S&A Digest: It's Too Early to Call the Bottom

Covered bonds to the rescue... Merrill Lynch raising billions... A stock to buy, a stock to sell... Pickens copies Icahn's homework... Legalizing drugs... That ain't the bottom...

At Treasury Secretary Hank Paulson's urging, JPMorgan Chase, Bank of America, Wells Fargo, and Citigroup will start issuing covered bonds to try to prop up the mortgage market.

Frankly, I'd never heard of covered bonds before. The Wall Street Journal cleared things up for me...

[Covered] bonds stay on a bank's balance sheet and are backed by a "cover pool" of high-quality mortgages that must meet certain criteria, such as being up to date in their payments. Investors are also protected because if the mortgages go bad, the bank must step in to ensure that bond holders get their interest.

Keeping them on the balance sheet is at least good discipline. But "high-quality mortgages"? Is there a banker in the country who knows what that means anymore? Are there enough such mortgages left to back enough covered bonds to make a difference?

FDIC Chairman Sheila Bair said of covered bonds, "There are no magic bullets to solve the housing crisis."

Bair is more likely than most to be a tad skittish these days. Two more banks failed over the weekend. Bair's organization has insured nearly $5 trillion of deposits, with a reserve of around $53 billion... a little over 1%. If the FDIC had to cover just 1% of the deposits it has insured, there wouldn't be money left to pay anyone else.

Well, how about that? Another taxpayer-supported program started during His Grand Imperial Highness FDR's reign of terror could be headed for insolvency. Social Security, Fannie Mae, Freddie Mac, the FDIC...

The Federal Reserve could be next, given the deterioration to its balance sheet caused by its handling of the credit crisis. Though started in 1913, the Fed Board of Governors didn't become the powerful organization it is today until the Banking Act of 1935.

FDIC or not... covered bonds or not... the housing market, like all markets, has its own idea about how to get back to normal. According to the S&P/Case-Shiller index, home prices in 20 major metropolitan areas fell a record 16% from May 2007 to May 2008.

Merrill Lynch will sell $8.5 billion of stock and liquidate $30.6 billion of bonds at $0.22 on the dollar. Temasek Holdings, the Singapore sovereign wealth fund that bought Merrill shares in December, will buy $3.4 billion of the new stock, although Merrill will pay the fund $2.5 billion for its previous losses.

The bank is also selling $30.6 billion of CDOs, collateralized debt obligations, to private-equity group Lone Star for $6.7 billion. And get this... Merrill is financing 75% of the deal, so Lone Star only has to put up $1.675 billion to gain control of over $30 billion in CDOs. That means Merrill is responsible for any losses from $1.675 billion to $6.7 billion, while Lone Star gets all the upside potential.

Of course, the man who was "on watch" during Merrill's destruction, Stan O'Neil, won't be bothered much by all this. O'Neil was pushed out in October, taking with him a retirement package worth over $150 million. Dennis Gartman pointed out the absurdity of all this in today's edition of The Gartman Letter:

We do feel some very real sympathy for [Merrill CEO] Mr. Thain's position at the moment for he is simply trying his best to repair the damage done by his predecessor, Mr. Stan O'Neal... who by the way was removed from his position and was made a deca-millionaire in the process. To the best of our knowledge, Mr. O'Neil's millions are not being written down even as the shareholders are having their positions massively corrupted. If there is a crime on Wall Street it is this.

Worse still is the position of Security Capital Assurance (SCA), a company that eliminated its exposure to $3.74 billion of Merrill Lynch CDOs by paying Merrill Lynch $500 million in cash to cancel the insurance agreement.

Word is, regulators from New York Insurance Superintendent Eric Dinallo's office were in SCA's offices, ready to start talking about shutting it down. That would have canceled all its insurance contracts... which, of course, would cause the market to have a much dimmer view of the debt being insured. SCA is in talks with 13 other firms, representing 80% of its CDO insurance contracts.

