A big change in the market

There was a big change in the market last week – a change few people noticed. When stocks sold off heavily last Thursday and Friday, the U.S. bond market fell. Over the past three years the opposite has happened, almost every time. Before last Thursday, as people sold U.S. stocks, they bought U.S. long bonds. This time, people sold stocks without putting their money in long bonds. That's a sure sign long-term interest rates are poised to rise.

What will people buy as they cash out of U.S. bonds? That's the $10 trillion question. As you know, our bet is energy and precious metals. The chart below shows the relative, one-year performance of U.S. long bonds (TLT), silver (SLV), gold (GLD), and oil (OIL). We believe the U.S. Congress, Ben Bernanke, and most American citizens are about to learn a painful lesson in basic economics: You cannot print up wealth.

Short seller Jim Chanos, founder of hedge fund Kynikos Associates, appeared on CNBC this morning to discuss the "unprecedented" bubble in Chinese real estate. Chanos said the Chinese are currently constructing 30 billion square feet of commercial real estate. While the entire amount likely won't be completed, 30 billion square feet is enough for a 5'x5' office cubicle for every person in China.

In addition to the glut of commercial space, Chanos is leery of China's GDP numbers: "In the West, GDP growth is the residual of the free market... In China, it is quite a bit of a different thing, very similar to the good old Soviet Union: GDP is a planning tool... We start with the GDP target and then figure out how it is we are going to get there."

Chanos also said fixed investment is forecast to reach 60% of Chinese GDP this year, up from around 50%. And it's taking more fixed investment to produce a dollar of GDP, so China is "getting less efficient, not more," he said.

I wouldn't argue with Chanos against investing in China as a whole. It seems overvalued to me, certainly. But if I were going to short a country, it wouldn't be the world's leading export economy, the world's leading source of labor, and the world's largest holder of foreign currency reserves. Watching an America investor sell short China is like watching a subprime mortgage holder complaining to OBAMA! that the bank lent him too much money.

On the other hand, I can't argue with success. S&A Short Report editor Jeff Clark has already made his readers a fortune on the short China trade this year. As one of his "two powerful trades to start off the New Year," Jeff shorted China via calls on the ProShares UltraShort China ETF (FXP). In only nine days, his readers made nearly 90% on the trade.

Last week, Jeff announced his most recent short trade: the Mexican ETF (EWW). After a 60% rally in 2009, Jeff thought Mexico's market was expensive at 25 times earnings. More importantly, one of Jeff's top technical indicators signaled Mexico was on the verge of a big decline. The day Jeff published his issue, Mexico fell for two days in a row. And the options Jeff recommended gained more than 90%.

When Jeff gets on a hot streak, like he is now, no other editor can match his returns. His short-term option trades can make you very rich. If you had invested $5,000 in each of Jeff's three recommendations this year, you'd be sitting on nearly $28,000 in less than one month. But it's not too late to get on board. Jeff is releasing his new trade tomorrow...

He's found an incredibly overbought sector that is a screaming short sell. He says this trade will make you 100% in two weeks. To access Jeff's trades, click here...

Also, tomorrow we're hosting a conference call about one of the most controversial stocks in the world today. Our S&A Resource Report editor, Matt Badiali, recently flew across the world to research what could be the largest oil and gas find in history. After meeting with top company executives and touring the drill sites, Matt thinks this stock will "add a zero" to its market cap – or make 1,000% for investors. He's urging readers to buy it... now.

Despite the hard evidence, many critics think this company is a huge fraud. In fact, we've asked this company's most vocal critic, a well-known fraud expert, to join the call. We want you to get both sides of the story. In addition to being informative, this call promises to be very entertaining. For more information, click here...

Last Friday, we unveiled our newest advisory service, Penny Stock Specialist, to the public. In this newsletter, editor Frank Curzio recommends explosive growth stocks that trade for less than $10. Frank's track record is superb. He didn't recommend a single losing stock in 2009. And in the last 12 months, five of his recommendations have returned between 143% and 488%.

To help readers better understand the strategies he uses in his newsletter, Frank recently filmed a video series. In these short, informative videos, Frank clearly explains the different methods he uses for picking winning penny stocks. We've released the first video today. To watch it, completely free of charge, click here...

