The Room - 10/17/2008

Dear Reader,

Keeping up with the complex drama now flashing across the global screen is becoming more challenging with each passing day.

In lazier days, a scene might be allowed to unfold at a measured pace, the interactions between major characters developed through subtle nuance and lingering shots and close-ups of, perhaps, the furrowing of a brow or the sly upturning of the corner of a mouth.

These are not those days.

Instead, we are living in the world of 30-second commercials, directed by a speed-addicted music video director, strung together in a nonstop explosion of two-second jump cuts.

One minute stock markets are soaring, the next crashing. Gold jumps $20, then falls $40. Banks fail, banks get bailed out. Politicians elbow each other out of the way to throw billions, trillions even, into deep, dark holes. Oil tumbles, then bounces, then tumbles again.

While the volatility has allowed me to make some fun money through the all-terrain investment vehicles of futures and options, it has also made the task of trying to keep current on the news and, more importantly, on what's important, daunting indeed.

Even so, it is Friday morning and so, cup of coffee at hand and the music turned up on Citizen Cope's Bullet and a Target (the very same position that the Fed now finds itself in), I turn to the task at hand... the task of trying to make some sort of sense out of the chaos.

Given the frenetic nature of the markets, I hope you'll forgive me if my commentary this week is similarly frenetic.

Unintended Consequences

As you likely know, we are not optimistic about the outlook for real estate, that lynchpin of the U.S. economy. This pessimism is evoked by a number of factors, starting with the simple fact that residential housing increased by about 50% between 1992 and 2007, massively outpacing population and income growth over the period. As you absolutely know, much of that excess inventory is in the hands of individuals who simply can't afford to pay the freight.

Then there is our hardened belief that the equivalent of an express train wreck is about to happen in the 4 – 6 trillion dollar U.S. commercial real estate market. There will be a lot less in the way of Ho! Ho! Ho! this holiday shopping season, and a lot more Oh... Oh... Oh's.

And none of it is helped by the inevitable rise in interest rates, which are today at near 50-year lows. While we might not be quite at the bottom, we're close... after which we expect a persistent rise as the government bailouts flow through the inflationary pipeline. Of course, wounded housing markets react about as well to rising interest rates as I do to the prospect of my taxes going up in the next administration.

Unfortunately for the housing market and by extension the U.S. economy, we are already seeing the ghosts of what's to come. This just in from Bud Conrad...

    The U.S. government's conservator status of Fannie and Freddie was supposed to lower mortgage rates, which it did for a few weeks. But we have now started to see the unintended consequences of guaranteeing the banks – namely that investors are moving away from housing-related debt and investing it in bank debt instead, pushing mortgage rates up. My sense is that movement by foreigners away from agency (Fannie Freddie) debt contributed to the half-point rise in mortgage rate, too. The TIC data confirm that shift.

    The result is that housing will be further hurt with the higher rates and will continue to fall in price.

On the same topic, the news is out this morning that in September, single-family home starts in the U.S. fell to the lowest level in 26 years. Just 544,000 new homes would be built over the next 12 months (if the trend were to stabilize here, which it won't).

Just so you have the right perspective, at the peak of the bubble, annualized housing starts in the U.S. were running at 2,265,000 units, so we're seeing about a 75% decrease.

By the time this is over, it wouldn't surprise me to see housing starts fall to 10% of the peak.

Of course, housing is far more than just "another" economic stat. In addition to the tragic financial and emotional implications of coming up short on the mortgage on a personal and even societal basis, there are the direct consequence to the broader economy. No more excess equity to borrow against to fund shopping sprees, and none to allow for a comfortable retirement for far too many.

This is, and will continue to be, a big problem for the economy. While there is no soft solution at this point, the best we could hope for is that the damage will be quick to come and quick to pass. But the only real way for that to happen is for house prices to fall to the point where ready buyers are available. And that entails workouts between lenders and borrowers, or outright foreclosures, to clean up the mess and allow the market to function as it certainly can, and will again... if left to its own devices.

