The S&A Digest: Gambling & Gold: Your Safe Haven in an 'Impossible' Economy

Bailouts everywhere... My e-mail to Ben Bernanke... Countrywide subprime delinquencies... The Chrysler playbook... How stupid you have to be to fail at financial guaranty... Tony Blair's new job: Weatherman... Enduring stagflation...

 Yesterday and today, the financial world reeks of the familiar, acidic stench of bailouts. It convulses in the back of your throat like a strong whiff of tequila, taken after a tough morning over the porcelain convenience. But maybe that's just my own prejudice showing. Judging from the Dow and S&P 500's behavior the last day or two, many see the ultimate bailout – Fed rate cuts – more like a hair of the dog that bit them than a reminder of what never to do.

Forgive the interruption, but before we peruse the various bailouts and other boondoggles going around, I just need to dash off a quick e-mail...

From: Dan Ferris [mailto:dferris@bearfood.com]

Sent: Tue 1/29/2008 10:10 AM

To: Ben Bernanke; New York Fed; Fed Governors; dubya@termover.com; hpaulson@sellout.gov

Subject: Thanks for the early birthday present

Dear Plunge Protection Team,

Thank you for the rally late yesterday, which I see is continuing today. Every minute you spend in the market, I appear to get smarter.

Signed,

Your best new pal,

Dan Ferris

P.S. I'm still down some. Please keep the money spigots wide open.

 Bank of America recently offered to buy out and bail out Countrywide Financial for about $4 billion. It's hard to know what BOA is thinking or if it's thinking at all. Countrywide says the housing market will hurt its mortgage business in 2008. The tea leaves are in Countrywide's $1.48 trillion servicing portfolio, where more than one-third of subprime mortgages are delinquent. The delinquency rate was 29% in September and is up to a staggering 33.6% today...

 Speaking of bailouts... remember Lee Iacocca's old ad campaign for cash rebates on Chryslers? He went on TV and said, "Buy a Chrysler, get a check." It wasn't long before comedians played on Chrysler's government-sponsored bailout, saying "Lose a billion, get a check."

Pretty soon we'll be joking, "Insure liar loans with zero reserves and maximum leverage, get a check," as troubled bond insurers like MBIA and Ambac Financial are taking a page out of Chrysler's book. The New York Federal Reserve is behind a push by New York Insurance Superintendent Eric Dinallo to bail out the scandal-ridden bond insurers. Dinallo has asked about a dozen banks for as much as $15 billion in loans. That's a big check for being criminally stupid at a really easy job. Dinallo also contacted billionaire investors like Wilbur Ross and Warren Buffett for help bailing out the bond insurers.

I wonder if Dinallo remembers what happened after the government's investment in Chrysler turned profitable? Chrysler tried to welch on the deal, saying the government's profit was excessive. I can't remember how it all turned out. If you remember, let us know at feedback@stansberryresearch.com.

 It would be strange for Buffett to participate in a bond-insurer bailout, since he's become their newest competitor. His company, Berkshire Hathaway, is starting its own bond insurance company... and Dinallo is the one who called up Buffett's top insurance executive, Ajit Jain, and suggested the move. Dinallo then worked to get Berkshire Hathaway quickly over the necessary regulatory hurdles in the state of New York. Now, the National Association of Insurance Commissioners is doing what it can to speed up licensing for Berkshire Hathaway's new bond insurer in several other states.

Bond insurance is a great business, as long as you stick to insuring the boring, safe municipal bonds. Less than 1% of muni bonds default. According to the insurance rating agency, A.M. Best, financial guaranty had the second-lowest combined ratio – losses plus expenses over net premium written – among all major insurance lines in 2006. Its combined ratio of 34.9% bested only earthquake insurance (28.8%). A lower ratio indicates lower losses and expenses, and higher profit. Over the 10-year period through 2006, the financial guaranty industry's combined ratio averaged 31%. From all of this I conclude that, for a financial guaranty company to require a bailout, some life form that can't use language or numbers must have run it. It is one of the truly wonderful businesses of this world.

 Al Gore's Nobel Prize must have inspired former British Prime Minister Tony Blair. Blair just got a job as "weatherman" at multinational insurer Zurich Financial Services. Blair will work on Zurich's new Climate Initiative with its Climate Change Advisory Council.

"Climate change" is Orwellian newspeak for, "I can predict the weather 50 years from now." When politicians and big business collaborate in an effort to change the weather 50 years from now, you had better hold on to your wallet like it's the last lifeboat on the Titanic...

 Last night, George Bush talked a little about the weather in his State of the Union address. Bush said there should be, "an international agreement that has the potential to slow, stop, and eventually reverse the growth of greenhouse gases." That would certainly slow, stop, and eventually reverse the growth of many developing economies, too. But he didn't mention any such thing. He also wants to stop the recession by some big government spending program... with money extracted from the economy, less expenses, or maybe just borrowed from us. Why not just abolish the income tax? Because that would actually work, putting the bailout team out of a job.

 Bush also bragged in his address about bailing out a few dumb borrowers. He even invited one to the speech, so he could put her on TV. If I were to become famous, I'd like it to be for something other than, "borrowed money he couldn't afford to pay back."

 If you're looking for real stimulus and not a boondoggle, consider Extreme Value pick Wal-Mart (WMT). The retail giant said today it's cutting prices 10%-30% on items it expects to sell before the Super Bowl. Wal-Mart is selling a Vizio 32-inch LCD television for $597, two 12-inch DiGiorno pizzas for $9, and two bags of Doritos for $6.

Considering that it accounts for 10% of every retail dollar spent in the U.S., its description of the price cuts as a stimulus package carries some real weight. It's also charging no interest for 18 months on purchases of $250 or more when made with a Wal-Mart credit card.

