Why we bought gold

Why we bought gold... Why we didn't buy hedge funds... Video game update... Tallying up America's debts... This week's conference calls... Trouble for Capital One... Grantham on why he's not buying banks... A nasty mailbag...

"Gold is the only asset that is completely outside of the credit system and the only asset that has no liability," says one of the best money managers of all time, Jean-Marie Eveillard, manager of the five-star First Eagle Gold Fund. Eveillard has 35% of the fund's assets in bullion. He doesn't own the gold-tracking ETF for the same reason we've always recommended bullion over any stock: "If you look at gold as insurance, then gold bullion is preferable." Readers of our newsletters have heard this advice regularly since 2001.

And... believe it or not... some readers took our advice:

I believe it was Steve who recommended buying the new 1 oz. $50.00 gold buffalos. Having never purchased gold coins but having some faith in you all, I screwed up my courage and purchased 10 proof buffalos @ $800.00 each directly from the mint. At the time gold was selling for about $670.00/oz so this was a leap of faith. To be honest, I did not tell my wife but just surreptitiously put them in the safe deposit box. I finally got around to sending them to PCGS for grading. Guess what? I have 3 2006 proof grade 70, 6 2006 proof grade 69 and one 68. So two years later the 10 coins are now worth about $12,000.00 based upon recent pricing and offers. – Paid-up subscriber Bob Kent

Another giant hedge fund, Citadel Investment Group, halted year-end withdrawals from its two biggest funds after investors looked to take out $1.2 billion, or 12% of assets. Withdrawals for the Kensington and Wellington funds may resume as early as March 31. The funds, which manage around $10 billion, are down 49.5% this year through December 5.

Something to watch this week... A certain video-game maker whose shares have been recommended in my newsletter (PSIA) will report earnings on Wednesday. We estimate the stock is currently trading for only $2 per share above its liquidation value. And we think the report is going to be much better than expected. Game software sales were up 11% in November, showing that games are still selling, despite a weak economy.

An update on America's insolvency... Cumulative U.S. federal debt is now more than $10 trillion, up from $9.1 trillion a year ago. (That figure doesn't include any unfunded liabilities such as Social Security or Medicare.) Total consumer installment debt: $2.5 trillion, up from $2.4 trillion a year ago.

This week will give you an excellent opportunity to get a real education on the state of the economy. On December 16, Best Buy will host its third-quarter conference call at 10 a.m. On December 17, Morgan Stanley's fourth-quarter call begins at 11 a.m. On December 18, it's FedEx's second-quarter call at 8:30 a.m.

Then, what I think are the two most important, also on December 18: Paychex's second-quarter call at 10:30 a.m. and Discover Financial's fourth-quarter call at 11 a.m. In one week, you'll get firsthand information on retail, investment banking, transportation/shipping, employment, and credit cards. We'll be listening. Will you?

We wrote it, did you short it?

I predict over the next 12 to 18 months, Capital One experiences defaults on more than 10% of its total loan book, resulting in losses of around $15 billion. That would erode a majority of the bank's equity. Depositors would quickly find a safer place for their money, and Capital One would find itself, like certain Wall Street firms of late, trying to raise capital in the midst of a panic. – Porter Stansberry's Investment Advisory, April 2008

Capital One is quickly approaching our predicted 10% default rate. The company said the annual net charge-off rate for U.S. credit cards increased to 6.98% in November up from 4.11% this spring. Its shares have traded as low as $23, down from $50 in April. I updated my readers on Capital One in the latest issue of PSIA. To learn more about PSIA and how to access the report, click here...

Jeremy Grantham, chairman and CEO of value mutual fund GMO, recently gave an interview to Fortune talking about what he's buying. He said buying high-quality stocks isn't that dependable in ordinary or even severe bear markets. It's only dependable when "economic fundamentals start to collapse." When people fear a recession, buy high quality.

Grantham says blue chips are the cheapest part of the market. His largest holdings are Coca-Cola (KO), Procter & Gamble (PG), Microsoft (MSFT), Wal-Mart (WMT), and Johnson & Johnson (JNJ). All five of these stocks are either Extreme Value or PSIA picks. In fact, Dan Ferris has been praising these corporate titans for months. You can read about it here, here, and here.

You won't find any bank stocks in Grantham's portfolio. Says Grantham, "The most difficult decision we've had to make in a long time was when we started our quality fund four years ago – the question was whether banks could ever be considered high quality. All the quants in the shop were saying, 'What do you mean? They've got high, stable returns.' But all the historians were saying, 'Yeah, but every 15 or 20 years, the market takes half of them out and shoots them. That doesn't happen to the Coca-Colas.' So in the end, we decided that no banks could ever be high quality."

New highs: none.