Unfortunately, the plans now being bandied about by the government envision pretty much the polar opposite of letting the market clean itself up. Rather, they involve taxpayers buying defaulting mortgages and even the imposition of a moratorium of some duration on foreclosures. Most people read news such as that and shrug it off. It may help to view these ideas through a narrower spectrum.

For example, imagine you are the president of a small bank and you had lent money in good faith to someone in the neighborhood. We'll call him Joe as that seems to be a popular name for these sorts of examples these days.

For reasons only known to him, Joe has stopped paying on his mortgage, leaving your little bank on the hook for $200,000. Following procedure, you have Mrs. Smith down in the lending department send Joe a nice letter asking him what's up, to which she receives no response. So you personally send him another letter, this one offering to have him down to the bank to have a chat and see if you can work things out.

No response, no money.

So, uncomfortable at having to perform the duty, you give Joe a call and he admits he is in over his head. When you offer to help him work out a payment plan, he calls you a blood sucker and hangs up on you.

Pained by the outcome of your loan, because you'd rather be getting paid back on the agreed-upon terms, you call up your lawyer and reluctantly authorize the expense of beginning the foreclosure proceeding. At that point, you know you will likely spend thousands and the better part of a year trying to get back your property (and it is your property). But what choice are you left with?

And then you hear – as does Joe - that Congress is going to pass a moratorium on foreclosures, and you reach into the locked drawer of your desk for the flask you keep there for such occasions. Joe, meantime, heads down to the local deli for a six pack to celebrate free rent for the foreseeable future, perhaps paying for his purchase by selling off the copper pipes he's ripped out of the guest bathroom.

This exercise is, of course, little more than the morning musings of a sleep-deprived mind, and I am well aware that the circumstances surrounding the defaulting on loans are as varied as humanity itself. Even so, the underlying principles are the same. There is a contractual agreement between a lender and a borrower that no one had to be waterboarded to sign. In the event of a failure to perform on the part of either party, it is up to the two parties alone to resolve -- with the help of an impartial judiciary if an impasse occurs. Interjecting an overreaching government run by perfect-worlders into the process can only gum up the works.

And, I would contend, result in just the sort of unintended consequences now being reflected in jumping mortgage rates. Or, for that matter, the entire housing mess in the first place... much of which is the unintended consequence of Greenspan ratcheting down interest rates instead of pouring himself a nice cup of tea and watching as the participants in the dot-com mania received their just desserts.

Personally, I am shocked by the rising cacophony of calls for more, not less, government regulation. Given the widespread chanting now going on in favor of elevated levels of oversight, retribution, taxation, meddling, and outright nationalization, it is clearer than ever that the views I just expressed are in a minority. And the situation is only going to get worse as the next wave of well-intentioned government operators step up to the controls... controls that are being firmly bolted onto the machinery of markets.

We are about to enter a dark period for the free markets. That's the bad news.

The very good news is that, seeing it coming, you can anticipate where the next unintended consequences will occur and position yourself to profit.

Getting Stupid

Despite gold weakening over this week, we remain utterly unconcerned about gold... and I couldn't mean that more sincerely. In fact, I just now paused for a moment to email my broker to sell a $750 put option on gold.

While somewhat off topic, I'll provide some details because I love this kind of trade (which I learned about at our Futures and Options Summit, as an aside).

  • Selling a $750 put earns me a fat premium – the higher the volatility, the higher the premium -- of $6,300. That money goes straight into my account. While there is a bit of nuance (for example, the potential for an inconvenient margin call), the worst case is that if gold is trading below $750 in March of 2009, when the option settles, I'll be on the hook to buy 100 ounces of gold at $750. Actually, less than that, because of the premium I have received. If at expiration, gold is at or above $750, I will have earned the premium with no money down.

    The trick, of course, is to want to own the underlying commodity at option price. And you can use this sort of strategy for stocks, too.

