"Rebuilding" the middle class

"Rebuilding" the middle class... Short coal, long natural gas... A "Black Swan" October... Hedge-fund rat motels... Side effects of the bailout... Get with the program...

"To rebuild the middle class, I'll give a tax break to 95% of workers and their families," promises OBAMA! in today's Wall Street Journal. As longtime readers surely know by now, our beat is finance, not politics. We have no dog in tomorrow's fight. In fact, I deliberately choose not to vote. I don't want to encourage either party. I would like to point out, however, students of history ought be chilled by OBAMA!'s rhetoric. When the government promises to do something – rebuild the middle class, end poverty, make the world safe for democracy, fight a "war" on drugs, etc. – it's best to duck.

We must admit, though, OBAMA! has always impressed us. Who else could pull off one obvious, audacious lie after another without losing any authority or confidence? It's not like Bill Clinton. We knew he was lying the whole time. But it was so much fun watching him do it. And it's not like George Bush, who can't lie without looking like a compete fool. OBAMA! is altogether different – people actually believe him.

And so, when OBAMA! says we can simply take more from Peter (who already pays marginal tax rates about 100% higher than average) to "rebuild" Paul with "tax refunds" (which are really welfare checks) and this will place America back on the path to prosperity, people actually believe him. It's incredible.

Where in history have we seen this kind of plan before? Argentina comes to mind. But where has it actually worked? Where has increasing the size of government, increasing the size of government handouts, and raising income taxes on the most productive citizens to more than 50% (state and federal combined) ever led to prosperity?

The American middle class was built by personal rectitude (hard work, saving, thrift), cheap energy, rising productivity, and the enormous surge in demand for American-made products and services following War World II. It cannot be "rebuilt" by the government or any president. It was a wonderful byproduct of American capitalism, personal responsibility, and the huge growth in free markets globally over the last 100 years. The government cannot give anyone "the good life." Profits must be earned. Capital must be saved. And risks must be assumed to pursue growth. There's no free lunch, as OBAMA!'s fans will soon be reminded, much to their sorrow.

When it comes to your money and OBAMA!, our general advice is to seek out tax-protected and tax-deferred investments, like muni bonds and master limited partnerships. We have one other specific idea: short coal, long natural gas. With the Democrats in power, we'll see a whole bunch of global-warming laws passed, including a "cap-and-trade" system, which will actually be the largest new tax passed since 1913. The government will begin to tax and regulate coal out of the market. (It's a fascinating way to help the middle class, isn't it? To essentially outlaw our great natural source of power...) Natural gas is the only fuel source that's immediately available to power the electric grid as coal power plants are legislated out of the market. Keep your eye on natural gas-based electricity producers, like Calpine, and coal-based producers like AES. The spread between these two stocks will probably continue to widen.

Nassim Taleb, author of The Black Swan, has long preached the devastating effects of random, improbable, and unpredictable events on financial markets. To put his teachings into action, Taleb started hedge fund Universa Investments. Separate funds in Universa's Black Swan Protection Protocol were up between 65% and 115% in October. The $2 billion fund bought far-out-of-the-money put options on stocks and indexes – betting markets would fall. Universa bought loads of cheap puts when the market was good and took small losses along the way. It held about 90% of assets in cash.

When the recent destruction hit, the value of the put options soared. The Wall Street Journal gave an example of one of Universa's trades...

In late September, when the Standard & Poor's 500-stock index was trading around 1,200, Universa purchased put options that would pay off if the index fell to 850 by late October. Since such a plunge was considered highly unlikely, such options cost only 90 cents. On Oct. 10, those options cost $60 as the S&P 500 tumbled sharply. Universa sold most of its position in the high-$50 range.

Yet another bank failed... Freedom Bank of Bradenton, Florida, became the 17th bank this year seized by regulators. Freedom, with $287 million in assets and $254 million in deposits, closed its doors yesterday. Fifth Third Bancorp will assume the deposits and buy $36 million of assets – the four branches opened today as Fifth Third branches. In the face of mounting failures, the U.S. government now expects 1,800 publicly traded institutions to ask for bailouts.

