Investment Strategy Newsletter

Over the last couple of years, the US consumer was basically the default buyer of the excess stuff produced in China and other fast developing countries. The money supply was generous and easy loans greased the wheels in many corners. Now we have however reached an inflection point where the credit spigot is being shut off, risks are being avoided, house prices are falling, interest rates are rising and the general party atmosphere is dying down.

Inflation is a serious problem. No longer a silent creeper, it has entered the consciousness of many folks who can see their paychecks losing muscle by the day. Up to very recently, governments have just manipulated statistics and treated the public like morons by telling them inflation was, say 2 or 3 percent, when everybody could see that the relevant rate was twice as high. But now inflation has become front page news. Sooner or later central banks have to ratchet up their rates. This, in combination with high energy prices and socialist taxation levels, will stifle the economy. The most likely scenario is stagflation, a horror we have already seen in the seventies of last century.

It won’t be an easy situation to navigate. Many assets will stagnate or fall in price. Even commodities could disappoint. Presently I don’t foresee a lost decade, rather a few lost years. Considering that over the last 8 years many indices ( certainly in the US and here the Nasdaq in particular ) have practically gone nowhere, this is not a bright outlook. I think the banks will remain in the doghouse for some time to come.

The winners will be those who can ride a seesaw, a market going nowhere while swinging wildly. That calls for deft traders who enter and exit hazardous places where furniture falls and ceilings collapse. It will probably be a good time for guys with money who are looking for property in Las Vegas or Spain, slightly used sports cars and other pretty but essentially superfluous things.

The most interesting item and the most difficult to forecast is oil: my guess is it may fall short term and rally again later. Oil is valuable and probably worth 130 usd/barrel or more. But its high price chokes off our economies which are built on oil. The recent jolt is now spurring a serious hunt for alternatives. But fossil fuel will still be important 20 or 30 years from now.

With regard to the forthcoming elections in the USA I’d presently bet on McCain. If he wins, oil and defense companies will be winners. And the dollar could rally.

Until about 10 years ago, banks were basically satisfied with their usual business, taking deposits from the public and lending it out to credible users. But in order to dramatically increase their profits and justify hundred-million dollar paydays, they had to enter a new business. Big time gambling under the rule: Heads: I win. Tails: you lose. They leveraged themselves to the hilt, signed derivative contracts in the trillion dollars and dealt in fantasy loans and paper.

Hey, it was good while it lasted. But just like cocaine addicts the greedy idiots in pinstripe costumes needed ever larger doses for their kicks and felt like invincibles.

The failed Wall Street house of Bear Stearns alone had 14 trillion dollars worth of derivatives outstanding. JPMorgan, which rescued Bear with 30 billion USD of public money, is the largest issuer of credit default swaps and has thus guaranteed a lot of bad stuff. It probably had to rescue Bear or pay out to the buyers of its guarantees. It is a rather complicated picture, but it’s clear that many, if not most banks in the world are connected in a spider web of derivatives, swaps and questionable securities. And the whole pile of junk was financed with up to 30 times leverage, meaning for every single dollar available from investors the managers borrowed another 30 dollars, just to spice up the game and increase their take.

But this game is over now.

We think that banks have still a long way to go down, and even if they can eventually sort out the garbage in their balance sheets, they won’t be able to generate big profits from the mad gamble they were engaged in previously. Eventually, bank shares will be a good investment. But they have to hit bottom first and be left for dead for a while.

What does all that mean for the real economy and for stocks other than financials?

Emerging markets, especially in South East Asia, could do relatively well because excess money won’t flow to the US as before, but will look for new destinations. Countries like Thailand, Taiwan or Singapore are thus comparatively attractive. Gold and commodities in general have become more volatile but still offer good opportunities.

A few days ago, there was an interesting report in the Financial Times: the so-called Empty Quarter (a giant desert in Saudi Arabia), which was supposed to hold immense gas reserves, turned out to be, well, empty. This confirms our long-held belief that oil and gas are bound to stay expensive. We therefore hold on to most energy investments despite the wide-held view that a US recession must knock down prices in the sector.

