The Short-Selling Ban Won't End the Bear Market

Eveillard's billion in gold... 10,000 foreclosures a day... WaMu deposits fleeing... Regional banks under pressure and in play... Paulson's 'Internet scam' letter... The short-selling ban won't end the bear market...

Legendary value investor Jean-Marie Eveillard says he has $1 billion in gold in a vault near Times Square as insurance against "extreme outcomes." Eveillard keeps as much as 8% of his $22 billion First Eagle Global Fund in bullion or gold-mining stocks.

According to Eveillard, "Gold is insurance. In most of those instances where things would get bad enough so you would get into equity bear markets, where economic and financial circumstances would be bad for a year or two or three," gold will rise.

It's too bad many value investors are dogmatic about following Warren Buffett, who, as far as I know, has never invested in gold in his life. Investment genius though he is, Buffett can't know everything.

Porter and I have both been telling you to buy some physical gold. I'll go even further. I think you should start looking through the higher-quality names in riskier businesses like exploration mining, oil and gas exploration, and finance.

Matt Badiali's S&A Oil Report has some great ideas in the oil and gas area right now. Click here to learn more about his latest discovery.

Ten thousand a day. That's the current rate of home-mortgage foreclosures in the United States. Housing foreclosures are why billionaire bankruptcy expert Wilbur Ross says at least 1,000 banks will fail in the next year. Ross said Monday, "None of these actions that have just been taken make it any easier for Middle America to meet their mortgage payments – it doesn't address that whole problem and that problem is what really caused this to begin with."

Walking slowly through the aisles of the grocery store this weekend, my wife and I ran into a friend who works for a regional bank in the area. She says hundreds of new customers have opened new accounts the last week or two. "It's weird," she says. "They come in five or six at a time, and they look scared." Our friend told us they're all from the same competitor: Washington Mutual.

In The Digest, we reported not long ago on how desperate banks and thrifts, like Wachovia and WaMu, were paying 5% and more for CDs, even though the average CD is paying less than 4%. Now we know why. WaMu depositors are running scared. At least they are in my neighborhood.

I mentioned the huge, ugly impact of Fannie and Freddie preferred stock on smaller banks a few weeks ago. Now, an American Bankers Association study says more than one-fourth of U.S. banks lost a combined $10 billion to $15 billion after the government bailed out Fannie and Freddie.

The survey shows 27% of the country's 8,500 banks held preferred shares of Fannie and Freddie, and those shares are expected to go to zero. The survey also found 85% of the harmed institutions are community banks – those with less than $1 billion in assets. The ABA CEO sent a letter to the Treasury saying, "These community banks are the lifeblood of communities across this nation." The banks are asking for the government to pay a "reasonable level" of dividends on the preferreds to preserve some value and to loosen federal capital requirements in the case of massive writedowns.

The only problem with that request is dividends aren't interest payments. Stockholders, preferred or otherwise, have only a residual claim on assets and earnings. When you're bankrupt, you have no earnings, and your residual assets... well... you probably have none of those, either. So the request for a reasonable level of dividends is very likely an unreasonable request. The banks took too much risk.

Of course, losses on Fannie and Freddie preferreds might not matter to community banks now that Goldman Sachs and Morgan Stanley are on the prowl. Both banks will likely go on buying sprees to build their deposit bases under their new status as bank holding companies.

While hundreds of firms scrambled to join the SEC's list of Covered Securities – those that can't be shorted – one firm voluntarily opted out. Starting today, Diamond Hill Investment Group, a $215 million regional brokerage house, will face the full fury of the market. Shares fell a little today. If anything, Diamond Hill's shares should skyrocket for its gall. Joining the no-short list is the ultimate warning sign that a company is in financial trouble.

New highs: none.

If you've recently changed banks because you're afraid your old bank is going to fail, please drop us a line at feedback@stansberryresearch.com.

