The S&A Digest: Hard to be a contrarian

Hard to be a contrarian... Sequoia Fund reopens after 26 years... The "neutron bomb of finance"... Write-down today, write-up tomorrow... Bank failures are about to rise... A market top in gold?!... Even more complaints...

 Man, it's hard to be a contrarian...

Housing must look great to contrarians right now. All the news is bad. March sales of new homes fell 8.5%, to their lowest level since 1991. New home inventories climbed to 11 months worth of supply, the highest level since September 1981. New home prices are still falling, too. The median price of a new home fell 13.3% in March, to $227,600.

The housing stocks look cheap, too. As a group, the homebuilders are trading at 84% of book value, according to Yahoo Finance.

Too bad the housing contrarians are just plain wrong. It would take a 20%-25% drop in housing prices from here to return to the long-term trend of home-price appreciation. Either that, or four to five years of flat pricing.

It's Not Different This Time...

Home Prices Are Set to Fall Farther

Our experience in cyclical markets tells us it's much more likely housing prices will fall well below trend, rather than simply return to the normal trend line. So a value opportunity is definitely brewing, but it's not ready for consumption yet. Contrarians who aren't contrarian enough will get burned.

 Some investors see value right now and are seizing the opportunity. One of the greatest mutual funds of all time is reopening to new investors on May 1, 2008. The Sequoia Fund (SEQUX), managed by Ruane, Cunniff & Goldfarb, closed its doors almost 26 years ago, on December 23, 1982. The Sequoia Fund has returned 15.1% per year since its inception in 1970, beating competitors and the S&P 500 by a wide margin. But its assets have fallen from $5 billion to $3.3 billion, due in part to an aging clientele.

The late Bill Ruane, Sequoia's former lead manager, was a close friend of Warren Buffett. According to Buffett, Ruane left Harvard Business School, went to Wall Street, "Then he realized that he needed to get a real business education so he came up to take Ben's [Graham] class at Columbia." The two met at Columbia. When Buffett dissolved his investment partnership in 1970, he recommended Ruane to his former partners, and Sequoia was born. For years now, Sequoia's largest position, at about 25% of the fund, has been Extreme Value pick Berkshire Hathaway. (Check out Sequoia's current holdings.)

Sequoia's history contains a great lesson for investors. From 1972 to 1974, the fund lost more than 40% of its value. Nobody wanted to own stocks. This is perhaps the biggest reason why most people lose money in stocks: When stock prices fall, they sell. The great thing about this is you can tell people about it until you're blue in the face, and they won't care. Their human emotions work against them. That's why value investing will always work. The great mass of investors, professional and individual alike, will keep reaching for lottery-like returns... and will continue to get lottery-like results, consistently losing money.

 Credit Suisse, Switzerland's second-largest bank, reported a $2 billion loss on $5.2 billion of write-downs tied to the credit markets. Shares rose in Swiss trading after CEO Brady Dougan said the capital position is "strong" and the bank won't need to raise capital.

The Financial Times points out that virtually every European bank that got into structured finance in a big way got burned by it. Banks like National Bank of Greece and Nordic banks, which stuck to retail and/or commercial banking, are in better shape today. In other words, there weren't any geniuses of structured finance in the European banks (or any other country's banks, I'd guess). You either avoided it or you got burned.

Structured finance was, just like Warren Buffett told us, one big financial weapon of mass destruction, like the neutron bomb, the one that kills all the people but leaves the buildings standing. This one kills all the investors' capital and leaves the bankers alive to go off and create the next bubble.

Up to this point, bank losses have come from writing down assets tied to the credit markets (mortgages, leveraged loans, etc.) Now, prudence will hurt banks' earnings for years to come. Banks build bad-loan reserves to cushion expected losses. Additions to these reserves, called "provisions," are booked as an expense – reducing earnings. As uncertainty grows in the credit markets, banks will increase their reserves and destroy earnings. Bank of America (BAC) is the perfect example. It missed earnings expectations in the first quarter because it added $6 billion to its loan-loss reserve, dwarfing a $1.3 billion trading loss.

My guess is the corporate world won't disappoint us here, either. They'll run off the end of the Earth with write-downs. Then, five or 10 years from now, we'll tell you how understated Bank of America's earnings appear to be, and how it's really selling for 10 times earnings, not 20.

I don't fault the financial world, or humanity for that matter, for its mistakes and overreactions. Somebody once told me NASA's Apollo missions were off course more than 90% of the time on their way to the moon and only reached their destination by constantly correcting... creating another overreaction from which to correct. On average, they were right. They still got where they were going, and that's all that counts. Just like with investing.

Today, I'm very bearish on many U.S. banks. One day, I can practically guarantee you, I'll be a banking bull. Maybe I should also guarantee you that I'll be wrong a lot. And now that you know about the moon missions, it won't strain credibility to suggest that perhaps I'll nonetheless be able to create a good result for my subscribers in the process.