In general we suspect that markets worldwide will trend lower over time. We are reminded of the situation in Japan and Thailand in the nineties when, after huge credit expansions, it took a decade to find a bottom, despite low interest rates. It will go faster this time, because the Americans are not as hesitant as the Japanese to clear the desk. But it could well take us into 2009 till we see a bright horizon again.

Meantime, stay liquid, buy the dips, get out quickly again, that’s what can be done for now.

The world of investment is presently covered in a cloud of doom and gloom. We’ve heard some details: Crazy lending practices, wild speculation, risks out of control. The damage is yet unknown, in a worst case scenario it could be trillions. Apparently this situation calls for maximum risk avoidance and a flight to safety.
Any arguments against that? A few:

First, the mood is already pretty bad, in itself a good sign.
Second: money is being pumped in, interest rates are low and falling.
Third: Large parts of the world are in good shape.
As always, it comes down to a question of timing. And here I would advise my readers to hold back the horses.
It’s very likely that the world of finance will announce a few more monsters as having escaped from its house of horrors. Banks and insurance companies are still the most obvious counters to avoid.
Commodities incl. metals have done extremely well, but at present highs there is a significant and growing danger of a harsh pull back. The longer-term uptrend is intact but it wouldn’t hurt to take a profit here and there.

The energy horizon is still bright. At this time I prefer the service companies, the likes of Schlumberger, Halliburton, National Oilwell Varco, Baker Hughes and Weatherford. All of the big oil companies are having extreme difficulties finding enough new oil.

The car industry is talking about better batteries for hybrids, perhaps an incremental improvement, but definitely not the big solution to its energy problems. Some years ago fuel cells were touted as the solution, but one hasn’t heard much about them recently. I guess cars will still run on petrol for a long time.

Old age is creeping up on all of us and that brings me to two long-term investment ideas: Zimmer Hldgs. and Medtronic are both world leaders in medical devices, orthopedic implants and pacemakers. Look them up and when the price is right, buy some of them.

The dollar is at all-time lows. That makes US assets more attractive for overseas buyers.

There are a lot of noises coming from the attic. Stocks go bump overnight and panic-stricken investors are leaving the haunted house. The Dow has “only” fallen by about 15 % from last year’s highs but it feels like more. Some widely-held shares, mainly from the finance and high-tech sector, have been cut off at the knees. Considering the general uncertainty, what should investors do?

First, some considerations: The USA will experience a recession, but that’s not necessarily reason for a full-fledged panic. Due to the weak dollar US exports will do reasonably well and results of multinationals will therefore look ok. Interest rates will drop noticeably and central banks are on standby to open the monetary gates. Our feeling is that the crisis is relatively well contained within the financial sector and that black box valuations will become clearer as the quarter proceeds. The turmoil might well continue for a few weeks longer but already now we can see some good buying opportunities. While still staying clear from the banks, brokers, car manufacturers etc. we wouldn’t be shy about buying a few energy stocks, perhaps a bit more gold and one or the other blue chip which has been hit by the door as crowds were on their way out ( think for example: GE, Intel, Schlumberger, Occidental Petroleum, Conoco Phillips and so on ).

This is not a green light to load up on stuff, just a hint that one might stick the toes in again. Keep in mind that the big trends which have moved markets over the last few years, e.g. the growth in China, India etc. are still intact and will be with us for a long time to come. Inflation will be our companion for the next few years and stocks have traditionally been a good long-term hedge against its negative effects.

Be prepared for further trouble and adjust your positions as necessary. But remember: a poltergeist upstairs and some falling furniture are not a good reason for adults to throw in the towel for good.

