Dyson's Realty Income holds ground

Dyson's Realty Income holds ground... "A doozy of a recession"... U.S. begins nationalizing banks... Chanos not short financials... Is Steve Cohen getting out?... "Recession-proof" toys...

I just spoke with Tom Dyson for a few minutes. We both marveled at the resiliency of Realty Income (O), a real estate investment trust we've both covered. The company owns a nationwide portfolio of freestanding retail properties. It rents to businesses that sell everyday products and services, like Children's World (daycare), Jiffy Lube, Taco Bell, and WaWa convenience stores.

Its investment standards are as rigorous as you'll find. During 2007, Realty Income's Investment Committee reviewed nearly $4 billion of potential transactions... in order to acquire $533.7 million in new properties. That's consistent with the past five years, when it acquired 15%, 14%, 8%, 26%, and 12% of what it reviewed. To get more of Tom's research on similar income opportunities, click here.

Yesterday, hedge-fund mogul Julian Robertson said, "We're just getting into the recession." A year ago, he said we were headed for a "doozy of a recession." He thinks it'll be 10-15 years before the economy is good again.

Robertson says his favorite trade is the "curve steepener," which he claims is the best way to hedge against inflation. As Robertson explains it, it sounds like you go long the two-year Treasury and short the 10-year and 30-year. He says the Fed can influence the two-year, but has no control over the 10-year or 30-year. So Robertson is betting the Fed will do everything it can to keep rates low, but the market will continue to push up the yields of longer-term bonds.

The nationalization of America intensifies... The U.S. will invest about $125 billion into nine leading financial institutions in exchange for preferred shares. The companies are Wells Fargo, JPMorgan, Bank of America, Merrill Lynch, Morgan Stanley, State Street, Bank of New York Mellon, Citigroup, and Goldman Sachs.

The FDIC this morning announced a new program under which it'll guarantee every penny of noninterest-bearing bank deposits, as well as the newly issued senior unsecured debt of financial institutions. This is said to decrease "systemic risk" and restore confidence. I don't know about restoring anything, but it's certainly a confidence game. Now that it's taking on even more risk, the FDIC has without doubt increased systemic risk by removing incentives to get financial institutions to figure out how to achieve real solvency.

FDIC boss Sheila Bair said in a press release the FDIC has "faith in our economy, our country, and our banking system," and that "the overwhelming majority of banks are strong, safe, and sound." If that were really true, we wouldn't need all this confidence boosting and reassuring and backstopping, would we?

My prognosis remains the same as it's been since the spring: Hundreds of banks will fail over the next two years as foreclosures soar and the burgeoning option-ARM crisis makes the subprime crisis look tame by comparison.

On Thursday, we noted that Jim Chanos, president of short-selling hedge fund Kynikos Associates, is short the least amount of financials in four years. Chanos recently said: "[Financials are] down quite a bit, and clearly with these kinds of rescue packages our view is the risk-reward is not great on the short side, probably selectively on the long side. We're looking elsewhere."

The market turned days after Chanos' interview... and financials had a huge rally. Morgan Stanley is up 127% in two days. Goldman Sachs jumped 42% since Friday. And Bank of America gained 35% since last Thursday.

A 2007 paper by Legg Mason's Michael Mauboussin had some interesting data about the significance of huge up and down market swings like we've had lately.

Black swans [highly improbable, unpredictable and significant events] also have an extreme impact. We can readily demonstrate this point by looking at long-term stock price returns. We gathered the daily price changes in the S&P 500 over the past 30 years or so, in excess of 7,300 observations. The compounded annual return over the period (excluding dividends) was 9.5 percent. We then asked a simple question: What would happen to the return if we knocked out the 50 worst, and 50 best, days?

The results are a testament to the impact of black swans. If you remove the 50 worst days (less than 0.7 of 1 percent of the sample), the return soars to 18.2 percent, 8,700 basis points above the actual results. Missing the 50 best days compresses the return to less than 1 percent, about a 900 basis point hit.

