"Where's the inflation you've been warning us about, Porter?" So says the imaginary chorus of our subscribers who follow me around, haunting the quiet and introspective moments of my life. I can't ignore them... And so I answer: Right in front of you! Then, my wife asks me, "Porter, who are you talking to?"
Here are the facts. An index of producer prices (the PPI) fell 0.6% last month – the biggest drop in wholesale prices. This small decline in prices along with the Fed's comments yesterday that it sees no reason to raise interest rates anytime soon has led stock investors to believe we may be back in what's commonly called the "Goldilocks scenario." In this situation, the economy is not too hot or not too cold – it's just right.
Folks who believe in Goldilocks (and other children's fantasies) would have you think the Fed can continue to inflate the U.S. economy through massive manipulation while the U.S. government continues to borrow 10% or more of GDP per year – forever – without any negative consequences. And therefore, equity prices should go much higher. That's why we've seen stocks (on the Dow) move higher for the last seven days in a row. The S&P 500 is now up 72% since the bottom last March.
What most people don't understand about inflation is it's not really a measure of commodity prices. That's only how the government chooses to measure inflation. Inflation has one true meaning: the increase of the money supply above the savings rate. Inflation isn't caused by a shortage of wheat or corn or oil, it is caused by one thing and one thing only: central bankers shrinking their reserve ratios.
One year ago the grand total of the Federal Reserve's bank credit was $1,989,877,000,000 – including $508,592,000,000 of securities (of dubious value) it purchased on the open market. Today, the Fed's total bank credit is $2,234,676,000,000 – including $1,912,690,000,000 of securities it purchased on the open market. The Fed, as promised, has spent an enormous amount of money buying mortgages and Treasuries over the last year. When central banks buy government debts or other credits, economists call it "quantitative easing," or monetizing. But you and I would simply call it printing money.
So over the last year, we've seen the Fed inflate by at least $250 billion. An increase of $250 billion in bank credit is roughly a 10% rate of inflation, based on the Fed's total credit. During this period, foreign holdings of our government's Treasury obligations increased by roughly $500 billion. (Our government debts far exceeded our domestic savings.) Thus, it's clear that, as a nation, we had zero net savings and the entire expansion of the Fed's balance sheet was inflationary. The impact of this inflation could be mitigated by increases in productivity. According to the latest data, productivity increased at almost a 6% rate in the most recent period, adjusted for various seasonal factors.
You, too, can be an economist... If you were going to guess what the likely effect on prices would be, across the entire economy, what number would you come up with? You've got 10% inflation minus about 6% productivity growth. That would leave you with about a 4% change in prices, right? So what was the change in PPI prices over the last year (not just the last month)? The PPI was up 4.4% compared to a year ago. Bingo.
Now... let me ask you a simple question. Today, the yield on 10-year U.S. government bonds is around 3.65%. You know for a fact the Federal Reserve monetized a huge amount of debt over the last year, increasing the size of its balance sheet by roughly 10%. You know the U.S. economy – despite shedding a huge number of workers – wasn't able to keep up with that inflation in terms of productivity. As a result, the value of our currency in our own economy fell by roughly 4%. Why on Earth would you buy the securities of a deeply indebted nation when the yield on its bonds doesn't even cover the rate of depreciation of its currency? You wouldn't, of course. That's why China, among other foreign creditors, has begun to sell.
Now... if you're not going to buy Treasury bonds because the yield isn't keeping pace with inflation, what else might you purchase? The U.S. has a tremendous account deficit because we continue to consume far more than we produce. The most recent figure I could find was $108 billion from the third quarter of 2009. So our foreign creditors have to buy something with their dollars, roughly $100 billion worth each quarter. If they're not going to buy Treasury securities, you might expect them to buy commodities, gold, or maybe even equities. Over the last year, gold is up about 20%. Silver is up about 30%. Copper is up 95%. Oil is up 64%. U.S. stocks are up 72%. What's down? Government bonds, about 10%. Where in our economy would you say inflation is affecting prices? When people tell you there's no inflation, try telling them to look anywhere besides the official government statistics.
My warnings about inflation aren't because I fear a 10% increase in the Fed's balance sheet. If increases of that size continue year after year, we'd eventually get in trouble, but the bigger risk is the effect of the U.S. government's fiscal policies. Quite simply, we are unwilling to pay for the size of the government we're demanding. Our government's soaring debts will have very real consequences.
