The poetry of inflation

The poetry of inflation... AIG lying about swaps?... Food, coal, and couture... Sellers now, losers tomorrow... Peltz likes credit...

It's not mere irony. It's poetry.

The whole world thinks holding U.S. dollars is the best thing to do with their money. Without the Fed's help, they drove T-bill rates into negative territory. Every Treasury exchange-traded fund under the sun is hitting new highs.

At the same moment when demand for the dollar is greatest, when investors great and small feel they need the safety they perceive in it alone, the gatekeepers of the U.S. dollar do everything in their power to devalue the currency.

I'm reminded of the late Dorothy Sayers, author of the Lord Peter detective novels, who said, "A society in which consumption has to be artificially stimulated in order to keep production going is a society founded on trash and waste."

I don't know about our whole society, but our currency and banking system is certainly founded on trash and waste. People in that industry went to Harvard and got straight As to learn how to print money and lie about which mortgages are triple-A and which ones are pure garbage...

So you get organizations like AIG, which appears to be lying about the value of its credit default swaps and could have another $30 billion in writedowns coming its way.

A year ago, then-CEO Martin Sullivan said AIG losses from subprime-related credit insurance were "manageable." Two bailouts and two CEOs later, the reported values of AIG credit default swaps guaranteeing $300 billion of debt don't reflect the distress in credit market, according to Donn Vickrey of research firm Gradient Analytics. In other words, the company is under-reporting the size of its massive liabilities. But AIG's new chief risk officer, Robert Lewis, says it "reports all its derivatives at fair value in accordance with U.S. generally accepted accounting principles."

Which one would you rather bet on, Vickrey or Lewis? Who has the bigger incentive to lie?

Major food producers General Mills and ConAgra both sound upbeat about their businesses. General Mills reported a 3% decline in second-quarter profits yesterday (mainly from commodity-hedging losses), but the company raised its full-year forecast. And ConAgra, maker of Healthy Choice meals and Chef Boyardee, said it expects growth in full-year revenue, too. Both companies are profiting from a fall in food costs – which were at record highs several months ago – and a weakening economy that is forcing more people to dine in.

Food-related stocks have been a relatively bright spot in 2008. Grocery chain Kroger, food wholesaler Nash Finch, and Wal-Mart, the country's largest grocer, are all higher than they were a year ago...

You can't expect me to resist pointing out Wal-Mart is up about 15% versus a year ago, market crash be damned, and that yours truly "pounded the table" until it broke about the stock, calling it "the best stock to buy right now" and "my No. 1 pick."

I'm still finding world-dominating franchises like Wal-Mart selling at dirt-cheap prices. In the current issue of Extreme Value, I cover a new one trading for less than six times pretax earnings. I also include the eight financial clues that tell investors they've found a true world dominator. Click here for details.

Coal prices haven't been nearly as weak as other energy prices since July. Appalachian coal is benefiting from steady demand and lower supplies as marginal producers shutter production due to the credit crisis. Now, a new Barron's article says much of what I've said about International Coal Group for two years. I think the stock will become a multibagger over the next few years.

At the opposite end of the spectrum from coal and groceries, luxury goods purveyor Hermes International is also succeeding. Despite struggling consumers, increasing pressure from short sellers (7% of the stock is on loan), and "sell" ratings by 20 brokerages, French clothier Hermes has gained 24% this year – the only European luxury stock to do so.

Some fund managers believe the upward movement is "Volkswagenesque," referring to the recent spike in Volkswagen stock that made it the largest company in the world for one day. Short sellers, including David Einhorn and Steve Cohen, were forced to quickly cover their bets after Porsche bought more Volkswagen stock, skyrocketing the price.

I won't speak for anyone else, but there's a reason why I've told my readers to short only one stock in the last six years (Lehman Brothers, which went bankrupt). Even if you're right, your downside is unlimited, your upside potential limited.

In a study covering the 20 years ending December 31, 2007, quant-research firm Dalbar found the No. 1 reason mutual-fund investors earned only 4.48% annually on average, even though the S&P 500 rose 11.8% a year... It wasn't mutual-fund fees. It was selling when the market fell. That's the biggest mistake you can make... selling low and buying high. I imagine the great unwashed herd has made that mistake in spades this year. If you're making it now, you can't say we didn't warn you.

