What if there's not another Great Depression?

What if there's not another Great Depression?... Three reasons to watch silver... Laffer on the bailout... TJ on government-led banks... Ethanol tooth fairies... W.L. Ross on today's best opportunities... Was it really the short sellers?... Subscribers can't read...

Everyone on TV says we're heading into the "Greater Depression." I'm not so sure... We went out for steaks last night in the fancy part of Baltimore – Harbor East. They used to call this part of town Fells Point... until someone built a Four Seasons Hotel on top of an old Super Fund toxic waste site. Last night, the expensive steak house was packed, even though it was Tuesday! Not an empty table in the entire place.

Also, my wife says the mall in suburban Towson, Maryland, is so crowded you can't find a place to park on weekends. Finally, one of our partners in the publishing company, Mike Palmer, put his house on the market recently. It sold in three days. Mmmn.... Maybe the world isn't coming to an end after all. And if we don't enter a severe recession, all the money the Fed is throwing on the street is going to produce some fireworks.

What kinds of fireworks? I'd keep my eye on silver... As my long-suffering subscribers know, I was wrong about silver this summer. I expected the financial crisis to lead investors into precious metals. Historically, that's what has happened.

But this time, we witnessed the great deleveraging of the commodities markets instead. As hedge funds and investment banks racked up losses, faced redemptions, and had their credit lines pulled, they sold commodities, including precious metals. This was particularly damaging to silver, which became uncoupled from gold, as you can see below. My bet is as October comes to a close and hedge-fund redemptions are completed, silver will rally.

For the statistically inclined among our audience, the mean gold-to-silver ratio over the last five years is 59 – using monthly samples – with a standard deviation of 8.7. Recently, the gold/silver ratio hit 80, the highest it has been in more than five years – nearly 2.5 standard deviations from the mean. If there's a "snap back" rally in commodities, silver ought to soar.

Says Jeff Clark about silver: "It now takes more than 80 ounces of silver to buy one ounce of gold. That ratio is quite high compared to historic standards – and compared to where it was just two months ago. In fact, this could set up as an interesting pairs trade (long silver and short gold). I like the idea of buying silver here. I also like the silver stocks. It's definitely not an easy trade, though."

Arthur Laffer is my kind of economist. He takes the simple real-life facts of human nature and uses them to figure out how different incentives influence future behavior. He published a very wise observation in the Wall Street Journal a few days ago:

When markets are free, asset values are supposed to go up and down, and competition opens up opportunities for profits and losses. Profits and stock appreciation are not rights, but rewards for insight mixed with a willingness to take risk. People who buy homes and the banks who give them mortgages are no different, in principle, than investors in the stock market, commodity speculators or shop owners. Good decisions should be rewarded and bad decisions should be punished. The market does just that with its profits and losses.

No one likes to see people lose their homes when housing prices fall and they can't afford to pay their mortgages; nor does anyone of us enjoy watching banks go belly-up for making subprime loans without enough equity. But taxpayers had nothing to do with either side of the mortgage transaction...

Now enter the government. To alleviate the obvious hardships to both homeowners and banks, the government commits to buy mortgages and inject capital into banks, which on the face of it seems like a very nice thing to do. But unfortunately in this world there is no tooth fairy. And the government doesn't create anything; it just redistributes. Whenever the government bails someone out of trouble they always put someone into trouble, plus of course a toll for the troll. Every $100 billion in bailout requires at least $120 billion in taxes, where the $20 billion extra is the cost of getting government involved.

If you don't believe me, just watch how Congress and Barney Frank run the banks. If you thought they did a bad job running the post office, Amtrak, Fannie Mae, Freddie Mac and the military, just wait till you see what they'll do with Wall Street.

The only thing I'd add to what Laffer wrote is that Wall Street's finest also did a terrible job running the banks and the brokers. But at least individuals could easily avoid the madness. If you thought investment banks levered 30-to-1 were like tubs of gasoline waiting on a spark, you didn't have do business with them, and you surely didn't have to own their stocks. But with the government taking over the losses of the bankers, taxpaying Americans have no escape.

The situation brings to mind a letter Thomas Jefferson wrote in 1802 to the Secretary of the Treasury, Albert Gallatin. "I believe banking institutions are more dangerous to our liberties than standing armies," Jefferson wrote. "If the American people ever allow private banks to control the issue of their currency... the banks and corporations that will grow up around the banks will deprive the people of all property until their children wake-up homeless..."

Speaking of government tooth fairies... How is the ethanol business doing, we wondered? The idea was simple. Take some corn and spend a whole lot of time, capital, and energy to turn it into a highly corrosive fuel, which most of our energy infrastructure didn't support. Over the last five years, private investors and the government have spent about $80 billion on the idea. We recall Buffett's partner Charlie Munger warning ethanol was the worst idea he'd ever heard and it would be a disaster.

Was he right? Just look at any of the companies that tried to make it work. Despite taxpayer subsidies of more than $11 billion, losses in the ethanol sector now total more than $8 billion in only two years. Verasun, a leading ethanol producer, went public at $30 in 2006. It now trades for $0.75.

In a CNBC interview, billionaire investor Wilbur Ross gave investors three rules for making money in the market: 1) Only buy things you understand. If people had followed this rule, they wouldn't have bought into subprime mortgages, CDOs, and other exotic products. 2) Don't use leverage right now. Instead, hold a pile of cash. 3) Have some degree of diversification, be it geographic, industry, or form of security (as in stocks and bonds).

