Many pundits have opined that the American consumer is on the ropes, so far in debt that he will be unable to contribute to the economic recovery. Because consumer spending has recently been about 70% of GDP, this has led many to declare that the recovery cannot proceed until a lengthy de-leveraging process has been completed. Factual information is available to assist in quantifying this concern: here is a link to the Federal Reserve's Household Debt Service and Financial Obligations Ratios. After downloading and studying this information, a plausible case can be made for the possibility that this process can be completed in a one or two year time frame, after which a strong and sustainable economic recovery would be possible.

The household debt service ratio - DSR - is an estimate of the ratio of debt payments to disposable personal income. Debt payments consist of the estimated required payments on outstanding mortgage and consumer debt. The Fed provides information going back to 1980, so it gives us a look at a number of troughs/recessions which preceded strong recoveries.

Eric Dinallo was on Bloomberg recently, talking about CDS and other regulatory issues. This clip is worth watching: he is the only politician or regulator who understands the dangers posed by CDS and inadequate regulation and is willing to talk about realistic solutions.

Dinallo, as former NY State Superintendent of Insurance has first hand knowledge of the issues involved, due to the problems he dealt with on AIG, MBIA (MBI), Ambac (ABK) and other financial guarantors. He and NY Governor Paterson attempted to bring the CDS issue to a head by offering to regulate them as insurance, if the Federal government did not step in and do something. At the time, it seemed that Congress would be doing something, but more than a year later CDS regulation is still being debated and in the process whatever we get is going to be too watered down to resolve the issues. Dinallo makes some excellent points:

Sigma Designs (SIGM) recently announced the acquisition of CopperGate for 160 million, to be paid with $92 million in cash plus the issuance of an estimated 4 million shares. Boards of both companies have approved the deal.

As has been happening lately, shares of the acquiring company traded down. Sigma closed Tuesday at 13.46, down about 6% on the day. After reviewing the slides that accompanied the company's conference call, I regard the acquisition as a favorable development, based on a good strategic fit and the ability to fund it without incurring debt.

ConocoPhillips (COP) released its 3^rd quarter interim results on 10/2, followed on 10/7 by an announcement of a dividend hike, together with plans to rationalize their portfolio and grow production. Shares closed Friday at 50.84, up 13% so far in October. Shiv Kapoor drew a lot of comments with his October 1^st article, suggesting COP may be a multi-bagger. Warren Buffett uncharacteristically admitted a mistake and took large losses on the company, a fact which seemed to distract some of the commentators from the fundamentals.

I have owned COP off and on for years, reliably extracting profits via covered calls at the lower end of its value range, and mentioned a recently added long position in a September article focused on changes in portfolio emphasis. However, I did not look that carefully at the selection when I made it, and I must confess to being a little surprised at the rapid price movement. Studying the 10/7 press release what I see is management's tacit admission of strategic errors, followed by corrective action, which is winning market support.

On September 30, Jim Cramer commented favorably on electric utility Exelon (EXC), after the stock closed at 49.62.

I was not listening (a little bit goes a long way) but according to Miriam Metzinger, he said that the cap-and-trade bill should benefit Exelon, which has nuclear power exposure. Investors have a good entry point because the "stock is way off."

Gulf Islands Fabrication Inc. (GIFI), at Friday's closing price of 18.06, is a value play in the oil and gas equipment and services industry. The initial attraction is a combination of low P/B (1.0) and low Price/5 Year Average Earnings (11.5). The company has numerous strengths, which over time should allow it to overcome current weakness in revenue and backlog and participate strongly in the growth area of deep water equipment.

I picked up the idea from a screen by Alan Brochstein here on Seeking Alpha. Checking further, the same name appears on a screen he did on 3/28 which also included Carbo Ceramics (CRR) and Lufkin Industries (LUFK), both successful picks I wrote up favorably and bought for my discretionary account. To some extent I work by affinity – I follow Alan and since this idea is a case where our thinking leads in the same direction, I did my own research, developing the following information and opinion.

Specialty steelmaker Haynes International (HAYN) at yesterday's closing price of 32.08, is interesting as a long-term play on industrial recovery. Attractions include a strong balance sheet, ample cash, technical expertise, and a diversified customer list that is a who's who of global industry. Weighing against that, the specialty alloy business is cyclical and highly competitive, capital intensive, and dependent on aerospace, chemicals and power generation - all areas that have been hard hit by the economic slowdown.