In the mailbag... I have to "straighten out" two subscribers who have gone way off the reservation. Just a hint for those of you who'd like to get along with your providers of financial research: Don't accuse us of fraud and don't insult us when we're mourning a parent. Send your comments, even if they're mean-spirited, here: feedback@stansberryresearch.com.

"Next year is my 45th year in business, we have gone thru some slow periods but nothing like now. Thank God I own the building that houses my store plus some rentals. I owe nothing on my commercial real estate and also my home. I have a 140 acre farm, with deer and wild turkey, in the summer I plant a 4000 sq. ft. garden, so I guess I'm as ready as any one to ride this thing out." – Paid-up subscriber TD Metts

"Could you elaborate on the liquidation value, more specifically the difference with Book Value. I would have thought that they should be similar, and in some cases they are, but I looked at BAC and the book value is $35.3 vs. $10 liquidation value." – Paid-up subscriber Franco Guastaferro

Porter comment: Liquidation value (which is part of our risk analysis in Put Strategy Report) is simply an estimate of what the company's tangible book value might be worth in a forced sale. Book value represents the current market value of those assets. But as you know, if you have to sell something in a hurry, you can't get a very good price. In the case of Bank of America, the liquidation value reflects a markdown of the credit-card and real estate assets it holds.

"I received an e-mail this morning from your company promoting the Put Strategy Report... The promotion was so convincing that I subscribed. Well what a surprise to find that the recommendation has gotten away and is beyond the price recommended... Your credibility with me has suffered significantly so I am going to be canceling my 2 subscriptions as they get close to the deadline to get back full refunds. I feel you misrepresented the information in your promotions and if you wish to get further business in future make sure the information is current. There is a lot of competition for your product out there so I think you had better wake up or go under like so many other businesses are doing now." – Paid-up subscriber David Kirkpatrick

Porter comment: So... you think I'm misrepresenting my work... but you're going to keep my newsletters up until the minute our guarantee expires? If you think I'm a liar, why would you bother reading my work at all?

The chart below shows the underlying stock price of the company David Kirkpatrick is complaining about. I recommended buying puts on this stock on last Tuesday night – December 10. Since then, the company's share price is essentially unchanged, if not a little higher. This means, intrinsically, the value of the puts I recommended buying are relatively unchanged.

Meanwhile, the fundamental reason for wanting to be short this stock (via put options) is because it is highly indebted and its main competitor is, as of Friday night, in default on $900 million in debt. This default will lead to forced asset sales, causing the price of similar assets to fall. This will put pressure on the stock we're shorting (via put options).

As you can see, the opportunity is every bit as good – if not better – than when I first covered it a week ago. But Mr. Kirkpatrick would have you believe I'm some kind of con artist simply because the market makers are gaming the price of the particular option I recommended buying. David doesn't mention that I thoroughly explained this situation in an update to ALL Put Strategy subscribers on Thursday. And I showed all subscribers precisely how to solve the problem:

Even better, the June $12.50 puts have an implied volatility of 168. By slightly varying the strike price and the expiration date, you should always be able to buy an option that's basically the same as the one I've recommended – no matter how much the market makers are fooling around with the prices.

David, it's not good business to turn away customers, but quite frankly I don't have the stomach for dealing with people like you – people who take full advantage of our products and our goodwill, while plotting to use everything we offer without paying a cent. And... to have someone like you accuse me of acting in bad faith is simply more than I can stand. Not only will I refund all of your money, I insist you take it back. And since we're parting as friends, I hope you'll oblige me by never subscribing to any of our products again.

For the rest of our Put Strategy subscribers, I'll fully update everyone on the most recent recommended trade tomorrow, plus I've got more research to share with you on dozens of desperately overleveraged corporations.

"I originally sent the message below and I apologize to a degree, I'm just at my wit's end. I've lost so much money in the stock market... it's not easy these days. I've sent other messages asking about Hedge Fund Redemption's before the end of the year, important things I would really like an answer to. Instead hearing about your family and not the real juice that I would really like answer to, well, I'm more than flustered. I would still like to know about your thoughts of Hedge Fund Redemption's before the year is out. Although many hedge funds are halting such activity, is there still more to come with one more wave of beat-downs before expiration? Lastly, although my apology may seem back-handed, if you answered the personal questions as well as the business questions... I think everything would be harmonious." – Paid-up subscriber Andrew Days

Porter comment: After insulting Steve Sjuggerud on the event of his father's tragic death, how could we possibly refuse such a request? Especially after receiving such a magnanimous apology – well, to a degree.

Andrew, if you offered me $10 million to answer a question from you, I still wouldn't. What I ought to do is publish your home address and leave you to the wolves. Plenty of people reading this Digest would love the opportunity to show you how to make a decent apology. Your behavior is completely beyond the pale.

Regards,

Porter Stansberry

Baltimore, Maryland

December 15, 2008

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