Here's a stock you can buy all day long... Boardwalk Pipeline Partners (BWP).

This year, one of the world's best value investors, Jim Tisch, put another $700 million of his company's money into the operator of natural gas pipelines. His holding company, Extreme Value pick Loews (L), is like a junior Berkshire Hathaway, the holding company Warren Buffett has used to make himself and his investors billions.

Tisch likes Boardwalk "a lot" and says there's been a huge increase in the cost of building new pipelines. Now his lines are way more valuable. If you built a new line today, you'd have to charge 50%-100% higher than what BWP charged one year ago. The stock yields around 8%.

Pipelines are wonderful businesses, especially in a country like the U.S., where you need government approval to blow your nose. You put goop in one end and pressurize it. Then it comes out the other end. Not hard to figure out. As long as you don't run out of goop, you're golden. And once a pipeline is built through a given area, chances are there won't be any competition coming around any time soon.

Boardwalk fits into Tom Dyson's "Fannie Mae and Freddie Mac Survival Plan." You can read his write-up in this edition of DailyWealth.

And here's one stock to sell... Oilman T. Boone Pickens dumped his 10 million-share position in Yahoo and called its management "pathetic" for failing to strike a takeover deal with Microsoft. Pickens, who bought his position in May, said he was tired of waiting for a deal and sold at a loss.

Pickens admits he followed Carl Icahn into the position and didn't know all the details of the deal. Can you imagine making a multibillion-dollar investment, just because Carl Icahn is in it?

Icahn has many such investments, and doesn't need any one of them to do well for him to produce a good return overall. Believing you are able to cherry-pick the best ideas from someone else's portfolio, and without doing any deep research, that's just dumb.

I hope you never do this. Don't buy stocks just because someone else tells you to buy them. You shouldn't buy any stock unless you would be thrilled to watch it fall in half so you could buy more. The way you do that is to identify well ahead of time which stocks you'll buy and which ones you won't. But nobody wants to do that. Everybody looks at the stock market the same way they look at a casino: easy money. And most people do about as well in stocks as they do at the casino: They lose half of everything they bet.

New highs: none.

In the mailbag: Save the world with more taxes? And someone thinks we're doing it right, for a change. If you think we've got it all wrong, let us know: feedback@stansberryresearch.com.

"I just tried Cuil [www.cuil.com] and the results were horrible. Just because the creators worked with Google and could raise $33 million from venture capitalists doesn't mean they can out do Google. They need to work out some kinks." – Paid-up subscriber S. Thomas

"My suggestion would not solve the whole problem but would have many different beneficial effects. Legalize pot, cocaine, and heroin. Once they are legalized you could tax them like tobacco or alcohol. The druggies and their suppliers are tying up the whole justice, police, and prison systems. The US has the highest incarceration rates of any country and the vast majority of them are for drug offences. This presents many different problems. For one, kids get the impression that they can get rich by selling drugs. This makes it hard to concentrate on staying in school another 2 or 3 years to earn the chance to get an interview for a job that pays minimum wage when they could be selling drugs on the street now. They do not believe in the figures from the book Freakonomics, which states that the average street-level dealer makes less than the minimum wage and has to face a death rate which is much higher than convicts on death row face.

"Once a kid has gone to jail 2 or 3 times he is unable to get a legal job so he becomes either a career criminal or a welfare bum. He becomes a charge upon society. He is quite likely to become a father but very unlikely to get married. This means that his children will be brought up by a single mother. Again quoting Freakonomics, his children will be much more likely to spend their lives going in and out of jail so the cycle amplifies itself with each generation.

"By legalizing and taxing drugs it would be possible to take the biggest industry in the country from being a drain on the taxpayers to being the biggest source of taxes.

