Yet their demise hurts anyone trying to manage an investment portfolio in a prudent manner — similar to how Bear Stearns and Lehman Brothers permanently stained the entire investment banking industry. It’s a case of a few bad apples spoiling the whole barrel. Unfortunately, it remains to be seen how regulators and politicians will punish every investor, including those who have acted prudently.

For example, I just read a publicly released copy of a letter dated Oct. 2, sent from the U.S. Congress to Harbinger Capital Partners. It asks Phil Falcone of Harbinger Capital to reveal practically everything that’s confidential about his funds and to testify before a committee. Let’s hope U.S. regulators don’t take action to drive even more investment talent overseas, because we need them here to help keep our markets efficient.

It amazes me how long this environment of panic has lasted. Last Thursday was one of the most violent days I’ve ever experienced in the markets, including the bursting of the tech bubble, and the turmoil continues this week. Quality companies in the oil services, coal, steel, and agriculture sectors were liquidated in violent fashion — many of them down 20% in a day and 50% over the past month. These are real companies performing vital functions necessary to keep the lights on and food on shelves, not speculative Internet stocks.

The list of victims includes companies that are very likely to deliver good earnings over the next few years. The list includes several of the stocks I’ve recommended in past issues of Strategic Investment, and still follow closely. If you’re a long investor, there are some screaming bargains out there — unless, of course, half of the world’s population stops using food, electricity, and oil. I doubt that will happen in a world of unfettered deficits and central banks, but anything’s possible. I’ll have more to say about this in an upcoming issue of Strategic Investment.

For immediate ideas, I strongly recommend considering the long list of bargains that my colleague Chris Mayer has recommended in Capital & Crisis and Mayer’s Special Situations. It’s mind-boggling how cheap some of them have become. Chris is an excellent stock picker. He goes to great lengths to find safe, cheap investments.

Government Inflation vs. Private Deflation

The money managers that survive this environment will probably look to own some of the dirt-cheap stocks in the energy, commodity, and agriculture sectors, rather than expensive stocks that thrived on spending from home equity loans. Once this credit market panic subsides, I expect we’ll see this shift in sector focus. Fund managers will have to start distinguishing between earnings that resulted from fake, bubble-induced consumption, and earnings that resulted from real, sustainable demand. I’m looking forward to earnings season, when analysts and fund managers can finally get some guidance about which companies’ earnings will hold up best during this recession.

Even the best fund managers and stock pickers in the world — several of them listed in this Bloomberg article — are down for the year. A few of these managers saw the credit crisis coming, and made nice profits shorting financial stocks. But the SEC’s totally arbitrary rule changes in recent weeks have created an environment that’s very difficult to navigate.

The SEC’s short selling ban has not changed much, other than taking efficiency and liquidity out of the market. For example, Allied Capital was on the “do not short” list. Yet it crashed earlier this week upon announcing the bankruptcy of Ciena Capital. That was a case of long investors all trying to squeeze out of a narrow door of liquidity.  It was not a “short attack.”

Uncertainty about the banking system is causing this panic in the credit markets. Innocent bystanders are suffering from the fallout from this credit bubble.

For example, I’ve read several accounts of hedge funds whose assets are stuck in the black hole that is Lehman Brothers’ balance sheet. I’m not referring to people who own Lehman bonds, I’m referring to funds that had custodial agreements with Lehman. Custodial agreements are supposed to ensure that Lehman could only execute trades for the pool of assets under its custody — not take actual possession of the assets.

It seems that in the days and hours before declaring bankruptcy, Lehman moved certain assets — many of which it did not own — to its subsidiaries all around the globe. Now, hedge funds with no perceived credit exposure to Lehman are joining the line of creditors, fighting to get their clients’ assets back in bankruptcy court.

This total destruction of confidence in counterparty risk is the reason why credit is drying up. So what has the Federal Reserve been doing as the lender of last resort?

It has nearly doubled the size of its balance sheet in the past few weeks. The Oct. 3 issue of Grant’s Interest Rate Observer describes:

“After a flat-footed start, [the Fed] had shown its ability to degrade its balance sheet by selling off its Treasuries and acquiring dubious mortgages. But it had not really put its back into dollar debasement. The sum total of its earning assets, i.e., Reserve Bank credit, was rising at year-over-year rates of just 3% to 4%. Where was the push to print up enough dollar bills to smother the debt crisis of 2007-8 — assuming the problem was susceptible to smothering through money printing?

“Mystery solved: Reserve Bank credit is suddenly flying. It surged by $203.6 billion, to $1.135 trillion, in the banking week ended Sept. 24. And if Merrill Lynch’s guess is on the mark, it has soared to $1.730 trillion in only the past few days, a near doubling since May 2007 [emphasis added], when the latent crisis became manifest.”

After the panic subsides, the Fed will rein in much of this new money. Right now, banks are “stuffing it under the mattress,” so to speak. Banks and individuals are crowding into the perceived safety of Treasury bonds. That’s why consumer prices aren’t immediately rising; private market credit is contracting as fast as the Fed’s balance sheet is expanding. The Fed will always lend when no one else is willing to do so. “The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost,” said Fed Chairman Bernanke in November 2002. This means that there will always be paper money available to lend. However, the U.S. dollar is getting debased on an unprecedented scale.

