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The Daily Reckoning | Wednesday, March 10, 2010 Deciphering the VIX Index The Rally in Overconfidence Joel Bowman Hip hip, hooray! Hip hip, hooray! Our little big bull market celebrated its one-year anniversary yesterday, albeit in tentative style. The Dow managed to eke out an 11- point gain, while the broader S&P 500 fared only slightly better. Investors, it appears, are awaiting the next catalyst to keep the momentum going. But are they running out of excuses to buy? It is difficult to know precisely what is going on inside the collective brain of the marketplace, but one indicator gives us a hint. The VIX Index, also known as Wall Street's "Fear Gauge," measures the implied volatility over the coming thirty days. A high reading represents costlier options, commonly used to hedge against any sudden down trend. A low reading indicates a lower hedging cost, meaning that traders expect relatively calm waters ahead. At its extremes, the VIX Index is a rather useful tool for contrarians. When the VIX breaches its moving averages to the upside, it's usually a pretty good sign that the market is oversold. Conversely, when the index dips below certain key points, it's probably a good time to expect the unexpected, so to speak. Right now, the VIX is bobbing around close to its 18-month lows. That means traders are not forecasting much of anything...a pretty good sign that we'll see quite a bit of something. Last Friday, the measure fell to 17.5, a level not seen since January...when the S&P promptly fell from around 1,150 to 1,050. Before that, the VIX had not seen a reading of 18 since August of 2008...right before the market went skydiving without a parachute. By March of 2009, a few short and painful months later, indexes around the world had almost managed to saw themselves in half...and worse. Just before the global financial collapse, your editor took advantage of the rampant overconfidence in the market to implement a little preemptive "austerity plan" of his own. And so, from the gaudy bubble- central of Dubai we took the long road east, making sure to pass through notably inexpensive destinations like India, Nepal and Southeast Asia. Without a country full of union workers to protest the move, this was relatively easy to do (sorry Greece...and France...and Britain...and, well, Europe). Here in the Far East, we can enjoy the same or better lifestyle for a fraction of the price. Rent is less than half what it was in Dubai. Food costs next to nothing. And, as an added bonus, your editor's girlfriend is not obliged to dress like a ninja when we take weekend trips to neighboring countries...not even when we visit Japan. One would need a degree in modern economic theory not to see the problems lurking below the surface of this market rally. That or a job in a government office...in which case you're paid not to notice. But the fortunately untrained eye can't help but notice the worsening unemployment situation, a deteriorating real estate market - especially in the commercial sector - and a public balance sheet that looks even worse than the private one that led us all into this mess in the first place. While on our little pilgrimage of austerity - back at the end of '08 - early '09 - we ran into dozens of ex-bankers and newly redundant financial services workers. We found them lazing on the beaches of Viet Nam and sipping $2 daiquiris at the bars around Bangkok. A few of them had plans for the future, but mostly they were there to somehow, vaguely, "ride it out." Our little big bull market may be a year old but, if we had to bet, we'd say it's a rally in overconfidence only, as presently exhibited by the VIX index. On the bright side, the bar staff at the resorts in Phuket can look forward to another influx of lost souls armed with loose severance packages. Comforting as $2 beachside daiquiris can be, you needn't entrust your entire financial future to their temporary consolation. In today's column, Chris Mayer offers a few of his favorite ways to ride out the coming storm. His insights are below but, before we get to them, make sure you arm yourself with a $1, one-month trial to his premium research service, Mayer's Special Situations. The special offer we've been telling you about recently closes tomorrow at 5 PM. After that, the price goes back to the usual $995 per year. Details here. The Daily Reckoning Presents Water Stocks: A Few of My Favorite Things, Part I Chris Mayer Water - I've been urging my subscribers to invest in water stocks for several years...and Hyflux is one of my favorites. Hyflux (HYFXF: OTC Bulletin Board) operates in China, Southeast Asia, India, the Middle East and North Africa. It is involved in a variety of water projects, from desalination to recycling. It was among the first stocks ever recommended in my investment service, Mayer's Special Situations, when I launched