The S&A Digest: Why I'm bullish

Why I'm bullish... Mark-to-market vs. intrinsic value... Mortgage notes vs. mortgage securities... Mutual funds raise cash... A top in commodity prices?... Richard Russell leans bullish, too... Revoking our refund policy?...

Like I told my subscribers in the last issue of my newsletter (Porter Stansberry's Investment Advisory), you might be surprised to learn I'm personally bullish on stocks... financials, in particular. "Whenever I see people panicking, I get interested. And people are panicking right now in a way I haven't seen since the bottom of the market in 1998 after the Russian default..."

Last Monday, I put about half my liquid assets into the financial sector. I plan to buy more this week, too. I'm going to look at high-quality insurance stocks, retail banks, and conservative mortgage lenders. Why?

The "losses" being taken right now stem from mark-to-market accounting and will almost certainly not materialize. Accounting rules require the owners of securities to faithfully mark down any declines in price, regardless of whether or not the holders of the securities would consider selling. These rules have proven disastrous for highly leveraged firms, like investment banks, and other companies with exposure to mortgage securities – for example monoline insurance companies like MBIA, and Freddie and Fannie, which also insure mortgages. The simple fact is, large pools of highly rated, non-subprime mortgages are very unlikely to suffer any permanent impairment – despite their current prices in the market.

Indicative of the relative differences between mark-to-market accounting and the likely intrinsic value of mortgage securities, JPMorgan quintupled its all-stock offer for Bear Stearns to $10 per share. Bear jumped 67% this morning to $9.94. The increased bid values Bear around $1.3 billion, up from $236 million with the original $2 bid.

And here's an even better example: Corus Bankshares is a Chicago-based bank that specializes in providing mortgage lending to condo developers in all of the worst-hit markets: Miami, Vegas, Atlanta, New York, etc. Several of its billion-dollar condo loans are in trouble, and its nonperforming loan totals are soaring. Clearly the asset base of Corus Bank is in trouble – it owns the notes on more than a dozen downtown Miami condos still under construction. However, troubled mortgages may not lead to actual losses. Corus will probably be able to sell the defaulted buildings to apartment REIT companies for 60% of their former value, which represents a 100% recovery for Corus.

On the other hand, Fannie Mae owns the largest pool of high-quality residential mortgage securities in the United States. Its share price fell massively over the last two months as the market for mortgage securities collapsed. The Bear Stearns bailout and the Fed's decision to lend to broker dealers (and to accept mortgage securities as collateral) have eased the pressures on the mortgage market and, as you can see, Fannie's share price has greatly recovered. Meanwhile, the intrinsic value of Fannie's mortgage portfolio most likely remains totally unchanged.

The second reason I'm particularly bullish is the diverging actions of the best mutual fund managers and "the rest."

The average mutual-fund manager is scared stiff right now. Forty-three percent of money mangers surveyed by Merrill Lynch report shifting assets into cash – the highest percentage since Merrill began compiling the data in April 2001. The ratio of cash to total mutual fund assets is also at a five-year high.

Meanwhile, the world's elite money managers are, for the first time in years, piling into stocks. David Winters (Wintergreen Fund) normally holds 25% of his portfolio in cash. As of last month, he was down to 11%. He told the Wall Street Journal, "It's the gigantic after-Christmas sale." Jean-Marie Eveillard (First Eagle) has cut his cash position in half. Marty Whitman (Third Avenue Value) is down to 10% cash, from the mid-20% range. And Mason Hawkins (Longleaf) is fully invested.

Finally... and this will be very unpopular with many subscribers... I think the bull market in commodities is reaching a blow-off top. While I will continue to own gold and silver as a hedge against further monetary problems, I suspect the huge moves we've seen in agricultural prices, base metals, and energy are not sustainable and will eventually (in the next year?) correct.

While the best trade of the last 10 years has been to short financials and buy commodities, I think the trend will soon reverse. Over the next 10 years, I think financials will vastly outperform commodities. I'm taking the other side of the Jimmy Rogers trade, in other words. The chart below, taken from Outstanding Investor Digest, tells the story. Commodities have become as expensive as they've ever been, relative to financials. Trees don't grow to the sky, even when they're used to make ethanol.