Putting additional strain on our government's credit rating is the fact that over the last two years, we replaced so much of the country's private balance sheets with the public balance sheet. GE, for example, relies on a $500 billion guarantee for access to the credit markets. Fannie and Freddie underwrite 90% of mortgages. GM required a $100 billion bailout, as did AIG, Merrill Lynch, and Bear Stearns.
Sooner or later, our government's creditors are going to be struck by the fact that not only are they not being paid a fair rate of interest for our Treasury bonds, they are also unlikely to ever be repaid the principal amounts of their loans. When that realization hits, the Federal Reserve will be forced to monetize a substantial portion of the Treasury bond market. That will be a very bad day for investors...
When is this going to happen? Yogi Berra famously said predictions are hard to get right, especially about the future. And I would posit the Stansberry Corollary to Berra's maxim, "It's even more difficult when the Federal Reserve is manipulating the future..." So I can't tell you when. It all depends on how fast our debts grow compared to our economy and how long our creditors remain willing to take a chance on us. But when I'm asked this question, I simply point out what's obvious to me: If you knew you were riding with a drunk driver, when would you ask to be let out of the car?
Bond King Bill Gross continued his strategy of positioning his Total Return Fund to profit alongside the U.S. government. Gross recently increased U.S. government debt to 35% of the portfolio from 31%, the first increase since October 2009. He also lowered net cash to 2% from 9%. His move came just before Bernanke's Tuesday announcement the Fed will maintain the federal funds rate near zero for "an extended period." Assuming Gross purchased long-term government paper, he's betting rates will remain low and we'll see a period of short-term deflation.
While the Fed is maintaining its key inflation-fighting tool, the federal funds rate, near zero, it is gradually withdrawing other forms of quantitative easing. The Fed's $1.25 trillion mortgage-backed security purchasing program will end this month. That's a lot of liquidity disappearing, which probably explains Bill Gross' move. Mortgage demand is already floundering despite rates of less than 5% and the $8,000 first-time homebuyer credit (which expires next month). Without government support, mortgages rates will surely rise, hurting the housing market even more.
Brookfield Properties, owned by the Canadian value-investing powerhouse Brookfield Asset Management, is considering purchasing about 20 buildings in or near Washington that defaulted last summer. There's no doubt Brookfield realizes government is the only growth industry left, so occupancy for these buildings (which house lawyers and lobbyists) will be steady.
What's more important is how Brookfield is orchestrating the takeover. The group acquired about half of the $570 million in debt secured by the properties. Though details aren't available, you can be sure Brookfield acquired this debt at a substantial discount. If you know what you're doing, you can get outrageous deals in the distressed debt world. The markets are super-inefficient. Most holders of commercial real estate debt are conservative investors only interested in yield. When the debt defaults, they want out, and they'll sell at nearly any price.
So firms like Brookfield can buy lots of debt on the cheap. In the case of bankruptcy or default, equityholders are usually wiped out. But the creditors have first claim on the assets. So Brookfield is in the control position. It used the same strategy in the 1990s, buying up swaths of prime New York real estate. Just last December, Brookfield took over a 42-story San Francisco building after the former owner handed the property to lenders. Brookfield owned a chunk of the $224 million loan.
While he's not taking over high-rise buildings, our True Income analyst Mike Williams does a great job of analyzing valuable, distressed debt. The same principles apply when buying the debt of a corporation. In the case of bankruptcy, the equity holders are wiped out, while the bondholders gain control. Debt is by far the more valuable asset...
And Mike is an expert at finding quality bonds that yield double digits and trade for pennies on the dollar. He's producing amazing returns for his subscribers (his best-performing bond returned 200%), all while avoiding the riskier and more volatile stock market. To learn more about True Income and find out how to diversify out of stocks, click here...
A quick note to Digest readers... I know most of you are familiar with The Atlas 400, the private social club I started last year. The idea of the club is simple... All of the great things that have ever happened in my life, whether financial or personal, were due to valuable contacts I made along the way. My business, my wife, my best investment opportunities are all a direct result of the relationships I've formed. I started The Atlas 400 to expand that network and share my existing network with new club members. And the idea is working.
The club has close to 50 members. And we've already hosted successful events, traveling to Munich for Oktoberfest and Porsche racing and Miami for the Super Bowl. Our next trip – a private fishing tournament in Panama, at the world's best deep-sea fishing lodge – is coming up April 2.