Former Drexel Burnham Lambert bankers Jay Bloom and Dean Kehler are joining Trian Partners, the firm run by billionaire activist investor – and fellow Drexel alumnus – Nelson Peltz. The group came up through Drexel together at the height of the 1980s junk-bond era, epitomized by the rise and fall of the firm and its bond chief, Michael Milken. And now, they think the bottom in the debt market is in.

"It's 1990 all over again," said Bloom. "But it's so much bigger and so much broader." The shift to bonds is a big move for Peltz, who usually invests in companies like Arby's and Heinz and agitates for change. "At the risk of hyperbole, this [bond market] might be a once-in-a-lifetime opportunity," said Ed Garden, Trian's vice chairman.

He's probably right. Investment-grade corporate debt yielded 5.74% more than similar-maturity Treasuries in early December, more than three times the five-year average spread.

Rumors abound that Obama's miracle bailout will cost taxpayers at least $850 billion, about 6% of the country's $14 trillion economy. Obama would use that money to repair U.S. infrastructure and create as many as 2.5 million jobs over the next two years. Economists believe the real number will be closer to $1 trillion. And Paulson may soon ask for the next $350 billion of the Troubled Asset Relief Program (TARP), as the GM and Chrysler bailout may deplete the initial $350 billion.

New highs: none.

In the mailbag... A change of pace: three reasons to like our advertising. You got a problem with it? Let us know: feedback@stansberryresearch.com.

"Dr Huang is soooo intelligent! I have been trying to find a nanotech company that makes a reasonable sense to invest in. I think he could separate the seed from the chaff I also think nanotechnology is the only thing that will bring us out of this depression or hyperinflation, whichever is the result of the US policy. I want to be in nanotechnology as a hedge." – Paid-up subscriber Steve

Ferris comment: George must be intelligent. He has a PhD in a discipline where you actually have to know something to get one (biochemistry). I don't know anything about nanotech, but George sent us a note yesterday, which I think you'll enjoy reading...

I believe it's the best trade I've come up with all year. The stock first came across my radar in October... now it's 40% cheaper. The company has $160 million in cash and no debt. The stock is trading at exactly cash level. The company is trying to sell an annual royalty stream of $30 million. The royalty is growing at double-digit rates. Using the most conservative estimates, I peg the value at more than $130 million. The deal should close in the next few quarters. You can double your money on cash alone.

The company collects another $40 million of royalty revenue off another drug. This money is enough to fund operations. At today's prices, we get both royalty streams and the pipeline for free.

Even better, the board has started a Dutch auction for $50 million worth of shares at a price range just slightly above cash. So the return for holding the stock could be even more spectacular. Best of all, the possibility of losing money in the near-term is close to nil. The tender is putting a solid floor on the stock price.

If you'd like to read George's full write-up in his S&A FDA Report, click here...

"I agree with your assessment of your picks. I don't subscribe to your service to invest in every idea. I am looking for original thinking. I just try to cherry pick your best ideas and your BUD call was a solid idea and a big winner for me this year. In a treacherous down market investing in stocks with a firm takeover bid on the table is a reasonably good bet, especially since Inbev was continuously declaring that they had the financing in place. BUD was still trading in the 50's a month before the merger so I bought the 65 calls and enjoyed a great trade when BUD went off the board at 70 giving me several hundred percent in profits in less than a month." – Paid-up subscriber Pete Ewing

"Maybe this will help stem the flood of whiners to your inbox: You should know that I LIKE the ads. Why? 1) When you have a NEW ad, I sometimes get a new perspective, a different way to see something your newsletters have already made me aware of but maybe there is a new twist provided that I hadn't seen before. 2) When it is an OLD ad, I scroll to the bottom to see what the special reports and what newsletter is offering them so I can pop over to that section of the web site for updates. For some reason, not all of the newsletter update announcements are coming to my primary e-mail box... 3) A quick scan of the ad reminds me of trading ideas that have fallen off the edge of my radar. So there are three good reasons to be thankful for the ads when you are an Alliance Member and already get all of the newsletters with your subscription!" – Son of a paid-up subscriber C. Vogt

Regards,

Dan Ferris

Medford, Oregon

December 18, 2008

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