Richard Russell reminds us that, eventually, all the bad news gets priced in:

The sentiment that rules the markets today – confusion and fear. Nobody trusts anybody, and Wall Street and the financial community are in a state of semi-shock. I've seen these periods before – they arrive, they hold Wall Street in their grip for a period of time. Then slowly investors regain their equanimity, the damage is tallied up – and grudgingly the losses are written off over time. From our standpoint as unemotional investors, the key question is this – at what point, at what Dow or S&P level, will the market have written off the worst that can be seen ahead. At some level the market will be saying – "This is it. This is the low, and no matter how bad the news becomes, I'm not going any lower. I've discounted everything."

Inside Strategist editor Brian Heyliger is another guy who's not afraid to take contrarian positions. He recommended homebuilder Hovnanian (HOV) last Wednesday, and his readers are up 27% in two trading days. As Brian proved, if you make smart bets in negative markets, you can make serious money. To learn more about Inside Strategist, click here...

We're not the only ones questioning Goldman Sachs' accounting. Standard & Poor's said Friday it may downgrade Goldman's credit rating. The company thinks "the likelihood of a precipitous decline in profits" at Goldman has increased. It's a little late to the game, considering last week Goldman announced a precipitous decline in profits. S&P thinks Goldman's aggressive willingness to take on risk will leave it vulnerable. The ratings agency also put Lehman Brothers on negative watch.

New highs: The market was closed on Friday.

In the mailbag, long-time subscribers object to our no-questions-asked, money-back, no-risk trial subscription policy. What's your opinion? Let us know: feedback@stansberryresearch.com.

"Just some worthwhile advice for these fools (names withheld but you know who you are) who sign up for investment advisories only to indignantly ask back their money after 2 months because 'I've seen 'nuff,' etc. We all know exactly what you're doing. You're scavenging for ticker symbols, for FREE. Or put more elegantly, you're STEALING, man! Just be careful. My guess is, the market will teach you a fearsome lesson, sooner or later. The newsletter writer's job is not to make you rich – just to point his finger at the opportunity. The responsibility and skill needed to prosper and become wealthy in the markets will unfortunately always rest with yourself. If you still don't know this, maybe it's time to get out of the hot kitchen altogether. I hope you'll print this, because normally you're too decent to do it. I think you take way too much BS from idiot subscribers." – Paid-up subscriber Eben van der Westhuizen

Porter comment: We'll sell a newsletter to anyone, no qualifications required. And we happily send out refund checks each month. We think it's a smart policy to part as friends, no matter what the dispute, for a simple reason: That's how we'd like to be treated, if our roles were reversed. If this policy costs us a bit because of the many semi-professional "tire kickers" out there who like to subscribe, get a free report or two, and then cancel... so be it. This has been our policy since we began operations and, as long as I'm the boss, it will remain our policy. (And, by the way, we do keep tabs on those "customers," and eventually we simply stop offering to do business with them.)

"I guess I am still a little irked with the comment about Lenny Dykstra in your last S&A Digest. For starters, he is not a day trader. He trades Deep-In-The-Money options. This is a system where you buy 5 or 10 call contracts of a stock at least 3 months out... You really have not been fair with your comments. If you have integrity, you will research his history of selections and outcomes. I'm sure if you contact him or TheStreet.com you can get them. If you have integrity, you will write the truth in the S&A Digest." – Paid-up subscriber Gary

Porter comment: We didn't intend for our comments to be disrespectful in any way. According to what "Nails" told the New Yorker, he does conduct a lot of day trading for his own account. While we don't have any knowledge of Nails' track record, we have always enjoyed our correspondence with him and we sincerely wish him the best with his new publishing endeavor.

"Get a clue... Wal-Mart is nonunion and that is the source of all the anti-Wal-Mart rhetoric, bumper stickers, etc. Here in my area, a strongly union state, the only group willing to put up money to file lawsuits to prevent them from being built are the unions." – Paid-up subscriber Joe

Porter comment: Yes, sure. We are well aware of the union pressure. But why would this attitude spill over into the professional and semi-professional investment community?

"Why is it you never talk about GM any more? Have they turned the corner? I see they have adopted the terrific Honda styling for the new CTS and Malibu. This cool new styling should do it for them, don't you think?" – Paid-up subscriber Jim Palcich

Porter comment: What more is there to say? I update our position each quarter in my now-famous "Letter from the Chairman."

Regards,

Porter Stansberry

Baltimore, Maryland

March 24, 2008

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