And if you'd like to read about Frank's latest recommendation – a small firm that recently landed a giant contract with one of the world's largest technology firms – click here...

New highs: Keyera Facilities (KEY-UN.TO), Icahn Enterprises (IEP).

In the mailbag... I'm not sure if I should be offended or amused by critics who apparently don't bother to even read The Digest. Let me know what you think about it: feedback@stansberryresearch.com.

"What's up with Porter's GE recommendation? I just read that GE's profit for this quarter topped Wall Street's forecast. How can a company that is essentially bankrupt (as Porter suggests) make a profit at all, let alone one that exceeds Wall Street's expectations? Is it time to get out of this trade?" – Paid-up subscriber K McG

Porter comment: I can understand you might not bother to read The Digest, but asking me the exact question I spent Friday's Digest answering seems a little rude. I mean, do you have to rub it in that you don't read my stuff?

In any case, the short answer to your question is simple: GE is still making money because the government has artificially lowered the interest rate the company is paying on its more than $500 billion debt load. (GE is paying barely 3%... the market rate would more than double this rate.) But even if you assume that Uncle Sam will back GE forever (and watching NBC's programming lately, you can tell that's what GE is aiming for...) things still don't look very good for the company...

GE's return on assets is much less than 1%. So ask yourself this question: What's more likely to happen, that GE is able to repay its debts (making less than a penny on each dollar of assets) or eventual interest rate hikes force it into bankruptcy? To me, the answer is so obvious it doesn't seem worth arguing about.

"'Greatness exists not only in being correct more often than not, but also in understanding why, when you are wrong, you were not right...' Porter was absolutely positive that Hershey would end up buying Cadbury and yet, that is not quite how events have transpired. Nearly every other day before the latest announcement, his plan to make huge, long-term profits off of this deal was being hyped.

"Fortunately, nothing bad came of it because his plan didn't come into play until after the deal was done. I have noticed a deafening silence regarding this failed prophecy. Not a single comment illuminating your readers as to how something Porter was so absolutely positive would happen, didn't. We can see the reasons clearly now, but did Porter consider them before?

"I happen to agree with all of the reasons Porter listed that Hershey was by far the most likely suitor. But this sort of miss is big and I think it deserves a few words. Any comments?" – Paid-up subscriber David Hopson

Porter comment: More fiery words from another nonreader... Oy vey. I hope this isn't a trend. OK... here's my reply... in three parts.

First, please at least read what I've written before you complain that I've been "silent." I explained the failed Hershey bid in some detail in last week's Digest.

Second, the trade I recommended was designed to increase our stake in Hershey from the normal 4% position to as much as an 8% position – if the deal materialized. I was appropriately cautious in timing our additional purchase because, as Yogi Berra famously explained, predictions are tough, especially about the future. I'm not a circus performer, and I don't claim to know the future. Or as I like to say, God does not whisper in my ear.

Finally, I'm an equity analyst, and I'm attracted to low-risk, high-return situations. Hershey fits the bill, in my view. And while a Cadbury deal might have unlocked more of Hershey's value faster, what I really care about is that our capital is safe and earning a good return.

In that regard, I've been right on the money. Specifically, I first recommended Hershey at $40 back in December 2007, about two months after the all-time high in U.S. stocks. Since then U.S. stocks fell by 50%, on average. But Hershey never budged. And it is still trading about where we bought it, after factoring in the dividends we've received.

It remains a fantastic investment opportunity. It boasts returns on assets of 13% annually and a return on equity of more than 60% annually. It requires remarkably little additional capital spending, and has a terrific track record of returning capital to shareholders. It's trading at roughly 10 times cash flow (which is dirt-cheap for such a high-margin, branded business), and its reported earnings grew 30% in the last quarter because it has been able to effectively raise its prices. Will the investment work out for us? Will Hershey soon trade at its intrinsic value (which I believe is at least $60 per share)? I can't know the future. Maybe not. But it sure doesn't hurt to try with a stock this safe.

(The chart below shows the price history of Hershey (HSY) and the S&P 500 (GSPC) over the period since I recommended it.)

Regards,

Porter Stansberry & Sean Goldsmith
Baltimore, Maryland
January 25, 2010