Using futures and options, which I earlier referred to as the all-terrain vehicles of the investment world, gives you a nearly limitless number of opportunities to profit... regardless of the direction of markets. (We'll be launching a trading service soon, but that is a story for another day.)

But there are opportunities outside of futures and options. In fact, the junior resource sector, which has been a big disappointment of late, is now officially reaching stupid levels of valuations.

On that front, this week I was looking at a high-quality junior gold exploration company that is being followed in our International Speculator letter. The company has been advancing a big deposit in a great location in Canada and has just released its first resource estimate. The report confirms that the company has proven up just shy of 5 million ounces in a near-surface deposit, and the deposit is still wide open, so you can expect them to add significantly to the resource in the months ahead.

Generalizing, in an "okay" market, gold in good ground sells for around $50 per ounce. And Ontario, Canada, the ground where this deposit is located, is some of the best (as opposed to, say, the Congo). In a better market, gold in the ground might sell for $80 to $100 per ounce. And in a heated-up market, such as we saw back in 2005, valuations can rise as high as $150 or even $200 (which would be steeply overvalued, at anywhere near today's prices).

So, what value is now being assigned to the 5 million ounces of gold (plus blue sky) this very well-run junior is sitting on? Dividing the market capitalization of the company by the number of ounces of gold gives us a valuation of an unbelievable price of just $5.20 per ounce.

Okay, okay, I can almost hear you saying, "What's the problem with the company? I bet they are low on cash, and so shareholders are going to get hugely diluted when they go back to the market to finance."

To which I reply, "Nope – they have enough cash in the bank to cover an estimated two years of operations." In other words, we have looked at the company in depth, and there is nothing wrong with it – other than the broader market and forced selling by cash-strapped funds and investors.

And, as good as this company is, there are any number of other quality juniors – virtually all of which are now selling for the sorts of prices you might have expected to pay back in 1998, before the gold price took off, and before the companies had even found anything. But in this case, the company has 5 million ounces on the books.

And it is not just in futures and options and junior golds where you can find opportunities now. There are some great businesses that have been as heavily punished by non-discerning selling as bad businesses.

While caution remains the watchword of the day for the majority of your portfolio, if you have the capacity, be vigilant for the sort of stupid values just discussed. No need to rush in, but rather buy in tranches, maybe taking positions in 20% increments over the next six months. It may take awhile for you to realize the big returns -- there is a real threat to the equity markets later this year as aggressive tax-loss selling meets up with the retraction in consumer spending in the traditional holiday shopping season -- but after that, things, for the right businesses, selling at the right valuations, should begin to look up.

Given our view of where the economy is headed, you'll need to pick your battles carefully... and we'll be on your side every step of the way... but the time to begin laying out your plans should begin now, and not after gold is racing for the moon with the gold stocks close behind.

So, no big rush... just some food for thought. Of course, we'll continue to keep our many ears close to the ground on your behalf.

The Greater Repression

In my spare time, I'm working on a separate article titled "The Greater Repression," the theme of which is that one of the outcomes of the current financial crisis will be an acceleration in the growth of the state, and the coercion that that implies.

On that topic, did you read how Henry Paulson got the heads of the nine major banks to sign on to the Treasury's plan to partially nationalize them? He basically called them into a room, put a one-page document in front of them and informed them that they were required to sign it. Some excerpts from a story out of the New York Times from earlier this week...

    WASHINGTON — The chief executives of the nine largest banks in the United States trooped into a gilded conference room at the Treasury Department at 3 p.m. Monday. To their astonishment, they were each handed a one-page document that said they agreed to sell shares to the government, then Treasury Secretary Henry M. Paulson Jr. said they must sign it before they left. 6:30, all nine chief executives had signed — setting in motion the largest government intervention in the American banking system since the Depression and retreating from the rescue plan Mr. Paulson had fought so hard to get through Congress only two weeks earlier.