the "Blue Gold Portfolio" back in the summer of 2006. Since I recommended it, Hyflux is up 75%, while the S&P 500 is down 10%. Recently, the company posted a fresh earnings report that showed record results. Hyflux announced net profits of $53 million - a record high and a 27% increase from the year prior. The order book also grew 20%. It generated solid cash flow and maintained a good balance sheet with $120 million in the bank. Below is a chart I like from the latest earnings presentation. It shows you the growing order book broken down into two categories. EPC is the engineering business that builds plants. This is a more volatile business. The O&M is for operations and maintenance. This is the business the runs desalinization plants and the like. This is a steady cash flow business. As you can see, the O&M part of the business is growing mightily. This lowers the risk of Hyflux's business and gives it more of a stable platform of cash flow. Hyflux is also gaining market share, especially in desalination. This next chart is also from the latest earnings presentation. It shows you Hyflux has emerged as a clear leader among its peers. Hyflux operates the largest seawater desal plant in China, in Tianjin. The company is also building the largest seawater desal plant in the world in Algeria. There is a ton of room for growth when you consider the urgent and long-term need for water along the New Silk Road. The stock trades for about 25 times earnings, which roughly matches its growth rate. Hyflux is no longer the great bargain it was; however, it remains one of the best ways to play Asia's long-term water needs. Gorman-Rupp (AMEX:GRC), another veteran of the Blue Gold Portfolio, reported good results last week. Gorman-Rupp makes water pumps of all kinds, as well as pumps used in other industries, such as oil and gas. It's been a great performer since I recommended it in mid-2006. We took half off the position the table after doubling our money. The other half has delivered nearly 12% annually, soundly beating the market. The S&P 500 has fallen 15% over that timeframe. Gorman-Rupp has a strong balance sheet with no net debt. Sales and earnings were lower in 2009 as a result of the recession, but the longer-term picture looks good. The company remains in good position to capture a share of the rising tide of spending on water and wastewater infrastructure over time. The construction of its new 460,000-square- foot facility is complete and the company moved in during the fourth quarter. The stock is not likely to light the world on fire, but it's a good long-term investment in the water sector. Patient investors should give it a look while it trades at depressed earnings levels. I also like Badger Meter (NYSE:BMI), which makes metering devices, and A.O. Smith (NYSE:AOS), which makes water heaters and has a booming business in China. Valmont (NYSE:VMI), which makes irrigation equipment, is another to watch. But in all cases, the price paid is important. I like to wait for opportunities to buy stocks on the cheap, like we did with Flowserve (NYSE:FLS), which makes pumps, valve and seals. The stock has doubled since I recommended it, with the promise of more to come. But if the stocks I like aren't attractively priced, I'll just sit tight and keep a watchful eye. Energy Services - T3 Energy Services (NASDAQ:TTES) reported good results last week. T3 is a cash flow machine. It generated $33 million in free cash flow and remains debt free. The market values the stock at $309 million. So you are paying only 9 times a depressed free cash flow number to own this stock. And things look to get stronger as the year goes on and the drilling rebound continues. One of the interesting notes from the quarter: About 60% of T3's backlog is for overseas work, confirming again a trend we've seen at work in Key Energy Services (NYSE:KEG). T3 sees a lot of demand from the Middle East. It also won a key certification in Saudi Arabia - which had been pending for over a year - for one of its products, which should greatly help sales there. The company also has a new product that is generating some buzz. It is a new frac system, used to coax more oil or gas out of a well. Without getting too technical, T3's system allows a driller to service multiple wells from a single location. T3 shipped one for $9 million, or about 17% of revenues for the quarter. After 45 days in the field, the system exceeded customer expectations. No other competitor currently offers this, and T3 will show it off at the upcoming Offshore Technology Conference. This could be an exciting new product for T3. The company is just above my buy-up-to price of $25, but I would urge buying the stock on any weakness. Business is clearly turning up, and there is lots of room for upside as we get strong results later in the year. Remember, two years ago, the stock hit $80 per share. Chris Mayer for The Daily Reckoning