As for his own cash pile, Ross said he's been putting money into financial services like mortgage servicing. He also recently bought a "huge slug" of municipal bonds because the spreads were too large over Treasuries. Ross has not invested in banks, yet, but he's getting closer to doing that now. He's looking at possible equity investments in banks in Florida and a few other states.

Ross also said the price of a barrel of oil is getting "very, very close" to finding costs. Over time, oil should trade at an excess to finding costs over time, he said... and it shouldn't trade much below today's levels.

Another billionaire, private-equity tycoon Steve Schwarzman said private-equity shops buying companies now may see "phenomenal" profits once things correct. "In periods like this, people get scared out of their minds. This kind of environment is tailor-made for making absolute fortunes in the private-equity business," Schwarzman told attendees at a venture capital meeting in Quebec City.

Schwarzman sees great opportunities "in almost every asset class." But he'd stay away from retail and commercial real estate. He expects "really terrible" fourth-quarter earnings for consumer-driven companies... "Consumers have run away in a panic," he said. "This cycle, all logic would say, will be tougher and deeper because of the nature of the coordinated global consumer fears. It will take longer to get out of."

He also told commercial real estate investors not to expect big returns for some time... "Real estate now is suffering because there is no liquidity on a global basis for companies. That liquidity will come back but it will come back relatively slowly."

You might recall last September when the investment banks began to collapse, the CEOs of Lehman and Morgan Stanley vociferously blamed short sellers for their falling share prices. The bankers persuaded the government to ban short selling for about a month in a lame attempt to prop up their insolvent businesses. (The move didn't help. It demonstrated how corrupt our markets are, forced hedged funds out of the financial sector, and sent share prices and investor confidence to new lows. Then, the rule was abandoned.)

Now we have enough data to know whether or not short sellers had anything to do with the declines in Lehman and Morgan Stanley. They didn't. In fact, the short interest on the major investment banks declined steadily from July. By September, less than 3% of Morgan Stanley's stock was sold short. What caused the massive declines in price? Desperate selling from longtime shareholders – corporate insiders.

PSIA short-sell recommendation Gannett (GCI), the country's largest newspaper publisher, announced it will lay off 10% of the workforce in its local newspapers division – in addition to a previous 1,000-job cut. Gannett's advertising revenue is down nearly 18% for the July-September quarter.

Brian Heyliger, editor of Inside Strategist, sent us this update on big insider moves:

McDonald's (MCD) CEO James Skinner bought $1.1 million of the fast-food chain in the open market last week... increasing his ownership by 9%.

Longtime Monsanto (MON) director William Parfet dropped $5 million into the company mid-October. This is the first insider buy since January this year. Two others followed with about $300,000 last week.

Best Buy (BBY) founder and chairman Richard Schulze is bullish on BBY, and so are other insiders... Combined insiders have spent $37.7 million on BBY shares in the last three months. Schulze is responsible for more than $37.3 million of the buys. BBY is a $10 billion company, and shares are down 55% YTD.

Heyliger also noted major selling in the trucking industry, specifically Knight Transportation and J.B. Hunt.

In his last four trades, Heyliger has generated for subscribers $7 in income on $54 in stocks and produced double-digit capital gains. He currently has got several great trades in the pipeline. To learn more, click here.

New highs: none.

In the mailbag... Subscribers who can't read. Please send your questions about the newsletters you don't bother to read, here: feedback@stansberryresearch.com.

"Last Friday, The Digest included all your analysts 3 'safest' picks, except Porter's. What are his 3 best?" – Paid-up subscriber Ed Caldwell

Porter comment: Try giving that Digest another gander. My picks are in the very next paragraph...

My three? eBay (EBAY), Coke, and Intel. How should you put these ideas to work in your portfolio? Here's my suggestion: Find three stocks from the list that you know well – businesses you greatly admire. Buy them. Put as much as 10% of your assets into each stock. Then sell calls against your shares each month. Look for calls about 10% out of the money. You'll earn something like 20% a year in call premiums doing this, which will protect you from any further negative volatility and generate a lot of income for you.

"Please explain short selling stocks again. How do I do this? What will my broker require from me to do this? Why should we do this over buying puts? What am I risking when I short sell? When I buy a put, I realize I can lose what the put cost me." – Paid-up subscriber Jeffrey Foss

Porter comment: When you sell a stock short, you're simply borrowing shares from a market maker and then selling them in the market. That generates immediate cash for your account. You're obligated to return the stock at some point in the future, which means you must buy it back to close the position. If the price of the stock falls after you've sold it short, you make a profit. If the price of the stock rises, you take a loss.

You can control your risk in a short position the same way you'd control your risk in a long position: use correct position sizes and stop losses. Trading options allows you to absolutely control your risk (you can only lose what you've paid for the option), but put options have decaying time premiums, meaning you've got to be right about the direction of the stock and right about the timing... which is very difficult.

"What happened to the Direct Line blog? Following your instruction given on October 21, I still do not see the link. We got an email explaining a slight delay, but thought a follow-up email would have been sent if not completed. Am I doing something wrong, or are still not gotten thru all the technical problems?" – Paid-up subscriber Sam Falwell

Porter comment: If you go to our website and click on "S&A Short Report," the following menu appears directly beneath the link you've just clicked on.

S&A Short Report

- Weekly Issues

- Special Reports

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- Direct Line

- Options Tutorial

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The "Direct Line" is the fourth menu selection. I don't know why you haven't seen it.

Regards,

Porter Stansberry

Baltimore, Maryland

October 29, 2008

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