"This would not solve all of the US's problems but would make a huge difference. It would also take the profit out of the illegal drug business that is the bane of countries like Mexico, Columbia and Bolivia. These countries suffer from the effects of the US idiotic attitude. They pay in corruption and crime for what is really a US problem. If I did not have any living relatives I could probably become police chief in Tijuana, a job that nobody else wants, chiefly because of the drug trade." – Paid-up subscriber David

Ferris comment: I'd rather drugs remained illegal and the government got less loot from them than see them legalized and turned into another source of boondoggle money for the whores in Washington.

"Just a quick note to say, 'Thanks.' True to your word, when I decided that True Income was not for me, I asked for a refund and it was promptly done. I've only been with your service a couple of years and I subscribe to several publications so I had little fear in trying True Income. Nice to see that someone in this world really lives up to their word." – Paid-up subscriber Mike Doyle

Ferris comment: We do that with all of our publications, including the one I research and write, Extreme Value. It costs $1,000 a year. Despite the high price tag, Extreme Value readers renew their subscriptions at a higher rate than any other letter we publish. They can't seem to get enough of it, even though the market hasn't exactly agreed with my long picks the last several months (but continues to love my Lehman short).

This month, I've got a company that will benefit from growing investor interest in gold, commodities, and currencies... whether they go up or down. If you didn't like True Income, I'm not sure you'll love Extreme Value. But if you want to learn more,

click here.

Regards,

Dan Ferris

Medford, Oregon

July 29, 2008

It's Too Early to Call the Bottom

By Ian Davis

"Our analysis suggests this low is consistent with a trough," wrote JPMorgan chief U.S. equity strategist Thomas Lee on Monday. "We believe equity markets will grind their way higher from here."

JPMorgan is calling a bottom. And it's not alone. According to the average estimate of nine strategists tracked by Bloomberg, the S&P 500 will rise 21% from its July 15 low by the end of this year.

But I'm not so sure. The long-term indicators I follow all unanimously agree the recent strength we've seen will be short lived... meaning it will be over within the next couple of months.

For starters, profit margins are still too high. Profit margins measure how much of every dollar in sales a company gets to keep in earnings. Over the last 60 years, the average corporate profit margin in the U.S. has been 6%. In the first quarter of 2008, profit margins were 7.9%... This is just a hair below their all-time high of 8.5%. They reached that high in 2006, when everything from home prices to commodities was booming.

When profit margins become too large, competition grows. Everyone wants a piece of the profit. This causes price-cutting and increased production. As a result, profit margins shrink. This is how economic cycles work. As far as profit margins are concerned, the cyclical decline still has a ways to go. Profit margins will need to shrink to below 6% before I'd consider calling a bottom. It generally takes below-average profit margins to really kick out the feeble performers and decrease supply.

Unemployment is also still too low. During periods of economic decline, inefficient, low-profit businesses fail. This culling of the herd leads to increased unemployment. The rise in the unemployment rate is even more dramatic if the economy is declining from a very overheated state. With unemployment near all-time lows and profit margins near all-time highs in 2007, we're coming off of an overheated economy.

Take a look at the following chart. It shows the rise in unemployment during three previous bear markets, all of which arose from an overheated economy.

Unemployment Isn't Up Much Since the Beginning of the Bear Market

As the chart shows, unemployment has risen by an average of 160 basis points (1.6%) the last three times we entered a bear market with low initial unemployment. Right now, unemployment is only up 80 basis points. It could easily rise by another 80 before this bear market is over.

The current default rate on U.S. homes is higher than it was during the Great Depression. Also, the International Monetary Fund recently reported that the current U.S. monetary crisis is the "largest financial shock since the Great Depression." If we are entering another Great Depression-like era, the rise in unemployment has barely begun...

During the Great Depression, the unemployment rate rose to around 25%. A staggering number compared to today's 5.5%.

So right now, I think we're in the midst of a short-term relief rally. You can take advantage of it by buying the most oversold sectors – like housing and financials – over the next few weeks. But based on my indicators, be cautious. We haven't seen the end of the bear market just yet.

Good investing,

Ian Davis

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