    What happened during those three and a half hours is a story of high drama and brief conflict, followed by acquiescence by the bankers, who felt they had little choice but to go along with the Treasury plan to inject $250 billion of capital into thousands of banks — starting with theirs.

    Mr. Paulson announced the plan Tuesday, saying "we regret having to take these actions."

    Pouring billions in public money into the banks, he said, was "objectionable," but unavoidable to restore confidence in the markets and persuade the banks to start lending again.

    ... All told, the potential cost to the government of the latest bailout package comes to $2.25 trillion, triple the size of the original $700 billion rescue package, which centered on buying distressed assets from banks. The latest show of government firepower is an abrupt about-face for Mr. Paulson, who just days earlier was discouraging the idea of capital injections for banks.

    ... "It was a take it or take it offer," said one person who was briefed on the meeting, speaking on condition of anonymity because the discussions were private. "Everyone knew there was

    only one answer."

    (You can read the full New York Times article by clicking here.)

But wait! Thanks to a top-secret Casey Research hidden video cam, you can actually watch a video clip of the meeting itself!

The video segment covers the pivotal point in the meeting when Paulson makes a convincing argument as to why bank presidents should fall in line and get on the team. Watch it by clicking here now.

No question about it, we are not only in uncharted waters economically but politically as well. All the media reports on the crisis have painted the free market as the culprit and called on the government to fix everything, whatever it takes.

It is like inviting a wolf into your house to get rid of a mouse. Sure, the mouse may go away (at least temporarily), but then the real trouble begins.

Bretton Woods II

This week, a number of you brought to my attention a rising call from the heads of some governments for a return to something that resembles the discarded Bretton Woods agreement, an agreement that had as a central tenet the convertibility of paper currencies into gold.

Naturally, we salute the notion of a return to a more disciplined approach to the handling of government finances than that which is now favored, and which might be loosely expressed by imagining a conversation such as "Hey Hank, Bennie here. Listen, I'm running short, can you print up a hundred billion or so and shoot them over when you get a chance? Thanks. No, no rush. Tomorrow afternoon would be fine. Best to the Missus, see you down at the club."

That the prime minister of Britain and the head of the European Central Bank have both referenced Bretton Woods this week can only be taken as encouraging. In time, we are convinced, circumstances will force a return to such discipline, with a system based on gold, or at least a mix of tangibles, including gold.

But I wouldn't start holding my breath. For starters, Bretton Woods was almost unilaterally shaped by the U.S. government to take unto itself the keys to a global monetary hegemony. It would border on delusional to think the U.S. will hand those keys off to anyone else until forced to it by events out of its control. Thus, while we might see a sit-down of top finance ministers at some point in the next year (in a six-star seaside resort, one might assume), the actual business of crafting a new monetary order will drag on and on and on.

The potential game changer will be if the currency crisis we foresee as inevitable reaches the point where no one wants any unbacked currency almost at any price. You'll know when that point is approaching when the price of gold blows through $5,000.

Burn, Baby, Burn

Last week, I shared my new basement digs for a day with Brian the electrician, who was putting in a fan and upgrading some fixtures. In addition to being a fine judge of music, commenting as he was putting away his tools at the end of the day that "The music here was the best of any job I've ever been on," our conversations revealed that he is also a financial analyst of no small potential.

"Early last year when I saw all the building going on and the prices of houses going up, I told myself that this couldn't last. So I let go of my employees and sold my new pick-up truck back to the dealer and bought a used one. I've been putting money aside ever since."

Smart guy. Of course, I asked him how business is now.

"Real slow," he answered in the cautious patois that marks a native New Englander. "Except for this one company that deals with fire and damage," he added. "They've been real busy, and they expect to be a lot busier."

"Oh, why?" I inquired.

"Well, apparently, it's because so many people have been putting in wood-burning stoves, trying to save on energy costs and all that."

"I wonder if it could also be because sometimes a fire can solve a problem," I asked. "You know, like a mortgage you can't afford or a business that is failing, if you get my drift."