When people lose money it’s most often not really lost. It has just been transferred to somebody else, a crook, a thief, a gambling lord, the government or an ex-wife. So, where in fact has all the money gone which banks claim to have lost recently through bad lending practices? Not a day passes by when some or other bank doesn’t announce it has lost hundreds of millions or even billions by lending to people who can not repay or by buying securities which turned out to be worthless. Does that mean that banks staffed with finance superstars earning tons of dollars have been done in by the bottom strata of society? Swindled by jobless dead-enders who have bought mansions despite having no assets to speak of? Possible, but highly unlikely. Perhaps you, dear reader, can set aside some quiet moments during the upcoming holidays to reflect on this arresting question.

Who’s benefited from the mess, that’s one part of the equation? The other is, who will pay? Certainly not Leona Helmsley who, besides being dead now, has previously and famously stated:”We don’t pay (.). It’s the little people who pay.” Right. How will they pay? My guess is: through inflation Just a few days ago the European Central Bank has injected 500 billion euros to grease the system and the Fed is also pump priming like mad. This at a time
when inflation is already running at multi-year highs.

All of the above and some more which we can’t elaborate on in this limited space will guarantee us a wild ride in the near and intermediate future. But please, do yourself a favor and don’t just run with the masses along the published consensus view. Rarely do people make money by following the consensus. For example: although the dollar is weakening and stock markets might collapse, the opposite could also happen. Whichever way things will turn out: buy and hold is probably not the right strategy for 2008. The
coming year might resemble a Hollywood studio set where shouts of “Action!” seem to come from every direction. And in such a scenario one particular status is very desirable: to be liquid. Liquidity was undervalued for many years. It looks increasingly valuable now.

My guess is that patience will be a virtue. Things might look tempting when they are down by a quarter; but how do they look at half that price again? We’ll have reached bottom only when most “advisers” will tell everybody to be extremely careful and don’t touch anything. We haven’t reached such a stadium yet.

Some quiet moments during the festive season should be used to reflect on one’s financial position. Is it age-adequate, is it reasonably safe, is it taking into account current concerns? If panic strikes you shouldn’t stand with the sheep but with the butchers.

Good luck, good health and happy holidays from all of us here.

The present market situation reminds me of the pinball games of my younger years:

Surrounded by a wall of noise the little ball was flipped back and forth through a field of obstacles to its inescapable destination, a black hole, into which it disappeared. A lot of money has now also disappeared from the scene. The squeeze is on and the pressure has not yet lessened much. Unlike the market crash of October 87 which looked like a decapitation, we are witnessing more of a strangulation now. Every other day a bank or insurance company seems to discover more losses. Bad news is oozing out like the slime of a fat snail. And I’m pretty sure of one thing: it ain’t over yet.

Because nobody knows the true value of assets for which there is no liquid market we can’t know the full extent of the mess into which the financial industry has driven itself. It was easy to spread loans around by the bucketful but the recovery process is arduous.

As I expected a few issues ago we are already seeing banks’ share prices much devalued but we haven’t hit the bottom yet. I guess we can wait to see some naked desperation around before we buy the stuff. Last time when Citibank was hovering near bankruptcy a Saudi prince bought a lot of its shares. The same guy has just become the first private customer for an Airbus A 380 which will cost him about half a billion bucks fully fitted.

Now I’m not saying we can do the same when we buy C at below 10 usd ( still two thirds down from today’s price ) but maybe it’s enough for a little sports car. Just wait. On to the oil price: while many experts have insisted year in and out that the oil price is unsustainable ( when it was at 50, at 60, at 70, at 80 and now at 97 dollars per barrel ) we here at Xam Capital have maintained since at least four years that the price is headed much higher. That’s perhaps one of the reasons why our share price is not gasping for air at the bottom of a swamp but holding steady not much below its all time high.

Another is that we don’t believe in staking our cash on mathematical models, based on assumptions, leveraged with insane borrowings as seems to be the fashion nowadays. Let’s hope we can stay that way, and why shouldn’t we?

