about $330 per vehicle

Oil prices continued down again this week. A barrel of crude dropped to under $34 a barrel Friday afternoon. But on Friday evening oil surged more than 10% to close the week above $37.50 a barrel on the NYMEX. It seemed traders realized OPEC could make more cuts in March and oil prices were just “too low.”

Whatever the cause for the spike was, the sharp upturn on Friday could signal a tradable bottom for a couple of reasons.

Jeremy Grantham: “Below 30, I’m definitely a buyer”

The first is the amount of buying interest in oil when it drops below $35 a barrel. In a recent interview Jeremy Grantham talks about a few of the least considered factors when it comes to oil: volatility. In the interview (view video here) Grantham states:

I thought that after 100 years at $16 a barrel, it had jumped to maybe $36 or $37 in real terms. And I think it has probably jumped again. It will be revealed in 20 years to what level. But my guess is $60, $65, maybe even $70.

But what people underestimate, even in the oil industry, is how volatile the asset class is. In other words, if the trend is $65, it is fairly routine for oil to sell below half, say $30, and more than double, say $145.

And people never get that. So you don't want to be too quick to buy into weakness or sell into strength, necessarily. But it can go a long way. But below 40, I must say, I do get a bit interested. And below 30, I'm definitely a buyer.

Grantham isn’t the only one interested in buying oil at the sub $35 a barrel level. There’s a lot of interest. But to go as far as saying “I’m definitely a buyer” under $30 is a very strong statement which will attract a lot of followers.

It’s looking like between $30 and $35 is at least, if nothing else, a temporary bottom.

Oil Stock Indicator

In OPEC: Too Little, Too Late we looked at how oil service stocks can be a good indicator of changes in oil price trends. The stock market is actually a very good predictor of oil prices. Oil service stocks (Oil Service HOLDRS ETF - OIH) tend to lead oil prices (U.S. Oil Trust - USO) for the past few years. When oil service stocks went up, oil prices have followed. When oil service stocks went down, oil prices followed.

As you can see in the chart below, oil service stocks have consistently led the way. Whichever way the OIH (red line) went, USO (blue line) followed.

Now it looks like oil stocks are trending flat to slightly higher while oil prices have fallen. In the past few years, that has been a good indicator of a rebound in oil prices.

Overflowing With Oil

From a fundamental supply/demand perspective, it’s tough to imagine things getting much worse in the short-term.

On the demand side China’s economic problems are well known and U.S. oil consumption is expected to decline for the first time since 1982.

On the supply side OPEC has successfully been able to stick to its quotas and oil inventories around the world are reaching record levels.

Oil stored in Cushing, Oklahoma climbed another 1.7% this week. Now 34.6 million barrels of oil are stored at Cushing. That’s almost three times the same levels in 2004 when oil prices started marching much higher.

On top of that, a few weeks ago Frontline (NYSE:FRO) reported, “Trading companies are storing an additional 80 million barrels aboard 35 supertankers and a handful of smaller tankers, the most in 20 years.”

In the end, you can make a case for oil over the medium and long-terms. We’ve been through the long and short case for oil before and looked into what the oil bubble left behind. But when we’re focused mainly on the short-term, it’s plain to see there is a lot of interest at the sub $35 a barrel and oil stocks are signaling a rebound in oil prices is on the way. I’m part of that interest and bought on Friday, but I’ll be a willing seller into any rebound.

Good trading,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

Disclosure: Long Horizons NYMEX Crude Oil Bull (TSX:HOU)

Once again Warren Buffett makes the best of a bad situation. Today Harley-Davidson (NYSE:HOG) announced it will be raising $600 million through an offering of 15% debt.

As you might expect, Buffett’s involvement in the deal sparked a rally in Harley shares. The shares of the beaten down motorcycle maker surged more than 15% today while the rest of the auto industry had a pretty rough day.

Is it a good move for Buffett?

Yes.

Is it a good move for investors to bid up shares of Harley-Davidson?

Probably not.

Frankly, it still blows my mind how many investors are willing to plow in after Buffett. Just take a look at the Goldman Sachs (NYSE:GS) deal he pulled off a few months ago. He put $5 billion into 10% Goldman’s perpetual preferred shares.

The Goldman deal gave Buffett one of his favorite types of investments - a (synthetic) convertible security. It’s the type of investment the University of Southern California’s Professor Tom Taulli says is “Buffett’s preferred method of investing.”

The net cost of the investment at the time was $5 billion cash for a position worth about $8.2 billion at the time (cost breakdown here). Regardless, investors still jumped on Goldman shares after they got, what many believed, was the Berkshire seal of approval.

A Tough Road Ahead

Harley is a bit of a different situation though. Harley hasn’t weathered the downturn well at all. Its sales last quarter were off by 19.6% in YOY terms. And when you’re considering today’s sales report from the automakers (about 40% decline on average I’d say), there’s probably not going to be much demand for top-of-the-line motorcycles.

What’s even worse is Harley borrowed the $600 million today in response to a $500 million debt coming due in a few weeks (although all or part of it could be getting refinanced, we don’t know yet) and to be used to lend more to its customers.

Maybe I’m looking at it a bit too simplistically, but a company can’t keep borrowing at 15% and lending at 1% or 2% forever. Yes, there are profits per sale and all that to consider, but from the bottom up, it doesn’t look very sustainable.

With no recovery in sight, there are probably more tough times ahead for Harley and this financing will only help the company partially weather the storm.