We're landing in Panama City on Friday for a welcome dinner and a night of festivities. Then we've chartered planes to take us to the fishing lodge. We already have 30 people attending, but a few spots are left. We're also hosting our annual meeting this June in New York City at The Plaza Hotel. Again, some 30 folks are attending, but we have room for a few more.
We're already putting together an event for later in the year. I can't share too many details, but I had lunch with one of the world's leading international asset protection attorneys yesterday (yes, he's an Atlas member), and he told me about one of the most amazing offshore wealth-preservation techniques I've ever heard of. That got me thinking... Why don't we head to Switzerland and invite the world's top international asset-protection attorneys, private bankers, insurance guys, gold dealers, etc. to present different options to our club members.
My friend liked the idea, but recommended we host the event in another country – a tiny European nation where the Swiss actually do their banking. This will be one of the most valuable events you'll attend in your entire life... I guarantee it.
So we wanted to give a select few Digest readers – some of our best customers – the opportunity to apply for membership to The Atlas 400. This club isn't for everyone... We're only looking for likeminded, successful people with valuable insights to share. And it's expensive to join. But if you think you fit the bill, watch your inbox tomorrow. We're sending more details about the club and a link to the application form. We hope to hear from you.
New highs: Fairholme Fund (FAIRX), Washington REIT (WRE), Hershey (HSY), McDonald's (MCD), Wal-Mart (WMT), Keyera Facilities (KEY-UN.TO ), Intel (INTC), Markel Corp 7.5% Senior Debentures (MKV), Markel (MKL), Longleaf Partners (LLPFX), Sequoia Fund (SEQUX), Automatic Data Processing (ADP), Altius Minerals (ALS.TO), Carpenter Technology (CRS), American Axle (AXL), MAG Silver (MVG), Westmoreland Coal (WLB).
In the mailbag... We're getting back to normal. Subscribers take us to task for bad picks and our aggressive marketing. We respond in kind. Plus, how Mark T. learned to be a vastly better investor. Enjoy. And let us know what you think about our work: feedback@stansberryresearch.com.
"Perhaps your marketing 'hype' pieces are one reason you haven't received much sympathy from the SEC or the legal system. Changing the names of those quoted and stretching quotes from people to marketing piece may seem trivial, but it's just foolish if you expect to stay out of trouble... I agree with most of your comments about the SEC case; but you can't be too surprised by litigation and unfavorable rulings when you are publishing something like the hype piece reviewed in the link below. And it is just one example among many.
"To be clear, I do enjoy the newsletters themselves; currently I subscribe to PSIA, True Wealth, and Inside Strategist (and now, DailyWealth Premium). All have provided good information, and any investor/trader with minimal skills can profit from the recommendations... [But] in my opinion, there is no need for you (and your copywriters) to put out misleading marketing pieces. There is enough value and strong performance (track record) in the products to 'keep it real' so to speak. Enthusiasm and whetting potential customers' appetites are fine – but pushing the envelope with misleading or false information is unnecessary and, it would seem, asking for trouble. Anyway, just my opinion; keep up the great work with the newsletters themselves. By the way, S&A Digest, The Growth Stock Wire, and Daily Wealth are all great free services for your subscribers, and are much appreciated." – Paid-up subscriber Dean Northrop.
Porter comment: Just to be clear, none of our marketing pieces contain any false information. Our legal department vets all of our marketing materials before we send them out. The cosmetic changes we make – to people's names, for example – are only done to protect their privacy or the name of the stock in question.
Teasing about investments is, after all, the primary way we sell newsletter subscriptions. Nothing about these practices is illegal or immoral, and I have a hard time understanding why you think it interests the SEC – it doesn't. The SEC simply wants to regulate what we can say about securities – period. It doesn't matter whether we write with a pen name or refuse to reveal the name of the stock.
Now... in regard to the larger question you raise – your preference for marketing pieces that don't contain "hype," I happen to agree with you. I know when I read our copy, I frequently feel a little embarrassed about it. (Recently, for example, one of my writers thought introducing me as a "rich jerk" would prove interesting and exciting for some potential subscribers. I don't think of myself as a rich jerk, but I'm sure it wasn't too difficult for my writers to come up with a few supporting examples.)