The printing press may be the only way to prevent a self-sustaining credit panic, but it doesn’t come without a price; it lowers the U.S. dollar’s stature even further in the eyes of our foreign creditors.

I’m betting that government inflation will defeat private market deflation. However, when the dust settles, I expect the Treasury and Fed to have its own set of negotiations with foreign creditors. The obligations they are assuming and monetizing are simply too enormous without inciting a potential panic among our generous foreign creditors. Maybe we’ll see a Bretton Woods-type agreement in 2009 — one where the U.S. dollar is devalued by 50% against certain foreign currencies overnight.

Best regards,
Dan Amoss, CFA
October 9, 2008

Strong Resource Companies Will Survive… The Dollar May Not was originally featured on Whiskey and Gunpowder

“…If Bernanke was expecting a 13% rise on Wall Street, he’s got a 45% rise in gold instead — plus a real disaster in U.S. Treasury bond yields…”

THIS WEEK MARKED THE SIX-MONTH ANNIVERSARY of the Fed’s first cut to U.S. interest rates during the current world-banking crisis.

And it’s been fun, fun, fun ever since for hard asset investors.

Aimed at promoting “orderly conditions” in the world of finance, that 0.5% cut to the Fed’s discount rate kick-started the sharpest collapse in dollar interest rates since…well, since the last time it tried to restore order to the value of U.S. financial assets.

But while short-term money markets remain tight six months later — and the subprime panic has since spread to “monocline” bond insurers, private equity groups, pan-national banking giants and even U.S. student-loan finance — the only order so far has come in raw materials, rather than finance.

A big fat order of whopper-sized gains, in fact, with a fried egg on top for good measure…

The price of gold meanwhile — whose only real utility, unlike all other natural resources, is as a store of value — has now risen in 20 of the last 27 weeks. Spot gold prices have gained 44.7% since the morning of August 17, just before the Fed announced its “extra-ordinary” rate change.

Whereas the S&P500 stock index has dropped 7.5% of its value. Which surely wasn’t the plan.

“Even the casual observer can have no doubt that FOMC decisions move asset prices, including equity prices,” said Ben Bernanke in a speech of Oct. 2003. “Estimating the size and duration of these effects, however, is not so straightforward.”

Then a mere Fed governor, rather than the big cheese himself, Bernanke related a pile of highly detailed and utterly pointless research he’d done with Kenneth Kuttner of the NY Fed. In short:

“The statistical evidence is strong for a stock price multiplier of monetary policy of something between three and six, the higher values corresponding to policy changes that investors perceive to be relatively more permanent. That is, according to our findings, a surprise easing by the Fed of 25 basis points will typically lead broad stock indexes to rise from between 3/4 percentage point and one-and-a-half percentage points.”

Oh sure, Bernanke was talking about the kind of gains he’d expect to see inside one day! But slashing the Fed funds target by 225 basis points since the global banking crisis provoked him to act back in August, Bernanke hasn’t even got 6.75% across six months…let alone a 13.5% rise on Wall Street.

He’s got a surge in the cost of living instead, driven by basic raw material prices. And that’s bad news — as in gruesome — for Treasury bond owners:

Yes, the Fed’s overnight lending rate — as well as short-term Treasury bond yields — tipped sharply negative after accounting for inflation during the Greenspan “emergency” of 2002 to 2005.

But longer-dated U.S. Treasuries — those bonds used to fund the vast bulk of Washington’s on-going finance needs — only briefly failed to keep pace with the cost of living. Unlike now.

Today they’re lagging inflation, and threatening to lag it badly:

The last time U.S. Treasuries paid a whole lot less than inflation, the crisis got so bad that government bonds became known as “certificates of confiscation.”

Money failed to flee into equities, however, even as the United States faced the very real prospect of being unable to find the cash to fund its government spending. To fix this mess in the world’s No.1 economy, it took a collapse in nominal bond prices — driven by record-high interest rates from the Fed — and the longest recession since the Great Depression to restore America’s credit.

Just how miserable might the real returns paid to bond-buyers become if inflation keeps rising today? The runaway producer price index, backed up with $100 crude, stood right behind it wearing knuckle-dusters, growling that things are about to get ugly.

And just how far might hard asset prices go as investors flee stocks, bonds, cash and property all at once…?

Yes, the current surge in gold prices looks a lot like that infamous “cathedral top” of 1980, right?

Gold spiked above $850 per ounce in the spot market in 1980…and then fell almost every year for the next two decades.

But the move above $800 per ounce came and went inside three days. And the run-up saw gold prices more than triple on their monthly average in little more than a year. Here in Feb. 2008 — and with US Treasury yields turning negative once again — gold has taken more than half-a-decade to repeat that feat.

Too much, too fast? With Bernanke at the Fed — and $100 oil heading for the pumps, as well as for real bond yields — just maybe we ain’t seen nothing yet.

Regards,
Adrian Ash
BullionVault
February 27, 2008

Inflation and Treasury Bonds was originally featured on Whiskey and Gunpowder