Overview – Haynes International is a leading developer, manufacturer and marketer of high performance nickel-and cobalt-based alloys used in corrosion and high-temperature applications. There is a good recent presentation on their website: rather than rehash that information, here is a link. Recent financial results include a large non-cash write-off of goodwill: future projections are in the break-even area for several quarters forward. However, the stock is attractively priced based on five year average earnings and should perform very strongly in a global economic recovery.

Multi-line insurer Allstate (ALL) was recently downgraded by Goldman Sachs, from neutral to sell. The analyst cited risk of loss of market share for Auto, low ROE on Homeowners, and uncertainty about the Life operation. The shares naturally gave up a few points on the news, so I thought I would go back over my thinking on Allstate. The shares closed Thursday at 30.33. TTM P/E is meaningless due to heavy write-offs and catastrophe losses in 2008.

5 Year Average EPS – Property and casualty insurance has a tendency to run in cycles: as soon as the companies start to make pretty good money, they compete by reducing prices and expecting to make it up on volume. That doesn't work for long, so they start to lose money, raise prices willy-nilly, and soon return to profitability. Because of this, analysis of profitability and valuation should rely on long term averages and specifically include any bad years with write-offs or restructuring charges. For companies that buy back their own shares, as Allstate does, the proper metric is 5 year average EPS, share count adjusted.

Obama's address to Wall Street was poorly received – a smattering of applause for the announcement of the CFPA, but otherwise a deafening silence, followed afterward by commentary that sees little probability of meaningful reform of financial regulation. Most denizens of Wall Street have missed the point. It is useful to go back over the speech, reading between the lines, and drawing information as to the solutions that will be legislated from the analysis presented as to the fundamental causes of the turmoil.

What Wall Street fails to comprehend is the anger of those who are impoverished by the ongoing transfer of wealth created by our political and financial system. When this anger is directed at President Obama because of his advocacy of health care reform, which seems to inevitably result in a transfer of wealth, they easily grasp that reform as the President envisions it is not politically feasible. From that they erroneously conclude that the he is politically powerless.

Webster Financial Corp. (WBS) is a regional bank, interesting as a value play where the investor has the benefit of the involvement of smart money - in this case, Warburg Pincus.

As a strategy, following the smart money into financials worked horribly during the meltdown, a prime example would be TPG and Washington Mutual. However, the exceptional circumstances which existed last year have now been resolved and/or incorporated into expectations, and this situation makes good sense as contrarian value play.

Sigma Designs (SIGM) closed Friday at $15.67, with a TTM P/E of $23.2 and a P/B of $1.32. It is well above its 52 week low of $6.93, dating back to late last year. This chipmaker has further upside potential, with the possibility of dramatic improvements, dependent on the successful development and marketing of its products into the cable industry. I picked up the idea from a screen by Marc Gerstein here on Seeking Alpha. The basic attraction is the combination of excess cash with a real business in a tech stock.

Overview – the company describes itself as follows:

Procter & Gamble (PG) filed an 8-K yesterday, summarizing the contents of a presentation made to a conference of institutional investors. The tone was positive, including a statement that the company expects to see a resumption of organic growth during its second quarter, ending December 2009. Organic growth is projected in a range of 1 to 4%. The CFO, Jon Moeller, noted that comparisons will get easier going into the second quarter. The stock was up 4%, closing at 56.04.

I included PG in a bullish series of diagonal spreads I did during August, and wrote up here on Seeking Alpha, the reasoning being that large, well-capitalized companies with strong brands can be expected to perform well as the safety and reliability of their earnings streams is better appreciated during what may prove to be a slow recovery.

Mr. Market was not impressed by Baker Hughes' (BHI) acquisition of BJ Services (BJS). BHI was down 10% on the day of the announcement, closing at 34.45. BJS was up only slightly, closing at 16.06. Commentators noted that the combination was a good strategic fit, giving BHI a position in pressure pumping similar to that enjoyed by Schlumberger (SLB) and Halliburton (HAL), at the same time compensating for BJS' lack of a strong international presence. Based on the strategic fit, the combination is worth more than the two companies separately.

A three or four way comparison is necessarily complex, but a simple analysis in terms of 5 year average EPS suggests that Mr. Market is getting it wrong:

Over the past several weeks, I have been changing the emphasis of my portfolio, based on four considerations: 1) target level for the S&P 500; 2) possible trajectory (smooth or jagged); 3) long term interest rates' and 4) future implied volatility. This essay briefly covers each point, going on from there to discuss a shift in strategic emphasis.

S&P 500 Target – I am investing in ways that will be profitable if the S&P 500 hits 1,200 by 12/31/2010. In July I did a study on Corporate Profits as reflected in GDP, postulating a relationship between that data and the S&P 500 index on a quarterly basis. Based on that line of thinking the 1,200 target seems reasonable.

