The S&A Digest: A big change in commodity markets

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A big change in commodity markets... Why precious metals have fallen... Buffett's buy list... Marty Whitman buys himself... The world's worst hedge fund... Buy a house for $1... How markets work...

The major issue in our office this week has been metals prices. The entire commodities complex is being hammered. Why? What's changed?

Says Jeff Clark about precious metals:

I'm not arguing the fundamentals are different. I'm arguing the market's perception of those fundamentals has changed. Back in 2000, the Internet was going to change the world. And Cisco Systems (CSCO), as the largest provider of Internet hardware, was destined to be the biggest beneficiary. CSCO makes more money now than it did in 2000. But the stock is 67% lower. Yes, the Internet has changed the world. And yes, CSCO has earned more money as a result. But shareholders haven't made anything.

Fast forward to today with gold. Yes, the dollar is a worthless currency. And yes gold will be the biggest beneficiary as the dollar dissolves. But this isn't a new revelation. So, maybe the dollar's demise is already factored into the metal's price. More to the point, gold is behaving differently than it has for the past six years. The 65-week moving average – which has been the strongest support line for the past six years – provided less support than a paper-towel bra in a wet t-shirt competition. Yes, I know and I agree gold is the best hedge against a currency collapse. And the U.S. currency will eventually collapse. But the sun will eventually burn out and die, too. I just won't bet on it happening tomorrow. As a trader, I have to go with what the charts are telling me. And right now, they're telling me the gold market is different today than it has been in the past six years...

From a fundamental perspective, I know something has changed: For the first time in 20 years, the supply of money around the world is drying up. Consider the availability of credit in the United States. Mortgage lending, the engine of our economy for the last 10 years, has ground almost to a halt. You cannot get a cheap mortgage anymore, and you can only get a mortgage if you've got great credit. That's a radical change from only two years ago. Likewise, all U.S. banks have tightened their lending standards across the board and have moved rates higher. While the Federal Reserve has been making credit available to troubled investment banks, the size of its overall balance sheet has barely grown at all – up only 2.1% in the last 12 months. The Fed can't permit the money supply to grow while it has interest rates set so low. The resulting inflation would be catastrophic. So... even though money is cheap to banks, money is also very tight for the first time in two decades.

Meanwhile, foreign central banks are buying U.S. dollar-denominated bonds at a furious pace. Why? I don't know. I only know holdings of U.S. Treasury securities have increased at a 34% annualized pace over the last three months. It looks like a dollar rebound is firmly in play, thanks to tighter credit conditions in the U.S.

In Miami, the economy doesn't appear to be suffering. You'll recall I flew down there this week to check out the condo market in South Beach. Over the long term, I'm very bullish on South Beach. It is already one of the world's great playgrounds, and I expect it will continue to grow. Real estate will, in time, rebound and see new highs. Unlike Vegas, Miami's tourist demand is still very high. Nearly everyone else staying at my beachfront hotel (the Raleigh) was from Europe – lots of French visitors. The high-end restaurant I went to (Prime One Twelve) was packed. At 9:00 p.m., a line snaked out the door, and people had to wait more than 30 minutes to get a table. This at a place where the average tab for two is more than $200.

As far as real estate, the South Beach area is still pretty expensive. It hasn't "cracked" the way I thought it might. Condos in nice buildings are still selling for more than $500 per square foot. Condos in the best buildings are still selling for more than $1,000 per square foot. So, I think the market will continue to fall, probably for another nine to 12 months. However, for the first time, I'm seeing short sales (where the bank will accept an offer below the amount owed on the mortgage) and foreclosure sales below $300 per square foot in good buildings. I'm making an offer on a two-bedroom condo in a nice waterfront building for $250 per square foot.

Warren Buffett announced some of his new purchases yesterday. He bought 3.24 million shares of NRG Energy, the second-biggest power producer in Texas, where electricity prices surged 24% from a year earlier. NRG is an unregulated power company that can charge whatever prices the market can handle. Buffett also reduced his holding in Anheuser-Busch by 61% in anticipation of the InBev takeover. He added to stakes in Ingersoll-Rand, a refrigeration-equipment maker, and Sanofi-Aventis, France's largest drugmaker.

Yesterday's purchase cost Berkshire Hathaway, Buffett's holding company, about $260 million. The company announced last week it spent $3.98 billion on equities, which leaves $3.5 billion unaccounted for.