 Losses in the subprime crisis are approximately $240 billion. The savings and loan crisis in the '80s and '90s only cost taxpayers $160 billion, but the repercussions were much worse. Coming off the rampant inflation of the '70s, banks were paying high interest rates on deposits, and most of their cash was tied up in long-term debt yielding much lower rates. Banks were paying more for deposits than they were earning in interest, and their cash evaporated. Thousands of banks failed. So far, we've only seen one large bank, Bear Stearns, fail... plus a couple of tiny ones in Missouri. (I discuss bank failures in the current issue of Extreme Value.)

Look at the graph below (which we found on Mark J. Perry's blog), and it seems bank failures have the potential to go through the roof in the next few years. See that little rise over on the left? That's the Great Depression, when approximately half the country's banks failed. We have a lot more banks today, but what if 10% of them fail? Or 15%? It could get very ugly out there...

 New highs: Stone Energy (SGY), StatoilHydro (STO), Ventas (VTR), Covidien (COV), ArcelorMittal (MT), Sadia (SDA).

 In the mailbag today, a sign of a top in gold and more thoughts on our marketing. Send your questions and comments to feedback@stansberryresearch.com.

 "Sign of a top - Bull Market in Gold Leads Some to Dig Out Old Dental Work." – Paid-up subscriber Robert Hooper

Ferris comment: Near term, I think you're right, but gold has a long way to go. I think it'll continue to fall for awhile, wiping out the weaker bulls' smugness and complacence. When they've all sold, the heavier hands will get back in the game. I don't have numbers or a time frame for you, though, just a gut feeling. That's about all you get with the gold price.

 "Your newsletters, go on and on, ramble on and on, talking about how to invest and increase wealth. However, after reading, and reading, and reading, and reading, and reading, page after page after page after page, hoping to gain some important knowledge or advice, you come to the end and find that in order to find out what the heck you've been telling us about; WE HAVE TO SUBSCRIBE TO ANOTHER NEWSLETTER, REPORT, OR SOMETHING ELSE, TO FIND OUT! THEN WHEN YOU SUBSCRIBE TO THAT NEWSLETTER, IT'S THE SAME RESULT, IT WANTS YOU TO SUBSCRIBE TO ANOTHER REPORT, NEWSLETTER, ETC. There is nothing of value in any of the things you offer, just a tremendous amount of wasted time reading and empty promises! It looks like a big scam to me." – Paid-up subscriber Jim Courtney

Ferris comment: It's hard to go more than a page or two in any Stansberry editorial without getting concrete, actionable advice. We've got actionable investing advice coming out our eyeballs around here. Don't mistake the marketing for the newsletters themselves. You pay for the editorial. We send you the marketing material for free.

And when you sit back and think about it, it's funny that anyone who thinks we offer a valuable service would ever criticize us for sending out too many promotions for that service. If you think we offer a valuable service and would like us to continue doing so, you should complain that we're not more aggressive with our marketing efforts. It all sounds silly, but it's true. It's true, that is, if you want to be consistent and rational about it. Those of you who wish to remain adrift in the seething herd, just keep complaining.

 "hey dude, I'm still long on you. so don't worry!!!" – Paid-up subscriber Rosa

 "I have read several times your phrasing of 'I did respond to the allegation that we do business in an "underhanded" manner, which is patently absurd' with regards to a few subscriber's negative feelings about the way you do business. I know your policies and money back guarantees, etc., so I am quite happy with your newsletters that I receive. I just want to know if the U.S. Patent office would allow me to obtain a patent on 'General Absurdity.' I could foresee a lot of value in many areas with such a patent." – Paid-up subscriber Robert M.

 "I do enjoy the research, but am also tempted often by the advertising to sign up for another newsletter. For example the course on selecting the best monthly dividend companies. I am really interested in that service, but I'm also currently oversubscribed (both tight on time and read a couple of other investment publications). So, I'm a satisfied customer who looks forward to reading communications from Stansberry Research." – Paid-up subscriber Mark Scoville

Goldsmith comment: Mark, I don't think a lack of time should stop you from checking out the Monthly Dividend Program. It should only take you two hours to read the entire course. And we tell you which 10 MDPs are our favorite in the market today.

For example, one of our REIT monthly dividend payers in the top 10 jumped more than 5% today. In one month, we're up 9% on this stock... And it's yielding 6.8%. We're also up more than 8% in our favorite corporate bond fund. It's yielding 7.5%. And we're sitting on an 8% gain with our No. 1 oil and gas income trust. That capital gain is in addition to a 13% yield. In total, our top 10 portfolio is up 5.5% in one month.

But best of all, the average yield on the portfolio is 9.5%. If you invest in each stock in our top 10, you will receive dividends from a balanced portfolio across real estate, stocks, bonds, and energy, and get an extra paycheck on average every three days.

With just our top 10, you should easily be able to make more than enough money in dividend payments to cover the sign-up costs for the Monthly Dividend Program. If you'd like to learn more, click here...

Regards,

Dan Ferris

Medford, Oregon

April 24, 2008

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