On the other hand, I NEVER apologize for our copy or the aggressive marketing we pursue. That's how we stay in business. Like it or not, this kind of copy and this amount of marketing is what works. We've sold substantially more newsletter subscriptions than any of our peers over the last six years – and we did so because I have the best team of copywriters in the business, by a wide margin. If hype didn't work in advertising, engineers would sell automobiles.
While I have to tell my copywriters to tone it down from time to time, they are the real reason so many people now read my newsletters. I thank them for that. And I support their efforts because I believe our newsletters are substantially better than the competition's and feel we deserve more readers. If you disagree, I'm always willing to return your money and part as friends. That's the civil thing to do. And we certainly don't need the government interfering with our arrangement.
"Porter lost 80% of his career credibility, to me, on just one piece – the long diatribe on CAL, all the reasons it had to go to zero, and the very strong recco to short, around 9. I did. Shorted more at 11. I have lost thousands. I researched the Advisory – desperate for some input as to what went wrong – found nothing – just an alert that said 'CAL has hit our stop – cover your short.' Pathetic. Ego, I suppose. You owe your subscribers a lot more. But... to highlight my ultimate masochistic stupidity, I'm still subscribing!" – Paid-up subscriber Michael N. Wood
Porter comment: These are the kinds of customers who absolutely kill me. They trusted me enough to take the action I recommended when I told them to establish a position. But they ignore – completely – all of my advice about the importance of being able, willing, and ready to take a small loss. Then, they blame me because they willfully ignored my best advice.
Listen... I constantly urge all my subscribers to cut their losses. In every single issue of my newsletter, I advise, "Our investment philosophy limits risk through the use of stop losses and trailing stop losses." The kind of investing we do in my newsletter – where we both buy and sell stocks – is designed to produce absolute returns. You can make money investing this way whether the stock market goes up or down. However, when the market goes into extreme periods, we have to close out of losing positions – or else our strategy isn't going to work.
The entire stock market is up 72% on average over the last year. The Fed has been piling money into the markets day after day. Almost nothing on the short side has worked all year. That's why I told you to cover the damn position!
The move has nothing to do with Continental – which is still losing money on a cash-flow basis (negative $19 million for 2009). When will this matter to investors again? I can't say for certain. Sooner or later, we'll short it again, and I'm sure if we're merely patient enough, we'll make back the small amount we lost and end up being dead-on-the-money right. But you'll never even know it because you'll have blown your account by ignoring our advice. And then, to add insult to injury, you'll continue to insist it was all my fault. Do me a favor: Just ask for your money back and let's part as friends.
"Per your sage advice I have been selling covered calls on selected stocks when attractive to do so. Now one of my stocks is about to be called away. If one likes the stock and would like to own it again, does it make sense now to sell a put (assuming an attractive premium) in hopes of getting back in?" – Paid-up subscriber Dave Rutherford
Porter comment: Makes sense to me... but why not sell puts in the first place? The premiums are bigger and you can use margin, which can really improve your returns on capital.
"Porter was a gentleman to not point out I was on the losing end of the Hilfiger debate, when I argued against buying it. It seemed crazy at the time to lock up my investment capital forever (translation: 3 to 5 years) when I could by something else that might double in a year. I shake my head now and chuckle at how immature I was back then, and how smart Porter and Dan were. Thankfully, in the 7 years since that debate took place, I have learned to spend less time debating them and a lot more time listening to Porter and Dan.
"Today, you will find companies like Hershey, Home Depot, Wal-Mart, Microsoft, St. Joes, and Disney in my portfolio. Some of them have been there for years. Back in 2003, I bought and sold over 20 stocks. I wasn't investing. I was learning an expensive tuition lesson. Last year, I sold 2. One was the company I work for, the other was a gold stock. Think the lesson has sunk in? Thanks to them, I am creating wealth by doing less, and making more. Try it." – Paid-up subscriber Mark T.
Porter comment: If you remember our debate back then, Mark, you'll recall you believed that because Hilfiger's stock had been such a dog for so long, it was unlikely to do well in the future. You were basing your expectations of the future return on the past results.
What you've learned to do now is evaluate a stock's potential based on its earnings power (intrinsic value) compared to its current price. The bigger the differential, the higher the likely future returns. Once you learn to see the markets that way, you're never the same: You're a vastly better investor.
Regards,
Porter Stansberry and Sean Goldsmith
Baltimore, Maryland
March 17, 2010