MBIA (MBI) and Ambac (ABK) were up 46% and 17.5% respectively as of Thursday's close, on no news. Options activity was florid: volume on many strikes was equal to or greater than open interest. Share volume on MBI was 25 million, compared to a daily average of 4 million; for Ambac, volume was 112 million as against 17 million. The mono-lines have been included in what the Fast Money crowd on CNBC has been calling the “dash to trash,” which began earlier this week, featuring Fannie Mae (FNM), Freddie Mac (FRE) and AIG.

Possible explanations

Political and regulatory risks are major factors in evaluating stocks in the Health-care Sector, especially health insurers. To the extent these risks are reflected in options implied volatility, the covered combo strategy (long shares, short a straddle or a strangle) may continue attractive for stocks in this industry.

An example - I wrote health insurer Humana (HUM) up favorably here on Seeking Alpha on March 23rd, suggesting the purchase of the stock at 24.43 together with the sale of the August 20 /30 strangle at 5.20. I did the trade myself, and at expiration Friday I expect the shares to be called away, earning 10.77 in five months for an out of pocket investment of 19.23, an annualized return of over 100%. High volatility on options made premiums attractive, enabling an investor to buy the stock at a bargain price (forward P/E of 4.1) and receive generous income for bearing the risks involved, at the same time retaining some exposure to upside price developments.

Yesterday the news came out that Toll Brothers (TOL) is getting increased sales orders for the first time in 16 quarters and that cancelations are now down to levels last seen before the housing meltdown. Shares rallied, predictably, about 15%.

I have been playing homebuilders on a price to book theory, buying them at a price to book of less than 1 and looking to sell at a ratio of 1.5 or better.

CDS reform is getting closer to becoming a reality: here is a link to the Treasury announcement. In addition to Geithner's version, which links to a draft of proposed legislation and states the intention to eliminate fraud, manipulation and abuse, there is an outline of principles from Barney Frank and Collin Peterson, which proposes the elimination of naked CDS, by forbidding transactions where the non-dealer party is not hedging a risk. Taken together, the two documents show that the Administration and Congress are moving closer to outlawing the conduct which came within inches of destroying the entire financial system. It has been a long wait: far too long. But the battle is not won: it is imperative to push our recalcitrant representatives to do their jobs and undo the harm they perpetrated by the Commodities Futures Modernization Act (CFMA), which completely exempted CDS from regulation and sowed the seeds of the debacle we have endured.

Financial regulatory reform is going to occur. The remaining questions have to do with the political agenda, whether the forces who stand to benefit from the continuation of the status quo will be successful in emasculating the coming legislation in order to maintain loopholes or niches where they can continue to exact spoils and tribute from legitimate investors, those who work, save and invest. The challenge while this plays out is to keep track of the important issues, one of which is naked CDS.

MBIA (MBI) reported 2nd quarter EPS of 4.30, an upward surprise although not directly comparable to consensus which called for a loss of (.92). Volume in the two days leading up to the announcement was extraordinarily heavy, with 28 million shares trading Tuesday and 13 million on Wednesday, for a stock that has been trading about 2 million shares a day. The high volume may have been due to quicksilver messengers, warning short-sellers of the impending surprise, or it could have been intuition, instinct, or simple prudence. In any event, the shares reportedly changing hands were sufficient to cover the entire short-interest.

Expected Recoveries - MBIA has recorded 1.1 billion in expected recoveries due to warranties and representations included in 2nd lien mortgage securitizations. Basically, if the mortgages don't conform to requirements, they are to be removed or replaced. The two prime offenders, Countrywide and ResCap, have been stonewalling: they have only provided 24% of the files requested for review and have declined to replace or remove the subject mortgages. MBIA has been paying the claims when due and has suits outstanding against Countrywide and ResCap.

NIPA Corporate Profits may be a better yardstick for measuring the level of the S&P 500 index than the actual GAAP earnings of the companies involved. NIPA stands for National Income and Product Accounts, one of which is Corporate Profits. The US Bureau of Economic Analysis – BEA – includes this number as a sub account in GDP, and as such it is logically consistent with GDP.

As reported earnings of S&P 500 companies fluctuate due to the application of GAAP accounting. GAAP as presently implemented is pro-cyclical – when things are going good, little provision is permitted for losses that are accumulating, almost unnoticed. When things are going bad, write-downs bring both past and future losses together in kitchen sink quarters. NIPA Corporate Profits differ from GAAP, as will be discussed briefly later in the article.