What really happened yesterday

So... what really happened yesterday?

Who knows? The rumor on Wall Street is a Citigroup trader mistakenly ordered a billion-share sale of Proctor & Gamble instead of a million-share sale. Frankly, the situation doesn't matter to me. I don't believe you ought to own stocks unless you're prepared to weather a 10% move in share prices. Likewise, since we always counsel you to use closing prices for the purposes of your stop losses, yesterday's intraday volatility shouldn't have mattered to you at all.

Besides, equity prices haven't made much sense to us all year. In my newsletter, I've mostly been selling and have maintained a "hedged book" on all of my new long recommendations. I've been expecting a big move down. And I still am... for reasons I'll explain below.

What most concerns me is the growing realization that most of Europe's governments are broke and likely to default on their debts. This problem will certainly get worse and will certainly spread to the U.S. – where total debt (public and private) is nearly 400% of GDP, putting us on par with Iceland prior to that country's collapse. In fact, it seems as though the world just got around to reading the February 2010 issue of my newsletter, PSIA...

Like dominoes, the highly indebted economies of Europe are going to topple. Greece was first. But plenty more problems are coming. Italy has no way to meet its obligations. Nor do Portugal or Spain... Events over the past two weeks in Greece should give you plenty of warning governments all over the world have too much debt. What will the U.S. do when a major European financial institution, like Italy's UniCredit – the predecessor of Kredit-Anstalt – fails?

If the resulting contagion causes one of America's major banks to fail, what will the U.S. government do? The answer, my friends, is simple: It will print, print, print, and print.

Here's the important fact to remember... The United States is the only government in the world that can actually afford to underwrite the world's banking system. That's not because we have any real savings, it's only because we control the world's reserve currency. It's a paper standard, which means we can always print more of it.

The current standard of money and banking – the U.S.-dollar paper standard – will end in a massive inflation over the next five years because the U.S. Federal Reserve will lose all its credibility as it tries to help finance U.S. government deficit spending while containing massive losses in the global banking system. Our creditors will demand much higher rates of interest, while also fleeing to gold, silver, and oil as reserve assets.

Analysts and banks were out in force this week, explaining various links – aka "exposures" – to Europe's weakest sovereign borrowers. But here's something you might not see anywhere else. It's a chart a subscriber sent to me yesterday showing the most widely held credit default swaps. Investors can hedge their exposure to any particular credit by simply buying insurance against a default – a credit default swap. The higher a credit is rated, the cheaper it is to insure. So in the chart below, you can see that Germany is the third-most popular reference for credit default swaps. Why? Because it has a very high credit rating and is cheap to insure.

For speculators to make money, Germany doesn't necessarily even have to default. Any downgrade of its credit ratings would have the impact of increasing the credit default swap price.

So for credit default swap investors, Germany is a good way to speculate on a collapse of the euro. In that case, Germany's credit rating would certainly deteriorate, thanks to its broad exposure to Ireland, Spain, Greece, Italy, and Portugal. Historically, credit default swap prices have been far more accurate indicators of credit quality than the credit rating agencies. The chart below indicates Italy, Spain, and Germany are likely to see their credit ratings tank over the next year.

And look who is fifth in this list of rogue creditors... Our friends at General Electric. I've taken a lot of heat from subscribers regarding my analysis predicting GE will go bankrupt. And while it's certainly possible I'll end up being wrong, the company's appearance on this list isn't a good sign for the bulls. Neither is the fact that GE's earnings continue to fall (down 35% year over year). Or that it must refinance (or repay) $118 billion this year.

For those of you who are interested in credit analysis, consider just these two facts: First, General Electric has a grand total of $25 billion in tangible equity. Second, its total debt exceeds $500 billion. Can anyone find another entity anywhere in the world that's leveraged 20-to-1 against tangible equity and that's still rated double-A? I bet you can't. And I bet GE's debt will be downgraded significantly sooner rather than later. As with GM, as GE's credit rating falls, its borrowing costs will grow. Go to your local pawnshop and ask the subprime borrowers you meet there to explain what's about to happen to GE...

In early July 2008 – before the collapse of the stock market – I was in Las Vegas for an investment conference. Even as the world's real estate markets were heading towards a massive collapse, MGM was still building City Center, its colossal new casino/hotel/condo development. I warned the readers of my newsletter that it would become a horrible disaster:

This is the largest privately financed development in the history of the United States. It sits in the middle of a desert, in a city whose economy is dominated by gambling. Those two facts alone would give most reasonable investors pause. The entire complex is five-star. One-bedroom condos here sold for $700,000. And the complex includes literally thousands of them. What will they be worth in foreclosure? I'd bet less than $200,000. And who will absorb those losses? I can't help but think in another two years we will look at those buildings and wonder, "What were they thinking?"

Young Goldsmith was in Las Vegas last weekend, attending Doug Casey's annual conference. We sent him to the new Mandarin Oriental Hotel, inside City Center, to look around. Says Goldsmith: "It was empty. During the weekdays, the staff told me they have less than 40% occupancy."

Yesterday, MGM reported its first full quarterly results since City Center's opening. The numbers are pretty scary. Revenues fell 4%. Operating income was negative $11 million. Aria, a huge hotel and casino in City Center, lost $66 million in the quarter. MGM's executives are confident when business picks up in Vegas, the company's huge investment in City Center will pay off.