"I usually tend to sit back and simply enjoy your commentary, but I happen to know a thing or two about low-cost brokerage companies, having used several over the years. I have found at least 3 online, low-cost brokerage companies that will allow you to purchase partial shares. BuyandHold.com, Sharebuilder.com, and folioFN.com all allow account holders to purchase dollar amounts of stock, as opposed to a certain number of shares. For example, if you have an account where you want your average position size to be $500 and yet you'd like to pick up some BRK.B, you would be allowed to purchase exactly $500 worth of BRK.B. At yesterday's closing price of $4355, this would give you 0.11481 shares of BRK.B, if you had an account with folioFN.com. I've used accounts with both BuyandHold.com and folioFN.com over the last 8 years, 6 with B&H, and the last 2 with folioFN. Both allow you to pay a flat rate monthly account fee, for as many trades as you might like to process. Obviously, as with most good things in life, there are a few restrictions, but that hasn't stopped me from making money almost every year I've had one of these accounts. In fact, for years I've told anybody who would listen that it is nonsense that they need to have thousands of dollars to open a brokerage account and make serious investment decisions. Instead, I've shown them how to use these kinds of brokerage houses to greatly reduce their trading costs and still generate decent returns, simply by being able to invest more money in each investment, rather than just a share or two, because they don't have hundreds or even thousands of dollars." – Paid-up subscriber Andy Prior

"Dear American:

"I need to ask you to support an urgent secret business relationship with a transfer of funds of great magnitude.

"I am Ministry of the Treasury of the Republic of America. My country has had crisis that has caused the need for large transfer of funds of 800 billion dollars US. If you would assist me in this transfer, it would be most profitable to you.

"I am working with Mr. Phil Gramm, lobbyist for UBS, who will be my replacement as Ministry of the Treasury in January. As a Senator, you may know him as the leader of the American banking deregulation movement in the 1990s. This transactin is 100% safe.

"This is a matter of great urgency. We need a blank check. We need the funds as quickly as possible. We cannot directly transfer these funds in the names of our close friends because we are constantly under surveillance. My family lawyer advised me that I should look for a reliable and trustworthy person who will act as a next of kin so the funds can be transferred.

"Please reply with all of your bank account, IRA, and college fund account numbers and those of your children and grandchildren to wallstreetbailout@treasury.gov so that we may transfer your commission for this transaction. After I receive that information, I will respond with detailed information about safeguards that will be used to protect the funds.

"Yours Faithfully Minister of Treasury Paulson" – Paid-up subscriber Bob

"Please explain why now is the time to buy corporate bonds, as you recently asserted, while referring to Mike Williams' newsletter for reference. It seems to me that interest rates have to rise from here, given the government's profligate borrowings and bailouts... Again, please explain your thinking, as I don't understand your position. Thanks." – Paid-up subscriber C.A. Jay

Porter comment: Mike Williams' newsletter, True Income, focuses exclusively on the lowest-rated corporate bonds, so-called "junk" bonds. These securities, or as we've coined the phrase, "guaranteed investment contracts," trade at a substantial discount to their face value – the amount of money they're worth in cash at maturity. The bond market is discounting these securities because investors fear the bonds will default. So while they may have a redemption value of $1,000, you can buy these bonds between $600 and $800 – or even less.

But... isn't that risky?

There's certainly no such thing as a risk-free, high-yield investment. But in this case, our analyst, Mike Williams, first determines whether the bond in question could be paid off in liquidation. That is, with these bonds, we feel confident our investment is safe, even in the event of a default or a bankruptcy. Plus, unlike when you buy a stock, when you own a bond, the company has a legal obligation to pay you back your investment on a specified date in the future. That's why we call these bonds guaranteed investment contracts.

The set-up reminds us of the famous line in the gangster movie, Goodfellas. Discussing debts owed to the mob, one gangster explains there's no alternative, no matter what happens, to repaying the debt. "Business bad? F--- you, pay me. Oh, had a fire? F--- you, pay me. Place got hit by lightening? F--- you, pay me." The same is true for bondholders. No matter what happens, the company must pay you back or liquidate all of its assets... and then pay you back.

That's why as these bonds approach their maturity date (almost all the bonds we cover will mature in less than five years), the discount from their redemption value disappears. And while you wait to cash in the capital gain, you will receive coupon payments through the duration of your investment.

Let me explain how this all works using the real numbers from our existing recommended portfolio. The average recommended price of the bonds was $720. Thus, on average, we expect to make a 38% capital gain on these securities upon maturity. These securities are also paying a cash coupon now of more than 10% per year. When you combine the capital gain and the coupons, you have a portfolio that should earn nearly 18% per year.