Among all the floating debris we see a possible opportunity in Thailand:
Elections will be held around Christmas and this has in the past often been a catalyst for steep upward swings. We presently expect the market to get slightly cheaper in sympathy with the overall sentiment and could then be buyers just before Santa arrives. At last a morsel from my perch in freezing Europe: Cocain consumption is rising steadily. The devil’s dandruff is getting cheaper all the time. Perhaps some recent market euphoria was based on that development.

The Fed has cut interest rates again but the markets are not responding enthusiastically.
The band has stopped playing. The jig is up.

What’s happening?

The bubble in financial and property assets which we have witnessed ( some lucky bastards enjoyed it; clever ones are out by now ) was financed with debt. Every “real” dollar has been leveraged again and again, mortgages and credit card debts have fuelled the fire. Even in seemingly solid countries like Germany and Switzerland banks have turned themselves into casinos. In these two countries alone more than 300,000 derivatives, so-called Zertifikate, have been issued by banks and sold to gamblers, sorry:”investors”. The gambling instinct in most people, combined with greed are being exploited not only by myriad games and lotteries but also by witch doctors in marbled banking halls. But the witches brew has not all been ladled out to buyers. Some of it stuck to the banks and thus we can now witness the spectacle of CEOs from Merrill Lynch to Citigroup floating down on golden parachutes from their sky suites.

In the US alone there are about two billion USD in subprime mortgages and credit card debts. Our estimate is that more and more apples will become rotten and the garbage will be piling up for some time to come. The Fed has only one instrument to alleviate the crisis, cheaper money. But rising inflation and a sinking dollar are hampering its usual rescue rides. We repeat our opinion voiced in our last report that we haven’t seen the low prices in certain financial stocks yet.

Therefore the recommended strategy shall be: Stay liquid, stay invested in commodities, especially energy and gold. Avoid long-term bonds. Be careful with money market funds: supposedly very safe, many have bought commercial paper which is now looking soiled.

Slowly, slowly the full extent of the mess appears before us. Banks have not only lent to deadbeat borrowers, they have also traded and invested extensively in all kinds of exotic and illiquid papers. We are talking about collateralized debt obligations, commercial mortgage papers, hedge fund CPs etc. Even worse, many banks have leveraged those instruments up to 20 times and hidden away the junk in off-balance sheet vehicles, called conduits. This may sound quite technical to some of you but to make it easy, just think Enron. Gross incompetence, stupid and criminal behavior, greed, that’s what we are talking about.

After the first blowups ( IKB and Sachsenhypo in Germany, Northern Rock in the UK, Countrywide in the US etc. ) we can hear the explosions coming closer. To make it short:

Interesting times are here and we hope to take advantage of the developments. It’s much too early to consider buying bank and finance shares while the full extent of the drama is playing out in front of our eyes. But in a few weeks we’ll probably see juicy opportunities, perhaps at a 30 % discount to present price levels. Yummy, yummy.

As mentioned before this Dr.Stock’s report is now the first one coming to you from Europe. After our arrival here, in an region where the increase in milk and other agricultural commodity prices is not only an abstract newspaper item but means cash in the bank for the locals, we have heard enough about regional financial scandals ( e.g. Meinl European Land and other crooks’ games ) to feel well at home. We thought we might miss the daily flood of news about corruption and idiocy which we sucked up for breakfast in our previous tropical habitat, but that fear proved unfounded. The level of financial corruption, backhand dealings and criminal arrogance we found here ( fortunately only in the papers ) shortly after our arrival was simply astounding. Talk about crony capitalism.

Anyway, our advice is: keep sitting on your cash and the gold and oil assets we have recommended previously. Stay away from everything else for the time being until the storm has cleared ( or better, is about to clear ) and prices are as attractive as a young maiden in a grass skirt on the beach of Bora Bora.

In 1999 some idiots thought the way to make money was to pay astronomical prices for internet start-ups with half-baked business plans and no earnings. They were taken to the cleaners.

In 2007 some other idiots ( or perhaps the same? ) thought the way to make money was to buy fancy paper secured by loans to people who essentially lacked the ability to pay back those loans. They are being taken to the cleaners right now.