We've seen dozens of hedge funds halt redemptions and close shop, but never one this big... GLG, one of Europe's largest hedge funds with around $23 billion in assets, will alert investors of a "liquidity review" this week. GLG is halting redemptions in its $1.5 billion Market Neutral Fund for six months. It will also tell investors looking to withdraw from the $2.5 billion Emerging Markets Fund that they will not receive a full return because parts of the fund are too illiquid to sell. The real trouble for GLG starts if assets fall to less than $15 billion. At that point, the fund would breach a loan covenant and be forced to liquidate more positions.

New highs: none.

In the mailbag... Questions about banks, brokers, and hedge funds. Send your questions here: feedback@stansberryresearch.com.

"I enjoy reading The S&A Digest. I learn a lot from you and the other very fine and knowledgable gentlemen who write it. Maybe you could explain something to me. Last week's evening news had a segment on the Bail out and how some of that money will likely go to pay bonuses to bankers, because that's what it will take for the banks to retain their 'best brains' who will otherwise (if denied their bonuses) go to work for hedge funds. Now tell me, was it not these 'best brains' that got the banks into the mess that they are in? Isn't a bonus supposed to be an award for having done something above and beyond the normal amount of good work that is already expected of an employee? What is it about their salary that makes it necessary to subsidize them with bonuses? The whole thing puzzles me. Considering the situation with the banks, these 'best brains' must have been asleep or worse. What now gives them entitlement to a bonus?" – Paid-up subscriber Michael

Porter comment: Lots of the employees of these investment houses (aka – gambling dens) didn't lose money this year. Just because the mortgage department wiped out the equity of the firm doesn't mean the guy trading muni bonds isn't owed a bonus. If all the investment banks had simply been allowed to fail (like Bear and Lehman), then none of these bonuses would be paid. But because your government decided to step in, the contracts are still valid and the bonuses must be paid.

This is just one of the many unintended consequences of Paulson's bailout – the one everyone said we couldn't live without. I disagreed. And I still do. We have a system for dealing effectively and efficiently with failed businesses. It's called bankruptcy. That's how you clear bad debts and get the system going again – you let the bad firms with the bad bets fail. The whole notion of "too big to fail" is at the root of the problem. Ask the Japanese.

"Porter – apparently Ferris doesn't share your opinion of the value of hedge funds, as he lauds the performance of David, 'the Tinhorn' Einhorn's 'smart move' in wrecking ALD [Allied Capital] with his long-running campaign of short selling and publicly defaming that company through various publications... " – Paid-up subscriber Bruce

Porter comment: I think it's foolish to pay anyone – even David Einhorn – 2% of your assets and 20% of your investment gains. On the other hand, I know Einhorn is a brilliant investor and a very honest man. I have enormous respect for him personally and professionally. (And I've met him... Have you?)

I find your criticisms of him childish and absurd. His book about Allied Capital – Fooling Some of the People All of the Time – ought to be mandatory reading for all investors. It will open your eyes to how Wall Street and Washington collude to take your money. As David Einhorn proved, Allied's senior management blatantly violated accounting rules and used the government's guarantee of small business lending to defraud taxpayers for years. The SEC willfully looked the other way, thanks to former SEC officials now employed at Allied. That's how Washington and Wall Street really work, as I know all too well...

"I bought ICO and was up 115% at one point. I didn't do the 25% trailing stop loss you recommend and now I am down 21%. I only put about 1% of my holdings in it. Your advice was dead on. I learned the hard way to follow good advice." – Paid-up subscriber Lonny Watson

Porter comment: The good news is, it usually only takes one big loss to get with the trailing stop-loss program.

Regards,

Porter Stansberry

Baltimore, Maryland

November 3, 2008

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