That's far more money than just about anyone earns in stocks. And you're not taking the risk of owning a stock, which could be worth zero. Instead, you own a security that companies are legally obligated to repay.

You asked about rising interest rates. The high yield and the decaying risk premium as the bond approaches maturity mean these securities face essentially no interest-rate risk. The market for these bonds isn't interest-rate sensitive.

What moves the market for junk bonds? The perception of default risk.

When investors get scared that lots of businesses will go under, the spread between the yields on junk bonds and the yields on government bonds will increase. That's the time to buy. It may seem counterintuitive, but it's a contrarian strategy that works. You're getting the bonds at a super-cheap price, which more than compensates you for the risk you're taking.

As you can see in the chart below, the risk spread between junk bonds and government bonds has rarely been higher than it is right now. Specifically, the previous high occurred on October 10, 2002, when it rose to 10.6%. Last Thursday, it reached 8.9%, a point that's likely to be the high – or very near the high – for this cycle.

The Risk Spread Nears Its October 2002 Peak

Finally, as with stocks, which bond you buy matters.

Most individual investors don't buy individual bonds because they don't know anything about how to evaluate the risk of default. That's what we're providing in True Income. Mike Williams, our analyst, is 62 years old. He has spent his entire professional life analyzing bonds. He is the only Chartered Financial Analyst on our staff. I have total confidence in his ability. I know you will too once you've read his newsletter.

Right now, we're offering nearly half-off the regular price for a risk-free True Income subscription... but only until midnight tonight. Click here to get the details.

Regards,

Dan Ferris

Medford, Oregon

September 23, 2008

The Short-Selling Ban Won't End the Bear Market

By Ian Davis

Last Friday, the SEC banned the short sale of 799 finance-related stocks.

Despite the SEC's best intentions, this probably won't have much of a long-term impact on the bear market... You see, banning short selling isn't an entirely unprecedented move. It happened on two separate occasions during the Great Depression.

Let's look at what happened...

The first of the restrictions was a precursor to the up-tick rule... The up-tick rule forces a short seller to wait until the price of a stock rises before shorting it. Let's call this first ban the "mini up-tick rule."

The mini up-tick rule, which was enacted on October 6, 1931, by the New York Stock Exchange, prohibited the short sale of a stock while its price was falling. Thus, if a stock's price was unchanged (or rising) between any two trades, shorting was still allowed.

At first, this rule encouraged investors who believed it would prevent the "evil" short-sellers from shorting a stock into the ground. The Dow rose 17% over the following five weeks.

However, the rally didn't last... After those five weeks, it lost steam. The Dow fell 64% for another nine months before the bear market turned around.

The second restriction on short selling came six months after the first, on April 1, 1932. This restriction forced brokers to acquire written permission from investors to short sell a stock. Like today, investors who bought a stock back in 1932 would usually leave the shares with their brokerage house. The brokerage house would then let short sellers borrow these shares. But the new restriction forced the brokerage house to get written permission from the stockholder first.

This initially reduced short selling to a trickle, since brokers found it nearly impossible to get the needed permission. However, the restriction provided only a temporary reduction in short selling. This is because most stocks didn't have a large short interest anyway. It took only a small percentage of investors willing to lend out stock to meet demand.

The Dow rallied by 4.3% in the three weeks following the announcement of the new restriction. (The announcement came on February 18, 1932, but didn't take effect until April 1). But again, the restriction didn't provide a long-term bottom. The Dow didn't bottom until after another six-month and 50% fall.

The top pane of the chart shows the Dow during the recent bear market and has the same scaling as the bottom pane. The bottom pane shows the Dow during the Great Depression.

Short-Selling Restrictions Didn't Stop the 1930s Bear Market

As you can see, although the restrictions occurred late in the Great Depression bear market, they certainly didn't end it.

It is worth noting that this bear market is puny compared to the one that occurred during the Great Depression. Back then, the Dow fell 89.2% peak-to-trough. If the Dow repeats its 1930s collapse, it would need to drop another 86% over the next two years (the Great Depression bear market lasted about three years).

Another 86% decline would put the Dow at 1,529.8... I don't believe the market will repeat such a monumental crash. However, despite this government-induced short-term rally, I do see some more downside ahead.

Trade accordingly,

Ian Davis

Stansberry & Associates Top 10 Open Recommendations

Stansberry & Associates Hall of Fame