In both cases the guys who set-up, packaged and traded the deadbeat paper got away with their fat commissions and are sitting pretty. The victims, if you good-naturedly call them that, turn out to be yokels who had tried on shoes which were a few numbers too big for them.

Who for God’s sake has ever heard of IKB Bank in Germany or Bawag in Austria? Yet these institutions were loading up on hedge fund derivatives and subprime loans. I’m sure there will be quite a few more banks, insurance companies and pension funds everywhere which suddenly discover their balance sheets loaded with toxic waste.

The Orwellian newspeak generated with all the crap was funny and yet telling: What sounds nobler than “Private Equity” for example? In fact we are talking about heavily leveraged asset strippers and flippers who don’t give a damn about the companies they are (man)handling. Then we have “Carried Interest” which means naked profit but again sounds like a benevolent theme of some Save-the-World outfit.

Or take “Hedge Fund”. What does that actually mean?Evidently not much, except that you’re free to spin and speculate at will with other people’s money until you either get a fat bonus or you blow up.

Where does all that leave us?

I guess we shall remain down-to-earth, conservative investors who focus on asset allocation.

During the present market turmoil it’s best to stay on the sidelines. Good quality stocks shall be kept, not sold in a headless panic. I don’t think we are headed towards a serious crash. It looks more like a normal market correction during which the “weak hands” get shaken out.

Some timeless lessons which apply now:
Stick with what you know and understand.
Don’t buy any derivatives where you’d need an advanced degree in mathematics
to understand them.
Keep some cash
Keep some gold.
Energy is still very important.
Don’t make rush decisions in panic or euphoria. Buy and sell in blocks, not everything in one go.
Stay away from the badlands of banks, finance and mortgage companies, insurers, real estate and related businesses ( this applies mainly to the USA and partially also to other markets ).
Never bet when you can’t afford to lose.

This is the last dr.stocks letter from Asia for about a year. dr.stocks will base himself in Europe now and report from there. Keep good.

If you have a good stomach for risk taking, or if you are working with other people’s money, here’s an easy way to make about 7% in the next twelve months. Call your bank and borrow yen to invest in 2-year German government bonds. The yield difference is about 3.4% and you can expect to gross another 4% or so from the weakening yen. The yen dropped 14% over the last year against the Euro, so our assumption ( based on rising euro and stagnant yen interest rates ) is pretty conservative. Of course you could leverage the deal to get, say, 35% instead of the 7% mentioned above. In case you wondered, that’s how the guys driving around in Bugattis and buying sharks in formaldehyde for 12 million dollar a pop are making their money.

Now, seriously, the yen carry trade and the US consumers’ voracious appetite for imports have been the two pillars holding up the boom. Experience shows that such booms usually last a while longer than skeptics expect. But end they must and end they will, and when the time comes some guys will be found disastrously exposed.

Some more about the yen: the ridiculously low interest rates ( 0.5 % p.a.) are not helping the Japanese economy. Instead they are maintaining a defeatist and deflationary attitude, especially because private savings are huge in Japan ( and people don’t get any return on their deposits ). The essentially free money is flooding into the rest of the world and contributing to a sea of liquidity which in turn nourishes waves of mergers, buyouts and wild speculation. It is a game of musical chairs which provides fantastic profits for financial artists and when it ends it won’t be a pretty picture.

I think it’s too early to bet on a yen resurgence but recommend to prepare for a turnaround ( e.g. by selecting the right instruments, options and/or certificates which would be most suitable ).

The dollar has just reached an all-time low against a trade-weighted basket of currencies. Again, a turnaround will come, but not just yet. The US economy is still weakening. This will reduce the trade deficit over time ( and help the dollar ).

When the liquidity tide turns most assets which are booming now will see severe corrections. I’m thinking Chinese stocks, commodities etc. Make sure that you won’t sit high on the bough when it breaks.