The S&A Digest: Cash Hoards Could Unleash an Explosive Market Rally

AAA tax-free muni bonds are cheaper than T-bills... Ackman vs. Whitman, round two... Buffett's Big Four... Pent-up buying power...

 Finally, an opportunity for investors who don't want to dig through mountains of public filings, or gamble on a leveraged financial company, or try to guess how many bad loans a company might be holding...

Imminent downgrades for bond insurers, failures in the auction-rate securities market, and a general fear of what will happen to the $2.6 trillion of insured municipal bonds are creating fat yields for investors.

Municipal bonds usually trade at a 20% discount to Treasury-bill yields because they are tax-free. Now 10-year AAA munis are yielding more than 4.1%, a record 25% premium to Treasury yields. Many of these bonds, though they're rated AAA due to bond-insurance guarantees, would still be investment grade – and well worth buying –  without the bond insurance.

 We've thoroughly documented the short argument for the bond insurers, often noting Bill Ackman's public attacks on MBIA and Ambac Financial. But we've only briefly covered the long argument for the bond insurers. The most vocal advocate is value legend Marty Whitman. His Third Avenue Management holds nearly 10% of MBIA, the world's largest bond insurer. He also holds a large position in the No. 2 bond insurer, Ambac.

Whitman is a master of distressed securities and insurance, with decades of experience behind him. He's referred to Ackman as a "slick salesman who does not know much about insurance." In his latest shareholder letter, he admits that Ackman is "an articulate advocate," but says Ackman's arguments are "off base." Whitman's latest quarterly letter is a must-read for equity investors.

 Here's a summary of Whitman's rationale for going long bond insurers and mortgage insurers:

Ambac Common, MBIA Common, MGIC Common and Radian Common [both mortgage insurers], have been selling at discounts of around 70% from tangible book value, or NAV. In Management's opinion, there is much profit to be made in these issues at these prices whether the companies continue as going concerns, or enter into a period when the companies run-off their books of business in whole, or in part, as we wrote to you last quarter. Management classifies these investments as "distress investments", where the Fund tries to acquire meaningful positions in the most senior issue which will participate in a reorganization, i.e., the fulcrum security. In prior distress investing for the Fund, the fulcrum security had always been a debt instrument. In these cases, however, the fulcrum security is the common stock.

If Whitman is right, and MBIA and Ambac don't go to zero, those cheap muni bonds could appreciate quite handsomely in the coming year.

 Like Whitman, billionaire Wilbur Ross' recent investment in Assured Guaranty (AGO) reflects a long, successful career investing in bankrupt and other distressed companies.

 Another victim of the selloff in securities markets is Extreme Value pick American Express (AXP), which now sells for less than six times free cash flow. It's about 37% off its 52-week high (and it was cheap at that price).

Typically people think the American consumer, having lost his ability to cash out his home equity, will now run up his credit-card bill... and default on that, too. American Express experienced much higher charge-offs in 2007 (3.8%) compared to 2006 (2.9%). All but eight of the top 50 credit-card issuers, as listed in the monthly Nilson Report, experienced higher charge-offs in 2007 than in 2006.

In his annual shareholder letter, Warren Buffett wrote, "We do not measure the progress of our investments by what their market prices do during any given year. Rather, we evaluate their performance by the two methods we apply to the businesses we own. The first test is improvement in earnings, with our making due allowance for industry conditions. The second test, more subjective, is whether their 'moats' – a metaphor for the superiorities they possess that make life difficult for their competitors – have widened during the year. All of the 'big four' scored positively on that test."

The big four – Berkshire's four largest common stock investments – Coke, Wells Fargo, Procter & Gamble, and... American Express.

Wells Fargo's 2007 credit-card charge-offs equaled 4.49% of outstanding balances, compared to 4.05% in 2006. Berkshire owns 9% of Wells Fargo and 13% of American Express.

 New highs: streetTRACKS Gold (GLD), CurrencyShares Japanese Yen (FXY), Covanta (CVA), XTO Energy (XTO).

 Once again we remind you, Porter's on vacation in Captiva with his family. He'll be back next week, and you can let the viciousness flow. If you want to leave him something for his return, do so at feedback@stansberryresearch.com.

 "Last year at least one your Advisories pushed very hard a stock, Winthrop Realty Trust (FUR). It was touted as a great investment and because of this I've been buying it as I watch the price dwindle. I don't know if I should sell which I usually do when one of my stocks fall as much as this stock has. I have only held on because it was given such an enthusiastic endorsement. Who pushed it? Is anyone still following it?" – Paid-up subscriber Allen Schwalb

Ferris comment: I recommended Winthrop in the S&A Penny Letter, which we no longer publish. On the fourth Tuesday of each month, I send out portfolio updates by e-mail to everyone who subscribed to it. So check your inbox, you should find my most recent advice on that stock there.

 "Did Gartman ever stop to think that maybe the reason people are walking up to him on the street to ask him about gold is because he is on television every single day of the week? The only thing getting 'tired' is his ugly mug on the tube. Buy more gold!"

– Paid-up subscriber B. Fromme

 "You may crow about Jeff's record with Advanced Income but you certainly can't say the same about the S&A Short Report, at least since I subscribed in mid-Feb."

– Paid-up subscriber John Haupts

 Ferris comment: Why don't you give it some time, John? You've only been a subscriber for about a month. In January, Jeff made S&A Short Report subscribers 147% on his DR Horton trade and 156% on Citigroup.

 "OK. Fess up. What have you done with Porter? Not the one that pretends to be him every few days and talks about stuff like gold coin shops. Where's the real Porter, you know, the one who has trouble getting his head through a doorway. Is he doing community service? Incarcerated? Working at Walmart? Tell us the truth, we can take it." – Paid-up subscriber Ignorant Dupe

Regards,

Dan Ferris

Medford, Oregon

March 4, 2008

Cash Hoards Could Unleash an Explosive Market Rally

By Ian Davis

Are you scared of the stock market right now?

Most investors are petrified...

Here's how I know. When the stock market is soaring, investors take on debt. They do this in order to buy more stock than they could otherwise afford. They assume the gravy train will continue into the future, and they want a larger piece of the action.

Conversely, when the stock market is weakening, investors buy less stock than they can afford, leaving some of their account in cash.

Right now, we are in the latter situation.

Investors have more pent-up buying power than any other time in the last 16 years.

You can calculate investors' buying power easily. The New York Stock Exchange reports the total balance of margin debt and free credit for its member organizations (which are basically the organizations that trade on the NYSE floor). You can calculate buying power by subtracting the total margin of debt on the exchange from the total free credit that is in cash accounts and margin accounts.

As you can see from the following chart, investors are sitting on more buying power than any other time in the history of the data set.

Investors Are Sitting on a Ton of Cash

The chart shows investors were cash-poor throughout the '90s bull market and cash-rich during the dot-com crash.

You can also see that peaks in cash coincide with short-term bottoms in the stock market. Similarly, peaks in debt correspond with short-term tops in the stock market.

So what does this mean for you, the individual investor?

When investors are poised with lots of cash, a small rally can turn into an explosive one in short order. I believe we are entering that situation right now...

(Please note: The most recent data available is from January 1, 2008. However, the NYSE composite index is currently 7.9% lower than it was on January 1. So I think this pent-up buying power is still waiting to be unleashed.)

The key question remains how will we time our jump into the market to take advantage of the rally and exit safely before the bear market reasserts itself.

Until next time,

Good investing

Ian Davis

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