But as I've pointed out to our readers several times over the past two years, MGM isn't in a good position to wait for things to improve. Even when you ignore all of its noncash expenses (depreciation), it's not making enough money from its casinos and hotels to pay its interest expenses. MGM made $155 million in the last quarter – down from $344 million in last year's first quarter on a cash basis, not including one-time charges like City Center's startup costs. It paid $264 million for interest, up from $171 million in last year's first quarter.

I don't think MGM can avoid a bankruptcy filing, something I've been saying since 2008. And I believe its common stock is worth precisely zero. Here's what you have to know...

MGM's debt service (interest) is now almost $300 million per quarter. In 2011, MGM must repay $1.4 billion in principal and come up with another $1 billion in interest. If you assume it will continue losing money each quarter, it'll need to come up with more than $2 billion to avoid a bankruptcy filing. It won't be able to borrow the money because it's out of collateral.

On the books, MGM says its hotels and properties are worth $15 billion... but judging from actual recent deals in Vegas, I sure they're only worth about $13 billion – the amount MGM has already borrowed. And obviously, in liquidation these assets will be worth a lot less.

I bring up the MGM story now because the world's debt problems are NOT limited to sovereign borrowers or Wall Street's big banks. As a result, not all of these problems can be resolved by printing money or rearranging government debts. A lot of malinvestments were made during the boom – perhaps none more so than in Las Vegas.

It's going to take a long, long time before all of these problems work themselves out through bankruptcy and reorganization. Keep some of your powder dry. Over the next several years, you'll have dozens of opportunities to buy blue-chip assets at dirt-cheap prices.

Where should you put your money in the meantime? Well, gold and silver are my best ideas. But you have lots of ways of investing in these metals. If you want to know the very best way to invest in gold and silver right now, I have to recommend my friend John Doody.

I don't publish (unfortunately) his newsletter, Gold Stock Analyst, but I do read it twice a month. Why? Because no one in the world knows more about gold and silver producing companies than John Doody. No one else even comes close. His famous Top 10 list of gold and silver stocks now regularly outperforms gold. This year alone, it has outperformed the metal by 100%.

How does he do it? By carefully studying gold production at various companies and comparing the value of their production to the price of gold, John can tell investors when it's cheaper to own gold via gold stocks or when it's better to simply buy gold directly. Knowing these valuation facts is critical to investing in the precious metals sector.

If you're investing in gold and you're not reading John Doody's letter, you're going to make a costly error. To learn more about his letter, please read this. Also note, right now you can get a discounted subscription. But the offer is only open through next Wednesday.

New highs: Eldorado Gold (EGO) and PowerShares UltraShort Euro (EUO).

In the mailbag... subscribers who weathered the storm yesterday and even made some money on the big move down. How did you handle it? Let us know: feedback@stansberryresearch.com.

"Your continued and oft repeated advice about not entering the stop loss orders into the brokerage account probably saved readers millions of dollars in triggered stop loss orders. I wonder how many people got taken out at abnormally low prices only to see the price rebound minutes later. You sure saved me since I used to always have my trailing stops entered in as pending orders." – Paid-up subscriber Alan Adler

Porter comment: Yes... that's enormously important. Always keep your trailing stops close to the vest. Don't tell your broker. Don't enter them in the market as limit orders. If you need help keeping track of your stops, try using a software package one of our subscribers, Richard Smith, has set up: www.tradestops.com.

"Jeff... Today I had to leave my office at about 11:30 CDT. So I followed your advice to sell at a set price by entering a sell order, although I had no reasonable expectation of the market moving so precipitously that there would be any realistic possibility of a fill. If I remember it correctly, you originally suggested, for those who got in at 0.75, that 3.00 – a 300% profit, was a possibility. That kind of math caught my attention. Since I got in at .70, I set my sell price on the order today at 2.80, which for me represented the 300% profit you had mentioned.

"You might imagine my surprise when I heard that the markets had collapsed. I didn't get back to my office until after the markets had closed... Sure enough, it sold at 2.80, just before the low of the day... My original investment of $1,778.74 turned in to $5,800.94, a net profit after trading expense of $4,022.20... . I wanted you to know that for some of us who follow you as our option market guru, at least with regard to this trade, you were golden... Please keep up the good work. And please tell Porter I said so." – Paid-up subscriber Chuck Blumenfield

Porter comment: Thanks for the note, Chuck. To clear up any confusion some might have about this, realize that a stop loss order entered into the market is far different than a profit-taking order entered into the market. A stop loss order entered into the market is essentially advertising that you'll dump your shares at a set price. Think of it like a poker player showing his hand. A profit-taking order – as Jeff recommended – is based on having a reasonable expectation of how much profit a trade can produce… then telling the market that you're happy to sell your position for a big profit. This is like having a sign outside your $200,000 house that tells the world you’re willing to sell it for $600,000.

The mirror image of a profit-taking order is what's called a "stink bid." This is where you tell the market that you're willing to buy a stock for less than what it's currently selling for. Say you think a company is a bargain at $20 per share… but it currently trades for $24 per share. You can enter your stink bid into the market and tell the world you're willing to buy the company at $20. If a market panic pushes down the shares to $20, you're filled.

Regards,

Porter Stansberry
Baltimore, Maryland
May 7, 2010