Another value legend, Marty Whitman of Third Avenue, released his firm's third-quarter shareholder letter yesterday... and shareholders aren't happy. In the quarter, investors redeemed almost 10 million shares of Third Avenue Value Fund (TAVFX) – worth nearly $500 million. And like a true value investor, while everyone is running for the door, Whitman is buying. He added $1.5 million to his fund, bringing his holdings to more than 1.5 million shares (almost $75 million). Third Avenue added to its bond-insurer positions and initiated a new position, 10 million shares of Sycamore Networks, a $1 billion networking company. Currently, Third Ave. has 28.1% of the fund in mainland Chinese holding companies – its largest allocation.

This could be the worst hedge fund in the world... Jonathan Wood, a former UBS trader, founded hedge fund SRM Global Master Fund two years ago. Now he's bust. Wood took positions in Bear Stearns, the defunct investment bank; Countrywide Financial, the posterboy of the mortgage debacle; and Northern Rock, the U.K. bank that experienced a run on its assets. SRM Global Master Fund raised $3 billion in 2006 and is down 85% through July. Investors agreed to a five-year lockup, so they haven't been able to redeem. See what you get for "2 and 20?"

And this is one of the best... Philip Falcone's Harbinger Capital Management, an activist hedge fund that returned almost 50% last year, bought a 4.9% stake in Cablevision Systems – the Dolan family-controlled New York cable provider.

Apparently $466 million isn't enough money for Bill Ackman. That's approximately what his hedge fund Pershing Square made after CVS bid for Longs Drug Stores one week after Ackman took a position. Pershing Square upped its stake in Longs to 23.6% after the announcement. And now Ackman is telling the company to hold out for a higher offer.

You can now buy a house in Detroit for $1. A local bank recently sold a house, bought for $65,000 in November 2006, for $1. Vandals stripped the foreclosed home of its valuables. Even at $1, it took 19 days to sell the house. In a sign of how desperate the banks are to sell, the owner paid $10,000 in back taxes, sales commission, and closing costs to seal the deal. We might have to send Dyson back...

New high: Idenix (IDIX).

In the mailbag today... A review of the basics... Why investing works, and why free markets work. Enjoy. And send us your questions or comments: feedback@stansberryresearch.com.

"Isn't all of your/our investing research and diligence ultimately for naught? With rigged markets (PPT), crooked trading (BS puts, naked shorts), phony numbers (inflation, unemployment, etc.), and 'laws' that change daily (option restrictions, Fed bailouts and power grabs) nothing can outweigh the fact that all the numbers and data we use is being manipulated by the criminals who are running things behind the big curtain. So, do your poker skills and knowledge of the odds really matter if the dealer is using a marked deck? At what point should you leave the table?" – Paid-up subscriber Jim Buckley

Porter comment: Why would "rigged markets," crooked trading, phony numbers or constantly changing "laws" bother me, as a long-term investor? And how would any of these things be different now than they've always been? I've written, ad nauseam, about the nonsense "problem" of short selling, naked or otherwise. Likewise, I never expect the market makers to give me a good deal: They're looking to make a profit too.

But the fact of the matter is, when you can buy a great asset for considerably less than its private market value or at a discount to its future earnings power (its intrinsic value), none of these things matter. Owning a great business is the best hedge in the world against corruption, inflation, and dirty dealers.

"At age 62, I am still a neophyte investor with but a shallow background in economics (and so must rely on the wisdom of services such as yours which come to me as an Alliance member). Perhaps someone can explain why Congress will not insert a stipulation that drilling contracts (leases) sold in the U.S. will require that the oil generated be refined and sold to Americans rather than on the world market. Such a plan would surely affect the oil futures market." – Paid-up subscriber Tedd Leighton-Hermann

Porter comment: Why would they bother? America is a net energy importer. The "problem" of high-energy prices isn't because of export demand. (And, by the way, I don't think high-energy prices are bad, at all. High prices are the only way to finance the exploration and infrastructure investments that are necessary to increase supply.)

Maybe you don't like the way markets work, where high prices signal to entrepreneurs and investors a good opportunity, but you should try living in an economy where the market isn't allowed to function. Like North Korea.

Regards,

Porter Stansberry

Baltimore, Maryland

August 15, 2008

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