"Yep," he said with a knowing nod, "and there's that, too."

I was reminded of that conversation the following day as I was watching cable television while laboring down at the gym on the stairway to good health, otherwise known as the cursed StairMaster (it's the only time I watch cable, because I refuse to have it at home).

Through sweat-stung eyes, I watched video coverage by the ScareMasters – CNN, in this case -- of a wildfire somewhere in California. From the bird's-eye perspective of a helicopter cameraman, I watched as flames jumped a road and began doing their worst to what looked to be a dealership specializing in large pick-up trucks.

"Why," I panted to myself silently, "didn't the dealer, who surely knew the fire was approaching, gather around some folks and drive those nice trucks out of harm's way?"

Then I remembered my conversation with Brian the electrician and nodded knowingly to no one, imagining in my mind's eye the owner of the dealership watching the same broadcast and dreaming of a fat insurance check and a nice, long holiday followed by a fresh start. Who knows, perhaps he'll turn to selling the new fuel-efficient cars that U.S. car companies, freshly cashed up themselves with a nice $25 billion handout, will soon be producing with the aid of their five million new employees (I think that was the number bandied about by Obama in the debate).

But I digress. Because in addition to the economic motives for the pending wave of mysterious fires that are likely to descend on the nation, I fear a social motive.

In that regard, I have read and even heard on talk radio (which I occasionally listen to in order to keep my blood heated to the point where I won't fall asleep behind the wheel, a particular problem I have on any drive of more than about 30 minutes) that the Republicrats are all steamed up about the purported voter fraud being perpetuated by the lefties of Acorn.

Now, I can't say, because I can't know, whether or not Acorn and the Demopublicans are actually in the process of stealing votes, but I will say that that particular line of attack is one that has the potential to result in serious consequences.

Think it through.

Let's say that the drumbeat about Acorn really takes hold and fires up the imagination of McCain loyalists, as it certainly seems to be. Okay, now let's say that Obama wins, maybe thanks to a couple of squeakers in states such as Ohio. Could we perhaps see some serious civil disturbance, and maybe even worse, as good, patriotic Americans pick up their rifles and decide that their country has been taken over, unjustly, by terrorist lovers?

Could happen.

Okay, now let your mind swing the other way. That the Republicrats manage to challenge voter registrations in said key states and McCain actually wins? At that point, might the dashed aspirations of Obama's many admirers spill over into the streets? Certainly not out of the question.

Now, I am not saying that people shouldn't be vigilant about vote fraud... but it strikes me as the sort of issue that one wants to tread very carefully on – to double- and even triple-check the facts on the ground – before starting with a lot of arm waving.

Especially in an environment as politically charged and economically challenged as we are currently living in.

It has been a long time since I watched, as a teenager, the cities of America burn. And if I can make it all the way through to my long nap without seeing it again, that would be just fine.

In the final analysis, it won't really matter who wins – and I know that grates with many of you – but it's true. The economic stage has been set and the furniture cemented into place. The leading actors in the next act will be, as if marionettes controlled by the hands of a god, made to follow, not lead, the events that are now both inevitable and imminent.

The only question now is, will the transition to what's next be calm and orderly, or will the old war cry "Burn, Baby, Burn" be heard again?

I really don't know what makes the idea of the presidency so appealing that people would go through such personal trauma to attain the station. If you could, and did, walk in tomorrow and offer me the office, I would politely thank you for the offer and escort you as quickly as socially acceptable to the front door.

Laughing Between the Tears

On any given day, I swear I am going to delete all my email accounts, put the boots to my cell phone, and retreat to a nice, quiet cave. But then I get an email from a friend with a whopping good joke, and I forgive Mr. Email from stealing so much of my time.

This week, I received a few at least somewhat related to the current crisis and so thought I'd pass them along. This might become an occasional feature.

The first three came to me via Hugo in London...

    What's the difference between investment bankers and London pigeons? The pigeons are still capable of making deposits on new BMWs.