 When crises and bailouts and politicians turned weathermen are all around, what do you buy? What could possibly protect you from a world turned upside down? I know one answer that's still only beginning to gain popularity and costs more than $900 per ounce today.

I remember when gold was around $250 an ounce roughly 10 years ago. That's a long time. With no yield, no earnings, no cash flow, no complicated debt securities... nothing Wall Street needs to sell to make a living, gold has appreciated from $252 (if I'm not mistaken) to more than $900, nearly 14% a year for a decade.

 New highs: streetTRACKS Gold (GLD).

 Not much in the mailbag today. Just a slew of comments about Porter and Matt W's conversation on taxes and Porter's admiration for Ron Paul. I'll leave both topics for Porter to comment on tomorrow, if he wants to. Send us something to chew on at feedback@stansberryresearch.com.

 "I subscribe to your news letter but your estimate on farm land is low. Our last land auction in eastern Nebraska went for $3875.00 per acre and was on non irregated land. We have had as high as $4150.00 per acre last year. Land prices have taken a huge jump around here in the last two years." – Paid-up subscriber Terry

"Sometimes when I am reading reports published by you guys or even by others, comment is made about 'derivatives'. I don't understand what these are and how they can effect the economy. Can you please explain?"  – Paid-up subscriber Bill Moss

Ferris comment: This is a huge topic, but here goes... A derivative is a security whose value is derived from an underlying asset, commodity, or index. Stock options are derivatives. So are options on corn futures. And the corn futures are a derivative, too, since their value is based on the underlying commodity price. So, too are futures and options on stock indexes, like the S&P 500.

Today, however, the news stories about derivatives address mostly the esoteric, complex world of credit derivatives: the collateralized debt obligations, SIVs, credit default swaps and other derivatives. One problem is, it's very difficult to establish the value of CDOs, because no liquid market trades them. Their reported values are essentially guesses by accountants using overly complex math. A big problem lately is that financial guaranty companies like MBIA and Ambac Financial are on the hook for losses on derivatives backed by subprime mortgages. If the financial guaranty companies go under, that leaves trillions worth of debt essentially uninsured... and therefore much riskier... and therefore worth much less than everyone thinks it's worth right now.

Good investing,

Dan Ferris

Medford, Oregon

January 29, 2008

Gambling & Gold: Your Safe Haven in an 'Impossible' Economy

By Ian Davis

The U.S. economy is about to endure the impossible... for the second time in our lifetimes. Fortunately, a few sectors may offer safe haven.

Before the 1970s, economists believed that a slowing economy and high inflation would never occur simultaneously.

The two conditions seemed mutually exclusive. When an economy experiences slow economic growth, the unemployment rate tends to climb. This decreases the spending power of consumers and causes the demand for goods to fall. As demand falls, oversupply leads to lower prices and thus a slower rate of inflation.

This sounded like a good theory... until the 1970s came along.

In the 1970s, the U.S. endured so-called "stagflation" (a stagnant economy combined with inflation). In 1973, the price of goods rose 8.9%. Then, in 1974, the price of goods rose a painful 12.1%. Meanwhile, the economy weakened. The U.S. gross domestic product (GDP) rose only 4.1% in 1973 and fell by 1.9% in 1974.

The stock market suffered as well. The S&P 500 fell 48.4% between January 1973 and October 1974.

After the 1970s, economists reevaluated stagflation. They now attribute the 1970s occurrence to a "supply shock" – when the price of a good (like oil in an oil-importing country) rises sharply. In the 1970s, OPEC manipulated the global oil supply, causing prices to skyrocket.

The rise in the price of oil led to an increase in the cost of goods (since producing and transporting goods almost always requires oil). In addition, the spiking oil price also slowed the economy by making production less profitable.

So, if history does repeat itself, where should we invest for the next one to two years?

To answer that question I looked, once again, at the 99 DataStream sector indexes. Ninety of them had histories dating back to 1973.

The result is somewhat surprising and doesn't bode well for the stock market. For example, only two sectors ended the 1973 bear market with a positive return... the gambling and the gold-mining sectors.

The following table shows the five best- and five worst-performing sectors during the 22-month 1970s selloff. The table also shows how well these sectors have fared so far during this market downturn.

As you can see, there is little consistency between the performance of the sectors today and their performance back in the 1970s.

In the 1970s, many hard commodity stocks weathered the downturn admirably. Of the top five best-performers, four were mining stocks... everything from coal to gold.

Today, however, these commodity stocks are producing mixed results. Gold-mining and coal stocks have risen, while aluminum and nonferrous metal stocks have crashed.

The performance of gambling stocks also differed between the 1973 bear market and today's. In 1973, the index did extremely well... rising by double-digit amounts. However, since the current downturn began in October 2007, gambling stocks have fallen by more than 27%.

Other notable differences include the home-construction and the transportation-services indexes.

First, let's look at home construction stocks. They were destroyed to the tune of 84.3% during the 1973 bear market. Today, they have fallen by only about 7%... and they have been rallying in recent days. The oversold state of the housing market going into this downturn seems to be mitigating any damage that would otherwise be occurring.

Finally, the performance of the transportation services stocks also differed between 1973 and today. During the 1973 recession, transportation services stocks fell by 88.6%, but the sector is actually showing a 3% gain so far this downturn.

Traditional inflation hedges – like gold – as well as cheap alternatives to oil – like coal – tend to do well during periods of stagflation.

Conversely, retail stocks – like retail apparel and retail drug stocks – tend to do poorly... invest accordingly.

Good investing,

Ian Davis                                                                 

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