Hedge-fund giants are going to cash. Steve Cohen, who runs the $14 billion SAC Capital, recently moved about $7 billion into money-market and other short-term securities. Cohen plans to sit on the sidelines for the rest of the year. The rumor mill suggests Cohen is getting out with his $3 billion and shutting down. According to one source, Cohen told his traders, "You're all idiots. We're going to cash. I'll see you in January."

Israel Englander, who runs the $14 billion Millennium Partners fund, put about $6 billion into cash. John Paulson, of the $35 billion Paulson & Co. fund, has about 70% of his fund in cash.

These guys certainly have more experience and money than I do, but it sounds to me like they've fallen victim to the recency bias – basing actions on recent events, not probability. Recency bias is why investors sell at the bottom and buy at the top. Bull markets make them feel safe; bear markets make them scared. That's why Warren Buffett is always quoted as saying you have to be greedy when others are fearful and fearful when others are greedy.

Value investors Ken Heebner and Marty Whitman aren't scared. They're diving into beaten-down stocks. This is the opportunity of a lifetime," Whitman said. "The most important securities are being given away."

Heebner sees "a lot of tremendous bargains out there." He pointed to Chesapeake Energy, a natural gas producer. Heebner also said long-term investors should consider mirroring Buffett in his Goldman Sachs and General Electric investments.

It's a lot harder for me to imagine buying GE since I saw Jeff Matthews' presentation last week in New York. Author, blogger, and money manager Matthews showed compelling evidence Jack Welch created a culture totally focused on making the numbers at all costs. The result is an army of short-sighted managers, few of whom are thinking about the long-term health and success of the company. GE's current CEO, Jeff Immelt, is now dealing with the fallout.

Ideas like Chesapeake make a lot more sense right now. Much of the risk has been flattened out of risky industries like mining and oil and gas. Nobody wants risk right now, even professional risk takers like Cohen, Englander, and Paulson.

Apparently the smartest trader I know, our own Jeff Clark, agrees with me on this. He says it's time to buy natural gas, and he's come up with a new options trade for S&A Short Report readers to get the most bang for their buck. Click here to learn more about Short Report.

Beware the phrase "recession-proof industry." It usually means someone is trying to sell you a bad idea. The recession-proof idea of the moment: video games.

Analysts say people spend more on toys and games during economic slowdowns to replace more lavish spending like vacations and dining. "If people aren't traveling and stay home, what are they going to do? They'll want relatively cheap home entertainment," said David Gibson, senior analyst at Macquarie Research Equities. The gaming industry also overcomes economic downtuns because "core gamers will buy the titles when they come out, regardless of the economics," Gibson said.

I live in a house with three teenagers, any one of whom can kick my butt on Guitar Hero or Rock Band. We have Xbox, Xbox 360, and GameCube. I promise you, $50-a-pop video games would be among the first casualties, should we need to tighten our belts further.

New highs: Our short position in Gannett (GCI).

We're holding our conference call with Porter, Steve, Dan, and Jeff this Friday. We don't have a specific time, but we'll keep you updated as we get closer to the date. This call will be free for all paid subscribers. Click here to sign up. If you've got any particular questions you'd like answered during the call, please send them to feedback@stansberryresearch.com.

"A friend recently sent me some new definitions of market terminology: Bull Market – a random market movement which causes the average investor to mistake himself for a financial genius. Bear Market – a six to eighteen month period during which the kids get no allowance, the wife gets no jewelry and the husband gets no sex. That about sums it up pretty well... well, except for those who have actually listened to your advice instead of critiquing your math skills." – Paid-up subscriber Mike Carroll

"I think the idea behind the Put Strategy Report is fantastic. However, given that the report was issued after market close on Friday, and the markets were sharply up on Monday, none of the trades are close to the recommended entry price(s). Are you planning to address in a subsequent message, or is the thought to wait to see if the prices eventually fall to the recommended range?" – Paid-up subscriber Dave

Goldsmith comment: Porter sent an update to his Put Strategy Report readers this afternoon. As of Monday, his recommended trades were yielding between 26% and 49%. If you're interested in learning more about the Put Strategy Report, click here.

Regards,

Dan Ferris

Medford, Oregon

October 14, 2008

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