    For Geography students only: What's the capital of Iceland? Answer: About Three Pounds Fifty...

    Quote of the day (from a trader): "This is worse than a divorce. I've lost half my net worth and I still have a wife."

Here's another one, from subscriber and correspondent Ronin...

    Back in 1990, the government seized the Mustang Ranch brothel in Nevada for tax evasion and, as required by law, tried to run it. They failed and it closed.

    Now we are trusting the economy of our country to a pack of nit-wits who couldn't make money running a brothel and selling booze?

Today, I received the following from the hard-working researcher/editor Shannara Johnson.

As the topic is Sarah Palin, those of you who are Obama fans will especially appreciate it... but so will anyone with a sense of humor or an appreciation for creativity and technology. Click the link here: After you click, an interactive photo will load. Clicking on the items in the room and on the desk makes fun things happen!

Joke of the Week

This came to me via Clyde Harrison, one of the smartest (and funniest) guys working in the commodities sector today...

    Young Chuck moved to Texas and bought a donkey from a farmer for $100. The farmer agreed to deliver the donkey the next day. The next day he drove up and said, "Sorry son, but I have some bad news, the donkey died."

    Chuck replied, 'Well, then just give me my money back."

    The farmer said, "Can't do that. I went and spent it already."

    Chuck said, "Ok, then, just bring me the dead donkey."

    The farmer asked, "What ya gonna do with him?"

    Chuck said, "I'm going to raffle him off."

    The farmer said, "You can't raffle off a dead donkey!"

    Chuck said, "Sure I can. Watch me. I just won't tell anybody he's dead."

    A month later, the farmer met up with Chuck and asked, "What happened with that dead donkey?"

    Chuck said, "I raffled him off. I sold 500 tickets at two dollars apiece and made a profit of $998."

    The farmer said, "Didn't anyone complain?"

    Chuck said, "Just the guy who won. So I gave him his two dollars back."

    Chuck now works for Goldman Sachs.


  • Phyles. Herb in Jacksonville is looking for additional phyle members. Ditto, Ron in Southern British Columbia is going to try to start one. And I have had some correspondence with Vermonters interested in getting together. Not sure when or where, but if you contact us, we'll try to set something up with some of the Casey crew. As always, if you are interested in meeting up with other Casey subscribers, drop Kristen a note at [email protected]
  • Bud in New Zealand. Bud Conrad will be the keynote speaker at the CFA Society of New Zealand's Fourth Annual Forecast Dinner in Auckland, Thursday, November 6. I am sure that he'd be happy to take time during his trip to meet up with subscribers in the area. Drop us a note at [email protected] and we'll try to set something up.

And that, dear readers, is it for this week.

As is my habit, I turn (with no small sense of suspense) to the screens to see how the day is going for things financial. I see that the DJIA is up 166 points on news that consumer confidence has fallen the most on record. Now, there's a reason for a stock market rally!

And gold is down, again, to $784 in spot markets, while oil has come back a bit... to just a touch over $70 per barrel. And that gold stock that just announced a 5-million-ounce deposit? I just took a glance at the portfolio page of the International Speculator, on our web site, and see that it is down another 11% today!

My next task after signing off is to call my broker. I could, and probably will, take a loss over the short term, but I don't care, because I would kick myself if I missed the bounce on that particular stock.

(As an aside, I am not being coy by not sharing the name of the stock with you... I have mentioned it to provide a real-life example of how stupid valuations are getting in the resource sector. It would be unfair to existing International Speculator subscribers to share the name here, in the open. They are entitled to buy their fill without any added competition. I hope you understand.)

And with that, I must sign off by thanking you sincerely for spending some time with me this week, and for being a subscriber to a Casey Research publication.

Hang in there – and hang on tight – because who knows where this joy ride is heading next.

David Galland

David Galland

Managing Director

Casey Research, LLC.

Posted 10-20-2008 11:31 AM by David Galland