A Win/Win Buffett Style

Regardless of what you think of Harley shares, this deal looks to be another win/win for Buffett. As Harley continues to scrape by, it’ll have to pay those 15% interest payments to Berkshire. In a worst case scenario, if Harley would get crushed by the weight of its own debt, Berkshire would get an ownership stake in one of America’s most iconic brands (how many other brands are thousands of people willing to have tattooed on their bodies?).

This deal does tell us one thing, Buffett is seeing value in bonds. We’ve covered the how corporate bonds are likely to beat stocks in the short and medium terms in the Prosperityu Dispatch (Sign up 100% free here) a few times and it’s good to see Buffett more and more on bonds. When it comes to the Harley deal itself, it’s a win/win for investors, like Buffett, in these high-yield bonds. As for the shares of the company which soared today, it’s a totally different story.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

So far OPEC has been relatively successful at cutting oil production and keeping oil prices propped up. Saudi Arabia is leading the charge saying, more or less, it’s going to do what needs to be done.

They have been able to stick together, but how long can it really last?

It’s been somewhat of a surprise to see most of the OPEC members “stick to the plan” so far. Back in A Slippery Slope Ahead for Oil Prices, we looked at:

Falling oil prices puts these countries into a bind…

…a lot of countries will be facing big problems if oil falls further or if they cut production enough to keep oil prices propped up. When hard times hit, OPEC members look at what’s best for themselves instead of the group.

Since then oil prices have fallen off quite a bit and have reached what appears to be a bottom – at least a temporary one. And anytime oil prices to start to move up, there’s always some government economic data or Nouriel Roubini to knock oil prices right back down.

You’ve got to remember, it’s only been six months since oil was over $140 a barrel. Oil producing countries made it through the first part of the downswing, but some big budget shortfalls are coming.

A recent IMF study shows a lot of countries are truly “addicted to oil.” In fact, most of the leading oil producing countries, OPEC and non-OPEC, won’t even be able to pay the bills in 2009 without oil prices rebounding - quickly.

There’s plenty more that lived high on the hog while oil prices were high. Venezuela needs $95 oil just to fund all his social programs and breakeven in 2009. Russia will be running a deficit too if oil doesn’t average $70 a barrel next year.

They’ve all got to do something. They can borrow at extremely high rates of interest, if any lenders are even available. They could cut spending; raise taxes, or some combination thereof. None of which is likely going to go over too well with the citizens. Or they can just print money. Regrettably, the easiest option is probably the worst.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

Earlier today, China announced its economy grew at a 6.8% in Q4. This is not very good news at all. China’s GDP growth is inching perilously close to 6% economic growth. Which is viewed the minimum to keep the lights on. It’s a critical level the world is watching closely.

Say what you want about the validity of China’s “official” numbers, but it’s bad and it’s probably going to get worse. As you can see in the table below, the downtrend is still accelerating.

The U.S. is Sneezing…

At this rate, China is on its way to a full-blown crisis. As we looked at a few months ago when the first wave of manufacturer shutdowns in China swept through the country, there would be a lot more to come. After all, about 1/3^rd of China’s economy comes from production, manufacturing, and exports and about 1/3^rd comes from expanding export and production capacity.

That’s why China’s economy takes a double hit during tough times. When toy factories are shutting down, the economy loses the jobs. Of course, there’s no need for new toy factories either, so the production expansion sector of its economy gets hit too.

The old saying, “when the U.S. sneezes, the rest of the world catches a cold,” certainly seems to be proven in China. China Daily estimates, “A drop of 1 percentage point in the economic growth of the US and Europe would send the Chinese exports falling by 4.75 percent, and the exports of electronics and textiles down by 0.5 percent respectively.”

Now, we’re starting to see the impact on GDP growth. Of course, the quickest way to get China back on track is to get exports rolling again. As we saw a few weeks ago, that’s not going to happen anytime soon. That’s when China announced its exports fell for at the fastest in over a decade.

This is the first time China has had to deal with all three its top customers – U.S., Europe, and Japan - being in recessions.

What’s this mean for China stocks?

Well…since November, there still is a lot of interest in China stocks. It’s pretty tough to make a case against the long-term opportunities in China. The country’s economy is showing signs of change. For instance, last month retail sales increased more than 17%. So internal demand is growing, but it’s got a long way to go. The short-term outlook, however, isn’t very strong at all.

One indicator I look at is the volatility component of long-term options on the iShares FTSE/Xinhua China 25 Index ETF (NYSE:FXI) which tracks 25 of the largest publicly traded Chinese companies. The volatility on the FXI is the equivalent of the VIX (CBOE Volatility Index, or “Fear Index”, for the S&P 500). Although it has a bigger exposure to mining and energy stocks than the S&P 500, it’s the closest thing to a “China VIX” as you’re going to find.

The VIX is basically a way to value the cost of downside protection. It’s the cost of insurance. When the market is falling, the VIX goes up and vice versa. Today, the China VIX ticked up to 80 (for the January 2010 FXI 25 Put option). Compare that to the S&P 500 VIX of 50 and it shows there’s still some strong demand for “insurance” against Chinese stocks, but it’s not near crisis or panic levels.

Combine a steadily declining economy, and growing fear, and it’d be a pretty safe bet there will be an opportunity to “buy China” down the line at a noticeably better price. Remember, China’s economy is built for booms and no one knows how well it’s going to fare during a downturn. So far, it hasn’t fared well at all.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing