The S&A Digest: Gold Should Get a Boost from an Old Friend

Get well, Richard Russell... Silver and hemorrhoids... Insurers under reserved... Big bank failures coming... Housing and financials: Siamese twins... The gold rally...

 A month or so ago, I was having trouble making a rather important business decision, so I called someone I thought could help: Richard Russell, editor and founder of the excellent Dow Theory Letters. Richard suffered a series of small strokes recently and has decided to work less often and have more balance in his life.

Richard, thanks for your time a few weeks ago. It was a big help. Hearing you say, "This is Russell," on the other end of the phone was a thrill and an honor for me. I know everyone at Stansberry joins me in wishing you the speediest recovery, as well as a long and happy life.

 U.S. gymnast Nastia Liukin is quoted in today's Wall Street Journal saying that three Olympic silver medals "is kind of hard to take." I can't speak from experience, having been good at only one sport in my entire life (tennis), and never having played enough of it at that. But the way I see it, hemorrhoids are hard to take. Silver medals? Not so much.

 Less difficult than three silver medals, but not as bad as hemorrhoids, is what I've been telling Extreme Value readers since February: Most insurance companies don't have adequate reserves to account for the effects of inflation. Last Thursday, a Fitch ratings analyst told investors, "Inflation is a significant challenge to loss reserves. When unexpected inflation costs go up, (insurers) tend to underestimate loss costs."

In Extreme Value, I've been writing about the one insurer I know of to warn investors about the harmful effects of inflation on loss reserves. The founder and CEO has been discussing the topic for years, and his company is one of the best-performing stocks of the last 25 years, returning more than 20% a year on average.

The details are in a new special report we've just put together, called The Greatest Business in America. To get it, click here.

 The other thing I've been harping on in Extreme Value is the wave of bank failures that's coming. If you look around at financial stocks, they've been discounting bad times over the past year... but not enough. If you won't take it from me, here's a famous person with lots of credentials who says the same thing:

The worst is yet to come in the U.S. We're not just going to see mid-sized banks go under in the next few months, we're going to see a whopper, we're going to see a big one, one of the big investment banks or big banks.

That's Kenneth Rogoff talking at a conference in Singapore recently. He's the former chief economist of the International Monetary Fund and a Harvard professor. I thought guys like him were supposed to hold up the status quo. I hope he doesn't get fired for being right. Academia is notoriously status quo on this sort of thing.

Rogoff also says Fannie and Freddie should have been closed 10 years ago and they probably won't survive. He also thinks Fed rate cuts during the crisis will lead to high inflation over the next few years.

 T2 Partners' Whitney Tilson and Glenn Tongue write in their most recent monthly investor letter (we produced this chart):

In light of the latest rally, one might reasonably ask why we don't declare victory, cover our financial shorts and move on – after all, we've still made enormous profits here. The answer is that we believe this is yet another bear market rally in this sector, of which there have been many over the past year...

If you want to know how to look at financials, it's simple: As falls housing, so fall financials. (I'm getting major mileage out of that Pat Metheny quote!)

Tilson makes what appears to be a reasonable guess about the future of home prices, a guess with which I've agreed since I first saw his mortgage/housing presentation last year. Through May, home prices are 18.4% off their July 2006 high (based on S&P Case-Shiller data). Tilson suggests prices are about halfway through their decline. That'd be an all-in top-to-bottom move of approximately 30%-40%. He also says don't look for the bottom until 2010 at the earliest, adding, "Needless to say, our view is significantly more pessimistic (we prefer to think realistic) than that of most analysts, CEOs of financial companies and other 'experts.'"

 New housing starts hit their lowest annualized rate in 17 years in July. But don't for a minute believe new homes are in short supply. Countrywide had more than 15,000 existing homes for sale, as of August 11, according to a blog that tracks the firm's foreclosed properties.

 Word is, Extreme Value short pick Lehman Brothers is talking to private-equity and "strategic" buyers about selling all or part of its asset-management arm, Neuberger Berman. One senior executive at a private-equity firm said Lehman is considering its options because it "has to fill the void." I believe the void in question is Lehman's net worth, which is very likely negative.

Lehman bought Neuberger Berman in 2003 for $2.6 billion. Some think it's worth $10 billion. Bernstein Research says it's worth $7 billion.

Selling Neuberger falls in the same category as Merrill Lynch selling off its stake in Bloomberg. When you have few choices and your back is against the wall, you sell what anyone will buy. Which would you rather own, the business that's making money today or the one that might blow up even more?

 Lehman's potential sale of Neuberger might not be so easy. When Lehman bought it, 30 top fund managers got Lehman share packages with long holding periods. Obviously, those shares are way down now. A Neuberger buyer would have to come up with incentives to keep those managers from leaving. The private-equity executive we mentioned above asks, "Can you come up with enough economics for employees and still offer Lehman enough to convince them to sell?"

 If you want to know how bad it can get for a big financial company's creditors when it all goes south, look at American Home Mortgage Investment, among the largest U.S. home-loan providers before seeking bankruptcy protection a year ago. American Home says it'll pay unsecured creditors no more than 5.9 cents on the dollar as it liquidates assets.

In a disclosure statement filed Friday with the U.S. bankruptcy court in Wilmington, Delaware, the company said many unsecured creditors will get between zero and 2.2 cents on the dollar on their claims. Secured creditors, whose claims are backed by collateral, will get the full amounts owed. Shareholders get nothing.

 New highs: none.

 In today's mailbag... confusion over where gold is headed. Send your financial puzzles to: feedback@stansberryresearch.com.

 "A conundrum wrapped inside an enigma? CNBC reports that the speculation in Gold is over and the metal is headed to $600.00. Television ads want us to send our old Gold in to a smelter somewhere for quick cash. Jeff says that the metal is likely headed down due to perception? Steve thinks buying miners is a good idea. Asian stock markets are breaking through support. Is this more than money supply?" – Paid-up subscriber Shawn McGuire

Ferris comment: I can't predict the future, but I can tell you something about the past. On its way from $35 to $850 in the '70s, gold went through three big retracements. I think it's insane not to own some physical gold right now. I think we're going to have more, not fewer, wars. I think the Fed and the Treasury will become more involved in the U.S. economy, not less. I think the U.S. dollar will be worth less, not more, a year from now. The U.S. will be a worse place to live in a couple years, worse than it is now, and probably worse than it's ever been. All reasons to own physical gold.

Regards,

Dan Ferris

Medford, Oregon

August 19, 2008

Gold Should Get a Boost from an Old Friend

By Ian Davis

Gold is sinking like... well, like a brick of gold.

In the last month, gold has plummeted from $986 an ounce to $792, a fall of almost 20%. It's down 21.7% from March, when it reached its all-time peak of $1,011.60.

However, I think gold should get some support soon.

Just this morning, the latest producer price index (PPI) number came out... And its results are good for gold.

The PPI is a way to measure inflation. It measures the change in price of a basket of goods. Unlike the consumer price index (CPI), the PPI focuses on goods sold to producers, not goods purchased by consumers. Since producers often pass price increases on to consumers, moves in the PPI often precede those in the CPI.

And this morning's PPI numbers were higher than expected. The producer price index rose 1.8%, or 9.8% year-over-year. That's the highest rate of inflation in 27 years.

In 1979 – the last time inflation rose above 9% – the price of gold went from $207 to $457 over the following year. When inflation heats up, the price of gold skyrockets. Take a look...

Is the Gold Rally Over? 

Since 1968, the PPI was rising (above its 12-month trend line) 54% of the time. During those periods, gold returned an annualized 19.5%. The rest of the time, when the PPI was falling, gold returned an annualized -4.1%.

Right now, the PPI is almost 45% above its 12-month trend line.

If inflation continues to heat up, gold's current downtrend should reverse itself. However, gold is extremely volatile these days. So if you're trading gold, wait until you see the start of an uptrend before you buy.

Good investing,

Ian Davis

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